Management (Control) Strategy and Performance. Phases of Management Control. MOS Management Control Systems. John Siambanopoulos

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1 Management (Control) Management: process of organizing resources and directing activities to achieve organizational goals Management Controls: Creating systems to influence behavior that is congruent, effective and efficient with the goals of the organization 2 Strategy and Performance What gets rewarded, really counts What counts, gets measured Strategy: What really counts? What gets done, gets rewarded What gets measured, gets done 3 Phases of Management Control 1. Strategic planning 2. Budgeting 3. Measurement and reporting 4. Evaluation At some point, owners of a new firm need help and will have to hire people as the size and complexity of the firm increases Without proper control systems in place, decentralization can lead to decisions and behaviour that are incongruent with the firm s objectives 4 5 1

2 Decentralization and Segment Reporting Effective decentralization requires segment reporting so that the profitability and performance of various segments can be evaluated Segmentation can be done by product line, geography, division, etc. Good Information Systems can aid in analysis Accounting Information and Control Two ways of classifying costs with relation to management control and responsibility accounting Controllable Costs Engineered, discretionary, or committed costs 6 7 Controllable Costs A costs that is significantly influenced by the responsibility centre 1. Refers to a specific responsibility centre 2. Controllability is significant (not just complete which is rare) Wages are set by the College and Faculty not each department Controllable Costs versus Direct costs: all controllable costs by definition are direct but not vice versa E.g. depreciation for the production department Variable costs: most are controllable but not always The source of inputs may be dictated 8 9 2

3 Hindrances to Proper Cost Assignment Omission of costs All costs attributable to that segment from the firm s entire value chain should be included Inappropriate methods for allocating costs among segments Failure to trace costs directly Inappropriate allocation base Arbitrarily dividing common costs among segments 10 Making Uncontrolled Costs, Controlled 1. Change the basis of the assignment Allow the item to be traced and therefore controlled e.g. electricity not part of overhead Allow the item to be measured and charged e.g. maintenance charge by the hour not part of an overhead rate 2. Decentralization Letting someone else make the decisions on the item (purchase of fixed assets, etc.) 11 Engineered, Discretionary & Committed Costs Engineered (similar to standard costs) The amount of a cost can be estimated reasonably Discretionary These are costs at literally at the discretion of the manager and can be added or cut easily Committed costs (sunk costs) Costs that are results of previous commitments and in the short run cannot be changed 12 Responsibility vs. Full Cost Accounting Difference? 13 3

4 Responsibility Accounting 1. Inputs and outputs that managers can actually control 2. Ensures someone is responsible for those inputs and outputs Information is structured to track true responsibility What measurement/standard do you use to test if people are doing a good or bad job? Many different ways to motivate but realize: Managers pay close attention to those aspects of their job that are measured and evaluated Types of Responsibility Centres Revenue: accountable for the OUTPUTS of the centre measured in monetary terms Have some control over how they sell, pricing, sales mix & selling expenses (not necessarily cost of goods) E.g.? Types of Responsibility Centres Expense: accountable to the costs incurred (NOT the outputs) Outputs either can t be measured or not needed E.g.? Legal, payroll, printing etc

5 Types of Responsibility Centres Profit: accountable for both (remember that outputs don t have to be sold to only outside customers) Creates a small business mindset E.g.? Bookstore, Cafeteria Criteria for Profit Centres 1. Must be able to perform extra bookkeeping (outputs and inputs must be measured in revenue terms, probably $) 2. Must have some control over quantity and quality of output 3. The service or good offered by the centre has a price and cost 4. Outputs are fairly homogeneous 5. The spirit of competition is good for the centre Investment Centre Problems with Investment Centres Responsibility centre in which the manager is held responsible for profit but also the use of assets Therefore they have control over purchase and disposal of assets This is like owning a free-standing company EVA, RONA, ROI and residual income Evaluation of performance Different sizes of centres and comparison Valuation of fixed assets (types of assets can have different valuations) Allocation and use of cash from headquarters

6 Financial Measures Return on Investment Variance analysis Profitability (if profit/investment centre) Transfer pricing ROI/EVA 23 Remember that a firm invests in assets in order to generate income Net operating income Average operating assets Net operating income Income before interest and taxes (EBIT) Average operating assets Includes cash, accounts receivable, inventory and plant and equipment 24 Shortcomings of Return on Investment Non-financial goals are not included and could be ignored An increase in ROI could actually be inconsistent with the firm s strategy or be harmful in the long run New managers inherit many committed costs that are often out of their control ROI may cause managers to reject good investment opportunities 25 Transfer Pricing The measure of a good or service furnished by profit centre to other responsibility centres Therefore, revenue is created for one area and a cost is created for another What are the potential problems here? Key goal of the transfer price is to motivate the managers to act in the best interest of the overall firm. 26 6

7 Three Methods of Transfer Other Issues Negotiation and arbitration Depends greatly on ability to go outside the firm ( sourcing freedom ) Risk of sub optimization Risk of increasing the profit centre s reported income but not the TOTAL company s income Ranges of Acceptable Transfer Prices Seller: Price VC + any contribution on lost or potential sales Buyer: Price Price of outside supplier Other Considerations: Idle capacity (vs. none) Customer commitments vs. flexibility Availability of outside suppliers Two Philosophies on Incentive Fixed Pay Recruit good people Pay them well Expect good performance Performance-based pay Recruit good people Expect good performance Pay them well IF performance is actually good

8 Agency Theory Describes the contract between a principal and an agent (acting on the principals behalf) CEO acting on behalf of a Board of Directors Assumes that all individuals act in their own self-interest How do you ensure goal congruence between an agent and organisation? Incentive and Compensation Systems Intrinsic vs. Extrinsic Money vs. stock vs. something else Tying rewards to performance Keep in mind that all performance is compared to some kind of set goal: Budgets Should Rewards = Performance? Based on financial performance Based on nonfinancial measures of performance Based on group or individual performance Money Rewards Performance-based salary increases Short-term incentive rewards Bonuses, formula awards, profit-sharing Long-term incentive rewards Options, stock appreciation rights (SARs)

9 Evaluating Reward Systems Valued benefit (valence) Impact: Does the value have an impact on motivation? Understandable Timely Is performance being measured accurately? Difficulties Fixation on financial results Poor timing of results Poor correlation between nonfinancial measures and results Creative accounting (loopholes etc.)