Management Control and Strategic Performance Measurement

1. Chapter Seventeen Management Control andStrategic Performance Measurement

2. Learning Objectives • Identify the objectives of management control • Identify the types of management control systems • Define strategic performance measurement and show how centralized, decentralized, and team-oriented organizations can apply it • Explain the objectives and applications of strategic performance measurement in three common strategic business units (SBUs): cost SBUs, revenue SBUs, and profit SBUs

3. Learning Objectives (continued) • Explain the role of the balanced scorecard (BSC) in strategic performance measurement • Explain the role of strategic performance measurement in service firms and not-for-profit organizations

4. Performance Evaluation and Control • Performance evaluation is the process by which managers at all levels gain information about the performance of tasks within the firm and judge that performance against preestablished criteria as set out in budgets, plans, and goals • Top management, middle management, and operating-level personnel should be evaluated • Management control refers to the evaluation by upper-level managers of the performance of mid-level managers

5. Performance Evaluation and Control (continued) • Operational control means the evaluation of operating-level employees by mid-level managers • Management control focuses on higher-level managers and long-term strategic issues (a broader objective), while operational control focuses on detailed short-term performance • Operational control is a management-by-exception approach while management control is more consistent with the management-by-objectives approach

6. Performance Evaluation and Control (continued) Chief Executive Financial Management Management Control Operations Management Marketing Management Plant A Plant B Region A Region B Operational Control Employee1 Employee2 Employee3 Employee 4

7. Management-by-Objectives • In a management-by-objectives (MBO) approach, top management assigns a set of responsibilities to each mid-level manager depending on the functional area involved and the scope of authority of the mid-level manager • Areas of responsibility are often called strategic business units (SBUs) • An SBU consists of a well-defined set of controllable operating activities over which the SBU manager is responsible

8. Management Control Objectives • Motivate managers to exert a high level of effort to achieve the goals set by top management • Provide the right incentive for managers to make decisions consistent with the goals set by top management (that is, to align managers’ efforts with the desired strategic goals) • Determine fairly the rewards earned by managers for their efforts and skill and the effectiveness of their decision making

9. Achieving Management Control Objectives • A common mechanism for achieving these multiple objectives is to develop an employment contract between the manager and top management • A contract promotes goal congruence: the contract specifies the manager’s desired behaviors and the compensation to be awarded for achieving specific outcomes by using these behaviors • Contracts can be written or unwritten, explicit or implied

10. Employment Contracts • An economic model, the principal-agent model, is a prototype that contains the key elements that a contract must have to achieve the desired objectives • There are two important aspects of management performance that affect the contracting relationship, uncertainty and lack of observability • Managers operate in an environment that is influenced by factors beyond the manager’s control; there is some degree of uncertainty

11. Employment Contracts (continued) • Many efforts and decisions made by the manager are not observable to top management, and the manager often possesses information not accessible to top management • Because of uncertainty and the lack of observability, three principles should be followed in the preparation of an employment contract: • Separate the performance of the manager from the performance of the SBU

12. Employment Contracts (continued) • Exclude known uncontrollable factors from the contract • Risk-adverse managers make decisions to avoid risk when top management might prefer choices that involve some risk. It is therefore necessary to separate the value of the outcome from the positive or negative weight associated with the risk due to uncertainty. • Management control systems should be designed to reduce the negative effects of risk preferences

13. External Factors Accounting Top Management PreparePerformanceReport Pays Manageron the Basis of thePerformance Report Uncertainty RiskAversion DecisionMaking Effort ReceivesPay The Principal-Agent Model Outcome of manager’s decision and effort Manager

14. Designing Management Control Systems There are four questions management must ask when developing a management control system: • Who is interested in evaluating the organization’s performance (owners, directors, creditors, employees, etc.)? • What is being evaluated (an individual, team, or SBU)? • When is the performance evaluation to be conducted, and should it be based on the master budget (resource inputs –ex ante) or the flexible budget (outputs of the manager’s effort–ex post)? • Should the system by formal or informal?

15. Types of Management Control Systems

16. Strategic Performance Measurement • Strategic performance measurement is a system used by top management to evaluate SBU managers • Before designing strategic performance measurement systems, top managers determine when delegation of responsibility is desirable • A firm is decentralized if it has chosen to delegate a significant amount of responsibility to SBU managers • A centralized firm reserves much of the decision-making at the top-management level

17. Strategic Performance Measurement (continued) • Centralized firms provide more control and the expertise of top management can be effectively utilized • Decentralized firms are able to make more timely decisions at the operational level; top management lacks the necessary local knowledge • Decentralized firms are often more motivating for employees, are an excellent environment for training future top-level managers, and are a better basis for performance evaluations

18. Types of SBUs • Cost SBUs are a firm’s production or support departments that are charged with the responsibility of providing the best quality product or service at the lowest cost (examples: a plant’s assembly department, data-processing department, and its shipping and receiving department) • Revenue SBUs focus on the selling function and are defined either by product line or by geographic area • When an SBU both generates revenues and incurs the major portion of the cost for producing these revenues, it is considered a profit SBU • Investment SBUs include assets employed by the SBU as well as profits in the performance evaluation

19. Types of SBUs (continued) The choice of a profit, cost, or revenue SBU depends on the nature of the production and selling environment in the firm: • Products that have little need for coordination between the manufacturing and selling functions are good candidates for cost and revenue SBUs • For products that require close coordination between these functions, profit SBUs would be the preferred option

20. Cost SBUs • Direct manufacturing and manufacturing support departments are often evaluated as cost SBUs since these managers have significant direct control over costs but little control over revenues or decision-making for investment in facilities • Several strategic issues arise when implementing cost SBUs: • Cost shifting occurs when a department replaces its controllable costs with noncontrollable costs (e.g., variable costs to fixed costs)

21. Cost SBUs (continued) • Many performance-measurement systems focus excessively on short-term cost figures, neglecting long-term strategic issues • The majority of SBUs have some amount of budgetary slack, which is the difference between budgeted and expected performance • Budgetary slack can be good as it reduces risk aversion, but too much slack can result in reduced employee effort and (as indicated in Chapter 8) can complicate the planning process

22. Two Methods of Implementing Cost SBUs in Production and Support Departments

23. Implementing Cost SBUs in General and Administrative Departments These departments have the same two methods to choose from, but the proper choice may change over time: • For example, if cost reduction is a key objective, the HR department might be treated as an engineered-cost SBU • Later, it might be changed to a discretionary-cost SBU to motivate managers to focus on the achievement of long-term goals

24. CostVariance 250 Implementing Cost SBUs in General & Administrative Departments TotalCost Engineered Cost 4,800 3,600 2,400 1,200 Cost behavior in administrative support SBUs is often a step cost 100 200 300 400 CostDriver (number of applications)

25. Cost SBU—Miscellaneous Considerations for Performance Reporting • Many firms are choosing to outsource manufacturing, customer service, engineering, and other services • When using a cost SBU, how should the firm allocate the jointly incurred costs of service departments to the departments using the service? • An allocation method should be chosen based on its ability to motivate managers, encourage goal congruence, and provide a basis for fair evaluation of management’s performance

26. Cost SBUs—Implementation Considerations (continued) • Dual allocation is a useful guide in choosing a cost allocation method • Dual allocation is a cost-allocation method that separates fixed and variable costs; variable costs are directly traced to user departments, and fixed costs are allocated on some logical basis • Indirect costs could be traced to cost SBUs using activity-based costing (ABC)

27. Revenue SBUs • Management commonly uses revenue drivers in evaluating the performance of revenue SBUs • Revenue drivers in manufacturing firms are the factors that affect sales volume, such as price changes, promotions, discounts, customer service, changes in product features, delivery dates, and other value-added factors • Revenue drivers in service firms focus on the quality of the service

28. Marketing Departments Marketing departments can be either a revenue or a cost SBU: • The revenue SBU responsibility stems from the fact that the marketing department manages the revenue-generating process and produces revenue reports for evaluation • This department can also be a cost SBU as it incurs two types of costs, order-getting (advertising and promotion) and order-filling (warehousing, packing, and shipping) costs

29. Profit SBUs • The profit manager’s goal is to earn profits • Three strategic issues cause firms to choose profit SBUs rather than cost or revenue SBUs: • Profit SBUs provide the incentive for the desired coordination among marketing, production, and support functions • Profit SBUs motivate managers to consider their product as market able to outside customers • Profit SBUs motivate managers to develop new ways to earn a profit from their products and services

30. Cost Leadership, Differentiation, and SBUs Cost Leadership Sales Manufacturing Plant Warehouse Revenue SBU Cost SBU Sales Manufacturing Plant Differentiation Profit SBU Profit SBU

31. Contribution Income Statement • A common form of profit SBU evaluation tool is the contribution income statement, which is based on the contribution margin developed for each profit SBU and for each relevant group of profit SBUs • Detail of the statement varies based on management’s needs • Contribution by SBU (CSBU) measures all costs traceable to, and therefore controllable by, the individual SBU, including traceable fixed costs

32. Controllable and Noncontrollable Fixed Costs Fixed costs can be either controllable or noncontrollable from the perspective of each profit SBU: • Controllable fixed costs are fixed costs that the profit SBU manager can influence in approximately a year or less, such as advertising, data processing, and management consulting expenses • Noncontrollable fixed costs are those that are not controllable within a year’s time, such as depreciation and taxes

33. Profit SBU Performance Evaluation • Subtracting controllable fixed costs from the contribution margin results in the SBU’s controllable margin • The contribution margin income statement can also be used to help determine whether a profit SBU should be dropped or retained • One complication in the preparation of this statement is that some costs that are not traceable at a detailed level are traceable at a higher level

34. Contribution Income Statement Example This statement shows the operating results for Machine Tools, Inc. (MTI) as a whole

35. Contribution Income Statement Example (continued) This statement shows the operating results by division

36. Contribution Income Statement Example (continued) This statement shows the operating results by product for Division B

37. Variable vs. Full Costing • The use of the contribution income statement is often called variable costing because it separates variable and fixed costs • Full costing is the conventional costing system that includes fixed manufacturing cost as part of “product cost” • Full costing, also called “absorption costing,” is required by GAAP for financial reporting and by the IRS for computing taxable income • Full costing satisfies the matching principle while variable costing meets the three objectives of management control systems

38. Variable Costing • There is an additional reason for using variable costing • Although net income determined using full costing is affected by changes in inventory levels, net income using variable costing is not affected • This is because under variable costing, fixed manufacturing costs are treated as period costs, not product (inventoriable) costs • The following example compares the two costing methods over two periods, one with increasing inventory and the other with decreasing inventory

39. Variable vs. Full Costing Example Inventory increased by 40 Inventory decreased by 40 $4000 ÷ 100 units = $40 fixed unit cost

40. Variable vs. Full Costing Example (continued)

41. Variable vs. Full Costing Example (continued) Difference in Beginning Inventory$2,800 - $1,200 = $1,600 Difference in Income$2,300 - $3,900 = $1,600

42. Variable vs. Full Costing Summary Analysis • Full (absorption) costing net income exceeds variable costing net income (by the amount of fixed cost in the inventory change) when inventory increases, and variable costing net income is higher than full-costing net income when inventory decreases • Variable costing is not affected by the change in inventory because all fixed costs are deducted from income in the period in which they occur; fixed costs are not included in inventory so that changes in inventory levels do not affect net income

43. Strategic Performance Measurement and the Balanced Scorecard (BSC) • The BSC measures SBU performance in four key perspectives: • Customer satisfaction • Financial performance • Internal business processes • Learning and innovation • Cost, revenue, and profit SBUs focus on the financial dimension

44. The Balanced Scorecard (BSC) and Performance Evaluations There are several implementation issues when using the BSC in performance evaluations: • Measures are difficult to compare across SBUs • Validation of the links between measures that are assumed to improve performance throughout the strategy map is required • Managers must provide information on the strategic linkages in the strategy map

45. The BSC and Performance Evaluations (continued) • Many large firms have installed enterprise resource planning systems (ERPs) to collect BSC information, but firms lacking such a system may have trouble collecting the necessary data • The nonfinancial information used in the BSC is not subject to control or audit and may be unreliable or inaccurate • Nonfinancial information is often prepared on a weekly or daily basis while performance reviews are generally conducted quarterly or annually • Concern arises related to the timeliness and reliability of nonfinancial data prepared by external sources

46. The Strategy Map The strategy map uses the BSC to describe the firm’s strategy in detail by using cause-and-effect diagrams Financial Goals: Earnings, sales, growth Goals: Customer satisfaction, better staff response to customer needs Customer Goals: Staff apply their competencies and strategic awareness Operations Goals: Staff competencies, strategy awareness Learning and Innovation

47. Managements Control in Service Firms and Not-for-Profit Organizations • Service firms and not-for-profit organizations commonly use cost (most common) SBUs and profit SBUs • Cost SBUs are used when the manager’s critical mission is to control costs • Profit SBUs are preferred when the department manager must manage both costs and revenues, or alternatively (in a not-for-profit), manage costs without exceeding budgeted revenues

48. Chapter Summary • There are formal, informal, team, and individual management control systems • The objectives of management control are to: • Motivate managers to exert a high level of effort to achieve the goals set by top management • Provide the right incentive for managers to make decisions consistent with the goals set by top management (i.e., to align managers’ efforts with the desired strategic goals) • Determine fairly the rewards earned by managers for their efforts and skill and the effectiveness of their decision making

49. Chapter Summary (continued) • Strategic performance measurement is a system used by top management to evaluate SBU managers • Before designing strategic performance measurement systems, top managers determine when delegation of responsibility is desirable • A firm is decentralized if it has chosen to delegate a significant amount of responsibility to SBU managers • A centralized firm reserves much of the decision making at the top management level

50. Chapter Summary (continued) There are four types of SBUs: • Cost SBUs are a firm’s production or support SBUs that provide the best quality product or service at the lowest cost, such as a plant’s assembly department, data processing department, and shipping and receiving department • Revenue SBUs focus on the selling function and are defined either by product line or by geographic area • When an SBU both generates revenues and incurs the major portion of the cost for producing these revenues, it is a profitSBU • Investment SBUs include assets employed by the SBU as well as profits in the performance evaluation