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