Management Control Systems Robert N. Anthony

The parts and linkages of the budget

Revenue budgets Production costs and COS Marketing expenses General and Administrative expenses (G&A) R&D expenses Income taxes Capital budget Budgeted balance sheet, Budgeted cash flow statement

Variance analysis The next step is to use variance analysis, so that the TMT can analyze the financial performance in detail.

Revenue variance: Market penetration and industry volume: Expense variances:

Alternatives to budgeting

Rolling forecasts: a rolling forecast does not limit itself to a calendar year. It may be prepared any month of the year, and can concern any month of the year. The word 'rolling' indicates that the budgets usually overlap. Moreover, rolling forecasts are usually focused on a number of KPI's and the aggregated budget is much less concerned about individual costs or sales items. KPI's and relative targets: KPI's are usually key performance indicators based on both financial and non-financial indicators. Decentralization: budgeting is often seen as a step towards decreasing the centralization in organizations. Especially tight budgeting confines the autonomy of sub-units and lower-level managers, and preserves the hierarchical and centralized structure of organizations.

Control mechanisms

Since the control mechanisms would be the same as agency theory if intrinsic motivation was low, we will discuss the control mechanisms when intrinsic motivation was high. These concern: financial compensation (a justified amount), interesting assignments, communication, involvement and affiliation.

Transfer pricing methods A transfer price is stated as: the value placed on a transfer of goods or services in transactions in which at least one of the two parties involved is a profit center. Such a price typically includes a profit element, since an independent company would normally not transfer goods or services to another independent company at cost or less. When profit centers of a company buy or sell products, two decisions must be periodically made:

Sourcing decision: should the company produce the product inside the company or purchase it from an outside vendor? Transfer price decision: if produced inside, what should the transfer price be?

Simons' idea revolves about four spans (see also the table about the four spans):

Span of control: the span that defines the range of resources (people, assets & infrastructure), for which a manager is given decision rights. Span of accountability: the range of trade-offs affecting the measures used to evaluate a managers achievements. Span of influence: the width of the net that an individual needs to cast in collecting data, probing new information and attempting to influence the work of others. Span of support: refers to the amount of help an individual can expect from people in other organizational units.

Additional considerations and limitations of variance analysis

Standards have limitations: managers tend to forget that the first step of a variance analysis is an examination of the validity of the standard. When calculating variances, this chapter has used a pre-determined standard. However, if not carefully prepared and coordinated, historical standards or benchmarking might be better! Watch out with discretionary expense centers: here, a very favorable variance is actually unfavorable ;) Limitations: variance analysis does not tell us why the variance occurs, there is not objective measure to determine if a variance is significant, and trough aggregation, managers might be able to mask unfavorable

A couple of factors could influence the amount of gaming:

Superiors: tight budgeting: more gaming (especially hedging), loose budget control implies less risk to discover gaming. With loose control, budgetees have room to behave tactically. Profitability: if the economic situation is bad, budgetees are more likely to exposure (if they show a very bad budget, superiors may close this part of the organization). Likewise, in good economic times, budgetees are likely to hedge their results. Just in case, or for showing (even) better profits at the end of the year. Uncertainty: budgetees may want to create buffers Reward system: depending on the reward system, gaming is always possible. The most apparent method is to create slack. Personality: individuals may just be risk averse. These managers are more likely to hedging.

• BSC and strategy maps:

The balanced scorecard is a management control model with the explicit intention of linking performance measurement to strategy. BSC is a system that, apart from the financial perspectives, incorporates other perspectives (customer, process and innovation perspectives). However, the BSC is also claimed to express the strategy of the organization. Starting from the mission and vision and going down to the measurement, the BSC could help formulate strategy (exh. 4.13 on page 164).

• Target costing:

The basic idea is very simple: take the traditional costing method and 'turn it upside down'. If target costing was applied, we would not start with costs but with price instead. What is a good price for the current product? The profit margin is then deducted and we reach target costs. If it turns out the costs are higher than our target costs, we have a cost gap that needs to be closed.

The parts and linkages of the budget General and Administrative expenses (G&A)

engineered expenses. In budget preparation, much attention is given to these kind of costs, since the appropriate amount to authorize is heavily debated.

Compensation and incentives The compensation paid out to managers has a lot of functions, as outlined on page 422 and 423. They are:

pay for services employees provide, attracting people, keep employees, effort, inspiration, goal- congruence, and flexible compensation based on performance.

Planning and budgeting Planning role

planning involves is going to do during the budgeting period. This may include what is going to be bought and sold. a. Resource distribution: given that an organizations knows what their planning is, it is also possible to estimate how much resource every department will need in order to fulfill the plan. b. Coordination: budget planning is a way to ensure that all parts of the organization follow the same plan. After all, the plan can only succeed if every department does what is expected.

Expense center Expense centers are centers whose inputs are measured in monetary terms, but its outputs are not. There are two types of expense centers:

Engineered expense centers Discretionary expense centers

Engineered expense center

Engineered expense centers (EEC) can usually be found in manufacturing operations. Their input can be measured in monetary terms, while their output can be measured in physical terms. Moreover, their optimum euro amount of input required to produce one unit of output can be determined. The assessment of a EEC is usually done by comparing the difference between theoretical ( output * standard cost price) and actual costs. Although managers are primarily responsible for expenses, other keywords are: quality, volume of production and effciency (since lower quality = less expenses). Moreover, managers of EEC can be responsible for training and employee development.

The parts and linkages of the budget Marketing expenses

Expenses to sell products. Most expenses have been incurred well before the beginning of the budgeting year. An exception are the logistic costs. These costs behave more like production costs, but usually included here as marketing is responsible for them.

Variance analysis Revenue variance:

How to calculate the actual selling price, volume and mix variances. The results are aggregated to calculate the total variance. Positive variance is favorable, while a negative variance is unfavorable. Selling price variance: actual volume*∆price(actualprice- standardprice) Mix and volume variance: ∆volume * budgeted unit contribution Mix and volume could also be calculated separate, look at pages 389 + 390 for that.

Why Combine financial and non-financial performance measures? Relying solely on financial measures is inadequate and can be dysfunctional for various reasons:

It may encourage short term actions that are not in the company's long term interest. The more pressure is applied to meet current profit levels, the more likely the business unit manager will have to take short-run actions. These are errors of commission. Business unit managers may not undertake useful long-term actions to obtain short-term profits. Managers may not invest in R&D or propose safe investments instead of high-risk projects. These are errors of omission. Using short-term profit as the sole objective can distort communication between a business unit manager and senior management. Business unit managers may try to set profit targets they cannot easily meet, leading to erroneous planning data for the whole company. Tight financial control may motivate managers to manipulate data.

Control of managerial input:

Managerial input addresses three functions of applicable controls: staffng (designing job- descriptions and recruiting the right people), development (ensuring basic conditions that enable managers to be informed about the organizational goals and help them behave congruent. Examples are training programs or enhancing health and safety of staff), and culture building (leading managers into showing the right kind of behavior. E.g. 'tone at the top').

Difficulties with profit centers

"Down": Decentralized decision making forces top management to rely more on management control reports, rather than personal knowledge, entailing some loss of control. "Down": Friction may increase because of arguments over the appropriate transfer price (see chapter 8). "Down": Divisionalization may impose additional costs because of the additional management, staff personnel and record keeping required. "Down": Competent general managers may not exist in a functional organization because there was no training ground. "Down": There may be too much emphasis on short run profitability at the expense of long-run profitability. In the desire to report profits as high as possible, a manager may skip investing in R&D for example.

However, decentralization also brings some challenges. In organizations, providing lower-level managers with decision-making authority creates the need for MC. As explained in chapter 1, there are three main reasons why decentralized organizations require appropriate MCS:

"Down": Decentralized managers do not automatically understand the goals and strategies developed by higher level managers, nor how the can contribute to these goals and strategies. "Down": Decentralized managers do not automatically agree with organizational goals and strategies developed by higher-level managers. "Down": Decentralized managers do not automatically have the resources needed to act with organizational goals and strategies developed by higher-level management.

The framework Otley proposed has number of strengths and weaknesses:

"Upp": It provides a helpful structure for analyzing MCS by focusing on five key areas. The general nature of this framework enables other frameworks to complement it. It application is straight forward. The framework facilitates the process of dealing with data. "Down" It does not consider the role of vision and mission in the MCS. The framework focusses on what Simons calls diagnostic control systems, yet considering all four levers of control is vital! The framework does not stress the ways in which accounting and control information is used by the organization Tends to look at the MCS from a static perspective, as it was a snapshot Interconnections between different parts of the PMS are not clearly addressed.

The delegation of decision rights comes with advantages:

"Upp": Decentralization improves the quality of decision making at higher management levels. As their span of control is reduced, the board can shift, their attention to tactical and strategic issues. "Upp": Decentralization improves decision quality at lower levels. Lower-level managers are empowered to make well-informed decisions quickly, without pending for authority. "Upp": Decentralization facilitates the increased economies of scale and specialization. Decentralized units can dedicate their time to specific goods/services, which can increase their local knowledge and innovation optimal use of production resources. "Upp": Decentralization supports management development. Junior managers will have the opportunity to develop skills needed for senior positions.

Business unit structure (or division) :

"Upp": Divisional structure provides a training ground for general management "Upp": The business unit is closer to the market than headquarters, its manager may make sounder decisions concerning production and marketing. Moreover, they can detect opportunities or threats more quickly. "Down": Each business unit staff may duplicate some work that in a functional organization is done by headquarters. The business unit manager is presumably a generalist, but the subordinates are functional specialists, and they must deal with many of the same problems addressed by specialists both at headquarters and in other business units as well. "Down": Disputes between functional units may be replaced by disputes between divisions. There may also be disputes between divisions and headquarters.

Shared services centers As highlighted before, one principal challenge of a decentralized organization is to avoid task redundancies. As a result, companies implement shared service centers (SSC) in which a subset of 'non-core' business functions are concentrated into a new business unit (HRM, IT, legal).

"Upp": Economies of scale (cost reduction) due to centralization. "Upp": Improves clarity about strategic alignment due to simpler organizational structure. "Upp": Customer focus and quality (service improvement) will be enhanced as the support activities are considered the core activity for the new shared service center. "Down": Since standardization is often a key feature, there is a risk that customer demand with a need of variety will suffer. "Down": Variations in, for instance, IT or HR are different to standardize, reducing customers perceived quality of the services.

Functional structure UPS/DOWNS

"Upp": Effciency "Down": No unambiguous way to determine effectiveness of a manager, since each function contributes jointly to the profits. Therefore, fractions of profits cannot be allocated. "Down": A dispute between managers can only be solved at the top, though it may have originated at a much lower level (example page 198). "Down": Functional structures may be inadequate for a firm with diversified products and markets. "Down": Functional organizations tend to create 'silos' for each function, hindering cross-functional coordination (for example: in new product development).

Advantages of profit centers

"Upp": The quality of decisions may improve because they are made by managers closest to the point of the decision. In addition, profit center managers are subject to fewer corporate restraints and are freer to use their imagination and initiative. "Upp": Training ground for general management. "Upp": Profit consciousness is enhanced because who are responsible for profits will constantly seek ways to increase them.

Describing an organizations MCS as tight or loose can give insight in the controls applied, and their stringency. In such terms, a tight system has two important benefits over a loose control system:

"Upp": Tight control prevents managers from becoming wasteful or ineffcient. "Upp": Consistent pressure motivates the manager to look for better wats to perform existing operations. "Down": Short term actions that are not in the interest of the companies long term interest may be encouraged. If, in addition to tight controls, the manager is given considerable discretion, there is danger of encouraging uneconomic short-term actions (errors of commission). "Down": Myopic behavior, managers refrain from useful long term actions. "Down": Tight control may motivate managers to engage in data manipulation, because of the constant pressure on achieving results.

Loose control:

'I hire good people, and leave them alone to do their jobs.' In loose control, the budget is basically used as a communication and planning tool.

There are four type of centers:

(1) revenue, (2) expense, (3) profit and (4) investment centers.

The fundamental principle of transfer pricing is that the transfer price should be similar to the prices that would be incurred (sold/paid) in the event of 'using' the market. However, a market price-based rarely exists. Rather, the following list should be regarded as recommendations to improve the current transfer price mechanism:

- Competent people: Managers should value both short term and long term profits. Staff involved in negotiations should also be competent. - Good atmosphere: Managers must regard profitability as an important part of their performance indicator. They should believe that prices are just. - A market price: the ideal transfer price would be based on an established 'normal' price. Price can be adjusted downward to reflect savings accruing to the selling unit from dealing inside the company (advertising and selling costs would be smaller). - Freedom to source: alternatives for sourcing should exist, and managers should be free to choose the alternative that is in their best interest. - Full information: transparent market/business units- Negotiation: a smooth mechanism for negotiating 'contracts' between business units. If all of these conditions where present, a transfer system based on market prices would induce goal- congruent decisions. However, this is rarely the case, as there are many constraints possible.

Management control and shared service centers SSC's are not the same as centralized service units: head office should not dominate the SSC. These kind of centers should be relatively free andindependent. However, top management should still be involved in some decisions. Top management should:

- Consider what core and non-core activities are, and if they are suited to be a SSC. - Motivate clearly why SSC's are implemented, as they are often met with a lot of resistance. - Decide if business units are also permitted to purchase support services from outside the company, and if the SSC is also permitted to sell outside the company. A key management control issue for SSC is determining the level of service business units are willing to pay for, and the price for the services. Since outside threat (even if not permitted by top management) is always there, the centers can usually negotiate a fair price. Services need to be broken down and formally stated in a service level agreement (both financial and non-financial stuff).

Constraints on sourcing

- Limited markets: Markets for the buying or selling of products may be limited. Examples of constraint and the solution to find out what the competitive prices is, are on pages 292/293. - Excess or shortage of industry capacity: The selling business unit has excess capacity and the buying unit sourced their product from the outside, or vice versa. This will result in sub- optimal profits.

Decentralization can be defined in many different ways, but almost always includes these three elements:

1. Delegation of decision-making rights to lower levels of the organization. 2. Provision of suffcient material and formal resources to execute that authority. 3. Assignment of accountability and responsibility for the quality of decision making.

Every controlled system has at least five elements

1. Detector/Sensor "Whats happening" 2. Assessor "Determines the significance of what's happening by comparing it with some standard or expectation. 3. Effector "Alters behviour if the assessor indicates the need to do so" 4. Communication network "Devices that transmits information between the detector and the assessor and between the assessor and the effector" 5. Predictive model "Knowledge about the effect of the behavioral changes made by the effector"

Cost-based transfer prices If competitive prices are not available, transfer prices may be set on the (1) basis of cost plus a (2) profit markup. The usual basis is standard costs. Actual costs should not be used because production inefficiencies will be passed on to the buying profit center! Moreover, the profit center that finally sells to the outside market may not be aware of the upstream costs incurred. Even if they were, they might be reluctant to reduce their own profits to optimize company profit. There are a couple ways to deal with this problem:

1. Agreement among business units: representatives from buying and selling business units meet periodically to decide on outside selling price. Only worth the while if profits offset the costs of these meetings. 2. Two-step pricing: this kind of transfer price includes two charges: (1) charge for each unit sold that is equal to the standard variable cost of production. (2) A periodic charge is made that is equal to the fixed costs associated with the costs of facilities reserved for the buying unit. There are, however, some points to consider! page 296. 3. Profit sharing: if two-step is not feasible, this might be a good alternative. Basically, the profit is shared once the product is sold on the market. "Down": Disputes might exist over the way profit is divided me consuming and TMT has to intervene. "Down": Arbitrarily dividing profits does not give valid information about different business units. "Down": Contribution is not allocated until after the sale has been made (depends on marketing ability to sell and negotiate price). Might be perceived as unfair by manufacturing units. 4. Two sets of prices: two different prices: manufacturing units are credited at the outside sales price, and the buying unit is charged the total standard costs. The difference is charged to a headquarters account and eliminated when consolidated. "Down": The sum of business unit profits is greater than the overall (real) profit. TMT must be aware of this! "Down": Additional bookkeeping expenses. "Down": There are less conflicts over prices, but this could also be a weakness!

in reality goal-congruent behavior is hard to obtain and assess in a timely manner, because:

1. As stated above, managers do not always understand the strategies of the company. 2. The concept of goal-congruent behavior is problematic in itself, as it is not always a priori clear which behavior is goal-congruent and which is not. MC should at least control for behavior that is congruent a priori. 3. Good management control is often hard to exercise as a lower-level manager, as they might not know what is expected of them.

Pricing corporate services There are two types of corporate services: (1) central services the business unit must accept but can at least partially control and (2) the central services that a business unit can decide whether or not to use. Business units may be required to use company staff for stuff like IT and R&D. In this situation, the manager cannot control the efficiency, but he can control the amount used. There are three different views on how to deal with such services (pros and cons on page 297):

1. Business units should pay standard variable costs. 2. Business units should pay full price. 3. Business units should pay market price. If the manager can choose whether or not he uses the services, the services could be outsourced. Because managers can control both the amount and the efficiency of the service, providers should base their transfer prices on the same considerations as those governing other transfer prices.

Measuring profitability The performance of a profit center may be evaluated by five different measures of profitability (also take a look at exh. 7.1 on page 260):

1. Contribution margin The spread between revenue and variable expenses. 2. Direct profit Contribution to the general overhead and profit of the corporation. In incorporates all expenses incurred or traceable to the profit center, even the ones that are out of the managers control. 3. Controllable profit Headquarters expenses are divided in controllable and non-controllable. Profit will be what remains after deducting all expenses that can be influenced by the profit center. 4. Earnings before interest expenses and taxes (EBIT) In this measure, all corporate overhead is allocated to profit centers based on the relative amount of expense each profit center incurs. "Upp": Corporate service units have the tendency to increase their power base and enhance their own excellence without regard to the firm as a whole. Allocating these costs to profit centers helps keeping them in check. "Upp": The performance of the profit center will become more realistic. "Upp": When managers know that their centers do not show profits until all costs have been covered, they are more motivated to make optimum long-term marketing decisions. "Down": Managers are held responsible for costs they cannot influence. "Down": May be hard to correctly allocate these costs. If profit centers are to be charged for a portion of corporate overhead, this item should be calculated on the basis of budgeted (rather than actual) costs. 5. Net income The amount of income after tax. There are two principle arguments against using this measure: - After-tax income is often a constant percentage of the pre-tax income,in which case there would be no advantage in incorporating income taxes. - Many of the decisions that affect taxes are made at headquarters, it is not appropriate to judge profit centers on the consequences of these decisions. - In most situations, it is not desirable to include taxes! So don't learn this in depth.

Management control can be divided into these three elements:

1. Control of managerial input: 2. Control of managerial decisions: 3. Control of managerial output (performance):

Management control and cross-functional management The problem with inter-unit integration is largely a problem of motivation. Therefore, senior management should impose a management control system that:

1. Creates incentives for inter-unit cooperation 2. Creates an atmosphere where being part of the cross-functional team matters, and matters equally to all partcipants. 3. Reduces the distance between the cross-functional team members whenever possible. 4. Requires senior management support. One example is the sponsoring of learning programs for the cross-functional teams.

three reasons why automatic organizational goal achievement by decentralized management may not always be possible. Thus, there is a need for a MCS.

1. Decentralized managers do not automatically understand the goals and strategies developed by higher level managers, nor how they can contribute to these goals and strategies. 2. Decentralized managers do not automatically agree with organizational goals and strategies developed by higher-level managers. 3. Decentralized managers do not automatically have the resources needed to act with organizational goals and strategies developed by higher-level management.

this framework includes four strategic archetypes

1. Defenders: stick to one product or market (or even to a niche), and do not have ambitions to enter other markets. 2. Prospectors: opposite of defenders. Continuously look for new opportunities in their changing environment. They usually drive change and force competition to follow. Usually more focused on innovation than efficiency. 3. Analyzers: operate in both stable and dynamic markets. In stable markets they work in a structured way towards increased efficiency. In dynamic markets they keep a close eye on their competitors and adapt the most attractive innovations. Basically, analyzers are a combination of prospectors and defenders. One difference: where prospectors create change, analyzers follow. 4. Reactors: operate in dynamic areas but are to slow or inefficient when it comes to adapting to change. An organizations becomes a reactor when: (1) there is no formulated strategy, (2) strategy is not implemented or (3) strategy has not changed despite changing environment.

Organizational structure One way to influence behavior of management is by selecting and operating a structure that is appropriate for the type of organization. Although organizations can be vastly different, they can be grouped into three categories (images on page 199):

1. Functional structure: each managers is responsible for a specified function... Rationale: manager has specific knowledge, as contrasted by the general manager. 2. Business unit structure (or division) : managers are responsible for most activities of the unit. The unit is basically a semi-independent part of the company. However, headquarters still have some authority (otherwise, these business units would be separate companies)..... Performance measure is simply the profitability of the division. 3. Matrix structure: functional units have dual responsibilities. Therefore, it can be seen as a mix of the other two.

Budget preparation

1. Initial budget proposal: managers of responsibility centers develop budgets, based on historic information. Deviation from those figures can be caused by (1) changes in external forces and (2) changes in internal policies and practices (examples of both on pages 345-346). 2. Negotiation: the budgetee discusses the budget with the supervisor. The superior attempts to judge the validity of the figures (no slacks incorporated?). This is the heart of the budgeting process 3. Review and approval: the proposed budgets are reviewed by the top. In part, analysis is done on consistency (sales expectations in accordance?). On the other hand, the budget will produce an expected profit. If the number is not satisfactory, budgets are send back for re-working. 4. Budget revisions: two types: (1) procedures for a systematic, periodical, revision and (2) procedures that allow revisions under special circumstances.

Before all else, let us consider what is necessary to establish a profit center:

1. Lower-level managers should have access to relevant information needed for the decision. 2. There should be some way to measure the effectiveness of the trade-offs the manager has made.

it is useful to distinguish between three sources of managerial motivation:

1. Managers are motivated by the goals that they are asked to achieve. 2. Managers are motivated by the rewards that they may get for their efforts. 3. Managers are motivated by the social context in which they work.

However, focusing primarily on revenue raises issues:

1. Marketing and sales decisions have an impact on expenses somewhere else in the organization (e.g. customization which costs more for production, extended credit terms). Solve by including non-financial performance measures. 2. The sole focus on revenues gives the salespeople little incentive to promote the most profitable products. Specific goals should be made! 3. If different revenue centers have the same customer base, a revenue center may be less eager to help someone if the revenues are allocated at another revenue center.

Formal control systems, that govern the behavior of managers, typically consist of three dimensions:

1. Organizational structure 2. The organizations set of rules 3. The organizations formal planning and control cycle

Planning and budgeting A budget is the very heart of a MCS in many organizations and a lot of attention is devoted to both preparing and following up the budget. The purposes or roles of the budget can be divided into four groups:

1. Planning role 2. Accountability role 3. Process role 4. Ritual role

In terms of corporate level strategy, businesses can be divided into three categories (see also exh. 4.3 page 150).

1. Single industry (Microsoft) Operates in one line of business. 2. Related diversitication (Apple) Operates in multiple industries, but these industries are connected to one another through operating synergies. Operating synergy can exist in two ways: (1) ability to share common resources, and (2) ability to share core competencies. 3. Unrelated diversification (Virgin group) An unrelated business firm operates in business that are not related to one another. The connection is pure financial.

Tight controls are pre-set, mostly financial, performance targets. To be able to apply these controls in the first place, a couple things should be considered:

1. The business unit manager should be able to exercise a sufficient amount of discretion. 2. The unit managers should be able to influence the performance variables suffciently (variables should not be overly distorted or influence by external factors). 3. The relative uncertainty inherent to the operation should be not prohibitively high. 4. The time span of the impact of managers decisions should match the period in which the performance of the manager is compared with period targets.

The PMS revolves about 12 things, as seen on page 268:

1. Vision and mission: purposes and objectives, the main reason of existence. 2. Key success factors: those activities, competencies and capabilities that are seen critical for the success of the organization. 3. Organizational structure 4. Strategies and plans 5. Key performance measures: the financial or non-financial measures from the KSF's 6. Target setting. 7. Performance evaluation: both formal performance evaluation activities (both routines and actually operated by senior managers). Performance evaluation can be subjective, objective or anything in between. Subjective: me-consuming process with manager involved Objective: a formula, for example 8. Reward systems: can include both financial and non-financial rewards. Group-reward practices are also possible. 9. Information flows, systems and networks: act like a nervous system in the human body. Feedback information: information used to enable the undertaking of corrective/adaptive courses of ac on (information flows aimed at the correction of past shortcomings). Feedforward information: information used to enable the organization to learn from its experience, to generate new ideas and to recreate strategies and plans (information flows which attempt to anticipate future events and respond in advance to their occurrence). 10. PMSs use: the way accounting and control information is used. 11. PMSs change: change log for the PMS (Is the PMS adequately changed given changes is strategy, vision?) 12. Strength and coherence: PMS is greater than the sum of its parts. There is a need for alignment and coherence between the different parts (i.e. the relationships between elements).

The euro amount of RI does not provide a comprehensive basis for comparison like the ROI(%) does. Nevertheless, the RI approach has advantages:

1. With RI, all business units have the same profit objective for comparable investments (example page 265). 2. Decisions that increase a units ROI may decrease overall profits. 3. Different interest rates can be used for different types of assets. 4. RI motivates managers to take actions consistent with increasing shareholder value (example on page 266).

PMS

12 questions, stated on pages 266 and 267 of paper. Contextual factors and organizational culture are not addressed, as they view them as con tingent variables that might explain certain things, instead of a characteristic of the control system themselves.

Agency theory

A principal hires an agent to perform a service, but the agent might not act in the interest of the shareholders. Incentive contracts may reduce these divergent preferences. As agency theory is like theory X, the rationale is that agents are likely to be lazy. Or even worse: deliberately withholding effort (shirking). Moreover, agents and principals also diverge on risk preferences. Agents typically have much of their wealth (financial and reputation) tied up in the firm, so they are more risk-averse. These risks exists because principles cannot always observe the actions of the agent. Remember: moral hazard (after contract is drawn up) . There are two ways to fix these problems of diverging objectives: (1) monitoring and (2) incentives. These two are formally titled: agency costs. Monitoring: usually done by the BoD, or through an audit firm for example Incentive contracting: align the agents goals with that of the firm.

Responsibility centers:

A responsibility center is an organizational unit that is headed by a manager who is responsible for its activities. In a sense, the company is a collection of responsibility centers. A responsibility center exists to accomplish one or more purposes (objectives). In order to do so, it transforms inputs (with the help of working capital) to outputs. These outputs can then be inputs for another center, or be sold on the market.

Control of managerial output (performance):

A third way to control managerial behavior is by making managers accountable for certain results. Examples are target setting, the balanced scorecard, or Managing by objectives (MBO).

the contingency theory

According to this theory, MC in organizations should be designed to be in line with the environments, or contingencies, the organization is facing. One classic approach distinguishes themechanistic (stable situations) and the organic (dynamic situations) approach.

Issues related to implementing the BSC

Although the controller keeps track of the BSC, the top management and the employee involvement is vital. A BSC should be balanced between operational measures for employees, but with an overall coherence for top management. If companies do not (yet) have system support, managers should be aware of incremental costs associated with measuring. Once the scorecard is up and running, senior management should consistently and periodically review results. Thoroughly think interdependencies between non-fin and financial results through. There is no guarantee that non-fin KPI will lead to financial results! Update measures frequently Avoid measurement overload Linking your incentive system to the BSC can be useful, but be sure that it is well designed! Poorly designed incentive programs create additional pressure.

Long-range strategic planning: benefits and limitations of long- range strategic planning

An operating budget calls for resource commitments over the coming year: it is essential that managers have a strategic plan to guide the operating plan. Formal strategic planning could be an excellent tool that provides managers with a process for thinking about strategies and their implementation. Moreover, long- term strategic planning forces the managers to think 'long-term'. These two arguments align with the process role of the budget, discussed earlier. Additionally, long- term planning can also be used to align managers with the corporate strategies. However, there are also some negative sides. First, the planning can become a bureaucratic exercise, devoid of strategic thinking. Second, the organization may delegate the implementation of the strategic plan to the staff, forfeiting the input of line management, as well as the educational benefit for those managers. Third, strategic planning is me-consuming and expensive. The strategic planning process consists of the following steps: reviewing and updating, deciding on assumptions and guidelines, first iteration of the plan, analysis, and the second iteration of the plan (page 338/339).

Cross-functional management

As discussed in the introduction, one principal challenge to managing decentralized organizations is to ensure that independent profit centers cooperate in such a way that they work jointly for the goals of the organization. This is particularly important when interdependencies between units are significant (new product development and materials management). In that case, evaluating each unit individually increases the risk of sub-optimization. It is important to achieve integration and coordination between units so that they take good decisions from an organizational standpoint. One way to achieve this is by introducing cross-functional management, where management from different responsibility centers work together in cross-functional teams on a common value chain or process.

Gaming and tactical behavior

Budget gaming refers to behavior that does not necessarily have the sole purpose of improving control in an organization: it can be beneficial in also helping individual goals or departments' goals. Gaming refers to either showing a better or a worse budget. Better is called exposure, while a worse budget is called hedging.

Beyond budgeting movement (critique against budgeting)

Budgeting creates internal gaming and myopia: Budgeting is too resource-consuming: Calendar year is not a good period: It is impossible to make a reliable budget these days: Budgets make organizations less flexible:

Critique against the beyond budgeting movement

Budgets fulfill many purposes: how can one be sure that all these purposes are fulfilled if we suddenly chose another method to plan and measure performance? Different contingencies require different MCS: in line with contingency theory, this argument claims that every organization has to design its MCS depending on the contingencies it is facing. Beyond budgeting is just budgeting in disguise: beyond budgeting is not really another system, rather just normal budgeting with some alterations.

11. Compensation, incentives and motivation

Compensation is the most publicly debated part of the MCS. In this chapter, we discuss the effects that compensation and other forms of incentives have, on motivation and performance. We do this by discussing from two viewpoints: the (1) economic rationale (agency theory) and (2) the sociological rationale (motivation crowding theory).

Consequently, business units represent trade-offs between unit autonomy and corporate constraints. Two type of constraints are given below:

Constraints from other business units: if a manager controls the (1) product decision, the (2) marketing decision and the (3) procurement of sourcing decision, there is usually no difficulty in assigning profit responsibility and measuring performance. But if the degree of integration is greater, then it might be tough to separate the contribution of each units of the overall success. Constraints from corporate management: The constraint from corporate management can be grouped into three types: 1. Constraints from strategic considerations: the board is in charge of investment, you will have to compete to earn investment budget. Additionally, companies require local managers to refrain from strategic opportunities outside their 'charter' (page 258), even if it might be profitable. 2. Constraints from required uniformity: Examples are accounting and management control systems. 3. Constraints resulting from economies of centralization: i.e. centralize accounting for example, to profit from economies of scale.

Goals related to other stakeholders

Customers; factors like functionality, quality of the product, prices, inventiveness, adaptability, ability to deliver on time etc. Employees; employee satisfaction, employee competency. Suppliers; usually, goals regarding suppliers are formulated in terms of what the supplier delivers to the organizations in terms of price, quality, timely deliveries etc. However, in some organizations it is policy to buy from suppliers that have a good working relationship (rather than the cheapest ones, for instance). Lenders; Want their money back, and expect the company to maintain the same risk profile. Examples: positive cash-flows, good liquidity and solvency. Society; the organizations relationship with society has many levels. The most obvious one is obeying the law. Furthermore, it is expected of companies to act ethical. This will be discussed later, with CSR.

10. Performance measurement and alignment

Designing and using appropriate performance measurement systems are seen by many managers as the core element of the management control process. In setting up these systems, managers should select the measurements that best correspond with the company's strategy. One difficulty is deciding which measures to focus on (RI, ROI, EVA, non-fin measures like customer satisfaction and so on). However, deciding on appropriate financial performance measures (i.e. the content of chapters 6 & 7), is only the first step in evaluating the financial performance of different responsibility centers. The next step is to use variance analysis, so that the TMT can analyze the financial performance in detail.

Discretionary expense center

Discretionary expense centers (DEC) include units like accounting, HRM or R&D. The output cannot be measured in monetary terms. Moreover, output cannot really be measured at all. For instance, it is difficult to appraise R&D on a yearly basis, because the completed product may take years to develop. Even if was possible to do so, it is not possible to determine the value of the output.

The parts and linkages of the budget Capital budget

During the year, proposals for capital expenditures are reviewed and approved/denied. During budget period, the assess all CAPEX. If investments are two high, some projects are deleted.

The concepts of inputs, outputs and expenses can be used to explain the meaning of efficiency and effectiveness, which are the two criteria on which performance centers are judged.

Efficiency: the ratio of output to inputs, or the amount of output per unit of input. Effectiveness: determined by the relationship between a responsibility center's output and its objectives. The more the output contributes to the objective, the more effective the center. a responsibility center is effcient if it does the things right, and effective if it does the right things.

Motivation crowding theory

Extrinsic rewards are everything a person gains from carrying out a certain task, intrinsic rewards concern the satisfaction of carrying out a task and reaching the goal. In agency theory, only extrinsic rewards exist. MCT considers both extrinsic and intrinsic rewards. More specifically: if the extrinsic reward for a certain task is changed, not only will the extrinsic motivation change, so could the intrinsic motivation! If the extrinsic motivation is increased due to increase of extrinsic rewards, it might be very well that the change 'crowds out' intrinsic motivation the total motivation will decrease. The opposite can also be true: increasing both extrinsic and intrinsic motivation through better extrinsic rewards. This is called 'crowding in'. If the intervention is perceived as controlling, the crowding out effect will occur. If it is perceived as supportive, the crowding in effect will occur. Other situations where the crowding out effect may not occur is when rewards are not directly linked to performance.

Variance analysis Expense variances:

Fixed costs: simply by subtraction, not affected by anything. Variable costs: the budgeted variable costs must be adjusted to the actual volume of production! - Variances are called: spending variances (again, either favorable or unfavorable). - The volume that is used is the manufacturing volume and not the sales volume, since the latter was already used in finding the revenue variances. If production differs from sales volume, it will show up in the inventory.

There are different types of pay:

Fixed pay: a reasonably good level of fixed pay may make employees feel appreciated and valued, which may well contribute to their motivation. Short-term financial incentives: the simplest way is to set a bonus as a % of profits. While the bonus may be calculated annually, the pay-out could well be spread over a couple of years to ensure compliance and counteract to myopia and short-termism. Stock options: a stock option is a right to buy a number of shares at a given date in the future, at a price agreed upon right now. Incentives based on non-financial performance measures Non-financial incentives

Otley (1999) framework The five areas addressed are:

Identification of key organizational objectives and the processes and methods involved in assessing the level of achievements in each of these objectives. The process of formulating and implementing strategies and plans, as well as the performance measurement and evaluation processes associated with their implementation. The process of setting performance targets and the levels at which such targets are set. The rewards system and the implications of achieving or failing performance targets The type of information flows required to provide adequate monitoring of performance and to support learning.

Investment centers

If a manager can not only influence profit, but also the assets employed in earning it, the center is an investment center. In an investment center, the relationship between profit and investment is measured, and the manager is responsible for both capital investment and profit. The sum of the assets employed is called the investment base. The book uses two primary methods of relating profit to the investment base: Return on investment (ROI) and residual income (RI).

Administration of transfer prices

If units are not able to negotiate a transfer price, senior management must step in. Solutions range from a single executive stepping in, to a committee that is responsible for (1) settling disputes, (2) reviewing sourcing changes and (3) changing the 'ground rules' if needed. Either way, there needs to be some kind of arbitration present. Moreover, TMT could place constraints on outsourcing. Some companies divide products in two classes: (1) a class that senior management wishes to control sourcing, and (2) a class where sourcing is decided by junior management. See page 300.

Revenue centers

In a revenue center, output is measured in monetary terms, but no formal attempt is made to relate input to output. Typically, revenue centers are marketing/sales units. When evaluating the manager of a revenue center, actual sales or order booked are measured against budgets or quotas. Thus, control of a revenue center depends on the effective establishment of a reference point to which the actual revenues can be compared.Managers are responsible for revenue only (although, in practice, they are responsible for some costs as well). Focusing on revenue is a simple and effective way to motivate salespeople.

In summary; the mechanistic management control system presumes that people only work for money. It consists of narrow defined tasks and relies heavily on hierarchy. A pure organic management control system is based on the assumption that people want and can contribute to meaningful goals. Import aspects include teamwork and the fact that employees are encouraged to take initiatives. Depending on the kind of strategy chosen, one of these two might be the better fit (see exh. 4.10 on page 160).

In summary; the mechanistic management control system presumes that people only work for money. It consists of narrow defined tasks and relies heavily on hierarchy. A pure organic management control system is based on the assumption that people want and can contribute to meaningful goals. Import aspects include teamwork and the fact that employees are encouraged to take initiatives. Depending on the kind of strategy chosen, one of these two might be the better fit (see exh. 4.10 on page 160).

Business units as profit centers

Many business units are created as profit centers. Managers of profit centers have a lot of freedom. To fully realize the benefits of the profit centers concept, a business units managers would have to be as autonomous as the CEO. This is not practical, because the organization would then lose all its advantages of size and synergy. Consequently, business units represent trade-offs between unit autonomy and corporate constraints. Two type of constraints are given below:

Examples of stakeholders are:

Owners Customers Employees Suppliers Lenders Society Secondary stakeholders like media or the government

2. The organizations set of rules Some specific rules are specified below.

Physical controls: security guards, computer passwords, vaults etc. Manuals System safeguards: cross-checking totals with details, requiring signatures, separating duties, checks by internal and external auditors etc.

Goals related to owners

Profftability (usually stated as ROI) Risk (preserve companies assets)

ROI: a ratio. EBIT/Assets employed.

Research shows that most companies use ROI rather than RI. ROI is affected by all changes in the financial statements, easy to calculate, can be applied to all types of businesses and can be disaggregated using the Du-Pont formulas.

Emerging strategies:

The emerging strategies perspective is quite different from the deliberate one. The background is: strategies, no matter how cleverly designed, might not be successfully implemented and even if they are, might not work out in practice. We separate deliberate from emerging strategies based on the following rationale: deliberate strategies are formulated by top management in a certain way (mentioned above), while emerging strategies gradually emerge out of how problems are being dealt with in practice.

Otley (1999) framework

The framework highlights five central issues that need to be considered as part of the process of developing a coherent structure for the performance management system (PMS).

3. The organizations formal planning and control cycle

The organizations formal planning and control cycle is the combination of all formal procedures that organizations follow in the implementation of their strategies. This includes things like operationalization of strategic objectives and procedures through which goal attainment are measured. We will discuss this in the following chapters.

Budgeting for a Discretionary expense center

The planning function for a DEC is usually carried out in one of two ways: (1) incremental or (2) zero- based budgeting.

The parts and linkages of the budget Production costs and COS

The standard material and labor costs * prices. Production managers make plans for obtaining material and labor. Moreover, they also develop production schedules to ensure that resources needed are available. The COS reported in the summary budget are the standard costs of budgeted products to be sold! The variation is explained in inventory.

• Value chain analysis:

The value chain framework is a method of breaking down the chain (from raw materials to end-use customers) into specific activities in order to understand the behavior of costs and the sources of differentiation. The value chain helps the firm to understand the entire value delivery system, not just the portion of the chain in which the firm participates. In other words: information sharing between units of the chain may contribute to a better end-product/less costs etc.

According to Porter, a low-cost strategist is likely to follow these requirements:

Tight cost control Frequent, detailed control reports Structured organization and responsibilities Incentives based on strict quantitative targets

Budgeting process (3st)

Top-down budgeting Bottom-up budgeting Iterative budgeting

Transfer pricing

Transfer pricing is about how to devise a satisfactory method of accounting for the transfer of goods from one responsibility center to another. The transfer price should be so designed that it accomplishes the following objectives: - It should provide each business unit with the relevant information needed to determine the optimum trade-off between company costs and revenues. - It should induce goal-congruent decisions. - It should help measure economic performance of the individual business units. - The system should be easy to understand and simple to administer.

Control of managerial decisions:

Will be discussed more in depth in chapter 5. Some examples: the formal delegation of decision- making authority to lower-level managers, the formal delegation of decision-making responsibility to lower-level managers, and the prescription of managerial behavior in certain situations.

ROI

a ratio. EBIT/Assets employed.

The parts and linkages of the budget Budgeted balance sheet, Budgeted cash flow statement:

are deprived of the above mentioned blocks, depending on their position. See also: exh. 9.3 on page 341.

Variance analysis Market penetration and industry volume:

as an extension of revenue analysis, you could split the mix and volume variances into the amount caused by the differences in market share (managers are responsible for this) and the differences caused by industry volume (managers cannot control this, so are not held accountable for this).

Tight control:

based on the idea that subordinate managers work most effectively when they are required to meet short term goals, and senior management can assist subordinates in solving many day-to-day problems. A tight control system is one where managers' performance is evaluated primarily on the ability to attain budgetary objectives.

Iterative budgeting

because of the shortcomings of the first two methods, iterative budgeting was designed. It starts like bottom-up budgeting, but it is repeated one or more time until TMT is content with the figures. "Upp": Participation from lower-level managers while incorporating wishes TMT. "Down": Taking a lot of time. "Down": If this method is used every year, and managers know there will be a revision, they might incorporate some form of slack.

Corporate strategy

being in the right mix of businesses. Thus, corporate strategy is more concerned with where to compete rather than how to compete. Example of corporate level decision: how/where to allocate resources?

The parts and linkages of the budget Revenue budgets

consists of the sales projection * expected sales price. The revenue is the most critical of the building blocks, but also the most uncertain one. Managers cannot simply predict the economy.

Business Unit Strategy

how to compete in a certain industry

Corporate governance

involves a large number of different means that can be used by the owners or by others in the interest of the owners to govern the company.

RI

is a euro amount, rather than a ratio. EBIT - Capital charge, where capital charge = (cost of cap * assets employed). Assets employed is also referred to as the 'asset base'. (EVA is just adjusted EBIT - (COC * adjusted assets employed).

The hinge

is a manager or controller who understands both the operational and the financial measures.

Corporate Social Responsibility

is not clearly defined. However, one common definition is the following: 'CSR is about an organizations voluntary concern about social and environmental issues.'

strategic planning perspective

is not so different from the design perspective, but has taken some steps forward towards a useable model. Basically the same, but with a larger checklist, that highlighted the links between goals (of the organization), strategy and MC-control tools.

positioning perspective

is not so far from the other two. However, the focus here is on choosing a generic strategy, rather than to design a very specific strategy for a certain organization. The leading figure (Porter), stressed that organizations should be based on market structure. In order to gain competive advantage, there were basically two strategies to choose from: cost leadership or differentiation. Porter later added the focus/segmentation strategy, which means focusing on a smaller market. However, this would still mean an organization had to choose between CL of differentiation.

Bottom-up budgeting

lower-level managers participate in the budgeting process. "Upp": Participation, as highlighted above. "Down": Managers may want to include 'butters' in the budget figures. "Down": Likely that the consolidated budget is not in line with the ambitions of the TMT.

Planning and budgeting Accountability role

managers at different levels prepare budgets for their respective part of the organization. Once this budget is approved by senior management, the junior management is made accountable for it. - Monitoring: the part of accountability that involves superiors checking if the manager sticks to the budget. - Motivation: motivation through the budget is mainly achieved by settng goals. If managers or employees have goals to strive for (including rewards), their motivation will increase.

Top-down budgeting

senior management sets the budget for lower levels. Lower managers just have to check if figures are realistic before accepting them. "Upp": Fast and easy "Upp": Managers have little input. This can mean that the budget will become less realistic. Moreover, having no input leads to lack of commitment from lower managers. However, research shows that budgeting partcipation has positive effects on lower-level managers, for two reasons: - There is likely more acceptance if the managers view goals as 'under own control'. This leads to higher personal commitment. - Participate budgeting leads to effective information exchanges.

Design perspective

states that strategy should be designed to fit the organization's environment and capabilities. A firm develops its strategies by matching its core competencies with industry opportunities, often by the use of a SWOT-analysis. This perspective is in line with the contingency- theory and suggests that strategy should be based on both external and internal contingencies.

typical control system elements

strategic planning, budgeting, resource allocation, performance measurement, evaluation and reward, responsibility center allocation, and transfer pricing.

The parts and linkages of the budget R&D expenses

the R&D budget uses one of two approaches, or a combination of them. - Focus on total amount. - Aggregating planned expenses

Planning and budgeting Ritual role

the budget has become a ritual. In this case, it is no longer used for the purpose of MC, but for other reasons. Reasons include: a. Habitb. Legitimacy: rationale: professional organizations make budgets, period.

incremental budgeting Budgeting for a DEC

the current level of expenses is taken as a reference point. This amount is adjusted for stuff like inflation or anticipated changes in workload. There are two drawbacks to incremental budgeting: 1. DEC current level of expenses is accepted and not re-examined during the budget preparation process. 2. Managers of DEC typically want to increase the level of services. Thus, they request more resources and raise overhead in total. During a crisis, overhead can usually be drastically reduced without consequences expenses are not efficient, then?

Deliberate strategies:

the general direction in which an organizations plans to move to a attain its goals 1. Design perspective 2. strategic planning perspective 3. positioning perspective

Planning and budgeting Process role

the purpose of the budget is not so much tied to the outcome, but the budgeting process. While the budget may be outdated once approved, the process of budgeting may have led to useful insights. - Reflection: reflecting on own achievements. Managers take me, and think about (reflect) important long-term things, instead of the day- to-day stuff. - Communica on: during re4ec on, managers will come to the insight that they do not have all the answers themselves. Hopefully, they will talk to other people (employees, customers, suppliers) to resolve the uncertainty.

The goal of management control systems (MCS)

to implement organizational strategies

zero-based budgeting: Budgeting for a DEC

to make a thorough analysis of each DEC on a rolling schedule, so that all are reviewed at least once every five years, for example. In contrast, this intensive review attempts to ascertain, from scratch, the resources actually required to carry out each activity within the expense center. This analysis provides a 'new' base, at which point the annual budget review simply attempts to keep expenses reasonably close to that base. Moreover, information from other sources can also be used as a base (benchmarking). It is important to note that making these results comparable can be though. Moreover, zero-based budgeting as a whole is me consuming.

However, from a management control point of view, there are principal challenges in managing such a decentralized organization. This chapter deals with three such challenges:

transfer pricing, shared services centers and cross-functional management.

the adaptive cycle

which is the continuing process of assessing the environment and deciding how to cope with environmental decisions. The cycle is broken down into three problems that management must continually solve. 1. Entrepreneurial problem: choosing a specific product/service and market to focus on. 2. Engineering problem: the creation of a system that places the solution to the entrepreneurial problem into operation. 3. Administrative problem: how the organization deals with the rationalization of current processes and innovation into new areas.

We will take a look at three Strategic management accounting- methods:

• Target costing: • Value chain analysis: • BSC and strategy maps:

Theories on incentives and motivation

• X/Y theory: X human beings have an instinctive aversion against work. Y theory states that humans view working as 'normal' as sleep. Agency theory is more in line with theory X, where motivation crowding theory is more in line with theory Y.