1.Principles of Management Control Systems ICFAI UNIVERSITY ForIB S U se O nly C lass of2009

2. Principles of Management Control Systems ICFAI Center for Management Research Road # 3, Banjara Hills, Hyderabad 500 034 ForIB S U se O nly C lass of2009 3. ISBN 81-7881-995-3 Ref. No. PMCS/A 01 2K6 31 For any clarification regarding this book, the students may please write to ICFAI giving the above reference number, and page number. While every possible care has been taken in preparing this book, ICFAI welcomes suggestions from students for improvement in future editions. The Institute of Chartered Financial Analysts of India, January 2006. All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, used in a spreadsheet, or transmitted in any form or by any means electronic, mechanical, photocopying or otherwise without prior permission in writing from Institute of Chartered Financial Analysts of India. ForIB S U se O nly C lass of2009 4. Contents PART I: AN OVERVIEW OF MANAGEMENT CONTROL SYSTEMS Chapter 1 Introduction to Management Control Systems 3 Chapter 2 Approaches to Management Control Systems 15 Chapter 3 Designing Management Control Systems 28 Chapter 4 Key Success Variables as Control Indicators 42 PART II: MANAGEMENT CONTROL ENVIRONMENT Chapter 5 Organizing for Adaptive Control 57 Chapter 6 Autonomy and Responsibility 71 Chapter 7 Transfer Pricing 87 PART III: MANAGEMENT CONTROL PROCESSES Chapter 8 Strategic Planning and Programming 99 Chapter 9 Budget as an Instrument of Control 114 PART IV: MANAGEMENT CONTROL TOOLS Chapter 10 Reward Systems 139 Chapter 11 Management Control of Operations 152 Chapter 12 Continuous Process Improvement Methods 163 PART V: MANAGERIAL COSTING Chapter 13 Strategic Cost Management 177 Chapter 14 Auditing 185 Chapter 15 Audit of Management Functions 208 PART VI: MANAGEMENT CONTROL IN SPECIFIC SITUATIONS Chapter 16 Control in Multinational Corporations 221 Chapter 17 Control in Nonprofit Organizations 234 Chapter 18 Control in Service Organizations 242 Chapter 19 Management Control of Projects 258 PART VII: MANAGEMENT CONTROL AND EMERGING AREAS Chapter 20 Control in the Age of Empowerment 279 Chapter 21 Management Control and Ethical Issues 287 Glossary 295 Bibliography 301 Index 304 ForIB S U se O nly C lass of2009 5. Detailed Contents PART I: AN OVERVIEW OF MANAGEMENT CONTROL SYSTEMS Chapter 1: Introduction to Management Control Systems: Importance of Control Systems: Elements of a Control System Nature of Management Control Systems: Important Features of Management Control Systems, Management Control Process, Characteristics of a Good Management Control System, Distinction between Strategy Formulation, Management Control and Task Control Types of Management Control Systems: Formal Control System, Informal Control System Subsystems and Components of Management Control Systems: Formal Control Process, Informal Control Process Chapter 2: Approaches to Management Control Systems: Cybernetic Approach to Management Control Systems: Characteristics of a Cybernetic System, Cybernetic Paradigm and the Control Process, Designing Management Controls, Control Process Hierarchy Contingency Approach to Management Control Systems: The Need for the Contingency Approach Strategy and Control Systems: Corporate Strategy, Business Unit Strategy Chapter 3: Designing Management Control Systems: Steps in Designing Management Control Systems: Choice of Controls, Tightness of Controls Factors Influencing the Design of Management Control Systems: Managerial Styles and the Design of Control Systems: Corporate Culture and Design of Control Systems, Decentralization and Design of Control Systems, Organizational Slack and Design of Control Systems, Stakeholder Controls and Design of Control Systems, Communication Structures and Control Process Establishing a Customer-Focussed Total Quality Culture: Implementing Total Quality Management Impact of Information Technology on Control Systems Design: Providing Information for Operational and Strategic Decision Making Chapter 4: Key Success Variables as Control Indicators: Concept of Key Variables - Identifying Key Variables: Input Variables, Production Variables, Marketing Variables, Asset Management Variables, Sources of Key Variables, Types of Key Variables Key Success Variables and the Control Paradigm: Dynamics of the Control Process, Identifying Key Variables Comprehensive Performance Indicators: Limitations of Indicators Key Variables in Selected Industries: Insurance Industry, Hotel Industry, Sugar Industry, Management Training Institute, Power Industry PART II: MANAGEMENT CONTROL ENVIRONMENT Chapter 5: Organizing for Adaptive Control: Strategy, Structure and Control Decentralization Vs Centralization Response of Structure to Strategy: Evolution of the Matrix Structure: Project Organizations, Product Organizations, Service Organizations, The Matrix Structure and the Multinational Firm Evaluation of the Control Factors in Organizational Design: Matrix Versus Functional Controllers Organization Adaptive Organization: The Need for Adaptive Organization, Adaptive Controls that Support the Adaptive Organization ForIB S U se O nly C lass of2009 6. Chapter 6: Autonomy and Responsibility: Divisional Autonomy: Management Style and Process, Responsibility Structure, Measurement of Reward Systems Responsibility Structure: Overall Effectiveness Measures: Return on Investment (ROI) Responsibility Centers: Nature of Responsibility Centers, Types of Responsibility Centers Performance Measurement of Decentralized Operations: Measuring Divisional Operations Inter Profit Center Relations: Setting Transfer Prices Chapter 7: Transfer Pricing: Objectives of Transfer Pricing Principles of Transfer Pricing: Goal Congruence Methods of Calculating Transfer Price: Market-Based Pricing Method, Cost-Based Pricing Method, Negotiated Pricing Method Upstream Fixed Costs and Profits: Two Step Pricing, Profit Sharing, Two Sets of Prices Administration of Transfer Prices: Negotiation Arbitration and Conflict Resolution, Product Classification PART III MANAGEMENT CONTROL PROCESSES Chapter 8: Strategic Planning and Programming: Elements of Strategy Characteristics of Strategic Planning: Benefits of Strategic Planning, Organizational Relationships, Top Management Style Strategic Planning Process: Reviewing and Updating the Strategic Plan, Deciding on Assumptions and Guidelines, First Iteration of the Strategic Plan, Analysis, Second Iteration of the Strategic Plan, Final Review and Approval Analyzing Proposed New Programs: Rules, Avoiding Manipulation, Acquaintance to Planning Models, Organizing for Analysis Analyzing Ongoing Programs: Analysis, Activity Based Costing, Expense Center The Programming Process: Bower's Model of the Investment Decision-Making Process. Parameters of the Programming Process, Mutually Supportive Management Systems for the Implementation of Strategy through Programming Decisions, Formal Programming Procedures Chapter 9: Budget as an Instrument of Control: Need for Budgeting Forecasting, Budgeting and Strategic Planning Budgeting Process and Control: Budget Preparation Process, Budgetary Control, Behavioral Dimensions of Budgeting Master Budget: Steps in the Preparation of the Master Budget, Budget Balance Sheet Zero Based Budgeting: The ZBB Process, ZBB Vs Traditional Budgeting, Implementing Issues, Advantages and Disadvantages of ZBB Performance Budgeting: Steps in the Implementation of Performance Budgeting, Performance Budgeting Vs Traditional Budgeting Participative Budgeting Variance Analysis for Control Actions: Revenue Variances, Expense Variances, Summary of Variances, Limitations of Variance Analysis PART IV: MANAGEMENT CONTROL TOOLS Chapter 10: Reward Systems: Purpose of Reward Systems: Components of Incentive Compensation Plans CEO Compensation Incentives for Business Unit Managers: Size of Bonus Relative to Salary, Cutoff Levels, Bonus Basis, Performance Criteria, Benchmarks for Comparison Balanced Scorecard Design Considerations: Rewards Integrated with MSSM (Mutually Supportive Systems Model), Attainability, Formal Rewards, Informal Rewards Agency Theory: Concepts of Agency Theory ForIB S U se O nly C lass of2009 7. Chapter 11: Management Control of Operations: Information used in control of operations: Informal Information, Formal Information, Non Financial Information Just-In-Time Techniques: Advantages of Just-In-Time Techniques, Implications for Management Control Total Quality Management: Consequences of Poor Quality, Total Quality Management Approach, Implications for Management Control Computer Integrated Manufacturing Decision Support Systems: Nature of Decision Support Systems. Implications for Management Control Chapter 12: Continuous Process Improvement Methods: Target Costing: Planning Stage, Development Stage, Production Stage, Benefits of Target Costing Benchmarking and Benchtrending: Planning Phase, Analysis Phase, Benchtrending, Process Benchtrending Quality Improvements: Process Quality Teaming Activity-Based Costing: Traditional Costing vs Activity Based Costing (ABC) PART V: MANAGERIAL COSTING Chapter 13: Strategic Cost Management: Evolution of Strategic Cost Management: Strategic Measures of Success Three Key Themes of Strategic Cost Management: Value Chain Analysis, Cost Driver Analysis, Strategic Positioning Analysis Strategic Management and Strategic Cost Analysis Chapter 14: Auditing: Benefits of Audit: Identify Opportunities for Improvement, Reality Check, Identify Outdated Strategies, Increase Managements Ability to Address Concerns, Enhances Teamwork, Increase Commitment to Change Limitations of Audit Timing of an Audit Audit Process: Staffing the Audit Team, Creating an Audit Project Plan, Laying the Ground Work for the Audit, Analyzing Audit Results, Sharing Audit Results, Writing Audit Reports, Dealing with Resistance to Audit Recommendations, Building an Ongoing Audit Program Audit Tools and Techniques: Budget, Timing, Projectability, Geography, Surveys, Questionnaires, Focus Groups, Interviews, Direct Observation Management Audit: Objective of a Management Audit, Development of Management Audit, Benefits of Management Audits, Types of Management Audit, Organizing the Management Audit, Conditions for Successful Management Audit Internal Audit: Need for Internal Auditing Financial and Cost Audit Social Audit: Social Accounting versus Social Audit, Definition of Social Audit, Features of Social Audit, Approaches to Social Audit, Types of Social Audit Audit Evidence: Persuasive, Relevant, Unbiased, Objective Auditing for Continuous Improvement Chapter 15: Audit of Management Functions: Audit of the Purchasing Function: Purchasing Procedure, Characteristics of an Effective Purchase Department Purchase Audit Areas Human Resource Audit: Conducting an HR Audit Research and Development Activities Audit: Evaluation of R&D Activities Production Audit: Characteristics of a Good Manufacturing Audit Marketing Audit: Characteristics of Marketing Audit Sales Audit: Approaches to Sales Audit, Conducting a Sales Audit, Characteristics of a Sales Auditor, Process of Collecting Data During Sales Audit ForIB S U se O nly C lass of2009 8. PART VI: MANAGEMENT CONTROL IN SPECIFIC SITUATIONS Chapter 16: Control in Multinational Corporations: Types of Controls Used By MNCs: Personal Controls, Output Controls, Cultural Controls, Result Controls, Bureaucratic Controls Concept of Strategic Control: Headquarters-Subsidiary Environment, Impact of Global Competition, Impact of Host Government Demands, Impact of Joint Ventures Factors Affecting Control Systems in MNCs: Cultural Differences Across Countries, Differences in Business Environment Analysis of Foreign Investment Projects by MNCs: Taxes on Income from Foreign Investment Projects, Political Risks, Economic Risks, Exchange Rate Risk Transfer Pricing in MNCs: Situation 1-Paying Some Tax, Situation 2-Inflating Profits, Situation 3-Paying No Tax, Situation 4-Getting Tax Rebates, Tax Avoidance Inflates Profits, Methods of Transfer Pricing Control of Foreign Affiliates: Currency Translation, Budgeting for Foreign Affiliates Chapter 17: Control in Nonprofit Organizations: Mission of Nonprofit Organizations Key Characteristics of Nonprofit Organizations: Atmosphere of Scarcity, Bias towards Informality, Participation and Consensus, Dual Bottom Lines: Mission and Financial, Difficulty in Assessing Program Outcomes, Governing Board with both Oversight and Supporting Roles, Mixed Skill Levels of Staff, Participation of Volunteers Designing Control Systems for Nonprofit Organizations Employee Characteristics and Organizational Culture: Rewards, Performance Measurement, Fund Accounting, Programming and Budget Preparation Chapter 18: Control in Service Organizations: Control in Professional Organizations: Characteristics of Professional Organizations, Control Systems in Professional Organizations Control in Government Organizations: Political Influences, Public Information, Attitude towards Clients, Management Compensation Control Systems in Government Organizations: Strategic Planning, Performance Measurement Control in Financial Service Organizations: General Characteristics of Commercial Banks, Regulatory Capital, New Products, Management Control Implications, Basle Committee Principles on Banking, General Characteristics of Insurance Companies Control in Securities Firms: Management Control Implications Chapter 19: Management Control of Projects: Differences between the Control of Projects and the Control of Ongoing Activities: Single Objective, Focus on Projects, Need for Trade-offs, Less Reliable Performance Standards, Frequent Changes in Plan, Difference in Rhythm, Environmental Influence Project Planning: Planning Process, Nature of Project Plan, Project Scope, Project Schedule, Project Cost, Project Scheduling Project Control: Objectives of Project Control, Control as a Function of Management Reporting for Control: Effective Reporting System, Types of Project Reports Project Team and Matrix Structure: Matrix Structure Project Audits: Levels of Audit Project Evaluation: Evaluation of Performance, Evaluation of Results ForIB S U se O nly C lass of2009 9. PART VII: MANAGEMENT CONTROL AND EMERGING AREAS Chapter 20: Control in the Age of Empowerment: Balancing Empowerment and Control: Diagnostic Control Systems, Belief Systems, Boundary Systems, Interactive Control Systems Control Systems and Conflict Resolution: Conflicts in the Planning Subsystem, Conflicts in the Measuring Subsystem, Conflicts in the Recording Subsystem, Conflicts in the Appraisal Subsystem, Conflicts in the Reporting Subsystem, Conflicts in the Subsystem for Remedial Action Framework for Conflict Resolution Chapter 21: Management Control and Ethical Issues: Identifying Control- Related Ethical Issues: Creating Budgetary Slack, Responding to Flawed Control Indicators, Managing Earnings, Using Excessively Tight Control Measures Designing Control Systems to Regulate Ethical Conduct: Cybernetic Control Process for Developing an Ethics Program Control System Supporting the Ethics Program: Management Style and Culture, Infrastructure, Rewards, Coordination and Integration The Ethical Principle of Fairness In the Design of Control Systems ForIB S U se O nly C lass of2009 10. PART I: AN OVERVIEW OF MANAGEMENT CONTROL SYSTEMS ForIB S U se O nly C lass of2009 11. Chapter 1 Introduction to Management Control Systems In this chapter we will discuss: Importance of Control Systems Nature of Management Control Systems Types of Management Control Systems Subsystems and Components of Management Control Systems ForIB S U se O nly C lass of2009 12. 4 Principles of Management Control Systems In 2001, Enron Corp., the global energy giant, collapsed in one of the largest cases of bankruptcy filing in U.S. corporate history. Tyco International, a diversified manufacturing and service company, had to abandon plans to split into four parts, because of doubts about its accounting practices. The stunning news that WorldCom, the telecom giant, had artificially inflated its earnings by $3.8 billion rocked the corporate world and shook investors confidence in stock markets. WorldCom's accounting irregularities involved the deliberate mis-recording of expenses as capital expenditures, in order to inflate its cash flows. The accounting irregularities included transfers between internal accounts of $3.06 billion in 2001 and $797 million in the first quarter of 2002. As these examples illustrate, the absence or malfunctioning of control systems can lead to huge losses, and even to corporate bankruptcy. Defective products and poor coordination between departments also arise due to weak control systems. This chapter focuses on the importance of control systems, the nature of management control systems, types of management control systems, and the subsystems and components of management control systems. IMPORTANCE OF CONTROL SYSTEMS A control system is a set of formal and informal systems to assist the management in steering the organization towards its goals. Controls help in guiding employees effectively towards the accomplishment of the organizations goals. Establishing a control system in an environment of distributed accountability, reengineered processes, and local autonomy and empowerment is a challenging task. The control process in any organization can be undertaken at three levels. These are: the strategic level, the management level, and the operational level. Each type of control occurs primarily at one of the three distinct levels of the organizational hierarchy. Strategic control deals primarily with the broad questions of domain definition, direction setting, expression of the organizations purpose, and other issues that impact the organization's long-term survival. Strategic control overlaps to some extent with the process of strategy formulation. Strategic control also deals with issues relating to general company objectives and the implementation and monitoring of progress. Management control deals with effective resource utilization, the state of competitiveness of the unit, and the translation of corporate goals into business unit objectives. Operational control is primarily concerned with efficiency issues. Occurring at very specific functional or sub-departmental levels of the organizational hierarchy, this mode of control generally conforms to traditional control models. The time horizon of control is very short, the benchmarks are known and well defined, and the outcomes are tangible and easily measurable. ForIB S U se O nly C lass of2009 13. 5 Introduction to Management Control Systems It is important to recognize that the three levels of control are not mutually exclusive. They represent a nested arrangement. If the control process does not identify and deal appropriately with a problem occurring at a lower level, the problem worsens. The problem then gets kicked up to a higher level of control. This can be illustrated through the example of Kimberly-Clark in Exhibit 1.1. In extreme cases, when the issue gets more complicated, threatening the organizations survival, the problem needs to be handled from the highest levels, in terms of strategic control. Increased control in an organization will result in reduced creativity and entrepreneurship. Hence it is important for organizations to establish the trade- off between the amount of control and the level of freedom for employees, and to choose the right mix of controls. Elements of a Control System Any control system has four important elements. They are a detector or sensor, an assessor, an effector and a communications network, as can be seen in Figure 1.1. The detector analyzes the situation that is being controlled. An assessor helps in comparing the actual results with the standard or expected results. An effector is used to reduce the gap between the actual and the Exhibit 1.1 Management Control at Kimberly-Clark Kimberly-Clark, the manufacturer of household and health products, is an example of a company that mixed up operational and management control issues. The company has a good reputation as a manufacturer of household and health products. Since 1950s, it also started selling cigarette paper and sheets of pressed, reconstituted tobacco-to-tobacco companies for use in cigarettes. The tobacco reconstitution process used by Kimberly-Clark enabled tobacco companies to manipulate nicotine levels in cigarettes. The state of West Virginia in the US alleged that Kimberly-Clark conspired with cigarette companies to deceive the public about the hazards of smoking. When the company realized that its tobacco business was becoming a legal and financial liability, it spun off the tobacco unit. At the operational control level, the company did not ascertain whether the advertisements claiming that the tobacco reconstitution process allows nicotine levels to be adjusted to a smokers individual requirement was indeed misleading. At the management control level, the company did not act immediately once smoking related illness became common. The strategic control failure was not making a conscious determination whether the tobacco business was consistent with the company's mission and values. If the tobacco business was consistent with the mission and values, the company then needed to follow up by instituting proper operational and management control systems that protected the organization against legal liability. Adapted from Veliyath, Raj; Hermanson, Heather M. Organizational control systems: Matching controls with Organizational levels Review of Business, Winter97, Vol. 18 Issue 2, p2. ForIB S U se O nly C lass of2009 14. 6 Principles of Management Control Systems standard result. The communication network transmits information between the detector, the assessor and the effector. The process of control usually involves four important steps. They are: Identifying the goals or objectives, Implementing the programs or policies, Measuring and comparing outcomes against targets, and Analyzing whether the achieved targets are in accordance with the goals or objectives. NATURE OF MANAGEMENT CONTROL SYSTEMS The role of the management is to organize, plan, integrate and interrelate organizational activities to achieve organizational objectives. The achievement of these activities is facilitated by management control systems. A management control system is designed to assist managers in planning and controlling the activities of the organization. A management control system is the means by which senior managers ensure that subordinate managers, efficiently and effectively, strive to attain the company's objectives. According to Anthony, Dearden and Govindarajan1 (1992), management control is the process by which managers ensure that resources are used effectively and efficiently in the accomplishment of the organization's objectives. If the management monitors the activities of the business units frequently, then it is exercising tight control. Limited monitoring of the business units activities can be termed as loose control. The difference between tight and loose control thus relates to the degree to which the management monitors the 1 Robert N Anthony and Vijay Govindarajan, Management Control Systems, Eight Edition Irwin Publications. Figure 1.1 Elements of the Control Process Control device 2. Assessor. Comparison with standard 1. Detector. Observed information about what is happening Entity being controlled 3. Effector. Behavior altering communication, if needed Source: Robert N.Anthony, Govindarajan, Management Control Systems, (USA: Irwin, 1995) 5. ForIB S U se O nly C lass of2009 15. 7 Introduction to Management Control Systems activities of a unit. When there is tight control by the management, there is extensive involvement of the management in the day-to-day operations of the business unit. The budget is considered a binding constraint with a strong emphasis on meeting the budgeted targets. Deviations from the budget are generally not considered acceptable. Loose control is characterized by limited involvement by the management in day-to-day operations. Under loose control, the budget is regarded more as a tool for planning and communication than as a binding commitment. Management control systems involve a number of activities in an organization, including: Planning the future course of action Coordinating and communicating the various activities of the organization to different departments Evaluating information and deciding the various activities; and finally, Influencing people to work in accordance with the goals of the organization. Important Features of Management Control Systems Nature of decisions Management control decisions are based on the framework established by the organization's strategies. Management control decisions also take into account the quantity and quality of resources available. Within the constraints of the available resources and the policies of the organization, a manager should be able to implement activities that are best suited for a particular business unit. Decisions are made at the highest level, but their actual implementation may require some time. For instance, employees need time to adapt to a new technology. Decisions are systematic and rhythmic Decisions in management control process are systematic and rhythmic i.e. they are in accordance with the strategies and procedures laid down by the top management. Plans developed for a unit must encompass the whole organization, and the plans for each of the organizations units must be coordinated with one another, so that there is a balance between different activities. For example, operations and distribution should be balanced with the sales program. Strategy implementation tool Management control helps an organization to move towards its strategic objectives. It is an important vehicle for the execution of strategy. Figure 1.2 explains how strategies are implemented through management controls, organizational structures, human resource management, and culture. Effective execution can take place with the help of an efficient organizational structure, human resource management and culture. All these are influenced by the system of management control, and hence it is an important aspect of strategy implementation. ForIB S U se O nly C lass of2009 16. 8 Principles of Management Control Systems Behavioral considerations People are important assets for an organization. Without the cooperation of the employees, managers cannot implement their decisions. To manage people effectively, control systems are required for the following three reasons- lack of direction, motivational problems and personal limitations. Poor performance in organizations can be attributed to lack of direction among employees. Giving employees the required support and direction to accomplish organizational goals is one of the important functions of management control systems. Motivation is important to help employees perform to their full potential. Most of the organizations problems occur because individual goals and organizational goals do not match. This results in demotivated performance by the employees. At the managerial level too, lack of motivation will result in employees taking decisions that are harmful to the organization. The decisions may be made in order to advance the personal interests of the employees involved. In extreme cases, this could lead to employee fraud and theft. In IT companies, computer-related crime can result in huge losses for the organization. Hence, there is a need to control such behavior in an organization. Another behavioral problem that can have serious consequences for an organization is personal limitations. In spite of high motivation to perform, certain employees may be unable to perform because of their personal limitations. These limitations are specific to individuals, and could also be because of inadequate training, lack of knowledge or information, and inexperience. Job design also plays an important role in performance. Some jobs are designed in a manner that creates stress. This can lead to accidents and errors in decision-making. Training plays an important role in reducing Figure 1.2Framework for Strategy Implementation Implementation mechanisms Management Controls Organization Structure Culture Human Resource ManagementStrategy Performance Source: Robert N Anthony and Vijay Govindrajan, Management Control Systems (USA: Irwin, 1995) 11. ForIB S U se O nly C lass of2009 17. 9 Introduction to Management Control Systems the severity of limitations at the individual level. Finding effective tools for control of such limitations is an important part of control systems. Management Control Process The management control process involves three interrelated activities communication, motivation and evaluation. First, it involves communication between the superior and the subordinates. Communication helps the subordinates understand the goals of the organization. The superior should make sure that the subordinates understand what the organization expects of them. Second, for the subordinates to put in their best efforts to achieve organizational goals, they have to be motivated. It is the responsibility of the superior to motivate the subordinates. Finally, for effective performance, superiors should evaluate the work of the subordinates and give them feedback periodically. It is essential for the superior to evaluate the performance of subordinates without any bias. Characteristics of a Good Management Control System A good management control system ensures success for an organization. Good management control here implies that the goals of the organization are clearly communicated to the employees, and that the employee is confident about performing his tasks well. For example, good inventory control means that employees have information about the quantity of inventory present and its availability at different locations. An organization does not usually have perfect control. For perfect control all the employees should be working in the best possible way. But this is not always possible as employee behavior is not stable. Good control can be achieved in the following ways: Future-oriented Planning is always oriented to the future. The organization should be focused on the future. Employees should be encouraged to be flexible so as to respond effectively to change. Clear Objective Good control cannot be established unless the multiple objectives of a particular task are considered separately. For example, to assess the control system relating to production, all major performance parameters like efficiency, quality and asset management, have to be measured. Minimum control losses Control devices are costly and not always economically feasible. So, control devices should be put in place only when the economic benefits exceed the costs. The difference between the performance that is theoretically possible and one that can be reasonably expected is called control loss. An organization achieves optimal performance when control losses are minimized. ForIB S U se O nly C lass of2009 18. 10 Principles of Management Control Systems Distinction between Strategy Formulation, Management Control and Task Control It is important to analyze the differences between management control and other types of control. Management control needs to be distinguished clearly from strategy formulation and from task control. While strategy formulation takes place at the highest level in an organization, task control takes place at the individual level. Management control lies at the middle level between strategy formulation and task control. Figure 1.3 explains the distinction between strategy formulation, management control and task control. Distinction between strategy formulation and management control Strategy formulation takes place at the highest level of the management and involves formulation of new strategies, whereas management control involves implementation of these policies. Strategy formulation takes place in accordance with situations, both internal and external to the organization. Hence, strategy formulation may not always follow a clearly defined system. The management control process takes place in a systematic manner, and involves managers and staff at all levels in the organization. Strategy formulation usually involves only those at the highest level of the organization. There may be changes in one or a few strategies, while others remain unaffected. In contrast, the management control process involves the whole organization, and changes affect all the parts since they are linked with one another. Therefore, a high level of coordination is required. Task control vs. management control Task control involves the control of individual tasks. These tasks are carried out according to the rules and regulations laid down by the management Figure 1.3 General Relationship among Planning and Control Functions Activity Nature of End product Strategy formulation Goals, strategies and policies Management control Implementation of Strategies Task control Efficient and effective performance of individual tasks Source: Robert N.Anthony, Govindarajan, Management Control Systems, (USA: Irwin, 1995) 9. ForIB S U se O nly C lass of2009 19. 11 Introduction to Management Control Systems control process. Usually the techniques in operations research and management science focus on task control. The information important for task control in an organization is usually quantitative in nature e.g. the number of items ordered by the customers, the components used in manufacturing the products, the number of man-hours used in a particular process, etc. The devices used for task control include programmable machine tools, process control computers and robots. In task control, each task requires a different task control system (a production control system is different from a cash management system). Thus, it can be concluded that task control is quantitative in nature whereas management control is oriented towards behavior. In task control, in some cases, such as automated processes, employees may not be involved; in other cases, there may be interaction between a manager and a worker. Management control involves interaction between two managers or between a superior and subordinate. TYPES OF MANAGEMENT CONTROL SYSTEMS Control systems in an organization fall under two broad areas: formal and informal. Formal controls are laid out in writing by the management, whereas informal controls arise as a result of employees behavior. Examples of formal controls are plans, budgets, regulations and quotas. Informal controls include group norms and organizational culture. Formal controls are framed by the managers, whereas informal controls often originate with employees and are affected by general socio-cultural factors. Formal Control System Formal control systems are written, management-initiated mechanisms that influence the behavior of employees in achieving the organizations goals. Formal controls can be classified into three types, based on the nature of management intervention. They are: Input controls These are the actions taken by the company before a planned activity is implemented. These measures help the company to select the right way to undertake the activity. Input controls include selection criteria, recruitment and training programs, manpower allotments, strategic plans and resource allocations. Process controls Process controls involve tracking certain variables and taking corrective action whenever there is any deviation from specified parameters in the variables. The control action takes place before the process of transformation is completed and the output is produced. Process control is exercised when the firm attempts to influence the ongoing activity to achieve the desired ends. The control is applied to the behavior or activities rather than the end results. For example, under a feed-forward system of inventory control, the factors that affect inventory levels of finished goods, such as the rate of sales or ForIB S U se O nly C lass of2009 20. 12 Principles of Management Control Systems dispatch delays, are tracked. When the sales begin to decline or there is a dispatch bottleneck, this information is fed forward, and the level of the finished goods inventory is controlled by reducing production. Thus, the inventory levels are prevented from exceeding required levels. Alternatively, the managers may realize that the original standards for sales or dispatch delays are no longer appropriate and must be revised. This again feeds into a loop, which leads to the inventory objectives or plans being updated. Process control can also be illustrated using the example of a salespersons job. The management may direct the salesperson to follow certain procedures for new market development, but may not hold the salesperson responsible for the extent of new business generated i.e. the end result. In such a case, process control has been exercised. Output controls Output control is exercised when performance standards are set and monitored, and the results are evaluated. Output control takes place when the control activity is based on the comparison of actual and planned outcomes. Such controls are applicable when it is easy and inexpensive to measure the output and when there are few elements of uncertainty. In this type of control, the management expects the employee to perform in a result-oriented way, as it believes that the employee has the requisite knowledge to undertake the activities required, in a suitable manner, and to complete the assigned task without management intervention. Informal Control System These are unwritten, typically worker-initiated mechanisms that influence the behavior of individuals or groups in business units. There are three types of informal controls. They are: Self-control It deals with the establishment of the personal objectives by the individual, monitoring their attainment and adjusting the behavior in the organization to attain the goals. Self-control can be beneficial to an organization if the organizations goals are in congruence with the individuals goals. But if the goals do not match then the performance of the employee can suffer. Social controls Social control refers to the prevailing social perspectives and patterns of interpersonal interactions within subgroups in the firm. In this type of control, an organization establishes certain standards, monitors conformity with the standard and takes action when deviations occur. Social control arises out of the internalization of values and mutual commitment towards some common goals. Cultural controls According to William G Ouchi, culture is the broader values and normative patterns that guide worker behavior within the entire organization. Cultural control can be realized by norms of social interaction, and stories, rituals and legends relating to the organization. ForIB S U se O nly C lass of2009 21. 13 Introduction to Management Control Systems SUBSYSTEMS AND COMPONENTS OF MANAGEMENT CONTROL SYSTEMS The subsystems and components of control systems can be discussed on the basis of formal and informal processes. Formal Control Process The formal control process has two dimensions- formal planning and formal reporting. Formal planning process The formal planning process has two dimensions: strategic planning and operations planning. In most organizations there are two budgets- one for operations and one for strategy; and, there are two sets of reports - one for strategic projects and one for operating activities. The formal planning and control process should support the style and culture of the organization, and should be supported by the infrastructure, the rewards, and the communication systems in the organization. A strategic planning system is necessary to assist the organization in the planning and control of projects. It helps the organization to decide its goals and objectives, and key strategies. An operational planning system undertakes activities that are short term in nature. Formal reporting process Detailed reports help the organization to assess the progress of its strategic and operational planning. Monthly, quarterly or yearly reports help the organization to analyze its performance periodically, and to decide on the next set of programs to be undertaken. Although planning and reporting appear to be two distinct processes, there should be a certain degree of integration. Strategic programs are funded out of current operations and grow out of current activities. Further, strategic plans and programs have a great impact on current operations and so, these strategic plans should be adjusted from time to time in line with their effect on operations. Informal Control Process Management decisions are based upon experience, intuition and feeling. Informal control processes are formed as a result of interaction between people. The informal control process helps in the development of new goals and objectives. There are a number of mechanisms for control through informal systems. One mechanism is the use of ad hoc teams to solve problems, improve productivity and achieve organizational change. Informal teams usually consist of cross-organizational groups which work in coordination to solve problems related to a particular client, product or market. Informal communication systems evolve as people develop work relationships. Informal communication is helpful in supporting the key values of the organization. Fostering informal communication is critical to the development and maintenance of effective informal controls. ForIB S U se O nly C lass of2009 22. 14 Principles of Management Control Systems Informal rewards and recognition are conferred upon the key team members within the informal system. The respect an individual is shown is an informal reward for performance. Communication systems are not highly guarded in informal systems. SUMMARY The purpose of control is to ensure that an organization meets desired objectives and that individual members behave in a manner consistent with organizational objectives. In recent times, several companies have lost billions of dollars because the necessary controls were absent. Management control systems are considered essential for the successful attainment of corporate objectives. It is the means by which senior managers effectively and efficiently strive to attain company's objectives. Any control system in an organization has four important elements that help in synchronizing the organizations various activities. They are the detector (which provides information about the situation), the assessor (for comparison with benchmarked standards), the effector (which tries to bridge the gap between the actual situation and the standard required), and finally, the communication systems (that help in passing the information between the other three elements). Control systems can be divided into formal and informal controls. Formal control systems can be classified as input controls, process controls and output controls. Informal control systems can be classified into self- control, social control and cultural control. A clear corporate strategy, corporate structure, well-defined centers of responsibility, and reliable information centers are essential for management control systems to be successful. A good management control system is oriented towards the future, has clear objectives, and minimizes control losses. It is important to analyze the distinction between strategy formulation, task control and management control. Strategy formulation takes place at the higher level of the management, and task control involves the control of individual tasks. Management control lies at the intermediate level between the levels of strategy formulation and task control. It helps in the implementation of the desired strategies. The subsystems and components of control systems can also be divided on the basis of their use in formal and informal systems. Managerial style and organizational culture play an important role in determining which components are used, and whether the formal or informal processes are dominant. ForIB S U se O nly C lass of2009 23. Chapter 2 Approaches to Management Control Systems In this chapter we will discuss: Cybernetic Approach to Management Control Systems Contingency Approach to Management Control Systems Strategy and Control Systems ForIB S U se O nly C lass of2009 24. 16 Principles of Management Control Systems In the introductory chapter, we discussed the importance of controls in achieving organizational objectives. In addition to the amount of control, the appropriate mix of controls should be used to maintain the right balance in an organization. In this chapter, we discuss the various approaches to the implementation of management controls. Organizations are complex structures; hence, there is a need to design controls for them to function effectively. The cybernetic approach helps us to understand the elements and design of the control process in an organization. The contingency approach to management control systems provides a potential explanation for the bewildering variety of management control systems actually practiced. Strategies at the corporate and business unit levels have a bearing on the form and structure of control systems in an organization. CYBERNETIC APPROACH TO MANAGEMENT CONTROL SYSTEMS Cybernetics has its origin in the Greek work Kybernetes which means steersman. A steersman is a person who directs the movement of the ship along the planned course or direction. In the 1940s, Norbert Weiner coined the term cybernetics. According to his definition, cybernetics is the study of the entire field of control and communication theory, whether in the machine or the animal. Cybernetics deals with the self-regulating principles in a variety of systems ranging from the human biological system to machine systems. The human brain is a complex structure that helps in regulating the body functions and helps the body perform complex activities. Organizations too are complex, as they are made up of different individuals. Cybernetics has been applied in such diverse fields as radar control, animal genetics, inferential automation, cryptography and deciphering, automatic machine tool control, language translation, teaching machines, artificial intelligence and robotics. Due to its broad applicability, it has been popular with general systems theorists as a unifying theory of self-regulation. Characteristics of a Cybernetic System The following are the characteristics of a cybernetic system: Complex structures There are number of heterogeneous interacting components in a cybernetic system, making it complex. Mutual interaction The various components of a cybernetic system interact in a way that creates multiple interactions within and among the subsystems. Complementary In cybernetic systems multiple interactions take place as a result of multiple processes and structures. There are a number of subsystems which interact; and hence, there is a need for multiple levels of analysis which complement one another. Evolvability Cybernetic systems tend to evolve and grow in an opportunistic manner, rather than being designed and planned in an optimal manner. ForIB S U se O nly C lass of2009 25. 17 Approaches to Management Control Systems Constructivity Cybernetic systems are constructive. They increase in size and complexity by building on their existing characteristics and also developing new traits. Cybernetic Paradigm and the Control Process The cybernetic paradigm devised by Griesinger in the late 1970s helps in designing the control process in an organization. The cybernetic paradigm not only helps in capturing the essential elements of the repetitive control process (refer Figure 2.1), but also does it economically. The essential elements of the repetitive control process are the following: Setting goals and performance measures Measuring achievement Comparing achievement with the results Computing the variances resulting from the preceding comparison Reporting the variances Identifying the causes of the variation Taking the required action to eliminate the variances in the future Follow-up to ensure that the goals are met. All goal-oriented controls reflect the basic elements of the cybernetic paradigm. The paradigm begins with the assumption that decisions are made because of the interaction between the decision maker and the external environment. The manager of each business unit scans the external environment for data that could be useful for the organization. The mechanisms through which managers collect data are called sensors. Sensors can collect data through formal methods like reports, or through informal Figure 2.1: The Cybernetic Paradigm of the Control Process Environment Feedback Goals Perception Behavior Choice Value Premises Comparator Factual Premises Source: Joseph A Maciariello and Calvin J Kirby, Management Control Systems, (USA: Prentice-Hall, Inc, Second edition) 42. Behavioral Repertoire ForIB S U se O nly C lass of2009 26. 18 Principles of Management Control Systems methods like interactions with the members of the organization. Sensors can be used to collect data with regard to both the internal and external performance of the business unit. Based on the data collected, the manager builds up certain assumptions about the external environment and the present performance of the unit. These assumptions are a starting point for the analysis and are termed as factual premises. Factual premises are formed on the basis of perceptions, which are affected by past experiences, organizational goals and personal goals. The next step involves comparing the factual premises with the organizational goals and performance measures. When there is difference between the decision makers assumptions (value premises) and the assumptions made about the environment (factual premises), then every possible step is taken to bridge the gap. This is done with the help of a comparator that analyzes the difference between performance as measured and performance information desired. When there is a shortfall in performance, the decision maker searches for a course of action that will help to cover the shortfall; this is referred to as behavioral choice. Choice of behavior could involve selecting a solution on the basis of previous experiences. In case there is more than one alternative solution to the problem, the feasible alternative with the highest subjective utility is chosen. In case no suitable alternative is found, the decision maker expands his search for a viable option. After an appropriate method is found to cover the shortfall, the next step is the implementation process. The implementation process starts with the manager (effector) acting as an agent for change by implementing the desired controls. After implementation, the next step is to get the required feedback to determine the effects of the action. This feedback helps the manager to judge whether the chosen behavior or action has helped move towards the desired performance. If the feedback is positive, this action can be selected again when similar situations arise in the future. The feedback also helps in assessing whether the goals set are being achieved. If the goals are not achieved, the manager has to go through the whole process again. Hence all goal-oriented controls reflect the basic elements of a cybernetic paradigm. To achieve goals, organizations need to design effective individual controls for each activity. Designing Management Controls There are many issues to keep in mind while designing controls for an activity: The process of establishing controls should be seen as a constructive exercise that will help in enhancing the performance of the employees. The standards set should be challenging, but at the same time, attainable. The objectives should be measurable to enable evaluation of performance. Controls should focus on the objectives and key results of an activity. There should be a restricted number of objectives. There should not be too much focus on easily measurable factors and short-run variables. Attention should be paid to all the important variables in a balanced fashion. Responsibility for results should rest with a single individual to avoid duplication of work. ForIB S U se O nly C lass of2009 27. 19 Approaches to Management Control Systems To get the desired results, it is important to compare the actual performance with the desired results. Comparing actual performance with the desired results could be useful for setting controls for the next year. When establishing controls, the factors that could be hampering the work process, such as stress, tiredness at work and absenteeism, should be identified. Good feedback is an indication of the quality of the control process. Early predictors, can help organizations to improve their performance. It is advisable to take a sample of the variables to be controlled. This can be done statistically or through observation. An acceptable range of variation for the value of each variable should be established. While preparing reports there should be exceptions to desired results and these should be promptly reported to the person responsible for the reports. The severity of the problem should be determined by analyzing the cause of the problem and then corrective action should be taken. The results of these actions have to be monitored and compared to the expected values. A system of controls requires judgment and insight by those establishing them and interpreting results. Control Process Hierarchy The control process in an organization involves the relationship between the superior and the subordinates. The relationship can be termed as a means-end relationship because the superior communicates the goals of the organization to the subordinates, who, in turn, devise strategies to achieve those ends. The goals of the subordinates should be congruent to the goals of the superior. Congruency in goals can be achieved through negotiation, and depends on the style of management and the communication process in the organization. The hierarchy of the control process can be illustrated with an example. In a hierarchical organization with decentralized decision-making and authority, the control process begins with the superior meeting the subordinates and negotiating goals, objectives and targets for the next year. After the goals are finalized, the performance is tracked at periodic intervals. The superior and subordinates review the overall performance. In areas where performance has been unsatisfactory, they try to find the reasons for the unsatisfactory performance. Once the reasons are identified, a plan of correction is prepared. This plan is prepared on the basis of past corrective actions and the current performance. Thus the targets and course of action for the next year are set. The same process is carried out throughout the organization. A reward system based upon the performance of the employees is designed. First, managers decide on the targets they want to give their subordinates. Next, there is negotiation between the superior and the subordinates with regard to the targets. At this stage, it can be analyzed whether the subordinates objectives are in congruence with the objectives of the superior. All the targets should be specific and measurable. There should be a limited number of targets, so that they can be managed well. The targets should cover qualitative variables ForIB S U se O nly C lass of2009 28. 20 Principles of Management Control Systems (employee training and development, and new product development) as well as quantitative variables. To summarize, the goal-oriented control process follows the cybernetic paradigm and involves planning, decision-making and controls. It operates through a hierarchy of control, and its main purpose is the attainment of organizational goals and objectives. CONTINGENCY APPROACH TO MANAGEMENT CONTROL SYSTEMS Contingency theory is based on the premise that the design and use of control systems is contingent upon the particular context of the organizational setting in which the controls operate. Contingency theory was propounded in response to the universalistic approach that argues that there is an optimal scheme for control design which is applicable in all settings and firms. In contrast, contingency theory states that the appropriateness of different control systems depends on the business setting. Contingency approach is an extension of scientific management theory The theory also states that the appropriateness of different control systems depends on the setting of the business. The term contingency implies that the structure and process are contingent on various external and internal factors. Prior to the contingency theory, the classical theory developed by management scientists like Fayol, Burns and Stalker, and Lussato assumed that people were motivated by economic rewards. It also assumed division of labor based on specialization, and the delegation of routine tasks to subordinates by hierarchical superiors. Contingency theory focuses on the interaction between the organization and its environment. It is assumed that the organization imports energy and resources from the environment, and converts them into goods, services and by-products. The goods, services, and by-products are then 'exported to the environment, thus changing the environmental circumstances in which the organization operates. The Need for the Contingency Approach Factors such as technology, organizational structure and the environment have led to the emergence of contingency formulations in control systems. Technology It has long been recognized that technology influences the design of control systems. New computer systems enable companies to respond to changes in the environment and refashion corporate policies rapidly. Revision of plans and estimates and new incentive programs can be worked out quickly and passed on to the workforce rapidly. Technology can help managers to use resources more effectively, and to collect data for strategic and operational decision-making. The increased use of technology has brought in new control systems that can help managers identify specific problems in administration or factory operations. The contingency approach is able to utilize the new technology very effectively in control systems. ForIB S U se O nly C lass of2009 29. 21 Approaches to Management Control Systems Organizational structure A modern organizations structure should be such that it can cope with a high degree of uncertainty, as new tasks are constantly incorporated into the production or work process. An organic1 ' organizational structure adapts easily to unstable conditions in rapidly changing environments. As a business grows, the work of the management increases, and the organizations structure becomes more complicated as new tasks or lines of production are added. The management control system for such organizations is complex. The contingency approach helps in designing a control system that meets the demands of complex organizational structures. Environment In order to survive, organizations have to adapt to the demands of their environment. Management controls in an organization are greatly influenced by the type of competition faced by the firm. The contingency approach helps to develop a highly sophisticated control system in line with the intensity of competition the firm faces. Contingency theory greatly expanded the scope strategy and management control. It emphasizes the fit between external environmental factors and the internal resources of the organization. It analyzes the components of the organization, its structure and cultural setting, and its ability to adapt to technological and structural changes. Fisher2 (1998) developed an approach to contingency theory and management control by reviewing- contingency theory, management control systems and firm outcomes. He suggested that the assumptions that underlie contingency theory are too narrow. Fisher's approach focuses not only on the unique, characteristics of control systems, but also on the environment in which some control systems have a better fit. Fisher points out that the contingency approach has enabled researchers to develop generalizations about control systems relative to business and organizational settings. By studying contingency factors in different business settings, Fisher identified five contingent control variables: uncertainty; technology and interdependence; industry, firm and unit variables; competitive strategy; and mission and observability factors. These factors can be either external or internal to the organization, and can affect organizational outcomes, performance, resource allocation and distribution of rewards. He suggested potential research areas in contingency control that include: causal relationships of multiple variables; study of control systems in relation to other organizational aspects; human resources policies and cultural systems. These also included non-financial factors such as cycle time, lead time, frequency of orders and production performance factors. The financial factors included budgeting and standard cost systems. Fisher suggested new directions in contingency control research that would move from financial to operational and production control factors critical to organizational 1 The organic organization is structured to encourage flexibility and change. The structure also motivates and creates a rewarding work environment. 2 Fisher, Joseph G "Contingency theory, management control systems and firm outcomes: Past results and future direction." Behavioral Research in Accounting 1998 Supplement, Vol. 10, p47 ForIB S U se O nly C lass of2009 30. 22 Principles of Management Control Systems performance. For example, the contingency approach could be used to explain variations in the adoption of just-in-time and activity-based costing methods in different organizations. STRATEGY AND CONTROL SYSTEMS According to Kenneth R Andrews, strategy is a process by which senior executives evaluate company's strengths and weaknesses in light of the opportunities and threats present in the environment, and decide on a product market that fits the company's distinctive competencies with environmental opportunities. Organizations usually treat strategy and control as distinct organizational functions. Strategies are developed first, as managers study their current and potential role in the environment and determine the appropriate response. Controls are designed to help organizations to achieve their goals. An organization can gain competitive advantage by integrating the usually separate functions of strategy and control. Management control systems are the tools which help in the effective implementation of strategy. It is important to analyze the different kinds of strategies, as control systems can be designed based on the types of strategies. Strategies can be considered at two levels in an organization. There are strategies for the organization as a whole (corporate strategy) and strategies for each business unit (business unit strategy). For the formulation of corporate strategy, an organization should consider the suitability of the area of business for the firm, and the mission or purpose of each business unit. This analysis will help the firm decide whether to divest or retain a particular business, and the amount of resources to allocate for each business. At the level of the business unit, a firm has to analyze the business units mission, and the steps it should take to accomplish the mission. Corporate strategy is a guide to the individual business units, helping them to function in accordance with the organization goals and strategies. Corporate Strategy Corporate strategy relates to the firm as a whole. Corporate strategy involves making plans regarding where and how the firm can compete in an industry. At the level of corporate strategy, controls refer to the mechanism by which corporate executives influence the strategic direction of the firm and the level of achievement of the firm's objectives. Corporate strategy and controls should be integrated in order to keep employee behavior in congruence with managerial goals. An organization has a well-aligned structure, it will not function effectively without a control system in place. The organizational structure of a firm refers to its hierarchies and reporting patterns. For the effective functioning of the structure, appropriate control systems are needed. Since planning and control requirements are different for different corporate strategies, they need to be designed in accordance with the corporate strategies. For example, in the electronics business, channels of communication and transfer of competencies across various business units are critical for effective functioning, and therefore the various departments are interdependent. In such companies, the ForIB S U se O nly C lass of2009 31. 23 Approaches to Management Control Systems corporate level managers need to have wide range of control across various departments. Managers should also have extensive knowledge about the various departments and their work processes. Control systems can be framed according to the class into which a company fits. Companies can be classified into three categories: a single business firm operating in one line of business; a firm which has undertaken diversification into businesses that are related to one another; and, a firm which has diversified into businesses that are not related to one another, (except in being owned and managed by a common concern.) Corporate strategies of firms are distinctly different in firms with different levels of diversification. Firms can be classified into three categories based on the extent and type of diversification undertaken by them. Single business firm: The firm concentrates on a single business. For example, Apple Computers pursues a single business strategy of manufacturing computers. Related diversification: The firm has diversified into businesses that are related to one another and have a common set of core competencies. Unrelated diversification: The firm operates in different areas of business which are unrelated to one another. The only common link between them is that they are managed and financed by a common concern. Control systems will differ on the basis of corporate strategy with regard to diversification. More diversification requires that the managers at the corporate level should have a wide range of expertise and knowledge relating to the various activities of the firm. Management control in diversified firms is often difficult. . Single business firms and firms with related diversification are based on company-wide core competencies. Hence it is important to have good channels of communication that can allow interdependence among the different units. In the case of undiversified firms, there is comparatively less interdependence among various units. As a firm becomes more diversified, control systems should be altered to foster better cooperation among the diverse units and to encourage their entrepreneurial spirit. There are specific activities that need to be considered when designing a control system for different corporate strategies Strategic planning: Conglomerate businesses usually use vertical strategic plans i.e. the different business units prepare strategic plans, which are reviewed by the senior management. Strategic planning systems for diversified business units are usually both horizontal and vertical. The horizontal process involves the preparation of a plan on behalf of each unit or group by an executive, with synergistic inputs from the different business units of the organization. The managers of the individual business units identify the various linkages to other business units so that they can synergize their operations. These interdependent units also require joint strategic plans. ForIB S U se O nly C lass of2009 32. 24 Principles of Management Control Systems The strategic plans of the individual business units are often circulated among the various business units as this helps in getting feedback. Budgeting: In a single business firm, the chief executive can control the budgeting operations through informal methods and personal intervention. In a conglomerate, it is not possible to rely on informal interpersonal relationships, and the chief executive officer may is unlikely to be able to control all the budgeting activities in all the businesses. Hence, business unit managers have greater influence in developing their product/market environments. Incentives and compensation: The plan for employee incentives and compensation in organizations varies according to the level of diversification of the organization. In the case of conglomerates, bonus is usually formula- based. Formula-based plans are not usually popular in highly interdependent firms as their performance is based on the decisions and actions of other units. In a single business firm, bonus is determined on the basis of subjective factors such as the performance of the business. In the case of a business unit manager, the bonus is tied to the performance of the particular unit rather than the profitability of the whole firm. In the case of single business firms and those with related diversification, the compensation is usually tied to the performance of the unit and also the performance of the whole firm. Linking incentives to the overall performance of the organization helps to increase teamwork and interdependencies. Business Unit Strategy Diversified companies segment themselves into business units and assign different strategies to different business units. Such companies do not have a standardized approach for all their business units, but develop separate strategies for each business. Business unit strategy deals with creating and maintaining competitive advantage in all the businesses the company operates in. Business unit strategy for an organization has two interrelated aspects: mission and competitive advantage. Mission A mission statement is a broad organizational goal, based on planning premises, which justifies an organizations existence. There should be congruence between the mission statement of the organization and the controls being used. Management control systems help the manager to make decisions on the trade-off between the short term and the long term. In a diversified business, the primary task of the CEO is to make basic decisions on the businesses to undertake, the resources to deploy in each, and the integration of the multiple businesses to make them most effective. There are various planning models that help managers at the corporate level to allocate resources among different businesses. These models of planning also help in identifying the missions of individual business units. The focus of all the planning decisions are based on certain factors: Concentrating on the internal and external factors of the business that determine the attractiveness of the market opportunities available to business units. ForIB S U se O nly C lass of2009 33. 25 Approaches to Management Control Systems The competitive ability of the business unit is likely to vary from one unit to another. So a firm has to emphasize on the performance of each business unit before allocating resources. The attractiveness of the industry in which a unit is operating is likely to vary. Hence it has to be considered when allocating resources. Two of the planning approaches most widely used are the Boston Consulting Group's two-by-two growth share matrix and General Electric Companys three-by-three industry attractiveness-business strength matrix. While the models differ on the methodologies adopted, they have the same set of missions for a business unit to choose from: Build, Hold, Harvest and Divest. The company should have a clear idea of the type of mission the business units have chosen, as this will help in deciding on the control systems to be used. Build: This mission indicates that the business units goal is to increase its market share, even at the expense of short-term earnings and cash flow. A business unit following this mission is typically a resource user due to the heavy investment required to build a competitive position. Business units with low market share in high growth industries typically pursue a build mission. Hold: This strategic mission aims to protect the business unit's market share and competitive position. The cash outflows, for a business unit following this mission, would usually be approximately equal to cash inflows. Typically, businesses with high market share in high growth industries pursue a hold mission. Harvest: This mission has the goal of maximizing short-term earnings and cash flow, even at the expense of market share. A business unit following such a mission would be a resource provider in that it generates more cash than that required for further investment. Typically, businesses with high market share in low growth industries pursue a harvest mission. Divest: This strategic mission indicates a decision to withdraw from the business either through a process of slow liquidation or outright sale. Typically, business units with low market share in low growth industries are divested. The missions discussed above should not be used in a mechanistic manner. They have to be combined with creativity, innovation and initiative by the managers for effective control systems. Thus while framing control systems a manager has to be aware of the mission adopted by each of its business units. The form and structure of a control system affects business units with different missions. Strategic planning, budgeting, and the incentive/compensation system are the main aspects determining the form and structure of the control system. Strategic planning process: Strategic planning needs to be designed keeping in mind the environment in which the company operates. In an environment where there are greater uncertainties, strategic planning assumes more importance. For this reason, the process of strategic planning is more critical for 'build' business units than for harvest business units. A build mission is usually undertaken in the growth stage of the product life cycle, and the ForIB S U se O nly C lass of2009 34. 26 Principles of Management Control Systems objective of the build mission is to increase the market share. Increasing a companys market share involves uncertainty, particularly with regard to competitors, for build units. Budgeting: Budgeting involves deciding on the allocation of resources and targets of each business unit. Budget revisions are more likely in the case of build units than for harvest units because of frequent changes in the market environment of build units. 'Build' managers, however, usually have greater influence on the formulation of budgets, and other important management decisions. For harvest units, the environment is usually stable, and so inputs from managers of harvest units are less essential. Incentive compensation system: When several elements enter into the design of an incentive compensation system for business units. Managers have to decide on the size of incentive bonus payments, the measures of performance to be considered for incentive bonuses ( sales volume, product development, return on investment etc.), the criteria on the basis of which subjective judgments are to be made, the frequency of incentive payments (annual, monthly, biennial), etc. The mission of the business unit influences the type of incentive package formulated. In many firms, the completion of riskier projects is rewarded by higher compensation. Managers in build units are therefore likely to have higher incentive payments than managers in harvest units. Performance may be measured either over the short term or the long term. If a firm links incentives to performance in terms of profits, cash flows and returns on investment, it is said to have a short-term focus, whereas if it links incentives to performance in terms of market share, new product development and development of human resources, it is said to have a long- term focus. Competitive advantage of a business unit In order to accomplish its mission, every business unit should develop a competitive advantage. In order to identify its competitive advantage, a business unit should analyze the competitive structure of the industry in which it plans to operate. Porters Five Forces Model analyzes the competitive structure of an industry on the basis of the following factors: Intensity of rivalry among the existing players Bargaining power of the buyers Bargaining power of the suppliers Threat from substitutes Threat of new entrants An understanding of these factors, can help a business unit to frame generic strategies through which it can respond to the opportunities in the external environment. Alternative generic strategies may be developed in terms of: Low Cost: The primary focus of this strategy is to achieve low cost relative to competitors. Cost leadership can be achieved through economies of scale in production, learning curve effects, tight cost control and cost minimization in areas such as research and development, service, sales force, or advertising. Differentiation: The goal of this strategy is to differentiate the product of the business unit, in order to create a product that is perceived by customers as ForIB S U se O nly C lass of2009 35. 27 Approaches to Management Control Systems unique. Differentiation may be based on brand loyalty, customer service, dealer network, product design and features, and product technology. Focus: This strategy requires the business unit to focus on a particular buyer group, segment of the product line, or geographic market. The focus strategy helps the unit to achieve core competency by narrowing its market segment. Additional considerations: Although a firm should adopt different controls for its units, there are some problems associated with this strategy. The external environment of a business unit changes over time and shifts in strategy may be required. If a control system is over-committed to a single strategy or level of diversification, it may become difficult for the manager to shift to a new strategy. Secondly, the control system should be appropriate for both the mission and the competitive advantage of the firm. Trying to design a control system that fits both may result in conflict. In such situations, the manager has to decide whether to give priority to the firms mission or to its competitive advantage. SUMMARY The cybernetic approach to management control systems helps in analyzing complex activities in an organization. The cybernetic paradigm helps to manage the repetitive control process in an organization. Contingency theory was propounded in response to the universalistic approach that argues that there is an optimal scheme for control design, which applies in all settings and firms. Changes in technology, organizational structure and the need to adapt to the environment of the industry have contributed to the emergence of contingency formulations in control systems. Management control systems are tools that help in effective implementation of strategy. Hence, it is important to understand the types of strategies firms use in respect of diversification and how control systems can be devised for each strategy. Strategies can be considered at two levels: the corporate level and the level of the business unit. Corporate strategy relates to the whole organization and involves decisions on where to compete and how to compete. Strategies at the corporate level can be differentiated on the basis of the level of diversification undertaken by the firm i.e., whether it is a single business firm, a firm with related diversification or a firm with unrelated diversification. Business unit strategies deal with creating and maintaining competitive advantage in all the areas of business in which the company operates. Business unit strategy has two interrelated aspects: mission and competitive advantage. The business units mission could be: to build, to hold, to harvest or to divest; while it can develop its competitive advantage in terms of low cost, differentiation or focus. ForIB S U se O nly C lass of2009 36. Chapter 3 Designing Management Control Systems In this chapter we will discuss: Steps in Designing MCS Factors Influencing the Design of MCS Establishing a Customer Focused Total Quality Culture Impact of Information Technology on Control Systems design ForIB S U se O nly C lass of2009 37. 29 Designing Management Control Systems A management control system is a set of interrelated communication structures that facilitate processing of information and coordination between different parts of an organization. Control systems help in the effective implementation of an organizations strategy. The subsystems and components of management control systems should be mutually supportive so that organizational goals can be achieved. When the subsystems are properly designed, they provide a basis for an organizational control system. The control systems should be designed in such a way that they reflect the goals and strategies of the organization. It is also important to design control systems in such a way that they contribute to the effective implementation of the organization's strategies. This chapter deals with the steps involved in designing control systems, factors that influence the design of management control systems, the relationship between the style, culture and design of control systems, establishing a customer-focussed total quality culture and the impact of information technology on control systems design. STEPS IN DESIGNING MCS Designing control systems requires an understanding of what the organization wants from each employee individually. This involves identifying the role of each individual from the chief executive officer to each employee at the lowest organizational level in achieving organizational goals. MCS cannot be designed without an understanding of the key actions being controlled. Since the purpose of a control system is to influence actions, identifying the desired actions is important. An organization must find out what knowledge and information it requires to control employees actions. Another way to understand what has to be controlled is to identify the key actions (KAs). KAs differ from firm to firm, and from individual to individual. For lower level employees, such as the production line workers, KAs are easy to identify, because they are routinized and mechanical. KAs of higher level employees which involve identification of problems, team building and making investment decisions may not be easily understood as they need professional judgment. It is not easy to judge whether the actions taken are appropriate without close monitoring done by someone who has equal or higher professional knowledge. Most companies have standard sets of actions for employees who prepare investment proposals, business plans, and give justifications for recruitment decisions. These are called action controls. Role demands can also be identified through the Key Results (KRs). Key results are the areas which are important for the growth of an organization. Examples are sales performance, customer orders received etc., Key results change according to the prevailing internal and external environment of an organization. The step that follows the understanding of role demands involves understanding the likely actions or results of the role demands. If the analysis shows that what is desired is not different from what is likely, then it can be concluded that the company has an effective management control system. If the analysis shows a difference between the two, then the reasons would have to be investigated. The reason may be lack of direction, motivational problems ForIB S U se O nly C lass of2009 38. 30 Principles of Management Control Systems or personal limitations. Depending on the severity of the situation, different controls should be applied. Choice of Controls The choice of controls depends on the severity of the problem. Control mechanisms can be selected from feasible alternatives (that would provide the maximum benefits). While analyzing these alternatives, managers should first consider personal or cultural control, as these have very few consequences and are less costly to implement. Usually in small organizations, most problems are solved by implementing cultural and personal controls. However, these controls work only when employees have clearly defined roles, understand their goals and expected performance levels. Choices among the various actions and results control depend on the advantages and disadvantages each control has in a particular setting. Action controls These are controls that work on the standard sets of procedures. The advantages of action controls are: They are directly linked to the task being performed. They direct managerial attention towards the actions being taken within the firm. Their application in an organization is uniform in nature and hence they aid in organizational coordination. Since these controls work on a standard set of actions, they act as a knowledge repository and guide the implementation process even when key managers leave the organization. In a positive sense, these controls are means for attaining efficiency, as they are a key element in the bureaucratic form of organization. These controls also have their own disadvantages: Action controls are useful only for highly routinized jobs. This type of control does not foster creativity and innovation among employees, as employees have to follow rigid rules. Since these controls do not encourage creativity, employees tend to quit their jobs. Because of the rigidity of rules, companies have difficulty in adapting to the changing external business environment. Result controls These are used to control the behavior of employees. These are effective in addressing motivational problems. They inform employees about what is expected of them and what they should do in order to produce the desired results. Results control can be established by first defining the dimensions on which the control has to be set. The dimensions could be either customer satisfaction or product profitability. The next step involves measuring performance based on these dimensions. Setting performance targets and providing adequate incentives to encourage employees to perform effectively is the final step. The advantages of results control are the following: ForIB S U se O nly C lass of2009 39. 31 Designing Management Control Systems These controls are feasible, and provide effective control even where knowledge as to what actions are desirable is lacking. Result control provides on-the-job training and also provides employees an opportunity to learn from their mistakes. Result control results in motivating employees, and commitment towards the job as it gives employees greater autonomy to perform their task. The disadvantages of result controls are these: Often the controllable results that the organization desires and the performance of the individual cannot be measured effectively. Any problem that arises as a result of this control is attributed to the employees mistake. Result controls and action controls are the major elements of management control systems in all organizations. After the choice of controls the next decision relates to the tightness of controls. Tightness of Controls Whether the control should be tight or loose depends on how the organization perceives the following issues-the benefits of tight controls, the costs incurred due to tight controls, and the side effects of tight controls, if any. Some organizations prefer tight control in areas that are most critical to their success. Some forms of tight controls are costly to implement, require a significant amount of the top management's time, and requires new information systems, measuring equipment or extensive studies to gather useful information. All these may add to organization's expenditure. Finally, it is necessary to know whether there are any harmful effects of the control being used. For example, if the environment in which the employees are working is unpredictable, then tight controls will not work, as employees need autonomy to take actions. As tight controls limit adaptability, employees will find it difficult to adjust to changing environment. The best control method would be a combination of tight and loose controls - an environment where autonomy, entrepreneurship and innovation are encouraged, and, at the same time, employees share a set of rigid values. FACTORS INFLUENCING THE DESIGN OF MCS The design of control systems is influenced by a number of factors: managerial style, corporate culture, organization structure, organizational slack, stakeholders control and communication structures. Management style and corporate culture pla