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Management Control and Strategic Performance Measurement

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Title: Management Control and Strategic Performance Measurement


1
Management Control andStrategic Performance
Measurement
Chapter Seventeen
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 B
Region A
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 managers 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 managers
    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
The Principal-Agent Model
Outcome of managers 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
    organizations 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 managers effortex 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 firms production or support
    departments that are charged with the
    responsibility of providing the best quality
    product or service at the lowest cost (examples
    a plants 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
Implementing Cost SBUs in General
Administrative Departments
Total Cost
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
Cost Driver (number of applications)
25
Cost SBUMiscellaneous 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 managements performance

26
Cost SBUsImplementation 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 managers 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
    managements 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 years time, such as
    depreciation and taxes

33
Profit SBU Performance Evaluation
  • Subtracting controllable fixed costs from the
    contribution margin results in the SBUs
    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 Inventory2,800 - 1,200
1,600
Difference in Income2,300 - 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
    firms 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 managers 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 firms production or support SBUs
    that provide the best quality product or service
    at the lowest cost, such as a plants 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 profit SBU
  • Investment SBUs include assets employed by the
    SBU as well as profits in the performance
    evaluation

51
Chapter Summary (continued)
  • The BSC measures SBU performance in four key
    perspectives
  • Customer satisfaction
  • Financial performance
  • Internal business processes
  • Learning and innovation
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