Management Accounting Practice and Research Related to Vertical Hierarchies within Organizations

1
Management Accounting Practice and Research
Related to Vertical Hierarchies within
Organizations

• Kenneth A. Merchant
• University of Southern California
• EIASM, December 2006

2
What is a vertical hierarchy?

• Organization built on series of
  superior/subordinate relationships
• Headquarters/divisions/departments
• Functional
• Divisionalized
• Geographical

3
Critical problems in vertical hierarchies

• The organizational coordination problem
• The management control/agency/motivation problem

4
Primary control alternatives in vertical
hierarchies

• Direct supervision (monitoring)
• Bureaucracy (rules and procedures)
• Meritocracy (autonomy plus accountability

5
Creating a meritocracy is generally the preferred
alternative

• Encourage coordinated actions.
• Energize the workforce.
• Stimulate learning, creativity/innovation and
  continuous improvement.

6
Management accounting in meritocracies

• Long history
• E.g., DuPont, General Motors, GE
• Centralized control with
• decentralized authority
• Responsibility accounting
• E.g., Solomons (1965)

7
Virtually all corporations of at least minimal
size

• Create financial plans/budgets
• Measure financial and operational performance
  monthly
• Use responsibility accounting
• Provide rewards based on financial performance
  (typically annually)

8
So is best practice well established?

• Not exactly

9
Among the things we dont know

1. Why so heavy an emphasis on summary financial
   measures of performance when it is known that
   these measures provide poor indications of value
   creation?

10
What we want (in for-profit organiations)

• Measures that go up when value is created and
  down when value is destroyed.

11
What weve got

• Correlation between annual accounting earnings
  and annual value creation .20

12
Lots of financial measurement alternatives

• Profit measures (e.g., PAT, PBT, operating
  income, EBITDA, OIBDA)
• Return measures (e.g., ROE, ROC, ROI, RONA,
  RAROC, CFROI)
• Residual measures (e.g., residual income, EVA?,
  economic profit)

13
Summary financial measures unsolved questions

• Which measures work best in which settings?
• Can the measures be improved?
• Are there roles for financial measures even if
  they do not reflect value changes well?

14
Correlations between accounting earnings and
value creation
One year Two years Five years Ten years Source
Easton et al, JAR, 1992. Should firms just
extend the measurement horizon?
.22 .39 .57 .79
15
Among the things we dont know (cont.)

• How best to link market, financial and
  non-financial measures of performance?
• Lots of frameworks for Integrated Performance
  Measurement Systems
• Balanced Scorecard
• Tableau de Bord
• Performance Prism
• Intellectual Capital Navigator
• SMART (Strategic Measurement and Reporting
  Technique)
• EFQM (European Foundation for Quality
  Managements Excellence Model)
• (Or more generally, MBO/CSF)

16
Measurement issues when using a combination of
measures

• How to test the assumed causal linkages?
• How many measures is enough?
• How should the measures be weighted in
  importance? (What is balance?)
• What to do when measures have interactive or
  non-linear effects on overall performance?

17
An example ofa non-linear relationship
18
We must understand better

• The different purposes of performance measurement
  systems.
• Does some combination of the major categories
  say it all? attention directing, problem solving,
  decision facilitating and/or decision influencing
  
• Difference between a dashboard
• and an objective function?
• Difference between a complete
• objective function and an
• optimally designed incentive
• system?

19
Among the things we dont know (cont.)

1. Why do so many organizations base
   performance-dependent rewards on corporate
   performance even though few employees can have a
   material effect on overall corporate performance?

20
Among the things we dont know (cont.)

1. Can budgeting be improved, or is it really passé?

21
Among the things we dont know (cont.)

• Why is the typical bonus formula so complex?
• For example
• Organizational level of performance
• Objective function
• Performance contingencies
• Shape of the reward function

22
Shape of a typical short-term bonus function
Rewards
Results
23
Among the things we dont know (cont.)

1. Why dont firms use truth-inducing incentive
   systems?

24
Among the things we dont know (cont.)

• Why are systems sometimes dramatically different
  across settings
• Individual contingencies and combinations of
  them
• Management style

25
Among the variances in practice that are
difficult to explain

• Differences in use of punishments
• Differences in tolerance for use of subjectivity
  in performance evaluations
• Differences in implementation
• of the controllability principle

26
Differences in application of the
controllability principle

• 1. One companys philosophy No tolerance for any
  excuses.
• President We dont pay for effort. We pay for
  results.
• Most(?) companies protect managers from some bad
  luck but reward them for virtually all good
  luck.

27
An important, poorly understood
contingencynational setting
Performance-dependent incentives for department
managers in automobile retailers U.S.
(n 433) earning formula bonus
64.3 Size of formula bonus ( salary)
54.6 Primary performance measureprofit
94.0 Formula bonus floor and cap 1.6
28
Cross-national differences in reward systems
(cont.)

• Performance-dependent incentives for department
  managers in automobile retailers, U.S. vs.
  Netherlands
• U.S. Netherlands
• (n 433) (n 145)
• earning formula bonus 64.3 10.3
• Size of formula bonus ( salary) 54.6 8.6
• Primary perf. measureprofit 94.0 15.4
• Formula bonus floor and cap 1.6 23.1

29
Among the things we dont know (cont.)

• More generally, what are the motivations of
  people in the hierarchy?
• We know that its often not
• Value maximization e.g., superiors encourage
  subordinates to create slack.
• Pure self-interest e.g., many people try to do
  the right things even at personal cost.

30
Conclusion

• There is a lot yet to be learned, even in this
  very mature area of management accounting.