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Summary - Management Control Systems (320121-M-6)
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A summary of the course Management Control Systems (320121-M-6) including lecture slides, notes, and the papers.
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Management Control Systems SMVHC 1
Introduction & define the principal-agent problem, with examples
Lecture goals
By the end of this session, you should be able to:
• Offer examples of decision-influencing and decision-facilitating role in principal-
agency relationships
• Explain the moral hazard and adverse selection problem
• Give some real-life examples of these agency problems
• Explain how management control systems (MCS) can manage these agency
problems and how agency characterization matters herein
• Understand how this course can design better MCS to motivate employees.
The Agency Problem
Gap: when organizations grow bigger than the gap can grow.
Accountant: “successful firms must devise mechanisms that help align employee
(agents) interests with maximizing the organization’s value. All these mechanisms are
part of the firm’s management control system”
Decision facilitating (guide decision making): goals are aligned, so there is no real
agent problem, but agent doesn’t know how to reach these (information is not there) →
information provision such that people take better decisions.
• Nudging: Google employees must base all their decisions on data → better
decisions and ‘data’ word is the nudge.
• Example: how to get profit → agent gets information about the costs, or he gets
a budget to use → then his information is better.
• Google: their employees must
Decision influencing (attract talent, offer incentives): goals are not aligned.
• Adverse selection & moral hazard (hidden information + hidden action)
• Google: compensation of employees is a fixed + variable segment (bonuses).
▪ Perks: free meals → reciprocity: you want to do something in return.
Select the employee that is right for the job = difficult → use contract to solve this.
But there is…
,Adverse Selection
= categorize principal-agent models in which an agent has private information already
before a contract is written. E.g., a worker may know his effort costs (or a buyer may
know his willingness-to-pay) before an employer (or a seller) makes a contract offer.
Example: a bonus-based contract helps you to attract the right persons for the job →
by offering a contract, you might learn something about the ability of a salesperson.
• E.g., you must sell 300 cars a week to get a bonus → those that are good in
selling, will sign the contract = selection effect.
Example: you get the following contract proposition: target for all your courses = 75%.
• If you achieve it, the university will pay a €1000 bonus.
• If not: you must donate €400 to charity.
• Would you sign in on this contract?
• Students are more likely to sign if they think they can achieve the target →
attract highly skilled students → selection effect.
Example: as collaboration is important in Google, it uses peer/ collective bonuses for
the employees → in this way, they attract people that like to work together = selection.
Types of information → management accounting; who to attract?
• Incentive contracts with employees that stipulate performance levels → ability
• Relative performance systems; against peers → competitive types
• Bonus contracts, variable pay (more risk) vs. fixed pay → risk taking people
• Set targets for financial and non-financial performance → long term focus
• Deferred compensation plans → people that don’t want immediate results
Moral Hazard (hidden information)
= principal-agent models where there is often symmetric information at the time of
contracting. The agent however can become privately informed after the contract or
has information that the principal is not aware of at the time the contract is concluded.
Example: you arrived in Greece and need to go to the center. What can happen?
• Taxi-driver is agent and has more information/ local knowledge about the
market that the principal does not have.
• Principal cannot always verify whether the information is correct or not → agent
can ask a higher price or drive a longer route.
• Or taxi-driver can become privately informed after the contract → you agree for
a ride as you both know the route/ price, but then he says the highway is
blocked so has to take a (longer) b-route, which you don’t know.
Example: who should propose sales targets for next year budget period?
Who should get these decision rights? HQ of managers at local BU?
• The manager has local knowledge about the market that principal
does not have → principal profits from local knowledge when local
manager decides
• Downside: as local manager, I will make my life easy by proposing targets that
are easier to reach; principal does not know what I can achieve → inaccurate
, forecast if local manager decides = moral hazard, people use hidden
information, but misuse this if they have too much decision rights/ power.
Example: Wells Fargo wanted employees to sell as much → salespersons made fake
accounts (as they had hidden information) in order to reach the targets, in that way it
looked that they were selling a lot of accounts, but at the end, Fargo had to pay fines.
Types of information: how to avoid this hidden information? → Monitoring
• Monitoring systems by peers to prevent theft
• Internal control procedures (e.g., submit forms)
• Video surveillance
• Increased documentation, supervision authority
• Centralize your decision rights more, otherwise local BU can take advantage.
Moral Hazard (hidden action)
= the entrepreneur cannot perfectly monitor the agent efforts. Again, symmetric
information at time of contracting (40h per week). The agent may become privately
informed after the contract is written. The agent is simply working less or spends some
of his time idle → real effort < 40 hours.
= gap in effort
Gap arises because…
• Providing effort on part of employee is costly
• Monitoring actions of employee by principal is costly
• Sometimes principal does not have enough knowledge
• Time theft: doing something else during working hours → e.g., on FB.
Why is this the case? Because contracts are imperfect → once the bonus is reached,
people work less hard.
Types of information: how to avoid this hidden action? → performance measurement
After (standard) effort X, people do effort Y for a variable wage → aardbeien plukken.
Management Control
• Reduce the gap & mitigate the agency problem → focus on creating value.
• Characterize, analyze, and improve principal-agent relationships.
, • Management Control System (MCS): everything a company can use to induce
their employees to act in the best interest of the firm. They range from:
Social norm: if you must grade your colleagues, the norm will be that you work
hard because you want a good grade.
Everyone is/ will subject to MCS
• All companies evaluate their employees on a regular (yearly bonus) or irregular
(promotion decision) basis.
• All companies want that their employees work harder.
• Even students are subject to MCS
Some of you will decide about or will have to evaluate the implementation of MCS as
an entrepreneur, manager, controller or accountant!
• Which PM should we use to reduce ‘the gap’?
• Do we need to control more or less?
• Do we need to rely on ‘hard’ or ‘soft’ control systems?
• Can the MCS in this company induce fraud, misreporting, earnings
management?
• What can I do to motivate my junior accountants?
What is more important: strategy or management control?
• Most directors think their company has the right strategies, but only a few think
that their companies were implementing them well.
• Companies lose about 50% of their strategic power during the execution phase.
• Developing appropriate MCS can make your company a leader.
But, sometimes, control doesn’t work. If innovation is the strategy, creative types want
to do their thing, and control will work against them.
The Characterization of the Agent
Homo Economicus Simpson
100% rational Not rational, he makes stupid decisions
100% focus on money as an incentive (at work) and is not focus on incentives.
Many behaviors is rooted into humans.
• We have the capacity for social norms.
• We have the need to compare ourselves to others.
• We indirectly reciprocate.
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