Most of the business owners I work with already control their business. They just do not call it that, and they cannot show you where it happens. It lives in their head, in a notebook, in the fact that nobody orders stock without asking them first. That works at one branch. It stops working at three.
Management control is the boring name for the thing that replaces you standing there. It is how you know, without being in the room, whether the people running your business are actually doing what you agreed they would do.
This post started as my own reviewer for the UP MBA comprehensive exam, built primarily from Anthony and Govindarajan’s Management Control Systems. The Galvor and Enager cases are theirs. The Balanced Scorecard is Kaplan and Norton’s. The cultural dimensions are Hofstede’s. I have kept their frameworks intact, because they are the standard ones and they hold up.
What I have added is the translation. These concepts were written for corporations with divisions and shareholders. I spend my time helping Philippine MSMEs build strategy, and almost every idea below has a small-business version that matters more than the textbook one. Where it does, I say so. If you would rather have someone work through this with your actual numbers, that is what I do for a living, and you can read about it on my consulting page.
Table of Contents
The Nature of Management Control Systems
Understanding Strategies
Responsibility Centers: Revenue and Expense Centers
Profit Centers
Transfer Pricing
Investment Centers
Strategic Planning
Budget Preparation
Analyzing Financial Performance Reports
Performance Measurement
Management Compensation
Controls for Differentiated Strategies
Service Organizations
Multinational Organizations
The Nature of Management Control Systems
A management control system is not one thing you buy or install. It is a set of parts that only works assembled: strategic planning, budgeting, resource allocation, performance measurement, evaluation and reward, responsibility center allocation, and transfer pricing. Miss one and the others start compensating for it, usually badly. A business with budgets but no performance measurement is just guessing with more paperwork.
Control simply means devices are in place to make sure your strategic intentions actually happen. Every control system, from a factory to a sari-sari store, has the same four parts:
- Detector — the measurement of what actually happened
- Assessor — comparing that against the standard
- Effector — changing behavior, if needed
- Communications network — how the message gets where it needs to go
Your daily sales report is a detector. Comparing it to your target is the assessor. Calling your branch manager about it is the effector. If any one of those is missing, you do not have control, you have record-keeping.
Management starts from a simple premise. An organization consists of a group of people who work together to achieve certain common goals. The management control process is how managers at every level make sure the people they supervise implement their intended strategies. Note the wording. Not “work hard.” Not “stay busy.” Implement the strategy you chose.
A system is a prescribed and usually repetitious way of carrying out an activity or set of activities. The repetition is the point. If it only happens when you remember to check, it is not a system.
Management control is the process by which managers influence other members of the organization to implement the organization’s strategies. It shows up as six activities:
- Planning
- Coordinating
- Communicating
- Evaluating
- Deciding
- Influencing
Management control is made easier by a formal system built on a recurring cycle of those activities. Recurring, again. Monthly beats heroic.
Goal congruence is the one to remember if you remember nothing else. The goals of the individual people in your business should line up with the goals of the business itself. Your control system should be designed and operated with that in mind.
This is where most small businesses quietly break. You pay a salesman on volume, then wonder why he keeps promising delivery dates production cannot meet. He is not disloyal. He is responding exactly as you paid him to respond. The system was congruent with his wallet and not with your business.
Strategy formulation is the process of deciding on the goals of the organization and the strategies for attaining them. That is a different job from control. Strategy formulation decides where to go; management control makes sure you are going there.
Task control is the process of ensuring that specific tasks are carried out effectively and efficiently. It sits one level below management control:
- Transaction-oriented
- Performance of individual tasks according to rules established in the management control process
- Draws on management science and operations research techniques
And the management control system itself is simply the system management uses to control the activities of an organization. Everything after this is detail on how the pieces work.
Understanding Strategies
Before you can control anything, you have to be honest about what you are optimizing for. Textbooks list these as if a company picks one. In practice you are trading between them constantly.
Profitability is the obvious one, and the one most owners think they are measuring when they are actually measuring cash in the drawer.
Maximizing shareholder value means the market price of the corporation’s stock. If you are not listed, this one does not apply to you directly, but its private cousin does: what would someone pay for this business if you wanted out? Very few owners can answer that, and it is a useful question to be able to answer before you need to.
Risk is the constraint on the other two. Profit taken by betting the business is not the same quality of profit.
The multiple stakeholder approach says you operate in three markets at once: the capital market, where the firm raises funds; the product market, where your customers are; and the factor market, where your employees and suppliers are. Squeeze one to win in another and it usually comes back. Underpay staff to protect margin and you pay for it in turnover and training.
Corporate strategy is concerned with where to compete, rather than how to compete in a particular industry, which is business unit strategy. Corporate-wide strategic analysis produces decisions about which businesses to add, retain, emphasize, deemphasize, or divest.
The question is: what set of businesses should the firm be in? Three options:
- Single industry
- Related diversification
- Unrelated diversification
This is a live question for MSMEs, not a corporate abstraction. The hardware store owner who opens a catering business has chosen unrelated diversification, usually without calling it that, and usually because someone said it was a good idea. Related diversification, where the second business feeds off the first, works far more often.
A core competency is an intellectual asset a firm excels at. Yours is rarely the product. It is more often a relationship, a location, a permit, or the fact that you can get something delivered when nobody else can.
Business unit strategy depends on two interrelated aspects. First, its mission — what are its overall objectives? The generic business unit missions are build, hold, and harvest. Second, its competitive advantage — how should the business unit compete in its industry to accomplish that mission? The generic advantages are low cost and differentiation.
Build, hold, harvest is worth sitting with. If you have three product lines, they almost certainly should not all be managed the same way. One is worth investing behind, one should be kept steady, and one you should be quietly milking for cash while it lasts. Owners get into trouble by treating a harvest product like a build product, pouring money into something the market has already moved past.
Three tools help develop business unit strategy:
- Portfolio matrices — plotting market attractiveness against market share
- Industry analysis — systematically assessing opportunities and threats in the external marketplace, most commonly by analyzing the five competitive forces: competitors, buyers, suppliers, substitutes, and new entrants
- Value chain analysis — the linked set of value-creating activities that take a product from basic raw materials all the way into the final customer’s hands
Value chain analysis is the most useful of the three for a smaller business, because it is the one that shows you where your margin actually comes from and where it leaks. It is a practical tool for building competitive advantage on low cost, on differentiation, or on a combination of both.
Responsibility Centers: Revenue and Expense Centers
A responsibility center is an organization unit headed by a manager who is responsible for its activities. That is the whole idea: a piece of the business, and one name attached to it.
Every responsibility center exists to accomplish one or more purposes, and those purposes are supposed to help implement the company’s strategies and reach its goals. If you cannot explain what a department is for in one sentence, that is a finding, not a technicality.
Inputs and outputs. Management is responsible for ensuring the best possible relationship between what goes in and what comes out. Control focuses on using the minimum input necessary to produce the required output, at the correct specifications and quality, at the time requested, in the quantities desired. Some functions resist this cleanly: advertising inputs are not directly related to outputs, and research and development is more ambiguous still.
Measuring inputs and outputs. Cost is a monetary measure of the amount of resources a responsibility center uses. Inputs are those resources. Outputs are harder, and it is not always easy to calculate their value, so you often end up using an approximation or a surrogate number. That is normal. A rough measure you review monthly beats a perfect measure you never build.
Efficiency and effectiveness are the two criteria for judging a responsibility center’s performance, and they are not the same thing.
Efficiency is the ratio of outputs to inputs — the amount of output per unit of input. A center is efficient if it uses fewer resources to produce the same output, or the same resources to produce more. Efficiency is measured by comparing actual costs against standard costs.
Effectiveness is determined by the relationship between a responsibility center’s output and its objectives. The more the output contributes to the objectives, the more effective the unit. Effectiveness tends to be expressed in subjective, non-analytical terms, which is exactly why it gets ignored in favor of the number that is easy to compute.
The clean way to hold both in your head: a responsibility center is efficient if it does things right, and effective if it does the right things. Profit is useful because it measures both at once.
Worth pausing on. A delivery team that hits every route at the lowest possible fuel cost is efficient. If those routes are serving customers who never reorder, it is not effective. Efficiency is the easier number to chase and the more expensive one to chase alone.
There are four types of responsibility centers, and the difference is simply what you measure:
- Revenue centers — output is measured
- Expense centers — input is measured
- Profit centers — both input and output are measured
- Investment centers — the relationship between profit and investment is measured
Getting this wrong is one of the most common and most expensive mistakes I see. Hold a manager accountable for a number he cannot influence and you have not created accountability, you have created an excuse factory.
Revenue Centers
These are your marketing and sales functions. The defining features: they do not have authority to set selling prices, and they are not charged for the cost of goods they market. Actual sales are measured against budgets or quotas. The manager is held responsible for expenses incurred directly within the unit, but the primary measurement is revenue.
The moment you let a sales head discount freely to hit quota, you have stopped running a revenue center and started running something with no brakes.
Expense Centers
Expense centers split into two kinds, and the split matters more than it sounds.
Engineered expense centers carry engineered costs — costs whose right or proper amount can be estimated with reasonable reliability. Direct labor, direct materials, supplies, utilities. Manufacturing operations are the classic case: input is measured in monetary terms, output in physical terms, and you can determine the optimum peso of input required to produce one unit of output. Administrative and support departments doing repetitive work belong here too, such as accounts receivable, accounts payable and payroll sections, personnel records, the cafeteria, and shareholder records, because standard costs can be developed for repetitive tasks.
The controls that matter here: making sure manufacturing costs are not minimized at the expense of quality; funding training and employee development; and staying cost competitive by setting a standard and measuring actual costs against it.
Discretionary expense centers carry discretionary or managed costs, where no engineered estimate is feasible. Accounting, legal, industrial relations, public relations, human resources, and most marketing activities. Here the difference between budget and actual expense is not a measure of efficiency. It is just the difference between budgeted input and actual input.
That distinction is worth real money to you. Your production line going over budget by fifteen percent is a performance problem. Your marketing spend going over budget by fifteen percent is a decision, and judging it the same way is how good marketing gets cut.
How discretionary centers get controlled. Budget preparation starts with management determining the magnitude of the job that needs doing, across two types of work: continuing work and special work. One common technique is management by objectives (MBO), a formal process where the person being budgeted proposes to accomplish specific jobs and suggests the measurement to be used in evaluating performance. Related approaches include incremental budgeting and zero-base review.
On cost variability, management tends to approve changes in discretionary expense centers that correspond to anticipated changes in sales volume, so annual budgets for these centers tend to be a constant percentage of budgeted sales volume.
On the type of financial control, a discretionary expense budget controls costs by letting the manager participate in the planning. The key point: in discretionary expense centers, financial control is primarily exercised at the planning stage, before the costs are incurred. Once the money is committed, the control moment has passed.
On measurement of performance, a financial performance report for a discretionary center is not a means of evaluating the manager’s efficiency. Total control is achieved primarily through non-financial performance measures, such as judging quality of service through the opinion of the people who use it.
Administrative and Support Centers
Two control problems define these. First, difficulty in measuring output. Second, lack of goal congruence: the unit pursues its own goals without regard to the welfare of the company as a whole. A compliance department that blocks every transaction is technically doing its job and functionally strangling the business. Budget preparation is the main lever you have.
Research and Development Centers
The research program is not determined by calculating the total amount of approved projects. It is determined by dividing the research pie into what seem to be the most worthwhile slices. Annual budgets are essentially the calendarization of expected expenses for the budget period.
The budget process ensures actual costs will not exceed budgeted amounts without management’s knowledge, and variances should be approved by management before they are incurred.
For measuring performance, two types of financial report are used: a forecast of total cost against the approved amount for each active project, and a comparison between budgeted and actual expenses in each responsibility center. Neither one tells management whether the research effort is actually effective. That comes from progress reports and face-to-face discussion.
Most MSMEs think they have no R and D. You do. It is the new product you are testing, the new branch format, the supplier you are trying out. It is worth naming and budgeting rather than letting it eat operating cash invisibly.
Marketing Centers
Marketing is really two different animals wearing one label, and they need opposite controls.
Logistics activities are engineered expenses. Moving goods from the company to its customers and collecting the amounts due in return: transportation to distribution centers, warehousing, shipping and delivery, billing and the related credit function, and collection of receivables. For generating revenue, you compare actual revenue and physical quantities sold against budgeted revenue and budgeted units.
Marketing activities are discretionary expenses, where optimum amounts cannot be determined. Test marketing; the establishment, training and supervision of the sales force; advertising; sales promotions. Here, meeting the budgetary commitment is not a major criterion in the evaluation process. The sales target, not the expense target, is the critical factor.
For control technique, there is a correlation between sales volume and spending on sales promotion and advertising, so you cannot use flexible budgets. What is used instead is a percentage of sales: the higher the sales volume, the more the company can afford to spend on advertising.
Profit Centers
A profit center is a unit where you measure both what goes in and what comes out, and hold the manager to the difference. It is the most powerful delegation tool available, and the one most likely to backfire if you set it up carelessly.
The advantages
Running business units as profit centers lets you delegate more authority to operating managers, and lets them make expense and revenue trade-offs — increasing expenses where they expect an even greater increase in sales revenue. Beyond that:
- Better quality of decisions, because they are made by people closer to the facts
- Greater speed of operating decisions
- Top management is relieved of day-to-day decision making
- Managers are freer to use imagination and initiative
- It is a training ground for future general managers
- Profit consciousness spreads through the organization
- Ready-made information on each individual unit’s profitability
- The unit becomes more responsive to pressure to improve competitive performance
The difficulties
The costs are real and they are mostly the ones owners discover late:
- Loss of control by top management
- Quality of decisions may actually be reduced
- Friction over transfer pricing, assignment of common costs, and credit for jointly generated revenues
- Competition between units that should be cooperating
- Additional costs of divisionalization
- Competent general managers may simply not exist in your organization yet
- Too much emphasis on short-run profitability at the expense of the long run, causing managers to skimp on research and development, training programs, or maintenance
- Optimizing each business unit’s profit does not guarantee optimizing the profits of the company as a whole
That last one deserves emphasis, because it is counterintuitive. Every branch hitting its number does not mean the business made the most money it could have. Two branches competing for the same customers can both post good figures while the company as a whole leaves money on the table.
Business units as profit centers
Business unit authority always comes with constraints. Corporate keeps control over new investments. A “charter” specifies the marketing and production activities the unit is permitted to undertake, and it must refrain from operating beyond that charter even where there is a profit opportunity. There are constraints to maintain a proper corporate image, covering product quality and public relations. And there is a necessity for uniformity, since units must conform to corporate accounting and management control systems.
Expensive redundancy, maintenance costs, and productivity inefficiencies are the reasons administrative and support centers exist at the corporate level rather than being duplicated in every unit.
These constraints do not cause severe problems so long as they are dealt with explicitly. The major problems revolve around corporate service activities, particularly when business units could obtain those services more cheaply from an outside source.
Other profit centers
The decision on whether a business unit is a profit center rests on the amount of influence, even if not total control, that the unit manager exercises over the activities that affect the bottom line. That is the test. Influence, not org chart position.
Marketing can be a profit center when the marketing manager is in the best position to make the principal cost and revenue trade-offs. Using transfer pricing based on standard cost gives the marketing manager the information needed to make those trade-offs well.
Manufacturing is usually an expense center. When performance is measured against standard costs, it is advisable to evaluate quality control, production scheduling, and make-or-buy decisions separately.
Service and support units — maintenance, IT, transportation, engineering, consulting, customer service and similar activities — can also be profit centers. They may operate out of headquarters, serve corporate divisions, or sit within business units.
Measuring profitability
There are two distinct kinds of measurement, and confusing them causes a lot of unfair performance reviews:
- Measure of management performance — how well the manager is doing, used for planning, coordinating and controlling day-to-day activities
- Measure of economic performance — how well the profit center is doing as an economic entity
A manager can be excellent while running a unit that is economically weak. Judge the person on the first and the business on the second.
Five types of profitability measure, each with a trade-off:
Contribution margin. The reasoning is that fixed expenses are beyond the manager’s control. The problem is that senior management wants the profit center to keep discretionary expenses in line with the approved budget anyway.
Direct profit. Incorporates all expenses, controllable or not, but does not include headquarters overhead.
Controllable profit. Includes the headquarters overhead that is controllable, such as IT costs the profit center manager can influence. The disadvantage is that it excludes non-controllable headquarters overhead, which makes it hard to compare against published data.
Earnings before interest and taxes, with allocated corporate overhead. The arguments against are that finance, accounting and human resources are not controllable by the unit, and that the allocation is arbitrary. The arguments for are stronger than they first appear:
- Allocating corporate overhead makes profit center managers more likely to question cost increases, which keeps head office spending in check
- The profit center’s performance becomes more realistic and more comparable with competitors
- Because profit is affected by all costs, managers are motivated to make optimum long-term decisions on pricing and product mix, which benefits the company
One important refinement: allocated costs charged to a profit center should be calculated on budgeted, not actual, costs. That way no variance appears in the profit center; it appears in the reports of the responsibility center that actually incurred it. This directly answers the complaints about arbitrariness and lack of control over overhead.
Net income. Profit centers can influence income taxes through installment credit policies and the disposal or acquisition of equipment. Measuring at this level is not only about economic profitability; it also motivates managers to minimize tax liability.
Transfer Pricing
Transfer pricing sounds like something only conglomerates deal with. You have it the moment one part of your business hands something to another part and someone has to decide what it costs. Your commissary supplies your branches. Your delivery van serves two stores. What you charge internally decides which manager looks profitable, and if you set it carelessly you will be rewarding and punishing people for something none of them controls.
What a transfer price is supposed to do
- Provide the information needed to determine the optimum trade-off between company costs and revenues
- Induce goal congruent decisions, so that decisions improving business unit profits also improve company profits
- Help measure the economic performance of the individual business units
- Be simple to understand and easy to administer
That last one is not a throwaway. A transfer pricing scheme nobody understands will be quietly ignored, and you will be running on numbers that describe a system nobody is following.
The fundamental principle
The transfer price should be similar to the price that would be charged if the product were sold to an outside customer, or purchased from an outside vendor. Two separate decisions follow from it. The sourcing decision: should the company produce the product internally or buy it from an outside vendor? And the transfer price decision: if it is produced inside, at what price should it move between profit centers?
The ideal situation
A market-price-based transfer price will induce goal congruence if all of the following hold:
- Competent people — managers interested in the long-run as well as the short-run performance of their responsibility centers
- Good atmosphere — managers perceive the transfer prices as just
- A market price — adjusted downward to reflect the savings the selling unit gets from dealing inside the company
- Freedom to source — real alternatives exist and managers may choose what is in their own best interest. Market price represents the opportunity cost to the seller of selling inside; the transfer price represents the opportunity cost to the company
- Full information — managers know the available alternatives and the relevant costs and revenues of each
- Negotiation — a smoothly working mechanism exists for negotiating “contracts” between business units
Read that list as a diagnostic. If your internal pricing arguments never end, the cause is usually one of these six missing, and it is most often the second or the fifth.
Constraints on sourcing
Freedom to source may not be feasible, or may be constrained by corporate policy.
Limited markets are the common case. Internal capacity might limit the development of external sales. A company may be the sole producer of a differentiated product, so no outside source exists. Where fixed costs are high, a company is unlikely to use outside sources unless the outside selling price approaches its own variable cost.
The competitive price measures how well a profit center performs against competitors: the difference between the competitive price and the inside cost is the money saved by producing rather than buying. Competitive prices can be established from published market prices, by bids, on the basis of an outside price for a production profit center, or from competitive prices for proprietary products in a buying profit center.
Excess or shortage of industry capacity creates the disputes. An arbitration committee handles them: a buying profit center may appeal a selling profit center’s decision to sell outside, and a selling profit center may appeal a buying profit center’s decision to buy outside when capacity was available inside.
Senior management often chooses not to intervene, on the theory that the benefit of keeping profit centers independent offsets the loss from sub-optimizing company profits. Management should also be aware of the strong political overtones that sometimes appear in transfer price negotiations, since outside sources may genuinely provide better service and internal rivalry exists in divisionalized companies.
The bottom line: market price is the best transfer price. Where it is unavailable, the next option is a cost-based transfer price, eliminating advertising, financing and other expenses the seller does not incur on internal transactions.
Cost-based transfer prices
Two questions have to be answered. How do you define cost? The usual basis is standard costs. Actual costs should not be used, because then inefficiencies get passed straight on to the buying profit center. Set tight standards and improve them.
How do you calculate the profit markup? The basis is either a percentage of costs or a percentage of investment, though the investment basis has a problem: old assets are undervalued, which distorts the result. On the level of profit allowed, the allowance should approximate the rate of return the business unit would earn selling to outside customers.
Upstream fixed costs and profits
Three mechanisms are used, each with its own failure mode.
Two-step pricing charges the standard variable cost of production, plus a monthly charge equal to the fixed costs associated with the facilities reserved for the buying unit. Variable cost transfers on a per-unit basis; fixed cost and profit transfer as a lump sum.
Profit sharing transfers the product to marketing at standard variable cost, and after the product is sold the business units share the contribution earned, which is the selling price less manufacturing and marketing costs. The problems: arguments over how contribution margin gets divided between the two profit centers; arbitrarily dividing profits gives no valid information on each unit’s real profitability; and manufacturing’s contribution ends up depending on the marketing unit’s ability to sell and on the actual selling price, which manufacturing may perceive as unfair.
Two sets of prices credits manufacturing revenue as an outside sale while charging the buying unit at total standard cost. The problems are worse. The sum of business unit profits exceeds the company’s actual profits. It is misleading for approving budgets and evaluating performance against them. It creates an illusive feeling of making money while the company may in reality be losing it. It pushes business units to concentrate on internal transfers. It adds bookkeeping, since the difference has to be eliminated on consolidation. And it may fail to alert senior management to conflicts in organizational structure that transfer price disputes would otherwise reveal.
That last point is the useful one for an owner. Fights about internal pricing are often a symptom, not the disease. When two departments cannot agree on what a service is worth, it usually means you have not decided who owns the customer.
Pricing corporate services
Two conditions for transfers: central services the receiving unit must accept but can at least partially control the amount used, and services the business unit can decide whether or not to use at all. Costing is done at standard costs, at full costs, or at market price, standard full cost plus a profit margin, or a return on investment.
Administration of transfer prices
Negotiation. Business units negotiate transfer prices with each other rather than having headquarters set them. Three reasons: if headquarters controls pricing, line management’s ability to affect profitability is reduced; business managers can otherwise argue that low profits are due to arbitrary transfer prices; and business units usually have the best information on markets and costs, so they can arrive at reasonable prices.
Arbitration and conflict resolution. Responsibility sits with a financial or executive vice president, or with a committee set up to settle transfer price disputes, review sourcing changes, and change the transfer price rules when appropriate.
Product classification. Class I covers products where senior management wants to control sourcing, typically large-volume products, or products handled this way for quality or secrecy reasons. Class II covers all other products, transferred at market prices, usually relatively small volume and produced with general-purpose equipment.
Investment Centers: Measuring and Controlling Assets Employed
An investment center is a profit center that is also held accountable for the assets it ties up. This is the level most owners never reach, and it is the one that separates a business that makes money from a business that is worth something.
The structure of the analysis
Business unit managers have two performance objectives: generate adequate profits from the resources at their disposal, and invest in additional resources only when the investment will produce an adequate return.
Two measures dominate. Return on investment (ROI) is a ratio, where the investment base is total assets less current liabilities. Economic value added (EVA) is a peso amount rather than a ratio: net operating profit after tax, less a capital charge.
Put plainly, EVA asks a question most small businesses never ask. Your capital is not free even when it is yours. If you have ₱5 million tied up in stock and equipment and you clear ₱300,000 a year, you are working very hard to underperform a time deposit. That realization changes decisions.
Measuring assets employed
Two questions guide every choice here: what practices will induce business unit managers to use their assets more efficiently and acquire the proper amount and kind of new assets, and what practices best measure the performance of the unit as an economic entity?
Cash. Some companies omit cash from the investment base, since it approximates current liabilities.
Accounts receivable. The manager influences the level of receivables indirectly through sales, and directly by establishing credit terms, approving credit accounts and credit limits, and collecting overdue amounts. Receivables are carried at book value, meaning selling price less the allowance for doubtful accounts.
Inventories. Carried at standard or average costs. Advance or progress payments are either subtracted from gross inventory or reported as liabilities. Managers can influence the payment period allowed by vendors and should seek favorable terms. They might also forgo a cash discount in exchange for the additional financing a vendor provides, which reduces net current assets, but delaying payments can unduly hurt the company’s credit rating.
Working capital. Including it in full overstates the investment base from a motivational standpoint, if business units cannot influence accounts payable or other current liabilities. Measuring net of current liabilities is a good measure, but it implies managers are responsible for current liabilities they may have no control over.
Property, plant and equipment. This is where the measure gets genuinely distorting. Business units with old, almost fully depreciated assets will report larger economic value added than units with newer assets. Carried at net book value, profitability is misstated, though this remains the most popular method. Carried at gross book value, the true return is understated.
On disposition of assets, if assets are included at original cost, the manager is motivated to get rid of them even when they still have useful life, because disposing reduces the investment base by the full cost of the asset. Annuity depreciation shows the correct EVA and ROI. It is the opposite of accelerated depreciation: annual depreciation is low in the early years when investment values are high, and increases each year as the investment decreases.
Also weighed in the investment base: leased assets, where the interest charge of leasing is less than the capital charge applied to the investment base; plus idle assets, intangible assets, non-current liabilities, and the capital charge itself.
The practical version of this whole section: the equipment you bought years ago and already wrote off is still occupying space and still needs to earn its keep. Fully depreciated does not mean free.
EVA versus ROI
ROI has genuine advantages. It is a comprehensive ratio, so anything affecting the financial statements is reflected in it. It is simple to calculate, easy to understand, and meaningful in an absolute sense. It can be applied to any unit regardless of size or type of business. And competitor data is available, so it can be used for comparison.
But EVA wins on four counts:
- With EVA, all business units carry the same profit objective for comparable investments. Under ROI, a unit may forgo an investment whose return is below its current percentage but still above the cost of capital, which is a loss to the company
- Decisions that increase a center’s ROI may decrease its overall profits. Disposing of an asset returning below the unit’s ROI but above the cost of capital reduces the center’s absolute peso profit
- Different interest rates may be applied to different types of assets, reflecting their different risks
- EVA has a stronger positive correlation with changes in the company’s market value, and the best proxy for shareholder value is to create or increase EVA
EVA = NOPAT less the capital charge. Equivalently, EVA = capital employed multiplied by (ROI less cost of capital).
Four ways to increase it:
- Increase ROI through process re-engineering and productivity gains, without increasing the investment base
- Divest assets or products whose ROI is less than the cost of capital
- Make aggressive new investments whose ROI exceeds the cost of capital
- Increase sales or profit margins, or reduce the cost of capital, without affecting the other variables
Beyond the numbers, two further considerations remain: additional factors in evaluating managers, and separately, evaluating the economic performance of the entity. As with profit centers, these are two different judgments and should not be collapsed into one.
Strategic Planning
Strategic planning is the process of deciding on the programs the organization will undertake and the approximate resources each one will get. It sits between strategy formulation, which decides the goals, and budgeting, which commits the money for the coming year.
The distinction that matters: strategy formulation asks what business you should be in and how you should compete. Strategic planning asks what you are actually going to do about it over the next three to five years, and roughly what it will cost. Budgeting then takes the first year of that and turns it into commitments with names attached.
In my experience most Philippine MSMEs skip the middle step entirely. There is a vision, usually a good one, and there is a budget, usually built from last year’s figures plus a bit. Nothing connects them. The result is a business whose spending has no relationship to its stated direction, and an owner who cannot understand why five years of hard work has not moved the company anywhere in particular.
What a usable strategic plan needs, at any size:
- A small number of programs. Three to five things you are genuinely trying to accomplish. Not fifteen. A list nobody can recite is not a plan
- An approximate resource figure for each. Approximate is fine at this stage. Zero is not, because a program with no money attached is a wish
- A multi-year horizon. Long enough that this year’s costs can be justified by next year’s returns
- A named owner per program. Programs without an owner do not fail loudly. They just quietly do not happen
- A review rhythm. Revisit at least annually, because the plan is a hypothesis about the market, and markets move
The analysis of proposed new programs and the analysis of ongoing ones are different exercises. New programs get judged on expected return against required investment. Ongoing programs are harder, because there is history and pride involved, and because the money already spent is gone whether you continue or not. The discipline is to judge an existing program on what it will produce from here, not on what it has already cost you.
That is the single most expensive habit I see in owner-run businesses: continuing to fund something because of what has already been sunk into it. The money spent is not coming back either way. The only live question is whether the next peso is better spent here or somewhere else.
Budget Preparation
A budget is a plan stated in money, usually covering one year, and committing specific managers to specific numbers. That commitment is what separates a budget from a forecast, and it is the part most small businesses leave out.
The nature of a budget
Its relation to strategic planning is that the budget is the first year of the strategic plan, costed and committed. If your budget does not trace back to your plan, one of the two is decoration.
Its contrast with forecasting is the important distinction. A forecast is a best estimate of what will happen, and nobody is accountable for it. A budget is a commitment to make something happen, and someone is. A forecast can be revised whenever new information arrives. A budget is not revised simply because it has become inconvenient.
The uses of a budget are to fine-tune the strategic plan, to coordinate the activities of different parts of the organization, to assign responsibility to individual managers, and to establish the basis against which actual performance will later be evaluated.
The content of an operating budget covers revenue, cost of sales, marketing and logistics expenses, general and administrative expenses, research and development, and the resulting profit. Operating budget categories follow the responsibility center structure, which is why getting the centers right matters before budgeting season starts.
Other budgets
- Capital budget — the planned major projects and asset purchases
- Budgeted balance sheet — what the company’s position will look like if the plan holds
- Budgeted cash flow statement — when the money actually moves
- Management by objectives — the non-financial commitments that sit alongside the financial ones
The budgeted cash flow statement is the one to build first if you only build one. Profitable businesses do not usually die of unprofitability. They die of running out of cash in a month when the receivables were late and the rent was not.
The budget preparation process
- Organization — someone owns the process, usually a budget department or, in a smaller firm, the finance lead
- Issuance of guidelines — assumptions everyone builds on, so units are not each inventing their own inflation rate
- Initial budget proposal — built by the managers who will be held to it
- Changes in external forces — demand, prices, competition, regulation
- Changes in internal policies and practices — new capacity, new methods, new structure
- Negotiation — where the real budgeting happens
- Review and approval
- Budget revisions — the rules for these should be set in advance, not invented mid-year
- Contingency budgets — a pre-agreed plan for the downside scenario
Contingency budgets are cheap insurance and almost nobody builds them. Deciding in advance what you will cut if revenue drops twenty percent is a calm conversation in November. It is a panicked one in June.
Behavioral aspects
This is the part that decides whether the budget works, and it has nothing to do with arithmetic.
Participation in the budgetary process. Managers who help build the number behave differently toward it than managers who receive it. Imposed budgets get treated as head office’s problem.
Degree of budget target difficulty. The useful target is challenging but achievable. Set it too easy and you leave performance on the table. Set it impossible and managers stop trying, or start managing the numbers instead of the business.
Senior management involvement. If the owner does not take the budget seriously, nobody below will. Attention is the signal.
The budget department has to be seen as an honest broker rather than a policing function, or it will be fed optimistic numbers all year.
Quantitative techniques
Simulation tests what happens to the plan under different assumptions. Probability estimates attach likelihoods to outcomes rather than pretending to a single certain figure. Neither requires special software. A spreadsheet with a good case, a base case and a bad case puts you ahead of most businesses your size.
Analyzing Financial Performance Reports
The Galvor Company case from Anthony and Govindarajan is the standard teaching vehicle for this material.
The purpose of variance analysis is simple: you had a plan, you got a result, and the gap between them has causes. Finding those causes is worth more than the number itself.
Calculating variances
Variance computations become far more actionable when changes in actual results are analyzed against each individual expectation, rather than lumped together. The analytical framework runs:
- Identify the key causal factors that affect profits
- Break down the overall profit variances
- Focus on the profit impact of the variation
- Spin one dial at a time
- Add complexity sequentially, peeling the onion
- Stop when the added complexity is no longer justified
“Spinning one dial at a time” is the practical heart of it. Change three things and beat your target, and you have learned nothing about which one worked.
Revenue variances break into selling price variance, mix and volume variance, mix variance, volume variance, other revenue analyses, and market penetration and industry volume. On mix: if the business unit sells a richer mix, meaning a higher proportion of products with higher contribution margin, actual profit will come in higher than budgeted. A leaner mix drives profit lower, even when total sales look fine.
That is a common and demoralizing surprise for owners. You hit your sales target and made less money, because the mix shifted toward whatever was easiest to sell, which is usually whatever earns you least.
Expense variances cover fixed costs and variable costs. Within variable costs, the spending variance is spending in excess of the adjusted budget, and the volume used is the manufacturing volume, not the sales volume.
Variations in practice
Practice varies on the time period of the comparison and on the focus on gross margin, where unit gross margin is the difference between selling price and manufacturing cost.
Evaluation standards come in three kinds. Predetermined standards or budgets are excellent when carefully prepared and coordinated, and worthless when thrown together, since a haphazard budget provides no reliable basis for comparison. Historical standards use records of past actual performance; they are often used because predetermined standards are not available, but they carry two weaknesses: conditions change and invalidate the comparison, and the prior period’s performance may not have been acceptable in the first place. External standards are derived from other responsibility centers or other companies in the same industry, which is what benchmarking does when it identifies the best-managed company in the industry and uses its numbers as the reference.
Standards have limits. A standard may not have been set properly, or it may have been set properly and then made obsolete by changed conditions. Examining whether the standard is still valid is part of the job, not an optional extra.
Comparing yourself only to your own past is the trap here. Growing twelve percent feels good until you find out the market grew thirty.
On full-cost systems, both variable and fixed overhead are included in inventory at the standard cost per unit, assuming inventory levels did not change. Under a variable-cost system, fixed production costs are not included in inventory, so there is no production volume variance.
On the amount of detail, you can always go further: sales and marketing variances by territory or by country, manufacturing detail down to wage rates and material prices. The real problem is deciding how much detail is worthwhile, and the answer depends largely on what individual managers will actually use.
Limitations of variance analysis
Worth knowing before you over-trust the reports.
It does not tell you why the variance occurred, or what is being done about it. Deciding whether a variance is even significant is its own problem: statistical quality control can determine whether there is a real difference between actual and standard performance, but conceptually a variance should be investigated only when the expected benefit from correcting the problem exceeds the cost of investigating it. A variance that is significant but uncontrollable is not worth investigating at all. In the end you rely on judgment about which variances matter.
Offsetting variances can mislead the reader badly. Combining product lines at different stages of development obscures the actual results of each. Good performance at one plant hides poor performance at another. Averages conceal.
Managers also become more dependent on the explanations and forecasts that accompany the numbers. And the reports do not show the future effects of actions already taken. Cutting the training budget improves current profitability and may cost you considerably later, and nothing in this month’s variance report will tell you that.
Management action
The monthly profit report should contain no major surprises. If it does, the problem is not the report.
One of the most important benefits of formal reporting is that it creates useful pressure on subordinate managers to take corrective action on their own initiative, before anyone asks. The numbers in a formal report are also more accurate than informal sources, which tend to be general and imprecise, so they make a better basis for analysis.
But all of it rests on one condition. Profit reports are worthless unless they lead to action. A beautifully prepared monthly report that everyone receives and nobody responds to is a cost, not a control.
Performance Measurement
The Enager Industries case from Anthony and Govindarajan is the standard illustration for this material.
The goal of a performance measurement system is to implement strategy. That is worth stating flatly, because measurement systems drift into being scoreboards. A performance measurement system is a mechanism that improves the likelihood the organization will implement its strategy successfully. If a measure does not raise that likelihood, it is overhead.
Why financial control alone is not enough
The goal of the enterprise is to optimize shareholder returns, but optimizing short-term profitability does not necessarily achieve that. Relying solely on financial measures is inadequate and can be actively dysfunctional, for four reasons.
Financial measures may encourage short-term actions that are not in the company’s long-term interest. The more pressure to meet current profit levels, the more likely a business unit manager takes short-term actions that turn out to be wrong. Inferior-quality product gets delivered to customers to meet sales targets. These are errors of commission.
Managers may not undertake useful long-term actions, in order to protect short-term profits. They avoid investments that promise long-term benefits because those investments hurt short-term results. Research and development gets underfunded. Risky investments are not proposed, because uncertain cash flow reduces the probability of hitting short-term financial targets, so managers propose safe investments instead of high-risk projects that might produce high returns. These are errors of omission, and they are invisible, which is what makes them dangerous.
Using short-term profit as the sole objective distorts communication between a business unit manager and senior management. Managers set profit targets they can easily meet, so overall budgeted profit ends up lower than what could really be achieved. They also become reluctant to admit they will miss the budget, which delays corrective action past the point where it would have worked.
Tight financial control may motivate managers to manipulate data. Squeeze hard enough on a single number and you will eventually get that number, whether or not reality cooperates.
Relying on financial measures alone is insufficient to ensure strategy is executed successfully. The solution is to measure and evaluate business unit managers using multiple measures, non-financial ones such as key success factors and key performance indicators, as well as financial ones.
The clean way to hold the difference: financial measures indicate the results of past decisions. Non-financial measures are leading indicators of future performance. One tells you where you have been, the other where you are going.
The Balanced Scorecard
The Balanced Scorecard, developed by Kaplan and Norton, is the best-known example of a performance measurement system. Business units are assigned goals and then measured from four perspectives:
- Financial
- Customer
- Internal business
- Innovation and learning
It fosters balance among different strategic measures in order to achieve goal congruence, encouraging employees to act in the organization’s best interest. It is a tool that improves focus and communication, sets organizational objectives, and provides feedback on strategy.
A good scorecard uses a mix of measurements that accurately reflect the critical factors determining the success of the company’s strategy, show the relationships among individual measures in a cause-and-effect manner so it is clear how non-financial measures affect long-term financial results, and provide a broad-based view of the company’s current status.
You do not need software or a consultant to start one. Four numbers, one per perspective, reviewed monthly, beats a twenty-metric dashboard nobody opens. Sales this month, repeat customer rate, on-time delivery rate, and one thing your team learned or improved. That is a scorecard.
Additional considerations
A performance measurement system tries to address the needs of the organization’s different stakeholders by blending several kinds of strategic measure.
Outcome and driver measures. Outcome measures indicate the result of the strategy. They are lagging indicators, telling management what has already happened. Driver measures are leading indicators, showing progress in key areas of implementation, such as cycle time.
Financial and non-financial measures. During the 1980s, industries were being reshaped by changes in non-financial areas such as quality and customer satisfaction, which eventually showed up in financial performance. Even companies that recognized the importance of non-financial measures often failed to implement them, because non-financial measures tend to be much less sophisticated than financial ones and senior management is less practiced at using them.
Internal and external measures. Balance external measures such as customer satisfaction against internal process measures such as manufacturing yields.
Measurements drive change. The scorecard emphasizes cause-and-effect relationships among measures: understanding how a non-financial measure such as product quality drives a financial measure such as revenue. Scorecard measures must be linked together explicitly in a cause-and-effect way. The better those relationships are understood, the more able individuals are to contribute directly and clearly to the success of the organization’s strategy.
People change what they do based on what you count. That is the whole mechanism, and it works whether or not you chose the right thing to count.
Key success factors
Customer-focused key variables:
- Bookings
- Backorders
- Market share
- Key account orders
- Customer satisfaction
- Customer retention
- Customer loyalty
Key variables related to internal business processes:
- Capacity utilization
- On-time delivery
- Inventory turnover
- Quality
- Cycle time
Customer retention is the one I would put in front of most owners first. It is cheap to measure, almost nobody tracks it, and it predicts next year better than this month’s sales does.
Implementing a performance measurement system
Define strategy. The scorecard links strategy to operational action. Functional departments within a business unit should have their own scorecards, aligned with the business unit scorecard above them, and a corporate-wide scorecard should address synergies across business units.
Define measures of strategy. Focus on a few critical measures, linked to each other in a cause-and-effect manner.
Integrate measures into the management system. The scorecard should be integrated with the organization’s formal and informal structures, its culture, and its human resource practices. A scorecard that contradicts how people are actually paid and promoted will lose.
Review measures and results frequently. How is the organization doing on outcome measures, and on driver measures? Has the strategy changed since the last review? Have the scorecard measures changed to match?
Why these systems fail
- Poor correlation between non-financial measures and results. There is no guarantee that future profitability will follow from hitting targets in some non-financial area
- Fixation on financial results, because the payback on non-financial measures is long term and uncertain
- Measures are not updated as the strategy moves
- Measurement overload — too many metrics, no attention on any of them
- Difficulty in establishing trade-offs between measures that pull against each other
Measurement overload is the one that kills these efforts in smaller companies. Five measures that get discussed monthly will change your business. Thirty measures in a report will change nothing.
Beyond that, measurement practice comes down to the types of measures used, the quality of those measures, and how they relate to compensation. And interactive control, whose main objective is to facilitate the creation of a learning organization, is what keeps the whole system from calcifying.
Management Compensation
Incentive compensation is the sharpest instrument in the whole control system, and the one most likely to cut the person holding it. Everything else on this page influences behavior. Pay determines it.
The governing idea is one you have already met: goal congruence. An incentive plan works when the actions that make the manager better off are the same actions that make the business better off. Almost every compensation problem I am asked to look at is a break in that single line.
The main design choices:
- Fixed versus variable pay. How much of the package is at risk. More variable pay means stronger incentives and more volatility in behavior, in both directions
- Short-term versus long-term incentives. Short-term plans reward this year’s results. Long-term plans attach the manager to outcomes that outlast the current period. A business run entirely on annual bonuses will be managed entirely for annual results
- Financial versus non-financial criteria. Paying only on profit reproduces every weakness of financial control described above
- Formula versus judgment. A formula is transparent and gameable. Judgment is flexible and, if it is not trusted, corrosive. Most workable plans use a formula with a judgment component on top
- Individual versus group. Individual rewards drive individual effort and can quietly destroy cooperation between units that need each other
Three failure patterns are worth naming, because I see them repeatedly in owner-run firms.
Paying on a number the person does not control. A branch manager bonused on net profit, where head office allocates overhead he cannot influence, learns that his bonus is weather. He stops treating it as a target.
Paying on volume alone. This is the most common one. Commission on gross sales, with no reference to margin or collection, produces exactly what you paid for: large, badly priced orders from customers who pay late.
Discretionary bonuses with no stated basis. The owner knows the reasoning. Nobody else does. What gets learned is that pay depends on the owner’s mood, which is the opposite of an incentive system.
A practical test before you launch any incentive scheme: ask what the smartest, laziest person on your team would do to maximize the payout. Whatever you come up with, someone will find it faster than you did. If the answer describes behavior you would be unhappy to see, redesign the plan before you announce it, not after.
Controls for Differentiated Strategies
There is no single correct control system. The right one depends on the strategy it is meant to serve, and a control system borrowed from a business with a different strategy will fight you.
Recall the two strategic variables from earlier: mission (build, hold, harvest) and competitive advantage (low cost or differentiation). Both change what good control looks like.
Controls by mission
A build unit is growing share in a growing market. It faces more uncertainty, its managers make more decisions with incomplete information, and its results this year say little about whether it is winning. Control leans toward longer horizons, more tolerance of budget variance, greater weight on non-financial measures, and more judgment in evaluating managers.
A harvest unit is maximizing cash from a settled position. Uncertainty is lower and the environment is predictable, so budgets can be held tightly, short-term financial criteria carry more weight, and formula-based evaluation works well.
Hold units sit between the two.
The practical consequence for a smaller company is direct. If you have a mature product line paying the bills and a new venture you are trying to grow, running both on the same monthly targets will kill the new venture. It will miss its numbers every month for reasons that are structural rather than managerial, and the person running it will conclude that the sensible move is to stop taking risks.
Controls by competitive advantage
A low cost strategy competes on efficiency. Control emphasizes tight cost standards, variance analysis, engineered costs, and productivity measurement. Precision pays here.
A differentiation strategy competes on something the customer values enough to pay more for. Control has to protect that something. Squeezing costs the way a low cost competitor would erodes exactly what you are charging a premium for, so measurement leans toward quality, innovation, customer satisfaction, and brand strength.
This is the mismatch I see most often. An owner competing on service and reputation installs cost controls copied from a volume competitor, then cannot work out why the thing customers used to praise has quietly disappeared. The control system was doing its job. It was just serving a strategy the business had not chosen.
Service Organizations
Most Philippine MSMEs are service businesses, so this section matters more locally than its length in most textbooks suggests.
Service organizations differ from manufacturing in four ways that break the standard control tools.
Absence of inventory buffer. Services cannot be stored. An empty seat, an unbooked hour, an idle van is revenue that is gone permanently, not deferred. Capacity management therefore is the control problem, and unused capacity is the main cost to watch.
Difficulty in controlling quality. A manufacturer inspects before the customer sees the product. A service is produced and consumed at the same moment, in front of the customer, so quality control has to happen through hiring, training and supervision rather than inspection. You cannot recall a bad interaction.
Labor intensity. Costs are dominated by people rather than machines and materials. That changes the cost structure, makes standard costing harder, and puts most of your quality and most of your expense in the same place.
Multi-unit organizations. Many service firms grow by replicating a small unit across locations. That similarity is an asset for control, because it makes comparison between units genuinely meaningful in a way that comparing dissimilar divisions never is.
What this means for how you run a service business: your utilization rate, not your sales figure, is the number that tells you how you are doing. A shop at seventy percent capacity with high prices can be healthier than one at full capacity with low ones. If you run several branches, the spread between your best and worst branch on the same metric is the most useful management information you own, and it is free. The gap is either a practice worth copying or a problem worth fixing, and either way somebody in your business already knows what it is.
Multinational Organizations
You may think this section does not apply to you. It does, in one specific way that matters for Filipino businesses, which I will get to.
Cultural differences
Culture refers to shared values, assumptions, and norms of behavior. According to Hofstede, cultures differ across four dimensions, and each one changes what control system will work.
Power distance is the extent to which power is unequally distributed and centralized. In low power distance cultures, decentralization and greater participation in budget preparation are preferred. In high power distance cultures the opposite holds, and the Philippines is a high power distance culture.
That is the line worth stopping on, and it is why this section is not foreign material. Participative budgeting is standard advice in management writing, almost all of it produced in low power distance countries. Imported directly, it often produces a meeting where the owner proposes a number and everyone agrees with it. The participation was procedural. If you want genuine input in a Filipino firm, you generally have to design for it deliberately, by asking for proposals before you state your own view, and by making disagreement safe and specifically invited. Otherwise you get consensus that is really deference, and you will not find out it was deference until the budget fails.
Individualism and collectivism is the extent to which people define themselves as individuals or as part of a larger group. Individualistic cultures prefer rewards based on individual performance; collectivistic cultures respond better to group-based rewards. This has direct consequences for how you design incentive pay.
Uncertainty avoidance is the extent to which people feel threatened by ambiguous situations. Where uncertainty avoidance is low, subjective performance evaluation is more effective.
Masculinity and femininity is the extent to which dominant values emphasize assertiveness and materialism, versus concern for people and quality of life.
Hall adds a spectrum from low-context to high-context cultures, the latter being cultures where people establish personal relationships before doing business. In low-context cultures, formal planning and control systems work better. In high-context cultures, informal controls dominate, and building interpersonal familiarity and trust is essential. Anyone who has done business here will recognize which end of that spectrum we are on, and why a supplier relationship survives a bad quarter that a contract would not.
Transfer pricing across borders
When transfers cross national boundaries, additional considerations enter: taxation, government regulations, tariffs, foreign exchange controls, funds accumulation, and joint ventures. Each one can make an internally sensible transfer price externally expensive.
Exchange rates
Exchange rate movements affect how foreign operations are measured and how their managers are fairly evaluated. The principle is the same one running through this entire post: hold managers accountable for what they control. A peso that moved against you is not your import manager’s performance, and treating it as such teaches him that the scoreboard is not real.
Where to start if you are running a real business
That is a lot of framework. If you own a business rather than sit an exam, most of it is context and a few things are urgent. In the order I would actually do them:
- Check goal congruence first. List how each key person is paid or rewarded, then ask what behavior that actually buys. Fix any line where the answer is not the behavior you want. This is free and it is usually where the damage is
- Name your responsibility centers. For each part of the business, decide what that manager is genuinely accountable for, and make sure it is something they can influence
- Build a cash flow budget before a profit budget. Businesses fail on cash, not on profit
- Pick four measures, not thirty. One financial, one customer, one operational, one about learning. Review them monthly, out loud, with the people responsible
- Match the control to the strategy. If you compete on service, do not install a cost-cutter’s control system
None of this requires software or a finance department. It requires deciding what you are accountable for, deciding what everyone else is accountable for, and then actually looking at it every month.
If you would rather work through it with someone who has done it, that is the work I do with owners. You can find out how I approach it on my consulting page, or read more of what I have written for Philippine MSMEs at MBA for MSMEs.
