This summary is written in 2013-2014. Show 1.1 IntroductionManagement control is important for organizations because failures in management control can lead to large financial losses, reputation damage, and possibly even to organizational failure. Despite the importance of having good management control systems (MCSs), management critics have argued that adding controls does not always lead to better control and that the MCSs in common use cause managers to be excessively short-term oriented or are prone to stifle creativity and initiative. An old narrow view of a MCS is that of a simple cybernetic (regulating) system, involving a single feedback loop (thermostat). This book takes a broader view and recognizes that some management controls are proactive rather than reactive. Proactive means that the controls are designed to prevent problems before the organization suffers any adverse effects on performance. The benefit of management control is that the probability that the firm’s goals will be achieved increases. 1.2 Management and controlManagement literature includes many definitions of management. All relate to the processes of organizing resources and directing activities for the purpose of achieving organizational objectives. There are different functions, resources and processes of management:
To focus on management control we must distinguish the concept objective setting and strategy formulation:
Control systems have two basic functions:
Management controls are necessary to guard against possibilities that people will do something the organization does not want them to do or fail to do something they should do (behavioral orientation). 1.3 Causes of management control problemsThe causes can be classified into three main categories:
1.4 Characteristics of good management controlGood control means that management can be reasonably confident that no major unpleasant surprises will occur. It must be future driven and objectives driven. Out of control describes the situation where there is a high probability of poor performance. Perfect control would require complete assurance that all physical control systems are foolproof and all individuals on whom the organization must rely always act in the best way possible. Control loss is the cost of not having a perfect control system. Optimal control can be said to have been achieved if the control losses are expected to be smaller than the cost of implementing more controls. Assessing whether good control has been achieved must be future oriented (no unpleasant surprises in the future)and objectives driven (because the goals represent what the organization wants). But still it is difficult and subjective to determine control as ‘good’. 1.5 Control problem avoidanceThere are four avoidance strategies (to eliminate the possibility of control problems): Managers can sometimes avoid the control problems associated with a particular entity or activity by turning over the potential risks, and the associated profits to a third party. Transaction Cost Economics: whether specific activities (transactions) can be controlled more effectively through markets or internally. The use of computers, robots, expert systems, and other means of automation to reduce their organization’s exposure to some control problems. Automation can provide only a partial control solution at best. Limitations are: feasibility, cost and the replacement of control problems with others. Centralize decision-making in some areas of their companies at specific points in the histories to improve control. Sharing risks with outside entities can limit the losses that could be incurred by inappropriate employee behaviors. Risk sharing can involve buying insurance to protect against certain types of large, potential losses the organization might not be able to afford. Or share risks with an outside party is to enter into joint venture agreement. 1.6 Control alternativesIf control problems cannot be avoided, management controls must be implemented. These are what is addressed in this book. Results controls are an indirect form of control because they do not focus explicitly on the employees’ actions. Pay for performance is an example because it involves rewarding employees for generating good results. It is difficult to define what are ‘good’ results. However, they may create greedy and short-termism cultures. Results controls create meritocracies; the rewards are given to the most talented and hardest working employees. Results controls influence actions because they cause employees to be concerned about the consequences of the actions they take. 2.1 Prevalence of results controls These controls are used for controlling the behaviors of employees at many organizational levels. But especially for professional employees with decision authority. Decentralization and the design of the incentive system are two critical organizational design (organizational architecture) choices in a results control context. 2.2 Results controls and the control problems It is important that the results inform employees as to what is expected of them and encourages them do what they can to produce the desired results. Results controls are effective in addressing motivational problems and they can also address personal limitation problems and they can encourage all employees to address their limitations and to develop their talents to position themselves to earn the results-dependent rewards. The performance measures also provide some non motivational benefits of a cybernetic (feedback) nature. Management-By-Exception is investigating and intervening when performance is deviating from expectations (common in large firms). 2.3 Elements of results controls The implementation requires four steps:
The goals that are set should be congruent with the measurements that are made and are important to shape employees’ view of what is important At higher organizational levels, most of the key results linked to rewards are defined in financial terms. Lower-level managers are evaluated in terms of operational data that are more controllable at the local level. In the middle of the organization, managers must translate financial goals to operational goals. If more than one resulted is expected, weightings should be added.
Targets should be specified for every performance dimension that is measured. They affect behavior in two basic ways:
The rewards can be in the form of anything employees’ value: salary increases, bonuses, promotions, job security, power and so on. Punishments are the opposite of rewards. An extrinsic reward is an external reinforcement, which takes the form of a tangible item such as a trophy or money, or something intangible such as praise and public recognition. An intrinsic reward gives an individual internal (personal) satisfaction such as that derived from a job well done. The expectancy theory states that individuals’ motivational force is a function of (1) their expectancies or their belief that certain outcomes will result from their behavior and (2) their valences or the strength of their preference for those outcomes. The motivational effects of the various reward forms can vary widely depending on individuals’ personal tastes and circumstances. 2.3 Conditions determining the effectiveness of results controls Results controls work best only when all of the following conditions are present:
Organizations must know what results are desired in the areas they wish to control, and they must communicate those desires effectively to the employees working in those areas. Results desirability means that more of the quality represented by the results measure is preferred to less, everything else being equal. Different needs and tradeoffs are present in different parts of the organization. It is important that the combination of results and measures is congruent with the organization’s true objectives.
The employees whose behaviors are being controlled must be able to affect the results in a material way in a given time period. Results measures are only useful if they provide information about the desirability of the actions that were taken. Uncontrollable factors hinder efforts to use results measures for control purposes and they are not effective.
The measure must evoke the right behaviors in a given situation. Results measures should be (next to congruent, controllable and cost efficient):
Action controls involves ensuring that employees perform certain actions known to be beneficial to the organization. They are not effective in every situation. They are feasible only when managers know what actions are desirable and have the ability to ensure that the desirable actions occur. Personnel controls are controls to make it more likely that employees will perform the desired tasks satisfactorily on their own because employees are experienced, honest, and hard working. Cultural controls are controls to shape the organizational behavioral norms and to encourage employees to monitor and influence each other’s behaviors. 3.1 Action controls This is the most direct form of management control because it involves taking steps to ensure that employees act in the organization’s best interest by making their actions themselves the focus of control. There are four basic forms: This is a negative form of action control. These controls make it impossible, or at least more difficult, for employees to do things that should not be done. A psychical constraint is for example a lock on a desk, passwords, and limits to areas. An administrative constraint can be used to place limits on an employee’s ability to perform all or a portion of specific acts. An example is the restriction of decision-making authority or separation of duties (so that one person cannot perform the entire task). Separation of duties is required for good internal control but cannot prevent collusion (between different persons) A poka-yoke is a step built into a process to prevent deviation from the correct order of steps; that is, where a certain action must be completed before the next step can be performed. This involves the scrutiny of the action plans of the employees being controlled This control involves holding employees accountable for the actions they take. For the implementation there are four things important:
Action controls are most effective if the desired goals are well communicated. The actions for which employees are to be held accountable can be communicated either administratively (rules, policies, contracts, codes of conduct) or socially. Actions can be tracked directly (supervision or monitoring) or by examining evidence. This control involves assigning more employees (or machines) to a task than necessary. It increases the probability that a task will be satisfactorily accomplished. 3.2 Action control and the control problems
Action controls address one or more of the three basic control problems (see table) 3.3 Prevention versus detection Controls that prevent the undesired errors and irregularities from occurring are, when they are effective, the most powerful form of control because none of the costs of the undesirable behaviors will be incurred. Detection controls are applied after the occurrence of the behavior. Most action controls are used for prevention. However, accountability controls are designed to motivate employees to behave appropriately, it cannot be verified whether the appropriate actions were taken until evidence of the actions is gathered. 3.4 Conditions determining the effectiveness of action controls They are only effective when both of the following conditions exist to some extent:
2 ways: analyzing the actions/results patterns in a specific situation to learn what actions produce the best results or be informed by others.
They must have the ability to ensure or observe that the desired actions are taken. The effectiveness of behavioral constraints and preaction reviews varies directly with the reliability of the physical devices or administrative procedures. ‘Management override’ is when management overrides otherwise effective controls and is one of the reasons of undetected fraud. Refer to the previous chapter for precision, objectivity, timeliness and understandability. 3.5 Personnel controls This type of control builds on employees’ natural tendencies to control and/or motivate themselves. Three basic purposes:
Self-monitoring pushes most employees to want to do a good job. It’s effective because most people have a conscience that leads them to do what is right. Three major methods of implementing personnel controls:
Finding the right people to do a particular job and giving them both a good work environment and the necessary resources can increase the probability that a job will be done properly. This can provide useful information about what actions or results are expected and how the assigned tasks can best be performed.
Make sure that the job is designed to allow motivated and qualified employees a high probability of success. 3.6 Cultural controls This type of control is designed to encourage mutual monitoring; a powerful form of group pressure on individuals who deviate from group norms and values. They are most effective where members of a group have emotional ties to one another. Cultures are build on shared traditions, norms, beliefs, values, ideologies, attitudes and ways of behaving. A code of conduct is a set of rules outlining the responsibilities of or proper practices for an individual or organization. These formal, written documents provide broad, general statements of organizational values, commitments to stakeholders, and the ways in which management would like the organization to function. Group rewards are rewards based on collective achievement. This also encourages cultural control. Examples are bonus, profit-sharing, or gain-sharing plans that provide compensation based on corporate or entity performance in terms of accounting returns, profits, or cost reductions. They are different from individual accomplishment (result controls) because the link between individual efforts and the results begin rewarded is weak. Other common approaches to shape organizational culture:
3.7 Personnel/cultural controls and the control problems
3.8 Effectiveness of personnel/cultural controls Personnel and cultural controls, which are sometimes referred to as soft controls, have become more important in recent years. Organizations have become flatter and leaner. They have several important advantages over results and action controls.
The benefit of any MCS is derived from the increased probability that the firm’s goals will be achieved relative to without the MCS. Tighter MCSs should provide a higher degree of certainty that employees will act as the organization wishes. A firm can have tight or loose controls. Effective implementation of tight control requires that management has detailed and reasonably certain knowledge about how one or more of the control objects are related to the overall organizational objectives. 4.1 Tight results controls The achievement of right results control depends on:
For management control to be considered tight in a results control system, there are some requirements:
Tight results control also depends on the effectiveness of the measures of performance that are generated. Results controls are likely to be tighter if rewards (or punishments) are directly and definitely linked to the accomplishment (or nonaccomplishment) of the desired results. 4.2 Tight action controls Action controls systems should be considered tight only if it is highly likely that employees will engage consistently in all of the actions critical to the operation’s success and will not engage in harmful actions. Behavioral constraints can produce tight control in some areas of the organization. Physical constraints usually cost more if there is more of them. Administrative constraints provide widely varying degrees of control. Restricting decision authority to higher levels provides tighter control if it can be assumed that higher-level personnel will make more reliable decision than lower-level personnel. Good separation of duties makes the control system tighter. Preaction reviews are sometimes considered to be tight if the reviews are frequent, detailed, and performed by diligent, knowledgeable reviewers. They are typically tight in areas involving large resource allocations because many investments are not easily reversible and can, by themselves, affect the success or failure of an organization. The amount of control generated by action accountability controls depends on:
to achieve tight action accountability control, the definitions must be congruent, specific, well communicated and complete. Tight action control depends on the understanding and acceptance on the part of those whose behaviors are being controlled.
Control can also be made tighter by improving the effectiveness of the action-tracking system. Employees who are certain that their actions will be noticed will be affected more strongly by an action accountability control system than will those who feel that the chance of being observed is small. Control can be made tighter by making the rewards and punishments more significant to the employees affected. 4.3 Tight personnel/cultural controls In a few situations, MCS’s dominated by personnel/cultural controls can sometimes be considered tight. This is in charitable and voluntary organizations and in small family-run companies. Most of the time, the degree of control provided by the personnel/cultural controls is less than tight. Managers often use multiple forms of controls. Cultural controls are often more stable and strong because they derive from deeply held and widely shared beliefs and values. Direct cost in MSC’s are the cost of investing in MSC’s in return for one primary benefit: a higher probability that employees will both work hard and direct their energies to serve to organization’s interest. Indirect costs are many times greater than their direct costs. Some are created by negative side effects others are caused by a poor MCS design or by an implementation of the wrong type of control for a give situation. 5.1 Direct/ out-of-pocket costs This type of costs refers to the direct, monetary costs of implementing an MCS. These costs should affect decisions about whether the benefits of a particular type of control justify the costs and whether one or another form of control should be implemented. 5.2 Indirect costs These include the following: This is a side effect that can subject organizations to significant indirect costs. It occurs whenever the MCS produces, and actually encourages, behaviors that are not consistent with the organization’s objectives. It is most common with results or action accountability where the specification of the results or actions desired is incongruent. But some forms of personnel/cultural control can also produce behavioral displacement. In a results control system, behavioral displacement occurs when an organization defines sets of results measures that are incongruent with the organization’s true objectives. This happens when:
A form of action control-related displacement is often referred to as means-end inversion. This means that employees pay attention to what they do while losing sight of what they are to accomplish. Action control-related displacement can occur because the defined actions are incongruent or because the action controls promote compliant but rigid, nonadaptive behaviors. The latter often happens in bureaucratic organizations. Action controls and bureaucratization can be good in stable environments with considerable centralized knowledge about what actions are desired because they help establish good, efficient work habits. Behavioral control can also occur with personnel/cultural controls. It occurs when organizations recruit the wrong type of employees or provide the wrong training. Gamesmanship refers to the actions that employees take to improve their performance indicators without producing any positive economic effects for the organization. There are two forms:
Slack is the consumption of resources by employees that cannot be justified easily in terms of its contribution to organizational objectives. This often takes places when tight controls are in use. Budget slack is negotiating highly achievable targets that are deliberately lower than their best-guess forecast in the future. It protects managers against unforeseen contingencies and improves the probability that the budget target will be met. Slack is feasible only where there is information asymemetry. Advantages:
Disadvantages:
It involves an effort on the part of the employee being controlled to look good by fudging the control indicators. Two basic forms:
Accounting methods are interventions in the measurement process and operating methods involve the altering of operating decisions. Operating delays are an often-unavoidable consequence of the preaction review types of action controls and some of the forms of behavioral constraints. Where fast action is important, decisions delays can be quite costly. Bureaucracy can cause operation delays.
Most people react negatively to the use of action controls. Preaction reviews can be particularly frustrating if the employees being reviewed do not perceive the reviews as serving a useful purpose.
They can also produce negative attitudes. Lack of employees’ commitment to the performance targets defined in the MCS can be a cause. Negative attitudes can also be caused by the measurement system (accountable for things they cannot control) or the rewards (not equitable).
Table: control types and possible harmful side effects 6.1 Understanding what is desired and what is likely A better understanding of objectives and strategies: * yields a larger set of feasible control alternatives * provides a better chance of being able to apply each alternative tightly * reduces the chance of creating behavioral displacement problems What is desired is defined in terms of the actions desired. Knowledge of what is desired is most useful for management control purposes if it can be translated into knowledge of the specific demands on the roles of employees in the organization. It is important to identify the key actions that must be performed in order to provide the greatest probability of success. Key results are the things that must go right for the business to succeed. 6.2 Decision 1: choice of controls (see table previous page) The different types of management controls are not equally effective at addressing each of the management control problems. In deciding among the many management control alternatives, managers should also consider on the personnel or cultural controls. These controls have relatively few harmful side effects and relatively low out-of-pocket costs. These controls are sufficient only if employees: * understand what is required * are capable of performing well * are supported by the requisite organizational structures and systems * are motivated to perform well without additional reinforcements provided by the organization Advantages of action controls
Disadvantages of action controls
Advantages of results controls
Disadvantages of results controls:
6.3 Decision 2: choice of control tightness Should controls be tight or loose? Depends on three questions: what are the potential benefits of tight controls? What are the costs? Are any harmful side effects likely? Tight control is most beneficial in the most critical areas. The potential benefits of right controls is higher when performance is poor. Tight action controls would likely cause behavioral displacement and stifle creativity. Tight results controls would likely cause problems to select the right results measures and set adequately challenging targets. Simultaneous tight-loose controls are also found to work. Tight control should then be used over the few key actions or results that have the greatest potential impact on the success of the organizations. 6.4 Adapting to change Organizational growth pushes management controls in the direction of increased formalization of procedures for action accountability purposes and/or development of more elaborate information systems for results control purposes. 6.5 Keeping a behavioral focus The benefits and side effects of management controls are dependent on how employees will react to the controls that are being considered. No one form of control Is optimal in all circumstances. 6.6 Maintaining good control There are several causes of failures of MCS:
Controls that seem quite loose have some benefits: high creativity, a healthy spirit of cooperation or low cost. In financial results control systems, results are defined in monetary terms (revenues, costs, profits and returns). They have tree core elements:
Financial results control systems rely on internal controls, which ensure the reliability of the organization's information. 7.1 Advantages of financial results control systems
7.2 Types of financial responsibility centers These are responsibility centers in which individuals' responsibilities are defined at least partially in financial terms. Responsibility accounting is a reporting system that classifies accounting information about an organization's activities according to the managers who are responsible for them. There are four basic types: Managers are held accountable for the accounting returns on the investment made to generate those returns. Managers are held accountable for profit, which is a measure of the difference between the revenues generated and the costs of generating those revenues. They are not accountable for the investments made to generate them. The financial goal of many profit centers is to break even. Managers are held accountable for generating revenues, which is a financial measure of output. Revenue, rather than profit, provides a simple and effective way to encourage sales and marketing managers to attract and retain customers. Most revenue centers are also held accountable for some expenses. Not a profit center because there is no profit calculation relating outputs and inputs. Managers are held accountable for some elements of cost. Costs are financial measures of the inputs to, or resources consumed by, the responsibility center. In standard cost centers, the outputs are relatively easy to measure, and the causal relationship between inputs and outputs is direct and relatively stable. Control can be exercised by comparing standard cost with the cost that was actually incurred. In discretionary cost centers, the outputs produced are difficult to value in monetary terms. Control is usually exercised by ensuring that the cost center adheres to a budgeted level of expenditures while successfully accomplishing the tasks assigned to it. A gross margin center is a variation of a profit center. The managers may be quite low-level salespeople who happen to sell products of varying margins. The profit measure gives them an incentive to sell higher margin products, rather than merely generating additional, possibly unprofitable, revenues. The incomplete profit center managers do not have authority for all of the functions that affect the success of their products. Complete profit managers are accountable for all aspects of the worldwide performance of major business segments. 7.3 Choice of financial responsibility centers See the tables on page 263 and 266 for the different responsibilities of the managers. Decisions about an organization's structure do not necessarily precede decisions about the type of responsibility centers that should be used: the responsibility structure decision may come first. 7.4 The transfer-pricing problem Transfer pricing refers to the pricing of transferred within an organization. It directly affects the revenues of the selling profit center, the costs for the buying profit center and the profits for both entities. Purposes of transfer pricing (may be conflicting):
These multiple transfer-pricing purposes often conflict. Transfer pricing interventions undermine the benefits of decentralization. They reduce profit center autonomy and cause decision-making complexity and delay. Types of transfer pricing: this price could be the listed price of an identical product or service, the actual price the selling entity charges external customers, or the price a competitor is offering. Optimal in a perfectly competitive market. The selling profit centre should shut down if it cannot function using the market price and the selling profit centre should shut down i fit cannot function by paying the market price. Marginal costs approximated as the variable or direct costs of production. It provides poor information for evaluating the economic performance of either the selling or buying profit centers. Costs of providing the product or service. Several advantages:
They allow the selling profit centers to earn a profit on internally transferred products and services. Not responsive to changes in market conditions. Allow the selling and buying center managers to negotiate between themselves. Both profit centers have some bargaining power. Several problems:
One other variation is to transfer at marginal costs plus a fixed lump-sum fee. The lump-sum fee is designed to compensate the selling profit center for tying up some of its fixed capacity for producing products that are transferred internally. Advantages:
The major problem: managers involved must predetermine the lump-sum fee based on an estimate of the capacity that each internal customer will require in the forthcoming period. If this is incorrect the capacity will not be assigned to the most profitable uses. In dual transfer prices the selling profit center is credited with the market price but the buying profit center pays only the marginal cost of production Advantages:
However, it can destroy the internal entities' proper economic incentives. It is impossible to use two different multiple transfer-pricing methods and simultaneously serve both the decision-making and evaluation purposes because managers make decisions to produce the numbers for which they are being evaluated. Planning and budgeting systems produce written plans that clarify where the organization wishes to go (goals), how it intends to get there (strategies), and what results should be expected (performance targets). 8.1 Purposes of planning and budgeting systems They serve four main purposes:
8.2 Planning cycles Three cycles: the relatively broad processes of thinking about the organization's missions, objectives, and the means by which the missions and objectives can best be achieved. It involves analyzing the past and forecasts of the future. A complete, formal strategic planning process leads to definitions of the corporate diversification strategy and the strategies of all the strategic business units. Identification of specific action programs or projects to be implemented over the next few years and specification of the resources each will consume. The outcomes are almost always dependent on the track record, preparation, arguing skill, and political power of the managers involved. Preparation of a short-term financial plan, a budget, usually for the next 5 years. 8.3 Performance target setting Reviews that compare actual performance with plans and budgets can lead to improved understanding of what is and what is not working well. They also improve coordination and they provide important motivational benefits. Types of financial performance targets:
Model-based targets: provide a prediction of the performance that should ensue in the upcoming measurement periods. When they are used in areas where activities are programmable (direct and stable causal relationship between inputs and outputs) engineered targets. Historical targets: derived directly from performance in prior periods. Negotiated targets: negotiated between superiors and subordinates. Tight control is easiest to implement when targets are engineered because the link between effort and results is direct. Fixed targets do not vary over a given time period. Flexible targets are changed according to the conditions faced during the period. Most of financial targets: fixed, at lower organizational levels: flexible.
Internally focused: managers consider what is possible within the organization and focus on period-over-period, continuous improvements. Externally focus: organization benchmarks its performance and practices with those of other organizations. Two of the most important financial performance target issues are related to:
Targets must be challenging, but achievable. Advantages of highly achievable budget targets:
How much influence should subordinates have in setting their financial targets? Allowing them to participate in, and to have influence on, the process of setting their performance targets can have benefits:
Top-down target setting when:
Managers must be careful that their subordinates commitment to achieve the targets is still there. 8.4 Variations in practice Planning and budgeting system variations:
8.5 Criticism of companies' planning and budgeting processes They claim that planning and budgeting processes:
Incentive systems are important because they inform and remind employees as to what result areas are desired and motivate them to achieve and exceed the performance targets. 9.1 Purposes of incentives Three types of management control benefits: the rewards attract employees' attention and inform or remind them of the relative importance of often competing results areas. Effort-directing purpose. some employees need incentives to exert the extra effort required to perform tasks well. Effort-inducing purpose.
Performance-dependent rewards are an important part of many employees' total compensation package. Incentive systems also serve noncontrol purposes:
9.2 Monetary incentives Three main categories:
9.3 Incentive system design - Formula It is important for incentive systems to have an incentive formula. Also a part can be subjective. Superiors sometimes leave contract terms implicit because they may not know how to describe the bases for the rewards or the weigthenings of importance. They want to keep the contract flexible, also to ensure that employees do not stop when the target is reached. Employee risk can be decreased if it allows adjustments for factors outside of the employee’s control but increased if evaluation is based on different factors than assumed, if the evaluators are not trusted and if employees try to influence their evaluation. When the reward promises are formulaic, the link between rewards and the bases on which they are awarded is often determined by a rewards-results or incentives-performance function. Lower cutoff / threshold: below some significant fraction of targeted performance, managers are promised no incentive compensation for performance. Upper cutoff / cap: no extra rewards are provided for any additional performance above the cutoff. - size of incentive Variable pay should motivate and is likely to attract employees who are confident about their abilities. A risk premium (at-risk pay) should be offered if outcomes are not totally controllable by employees. 9.4 Criteria for evaluating incentive systems For ideal motivation, a system of performance-dependent rewards:
9.5 Group rewards Group rewards are good when the tasks are mutually connected. However they can also create the free rider effect. Group rewards can produce a beneficial form of cultural control. Team members may monitor and sanction each other's behaviors and produce improved results. 10.1 Value creation: the primary goal of for-profit organizations The value concept is important for management control purposes because it indicates that employees can increase the value of the firm or entity in which they work by increasing the size of the future cash flows, by accelerating the receipt of those cash flows or by making them more certain or less risky. Economic value is the change in firm value over any given period. 10.2 Market measures of performance Market measures of performance are based on changes in the market value of the firm or, if dividends are also considered, return to shareholders. You can measure the value created directly for any period as the sum of the dividends grated to shareholders in the measurement period +/- the change in the market value of the stock. These measures are attractive because they provide direct indications of the amount of value that has been created or destroyed. Advantages of market measures, if they are measured in terms of recent transaction prices: the values are:
There are also some limitations of market measures:
Basing rewards on stock market valuations if employees cannot influence those values will have no effect on the employees' behaviors. Stock market valuations are affected by many factors that the managers cannot control. For example: macroeconomic activity, interest rates, factor prices, exchange rates and the actions of competitors. Relative performance evaluations are used to improve market measures to make them more reflective of the controllable elements of performance. 10.3 Accounting measures of performance 2 basic forms: - residual measures (accounting profit measures): net income, operating income, EBITDA, residual income - ratio measures (accounting return measures): ROI, ROE, return on net assets, risk adjusted return on capital. Advantages, accounting measures:
Accounting income does not reflect economic income perfectly, because accounting measures:
Accounting measures do not reflect well changes in entities’ economic values, particularly in shorter measurement windows.
Investment myopia is the fact that holding managers accountable for short-term profits and returns induces managers to reduce or postpone investments that promise payoffs in future measurement periods, even when those investments clearly have a positive NPV. Operational myopia: making operational decisions to shift income across periods, even when harmful long-term It comes from two problems with accounting measures: their conservative bias and their ignoring of intangible assets with predominantly future payoffs. Managers are motivated to produce accounting profits and returns and to make no investments. They reduce expenses in the current period and do not suffer the lost revenue until future periods. Channel stuffing is a trick whereby near-term sales are boosted by extending lower prices to distributors encouraging them to load up while potentially hurting later sales. Investment myopia occurs only in businesses where investments are being made in the future. 10.5 Return-on-investment measures of performance Managers in divisionalized organizations are held accountable for profit of some form of accounting return on investment (ROI). An organization is decentralized when authority for making decisions is pushed down to lower levels in the organization. All divisionalized organizations are decentralized. Not all decentralized organizations are divisionalized. When decentralization is effected along functional lines of authority, the responsibility centers are usually cost and revenue centers, not profit or investment centers. Advantage of divisionalization: Local managers become experts in their specialized markets, and they are able to make good decisions more quickly. They are highly motivated because they control their own success to a significant extent. ROI is a ratio of accounting profits earned by the division divided by the investment assigned to the division. Advantages ROI:
Problems with ROI:
10.6 Residual income measures as a possible solution to the ROI measurement problems. The use of a residual income measure overcomes the suboptimatization limitation of ROI. It is calculated by subtracting from profit a capital charge for the net assets tied up in the investment center. The capital is charged at a rate equal to the weighted average corporate cost of capital. Residual income measures solve the suboptimization problem because the charge can be made equal to the corporate investment cutoff rate of return. Economic value added (EVA) = modified after-tax operating profit – (modified total capital x weighted average cost of capital). Modified after-tax operating profit: reflects the capitalization and subsequent amortization of intangible investments. Modified total capital: fixed assets, working capital and the capitalized intangibles. Weighted average cost of capital: reflects the weighted average cost of debt and equity financing. EVA reflects the results of a summation of transactions completed during the period and focuses on the past, while economic income reflects changes in future cash flow potentials. EVA measurement limitations:
Myopia is a dysfunctional side effect of financial results control systems, it is the tendency to focus on the short term. 11.1 Pressures to act myopically Managers must be made to understand how the stock market reacts to earnings announcements. Managers believe that the stock market reacts forcefully to every public earnings announcement, even quarterly disclosures. That’s why managers try to maintain a smooth, steady earnings growth pattern. The two most common forms of earnings management: The stock market is generally not short-term oriented. The stock market is not myopic. The stock market’s horizon is relatively long. There are six remedies to the myopia problem: 11.2 Measure a set of value drivers: combination-of-measures systems Focus also on other performance measure that are more future-oriented and use also nonfinancial performance measures. Most widely-publicized combination-of-measurement system: balanced scorecard. It proposes a combination of short-term measures and leading indicators framed in four perspectives:
Market measures are best suited for use at top management levels of publicly traded firms only. 11.3 Measure changes in shareholder value directly Try to measure economic income or shareholder value creation directly by estimating future cash flows and discounting them to the present value. Measurement precision and objectivity are still significant stumbling blocks to the use of direct measures of economic income. 11.4 Control investments with preaction reviews Use financial result controls to reward improvements in short-term operating performance only. The cost of longer-term investments are considered below the income statement line for which the managers are held accountable, so managers have no pressure to cut these investments to boost short-term profits. Distinguish operating expenses, necessary to produce current period revenues, and developmental expenses, incurred in order to generate revenues in future periods. Distinguish today businesses, managers are charged with making their business lean, efficient and profitable while they defend it against competitors, and tomorrow businesses, managers are charged with inventing new businesses that will augment or replace the existing today businesses. Today businesses: controlled through tight financial result controls. Tomorrow businesses: controlled with a combination of nonfinancial performance indicators and action controls. Two major limitations:
Make the accounting income measures more congruent with economic income.
These improvements are not without their costs. There are added processing, reporting, and reconciliation costs and possible costs of confusion that might not be inconsequential.
The longer the period of measurement, the more congruent are the accounting measures of performance with economic income. Long-term incentive plans can be a solution. Basing incentives on stock market valuations can lengthen mangers’ decision-making horizon if managers believe that the stock market is forward looking: if the stock market considers performance beyond a quarter or a year. Extending the period of measurement can avoid some of the congruence problems of accounting measures of performance. The payoffs must be potentially quite lucrative for the individual. To provide a better short-term/long-term balance, and thus to reduce a myopia problem, the rewards based on long-term performance must be much larger than those based on short-term performance.
Relax the pressure for generating short-term profits. The reductions in pressure can be communicated in two ways:
The danger is that managers lose the concentration on short-term results without focusing more on longer term targets. The controllability principle: people should held accountable only for what they control. Employees should not be penalized for bad luck or given extra rewards for good luck. Many important result measures are only partially uncontrollable. 12.1 The controllability principle When employees are hold accountable for uncontrollable factors, the organization bears the costs of doing so because the vast majority of employees are risk averse. Employees like their performance-dependent rewards to stem directly from their efforts and not be affected by the vagaries of uncontrollables. Risk aversion is the basis for the primary argument supporting the controllability principle. Owners are risk neutral because they can diversify their portfolios through elaborate financial markets set up for exactly that purpose. The owners’ rewards stem directly from the risk-bearing function they perform. 12.2 Types of uncontrollable factors. Types of factors:
Profit is affected by many factors that change and every other results measure can be affected by multiple, uncontrollable factors. Most evaluators do not buffer managers completely from changes in economic and competitive factors, although they might take steps to have the organization share some of the risk with the managers. These are large, unexpected, one-time, totally uncontrollable events, such as hurricanes, earthquakes, floods. It signifies that an organization’s or an individual’s area is not completely self-contained, and thus, the measured results are affected by others within the organization. Three types:
Interventions from higher-level management: higher-level managers can force a decision on a lower-level manager and in so doing significantly affect a results measure linked to one or more forms of rewards. 12.3 Controlling for the distorting effects of uncontrollables Managers can reduce some of the distorting effects by either of both of two complementary approaches.
Controlling for uncontrollables before the measurement period:
Controlling for uncontrollables after the measurement period: A technique developed to explain how and why two numbers are different. They are used to explain why actual results are different from predetermined standards, budgets or expectations. They have two purposes:
The performance that employees are expected to achieve given the actual conditions faced during the measurement period.
Employees’ performances are evaluated not in terms of the absolute levels of the results they generate, but in terms of their results relative to each other or relative to those of their closest outside competitors.
They take into consideration all the logic embodied in the objective methods of adjusting for uncontrollables. They can correct for flaws in the results measures. Popular with evaluators because they provide a significant source of power over their subordinates. However, it is likely to be biased and often leads to inadequate feedback about how performance was evaluated. Employees often do not understand or trust them. Subjective performance evaluations are expensive in management time. 12.4 Other uncontrollable factor issues Issues when considering adjustments for uncontrollables:
Corporate governance is the set of processes, customs, policies, laws, and institutions affecting the way a corporation is directed, administered or controlled. Corporate governance also includes the relationships among the many stakeholders involved and the goals for which the corporation is governed. Corporate governance is broader than management control, also covering control over top management. Corporate governance focus is on controlling the behaviours of top management, and through their direction, those of all the other employees in the firm. Two corporate governance orientations:
13.1 The Sarbanes-Oxley act of 2002 Sarbanes-Oxley is the most significant piece of legislation affecting corporate governance practices to be passed in the US since the Securities Act of 1934, and it has control implications beyond US borders. The goal was to improve the transparency, timeliness, and quality of financial reporting. Regulation of auditing, independence of audit committees, in-control rules (related to effectiveness of these controls) It will increase control costs, but is not a safeguard to failures (day-to-day ethical behaviour is a management matter). Section 404 mandated an evaluation of the effectiveness of a company’s internal controls by both management and the company’s external auditor and formal written opinions about the effectiveness of those controls. 13.2 Boards of directors Boards of directors have a fiduciary duty to foster the long-term success of the corporation for the benefit of shareholders, and also sometimes for debt holders. Elements:
Boards must be independent and accountable to shareholders, and they must exert their authority for the continuity of executive leadership with proper vision and values. Two main control responsibilities:
Most boards have at least the following standing committees: audit committee, compensation committee, and nominating and governance committees. 13.3 Audit committees They provide independent oversight over companies’ financial reporting processes, internal controls, and independent auditors. They enhance a board’s ability to focus intensively and relatively inexpensively on the corporation’s financial reporting-related functions. Audit committees must be comprised of at least three independent members. An audit committee charter must specify the scope of the committee’s responsibility and how it carries out those responsibilities. They must be directly responsible for the appointment, compensation, retention and oversight of the work of the external auditors. 13.4 Compensation committees They deal with issues related to the compensation and benefits provided to employees, and particularly top executives. They have fiduciary responsibilities for ensuring that the company’s executive compensation programs are fair and appropriate to attract, retain, and motivate managers and that they are reasonable in view of company economics and the relevant practices of comparable companies. Those committees rely on the company’s HR function for staff support. Controllers and auditors serve roles within the firm, such as corporate, group, and division controllers and internal auditors. They have two important roles:
14.1 Controllers In large firms, the finance/accounting related functions are typically divided between two roles:
Controllers play key roles in line management and in the design and operation of a MCS. They are the financial measurement experts within their firm. Roles controllers must play:
Organizational features that can be implemented to ensure that controllers fulfill their management oversight and fiduciary duties effectively:
14.2 Auditors An audit is a systematic process of:
External auditors are independent of management because they are employed by professional service firms. Internal auditors are employees of the company they are auditing. Common audit types In a financial audit, independent, external auditors are asked to express an opinion as to whether the financial statements prepared by the management are fairly presented in accordance with GAAP. It provides a tool by which outside regulators can enforce standards for the preparation and presentation of accounting information to interested parties who are outside the organization. In a compliance audit, the auditors are asked to express an opinion only as to whether actual activities or results are in compliance with the established standards. Many frauds and irregularities are uncovered by compliance audits. Performance audits are used to provide an overall evaluation of the general performance, or some specific aspect of the performance of an activity, department, or company, and its management. Audits create value in two ways:
The greater the potential consequences, the greater the potential value of the audit. Audits are also potentially more valuable where other control mechanisms are not feasible. Limitations and disadvantages:
Ethics seeks to address questions about morality; that is, about concepts like good and bad, right and wrong. Ethics is important for managers involved with MCSs because ethical principles can provide a useful guide for defining how employees should behave. Ethics is a difficult subject for managers to understand: most managers’ basic discipline training is in economics. Rational people should act to maximize their own self-interest and the primary purpose of employees in for-profit organizations is to maximize shareholder value. 15.1 The importance of good ethical analyses Unethical behaviors are costly to individuals, organizations, markets and societies. They create a need for extra laws and standards from governments and regulatory agencies, and extra rules, reviews, or supervision within organizations. To control unethical behaviors within an organization, managers need well developed ethical reasoning skills. Managers need moral expertise to make good ethical judgments. Training sessions, codes of conduct, and credos help employees identify and think through ethical issues. Managers should serve as moral exemplars: role models. 15.2 Ethical models Four common cited ethical models: The rightness of actions is judged solely on the basis of their consequences. An action is morally right if it maximizes the total of good in the world; that is, if it produces at least as much net good as any other action that could have been performed. Limitations:
Every individual has certain moral entitlements in virtue of their being human. Every right that an individual has creates a duty for someone else to provide, or at least not to interfere. Limitations:
People should be treated the same way except when they are different in relevant ways. Limitations:
Integrity, loyalty, and courage. Individuals with integrity have the intent to do what is ethically right without regard to self-interest. Loyalty is faithfulness to one’s allegiances. Courage is the strength to stand firm in the face of difficulty or pressure. 15.3 Analyzing ethical issues Good ethical behavior needs to be guided by more than people’s opinions, intuitions, or good feel. The following steps should be present in any ethical analysis:
15.4 Why do people behave unethically? There are four basic reasons:
15.5 Some common management control-related ethical issues Four common management control-related ethical issues:
Managers negotiate about performance targets and they want to distort their positions in order to be given more easily achievable targets. Managers at all levels of the organization negotiate for slack in their budgets, and everyone is aware of the behavioral norm.
Any action that changes reported earnings while providing no real economic advantage to the organization and, sometimes, actually causing harm. They are designed to:
Unethical because:
When the targets and prescriptions are not defined properly, they can actually motivate behaviors that employees know are not in the organization’s best interest.
15.6 Spreading good ethics within an organization Corporate specialists develop lists of specific standards, rules, and regulations embodying good ethical principles. They communicate these lists either through corporate policies and procedures manuals, corporate codes of conduct, or less formal sets of memoranda. Managers have to make sure that the employees follow the rules. Top-level managers must set a good tone at the top, and they must endeavor to maintain a good internal MCSs so that potential violators know there is a high probability they will be caught. There are no universal best control systems that apply to every situation in all organizations. Figuring out the relevant aspects of the situational context and their effects on MCS elements is difficult because:
16.1 Environmental uncertainty Environmental uncertainty refers to the broad set of factors that, individually and collectively, make it difficult or impossible to predict the future in a given area. It can stem from changes in natural conditions, the political and economic climate, or the actions of competitors, customers, suppliers, and regulators. It has some powerful effects on MCSs: it makes action controls difficult to use: These controls are effective only if there is knowledge as to which actions are desirable and if those actions are consistently desirable. Results controls can be used even in highly uncertain settings, as employees can be rewarded for generating more of what is known to be desirable. Also difficulties for results control:
16.2 Organizational strategy Two levels of strategy:
Determines what businesses it wants to be in and how resources should be allocated among those businesses. Viewing them from related to unrelated diversification:
Defines how a firm or entity within the firm chooses to compete in its industry and tries to achieve a competitive advantage relative to its competitors. Two primary competitive strategies:
Competitive strategy should be directly related to the results measures included in a results control system. Cost leadership: control employees' behaviors through relatively tight, formal financial controls and standardized operating procedures. Differentiation: a more informal control system, a participative decision-making environment, and they should reward employees and managers based on any of a number of forward-looking, nonfinancial performance indicators. 16.3 Multinationality Multinational organizations (MNOs) operate in more than one country. They must understand how they must adapt their management practices to make them work in each of their international locations. Problem with MNOs: they are organized not only by function and product line, but also by geography. Three sets of factors that affect MCS choices or outcomes across countries in a systematic manner: The collective programming of the mind that distinguishes the members of one group or society from another. People's tastes, norms, values, social attitudes, religions, personal priorities and responses to interpersonal stimuli differ across nations. Hofstede four cultural dimensions:
Social, government, and legal institutions vary significantly across nations. Accounting regulations differ dramatically across countries.
Business environments also differ significantly across countries. Elements of these environments can affect:
Local managers bear foreign currency translation risk if their performance is measured home-country currency. Can subsidiary managers control this risk?
If the managers of their foreign entities should not bear the foreign exchange risk:
17.1 Differences between for-profit and nonprofit organizations Purpose of a nonprofit organization: to provide some kind of public service. They have to generate revenues to fund their operations. 17.2 Goal ambiguity and conflict MCSs should be designed to enhance the probability that the organization's goal will be achieved, and assessments about MCS effectiveness should be predicated upon judgments of the likelihood goal achievement. No goal clarity in many nonprofit organizations: their values and interests conflict. Without clarity it is difficult to judge how well the MCS is performing. 17.3 Difficulty in measuring performance The degree of achievement of the organization's overall goals cannot be measured in financial terms. 17.4 Accounting differences Nonprofit organizations use other accounting standards than profit organizations. Most nonprofit organizations use fund accounting: it separates resources restricted for different purposes from each other. Each fund has its own set of financial statements. 17.5 External scrunity Nonprofit organizations have to answer to a number of external constituencies. 17.6 Legal constraints Many nonprofit organizations face legal constraints that are more extensive than those faced by for-profit organizations. Specific laws and conditions attached to the revenues they raise and also disclosures, regulatory oversight, and legislation regarding the compensation of their executives and employees. 17.7 Employee characteristics The size of the compensation packages of employees in nonprofit organizations are not competitive with those offered at for-profit organizations: can cause control problems if employee quality is diminished. Many non-profit organizations tend to attract employees who are highly committed to their organization's goals. This minimizes the other control problems: lack of direction and lack of motivation. |