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Notes

• For students doing Maths for Economists AND CFR2 who have a clash - HUMSS 144 11:00 – 13:00 Fridays 2 Feb & 16 Feb only

• Coursework: Post name & members on Blackboard by 5pm otherwise 5% lost

• “Group time” next Tuesday in this theatre – OPTIONAL but lecturer on hand to help

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Management Control Systems

January 23rd 2007

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Lecture objectives

• Describe the relationship between planning and control and distinguish between feed forward and feedback controls.

• Discuss the limitations of traditional budgetary planning and control systems in a modern business environment and assess the alternatives to traditional systems

• Examine the effect of behavioural issues on budgetary planning and control systems

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Different types of controls

• Action (or behavioural) controls• Personnel and cultural (or clan and social)

controls• Results (or output controls)• Action (or behavioural) controls

– Behavioural constraints– Preaction reviews– Action accountability– Focus should be on prevention rather than detection– controls

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Different types of controls

Social, personnel and cultural controls– Social controls involve selection of people who have

been socialized into adopting particular norms of behaviour.

– Personnel controls build on employees natural tendencies to control themselves (Emphasis is on selection, training and job design).

– Cultural controls represent a set of values, social norms and beliefs that are shared by members of an organization and that influence their actions.

– In recent years there has been a greater emphasis on cultural controls in the form of employee empowerment.

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Different types of controls

• Results or output controls• The focus is on reporting information about the

outcomes of work effort.• Results controls involve the following stages:

– Establishing performance measures that minimize undesirable behaviour.

– Establishing performance targets.– Measuring performance.– Providing rewards or punishments.

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Cybernetic control systems

• Results controls resemble a cybernetic (mechanical) control system.

• Cybernetic systems involve feedback controls (actions after the events) but ideally control should be based on control actions before the events.

• A cybernetic control system

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Harmful side-effects of controls

• Occurs when controls motivate employees to engage in behaviour that is not organizationally desirable (i.e. system leads to a lack of goal congruence).

• Results controls:– Encourages individuals to focus only on what is measured,

regardless of whether it is organizationally desirable – Focuses mainly on quantifiable and easily measurable items.– Subject to data manipulation.– Can lead to negative attitudes towards the control system.

• Action controls:– May discourage creativity

• Cultural controls:• Lack of goal congruence where group goals do not

coincide with firm goals

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The measurement reward process with imperfect measures

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Advantages and disadvantages of different types of controls

• Personnel/cultural controls:– Few harmful side-effects– Inexpensive to operate– Appropriate only in certain circumstances

• Action controls:– Direct link between control mechanism and the action.– Measurement problems do not apply.– Not feasible where cause-and-effect relationships are not well

understood or easily observable.– Best suited to stable situations.

• Results controls:– Can be applied where knowledge of what actions are desirable

is lacking.– Focus is on outcomes (individual autonomy is not restricted).

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Management accounting control systems (MACS)

• Tend to be the predominant controls in most organizations because:– Monetary measure provides a means of

aggregating results from dissimilar activities.– Profitability and liquidity are essential for

company survival.– Financial measures enable a common

decision rule to be applied.– Measuring results in financial terms enables

managers to be given more autonomy.

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Responsibility accounting

• Responsibility accounting is a fundamental part of the MACS.

• Four types of responsibility centres:– Cost or expense centres (Two types: standard

cost centres and discretionary cost centres).– Revenue centres– Profit centres– Investment centres

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The nature of MACS• Two core elements:

– Formal planning processes (e.g. budgeting and longterm planning) for establishing performance expectations.

– Responsibility accounting• Responsibility accounting assigns differences from the performance target to

the individual who is accountable for the responsibility centre.• Process involves:

– Setting performance targets.– Measuring performance.– Comparing performance against target.– Analysing variances and taking remedial actions.

• Responsibility accounting is implemented by issuing performance reports• Issues that must be addressed by responsibility accounting include:• Distinguishing between controllable and noncontrollable items (i.e. the

controllability principle).• Determining how challenging the targets should be.• Determining how much influence managers should have in the setting of

targets.

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A typical performance report

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The controllability principle• Principle advocates that it is appropriate to charge to a responsibility centre

only those costs that can be influenced by the manager of the responsibility centre.

• Implemented by either eliminating uncontrollables or reporting controllable and uncontrollable items separately.

• Types of uncontrollable factors:• Economic and competitive factors (Because managers can respond to

some of these changes most MACS do not shield managers completely from them).

• Acts of nature (Managers normally protected from them).• Interdependencies where outcomes are affected by other units within the

organization:– Pooled interdependencies– Sequential interdependencies– Reciprocal interdependencies– Adjustments for the distorting effects of uncontrollables can be made either

before or after the measurement period.

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Prior and Post Adjustments

• Adjustments before the measurement period:– Specify which budget line items are uncontrollable

(eliminate or report separately in performance report).– Insurance

• Adjustments after the measurement period:– Variance analysis– Flexible performance standards (e.g. flexible

budgeting and ex post budget adjustments)– Relative performance evaluations– Subjective performance evaluations

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An example of flexible budgeting

• Static budgets are prepared for a single, planned level of activity.

• Performance evaluation is difficult when actual activity differs from the planned level of activity.

• With a flexible budget you can – Estimate costs at different activity levels– Compare actual outcomes to expectations when

output levels are known

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Flexible budgeting

• To “flex” a budget for different activity levels, we need to know how costs behave with changes in activity levels– Total variable costs change in direct

proportion to changes in activity– Total fixed costs remain unchanged within

the relevant range

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Flexible budgeting

• Advantages– Flexible budgets show revenues and

expenses that should have occurred at the actual level of activityFlexible budgets may be prepared for any activity level in the relevant range

– Flexible budgets reveal variances due to good cost control or lack of cost control

– Ensures that managers are accountable for the conditions applying during the period and not those envisaged when the budget was set

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Budget techniquesFlexible budgets

• A simple example..• Output (units) 90 120

£ £• Revenue 900 1,200

• Variable costs 450 600• Variable overheads 90 120• Fixed overheads 300 300

• Total costs 840 1,020

• Profit 60 180

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Preparing the flexible budget

• From this we can see that certain costs clearly vary with levels of output.

• Obviously fixed costs don’t.• By calculating the relationship between

variable costs and output (as output drives the budget)

• We can calculate expected costs/revenues for any output level

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Preparing the flexible budget

• Clearly the relationships are (at a given level)

• Revenue £900/90 = £10 per unit

• Variable costs £450/90 = £5 per unit

• Variable overheads £90/90 = £1 per unit

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Preparing the flexible budget

• Output (units) 135

• Revenue 135 X £10 = 1,350

• Variable costs 135 X £5 = 675• Variable overheads135 X £1= 135• Fixed overheads £300 300

• Total costs 1,110

• Profit 240

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But what if there are semi-variable costs?

• There may be instances when the relationship between outputs and inputs is not clear

• Some costs may be part fixed and part variable

• High-Low technique

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High-Low method

• difference• Output 90 120 30

£ £ £• Revenue 900 1,200 300

• Variable costs 450 600 150• Variable overheads 435 480 45

• Total costs 885 1,080

• Profit 15 120

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High-Low method

• Compare costs/revenues at 2 levels of output• Divide cost/revenue change by change in output• For Revenue and variable costs £10 & £5

relationship still holds• Overheads are semi-variable• Therefore change can only be attributed to

variable element

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High-Low method

• Therefore change = 45/30 = £1.50 per unit• At output 90 units• Variable element = 90 X £1.50 = 135• So Fixed element = 435 – 135 = 300• To confirm, at 120 units of output• Variable element = 120 X £1.50 = 180• So Fixed element = 480 – 180 = 300

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Budget at different output level

• At (say) 100 units of output budget =

• Revenue (100 X £10) £1,000

• Variable costs (100 X £5)£ 500

• Overheads (£300 + 100 X £1.50) £ 450

• Total costs £ 950

• Profit £ 50

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Guidelines for applying the controllability principle

• Price and quantity of service controllable = Controllable expense

• Quantity controllable but not price = Manager accountable for difference between (actual quantity × budgeted price) and (budgeted quantity × budgeted price)

• Quantity and price not controllable = Non-controllable expense

• General principle = Hold managers accountable for performance areas to which you want them to pay attention

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Determining how challenging the targets should be

• A clearly defined quantitative goal is likely to motivate higher levels of performance.

• Level of budget difficulty should be related to task uncertainty.

• Targets must be accepted to motivate managers to achieve higher levels of performance.

• Literature identifies a theoretical relationship between budget difficulty, aspiration levels and performance

• Hypothesized relationships suggest that budget level that motivates best performance is unlikely to be achieved most of the time ( do not adopt a punitive approach for adverse variances)

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The effect of budget difficulty on performance (Source: Otley (1987))

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The effect of budget levels on aspiration and performance (Source: Hofstede (1968))

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Arguments in favour of setting highly achievable budgets

• Conflict between planning and motivational purposes.

• Psychological benefits (e.g. achievement and self-esteem).

• Shields managers from adverse impact of environmental changes.

• Alleviates harmful side-effects of controls.

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Determining how much influence managers should have in setting standards

• Advantages of participation in the setting of performance standards:– Targets more likely to be accepted– Reduces the information asymmetry gap– Reduces negative attitudes and dysfunctional behaviour

• Empirical studies provide conflicting evidence on the effectiveness of participation.

• Factors influencing the effectiveness of participation:– Personality variables:

• Authoritarianism• Locus of control

– Work situation– Job difficulty

• Limitations on the positive effects of participation:– Budgetee has the opportunity to negotiate lower targets.– Depends on personality traits and work situation.– A top down approach may be preferable where a large number of

similar units exist.

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Side effects of using accounting information for performance evaluation

• Hopwood observed three different styles of managerial use of accounting information for performance evaluation:– A budget-constrained style– A profit-conscious style– A non-accounting style

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Hopwood’s findings