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Chapter Seventeen. Management Control and Strategic Performance Measurement. Learning Objectives. Identify the objectives of management control Identify the types of management control systems

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Management control and strategic performance measurement

Chapter Seventeen

Management Control andStrategic Performance Measurement


Learning Objectives

  • Identify the objectives of management control

  • Identify the types of management control systems

  • Define strategic performance measurement and show how centralized, decentralized, and team-oriented organizations can apply it

  • Explain the objectives and applications of strategic performance measurement in three common strategic business units (SBUs): cost SBUs, revenue SBUs, and profit SBUs


Learning objectives continued
Learning Objectives (continued)

  • Explain the role of the balanced scorecard (BSC) in strategic performance measurement

  • Explain the role of strategic performance measurement in service firms and not-for-profit organizations


Performance evaluation and control
Performance Evaluation and Control

  • Performance evaluation is the process by which managers at all levels gain information about the performance of tasks within the firm and judge that performance against preestablished criteria as set out in budgets, plans, and goals

    • Top management, middle management, and operating-level personnel should be evaluated

  • Management control refers to the evaluation by upper-level managers of the performance of mid-level managers


Performance evaluation and control continued
Performance Evaluation and Control (continued)

  • Operational control means the evaluation of operating-level employees by mid-level managers

  • Management control focuses on higher-level managers and long-term strategic issues (a broader objective), while operational control focuses on detailed short-term performance

  • Operational control is a management-by-exception approach while management control is more consistent with the management-by-objectives approach


Performance evaluation and control continued1
Performance Evaluation and Control (continued)

Chief Executive

Financial Management

Management Control

Operations Management

Marketing Management

Plant A

Plant B

Region A

Region B

Operational Control

Employee1

Employee2

Employee3

Employee 4


Management by objectives
Management-by-Objectives

  • In a management-by-objectives (MBO) approach, top management assigns a set of responsibilities to each mid-level manager depending on the functional area involved and the scope of authority of the mid-level manager

  • Areas of responsibility are often called strategic business units (SBUs)

  • An SBU consists of a well-defined set of controllable operating activities over which the SBU manager is responsible


Management control objectives
Management Control Objectives

  • Motivate managers to exert a high level of effort to achieve the goals set by top management

  • Provide the right incentive for managers to make decisions consistent with the goals set by top management (that is, to align managers’ efforts with the desired strategic goals)

  • Determine fairly the rewards earned by managers for their efforts and skill and the effectiveness of their decision making


Achieving management control objectives
Achieving Management Control Objectives

  • A common mechanism for achieving these multiple objectives is to develop an employment contract between the manager and top management

  • A contract promotes goal congruence: the contract specifies the manager’s desired behaviors and the compensation to be awarded for achieving specific outcomes by using these behaviors

  • Contracts can be written or unwritten, explicit or implied


Employment contracts
Employment Contracts

  • An economic model, the principal-agent model, is a prototype that contains the key elements that a contract must have to achieve the desired objectives

  • There are two important aspects of management performance that affect the contracting relationship, uncertainty and lack of observability

    • Managers operate in an environment that is influenced by factors beyond the manager’s control; there is some degree of uncertainty


Employment contracts continued
Employment Contracts (continued)

  • Many efforts and decisions made by the manager are not observable to top management, and the manager often possesses information not accessible to top management

  • Because of uncertainty and the lack of observability, three principles should be followed in the preparation of an employment contract:

    • Separate the performance of the manager from the performance of the SBU


  • Employment contracts continued1
    Employment Contracts (continued)

    • Exclude known uncontrollable factors from the contract

    • Risk-adverse managers make decisions to avoid risk when top management might prefer choices that involve some risk. It is therefore necessary to separate the value of the outcome from the positive or negative weight associated with the risk due to uncertainty.

  • Management control systems should be designed to reduce the negative effects of risk preferences


  • The principal agent model

    External Factors

    Accounting

    Top Management

    PreparePerformanceReport

    Pays Manageron the

    Basis of thePerformance

    Report

    Uncertainty

    RiskAversion

    DecisionMaking

    Effort

    ReceivesPay

    The Principal-Agent Model

    Outcome of manager’s decision and effort

    Manager


    Designing management control systems
    Designing Management Control Systems

    There are four questions management must ask when developing a management control system:

    • Who is interested in evaluating the organization’s performance (owners, directors, creditors, employees, etc.)?

    • What is being evaluated (an individual, team, or SBU)?

    • When is the performance evaluation to be conducted, and should it be based on the master budget (resource inputs –ex ante) or the flexible budget (outputs of the manager’s effort–ex post)?

    • Should the system be formal or informal?


    Types of management control systems
    Types of Management Control Systems


    Strategic performance measurement
    Strategic Performance Measurement

    • Strategic performance measurement is a system used by top management to evaluate SBU managers

    • Before designing strategic performance measurement systems, top managers determine when delegation of responsibility is desirable

      • A firm is decentralized if it has chosen to delegate a significant amount of responsibility to SBU managers

      • A centralized firm reserves much of the decision-making at the top-management level


    Strategic performance measurement continued
    Strategic Performance Measurement (continued)

    • Centralized firms provide more control and the expertise of top management can be effectively utilized

    • Decentralized firms are able to make more timely decisions at the operational level; top management lacks the necessary local knowledge

    • Decentralized firms are often more motivating for employees, are an excellent environment for training future top-level managers, and are a better basis for performance evaluations


    Types of sbus
    Types of SBUs

    • Cost SBUs are a firm’s production or support departments that are charged with the responsibility of providing the best quality product or service at the lowest cost (examples: a plant’s assembly department, data-processing department, and its shipping and receiving department)

    • Revenue SBUs focus on the selling function and are defined either by product line or by geographic area

    • When an SBU both generates revenues and incurs the major portion of the cost for producing these revenues, it is considered a profit SBU

    • Investment SBUs include assets employed by the SBU as well as profits in the performance evaluation


    Types of sbus continued
    Types of SBUs (continued)

    The choice of a profit, cost, or revenue SBU depends on the nature of the production and selling environment in the firm:

    • Products that have little need for coordination between the manufacturing and selling functions are good candidates for cost and revenue SBUs

    • For products that require close coordination between these functions, profit SBUs would be the preferred option


    Cost sbus
    Cost SBUs

    • Direct manufacturing and manufacturing support departments are often evaluated as cost SBUs since these managers have significant direct control over costs but little control over revenues or decision-making for investment in facilities

    • Several strategic issues arise when implementing cost SBUs:

      • Cost shifting occurs when a department replaces its controllable costs with noncontrollable costs (e.g., variable costs to fixed costs)


    Cost sbus continued
    Cost SBUs (continued)

    • Many performance-measurement systems focus excessively on short-term cost figures, neglecting long-term strategic issues

    • The majority of SBUs have some amount of budgetary slack, which is the difference between budgeted and expected performance

    • Budgetary slack can be good as it reduces risk aversion, but too much slack can result in reduced employee effort and (as indicated in Chapter 8) can complicate the planning process



    Implementing cost sbus in general and administrative departments
    Implementing Cost SBUs in Support DepartmentsGeneral and Administrative Departments

    These departments have the same two methods to choose from, but the proper choice may change over time:

    • For example, if cost reduction is a key objective, the HR department might be treated as an engineered-cost SBU

    • Later, it might be changed to a discretionary-cost SBU to motivate managers to focus on the achievement of long-term goals


    Implementing cost sbus in general administrative departments

    Cost Support DepartmentsVariance

    250

    Implementing Cost SBUs in General & Administrative Departments

    TotalCost

    Engineered Cost

    4,800

    3,600

    2,400

    1,200

    Cost behavior in

    administrative

    support SBUs

    is often a

    step cost

    100 200 300 400

    CostDriver

    (number of applications)


    Cost sbu miscellaneous considerations for performance reporting
    Cost SBU—Miscellaneous Considerations for Performance Reporting

    • Many firms are choosing to outsource manufacturing, customer service, engineering, and other services

    • When using a cost SBU, how should the firm allocate the jointly incurred costs of service departments to the departments using the service?

      • An allocation method should be chosen based on its ability to motivate managers, encourage goal congruence, and provide a basis for fair evaluation of management’s performance


    Cost sbus implementation considerations continued
    Cost SBUs—Implementation Considerations (continued) Reporting

    • Dual allocation is a useful guide in choosing a cost allocation method

    • Dual allocation is a cost-allocation method that separates fixed and variable costs; variable costs are directly traced to user departments, and fixed costs are allocated on some logical basis

    • Indirect costs could be traced to cost SBUs using activity-based costing (ABC)


    Revenue sbus
    Revenue SBUs Reporting

    • Management commonly uses revenue drivers in evaluating the performance of revenue SBUs

    • Revenue drivers in manufacturing firms are the factors that affect sales volume, such as price changes, promotions, discounts, customer service, changes in product features, delivery dates, and other value-added factors

    • Revenue drivers in service firms focus on the quality of the service


    Marketing departments
    Marketing Departments Reporting

    Marketing departments can be either a revenue or a cost SBU:

    • The revenue SBU responsibility stems from the fact that the marketing department manages the revenue-generating process and produces revenue reports for evaluation

    • This department can also be a cost SBU as it incurs two types of costs, order-getting (advertising and promotion) and order-filling (warehousing, packing, and shipping) costs


    Profit sbus
    Profit SBUs Reporting

    • The profit manager’s goal is to earn profits

    • Three strategic issues cause firms to choose profit SBUs rather than cost or revenue SBUs:

      • Profit SBUs provide the incentive for the desired coordination among marketing, production, and support functions

      • Profit SBUs motivate managers to consider their product as market able to outside customers

      • Profit SBUs motivate managers to develop new ways to earn a profit from their products and services


    Cost leadership differentiation and sbus
    Cost Leadership, Differentiation, and SBUs Reporting

    Cost Leadership

    Sales

    Manufacturing

    Plant

    Warehouse

    Revenue SBU

    Cost SBU

    Sales

    Manufacturing

    Plant

    Differentiation

    Profit

    SBU

    Profit

    SBU


    Contribution income statement
    Contribution Income Statement Reporting

    • A common form of profit SBU evaluation tool is the contribution income statement, which is based on the contribution margin developed for each profit SBU and for each relevant group of profit SBUs

    • Detail of the statement varies based on management’s needs

    • Contribution by SBU (CSBU) measures all costs traceable to, and therefore controllable by, the individual SBU, including traceable fixed costs


    Controllable and noncontrollable fixed costs
    Controllable and Noncontrollable Fixed Costs Reporting

    Fixed costs can be either controllable or noncontrollable from the perspective of each profit SBU:

    • Controllable fixed costs are fixed costs that the profit SBU manager can influence in approximately a year or less, such as advertising, data processing, and management consulting expenses

    • Noncontrollable fixed costs are those that are not controllable within a year’s time, such as depreciation and taxes


    Profit sbu performance evaluation
    Profit SBU Performance Evaluation Reporting

    • Subtracting controllable fixed costs from the contribution margin results in the SBU’s controllable margin

    • The contribution margin income statement can also be used to help determine whether a profit SBU should be dropped or retained

    • One complication in the preparation of this statement is that some costs that are not traceable at a detailed level are traceable at a higher level


    Contribution income statement example
    Contribution Income ReportingStatement Example

    This statement shows

    the operating results for Machine Tools, Inc. (MTI) as a whole


    Contribution income statement example continued
    Contribution Income Statement ReportingExample (continued)

    This statement shows the operating results by division


    Contribution income statement example continued1
    Contribution Income Statement ReportingExample (continued)

    This statement shows the operating results by product

    for Division B


    Variable vs full costing
    Variable vs. Full Costing Reporting

    • The use of the contribution income statement is often called variable costing because it separates variable and fixed costs

    • Full costing is the conventional costing system that includes fixed manufacturing cost as part of “product cost”

    • Full costing, also called “absorption costing,” is required by GAAP for financial reporting and by the IRS for computing taxable income

    • Full costing satisfies the matching principle while variable costing meets the three objectives of management control systems


    Variable costing
    Variable Costing Reporting

    • There is an additional reason for using variable costing

      • Although net income determined using full costing is affected by changes in inventory levels, net income using variable costing is not affected

      • This is because under variable costing, fixed manufacturing costs are treated as period costs, not product (inventoriable) costs

    • The following example compares the two costing methods over two periods, one with increasing inventory and the other with decreasing inventory


    Variable vs full costing example
    Variable vs. Full Costing Example Reporting

    Inventory

    increased

    by 40

    Inventory

    decreased

    by 40

    $4000 ÷ 100 units = $40 fixed unit cost



    Variable vs full costing example continued1
    Variable vs. Full Costing Example (continued) Reporting

    Difference in Beginning Inventory$2,800 - $1,200 = $1,600

    Difference in Income$2,300 - $3,900 = $1,600


    Variable vs full costing summary analysis
    Variable vs. Full Costing Summary Analysis Reporting

    • Full (absorption) costing net income exceeds variable costing net income (by the amount of fixed cost in the inventory change) when inventory increases, and variable costing net income is higher than full-costing net income when inventory decreases

    • Variable costing is not affected by the change in inventory because all fixed costs are deducted from income in the period in which they occur; fixed costs are not included in inventory so that changes in inventory levels do not affect net income


    Strategic performance measurement and the balanced scorecard bsc
    Strategic Performance Measurement and the Balanced Scorecard (BSC)

    • The BSC measures SBU performance in four key perspectives:

      • Customer satisfaction

      • Financial performance

      • Internal business processes

      • Learning and innovation

    • Cost, revenue, and profit SBUs focus on the financial dimension


    The balanced scorecard bsc and performance evaluations
    The Balanced Scorecard (BSC) and Performance Evaluations (BSC)

    There are several implementation issues when using the BSC in performance evaluations:

    • Measures are difficult to compare across SBUs

    • Validation of the links between measures that are assumed to improve performance throughout the strategy map is required

    • Managers must provide information on the strategic linkages in the strategy map


    The bsc and performance evaluations continued
    The BSC and Performance Evaluations (continued) (BSC)

    • Many large firms have installed enterprise resource planning systems (ERPs) to collect BSC information, but firms lacking such a system may have trouble collecting the necessary data

    • The nonfinancial information used in the BSC is not subject to control or audit and may be unreliable or inaccurate

    • Nonfinancial information is often prepared on a weekly or daily basis while performance reviews are generally conducted quarterly or annually

    • Concern arises related to the timeliness and reliability of nonfinancial data prepared by external sources


    The strategy map
    The Strategy Map (BSC)

    The strategy map uses the BSC to describe the firm’s strategy in detail by using cause-and-effect diagrams

    Financial

    Goals:

    Earnings,

    sales, growth

    Goals:

    Customer satisfaction,

    better staff response

    to customer needs

    Customer

    Goals:

    Staff apply their

    competencies and

    strategic awareness

    Operations

    Goals:

    Staff competencies,

    strategy awareness

    Learning and

    Innovation


    Managements control in service firms and not for profit organizations
    Managements Control in Service Firms and Not-for-Profit Organizations

    • Service firms and not-for-profit organizations commonly use cost (most common) SBUs and profit SBUs

    • Cost SBUs are used when the manager’s critical mission is to control costs

    • Profit SBUs are preferred when the department manager must manage both costs and revenues, or alternatively (in a not-for-profit), manage costs without exceeding budgeted revenues


    Chapter Summary Organizations

    • There are formal, informal, team, and individual management control systems

    • The objectives of management control are to:

      • Motivate managers to exert a high level of effort to achieve the goals set by top management

      • Provide the right incentive for managers to make decisions consistent with the goals set by top management (i.e., to align managers’ efforts with the desired strategic goals)

      • Determine fairly the rewards earned by managers for their efforts and skill and the effectiveness of their decision making


    Chapter Summary (continued) Organizations

    • Strategic performance measurement is a system used by top management to evaluate SBU managers

    • Before designing strategic performance measurement systems, top managers determine when delegation of responsibility is desirable

      • A firm is decentralized if it has chosen to delegate a significant amount of responsibility to SBU managers

      • A centralized firm reserves much of the decision making at the top management level


    Chapter Summary (continued) Organizations

    • There are four types of SBUs:

      • Cost SBUs are a firm’s production or support SBUs that provide the best quality product or service at the lowest cost, such as a plant’s assembly department, data processing department, and shipping and receiving department

      • Revenue SBUs focus on the selling function and are defined either by product line or by geographic area

      • When an SBU both generates revenues and incurs the major portion of the cost for producing these revenues, it is a profitSBU

      • Investment SBUs include assets employed by the SBU as well as profits in the performance evaluation


    Chapter Summary (continued) Organizations

    • The BSC measures SBU performance in four key perspectives

      • Customer satisfaction

      • Financial performance

      • Internal business processes

      • Learning and innovation


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