This is an English summary of the book 'Management Control Systems', written for the MSc. course 'Accountancy & Control' at the University of Amsterdam. The summary includes all chapters, even tables are included. Dutch: This is an English summary of the book 'Management Control Systems'. I have a ...
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Title: Management Control Systems
3rd Edition (2012)
Authors: Kenneth A. Merchant & Wim A. Van der Stede
Publisher: Financial Times Prentice Hall
ISBN: 978-0-273-73761-2
Summarized by: Robin Kras, 2013
,Contents
1. Management and control .................................................................................................... 4
1.1. Causes of management control problems .................................................................... 4
1.2. Control problem avoidance ......................................................................................... 5
2. Results controls .................................................................................................................. 6
2.1. Elements of results controls ......................................................................................... 6
2.2. Conditions determining the effectiveness of results controls ...................................... 7
3. Action, personnel, and cultural controls............................................................................. 9
3.1. Action controls ............................................................................................................ 9
3.2. Personnel controls...................................................................................................... 10
3.3. Cultural controls ........................................................................................................ 10
4. Control system tightness .................................................................................................. 12
4.1. Tight results controls ................................................................................................. 12
4.2. Tight action controls .................................................................................................. 13
4.3. Tight personnel/cultural controls ............................................................................... 13
5. Control system costs......................................................................................................... 14
5.1. Direct costs ................................................................................................................ 14
5.2. Indirect costs .............................................................................................................. 14
6. Designing and evaluating management control systems .................................................. 17
6.1. Choice of controls ...................................................................................................... 17
6.2. Choice of control tightness ........................................................................................ 18
7. Financial responsibility centers ........................................................................................ 20
7.1. Advantages of financial results control systems ........................................................ 20
7.2. Types of financial responsibility centers ................................................................... 20
7.3. Choice of financial responsibility centers ................................................................. 21
7.4. The transfer pricing problem ..................................................................................... 21
8. Planning and budgeting .................................................................................................... 24
8.1. Purpose of planning and budgeting ........................................................................... 24
8.2. Planning cycles .......................................................................................................... 24
8.3. Target setting ............................................................................................................. 25
8.4. Planning and budgeting practices, and criticisms ...................................................... 28
9. Incentive systems ............................................................................................................. 30
9.1. Purposes of incentives ............................................................................................... 30
9.2. Monetary incentives .................................................................................................. 30
9.3. Incentive system design ............................................................................................. 32
9.4. Criteria for evaluating incentive systems .................................................................. 34
9.5. Group rewards ........................................................................................................... 34
2
,10. Financial performance measures and their effects ........................................................ 35
10.1. Market measures of performance ........................................................................... 35
10.2. Accounting measures of performance.................................................................... 36
10.3. Investment and operating myopia .......................................................................... 37
10.4. Return-on-investment measures of performance ................................................... 37
10.5. Residual income measures as a possible solution to the ROI measurement
problems ............................................................................................................................... 39
11. Remedies to the myopia problem .................................................................................. 40
11.1. Reduce pressures for short-term profit .................................................................. 40
11.2. Control investments with preaction reviews .......................................................... 40
11.3. Extend the measurement horizon ........................................................................... 41
11.4. Measure changes in value directly ......................................................................... 41
11.5. Improve the accounting measures .......................................................................... 41
11.6. Measure a set of value drivers................................................................................ 41
12. Using financial results controls in the presence of uncontrollable factors .................... 43
12.1. Types of uncontrollable factors ............................................................................. 43
12.2. Controlling for the distorting effects of uncontrollables ........................................ 44
12.3. Other uncontrollable factor issues.......................................................................... 47
13. Corporate governance and boards of directors .............................................................. 48
13.1. The Sarbanes-Oxley Act of 2002 ........................................................................... 48
13.2. Boards of directors ................................................................................................. 48
14. Controllers and auditors ................................................................................................ 50
14.1. Controllers.............................................................................................................. 50
14.2. Auditors.................................................................................................................. 50
15. Management control-related ethical issues ................................................................... 52
15.1. The importance of good ethical analyses ............................................................... 52
15.2. Why do people behave unethically? ...................................................................... 54
15.3. Some common management control-related ethical issues ................................... 54
15.4. Spreading good ethics within an organization ....................................................... 56
16. The effects of environmental uncertainty, organizational strategy, and multinationality
on MCS .................................................................................................................................... 57
16.1. Environmental uncertainty ..................................................................................... 57
16.2. Organizational strategy .......................................................................................... 57
16.3. Multinationality...................................................................................................... 59
17. Management control in not-for-profit organizations ..................................................... 62
17.1. Differences between for-profit and not-for-profit organizations ........................... 62
3
,1. Management and control
An old, narrow view of MCS (Management Control Systems) is that of a simple regulating system
involving a single feedback loop analogous to a thermostat that measures the temperature,
compares the measurement with the desired standard, and, if necessary, takes a corrective action
(like turning on or off an air conditioner). Many management controls in common use do not focus
on measured performance. They focus instead on encouraging and enabling employees to act in the
organization’s best interest.
There are two kinds of management controls:
• Proactive;
• Reactive.
Proactive means that the controls are designed to prevent problems before the organization suffers
any adverse effects on performance. Examples of proactive controls include planning processes,
required expenditure approvals, segregation of duties, and restricted access. Management control,
then, includes all the devices or systems managers use to ensure that the behaviors and decisions of
their employees are consistent with the organization’s objectives and strategies.
In the broadest sense, control systems can be viewed as having two basic functions: strategic control
and management control. Strategic control involves managers addressing the question: “Is our
strategy valid?” (“Are we still on the right track?”). Management control on the other hand focuses
on execution, and it involves addressing the general question: “Are our employees likely to behave
appropriately?” This question can be decomposed into several parts:
1. “Do our employees understand what we expect of them?”
2. “Will they work consistently hard and try to do what is expected of them?” (goal congruence)
3. “Are they capable of doing a good job?”
Managers addressing strategic control issues have a focus primarily external to the organization; they
examine the industry and their organization’s place in it. Managers addressing management control
issues, on the other hand, have primarily an internal focus; they reflect how they can influence
employees’ behaviors in desired ways.
1.1. Causes of management control problems
The causes of the needs for control can be classified into three main categories:
1. Lack of direction;
2. Motivational problems;
3. Personal limitations.
Some employees perform inadequately simply because they do not know what the organization
wants from them. When this lack of direction occurs, the likelihood of the desired behaviors
occurring will be haphazard. Thus, one function of management control involves informing
employees as to how they can direct their contributions to the fulfillment of organizational
objectives. Even when employees understand what is expected of them, some do not perform as the
organization expects because of motivational problems. Motivational problems are common because
individual and organizational objectives do not naturally coincide – individuals are self-interested
4
,(this is a lack of goal congruence). The final behavioral problem that MCSs must address occurs
where employees who know what is expected of them, and who may be highly motivated to perform
well, are simply unable to perform well because of any of a number of other limitations. Some of
these limitations are person-specific. They may be caused by a lack of aptitude (talent, capability),
training, experience, stamina, or knowledge for the tasks at hand. An example is the too-common
situation where employees are promoted above their level of competence.1 Note that these three
needs for controls correspond with the three management control questions stated earlier.
Good control means that management can be reasonably confident that no major unpleasant
surprises will occur. The cost of not having a perfect control system can be called a control loss.
Optimal control can be said to have been achieved if the control losses are expected to be smaller
than the cost of implementing more controls.
1.2. Control problem avoidance
Sometimes avoiding or preventing the control problems is a better way to achieve good control than
implementing MCSs. Four prominent avoidance strategies are:
1. Activity elimination;
2. Automation;
3. Centralization;
4. Risk sharing.
Managers can sometimes avoid the control problems associated with a particular entity or activity by
turning over the potential risks, and the associated profits, to a third party through such mechanisms
as subcontracts, licensing agreements, or divestment. This form of avoidance is called activity
elimination.
Automation is a second avoidance possibility. Managers can sometimes use computers, robots,
expert systems, and other means of automation to reduce their organization’s exposure to some
control problems. In most managerial situations, however, automation can provide only a partial
control solution at best. Two limitations are feasibility (can machines replace humans?) and cost.
Finally, automation may just replace some control problems with others. Computer automation
often increases control risks.
Centralization of decision-making is a third avoidance possibility, which is a key element of almost all
organizations’ MCSs. High degrees of centralization is where all the key decisions are made at top
management levels. When decisions are decentralized the decisions are made at lower levels of
management. Accountability for results is what makes delegated authority legitimate.
A final, partial avoidance possibility is risk sharing. Sharing risks with outside entities can bound the
losses that could be incurred by inappropriate employee behaviors. Risk sharing can involve buying
insurance to protect against certain types of potentially large losses the organization might not be
able to afford.
1
See also the Peter Principle: http://en.wikipedia.org/wiki/Peter_Principle
5
,2. Results controls
Pay-for-performance is a prominent example of a type of control that can be called results control
because it involves rewarding employees for generating good results. Results controls create
meritocracies2. In meritocracies, the rewards are given to the most talented and hardest working
employees.
Results controls are consistent with, and even necessary for, the implementation of decentralized
forms of organization with largely autonomous entities or responsibility centers.
Decentralization or “delegation of decision rights” to managers, and the design of incentive systems
to motivate these managers to generate the desired results, are two critical organizational design
choices in a results-control context. 3
Results controls alleviate or lighten a potential lack of direction. Results controls also can be
particularly effective in addressing motivational problems. And they also can mitigate personal
limitations. Because results controls typically promise rewards for good performers, they can help
organizations to attract and retain employees who are confident about their abilities. Results
controls also encourage employees to develop their talents to position themselves to earn the
results-dependent rewards.
2.1. Elements of results controls
The implementation of results controls involves four steps:
1. Defining the dimension(s) on which results are desired;
2. Measuring performance in the chosen dimensions;
3. Setting performance targets for employees to attain for each of the measures;
4. Providing rewards for target attainment to encourage the behaviors that will lead to the
desired results.
Defining performance dimensions involves setting an aim for the organization (e.g. should a firm’s
sole aim be to maximize shareholder returns, or should it also, or even primarily, be customer or
employee focused?).
It is critical to choose performance measures that are congruent or aligned with the chosen
performance dimensions because the goals that are set and the measurements that are made will
shape employees’ views of what is important (what you measure is what you get).
Performance targets affect behavior in two ways. First, they improve motivation by providing clear
goals for employees to strive for. Second, performance targets allow employees to assess their
performance.
Organizations can use any of a number of extrinsic rewards. They can grant additional monetary
rewards, such as in the form of cash or stock. They can use non-monetary rewards, such as by
granting high performing employees public recognition and additional decision authority. Conversely,
organizations can punish poor performance by threatening to reduce decision authority or decline to
fund proposed projects. Results measures can provide a positive motivational impact even if no
2
Meritocracy: A system in which advancement is based on individual ability or achievement.
3
See also Abernethy, M. A., Bouwens, J. and Van Lent, L. 2004. Determinants of Control System Design in
Divisionalized Firms. The Accounting Review 73 (3): 545-570.
6
,rewards are explicitly linked to results measures. People often derive their own internally generated
intrinsic rewards trough a sense of accomplishment for achieving the desired results.
Expectancy theory claims that individuals’ motivational force, or effort, is a function of (1) their
expectancies or their belief that certain outcomes will result from their behavior (e.g., a bonus for
increased effort); and (2) their valences4 or the strength of their preference for those outcomes.
Organizations should promise their employees the rewards that provide the most powerful
motivational effects in the most cost effective way possible. But the motivational effects of the
various reward forms can vary widely depending on individuals’ personal tastes and circumstances.
2.2. Conditions determining the effectiveness of results controls
Results controls cannot always be used effectively. They work best only when all of the following
conditions are present:
1. Organizations can determine what results are desired in the areas being controlled;
2. The employees whose behaviors are being controlled have significant influence on the
results for which they are being held accountable; and
3. Organizations can measure the results effectively.
Organizations must know what results are desired in the areas they wish to control, and they must
communicate the desired results effectively to the employees working in those areas. Furthermore,
the employees whose behaviors are being controlled must be able to affect the results in a material
way in a given time period. The results should be measurable and the key criterion that should be
used to judge the effectiveness of results measures is the ability to evoke the desired behaviors. To
evoke the right behaviors, in addition to being congruent and controllable, results measures should
be:
• Precise;
• Objective;
• Timely;
• Understandable;
• Cost efficient.
Measurement accuracy refers to the degree of closeness of measurements of a quantity to its actual
(true) value (e.g. the closeness of an arrow to the bull’s eye). Precision is the degree to which
repeated measurements under similar conditions who the same results (e.g. multiple arrows hit in
the same area). Results measures should be both accurate and precise.
An objective measure should be taken to mean here that it is not influenced by personal feelings or
interpretations. There are two main ways to increase measurement objectivity. The first alternative
is to have the measuring done by people independent of the process (e.g. the personnel in the
controller’s department). The second alternative is to have the measurements verified by
independent parties (e.g. auditors).
4
Valence: The degree of attraction or aversion that an individual feels toward a specific object or event.
7
,Timeliness refers to the lag between the employee’s performance and the measurement of results.
Timeliness is an important measurement quality for two reasons. The first is motivational. Measures,
and thus rewards, that are delayed for significant periods of time lose most of their motivational
impact. A second advantage is that timeliness increases the value of interventions that might be
necessary.
Two aspects of understandability are important. First, the employees whose behaviors are being
controlled must understand what they are being held accountable for. Second, employees must
understand what they must do to influence the measure.
A measure might have all of the above qualities yet be too expensive to develop or use, meaning that
the costs exceed the benefits. When that is the case, the firm may need to settle for an alternative,
more cost efficient measure.
8
, 3. Action, personnel, and cultural controls
3.1. Action controls
Action controls involve taking steps to ensure that employees act in the organization’s best interest
by making their actions themselves the focus of control. Action controls take any of four basic forms:
1. Behavioral constraints;
2. Pre-action reviews;
3. Action accountability; and,
4. Redundancy.
Behavioral constraints make it impossible, or at least more difficult, for employees to do things that
should not be done. You can think of physical constraints (e.g. locks, passwords, limited access etc.)
and administrative constraints (e.g. restriction of decision-making authority, separation of duties).
Pre-action reviews involve the scrutiny5 of the action plans of the employees being controlled.
Reviewers can approve or disapprove the proposed actions, ask for modifications, or ask for a more
carefully considered plan before granting final approval.
Action accountability involves holding employees accountable for the actions they take. The
implementation of action accountability controls requires: (1) defining what actions are acceptable
or unacceptable; (2) communicating those definitions to employees; (3) observing or otherwise
tracking what happens; and (4) rewarding good actions or punishing actions that deviate from the
acceptable.
Redundancy, which involves assigning more employees (or equipment) to a task than is strictly
necessary, or at least having backup employees (or equipment) available, also can be considered an
action control because it increases the probability that a task will be satisfactorily completed.
Redundancy is common in computer facilities, security functions, and other critical operations.
1. Control problems addressed by each of the action control types 6
Control problem Lack of direction Motivational Personal limitations
Type of problems
action control
Behavioral constraints ✓
Pre-action reviews ✓ ✓ ✓
Action accountability ✓ ✓ ✓
Redundancy ✓ ✓
Action controls can also be usefully classified according to whether they serve to prevent or to detect
undesirable behaviors. This distinction is important because controls that prevent the undesired
actions from occurring are, when they are effective, the most powerful form of control because the
5
Scrutiny: A close, careful examination or study.
6
Source: K. A. Merchant, Modern Management Control Systems: Text and Cases (Upper Saddle River, NJ:
Prentice Hall, 1998), p. 30.
9
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