Table of Contents
• The Nature of Management Control Systems
Responsibility Centers: Revenue and Expense Centers
Analyzing Financial Performance Reports
Controls for Differentiated Strategies
The Nature of Management Control Systems
1. Elements of management control systems: strategic planning, budgeting, resource allocation, performance measurement, evaluation and reward, responsibility center allocation and transfer pricing.
2. Control – devices must be in place to ensure that their strategic intentions are achieved.
Elements of control system:
- Detector – the measurement of actual
- Assessor – comparison with standard
- Effector – behavior alteration, if needed
- Communications network
3. Management: • An organization consists of a group of people who work together to achieve certain common goals.
• The management control process is the process by which managers at all levels ensure that the people they supervise implement their intended strategies.
4. System – is a prescribed and usually repetitious way of carrying out an activity or a set of activities.
5. Management control – is the process by which managers influence other members of the organization to implement the organization’s strategies. Management control activities:
Management control is facilitated by a formal system that includes a recurring cycle of activities.
6. Goal congruence: • The goals of an organization’s individual members should be consistent with the goals of the organization itself. Management control system should be designed and operated with the principle of goal congruence in mind.
7. Strategy formulation – is the process of deciding on the goals of the organization and the strategies for attaining these goals.
8. Task control: the process of ensuring that specified tasks are carried out effectively and efficiently;
- performance of individual tasks according to rules established in the management control process.
- focus on many management science and operations research techniques.
9. Management control system – the system used by management to control the activities of an organization.
2. Maximizing shareholder value – market price of the corporation’s stock
4. Multiple stakeholder approach – capital market (firm raises fund); product market (customers); factor market (employees and suppliers)
5. Corporate strategy: • Concerned with the question of where to compete than with how to compete in a particular industry (business unit strategy)
Corporatewide strategic analysis results in decisions: businesses to add, to retain, to emphasize, to deemphasize, to divest
What set of businesses should the firm be in? Options:
- single industry
- related diversification
- unrelated diversification
• Core competency – is an intellectual asset in which a firm excels.
6. Business unit strategies: • Strategy depends on 2 interrelated aspects: i. its mission (“what are its overall objectives?”) – generic business unit missions:
build, hold and harvest
ii. competitive advantage (“how should the business unit compete in its industry to accomplish its mission?”) – generic advantages: low cost and differentiation
• Three tools in developing business unit strategies:
i. portfolio matrices – market attractiveness and market share
ii. industry analysis 1. systematically assess the opportunities and threats in the external marketplace;
2. analyzing 5 competitive forces – competitors, buyers, suppliers, substitutes
and new entrants iii. value chain analysis 1. linked set of value-creating activities to produce a product from basic raw material sources to end-use product into the final customer’s hands.
2. Useful tool in developing competitive advantage based on low cost, differentiation or cost-cum-differentiation.
Responsibility Centers: Revenue and Expense Centers
1. Responsibility Center is an organization unit that is headed by a manager who is responsible for its activities.
• Nature of responsibility centers
i. Exists to accomplish one or more purposes/objectives
ii. Objectives of the responsibility centers are to help implement company’s strategies to achieve company’s goals • Relation between inputs and outputs i. Management is responsible for ensuring the optimum relationship between inputs and outputs.
ii. Control focuses on using the minimum input necessary to produce the required output according to correct specifications and quality standards, at the time requested and in the quantities desired.
iii. Advertising – inputs are not directly related to outputs
iv. R & D – relationship between inputs and outputs is even more ambiguous • Measuring inputs and outputs i. Cost is a monetary measure of the amount of resources used by a responsibility center.
ii. Inputs are resources used by the responsibility center.
iii. It is not easy to calculate the value of outputs – use of an approximation, or surrogate numbers. • Efficiency and effectiveness: 2 criteria of judging responsibility center’s performance i. Efficiency is the ratio of outputs to inputs, or the amount of output per unit of input. 1. Efficient: if a center uses fewer resources but produces the same output
2. Uses the same amount of resources but produces a greater amount.
3. Efficiency is measured by comparing actual costs with standard costs ii. Effectiveness is determined by the relationship between a responsibility center’s
output and its objectives. 1. The more this output contributes to the objectives, the more effective the unit.
2. Effectiveness tends to be expressed in subjective, nonanalytical terms iii. An organization ought to be meeting its goals in an optimum manner.
iv. Responsibility center is efficient if it does things right, and it is effective if it does the right things.
v. Profit measures both effectiveness and efficiency. • Types of responsibility centers i. Revenue centers – output is measured ii. Expense centers – input is measured
iii. Profit centers – input and output are measured
iv. Investment centers – relationship between profit and investment is measured.
2. Revenue Centers • Marketing/sales function
• Do not have authority to set selling prices and are not charged for the COGS they market
• Actual sales are measured against budgets or quotas
• Manager is held responsible for the expenses incurred directly incurred within the unit, but the primary measurement is revenue.
3. Expense Centers • Engineered expense centers: engineered costs – right or proper amount can be estimated with reasonable reliability; e.g. direct labor, direct material, supplies, utilities
i. Manufacturing operations
ii. Input measured in monetary terms; output in physical terms; optimum dollar of input required to produce one unit of output can be determined.
iii. Administrative and support departments – AR, AP and payroll sections; personnel records and cafeteria – HR; shareholder records – repetitive tasks for which standard costs can be developed.
Controls: Manufacturing costs are not minimized at the expense of quality;
training and employee development; Cost competitive by setting a standard and measuring actual costs against this standard. • Discretionary expense centers: discretionary costs/managed costs – no such engineered estimate is feasible; i. Accounting, legal, industrial relations, public relations, human resources and most
ii. The difference between budget and actual expense is not a measure of efficiency rather it is just the difference between the budgeted input and the actual input. • General Control Characteristics i. Budget Preparation – management formulates the budget for discretionary expense center by determining the magnitude of the job that needs to be done. 1. Two types of work: Continuing work and Special
2. Technique: management by objectives (MBO) – a formal process in which a
budgetee proposes to accomplish specific jobs and suggests the measurement to be used in performance evaluation. ii. Incremental budgeting
iii. Zero-base review
iv. Cost variability 1. Discretionary expense centers – Management tend to approve changes that correspond to anticipated changes in sales volume
2. Annual budgets for these centers tend to be a constant percentage of budgeted sales volume. v. Type of financial control 1. Discretionary expense budget is to control costs by allowing the manager to participate in the planning
Discretionary expense centers: Financial control is primarily exercised at the planning stage before the costs are incurred. vi. Measurement of performance 1. Discretionary: Financial performance report Is not a means of evaluating the efficiency of the manager.
2. Total control is achieved primarily through nonfinancial performance
measures. (e.g. quality of service – through the opinion of their users.)
4. Administrative and Support Centers • Control problems: i. Difficulty in measuring output
ii. Lack of goal congruence – pursue goals without regard to the whole welfare of the company. • Budget preparation
5. Research and Development Centers
• The research program is determined not by calculating the total amount of approved projects, but rather by dividing the ‘research pie’ into what seem to be the most worthwhile slices. • Annual budgets – calendarization of the expected expenses for the budget period.
i. Budget process ensures actual costs will not exceed budgeted amounts without management’s knowledge.
ii. Variances from the budget should be approved by management before they are
incurred.• Measurement of performance i. Assist managers in planning their expenses and assure that those expenses are remaining at approved levels.
ii. 2 types of financial reports 1. Forecast of Total cost vis-à-vis approved amount for each active project
2. Comparison between budgeted expenses and actual expenses in each responsibility center • Neither type of financial report informs management as to the effectiveness of the research effort – progress reports or face-to-face discussion.
6. Marketing Centers • Logistics Activities – engineered expenses
i. Moving goods from the company to its customers and collecting the amounts due from customers in return.
ii. Transportation to distribution centers, warehousing, shipping and delivery, billing and related credit function, collection of receivable. • Generation of revenue: Compare actual revenue and physical quantities sold with budgeted revenue and budgeted units, respectively.
• Marketing Activities – discretionary expenses; optimum amounts cannot be determined i. Test marketing: establishment, training and supervision of sales force; advertising; Sales promotions
ii. Meeting the budgetary commitment – not a major criterion in evaluation process
iii. Sales target – not the expense target – is the critical factor
iv. Control techniques: correlation between sales volume and sales promotion and advertising – cannot use flexible budgets but percentage of sales – budgeted marketing expenses; the higher the sales volume, the more the company can afford to spend on advertising
1. General Considerations • Advantages 1. Business units – to delegate more authority to operating managers
2. Expense/revenue trade-offs – increase expenses with the expectation of an even greater increase in sales revenue ii. Quality of decision
iii. Speed of operating decisions
iv. Relieved of day-to-day decision making
v. Freer to use imagination and initiative
vi. Training ground for managers
vii. Profit consciousness
viii. Ready-made info for individual unit’s profitability
ix. More responsive to pressures to improve competitive performance • Difficulties i. Loss of control of top management
ii. Quality of decisions may be reduced
iii. Friction – transfer pricing, assignment of common costs, credit for jointly generating
v. Additional costs of divisionalization
vi. Competent general managers may not exist
vii. Too much emphasis on short-run profitability rather than on long-run profitability;
skimp on R&D, training programs or maintenance.
viii. Will not ensure optimizing the business unit’s profitability will optimize the profits of the company as a whole
2. Business Units as Profit Centers • Constraints on business unit authority
i. Corporate control over new investments
ii. “Charter” that specifies the marketing and/or production activities that is permitted to undertake, and it must refrain from operating beyond its charter – even there’s profit opportunity
iii. Maintenance of proper corporate image – quality of products or on public relations activities
iv. Necessity for uniformity – conform to corporate accounting and management
control systems Expensive redundancy, maintenance costs and productivity inefficiencies –
reasons for administrative and support centers at the corporate level. • Constraints do not cause severe problems so long they are dealt with explicitly
• Major problems revolve around corporate service activities – business units can obtain such services at less expense from outside source.
3. Other Profit centersManagement decision whether a business unit is a profit center or not – based on the amount of influence (even if not total control) the unit manager exercises over
the activities that affect the bottom line.• Marketing – a profit center
i. When the marketing manager is in the best position to make the principal cost/revenue trade-offs.
ii. Use of transfer pricing based on standard cost provide marketing manager with relevant information to make the optimum revenue/cost trade-offs.
• Manufacturing – usually an expense center
When performance is measured against standard costs, it is advisable to make separate evaluation as to quality control, production scheduling, and make-or-
buy decisions. • Service and support units i. Units for maintenance, IT, transportation, engineering, consulting, customer service and similar support activities can be profit centers
ii. May operate out of headquarters, service corporate divisions, or within business units.
4. Measuring Profitability • 2 kinds of Measurement:
i. Measure of management performance – how well the manager is doing; used for planning, coordinating and controlling the day-to-day activities.
ii. Measure of economic performance – how well the profit center is doing as an economic entity. • Types of Profitability Measures i. Contribution margin – fixed expenses are beyond manager’s control; problem: senior management wants profit center to keep discretionary expenses in line with amount agreed on in the approved budget
ii. Direct profit – incorporate all expenses – controllable or uncontrollable; doesn’t include headquarters OH
iii. Controllable profit – includes headquarters OH which are controllable – such as IT that can be influenced by profit center manager; Disadvantage: excludes noncontrollable headquarters OH – not comparable with published data
iv. EBIT – with allocated corporate OH; 1. arguments against: finance, accounting and HRM are not controllable;
arbitrariness of allocation
2. arguments for: a. Allocating COH increases likelihood for profit center managers to question increases of costs – thus serving to keep head office spending in check
b. Performance of profit center more realistic and comparable with competitors
c. Since profit is affected by all costs – managers are motivated to
make optimum long-term marketing decisions as to pricing, product mix, ultimately to the benefit of the company 3. Allocated costs charged to profit center should be calculated on the basis of the budgeted not actual costs – no variance in profit centers; variance
would appear in the reports of the responsibility center that actually incurred these costs – to respond to the concerns of arbitrariness and lack of control over OH v. Net income 1. Profit centers may influence income taxes through installment credit policies, disposal/acquisition of equipment
2. Not only to measure economic profitability but to motivate managers to minimize tax liability
1. Objectives of Transfer pricing – it should:
• provide relevant information it needs to determine the optimum trade-off between company costs and revenues
• induce goal congruent decisions – the system should be designed so that decisions that improve business unit profits will also improve company profits.
• Help measure the economic performance of the individual business units.
• Be simple to understand and easy to administer.
2. Fundamental Principle: • Transfer price should be similar to the price that would be charged if the product were sold to outside customers or purchased from outside vendors.
• Sourcing decision: should the company produce the product inside the company or purchase it from an outside vendor?
• Transfer price decision: if produced inside, at what price should the product be transferred between profit centers?
3. The ideal situation: A market price-based transfer price will induce goal congruence if all of the following conditions exist:
• Competent people – managers should be interested in the long-run as well as the short-run performance of their responsibility centers.
• Good atmosphere – managers should perceive transfer prices are just.
• A market price – market price adjusted downward to reflect savings accruing to the selling unit from dealing inside the company
• Freedom to source – alternatives for sourcing should exist and managers be permitted to choose the alternative that is in their own best interests; market price represents the opportunity costs to the seller of selling the product inside. The transfer price represents the opportunity costs to the company.
• Full information – managers must know about available alternatives and the relevant costs and revenues of each.
• Negotiation – there must be a smoothly working mechanism for negotiating “contracts”
between business units.
4. Constraints on sourcing: freedom to source might not be feasible or if feasible, might be constrained by corporate policy.
• Limited markets
i. Existence of internal capacity might limit the development of external sales.
ii. A company is a sole producer of a differentiated product, no outside source exists.
iii. Fixed costs – it is unlikely to use outside sources unless the outside selling price
approaches the company’s variable cost
iv. Competitive price measures how well a profit center may be performing against competitors: the difference between competitive price and inside cost is the money saved by producing rather than buying.
v. Competitive prices established: 1. Published market prices
2. Market prices may be set by bids.
3. For production profit center: On the basis of outside price – 10% percent to the standard cost of product
4. Buying profit center: competitive prices for its proprietary products. • Excess or shortage of industry capacity i. Arbitration committee – a buying profit center appeal to the selling profit center’s decision to sell outside; a selling profit center appealing to the buying profit center’s decision to buy a product outside when capacity was available inside.
ii. Senior management do not intervene on the theory that the benefits of keeping the
profit centers independent offset the loss from sub-optimizing company profits.
iii. Management should be aware of strong political overtones that sometimes occur in transfer price negotiations. – outside sources provide better service; internal rivalry exists in divisionalized companies.
iv. Market price is the best transfer price. Next option: develop cost-based transfer prices – eliminate advertising, financing, or other expenses that seller doesn’t not incur in internal transactions.
5. Cost-based transfer prices: • How to define cost?
i. Usual basis is standard costs – actual costs should not be used because inefficiencies will be passed on the buying profit center; set tight standards and improve
standards • How to calculate the profit markup? i. What is the basis? 1. Percentage of costs
2. Percentage of investments – problem: increase costs because old assets are undervalued?
ii. The level of profit allowed? – the allowance should approximate rate of return to be
earned if business unit is selling to outside customers.
6. Upstream fixed costs and profits • Agreement among business units
• Two-step pricing i. Standard variable cost of production
ii. Monthly charge equal to the fixed costs associated with the facilities reserved for the buying unit.
iii. Transfer variable cost on a per-unit basis and fixed cost and profit on a lump sum
basis. • Profit sharing o Transferred to marketing at standard variable cost
o After the product is sold, business units share the contribution earned (Selling price
– manufacturing and marketing costs)
o Problems: • Arguments over the way CM is divided between two profit centers.
• Arbitrarily dividing up the profits between units does not give valid information on the • profitability of each unit.
• Manufacturing’s contribution depends on marketing unit’s ability to sell as well as the actual selling price. Manufacturing may perceive this situation unfair. • Two sets of prices o Manufacturing revenue is credited as outside sales; buying unit is charged at the total standard costs
o Problems: • Sum of business profits greater than the company’s profits.
• Misleading for approving budgets and evaluating performance against these budgets.
• Illusive feeling of making money but in reality might be losing money
• Business units to concentrate more on internal transfers
• Additional bookkeeping involved; first entry and eliminating the difference during consolidation
• May not alert senior management of conflicts on organizational structure or other management systems signaled by conflicts over transfer prices
7. Pricing corporate services • Conditions for transfers:
i. Central services that the receiving unit must accept but can at least partially control the amount used.
ii. Business unit can decide whether or not to use • Costing: i. Standard costs
ii. Full costs
iii. Market price/standard full cost plus profit margin/return on investment
8. Administration of transfer prices • Negotiation: Business units negotiate transfer prices with each other. Why?
i. If headquarters control pricing, line management’s ability to affect profitability is reduced.
ii. Business managers may argue that their low profits are due to the arbitrariness of the transfer prices
iii. Business units usually have the best information on markets and costs, are able to arrive at reasonable prices. • Arbitration and conflict resolution i. Financial vice president or executive vice president ii. Set up a committee 1. Settle transfer price disputes
2. Review sourcing changes
3. Changing the transfer price rules when appropriate. • Product classification 1. Class I – products which senior management want to control sourcing;
include large-volume products; for quality or secrecy reasons
2. Class II – all other products; transferred at market prices; relatively small volume, produced with general-purpose equipment.
MEASURING AND CONTROLLING ASSETS EMPLOYED
1. Structure of the Analysis • Two performance objectives of business unit managers
i. Generate adequate profits from the resources at their disposal.
ii. Invest in additional resources only when the investment will produce an adequate return. • ROI i. Is a ratio.
ii. Investment base = total assets less current liabilities • EVA i. Dollar amount rather than a ratio.
ii. NOPAT (net operating profit)– capital charge
2. Measuring assets employed • What practices will induce business unit managers to use their assets more efficiently and to acquire the proper amount and kind of new assets?
• What practices best measure the performance of the unit as an economic entity?
• Cash – some companies omit cash from investment base; it approximates current liabilities
• AR : i. Manager influence level of AR indirectly through sales, directly by establishing credit terms, approving credit accounts and credit limits, and collecting overdue amounts.
ii. at book value (Selling price – ADA) • Inventories: i. standard or average costs; advance payments/progress payments – subtracted from gross inventory or reported as liabilities
ii. managers can influence the payment period allowed by vendors; including to seek
iii. managers might forego cash discount for additional financing provided by vendors (to reduce net current assets) but delaying payments may unduly hurt the credit rating of the company • working capital i. overstates investment base – motivational standpoint if business units cannot influence AP or other current liabilities.
ii. Net of current liabilities – good measure but it imply managers are responsible for
current liabilities over which they have no control. • PPE: i. Business units that have old, almost fully depreciated assets will tend to report larger economic value added than units that have newer assets.
ii. At Net book value – MISSTATED profitability, but most popularly used. iii. Gross book value – understates the true return
iv. Disposition of assets – if assets are included at original cost, manager is motivated
to get rid of them – even if they have some usefulness – it would reduce the investment base by the full cost of the asset
v. Annuity depreciation – show the correct EVA and ROI; opposite of accelerated
depreciation in that the annual depreciation is low in the early years when the investment values are high and increases each year as the investment decreases • Leased Assets – interest charge of leasing is less than the capital charge that is applied to investment base.
• Idle assets
• Intangible assets
• Noncurrent liabilities
• The capital charge
3. EVA versus ROI • Advantages of ROI:
i. Comprehensive ratio – anything that affects FS is reflected in the ratio
ii. Simple to calculate, easy to understand, meaningful in absolute sense
iii. May be applied to any unit regardless of size or type of business
iv. Available data for competitors and can be sued as basis for comparison • EVA over ROI i. With EVA all business units would have the same profit objective for comparable investments 1. A business unit may forego an investment whose ROI is below a certain percentage but above the cost of capital. ii. Decisions that increase a center’s ROI may decrease its overall profits 1. Dispose an asset below ROI but cost of capital is below that amount, would decrease the absolute dollar profit for the center. iii. Different interest rates may be used for different types of assets 1. Different rates take on the different risks of assets iv. Has stronger positive correlation with changes in company’s market value 1. The best proxy for shareholder value is to create or increase EVA
EVA = NOPAT – capital charge; or, EVA = capital employed
(ROI-Cost of capital) • Increases of EVA: o Increase ROI through process reengineering and productivity gains without increasing the investment base
o Divestment of assets, product whose ROI is less than the cost of capital
o Aggressive new investments whose ROI exceeds cost of capital
o Increase in sales, profit margins, or decrease in cost of capital without affecting the
other variables in equation 2
4. Additional considerations in evaluating managers
5. Evaluating the economic performance of the entity
1. Nature of a Budget • Relation to strategic Planning
• Contrast with Forecasting
• Use of a budget
• Content of an operating budget
• Operating budget categories
2. Other Budgets • Capital budget
• Budgeted balance sheet
• Budgeted cash flow statement
• Management by objectives
3. Budget Preparation Process • Organization
• Issuance of guidelines
• Initial budget proposal
• Changes in external forces
• Changes in internal policies and practices
• Review and approval
• Budget revisions
• Contingency budgets
4. Behavioral aspects • Participation in the budgetary process
• Degree of budget target difficulty
• Senior management involvement
• The budget department
5. Quantitative techniques • Simulation
• Probability estimates
Analyzing Financial Performance Reports
• Galvor Company
1. Calculating variances • Results from variance computations are more “actionable” if changes in actual results are analyzed against each of these expectations.
• Analytical framework: i. Identify the key causal factors that affect profits
ii. Break down the overall profit variances
iii. Focus on the profit impact of variation
iv. “spinning one dial at a time”
v. Add complexity sequentially – “peel the onion”
vi. Stop the process when the added complexity is not justified… • Types of variances: i. Revenue variances 1. Selling price variance
2. Mix and volume variance – if the business unit has a richer mix (higher proportion of products with higher CM), the actual profit will be higher than budgeted; leaner mix, the profit will be lower.
3. Mix variance
4. Volume variance
5. Other revenue analyses
6. Market penetration and industry volume ii. Expense variances 1. Fixed costs
2. Variable costs a. Spending variance – spending in excess of the adjusted budget b. Volume used is the manufacturing volume not the sales volume • Summary of variances
2. Variations in Practice • Time period of the Comparison
• Focus on Gross Margin i. Unit gross margin is the difference between selling prices and manufacturing costs • Evaluation Standards i. Predetermined standards or budgets 1. Excellent if carefully prepared and coordinated
2. Haphazard manner – not provide a reliable basis for comparison ii. Historical standards 1. Records of past actual performance
2. Weaknesses: a. Conditions may change and invalidates comparison
b. Prior period’s performance may not have been acceptable 3. Often used because predetermined standards are not available iii. External standards 1. Standards derived from the performance of other responsibility centers or of other companies in the same industry
2. Benchmarking – identify the company – best managed in the industry and use numbers to benchmark iv. Limitations on standards: 1. The standard not properly set
2. Although set properly, changed conditions make the standard obsolete v. Examination of the validity of the standard is necessary • Full-Cost Systems i. Both variable and fixed overhead costs are included in the inventory at the standard
cost per unit
ii. Assumed that the inventory level did not change
iii. If the company has variable-cost system, fixed production costs are not included in inventory – there is no production volume variance • Amount of Detail i. Additional sales and marketing variances: sales territories, sales to individual countries, etc.
ii. Additional detail for manufacturing: wage rates, material prices
iii. The problem is to decide how much is worthwhile; in part, the answer depends on the information requested by individual managers • Engineered and Discretionary Costs
3. Limitations of Variance Analysis • It does not tell why the variance occurred or what is being done about it.
• To decide whether a variance is significant. i. Statistical quality control – used to determine whether there is a significant difference between actual and standard performance.
ii. Conceptually, a variance should be investigated only when the benefit expected from correcting the problem exceeds the cost of the investigation
iii. Significant but uncontrollable – no point to investigate
iv. Rely on judgment in deciding what variances are significant • Offsetting variances might mislead the reader i. When different product lines at different stages of development are combined –
obscure the actual results of each product line
ii. Good performance of one plant being offset by poor performance at another • Managers become more dependent on the accompanying explanations and forecasts
• Do not show the future effects of actions that the manager has taken i. Reducing amount for employee training vis-à-vis current profitability – may have adverse consequences in the future
4. Management Action • The monthly profit report should contain no major surprises
• One of the most important benefits of formal reporting is that it provides the desirable pressure on subordinate managers to take corrective actions on their own initiative
• The numbers in the formal report provide more accurate information – basis for analysis than informal sources – general and imprecise
• Profit reports are worthless unless they lead to action.
• Enager Industries
1. Performance Measurement Systems • The goal of performance measurement systems is to implement strategy.
• A performance measurement system is a mechanism that improves the likelihood the organization will implement its strategy successfully.
2. Limitations of Financial Control Systems • Goal of enterprise is to optimize shareholder returns
• Optimizing short-term profitability does not necessarily ensure optimum shareholder returns.
• Relying solely on financial measures is inadequate and can, in fact, be dysfunctional for several reasons: i. Financial measures may encourage short-term actions that are not in the company’s long-term interests. 1. The more pressure to meet current profit levels, the more likely the
business unit manager will be to take short-term actions that may be wrong in the long run.
2. Inferior-quality products delivered to customers to meet sales targets.
3. Errors of commission ii. Business unit managers may not undertake useful long-term actions to obtain short- term profits. 1. Managers may not make investments that promise long-term benefits
because they hurt short-term financial results.
2. Inadequate investment in R&D; may not propose risky investments – cash flow uncertainty reduces the probability of meeting short-term financial targets;
3. Managers may propose “safe” investments instead of high-risk projects that may produce high returns.
4. Errors of omission iii. Using short-term profit as the sole objective can distort communication between a business unit manager and senior management. 1. Business unit managers may try to set profit targets they can easily meet,
overall budgeted profit may be lower than the amount that could really be achieved.
2. Reluctant to admit they will miss the profit budget which delays corrective action.
iv. Tight financial control may motivate managers to manipulate data.
Relying on financial measures alone is insufficient to ensure strategy will be executed successfully. The solution is to measure and evaluate business unit managers using multiple measures, non-financial (key success factors or key performance indicators) as well as financial.
• Financial measures – indicate the results of past decisions
• Non-financial measures – leading indicators of future performance
3. The Balance Scorecard • An example of a performance measurement system
• Business units should be assigned goals and then measured from the following four perspectives: i. Financial
iii. Internal business
iv. Innovation and learning • Fosters a balance among different strategic measures in an effort to achieve goal congruence, thus encouraging employees to act in the organization’s best interest.
• A tool that helps the company’s focus, improves communication, sets organizational objectives and provides feedback on strategy.
• In creating balanced scorecard, mix of measurements that: i. Accurately reflect the critical factors that will determine the success of the company’s strategy
ii. Show the relationships among the individual measures in a cause-and-effect manner, indicating how nonfinancial measures affect long-term financial results;
iii. Provide a broad-based view of the current status of the company.
4. Additional considerations: PMS attempts to address the needs of the different stakeholders of the organization by creating a blend of strategic measures:
• Outcome and driver measures
i. Outcome indicate the result of the strategy – lagging indicators – tell management what has happened
ii. Driver – leading indicators, show the progress of key areas in implementing a strategy; e.g. cycle time; • Financial and nonfinancial measures i. During 1980’s industries were being driven by changes in nonfinancial areas, such as quality and customer satisfaction, that eventually impacted companies’ financial performance
ii. Even though they recognize importance of nonfinancial measures, failed to implement – nonfinancial measures tend to be much less sophisticated than financial measures and senior management is less adept at using them. • Internal and external measures i. Balance between external measures – customer satisfaction, and measures of internal business processes – manufacturing yields. • Measurements drive change i. Scorecard emphasizes the idea of cause-and-effect relationships among measures.
ii. Cause and effect relationship, understand how nonfinancial measures (e.g. product quality) drive financial measures (e.g. revenue)
iii. Scorecard must be linked together explicitly in a cause-effect way
iv. The better these relationships are understood – individuals more able to contribute directly and clearly to the success of the organization’s strategies.
5. Key Success Factors • Customer-focused key variables
iii. Market share
iv. Key account orders
v. Customer satisfaction
vi. Customer retention
vii. Customer loyalty • Key variables related to internal business processes i. Capacity utilization
ii. On-time delivery
iii. Inventory turnover
v. Cycle time
6. Implementing a performance measurement system • Define strategy.
i. Scoreboard links strategy and operational action.
ii. Functional departments within business unit should have their own scorecards, and the business-unit scorecard and the scorecards below that level be aligned.
iii. Corporatewide scorecard be developed to address synergies across business units. • Define measures of strategy. i. Focus on few critical measures
ii. Measures should be linked with each other in a cause-effect manner • Integrate measures in the management system. i. Scorecard should be integrated with the organization’s formal and informal
structures, culture and human resource practices. • Review measures and results frequently. i. How is the organization doing according to outcome measures? Driver measures?
Has organization’s strategy changed since the last review? Have the scorecard measures changed?
7. Difficulties in implementing performance measurement systems • Poor correlation between nonfinancial measures with results
i. No guarantee future profitability will follow target achievements in any nonfinancial area.
• Fixation on financial results
i. Long term, uncertain payback of the nonfinancial measures
• Measures are not updated
• Measurement overload
• Difficulty in establishing trade-offs
8. Measurement Practices • Types of measures
• Quality of measures
• Relationship of measures to compensation
9. Interactive control • The main objective is to facilitate the creation of a learning organization.
Controls for Differentiated Strategies
1. Cultural Differences • Culture – refers to shared values, assumptions and norms of behavior
• According to Hofstede, cultures differ across 4 dimensions: o Power distance – unequally distributed centralized • Low power distance – decentralization and greater budget preparation preferred
• High power distance – opposite is true (e.g. Philippines) o Individualism/collectivism – extent to which people define themselves as individuals or as part of a larger group Individualistic – prefer rewards based on individual performance
Collectivistic – group-based rewards o Uncertainty avoidance – extent to which people feel threatened by ambiguous situations
Low uncertainty avoidance – subjective performance evaluation is more effective
o Masculinity/femininity – extent to which dominant values emphasize assertiveness and materialism (masculine) versus concern for people and quality of life (feminine) • Hall, spectrum from “low-context cultures” to “high-context cultures” – people establish personal relationships before business o Low: formal planning and control systems will be better
o High: informal controls – building interpersonal familiarity and trust is essential
2. Transfer Pricing • Other considerations:
o Government Regulations
o Foreign Exchange Controls
o Funds Accumulation
o Joint Ventures
3. Exchange Rates