Table of Contents
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 its strategic intentions are achieved.
ii. Assessor – comparison with standard
iii. Effector – behavior alteration, if needed
iv. Communications network
• 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:
• 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:
• performance of individual tasks according to rules established in the management control process.
• focus of many management science and operations research techniques.
9. Management control system – 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:
• 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:
ii. related diversification
iii. unrelated diversification
• Core competency – is an intellectual asset in which a firm excels.
6. Business unit strategies:
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:
ii. industry analysis
2. analyzing 5 competitive forces – competitors, buyers, suppliers, substitutes
and new entrants
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.
ii. Objectives of the responsibility centers are to help implement company’s strategies to achieve company’s goals
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
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.
2. Uses the same amount of resources but produces a greater amount.
3. Efficiency is measured by comparing actual costs with standard costs
output and its objectives.
2. Effectiveness tends to be expressed in subjective, nonanalytical terms
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.
iii. Profit centers – input and output are measured
iv. Investment centers – relationship between profit and investment is measured.
2. Revenue Centers
• 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
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.
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.
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.
iii. Zero-base review
iv. Cost variability
2. Annual budgets for these centers tend to be a constant percentage of budgeted sales volume.
Discretionary expense centers: Financial control is primarily exercised at the planning stage before the costs are incurred.
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
ii. Lack of goal congruence – pursue goals without regard to the whole welfare of the company.
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.
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
ii. 2 types of financial reports
2. Comparison between budgeted expenses and actual expenses in each responsibility center
6. Marketing Centers
ii. Transportation to distribution centers, warehousing, shipping and delivery, billing and related credit function, collection of receivable.
• Marketing Activities – discretionary expenses; optimum amounts cannot be determined
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
2. Expense/revenue trade-offs – increase expenses with the expectation of an even greater increase in sales revenue
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
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
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
reasons for administrative and support centers at the corporate level.
• Major problems revolve around corporate service activities – business units can obtain such services at less expense from outside source.
3. Other Profit centers
the activities that affect the bottom line.
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-
ii. May operate out of headquarters, service corporate divisions, or within business units.
4. Measuring Profitability
ii. Measure of economic performance – how well the profit center is doing as an economic entity.
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;
arbitrariness of allocation
2. arguments for:
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
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
2. Not only to measure economic profitability but to motivate managers to minimize tax liability
1. Objectives of Transfer pricing – it should:
• 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:
• 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:
• 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.
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:
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.
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:
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
• Two-step pricing
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
o After the product is sold, business units share the contribution earned (Selling price
– manufacturing and marketing costs)
• 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.
• 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
ii. Business unit can decide whether or not to use
ii. Full costs
iii. Market price/standard full cost plus profit margin/return on investment
8. Administration of transfer prices
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.
2. Review sourcing changes
3. Changing the transfer price rules when appropriate.
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
ii. Invest in additional resources only when the investment will produce an adequate return.
ii. Investment base = total assets less current liabilities
ii. NOPAT (net operating profit)– capital charge
2. Measuring assets employed
• 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 :
ii. at book value (Selling price – ADA)
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
ii. Net of current liabilities – good measure but it imply managers are responsible for
current liabilities over which they have no control.
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
• Idle assets
• Intangible assets
• Noncurrent liabilities
• The capital charge
3. EVA versus ROI
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 = NOPAT – capital charge; or, EVA = capital employed
(ROI-Cost of capital)
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
• Contrast with Forecasting
• Use of a budget
• Content of an operating budget
• Operating budget categories
2. Other Budgets
• Budgeted balance sheet
• Budgeted cash flow statement
• Management by objectives
3. Budget Preparation Process
• 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
• Degree of budget target difficulty
• Senior management involvement
• The budget department
5. Quantitative techniques
• Probability estimates
Analyzing Financial Performance Reports
1. Calculating variances
• Analytical framework:
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…
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
2. Variable costs
2. Variations in Practice
• Focus on Gross Margin
2. Haphazard manner – not provide a reliable basis for comparison
b. Prior period’s performance may not have been acceptable
2. Benchmarking – identify the company – best managed in the industry and use numbers to benchmark
2. Although set properly, changed conditions make the standard obsolete v. Examination of the validity of the standard is necessary
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
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
3. Limitations of Variance Analysis
• To decide whether a variance is significant.
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
obscure the actual results of each product line
ii. Good performance of one plant being offset by poor performance at another
• Do not show the future effects of actions that the manager has taken
4. Management Action
• 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.
1. Performance Measurement Systems
• A performance measurement system is a mechanism that improves the likelihood the organization will implement its strategy successfully.
2. Limitations of Financial Control Systems
• 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:
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
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
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.
• Non-financial measures – leading indicators of future performance
3. The Balance Scorecard
• Business units should be assigned goals and then measured from the following four perspectives:
iii. Internal business
iv. Innovation and learning
• 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:
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:
ii. Driver – leading indicators, show the progress of key areas in implementing a strategy; e.g. cycle time;
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.
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
iii. Market share
iv. Key account orders
v. Customer satisfaction
vi. Customer retention
vii. Customer loyalty
ii. On-time delivery
iii. Inventory turnover
v. Cycle time
6. Implementing a performance measurement system
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.
ii. Measures should be linked with each other in a cause-effect manner
structures, culture and human resource practices.
Has organization’s strategy changed since the last review? Have the scorecard measures changed?
7. Difficulties in implementing performance measurement systems
• Measurement overload
• Difficulty in establishing trade-offs
8. Measurement Practices
• Quality of measures
• Relationship of measures to compensation
9. Interactive control
Controls for Differentiated Strategies
• According to Hofstede, cultures differ across 4 dimensions:
• High power distance – opposite is true (e.g. Philippines)
Collectivistic – group-based rewards
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)
o High: informal controls – building interpersonal familiarity and trust is essential
2. Transfer Pricing
o Government Regulations
o Foreign Exchange Controls
o Funds Accumulation
o Joint Ventures
3. Exchange Rates