Advances in Management Accounting, Volume 10 (Advances in Management Accounting) (Advances in Management Accounting) PDF

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ADVANCES IN
MANAGEMENT ACCOUNTING
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ADVANCES IN MANAGEMENT
ACCOUNTING
Series Editor: Marc J. Epstein
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Recent Volumes:
Volumes 1–9: Advances in Management Accounting
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ADVANCES IN MANAGEMENT ACCOUNTING VOLUME 10
ADVANCES IN
MANAGEMENT
1
ACCOUNTING
EDITED BY
MARC J. EPSTEIN
Rice University, Houston, USA
1
JOHN Y. LEE
Pace University, Pleasantville, USA
2001
1
JAI
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Running Head v
CONTENTS
LIST OF CONTRIBUTORS vii
EDITORIAL BOARD ix
1
AIMA STATEMENT OF PURPOSE xi
EDITORIAL POLICY AND

MANUSCRIPT FORM GUIDELINES xiii
INTRODUCTION
Marc J. Epstein and John Y. Lee xv
1 THE IMPACT OF WORK TEAMS ON PERFORMANCE:

A QUASI-EXPERIMENTAL FIELD STUDY
Priscilla S. Wisner 1
CREATIVE ACCOUNTING? WANTED FOR

NEW PRODUCT DEVELOPMENT!
Julie H. Hertenstein and Marjorie B. Platt 29
IMPLEMENTING COST-VOLUME-PROFIT
ANALYSIS USING AN ACTIVITY-BASED
1 COSTING SYSTEM
Robert C. Kee 77
AN EMPIRICAL STUDY OF THE APPLICATION

OF STRATEGIC MANAGEMENT
ACCOUNTING TECHNIQUES
Karen S. Cravens and Chris Guilding 95
THE LONG-TERM STOCK RETURN PERFORMANCE

OF LEAN FIRMS
Kyungjoo Park and Cheong-Heon Yi 125
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THE RELATION BETWEEN CHIEF EXECUTIVE

COMPENSATION AND FINANCIAL PERFORMANCE:
THE INFORMATION EFFECTS OF DIVERSIFICATION
Leslie Kren 141
PARTICIPATIVE BUDGETING AND PERFORMANCE:

A STATE OF THE ART REVIEW AND RE-ANALYSIS
Peter Chalos and Margaret Poon 171
11 INTERACTIVE EFFECTS OF STRATEGIC AND

COST MANAGEMENT SYSTEMS ON
MANAGERIAL PERFORMANCE
Andreas I. Nicolaou 203
THE ROLE OF QUALITY COST INFORMATION

IN DECISION MAKING: AN EXPERIMENTAL
INVESTIGATION OF PRICING DECISIONS
Asokan Anandarajan and Chantal Viger 227
11 RISK PERCEPTION AND HANDLING IN CAPITAL

INVESTMENT: AN EMPIRICAL STUDY OF SENIOR
EXECUTIVES IN HONG KONG
Simon S. M. Ho and Lloyd Yang 251
A FRAMEWORK FOR EXAMINING THE USE OF

STRATEGIC CONTROLS TO IMPLEMENT STRATEGY
Russ Kershaw 273
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Running Head vii
LIST OF CONTRIBUTORS
Asokan Anandarajan School of Management

New Jersey Institute of Technology,
USA
1
Peter Chalos Department of Accounting
University of Illinois at Chicago, USA
Karen S. Cravens School of Accounting

The University of Tulsa, USA
Chris Guilding School of Accounting and Finance

Griffith University, Queensland,
1 Australia
Julie H. Hertenstein Accounting Group

Northeastern University, Boston, USA
Simon S. M. Ho School of Accountancy

The Chinese University of Hong Kong
Robert C. Kee Culverhouse School of Accountancy

University of Alabama, USA
1
Russ Kershaw College of Business Administration
Butler University, Indiana, USA
Leslie Kren School of Business Administration

University of Wisconsin at Milwaukee,
USA
Andreas I. Nicolaou Department of Accounting and MIS

Bowling Green State University, Ohio,
USA
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Kyungjoo Park Department of Accountancy

Hong Kong Polytechnic University
Marjorie B. Platt Accounting Group

Northeastern University, Boston, USA
Margaret Poon Department of Accountancy

City University of Hong Kong
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Chantal Viger Accounting Department
University of Quebec at Montreal,
Canada
Priscilla S. Wisner Thunderbird, The American Graduate

School of International Management,
Arizona, USA
Lloyd Yang School of Accountancy

11 The Chinese University of Hong Kong
Cheong-Heon Yi Department of Accountancy

Hong Kong Polytechnic University
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EDITORIAL BOARD
Thomas L. Albright K. J. Euske

Culverhouse School of Accountancy Naval Postgraduate School
University of Alabama
1
Eric G. Flamholtz
Rajiv D. Baker University of California,
University of Texas, Dallas Los Angeles
Jacob G. Birnberg George J. Foster
University of Pittsburgh Stanford University
Germain B. Boer James M. Fremgen
Vanderbilt University Naval Postgraduate School
William J. Bruns, Jr. Eli M. Goldratt
1 Harvard University Avraham Y. Goldratt Institute
Peter Chalos Ronald V. Hartley
University of Illinois, Chicago Bowling Green State University
Chee W. Chow John Innes
San Diego State University University of Dundee
Donald K. Clancy Fred H. Jacobs
Texas Tech University Michigan State University
1 Robin Cooper H. Thomas Johnson
Emory University Portland State University
Srikant M. Datar Larry N. Killough
Harvard University Virginia Polytechnic Institute
Nabil S. Elias Thomas P. Klammer
University of Manitoba University of North Texas
Ralph W. Estes C. J. McNair
American University Babson College
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x LIST OF CONTRIBUTORS
Grant W. Newton Fredelle Spiegel

Perpperdine University University of California,
Los Angeles
Cecil A. Raibborn
Loyola University, New Orleans George J. Staubus
University of California, Berkeley
James M. Reeve
University of Tennessee, Knoxville Wilfred C. Uecker
Rice University
11
Jonathan B. Schiff
Farleigh Dickinson University Lourdes White
University of Baltimore
John K. Shank
Dartmouth College S. Mark Young
University of Southern California
Barry H. Spicer
University of Auckland
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Running Head xi
STATEMENT OF PURPOSE AND

REVIEW PROCEDURES
Advances in Management Accounting (AIMA) is a professional journal whose
purpose is to meet the information needs of both practitioners and academicians.
We plan to publish thoughtful, well-developed articles on a variety of current
1 topics in management accounting, broadly defined.
Advances in Management Accounting is to be an annual publication of quality

applied research in management accounting. The series will examine areas of
management accounting, including performance evaluation systems, accounting
for product costs, behavioral impacts on management accounting, and innovations
in management accounting. Management accounting includes all systems
designed to provide information for management decision making. Research
methods will include survey research, field tests, corporate case studies, and
modeling. Some speculative articles and survey pieces will be included where
1 appropriate.
AIMA welcomes all comments and encourages articles from both practitioners
and academicians.
Review Procedures
AIMA intends to provide authors with timely reviews clearly indicating the
acceptance status of their manuscripts. The results of initial reviews will
normally be reported to authors within eight weeks from the date the manuscript
1 is received. Once a manuscript is tentatively accepted, the prospects for publica-
tion are excellent. The author(s) will be accepted to work with the corresponding
Editor, who will act as a liaison between the author(s) and the reviewers to
resolve areas of concern. To ensure publication, it is the author’s responsibility
to make necessary revisions in a timely and satisfactory manner.
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EDITORIAL POLICY AND MANUSCRIPT

FORM GUIDELINES
1. Manuscripts should be typewritten and double-spaced on 8l/2⬙ by 11⬙ white
paper. Only one side of the paper should be used. Margins should be set to
1 facilitate editing and duplication except as noted:
(a) Tables, figures, and exhibits should appear on a separate page. Each
should be numbered and have a title.
(b) Footnotes should be presented by citing the author’s name and the year
of publication in the body of the text; for example, Ferreira (1998);
Cooper and Kaplan (1998).
2. Manuscripts should include a cover page that indicates the author’s name
and affiliation.
1 3. Manuscripts should include on a separate lead page an abstract not exceeding

200 words. The author’s name and affiliation should not appear on the
abstract.
4. Topical headings and subheadings should be used. Main headings in the

manuscript should be centered, secondary headings should be flush with the
left hand margin. (As a guide to usage and style, refer to the William Strunk,
Jr., and E.B. White, The Elements of Style.)
5. Manuscripts must include a list of references which contain only those works
1 actually cited. (As a helpful guide in preparing a list of references, refer to
Kate L. Turbian, A Manual for Writers of Term Papers, Theses, and
Dissertations.)
6. In order to be assured of anonymous review, authors should not identify

themselves directly or indirectly. Reference to unpublished working papers
and dissertations should be avoided. If necessary, authors may indicate that
the reference is being withheld for the reason cited above.
7. Manuscripts currently under review by other publications should not be

submitted. Complete reports of research presented at a national or regional
xiii
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conference of a professional association and “State of the Art” papers are

acceptable.
8. Four copies of each manuscript should be submitted to John Y. Lee at the

address below under Guidleline 12.
9. A submission fee of $25.00, made payable to Advances in Management

Accounting, should be included with all submissions.
11 l0. For additional information regarding the type of manuscripts that are desired,
see “AIMA Statement of Purpose.”
11. Final acceptance of all manuscripts requires typed and computer disk copies
in the publisher’s manuscript format.
12. Inquires concerning Advances in Management Accounting may be directed

to either one of the two editors:
Marc J. Epstein John Y. Lee

11 Jones Graduate School of Administration Lubin School of Business
Rice University Pace University
Houston, Texas 77251-1892 Pleasantville, NY 10570-2799
11
Running Head xv
INTRODUCTION
This volume of Advances in Management Accounting begins with an article by

P. S. Wisner reporting on the findings of an in-depth field study at Bell Atlantic,
1 now Verizon. The impact of teaming on productivity, quality, and employee
satisfaction was measured using research design methods not commonly found
in field study research, including a control group, pre- and post-test data, and
organizational data. The impact was significant, teamed employees demonstrated
larger gains in productivity than non-teamed employees, and teamed employees
also demonstrated significant improvements in service quality and employee
satisfaction. These findings provide empirical evidence that implementing work
teams does positively impact performance and create organizational value.
This volume continues with an article by J. H. Hertenstein and M. B. Platt
that deals with new product development. The article reviews the accounting
1 and control literature and the more extensive literature on marketing,
manufacturing and R&D contributions to new product success. It also reports
field research describing how two firms used accounting in new product devel-
opment. It proposes a conceptual framework hypothesizing how management
accountants’ participation can enhance the firm’s performance. The article by
R. C. Kee mathematically models the relationship between a product’s revenue
and cost functions, where a product’s cost function is estimated using activity-
based costing. The resulting cost-volume-profit model may be used to determine
the level of sales needed to break even and/or earn a level of profit sufficient
to justify the product’s production. The article illustrates how the financial
1 implications of ABC-stimulated product and process improvements may be
evaluated with CVP analysis.
The article by K. S. Cravens and C. Guilding appraises the frequency and
perceived usefulness of strategic management accounting. Four underlying
themes in strategic management accounting have been identified: “costing”,
“competitor accounting”, “strategic accounting” and “brand value accounting”.
Evidence of a positive relationship between strategic management accounting
application and company performance is presented.
The article by K. Park and C.-H. Yi examines the long-term stock return
performance of firms adopting lean production. The article finds that the post-
adoption stock return performances of lean firms shows significant improvement
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relative to the pre-adoption period returns, the CRSP value-weighted market

index and those of control firms. The article by L. Kren examines the effects
of product-market diversification on the relationship between CEO compensa-
tion and financial performance. The results indicate that unrelated-diversified
firms link CEO compensation more strongly to financial performance than firms
that are undiversified or diversified into related businesses.
The volume continues with an article by P. Chalos and M. Poon. This article
deals with the fact that, despite numerous empirical studies, a theoretical para-
digm of participative budgeting and performance is lacking. A multiplicity of
11 explanatory variables examining budgetary performance has generally yielded
mixed results and low explanatory power. This state of the art re-analysis
contributed to the resolution of these issues. The findings offer a theoretical
and methodological reinterpretation of the mixed results previously found
between budget participation and performance. The article by A. I. Nicolaou
examines the effect of the interaction between a firm’s cost management system
and its strategic systems on a financial manager’s performance in carrying out
tasks related to cost management. Another article by A. Anandarajan and C.
Viger addresses the issue that, despite its importance, a significant number of
companies still do not attempt to identify, measure, and accumulate quality
11 costs. The article examines whether presentation of quality cost information
influences the decisions of management.
The article by S. M. Ho and L. Yang examines the risk perception and risk
handling practices of senior Hong Kong executives in strategic capital invest-
ment decisions. The findings indicate that executives tend to perceive chance
events as causal and seek ways to control risk. The article by R. Kershaw
reviews research that has investigated the use of strategic controls to imple-
ment strategy. Studies examining the use of economic incentives and
performance measures to encourage strategy implementation are reviewed, and
a framework that identifies the key linkages between firm strategy and managers’
11 actions is developed.
We believe the eleven articles represent relevant, theoretically sound, and
practical studies the discipline can greatly benefit from. These manifest our
commitment to providing a high level of contributions to management
accounting research and practice.
Marc J. Epstein
John Y. Lee
Editors
THE IMPACT OF WORK TEAMS
ON PERFORMANCE: A
QUASI-EXPERIMENTAL FIELD STUDY
Priscilla S. Wisner
ABSTRACT
The impact of implementing work teams on corporate performance gener-

ates considerable interest in both academic and practitioner communities.
Theory and anecdotal evidence contend that implementing work teams
creates value for organizations; however, results of empirical studies are
not so clear. This paper reports on the findings of an in-depth field study
at Bell Atlantic, a large U.S. telecommunications company. The impact of
teaming on productivity, quality, and employee satisfaction was measured
using research design methods not commonly found in field study research,
including a control group, pre- and post-test data, and organizational data
spanning 15 months. The impact was significant: teamed employees demon-
strated larger gains in productivity than non-teamed employees, and
teamed employees also demonstrated significant improvements in service
quality and employee satisfaction. Additionally, a financial impact was
linked to the productivity improvements. These findings provide empirical
evidence that implementing work teams does positively impact performance
and create organizational value.
Advances in Management Accounting, Volume 10, pages 1–28.

Copyright © 2001 by Elsevier Science Ltd.
All rights of reproduction in any form reserved.
ISBN: 0-7623-0825-7
1
2 PRISCILLA S. WISNER
INTRODUCTION
The creation of value in an organization is receiving much attention in both
management and accounting communities (McNair, Polutnik & Silvi, 2000).
Identifying and measuring the drivers of corporate value requires an interdis-
ciplinary approach, and also requires managers to develop a set of measures
that link strategic objectives, management actions, and performance outcomes
(Atkinson & Shaffir, 1996). Models such as the balanced scorecard (Kaplan &
Norton, 1996), the Action-Profit-Linkage model (Epstein, Kumar & Westbrook,
11 2000), and the service profit chain (Heskett, Sasser & Schlesinger, 1997)
encourage a broad interdisciplinary approach to defining, measuring, and
managing performance. The balanced scorecard model of Kaplan and Norton
(1996, 2000) describes a systematic approach to strategy implementation that
links key success factors and performance indicators with improving organiza-
tional performance. Kaplan and Norton advocate that managers map the linkages
between employee performance, operational performance, customer outcomes,
and financial outcomes.
The Action-Profit-Linkage (APL) model described by Epstein, Kumar, and
Westbrook (2000) is a framework for identifying and measuring the key drivers
11 of business success and profitability. Interdisciplinary in nature, the APL frame-
work focuses on linking firm actions to their ultimate impacts on corporate
profitability. In the APL model, human resource actions, including organiza-
tional structure decisions, are one of the initial drivers of organizational
performance. Human resource management actions, such as job design and work
structures, impact employee behaviors and attitudes, productivity, and quality,
thereby positively impacting corporate performance and value (Becker &
Huselid, 1998; Gittleman, Horrigan & Joyce, 1998).
The service profit chain framework also describes the linkage between
management decisions and actions, employee satisfaction, customer satisfac-
11 tion, and profitability (Heskett, Sasser & Schlesinger, 1997). In a recent study
of Sears Roebuck’s implementation of the service profit chain, an improvement
in employee attitudes was related to a corresponding increase in customer
satisfaction, which in turn positively impacted firm revenue growth (Ittner &
Larcker, 1998a; Rucci, Kirn & Quinn, 1998).
In the 1990s, work teams emerged as an organizational structure favored by
many firms (Osterman, 1994, 2000; Joinson, 1999). In a 1990 study conducted
by the Center for Effective Organizations at the University of Southern
California, 47% of responding Fortune 1000 companies reported the use of
self-managing teams; in a follow-up 1996 study this number had climbed to
78% (Lawler, 1999). Creating a team-based organizational structure supports a
The Impact of Work Teams on Performance 3
number of business practices that have also increased in the past decade, such
as total quality management, lean production, business process re-engineering,
and creating flatter and more decentralized organizational structures (Ilgen,
1999; Ezzamel & Willmott, 1998). Many companies consider work teams to
be the organizational and productivity breakthrough of the 1990s (Attaran &
Nguyen, 2000).
Although companies are using work teams to implement business strategies
and improve performance, the empirical evidence of teams’ impact on organi-
zational performance is inconclusive (Russ-Eft, 1996). Most evidence linking
1 work teams and performance improvement is anecdotal or qualitative in nature,
and there is relatively little empirical data that links teaming and performance
outcomes (Banker et al., 1996; Elmuti, 1996; Russ-Eft, 1996). The relatively
few studies that have been published vary widely in terms of research methods,
controls, and outcomes. Research on team effectiveness has been criticized by
Macy and Izumi (1993) and others as lacking precise definitions, high quality
empirical findings, hypothesis testing, model building, organizational data, and
longitudinal evaluations.
Empirical studies published in the academic literature draw an inconclusive
picture of the effects of teaming. In one early review of 71 studies involving
1 autonomous work groups, just over one half reported positive performance
outcomes, while the other half reported negative outcomes or were inconclu-
sive (Pasmore, Francis, Haldeman & Shani, 1982). In a more recent
meta-analysis by Macy and Izumi (1993) of 131 studies, the findings were
similar. These researchers note that the success rates (positive findings) in the
samples are likely to be biased, since successes are more likely to be published
than failures. They also note that much of the organizational change research
suffers from a general lack of rigor in the research design, including the absence
of empirical analyses and control groups, the use of qualitative information as
a proxy for quantitative data, the use of single rather than multiple measures,
1 and the lack of a long enough time span to adequately assess behavioral effects.
This paper reports the results of a longitudinal study to measure the impact
of teaming on multiple constructs of organizational performance. Bell Atlantic,
a large U.S. telecommunications company, recently implemented work teams
in its customer service centers, expecting to increase corporate value through
resultant improvements in employee productivity, service quality, and satisfac-
tion. In this study, the impact of work teams on performance was evaluated
using research design elements not commonly associated with field-based
research. These design elements include an untreated control group, pre-test and
post-test data, multiple constructs of performance, quantitative data that is linked
to operational performance, and a longitudinal time span of data collection. This
3
study contributes to the body of research linking firm actions to performance

outcomes. The project is especially relevant because it provides evidence that
teaming creates firm value through its positive impact on productivity, quality,
and employee satisfaction.
LITERATURE REVIEW OF WORK TEAMS AND

PERFORMANCE
Defining performance for any one organization is dependent upon the organi-
11 zation’s business objectives and strategy. Spreitzer, Cohen and Ledford (1999)
broadly define organizational performance in terms of three sets of stakeholders:
owners, customers, and employees. Owners are most interested in stronger
financial performance, which typically results from increased productivity.
Customer satisfaction has a positive relationship with customer service, and
employee-level performance metrics include job satisfaction and commitment.
Becker and Gerhart (1996) advocate using performance measures that have
strong contextual relevancy, for example employee productivity and customer
satisfaction as key business unit-level measures. In the managerial accounting
domain, Kaplan and Norton (1996) advocate non-financial measurements of
11 productivity, quality, and employee attitudes as essential elements of analyzing
a company’s performance. The constructs of productivity, quality, and employee
attitudes, either singly or jointly, are reflected in the majority of models used
to test team effectiveness.
Productivity
Sociotechnical theories of organizational behavior contend that teams form a

link between the individual and the organization, making the organization more
effective and helping to advance organizational goals. Teams perform better
11 than individuals because the members combine their complementary skills and
experience to facilitate real-time problem solving, leading to an “enlarged solu-
tion space” when facing challenges (Katzenbach & Smith, 1993). Teams also
make it possible for companies to react with more speed and flexibility in
today’s competitive environment (Womack, Jones & Roos, 1990). Ezzamel and
Willmott (1998) describe teams as a “win-win” situation for the employee and
the organization, because teams are a more effective working method for the
organization and enhance job fulfillment for the employee.
Several empirical studies have measured the impact of teaming on productiv-
ity, with mixed results. A number of researchers reported positive relationships
between teaming and productivity (Banker et al., 1996; Campion, Medsker &
Higgs, 1993; Cordery, Mueller & Smith, 1991; Walton, 1972). However, other
studies reported mixed or inconclusive findings (Cohen & Ledford, 1994; Buller
& Bell, 1986; Wall et al., 1986; Gladstein, 1984). In a study of U.S. automotive
plants, Katz, Kochan and Keefe (1987) found that work teams had a negative
impact on plant productivity, although they attributed this result to initial imple-
mentation problems rather than problems caused by the teaming.
The empirical studies were weakened by a number of factors. First, almost
all the analyses were based on post-test measures only, and few had control
group data. This is very common in field-based research, because most
1 researchers don’t have knowledge of an organizational change until after it has
occurred. The lack of pre-test and control group data makes it difficult to estab-
lish that the teaming intervention impacted the productivity outcome. Another
weakness in these studies is the operationalization of the productivity construct.
Many studies use self-report data to measure productivity changes (e.g. a survey
question asking if the employee felt more productive since joining a team)
rather than strong organizational metrics. Employee absenteeism and turnover
are often used as proxies for productivity; arguably these could relate more to
employee satisfaction than to productivity. In two studies using strong produc-
tivity measures (e.g. Banker et al., (1996), measured number of units produced
1 per hour and Buller and Bell (1986) used tons per manshift), the Banker study
reported a positive association between teaming and productivity but the Buller
and Bell results were inconclusive.
A team-based structure is expected to improve productivity by facilitating
communication and learning between team members, and by fostering an atmos-
phere shared decision making and accountability. The following hypothesis is
proposed to test the impact of teaming on productivity:
Hypothesis 1: Implementing work teams will have a positive effect on
employee productivity.
1
Quality
Teaming is promoted as a key driver of improving quality, by creating a cross-

training environment where learning and best practices among team members are
routinely shared, as well as an environment of employee participation and
empowerment. Improving service quality has been linked to increases in customer
satisfaction (Heskett, Sasser & Schlesinger, 1997; Rust, Zahorik & Keiningham,
1995). Among the benefits of improved customer satisfaction are enhanced firm
reputation, increased market share, customer loyalty, additional revenues, and
reduced transaction costs (Ittner & Larcker, 1998b; Rust et al., 1995).
5
Empirical studies of teaming and quality outcomes have produced mixed

results. While some researchers have found positive results (Banker et al., 1996;
Crom & France, 1996; Batt & Appelbaum, 1995; Walton, 1972), others again
have found mixed or inconclusive results (Cohen & Ledford, 1994; Buller &
Bell, 1986). As with the productivity designs, few researchers used pre-test or
control group data, and often self-report survey data were used to measure
quality changes. Two studies using both pre-test data and strong organizational
measures of quality (number of defects and scrap rates) reported positive results,
but another similarly-designed study with the addition of control group data
11 reported inconclusive results.
Service quality by teamed employees is expected to improve performance
due to an increased amount of cross-training and through shared learning as a
team. Additionally, the physical grouping of the team makes it logistically easier
for team members to get help from a colleague to more effectively solve a
customer’s problem. Service quality should also be positively impacted by
teaming because the teamed organization structure increases employees’
feelings of participation and empowerment. The following hypothesis is
proposed to test the impact of teaming on service quality:
Hypothesis 2: Implementing work teams will have a positive effect on service
11
quality.
Employee Attitudes
Bowen and Lawler (1995) describe the “high involvement” organization as one
in which employees are empowered by company practices, such as teams, that
distribute power, information, knowledge, and rewards. Work teams empower
workers by transferring control from managers to employees. Employees that
are more involved in their job decisions are more likely to be satisfied with
11 their jobs and committed to the organization (Elmuti, 1996). Investment in
practices that enhance employees’ quality of work life promise paybacks such
as improved employee satisfaction, commitment, and turnover (Spreitzer, Cohen
& Ledford, 1999).
Research testing the relationship between teaming and employee attitudes has
produced mixed findings. A few studies have found positive results (Cohen &
Ledford, 1994; Cordery, Mueller & Smith, 1991; Gladstein, 1984), but others
have found inconclusive or mixed results (Batt & Appelbaum, 1995; Campion,
Medsker & Higgs, 1993; Wall et al., 1986; Walton, 1972). A recent study by
Spreitzer, Cohen and Ledford (1999) examined the relationship between
employee satisfaction and productivity, and between employee satisfaction and
customer satisfaction in service industry teams. No significant relationships were

found in either set of relationships.
The implementation of teams distributes knowledge, decision making, and
accountability to the employee level, making employees more involved in job
decisions that impact their work environment. This change is therefore expected
to positively impact employee satisfaction with their work environment. The
following hypothesis is proposed to evaluate the impact of teaming on employee
satisfaction:
Hypothesis 3: Implementing work teams will have a positive effect on
1
employee satisfaction.
METHODS AND ANALYSES
Research Setting and Methods
This study is an in-depth field study at Bell Atlantic, a large U.S. telecommu-
nications company that provides comprehensive telephone services to business
and residential customers. Operating in one of the most competitive markets in
1 the U.S., Bell Atlantic is the primary provider of local telephone services in
the mid-Atlantic states. Changes in the regulatory environment led to increased
competition and created strong pressure for Bell Atlantic management to main-
tain high levels of customer service while controlling costs. At the time of this
study, Bell Atlantic operated 45 consumer call centers providing sales and
service support to residential customers, employing approximately 6,000 sales
consultants. The company is now known as Verizon following its 2000 merger
with GTE, and is headquartered in New York.
The overall research methodology of this study was quasi-experimental. Cook
and Campbell describe quasi-experiments as those having “. . . treatments,
1 outcome measures, and experimental units, but do not use random assignment
to create the comparisons from which treatment-caused change is inferred”
(1979, p. 6). The conversion of each call center to a team structure took place
on a staggered schedule over the course of a two-year period. By early 1996,
approximately one-half of the call centers had been converted to teamed offices.
The treatment group, consisting of 53 sales consultants from two call centers
with the same manager, began team implementation in March 1996. The control
group for the study consisting of 84 sales consultants in a single call center,
was scheduled to begin team implementation in January 1997. Both the
treatment and control groups were located in the same geographic and sales
district; Table 1 contains basic demographic data for both groups.
7
Table 1. Demographic Data.

Control Group Treatment Group
Sales consultants 84 53
Gender – Female 65 (77%) 46 (87%)
Male 19 (23%) 7 (13%)
Mean length of service 10.8 years 13.5 years
Mean age 35.2 years 38.6 years
11 Through interviews and discussions with Bell Atlantic human resource,

business unit, and line managers, relevant performance metrics were identified
and selected. A wide variety of data, spanning a 15-month period from October
1995 through December 1996, were collected by the author for this study.
Sources of data included:
• Multiple measures of productivity that Bell Atlantic routinely records for all
call center transactions,
• Service quality data recorded by call center and Bell Atlantic quality
assurance managers,
• A Work Attitudes Survey administered before and after the teaming imple-
11
mentation to both control and treatment group sales consultants (Table 2),
• A Changes in Work Roles Survey administered to the treatment group sales
consultants (Table 3),
• Participation in management meetings,
• Management interviews,
• Focus groups with sales consultants, and
• On-site observation.
The study at Bell Atlantic measured the impact of teaming on productivity,
service quality, and employee satisfaction. The type and availability of data for
11 assessing each of these three outcomes varied, leading to different evaluation
methods for testing the impact of teaming on each of the constructs. Therefore,
the specific evaluation methods used for each construct are detailed in the
productivity analysis, service quality analysis, and employee satisfaction
analysis sections of this paper.
Teaming Implementation
In March 1996 the employees in the treatment group were randomly reorga-
nized into work teams, resulting in 11 teams averaging five employees each.
While the basic job function of the sales consultant remained the same for both
Table 2. Work Attitudes Survey Items.
1. I have a lot of variety in my job.

2. I feel as though my work is something that is not trivial, but is really worthwhile.
3. I am satisfied with the amount of responsibility I am given.
4. I am recognized for doing good work.
5. The feedback I receive about my job performance helps me to do a better job.
6. I have a lot of opportunities to use my abilities.
7. Attention is paid to suggestions I make.
8. I am free to choose my own method of working.
1 9. I am willing to put in a great deal of effort beyond that normally expected in order to help
Bell Atlantic succeed.
10. The goals and objectives for my job are clear.
11. It often seems like I have too much work for one person to do.
12. I am given an opportunity to offer my input in decisions that affect my job.
13. I talk up Bell Atlantic to my friends as a great organization to work for.
14. I am certain about what my job responsibilities are.
15. There is free and informal communication between coaches and employees in the RSSC.
16. The performance standards for my job are too high.
17. I am satisfied with the amount of job security that I have.
18. I feel that I am really part of a team.
1
19. I find that my values and RSSC values are very similar.
20. I know exactly what is expected of me on my job.
21. Generally speaking, I am very satisfied with my job.
22. My input is solicited regarding issues which affect my job.
23. I am satisfied with the amount of personal growth and development I get in my job.
24. I am generally satisfied with the kind of work I do in my job.
25. I am not given enough time to do what is expected of me on my job.
26. Managers keep employees informed about plans for the future.
27. I am satisfied with the amount of independent thought and action I can exercise in my job.
28. The evaluation of my performance on the team is fair and accurate.
1 29. I make innovative suggestions to improve my team’s work.
30. I orient or train new team members even though it isn’t required of me.
31. I am satisfied with the way my performance on the team is evaluated.
32. I am given performance feedback in a timely manner.
33. The members of my team get along well together.
34. The members of my team will readily defend each other from criticism by outsiders.
35. I look forward to being with the members of my team each day.
36. I find that I generally do not get along with the other members of my team.
37. I enjoy belonging to this team because I am friends with many group members.
38. The team that I belong to is a close one.
39. All in all, I am satisfied with my job.
9
Table 3. Changes in Work Roles Survey and Response Distribution.

Meana Agree Neutral Disagree
(%) (%) (%)
Since I began working on my team at Bell Atlantic . . .

. . . I have a better understanding of how to increase
customer satisfaction. 3.60 67.6 17.8 15.6
. . . I am held more accountable for my productivity. 3.70 65.2 28.3 6.5
. . . I receive more recognition for the work I do. 3.08 29.6 48.6 21.6
. . . I am responsible for maintaining team
11 productivity levels. 3.67 66.7 26.2 7.1
. . . I am responsible for backing-up by teammates
in their roles. 4.02 71.8 13.6 4.5
. . . I enjoy my work more now. 3.40 42.2 42.2 15.6
. . . The members of my team cooperate better to
get the job done. 3.98 73.3 26.7 0.0
. . . I have a clear understanding of my team role. 3.69 75.6 4.4 20.0
. . . I am more involved in decisions that affect my work. 3.50 59.1 22.7 18.2
. . . I feel more encouraged to come up with new
and better ways of doing things. 3.70 65.2 28.3 6.5
. . . I am more willing to put forth extra effort
toward my job. 3.80 71.1 24.4 4.4
11 . . . I am less confused about my job duties. 3.64 68.2 15.9 15.9
. . . Interactions with my coach are more adult-to-adult. 3.86 68.9 2.2 28.9
. . . The team coach helps my team to meet team goals. 3.79 69.8 23.3 7.0
. . . I am better able to handle my work load. 3.20 37.8 37.8 24.4
. . . My team role helps me to be a better sales consultant. 3.31 45.2 35.7 19.0
. . . I feel more empowered to achieve team goals. 3.74 69.5 21.7 8.7
. . . I feel more satisfied with my job. 3.46 50.0 34.8 15.2
a
Scale is a 5-point Likert: 1 - Strongly Disagree, 2 - Disagree, 3 - Neutral, 4 - Agree, 5 - Strongly
Agree
the treatment and the control group, the organizational structure for the treat-
11
ment group changed. These changes included:
• Office committee – An office committee was formed of four sales consul-
tants and an assistant manager. The office committee coordinated team
decision making, communicated between the office manager and the sales
consultants, and helped to identify and respond to training needs.
• Team formation – Teams were randomly created as each sales consultant
drew a number from a pool designating his or her team assignment.
Workstations were then physically grouped together by team to facilitate
communication and interaction between team members, and the furniture was
changed to remove high walls between team members.
• Training – Each team participated in 24 hours of formal team training over

a three-month period. The standardized training program included company
goals and objectives, the processes of employee involvement, and coopera-
tive communication and problem-solving skills. This training was distinct
from an on-going series of skills training that all Bell Atlantic sales consul-
tants receive periodically.
• Team meetings – Teams met once each week to discuss results, solve prob-
lems, or to cross-train team members. Some weekly sessions were structured
by a team facilitator or the office committee to address a specific issue, while
1 other sessions were structured by individual teams. Periodically, all teams
would meet to share ideas and information.
• Shared outcomes – In the control group, each sales consultant only received
feedback about their own performance and an average for the office. In the
treatment group, sales consultants received their own data, the team’s results,
and summary data about the other teams’ performance. This helped to create
an environment of acknowledgement and learning that many sales consul-
tants commented favorably upon. It also helped to identify “best practice”
sales consultants, who were then called upon to share their skills with other
team members.
1
Productivity Analysis
A current or potential customer contacts a call center to establish service, change

services, or with a service or billing problem. On average, a sales consultant
handles 40 to 60 calls per day. Figure 1 is an example of five calls handled by
a sales consultant in a 45-minute timeframe. Three calls are customer queries,
possibly relating to a new product offering, a billing problem, or a change in
service. The sales consultant is trained to take advantage of every customer
contact to “bridge” to a sale of a product. Two of the calls taken resulted in a
1 sales order. Each order is made up of one or more product sales, consisting of
items such as call waiting, caller-ID, three-way calling, and additional lines.
Bell Atlantic has designated certain products as strategic products, meaning that
the products are of key importance to Bell Atlantic. Bell Atlantic systemati-
cally tracks every sales consultant transaction by recording the call length, the
purpose of the call, and each product sold along with the associated revenues.
One key driver of corporate value is employee productivity. Bell Atlantic
managers defined sales consultant productivity as a function of four key
attributes – converting a customer contact into a sale, number of products sold
per contact hour, revenues generated from selling key products, and efficiency
as measured by average call length. Improvement in these productivity metrics
11
11
11
11
12
Fig. 1. Example of a Sequence of Calls Handled by a Sales Consultant.
PRISCILLA S. WISNER
creates value for Bell Atlantic by increasing overall revenues, increasing

revenues of key products, and by minimizing personnel costs through increased
efficiency. The four key productivity measures defined by Bell Atlantic
managers are:
• average call length – computed by summing the length of all calls taken by
a sales consultant and dividing by the number of calls. Bell Atlantic desires
a low average call length, so that each sales consultant can handle more calls,
thereby keeping headcount lower.
• bridge rate – represents the sales consultant’s ability to take advantage of
1
each call opportunity by generating an order from that call, and is calculated
as the number of orders divided by the number of calls. A higher bridge rate
indicates a sales consultant who is more effective at generating sales.
• products sold per on-line hour – calculated as the total number of products
sold divided by the total on-line hours.
• strategic revenues – relates to products that Bell Atlantic management has
designated as key products, and is calculated as the sum of all strategic
revenues generated by a sales consultant divided by the total number of orders
written.
1 Productivity transaction data from October 1995 through December 1996 were
available for both the control and treatment group. To test the effect of teaming
on productivity, the productivity measures recorded in the last quarter of 1996
were compared with the measures recorded in the last quarter of 1995, matched
by sales consultant. Forty-one sales consultants in the treatment group had both
pre- and post-test data; 69 sales consultants in the control group had both pre-
and post-test data. Statistical analyses did not identify any violations of
normality, multicollinearity, or homogeneity of variance-covariance matrices
assumptions. Three outlying data points were identified, one in the treatment
group and two in the control group. The statistical outcomes were essentially
1 the same with and without these three cases; therefore, they were not removed
from the sample.
Demographic data of age, gender, and length of service as a Bell Atlantic
employee were also available for each sales consultant. Based on discussions
with Bell Atlantic human resources managers, there was no a priori expecta-
tion that these demographic measures would influence the productivity variable.
Furthermore, no significant correlations were found between these demographic
data and productivity measures; therefore, none of these data were included in
the data model.
A multivariate analysis of covariance (MANCOVA) model was used to test
the hypothesis that implementing teams will have a positive effect on employee
13
productivity. In quasi-experimental research, the researcher must assume that

the treatment and control groups are non-equivalent. To analyze data from non-
equivalent groups, Cook and Campbell (1979) recommend using covariate
analysis (MANCOVA), elementary analysis of variance, gain score analysis, or
blocking or matching for statistical evaluation. The MANCOVA method was
used because it included an adjustment for possible pre-test differences between
the control and treatment groups. Evaluation of the data using elementary
analysis of variance and gain score analysis, which do not adjust for pre-test
differences, led to essentially the same statistical results as the MANCOVA.
11 Blocking or matching on pre-test characteristics was rejected because this
method requires the deletion of cases that cannot be matched, which would
reduce the sample size.
The MANCOVA model contained the four post-test observations for each sub-
ject as outcome variables (Y1 . . . Y4), the four corresponding pre-test observations
as covariates (X1 . . . X4), a dummy variable (TC) to indicate control or treatment
group and four interaction terms. The MANCOVA model statement was:
Y1 Y2 Y3 Y4 = ␤0 + ␤1X1 + ␤2X2 + ␤3X3 + ␤4X4 + ␤5TC + ␤6(X1TC)
+ ␤7(X2TC) + ␤8(X3TC) + ␤9(X4TC) + ␧
11 where:
Y1 = Average Call Length (mean of October–December, 1996)

Y2 = Bridge Rate (mean of October–December, 1996)
Y3 = Products Sold (mean of October–December, 1996)
Y4 = Strategic Revenues (mean of October–December, 1996)
X1 = Average Call Length (mean of October–December, 1995)
X2 = Bridge Rate (mean of October–December, 1995)
X3 = Products Sold (mean of October–December, 1995)
X4 = Strategic Revenues (mean of October–December, 1995).
11
The MANCOVA model was evaluated using the Wilks’ Lambda statistic, which
provides strong support for Hypothesis 1, that teaming has a positive effect on
sales consultant productivity (Wilks’ Lambda = 0.8943, F = 3.0729, Pr > F =
0.0195). The difference in productivity of the teamed employees was signifi-
cantly greater than the difference in productivity of the control group employees
over this 15-month time span.
Evaluating each component of productivity was useful to better understand
the teaming impact (Table 4):
• average call length – Average call length increased for both the treatment
and control groups, perhaps due to the expanded product set being offered
by Bell Atlantic to its customers. The call length increase for the treatment
group (8.8%) was slightly less than the control group increase (10.2%). In
focus group interviews, teamed employees reported that working as part
of a team helped them to process calls faster, because they were able to
get advice quickly and help from their teammates, resulting in less “on
hold” time for the customer. They were also able to transfer difficult calls
to team members who were more experienced. Conversely, in the control
group, sales consultants could only turn to a manager at a central work-
station for advice or help with problematic calls. Control group employees
1 reported that they were often reluctant to seek this help, because the
manager might be busy, or because they did not want the manager to know
that they needed help.
• bridge rate – The bridge rate increased 32.3% in the teaming group,
compared to a 16.7% increase in the control group. “Bridging” to sales, or
being able to generate a customer order from a customer call, is a highly-
valued skill at Bell Atlantic. Bell Atlantic has invested heavily in building
sales tools and techniques that help sales consultants take advantage of
every customer contact to make a sale. The teamed sales consultants appear
to be learning how to use these sales tools to generate customer orders at
1 a much faster pace than the control group of sales consultants. Sales consul-
tants reported that teaming created a “learning environment,” which made
it easier to recognize and ask questions of others who had specific skills.
Prior to teaming, the sales consultants reported that they felt more isolated
and were not encouraged to go to other sales consultants for help (in fact,
this behavior was discouraged). When asked why they did not go to the
managers for help with certain skills, one sales consultant responded that
“your team mates are more likely to help you and not hold your questions
against you. Managers will use your questions to evaluate you lower.”
• products sold per on-line hour – The number of products sold per on-line
1 hour increased at a greater pace in the treatment group (42.5%) than in the
control group (32.3%). Teamed sales consultants improved more at closing
sales than the control group employees. The strong increase in products
sold for the teamed employees could have been driven by a combination
of factors. One factor was the learning environment created by teaming,
meaning that the employees were getting better at their jobs. Another factor
that may have also impacted this performance was a sense of competition
that teaming may create in a group. In the teamed structure, each team
would get a set of team results by team member, which would be discussed
in the team meetings. Low performers could be identified and helped by
the team, and the sharing of information in a small group may have also
15
Table 4. Productivity Variables – Means and Standard Deviations.

Group Variable 1995 1995 1996 1996 Difference in Mean
Mean Std. Dev. Mean Std. Dev. 1995–1996
Control ACL 6.70 2.09 7.38 2.46 10.2%

Bridge 0.30 0.09 0.35 0.05 16.7%
Products 3.34 0.98 4.42 1.05 32.3%
Strrev 37.71 7.20 36.99 4.51 (1.9%)
Treatment ACL 7.87 2.83 8.56 2.75 8.8%
Bridge 0.31 0.06 0.41 0.11 32.3%a
11 Products 3.41 0.88 4.86 1.18 42.5%b
Strrev 40.52 5.90 38.67 4.29 (4.6%)
a
between-group difference in means significant at p < 0.05.
b
between-group difference in means significant at p < 0.0001.
compelled sales consultants to work harder so that they would not be a

lower-performing employee.
• strategic revenues per order – Strategic revenues declined slightly in both
the treatment and the control group, with slightly more decline in the treat-
ment group (4.6%) than in the control group (1.9%). Bell Atlantic managers
11
stated that this decline was likely a result of a change in Bell Atlantic’s
sales objectives during the year, as the initiative to sell certain strategic
products was not emphasized as much in late 1996 as it was in late 1995.
Link to Financial Results

The analysis of the productivity data reported in Table 4 demonstrates that the
teamed sales consultants showed statistically significant improvement in two of
the productivity metrics: bridge rate and products sold per on-line hour. While
the bridge rate difference indicates that the teamed sales consultants are more
11 successful at converting calls to sales, the products sold per on-line hour differ-
ence reflects how much more they are selling. Therefore, the revenue impact
of teaming is calculated using the products sold per on-line hour data.
The increase in products sold per on-line hour averaged 1.08 for the control
group and 1.45 for the treatment group. This difference is 44.4 more products
sold per month, or an average of 532.8 more products sold annually per teamed
employee (Table 5). Multiplying the 532.8 incremental products by an average
product revenue of $40 (Bell Atlantic estimate) produces additional revenue of
$21,312 for each teamed sales consultant. For the 53 employees in the treat-
ment group alone, this translates into over a million dollars in increased revenue.
Although this study was limited to two customer service centers, and therefore
Table 5. Potential Impact on Product Revenues.

Products sold per on-line hour
1995 1996 increase monthlya
Control group 3.34 4.42 1.08 129.6

Treatment group 3.41 4.86 1.45 174.0
Treatment Group difference (per month) + 44.4
Annualized Products Sold difference 532.8
Bell Atlantic annualized revenue per product (average) $40
1 Incremental revenue per sales consultant $21,312
Effect in TBO office studied (53 sales consultants) $1,129,536
a
based on 120 on-line hours per month.
the average per employee may not be representative of the impact throughout
the Bell Atlantic organization, it is likely that the impact for the whole orga-
nization of 6,000 sales consultants would be substantial. A complete financial
analysis of this impact would also require an accounting for the organizational
1 development and implementation costs incurred by Bell Atlantic including
program development, materials, sales consultant off-line time for training and
team meetings, and staff costs. These development and implementation cost
data were not available for this project, although it was believed by Bell Atlantic
managers that these total costs were substantially less than the $21,312 per
employee average revenue impact.
Service Quality Analysis
Service quality is represented by a score on a monthly scorecard of 13 service

1 quality criteria that a sales consultant must exhibit on a customer call. These
criteria measure how well a sales consultant demonstrates product knowledge,
process knowledge, and a customer service orientation. Sales consultant service
quality data are generated by a manager observing a sales consultant’s calls,
either “on station” or by listening from a remote station. Each sales consultant
is rated numerous times throughout the year, but not every sales consultant is
rated each month. Due to record-keeping differences between the control and
treatment group offices, monthly service quality data were available only for
the treatment group sales consultants. Figure 2 shows the change of the average
service quality scores on a quarterly basis for 1996 for the treatment group
sales consultants, indicating that service quality in the group improved
17
11
Fig. 2. Average Service Quality Scores.
throughout the year. According to the call center manager, the sales consultants
11 consistently achieving high service quality ratings were less likely to be rated
in a subsequent quarter. Therefore, the improvement trend shown in Fig. 2 is
actually understated.
Twenty-nine (29) sales consultants were rated both prior to teaming and again
after implementing teams. Three variables were computed to test the service
quality hypothesis:
• Pre-test score – mean of January, February and March 1996 scores
• Post-test score – mean of October, November and December 1996 scores
• Difference score – post-test score minus pre-test score
11 Table 6 reports the service quality scores for the treatment group, as well as
the standard deviations and score ranges. Evaluating the service quality differ-
ence score using a paired-difference t-test showed that service quality
significantly increased in the treatment group after the implementation of teams
and there was less variation in the service quality scores (T = 2.86, p < 0.01).
This result provides strong support for Hypothesis 2, that implementing teams
will have a positive effect on service quality.
Although limiting the analysis to the treatment group weakens the conclu-
sion that the increase in service quality scores resulted from teaming, interviews
with both managers and sales consultants support the finding of a positive rela-
tionship between teaming and service quality. One sales consultant commented
Table 6. Service Quality Scores.
Standard
Mean Deviation Minimum Maximum
Pre-test score 85.7 13.2 44.6 100.0

Post-test score 92.9 7.6 71.4 100.0
Service quality difference 7.3a 13.7 ⫺18.7 48.0
a
difference significant at T = 2.86, p < 0.01.
1 that teaming created an environment of “shared leadership, and that we work

together to fix things.” During the focus group interviews, the sales consultants
described how much easier and more satisfying it was to get help on a call in
the team-based structure:
Prior to teaming, a consultant would have to go to a service manager at a central station
for help, as opposed to a colleague at a near-by workstation. Accessing the service manager
took longer, and some consultants were reluctant to take problems to a service manager for
fear of being identified as inept. Often the service manager would take the call from the
sales consultant, and the sales consultant would never learn how the problem was resolved.
Asking a team member for help was a quicker process, and the sales consultants could also
1 experience real-time learning either by listening in as the teammate resolved the problem
or talked the sales consultant through the problem.
About nine months after changing to the teamed structure, the Changes in Work
Roles Survey was administered to treatment group sales consultants. As reported
in Table 3, 67% of the 27 respondents agreed with the statement: “Since I
began working on my team at Bell Atlantic, I have a better understanding of
how to increase customer satisfaction”. Seventy-one percent of these sales
consultants also agreed that they are more willing to put forth extra effort toward
their job and 65% reported that they felt encouraged to come up with new and
better ways of doing things. In focus groups and other conversations, the teamed
1 sales consultants indicated that their performance was improved because they
could share ideas and suggestions more freely, that there was more of an atmos-
phere of helpfulness between the team members, and that the shared knowledge
between the team members helped the sales consultants to do a better job
servicing the customer.
Employee Satisfaction Analysis
Two survey instruments were used to evaluate changes in employee satisfac-

tion. The Work Attitudes Survey measured levels of satisfaction and was given
to both the control and treatment groups. The Changes in Work Roles Survey
19
Table 7. Work Attitudes Survey Sub-scale Correlation Matrix.

Full Scale Satisfaction Dobbins and Warr, Cook
Zaccaro and Wall
Full Scale 1.000 0.796*** 0.688*** 0.884***

Satisfaction 1.000 0.428*** 0.643***
Dobbins and Zaccaro 1.000 0.527***
Warr, Cook and Wall 1.000
*** significant at p < 0.001.

11
measured the impact of teaming on the sales consultants’ jobs and therefore
was only administered to the treatment group. Both surveys were developed by
the author with the input of Bell Atlantic management, and were pilot tested
with separate groups of university and Bell Atlantic employees.
The Work Attitudes Survey (Table 2) is a 39-item employee satisfaction scale
developed for this study. The survey includes a scale of intrinsic job satisfac-
tion (Warr, Cook & Wall, 1979), a group cohesiveness scale (Dobbins &
Zaccaro, 1986), and two self-report items of satisfaction. There is a significant
11 amount of correlation between these three subscales and the full scale (Table
7), demonstrating the survey had strong construct validity (Nunnally &
Bernstein, 1994).
Sales consultants in the control and treatment groups took the Work Attitudes
Survey in March 1996 and again in January 1997. Bell Atlantic management
required that the surveys be anonymous and voluntary; however, employees
were requested to provide the first five letters of their mother’s maiden name
so that pre-test survey responses could be matched with post-test survey
responses. Twenty-six respondents provided this information.
Response rates for the March 1996 survey were 51% in the control group
11 and 93% in the treatment group, for a total of 128 surveys returned. In January
1997, 89 surveys were returned with the following response rates: control group
48%; treatment group 70%. The Cronbach alpha for the scale was 0.93,
indicating high inter-item reliability (Nunnally & Bernstein, 1994). The three
subscales also exhibited strong inter-item reliability, with the following metrics:
Warr, Cook and Wall (8 items, alpha = 0.85); Dobbins and Zaccaro (7 items,
alpha = 0.84); self-report of satisfaction (2 items, alpha = 0.90).
The purpose of this analysis was to measure changes in employee satisfac-
tion between the pre-test and post-test periods; therefore, sales consultants with
less than one year’s service or that did not report length of service were excluded
from the analysis. Pre-test and post-test scores were calculated for each sales
Table 8. ANOVA Results for Work Attitude Survey Responses.

Group Variable n mean std. dev. minimum maximum
control Pre-test 26 2.38 0.45 1.5 3.0

Post-test 26 2.76 0.67 1.4 3.8
treatment Pre-test 61 2.89a 0.39 2.0 3.9

Post-test 34 3.49b 0.46 2.1 4.2
a
difference in pre-test means significant at p < 0.000
b
1 no significant difference in post-test means.
consultant by summing all response scores and dividing by the number of survey
items; the possible range of scores was 1.0 (lowest level of satisfaction) to 5.0
(highest level of satisfaction).
An analysis of variance model (ANOVA) was used to analyze the differ-
ences in the treatment and control group means between the pre-test and post-test
periods. The change in satisfaction scores over time was positive for each group
(Table 8), with the control group mean increasing from 2.38 to 2.76 (16%),
and the treatment group mean increasing from 2.89 to 3.49 (21%). Although
1 the treatment group had a larger increase in mean satisfaction than the control
group, supporting the contention that teaming enhances employee satisfaction,
the ANOVA did not detect any statistical significance in these differences. This
result could be attributed to a data factor, that the two groups begin with signif-
icantly different means. The pre-test difference could not be accounted for using
a covariate as suggested by Nunnally and Bernstein (1994), because the pre-
test and post-test responses of the full data set could not be matched.
A more-sensitive matched pairs t-test was used to analyze the survey response
data for the 26 surveys matched using the mother’s maiden name (Table 9).
As shown in Table 9, the control group data did not show any significant differ-
1 ences in pre-test and post-test scores, while the treatment group differences
were strongly significant. The outcome of this test supports the hypothesis that
teaming has a positive impact on employee satisfaction; however, the small
number of cases limits the strength of the conclusion.
The Changes in Work Roles Survey is an 18-item survey administered to the
teamed sales consultants in January 1997, measuring the effect that teaming
has on their jobs and work environment. The survey results provide further
evidence that the teamed sales consultants have responded positively to the
teamed environment and are more satisfied than prior to teaming. As shown in
Table 3 the mean response to every survey item is higher than three (neutral),
showing that the level of satisfaction of the sales consultants increased after
21
Table 9. Work Attitudes Survey – Matched Pairs Analysis.

Group Variable # pairs mean std. dev. t-value df p > |T|
control Pre-test 7 2.63 0.52 1.28 6 0.249

Post-test 2.84 0.65
treatment Pre-test 19 3.10 0.35 4.80 18 0.000

Post-test 3.55 0.41
11 the implementation of teaming. The distribution of the responses between

“agree”, “neutral”, and “disagree” also supports the conclusion that employee
satisfaction has increased after teaming was implemented.
Hypothesis 3 therefore was supported statistically by the matched-pairs data
analysis, and by the trends that can be seen in the data patterns.
Discussion of Results
The empirical results of this study provide evidence that teaming is positively
associated with improvements in employee satisfaction, service quality, and
11 productivity. These improvements have both direct and indirect impacts on
corporate value, through increased revenues, lower costs, improved customer
satisfaction, and improved employee satisfaction. The statistical results
confirming the positive impact of teaming on performance were not surprising
to Bell Atlantic management; in fact, the results validated managers’ observa-
tions and impressions. Managers commented that sales consultants were
increasingly contributing to the work environment in previously-unseen ways.
Examples cited were that the number of employee suggestions increased,
employees participated more in meetings, employees took more initiative in
identifying and solving problems, and some volunteered to take on additional
11 assignments in the office.
The sales consultants who participated in the focus groups and project meet-
ings commented repeatedly that being in the team environment made them feel
more involved in their work and more empowered to make decisions. When
asked to describe how the work environment changed after teaming was imple-
mented, sales consultants had the following responses:
- “. . . you get a variety of everyone’s opinions.”
- “. . . you can speak out a little bit more.”
- “. . . you have input . . . other people hear your opinions.”
- “I’m working harder and without extra pay, but I feel good.”
The feeling of empowerment had a powerful influence on the sales consultants.

The motto of the offices was “people will support what they help to create,”
and the sales consultants reported that not only were they more involved in
creating their work environment and rules, but that they were more satisfied
and productive as a result. In two focus groups, 16 sales consultants were asked
if they would prefer to work in a teamed or non-teamed office in the future;
the unanimous answer was that they would prefer the teamed office environ-
ment (responses were written and anonymous).
The sales consultants interviewed commented how good and competent it
1 made them feel that management was asking for their opinions and sugges-
tions, which in turn made them feel better about coming to work. One sales
consultant commented: “I feel like my ideas and knowledge are more valued
when people (managers and other sales consultants) ask me what I think or
how I do things.” Sales consultants also reported that the positive aspects of
the team structure were that:
- they contributed more to decision making,

- they felt as though they could work together to solve problems,
- the management/sales consultant relationship was now more of an “adult to
1 adult” relationship as opposed to an “adult to child” relationship, and
- the decision-making process was much more real-time.
The sales consultants interviewed also discussed how teaming helped to make
them more effective at their customer sales and service jobs. The cross-training
environment gave them “real-time” skills, because they could now turn to others
in their team for help with sales tools and techniques. Teams would schedule
their training sessions based on their productivity reports; where they noticed
a deficiency in certain skills or outcomes, the team would use the next team
meeting to discuss how to use sales tools and techniques to improve results.
1 Sales consultants commented that the physical proximity between team members
also helped to increase learning, since team members could better observe how
their colleagues handled customer calls. Customers’ problems were also resolved
more quickly in the team environment. Instead of a sales consultant asking for
a manager’s help to resolve a difficulty with a customer order, the sales consul-
tant could easily turn to a team member for help.
Sales consultants reported that implementing and learning teaming was a
time-consuming process. One question in Table 3 indicates that teaming had
some negative impact on work loads, as 24% of the sales consultants reported
that their workloads were less manageable since the start of teaming. However,
Bell Atlantic managers felt that the start-up time involved in teaming contributed
23
to this work load pressure, as employees were receiving additional training and
learning new interactive skills. Many of the teamed employees commented on
the interpersonal skills required for team work, and noted that working with
team members was not always a smooth process. Some sales consultants
commented that they were initially upset by the physical re-arrangement of the
office space, but this was less of a negative factor over time.
There were also some sales consultants who did not want to participate in
teaming and therefore contributed little, if any, to the team. The reluctance to
participate seemed to have two primary origins. One was that some sales consul-
11 tants were more comfortable with an individual work environment. The other
was that some sales consultants commented that they felt as though they were
being asked to do “management’s work” (e.g. making decisions) without
receiving management’s pay.
Bell Atlantic management strongly believed that the new teaming structure
created value for the company. Reorganizing into a work-team structure was
implemented in the control call center in January 1997 as originally scheduled,
and subsequently in the remainder of the Bell Atlantic call centers. In addition
to implementing a team structure in the call centers, Bell Atlantic implemented
teaming in their management ranks and throughout the organization.
11
CONCLUSIONS
Limitations
The purpose of this study was to empirically evaluate the impact of work teams
on employee productivity, using extensive field study data. While being able
to study the effects of a job redesign in a field study is a strength of this study,
it also results in a number of limitations. One limitation of any field study is
11 the generalizability of the findings to other organizations. While this project is
a study of one organization, by employing strong research design elements and
linking management actions to performance impacts it provides additional
insights into the effects of an organization change.
Another limitation of a field study is that events may take place between the
pre- and post-test periods that could affect performance outcomes, such as a
fundamental change in the company, a change in office management, or other
more subtle organizational changes. Every effort was made during field visits
and in communications with Bell Atlantic personnel to track relevant changes
on the company, district, and sales office level that might have influenced the
outcomes. During the time of this study there were no changes to upper manage-
ment personnel, incentive or reward structures, or in other factors that would

have obviously impacted the outcome of the study.
Selection bias is a threat because the subjects for the study were not randomly
selected or assigned to the treatment and control groups. According to Cook
and Campbell (1979), even if the groups appear to be equivalent on pre-test
measures, the subjects may be maturing at different rates or may be influenced
by factors that are not apparent in the data. The two groups appeared to be
fairly equivalent from a demographic standpoint and the timing of when each
group would implement teaming showed no obvious selection bias.
1 Additionally, the statistical method used to analyze the productivity data was
conservative in that it assumed non-equivalent groups.
Finally, as with any change in work environment, the results may not have
been due to the specific change but rather to the fact that the environment was
changed. The threat of a potential Hawthorne effect was minimized by the
length of time between the implementation of the change and the collection of
the post-test data.
Contributions
1
Previous research about the relationship between teaming and performance have
created an unclear picture of the impact of teaming on employee and corpo-
rate performance. The study described here with Bell Atlantic is unique in that
the research took place as the change was happening, rather than afterwards.
Multiple measures of productivity, service quality, and employee satisfaction
data were available for employees in both a teamed group and a non-teamed
group, and the data measures were collected prior to the teaming changeover
and again nine months later. The majority of the performance data used in the
evaluations were data that Bell Atlantic routinely collected and audited for each
1 employee. These strong research design factors lend credibility to the findings
in this study, and increase confidence that the positive impacts found for the
performance outcomes actually do relate to the teaming implementation.
These findings help to inform financial executives about the impact of teaming
on strategic performance metrics and corporate profitability. As strategic
partners in executive teams, financial managers are charged with evaluating
management alternatives using both financial and non-financial metrics. This
study contributes to both the academic and practitioner communities by showing
how strong design metrics can be linked to a real world application of busi-
ness change, in order to evaluate the impact of that change and provide a link
to corporate value creation.
25
Further Research
The impact of human resource management practices is a function of many

factors, including training, compensation policies, incentive systems, and the
provision of benefits (Gittleman, Horrigan & Joyce, 1998; Becker & Huselid,
1998). Additional research is needed to identify under what conditions teaming
is successful, and what systems and structures are helpful for a company to
realize the benefits of teaming.
As identified by the APL model (Epstein, Kumar & Westbrook, 2000) there
11 are various dimensions that influence product and service delivery, customer
behavior, and ultimately corporate profitability. Very little research has been
done which gives a clear understanding of the interactions between these various
dimensions and, as importantly, the tradeoffs between various firm actions and
decisions. As most managers have a limited set of physical, technical and human
assets, it would be advantageous to understand how to most effectively leverage
these assets. Given the pressure on managers to increase profitability or share-
holder value, more research is needed that links the decisions and actions taken
in a company to desired outcomes, and then linking these outcomes to prof-
itability.
11
ACKNOWLEDGMENTS
The author gratefully acknowledges Holly Feist, formerly of Bell Atlantic, for
her assistance with this project.
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11
CREATIVE ACCOUNTING? WANTED
FOR NEW PRODUCT DEVELOPMENT!
Julie H. Hertenstein and Marjorie B. Platt
ABSTRACT
New product development (NPD) provides opportunities for management

accountants to add value to the firm. To highlight this potential, we review
the accounting and control literature and the more extensive literature on
marketing, manufacturing and R&D contributions to new product success.
We also report field research describing how two firms used accounting
in NPD. Finally, we propose a conceptual framework hypothesizing how
management accountants’ participation in NPD can enhance the firm’s
performance. Future research based upon these hypotheses is discussed.
1. INTRODUCTION
Consider two firms, each significantly involved in new product development

(NPD). At the first firm, accountants are rarely involved in early phases of
NPD. Preliminary product cost estimates and other financial analyses are left
to engineers. The engineers have only rudimentary understanding of accounting
models, especially the accounting model the firm uses to calculate the cost of
its products. Accountants take an active role in NPD only near the end of devel-
opment when product design is essentially complete and manufacturing
processes are well defined. At that juncture, they refine product cost estimates,
prepare capital expenditure requests for required equipment, and construct

2001 by Elsevier Science Ltd.
ISBN: 0-7623-0825-7
29
30 JULIE H. HERTENSTEIN AND MARJORIE B. PLATT
revenue, expense, and capital investment forecasts to evaluate the product’s

feasibility.
In contrast, at the second firm, accountants are actively involved in NPD
from the very beginning. They help the NPD team explore the financial
implications of design alternatives, thus ensuring the team considers issues like
product cost and profitability when choosing designs. Also, accountants develop
early revenue and expense forecasts to explore product feasibility. They contin-
ually update these forecasts and generate additional financial analyses of the
effect of the product on the firm’s suppliers, customers, distributors, and other
11 strategic partners.
Which firm will have greater new product success? Much recent research has
documented the value of combining diverse functional expertise and perspec-
tives in NPD. Most existing research on NPD comes from areas outside
accounting, particularly research and development (R&D), manufacturing, and
marketing which are recognized as key to NPD due to their direct roles in
developing, making and selling new products. Previous research focused on
these functions has revealed the following:
(1) Individuals from diverse functional areas must work together. For example, it
is more effective for R&D to work with manufacturing to develop a product
11
that can be readily manufactured than it is for R&D to develop the product and
hand it over to manufacturing to figure out how to manufacture it.
(2) Individuals from diverse functions must be included early in the product
development process. Early participation allows them to influence funda-
mental, interrelated decisions. If they are brought in near the end of the
process, they cannot be as effective because too many interrelated decisions
have been made and changing these decisions is difficult, costly and time-
consuming.
(3) Individuals participating in NPD must be proficient in functional skills
related to product development. Thus, it is more effective to have market
11
research conducted by marketing personnel than it is for R&D personnel
to conduct market research.
(4) NPD personnel need strategic guidance. Strategy focuses NPD personnel
on opportunities that have high value for the firm. Strategy provides a shared
vision to unite individuals from diverse functions and perspectives, and it
helps to prioritize diverse goals and objectives.
Although some (Hertenstein & Platt, 1998) have suggested that individuals with
accounting expertise should similarly be involved in NPD, the value of including
them remains largely unexplored by researchers. In addition, our research shows
that practitioners do not agree about the effect of including accountants early
Creative Accounting? Wanted for New Product Development! 31
in the NPD process. Some product developers are fearful that accountants will
impose financial constraints that will stifle creativity. Others argue, however,
that financial constraints challenge product developers to become even more
creative and innovative in finding a design solution that satisfies the full range
of customer needs including functionality, aesthetics, and product cost.
Of the two firms described in the opening, we believe the second firm is
more likely to develop a highly profitable new product. However, although
research reviewed in other functional areas lends credence to our hypothesis,
there is currently little research in the accounting literature to support this. In
1 this paper, we argue that management accountants can add value to new product
development. We also develop a conceptual framework and derive testable
hypotheses to measure improvements in NPD outcomes from effectively inte-
grating accounting participation.
To support this position, the paper first describes aspects of the NPD process
at one research site, Duraprod Company. Duraprod was selected from among
our research sites to illustrate that including accountants on the NPD team is
not sufficient; they must be effectively integrated. This research identifies key
variables that influence whether accounting participation in NPD is effective,
and to illustrate how firms miss opportunities when accounting expertise is not
1 effectively integrated in NPD. Duraprod further illustrates that non-financial
new product developers desire effective accounting participation in NPD. Next,
this paper reviews the limited accounting and control literature on the subject
and, for additional insight, the more extensive literature about the roles and
contributions of players long agreed to be key to new product success in
technology (R&D, engineering, manufacturing) and marketing. The literature
reviewed illustrates factors proven to increase the effectiveness of NPD.
Following the literature review, key findings from the literature are combined
with field research findings to create a conceptual framework for effective
accounting participation in NPD. A second research site, Comptech Company,
1 where accountants are effectively integrated in NPD, was selected to illustrate
how the conceptual framework works in practice. Finally, in the section, A
Guide to Future Research, a series of testable hypotheses are developed from
the conceptual framework to guide future research.
2. DURAPROD COMPANY1
At Duraprod, accountants and accounting information play a fairly limited role

in NPD, a situation common among many firms. One interpretation of this
situation is that it is consistent with Duraprod’s strategy, which assigns product
cost low importance. However, Duraprod is experiencing some financial
31
difficulties, and NPD personnel attribute these difficulties, in part, to

accounting’s role in NPD. An alternate interpretation of the Duraprod situation
is that accounting does not contribute effectively to NPD at Duraprod because
accountants are passive, their participation is concentrated late in the process,
and accounting data are misleading. NPD personnel envision a more significant
role for accounting to avoid missed opportunities. Although the accountants’
role at Duraprod has evolved modestly in recent years, NPD personnel want
accountants to do more. They articulate how accountants might better serve
NPD by being involved earlier in NPD, taking a more proactive, collaborative
11 approach to problem solving in NPD, and by creatively adapting their finan-
cial skills to address NPD needs.
To provide contextual understanding of NPD at Duraprod, we first present
background information on Duraprod’s products, positioning and strategy, and
its current performance. We then begin the NPD discussion by briefly discussing
the current links between corporate strategy and NPD, as corporate strategy
frames and guides the entire NPD effort. We next describe the current role of
accounting and accountants in NPD. More specifically, we describe manage-
ment accounting resources on the NPD team, and their current contributions to
NPD in terms of timing, expertise, and proficiency. We also discuss product
11 cost information used in NPD, especially overhead cost allocation, and finally,
how product cost information is used to address target cost overruns and to
assign accountability. Following an analysis of the current role of accounting
and accountants in NPD at Duraprod, we describe and discuss Duraprod’s
product developers’ future vision for them.
Background
Products, Positioning and Strategy

Duraprod is a large U.S. company that manufactures a wide variety of durable
11 products sold to businesses, typically large firms such as those in the Fortune
500. Duraprod’s product lifetimes are fairly long, lasting from a few years to
a decade or more with essentially unchanged product design.
Duraprod is a major player in its mature market. Duraprod’s domestic sales,
which exceeded 10% of the domestic market in 1998, were growing faster than
the domestic industry; non-U.S. sales were growing slightly faster. The product
market comprises both a commodity segment and a differentiated segment;
Duraprod participates primarily in the differentiated segment.
Product development team members indicate that participating in this differ-
entiated market segment requires them to “innovate to create aesthetics and
performance to establish a competitive advantage.” There is general agreement
that a key to creating competitive advantage is developing a product that facil-

itates the customers’ work. NPD personnel consistently indicate that product
cost is not the highest priority among key strategic objectives, but it ranks in
the middle. Time to market and quality rank higher.
Performance
Duraprod’s financial performance was moderate, and its stock price was falling.
Compared to the industry as a whole, Duraprod’s 1998 profitability ratios are
reasonable, but not outstanding, as shown in Table 1. Compared to a single,
1 comparable competitor, both firms have similar, increasing return on sales, as
shown in Table 2. However, the competitor’s other profitability ratios are higher
and strengthening whereas Duraprod’s not only are lower, but they are falling.
Further, compared to both the industry and the competitor, Duraprod’s high
capital intensity and asset intensity are evident, as measured by sales/total assets
and sales/net fixed assets. These factors may partly explain the 60% drop in
Duraprod’s stock price in the most recent two years.
Table 1. Duraprod’s 1998 Performance Relative to Industry.

1
Duraprod Relative to Industry
Return on Sales 7.9% 2nd Quartile

Return on Assets 10.8% Median
Return on Equity 16.3% 3rd Quartile
Sales/Total Assets 1.38 4th Quartile
Sales/Net Fixed Assets 4.11 4th Quartile
Table 2. Duraprod Performance Relative to Comparable Competitor.

1
Duraprod Competitor
1999 1998 1999 1998

Profitability:
Return on Sales 8.1% 7.9% 8.0% 7.5%
Return on Assets 10.1% 10.8% 18.6% 16.4%
Return on Equity 14.8% 16.3% 67.8% 55.6%
Asset & Capital Intensity:
Sales/Total Assets 1.26 1.38 2.31 2.19
Sales/Net Fixed Assets 3.71 4.11 5.58 5.91
33
Linking Corporate Strategy to New Product Development
Duraprod recently incorporated an explicit link to corporate strategy within its

formal NPD process. The corporate strategy itself, however, has been in flux,
as the firm was redefining and refocusing its strategy. Product developers indi-
cate that at times, due to the lack of strategic input, they feel they have to
“make up a strategy” to guide their efforts for products they are developing.
The Current Role of Accounting and Accountants in NPD

11
Current Management Accounting Resources on the NPD Team
A management accountant at Duraprod is referred to as “a finance person.”2 A
finance person is assigned to the NPD team when a business opportunity has
been identified. This occurs fairly early in the NPD process, although it follows
several earlier stages of advanced concept development. The finance person
continues to report to the finance function for purposes such as performance
evaluation and is described as “living within the finance function” while
assigned to the NPD team.
Assigning finance personnel to NPD teams is ad hoc. The primary criterion
11 appears to be availability when the assignment is made rather than, for example,
partnering a finance person with a team that he/she has worked effectively with
in the past. Finance team members are not considered as central to the NPD
team as other team members.
Current Finance Contributions to NPD: Timing, Expertise, and Proficiency

At Duraprod, the finance team member traditionally has been reluctant to
generate product cost estimates early in the NPD process because the company
has a “culture where there is a history of ‘holding people [especially finance
people] to cost estimates’ once they were produced.” Thus, finance personnel
11 are reluctant to estimate product costs early because “it becomes a reference
point that may be difficult [for them] to defend.” This culture also measures
and rewards those in finance for exactness and precision, although “trying to
apply precision to the early phases [of NPD] is a disaster.” Most product devel-
opers agree that as recently as a few years prior to the interviews, finance
personnel would not even calculate product cost estimates until the product
reached the prototype phase with design and parts clearly defined, even though
that resulted in designing products “that were [sometimes] strategically unsound
or financially unsound.”
There is some evidence that these traditional patterns are beginning to change.
According to one manager,
We have experienced big shifts in senior finance management. The result has been a relax-
ation of finance professionals who are becoming more service oriented, collaborative and
at ease.
Product developers agree that target cost estimates are becoming part of NPD
discussions earlier, appearing soon after advanced concept work in which
product ideas are created and market needs assessed, and NPD team formation.
The finance person mechanically derives the target cost from the target price
developed by marketing team members. Although the target cost has been seen
as fairly rigid throughout the NPD process, cost estimates for the product being
1 designed have been refined as product design evolves.
Some argue for even earlier cost information,
Product cost should enter the discussion immediately, but it doesn’t enter until industrial
design gives the design to a product engineer. [Failure to] enter the process soon enough
produces potential negative effects such as delays in scheduling or increased costs at imple-
mentation
Developing Product Cost Information in NPD

A primary role of the finance person is to estimate product cost. When the
design is finalized, engineering provides the drawings, manufacturing personnel
provide most of the cost elements, and the finance person uses these inputs to
1
develop the final product cost estimate. This requires estimating overhead to
allocate to the product. However, “burden [overhead] rates are calculated by
manufacturing cell, so the rates vary a lot.” Thus, estimating overhead means
first choosing the manufacturing cell(s) for the product, thus, “plant controllers
have input into [estimation of overhead costs].” Since all overhead at Duraprod
is allocated based on direct labor, once cells are selected, and direct labor is
estimated, overhead allocation is straightforward.
Several individuals have indicated that the firm is quite capital intensive:
“Duraprod is a high cost producer with high capital investment.” They further
indicate that using direct labor as the sole base for allocating manufacturing
1
overhead is linked to the capital intensity problem, which “leads to cost, price
and capital problems.” One finance manager indicates that the capital intensity
problem contributed to the adoption of an Economic Value Added (EVA) perfor-
mance measure:
All burden is still allocated based on direct labor. This is a seeming contradiction, with a
capital-intensive plant, and burden rates based on direct labor. However, EVA might balance
this seeming contradiction because now managers are focusing on capital.
Using Product Cost Information in NPD

We asked product developers representing five functions,3 “What if estimated
product cost exceeds target cost?” The finance manager and the product
35
engineer responded that they would initially consider increasing product price
to achieve an acceptable margin at the higher cost. However, if the price could
not be raised, both indicated they were likely to proceed without redesigning
the product despite the cost overrun because, “There is a tradeoff between
[re]design and time to market; time tends to win more than [re]design.” Then,
following product launch, “manufacturing will strive to reduce cost as they
‘learn’ the product.”
If the cost overrun is so significant that product cost has to be reduced, the
most frequent approach cited is to “reduce labor, since labor drives the
11 overhead costs.”4 Two people espoused simplifying assembly, which would also
likely reduce labor, although one noted that this approach might require
additional capital equipment. Other alternatives, each cited twice, were
outsourcing parts, changing the number of components, and changing aesthetics
or features.
Further, there is little accountability for the cost estimated during product
development. Although product engineers are considered responsible for product
cost during development, “they are not held accountable for it.” In addition,
the actual cost of manufacturing the product is not compared to the product
cost estimated during design.
11 Thus, Duraprod can not evaluate the accuracy of estimated costs. Once the
product reaches production, the plant manager is accountable for product cost
performance although cost is just one aspect of the plant manager’s perfor-
mance; schedule and quality are other aspects.
Analysis of Accounting’s Role in Duraprod’s Current NPD Process

The Duraprod data can be interpreted in two ways. The optimistic interpreta-
tion takes managers’ statements at face value and accepts that Duraprod is in
such a differentiated, high-value-added niche of their product market that
product cost is relatively less important than other key strategic goals. In this
11 scenario, it would be reasonable for finance personnel to be peripheral to the
NPD team. It would also be reasonable for finance personnel to play largely
mechanical roles when they do get involved: estimating target costs based on
target prices; combining product cost data gathered by other team members and
applying existing burden rates to develop product cost estimates. Where product
cost has low importance, it also may be reasonable for the company to choose
a simple, although possibly misleading, overhead allocation process. In this
context, it may also be reasonable not to work to reduce cost if estimated
product cost exceeds target cost, not to compare actual costs to estimated costs,
and not to hold NPD personnel responsible for differences between these two
costs.
There is, however, another interpretation of these data. Cost may be more
important to Duraprod than the managers assume, but they are prevented from
effectively addressing it due to limitations in the cost data and to the unwill-
ingness or inability of finance personnel to contribute more fully. Problems with
Duraprod’s existing approach are suggested by the firm’s high capital intensity,
moderate profitability, and falling stock prices. Further, despite repeatedly citing
the capital intensity problem, when NPD team members were asked how they
would address a cost overrun, they most frequently replied, “reduce direct labor”
even though they said this would likely increase capital investment. They further
1 stated that EVA had been implemented, in part, to address the capital intensity
problem. Thus, on one hand, NPD team members faced an incentive to increase
capital intensity (burden applied as a percent of direct labor) and on the other,
an incentive to decrease capital intensity (EVA).
This raises the question of whether Duraprod’s performance might improve
if the NPD team’s financial data were improved (including more realistic over-
head allocation approaches) and if the role for finance personnel in product
development were enhanced to facilitate the team’s use and interpretation of
these financial data. Those interviewed had a great deal to say not only about
Duraprod’s current situation, but also about their vision for the value finance
1 personnel could potentially contribute to NPD. As discussed below, they
described the needs of NPD, and the benefits that would accrue from changing
the role of finance in NPD.
Product Developers’ Vision for A New Finance Role in NPD
Finance personnel at Duraprod traditionally provide detailed cost information

near the end of the product development process, when the product design is
well defined. According to two product developers:
My experience with finance people is that they are great at dealing with what they know
1 in a concrete way. For example, if the designer shows them an artifact and identifies the
parts, and manufacturing tells them about the processes that will be required, and marketing
defines the market and the price points, then the finance person can run the numbers. But
that’s mechanical.
All finance people have the capability, but they are very timid. They tend to want to
give you answers with eight decimal places of precision. They need to take the existing
financial data and assess it.
Many individuals interviewed identified a new vision for finance personnel and
financial information in NPD. They discussed the need for cost information to
guide decisions early in the process, indicating, “we have no up-front infor-
mation to guide early decisions.”
37
To participate fully early in the product development process, finance

personnel would have to change how they view their responsibilities. They
would also need to become facile at working with rough, imprecise data.
When you begin a project, the team brings an amount of knowledge to the table and then
gathers more information. The team needs to digest the information to obtain insight [into
how the project will progress]. Finance people have to become more “diagnostic” [about
analyzing the implications of early data].
Having finance people on the team is different than having them understand what they can
contribute early. The finance people all have good finance skills. The also need to learn
how to work in product development teams. Further, they need to learn when and what
11 they can contribute to the product development process.
According to the NPD team’s vision, the finance person should not view his/her
role as “adding up the product cost at the end of design.” Rather, developers
want finance personnel who can function in a decision support role for the NPD
team throughout NPD. They further seek someone as thoughtful, proactive and
creative about the financial aspects of NPD as they are about the engineering,
user interface, and aesthetics.
Being on the team is one thing; knowing when to take initiative, to contribute to the team
is another. Often, the finance person waits for a request and then fills it, as opposed to
11 watching/listening to how the project is going and jumping in when he/she can contribute.
For example, if the team is talking about how much to spend on tooling, the finance person
could develop a pro forma to show the return or payback on the investment.
Here the finance person could make a huge contribution by modeling the financial
implications of different alternative uses of the incremental resources obtained by
the improved or changed design. I wish teams would do this. I wish teams would
consider the impact of strategic alternatives on price, cost, tooling, ROI.
What [finance people] are lacking is the ability to create a financial model.
They do not know what their function can contribute to the creative activity.
[On one design team] we encouraged the finance person to think, “What can
11 you contribute? The finance person was encouraged to think of himself as one
of the designers of the [artifact]. They need to think of themselves as not just
a finance person, but they need to have a sense of being part of the design
effort to bring their own expertise to bear on the outcome . . .. Every person,
when they make a contribution, whether about something financial, or about
the manufacturing process, has an impact on the design, so they must think of
themselves as part of the design process.
Product developers indicate that the finance person needs to think about “cost”
in a broad, flexible, creative way. The “full factory cost” concept, traditionally
espoused in cost accounting, is not sufficient, even in its more modern forms
such as activity-based-costing (ABC).
[Development teams] need to not only look at the cost to manufacture a product, but to
consider cost more broadly. For example, we need to look at complexity costs. We should
be looking at environmental costs. [Our product] is a complex system. There are also costs
at the customer [to consider]. In a “systems” cost, there are lifecycle costs.
Sometimes we think about designing a “product.” A more sophisticated approach could be
to think about the whole logistics chain. This creates a broader view of what happens with
a product, and a broader model to think about the possibilities to increase value or decrease
costs throughout the logistics chain. For example, look at the distributors. Or look at the
customers’ current cost structure with their existing products versus their cost structure with
the new products, including cash flow implications, tax implications, etc. This requires taking
a very external view, a very broad perspective, and not just thinking about financial impli-
1 cations from the perspective of the manufacturer. If you look at this chain, and find ways
to increase value/reduce costs for others, then you have the potential to recapture some of
this to reinvest in your own products or other projects.
Designers also view the finance person’s new role as creating benefits not only
for the product design, but for its marketing and selling as well.
The finance person could develop financial tools to support the marketing effort so that
marketing would be able to talk to people in the customer organization they currently cannot,
such as the CFO. The finance person could help develop compelling financial arguments
about the benefits of, for example, product flexibility, over the long term.
1 Duraprod’s Lessons for Accounting
The Duraprod interviews suggest that accounting can add value to NPD;
however that potential is not always realized. Although the role for finance
personnel is shifting from “adding up the cost at the end of design” to earlier
and increasing involvement and flexibility, Duraprod is still a long way from
the NPD team’s vision. In the judgment of non-finance NPD team members,
the evolution is incomplete. They argue articulately for even earlier finance
team member involvement, and for finance personnel to take a more proactive,
collaborative approach to working with NPD teams to address problems in NPD.
1 They also identify the need for financial proficiency beyond simply estimating
product cost, including the ability to model long-term costs and determine the
financial impact on customers if new products are purchased.
However, despite the needs expressed by product developers, the accountants
at Duraprod have as yet been unable to respond in a way that meets the product
developers’ needs. The research suggests that not just any accountant or any
accounting information will contribute effectively to NPD. Rather, specific types
of accounting expertise and accounting information will be more effective.
Yet, the recognition that appropriate, creative accounting expertise and infor-
mation in NPD can contribute to new product success is widespread at Duraprod.
And when new product success is defined not just as a popular product, but
39
one that achieves financial success as well, the argument that accountants can
contribute to this success is even more compelling.
The frustration at Duraprod and the difficulty of finding a workable solution
is, in many ways, not surprising: there is little information available on the
value of accounting contributions to NPD, either in the accounting research
literature or in practitioner reports. There are, however, data available from
related fields. To better understand the potential value of accounting contribu-
tions, we will first examine what is known about the contributions of players
in fields long agreed to be key to new product success, especially those in tech-
11 nology (R&D, engineering, manufacturing) and marketing. Technology’s
contributions to NPD have been studied extensively. More recently, marketing’s
contributions have been researched and documented. Reviewing factors
contributing to NPD success in these areas such as resources committed, profi-
ciency of activity, timing of participation, and degree of collaboration and
integration, will provide guidance on criteria for structuring accountants’ role
and constructing relevant accounting information to create value in NPD.
3. LITERATURE REVIEW
11 Cooper’s (1996) grouping of resources, process and strategy is helpful in

organizing this extensive literature. In the following review, we examine
variables in each area that have been proven to increase new product success.
In the case of resources, these variables include the personnel dedicated to NPD,
the skills and expertise they bring, the proficiency of their performance, and
the timing of their participation. An additional resource variable is the amount
of funds invested to support NPD. Process variables include having a
specified, documented NPD process, having well defined stages separated by
clear decision points, involving key personnel early, including financial analysis
up-front, and developing accurate product cost data. Strategy variables include
11 the presence of a clearly articulated strategy to guide NPD, and specific steps
linking strategy and NPD. Understanding how technology and marketing
resources combine with the NPD process and the company’s strategy to affect
new product success or failure provides insight into accounting’s potential
contributions.
In this section, we first discuss the findings on technical and marketing
resources, plus those that relate to the benefit from cooperation between these
key functional resources. We then present the need for financial resources
reported in technical and marketing studies. We conclude the discussion of
resources with a consideration of the implications for accounting of the
findings on resources. Next we present the findings on NPD process and strategy,
respectively, and discuss the implications of each for accounting. Finally, we

conclude this section with a brief summary.
Resources
In a major benchmarking study of industrial manufacturing firms from Europe

and North America, Cooper and Kleinschmidt (1995) found that the commit-
ment of resources by senior management to NPD significantly affected new
product performance. Companies were placed into one of four groups based on
1 new product profitability and impact.5 Firms that allocated more resource
support6 for NPD projects realized significantly higher profits and impact than
firms that allocated less support to NPD.
Numerous studies found that appropriate resources, defined as skills or exper-
tise, personnel or invested capital, are critical to new product success. Many
researchers have examined the effects of technical, marketing, and financial
resources.7
Technical Resources
Technical resources are commonly defined as skills, experience and expertise
1 in engineering, R&D, and manufacturing. Firms that not only possess these
resources, but also proficiently deploy them in NPD are more likely to achieve
new product success (Borja de Mozota, 1990; Calantone & di Benedetto, 1988;
Calantone, Schmidt & Song, 1996; Cooper, 1982, 1983; Cooper & de Brentani,
1991; Cooper & Kleinschmidt, 1987; Maidique & Zirger, 1984; Montoya-
Weiss & Calantone, 1994; Schmidt, 1995; Song & Parry, 1997a, b; Zirger &
Maidique, 1990). Indeed, Calantone and di Benedetto (1988) report that firms
lacking technical capabilities are more likely to produce products that
ultimately fail.
In an early study, Cooper (1979) found that successful products exhibit a
1 strong fit between the technical demands of the development project and the
firm’s product development resources, including R&D, engineering and manu-
facturing expertise and skills, while unsuccessful products lack this fit. In a
follow-up study, Cooper and Kleinschmidt (1987) reported that in addition to
technical synergies, new product success was also attributable to how well the
firms executed the technical activities.
Although Cooper’s data were collected from Canadian industrial firms, similar
results have been reported by others based on samples in the U.S. (Maidique &
Zirger, 1984, Zirger & Maidique, 1990), West Germany (Gerstenfeld, 1976),
Japan (Utterback, Allen, Hollomon & Sirbue, Jr., 1976) and China (Calantone,
Schmidt & Song, 1996). Moreover, the results are robust across various industries,
41
including industrial products, scientific instruments, electronics, software, finan-

cial services and chemicals.
While many studies have collected information on characteristics of
successful and unsuccessful products, most analysis has been descriptive or
correlational (Montoya-Weiss & Calantone, 1994). A few studies have used
multivariate statistical techniques to construct models to test hypotheses. For
example, Calantone and di Benedetto (1988) used a systems approach to
examine the independent effects of technical and marketing resources and
proficiency on new product success. They found evidence that having both tech-
11 nical and marketing resources and skills is a necessary but not sufficient
condition for new product success. They argue that adequate performance in
these areas is also a critical factor in determining new product success. Using
multiple discriminant analysis, Zirger and Maidique (1990) find that R&D excel-
lence, superior technical performance and synergy with existing competencies
were strong differentiators between successful and failed projects. Finally,
Schmidt (1995) used Cooper’s Canadian database combined with a data set
collected from a sample of US Fortune 500 manufacturing firms. He found that
the proficiency of technical activities was not only critical for the success of
products, but was more important than the proficiency of marketing activities.
11 Effective marketing, however, is also clearly relevant to new product success
and it is discussed below.
Marketing Resources
Early evidence on the need for marketing resources came from studies of prod-
ucts that failed. Studies of failed products found that ineffective marketing of
new products and poor or no market research were two important factors that
led to product failure (Cochran & Thompson, 1964; Cooper, 1975; Crawford,
1977; Hopkins & Bailey, 1971). Specifically, Cooper (1975) examined the
causes of 114 product failures. He found the most important cause of product
11 failure was sales below expectations. Lackluster sales were due to setting the
price too high for the market, overestimating market size, underestimating
competitors’ strength or product design problems. Further analysis conducted
to find the “latent causes” of these deficiencies revealed that the most signifi-
cant contributor was the lack of marketing research skills or personnel on the
NPD team; in other words, “marketing resources.” Cooper further observed that,
in contrast to the ample R&D resources allocated to these products, resources
were sorely lacking in marketing and market research.
Crawford (1977) subsequently looked at the relationship between new product
failure and the use of market research resources. He found that the predomi-
nant reason for new product failure was weak market research that led to product
offerings that were not unique or superior. Yet, these firms reported they had
market research resources that, if used properly in NPD, could have amelio-
rated the problem. Moreover, although senior marketing managers at these firms
oversaw the NPD process, mid-level marketing managers were not involved.
Crawford concludes that NPD managers did not understand the role of market
research in NPD and thus they allowed non-marketing personnel, such as design
or manufacturing engineers, to make marketing-related decisions.
Several researchers responded to these early studies of failed products with
studies designed to examine marketing’s contributions to NPD. As with the
1 research on technical resources discussed above, this research found that NPD
outcomes benefit from: (a) commitment of marketing resources, including
people with necessary marketing skills and financial resources dedicated to
marketing activities, (b) effective marketing execution, and (c) synergy between
market needs and a firm’s marketing resources (Calantone & di Benedetto,
1988, 1990; Calantone, Schmidt & Song, 1996; Cooper, 1982, 1995, 1996;
Cooper & de Brentani, 1991; Cooper & Edgett, 1996; Cooper & Kleinschmidt,
1987; Maidique & Zirger, 1984; Montoya-Weiss & Calantone, 1994; Poolton
& Barclay, 1998; Rothwell et al., 1974; Schmidt, 1995; Song & Parry, 1997a,
b; Voss, 1985; Yoon & Lilien, 1985; Zirger & Maidique, 1990). The following
1 discussion will highlight additional marketing factors that have been found to
significantly affect new product success.
One of the first studies to compare successful to unsuccessful new product
innovations was conducted by Rothwell et al. (1974) based on the chemicals
and scientific instruments industries in the UK. Two of five principal factors
that discriminated between successful and unsuccessful innovations were related
to marketing issues. More recently, these results have been replicated in studies
in varied industries and countries (Cooper, 1996; Cooper & Edgett, 1996;
Maidique & Zirger, 1984; Zirger & Maidique, 1990).
Specifically, Rothwell et al. (1974) report that successful firms better under-
1 stand user needs and recognize those needs earlier by involving customers in
NPD. Moreover, they found that a customer-need-pull market strategy led to
greater success for new products than a technology-push strategy. Zirger and
Maidique (1990) also found that successful innovations were better matched to
user needs. Cooper and Edgett (1996) have used the phrase “the voice of the
customer” to capture this essential ingredient for new product success and argue
that it is a primary component of a high quality NPD process.
The timing of marketing activities in the NPD process also makes a differ-
ence. Early participation by marketing personnel in the NPD process improves
the chances that the new product will be successful (Cooper, 1996; Cooper
& Edgett, 1996; Schmidt, 1995). Moreover, the proficiency of these early
43
marketing activities also affects new product success (Cooper, 1996; Cooper &
Edgett, 1996; Cooper & Kleinschmidt, 1987; Montoya-Weiss & Calantone,
1994; Schmidt, 1995). Researchers point specifically to early market research
and analysis as key to the future success of a new product.
Finally, the timing of product introduction is critical to the product’s
ultimate success. Many report that the earlier a product is launched, the more
successful it is (Cooper, 1995; Crawford, 1977; Maidique & Zirger, 1984;
Montoya-Weiss & Calantone, 1994). Cooper argues effective execution of
marketing tasks8 is critical to achieving targeted launch dates because when
11 marketing tasks are executed well, projects are more likely to stay on time.
Cooperation between Key Functions

The research discussed so far has considered the impact of technical or
marketing functions independently on new product success or failure. However,
balance and communication between technical and marketing functions have
been proven to be critical to new product success. It is not sufficient for the
firm to possess both technical and marketing resources/skills to achieve
successful new products; the functions must cooperate and be integrated as
well. Gupta, Raj and Wilemon (1986) propose a theoretical model to explain
11 the impact of R&D and marketing integration on new product success. They
put forward factors affecting the perceived need for integration and those
describing the actual degree of integration achieved. Their model describes how
a substantial “integration gap” between perceived need and reality negatively
affects new product success.
Empirical research has shown that effectively integrating these two functions
increases the chance of new product success (Griffin & Hauser, 1992; Hise,
O’Neal, Parasuraman & McNeal, 1990; Kahn & McDonough, 1997; Pinto &
Pinto, 1990; Song, Neeley & Zhao, 1996; Song & Parry, 1997a, b; Souder &
Chakrabarti, 1978). Hise et al. (1990) found strong evidence that shows that
11 collaboration between marketing and R&D functional units during the design
phase of NPD was a key correlate with new product success. Thus, it was not
just the magnitude of investment of key resources that led to success, but the
timing of the activities and the degree of cooperation.
One powerful way that firms can control NPD outcomes is through the
structure and specific membership of NPD teams (Takeuchi & Nonaka, 1986).
In particular, Takeuchi and Nonaka point out that separate, functional teams
handing off work in a sequential process is not as effective as an integrated
team approach for NPD. Larson (1988) further demonstrates that many
benefits accrue to teams in which members are cross-trained in each other’s
responsibilities, including shorter cycle times, achievement of critical cost and
time targets, and increased likelihood the new product will meet customer
needs.
Financial Resources
Although there is little in the accounting literature about NPD, the technical
and marketing literature briefly addresses some financial issues. Because finan-
cial issues are not the primary focus of this literature, the results are vague and
indirect. In an early survey of companies that had recently launched new prod-
ucts, Cochran and Thompson (1964) identified “higher costs than anticipated”
1 (both development and product costs) as the third most frequently cited cause
for new product failure.9 Higher costs translated to higher prices, which in turn
resulted in lower than expected sales volumes. Cochran and Thompson could
not determine which of the two costs, development or product cost, was
primarily responsible for product failure. While higher than expected develop-
ment cost adds to total cost, when contrasted with product cost, higher
development cost may not be substantial on a per unit basis.10
The most direct evidence of the effect of accounting resources on NPD
outcomes is evidence that product cost influences new product outcomes from
two early studies (Cooper, 1975; Rothwell et al., 1974). In their seminal study
1 of factors affecting new product success in the U.K., Rothwell et al. (1974)
found that when production costs are underestimated, the new product is more
likely to fail than succeed. Similarly, Cooper (1975) reported that when new
product failure was due to poor profit margins, the primary cause was that
product costs were higher than expected.
Indirect evidence of the relationship between product cost and new product
success was reported by Maidique and Zirger (1984) in a survey of innovative
projects undertaken by U.S. high-tech firms. They found that higher contribu-
tions were correlated with new product success. Higher contributions are
achieved either by setting a higher price relative to unit product cost or by
1 reducing unit product cost at a given price. In either case, product cost plays
an important role.
Further indirect evidence of the influence of product cost information and
analysis on new product success comes from studies based on data from Canada
by Cooper and Kleinschmidt (1986, 1987). In their first study, they analyzed 123
successful and 80 failed new products marketed by 123 Canadian manufactur-
ing firms. They found that business/financial analysis is related to new product
success. Business/financial analysis included activities such as forecasting costs
and sales, calculating discounted cash flow or return on investment analyses, or
conducting a detailed profitability analysis or cost review of production, mar-
keting and distribution costs. Many respondents desired more multidisciplinary
45
and multi-departmental inputs to the business/financial analyses as well as more

time for these analyses.11 Montoya-Weiss and Calantone (1994) echo these
concerns based on their meta-analysis of studies of factors associated with new
product success and failure. They call for more attention throughout NPD to
financial/business analysis, which they define as financial feasibility.
More recently, Cooper, Edgett and Kleinschmidt (1997) raise a caution about
one particular use of financial assessment in NPD. Specifically, they caution
that using financial analysis as the sole or primary criterion to kill NPD projects
early in the NPD process may be inappropriate. In their view, the uncertainty
11 associated with early phases of NPD leads to uncertainty and potential unreli-
ability about product costs and other financial data. Thus, if the firm attempted
to decide which projects to support or kill early in the NPD process based
solely on ranking projects according to early forecasts of their financial perfor-
mance, inappropriate decisions could result. This caution, however, is not
directed at other uses of financial information and analysis early in NPD.
Implications for Accounting

From this evidence, it appears that there is a link between accounting and finan-
cial analysis and new product success. Analogous to marketing and technology,
11 resources must be committed to accounting early in NPD. These resources
comprise not only personnel with appropriate skills to ensure that analysis is
conducted proficiently, but also investments in tools such as financial modeling
capabilities. Further, cooperation between accounting and other NPD functions
is required to ensure effective communication and integration.
The reported importance of product cost argues strongly for the participation
of management accountants in NPD since product costing has long been a key
focus of their training and work. Management accountants are well positioned
to utilize and interpret firm-specific cost information. They would be less
inclined than engineers to base their financial analyses on general cost infor-
11 mation contained in widely available programs, such as computer-aided-design
(CAD) programs, which have been reported to cause problematic results
(Anderson and Sedatole, 1998). Given that it is reported that 75%–90% of
product costs that are actually realized are established during NPD (Berliner &
Brimson, 1988; Potter, et al., 1991; Shields & Young, 1991) it would appear
especially likely that management accountants could add value to NPD.
The New Product Development Process
Resources or skills alone will not ensure a successful new product. A well
designed, repeatable NPD process is also necessary to achieve new product
success (Cooper & Edgett, 1996; Cooper & Kleinschmidt, 1995; Rochford &
Rudelius, 1997). As these studies indicate, a well-documented process not only
insures that critical tasks and analyses will be performed, thereby increasing
the likelihood of new product success, but it also enables senior management
to assess process effectiveness which can lead to continuous process improve-
ments.
Specified NPD Process with Clear Stages

Cooper (1983) first advanced the idea of an NPD process with clearly defined
1 stages and management decisions, called “stage-gate decisions,” following every
stage.12 Cooper and colleagues (Cooper & Edgett, 1996; Cooper &
Kleinschmidt, 1995) characterize a high quality NPD process as one that is
complete, focuses on quality execution, emphasizes up-front homework, is
flexible, forms a sharp, early definition of the product before development, and
involves tough go/kill decision points. Senior managers utilize a well-structured
process to control product development with periodic reviews to kill projects
if certain criteria or milestones are not met (Cooper, 1993). Griffin (1997a)
reports that 52% to 69% of sampled manufacturing firms utilize some type of
stage-gate NPD process.
1
Up-Front Homework and the Role of Financial Analysis
Some have found that activities undertaken in the early stages of the NPD
process, called up-front homework, are critical to new product success (Cooper,
1995, 1996; Cooper & Edgett, 1996; Cooper & Kleinschmidt, 1987, 1995). This
up-front homework includes initial screening, preliminary marketing and tech-
nical assessments, detailed market studies and market research, and business
and financial analyses. It has been found that firms that move too quickly from
the idea stage into development tend to produce products that fail in the market-
place (Cooper & Kleinschmidt, 1995). By contrast, Cooper and Edgett (1996)
1 found that excellent up-front homework before a project goes into development
boosted a new product’s success rate 82%. Moreover, Cooper (1995) has found
up-front homework is related to timeliness of product launch and product prof-
itability.
It is not clear, however, just what role financial analysis, especially product
cost analysis, plays relative to the other up-front homework activities in helping
NPD teams achieve success with new products. Traditionally, as we saw above
at Duraprod, companies perform financial analysis in NPD only after much of
the development work is done (Cooper & Chew, 1996). The typical analyses
include capital investment requirements and forecasts of sales or profits (Cooper
& Chew, 1996; Cooper & Kleinschmidt, 1986).
47
Early Involvement of Key Personnel

Just as key up-front homework is critical to new product success, so is early
involvement of key personnel in the NPD process. As discussed above, early
involvement of marketing personnel in the NPD process yielded substantial
returns to new product success (Hise et al., 1990). Researchers have also found
that early involvement of other key players in NPD results in greater success,
for example, early involvement of production personnel facilitates design for
manufacturing or assembly which leads to product cost reduction in the long
run (Fitzgerald, 1997a, b; Larson, 1988). Others argue that component suppliers
11 should be involved early in the NPD process to help design cost out of the
product before it goes into production (Fitzgerald, 1997a, b; Harbour, 1991).
Still others suggest that procurement engineers need to be part of early NPD
discussions. Their presence insures manufacturing feasibility of designed-in
components, minimizes cost during design rather than attempting to take cost
out after the product is in production, and steers NPD teams toward preferred
suppliers resulting in lower product cost due to increased use of standard parts
(Carbone, 1996; Minahan, 1998).
11 Implications for Accounting

Accountants clearly can contribute to financial analysis conducted in up-front
homework, which has been reported to play a role in NPD success. Further,
arguments for early inclusion of management accountants on NPD teams have
been made, analogous to those for marketing and technical personnel. Early
involvement enables critical information or analysis from all functional perspec-
tives, including accounting, to inform decision-making, thereby resulting in a
design alternative that is optimal across a variety of dimensions, not just one
or two. Hertenstein and Platt (1998) suggest that firms on the forefront of design
implementation include accountants on NPD teams from the start.
11 Target costing, a relatively new cost management tool, offers another prime
opportunity for management accountants to contribute to NPD. When under-
taken early in the process, target costing enables NPD teams to design products
to meet cost targets and thus achieve profit targets (Gagne & Discenza, 1995).
Cooper and Chew (1996) further suggest that target costing combined with the
firm’s new product strategy enables NPD teams to bring profitable products to
market at the right price with the appropriate quality, functionality and feature
sets. Moreover, they suggest that aggressive cost targets challenge NPD teams
to consider all possible creative design solutions and extend value engineering
to its limits. Indeed, target costing is an area where marketing, engineering,
manufacturing, purchasing, and accounting intersect.
Strategy as a Critical Success Factor
Clear Strategic Guidance for NPD

Another activity identified as critical to new product success is a well-defined
strategy communicated to all involved in NPD. Corporate strategy helps the
firm realize its ultimate profit potential by positioning the firm to best address
the competitive forces and leverage its core competencies (Porter, 1979;
Prahalad & Hamel, 1990). Cooper (1984a) observed that NPD is integral to the
firm’s strategy, as it helps the firm define its range of product choices. Since
1 that time, empirical studies have found that having a strategic focus to the NPD
program contributes to new product success (Cooper, 1984b, 1996; Cooper &
Kleinschmidt, 1993, 1995; Droge & Calantone, 1996; Griffin, 1997a; Nobeoka
& Cusumano, 1997; Zirger & Maidique, 1990). For example, Cooper (1984b)
found greater new product success when firms followed strategies that targeted
high growth markets and that leveraged existing firm resources and competen-
cies. Successful implementation of such strategies produced a high quality,
differentiated product that commanded a premium price. Johne and Snelson
(1988) found that more successful innovators perceived NPD as an integral part
of the firm’s growth strategy, whereas less successful firms saw NPD as a
1 disruption to their normal operations.
Linking NPD to Strategy

Griffin (1997a) cites a Mercer study that states that formulating new product
strategy early and communicating that strategy were factors that differentiated
new product success from failure. Griffin (1997a) found that firms that were
successful innovators included strategy as a specific, early step in the NPD
process. Hertenstein and Platt (1998, 2000) report that companies engaged in
high quality product design changed their NPD process to link business strategy
to new product ideas thereby stimulating the search for and development of
1 products consistent with the firm’s strategy.
A meta-analysis of NPD research studies by Montoya-Weiss and Calantone
(1994) confirms the results described above. They found that product advan-
tage, a strategic factor, was among four components consistently related to new
product success. Despite the work done thus far, Montoya-Weiss and Calantone
call for more research to replicate the empirical findings concerning strategy,
other process factors and NPD. They point out that much work to date is based
on descriptive analysis and that studies tend to focus on one or several sets of
factors, excluding possible important mediating or moderating variables.
The prior research on the connection between NPD and strategy has focused
primarily on single projects; however, recent work has begun to look at multiple
49
projects or portfolios. Nobeoka and Cusumano (1997) found that strategic plan-
ning facilitated effective technology transfer across multiple NPD projects.
Firms that leveraged core technologies in multiple new products reported higher
sales growth and increased market share than those that developed new tech-
nologies for each new product. Similarly, Cooper, Edgett & Kleinschmidt (1997)
emphasized the portfolio approach to NPD in which management should make
resource allocation decisions within the context of a project’s strategic fit with
the firm’s overall strategy.
11 Implications for Accounting: Strategic Controls for NPD

As discussed above, NPD needs strategic guidance. A key responsibility of
management accountants is the development of management control systems
(MCS). A key purpose of MCS is to provide strategic guidance. Indeed,
Hopwood (1987) and Dent (1990) argue that MCS can play an active role in
shaping strategy. Similarly, Anthony and Govindarajan (1998, p. 8) assert that
MCS are tools for implementing strategies; they aid management in moving an
organization toward its strategic objectives. Further, MCS empirical research
focused broadly on strategic business units (SBUs), or on senior management,
documents a relationship between MCS and strategy (Daniel and Reitsperger,
11 1991, 1992; Langfield-Smith, 1997; Simons, 1987). In particular, when strate-
gies have changed, related MCS changes have been documented (Daniel &
Reitsperger, 1991).
Thus, MCS might be expected to play an integral role in guiding NPD.
Further, NPD presents a management control challenge because of the many
tasks involved, the coordination required across functions, and the creativity
needed throughout NPD to conceive, develop, manufacture, and launch a
commercially viable new product. Yet, virtually no MCS research to date has
focused on NPD. Evidence is lacking on how effectively management control
of NPD is being accomplished, and there is no clear research guidance on how
11 most effectively to structure management control of NPD.
In fact, most MCS research has focused on the impact of MCS at the SBU
level, or during the downstream activity, manufacturing production. A few
studies have examined the linkage between MCS and one upstream activity,
R&D (Abernethy & Brownell, 1997; Rockness & Shields, 1984, 1988).
Rockness and Shields (1984) found that behavioral controls are most important
for conditions that reflect the development phase of R&D, where there is
knowledge of the transformation process. Abernethy and Brownell (1997)
extended this research, and found that personnel controls are used mainly during
the research phase of R&D. Like Rockness and Shields, they also found that
behavioral rather than accounting controls are more likely to be used in the
development phase of R&D. Nonetheless, Rockness and Shields (1988) report

that accounting controls are used in some parts of R&D. They found that
accounting controls were more useful in planning and monitoring but less useful
in evaluation and determining rewards.
NPD is related to R&D, as it overlaps the “development” aspect. Thus, MCS
research results from R&D may be suggestive of factors affecting NPD. Yet,
NPD is distinct from R&D, as employees from many business functions, not
just R&D, collaborate to plan, design, develop and launch new products. Further,
NPD, unlike R&D, usually follows a well-defined process. In addition, NPD is
1 closer to downstream manufacturing and marketing activities that produce
measurable operating results. Thus, NPD is unique, with management control
issues that may be similar to those found in R&D, yet with potential differ-
ences as well. MCS research specifically focused on NPD is needed.
Johne (1984) investigated the extent to which management exerts tight or
loose control over the NPD process. He separated the process into two phases:
initiation, ranging from idea generation through concept testing, and imple-
mentation, including all steps between product development and product launch.
Active innovators tended to use loose control during initiation to encourage
freedom of thought or ideation, but tight control during implementation. By
1 contrast, less active innovators did the reverse. They established tight functional
control over initiation, but loose control during implementation during which
the firm either did not have a NPD process manual or did not mandate adher-
ence to the process.
One control mechanism of particular interest in NPD is performance measure-
ment to assess the achievement of strategic goals. Performance measures
communicate desired outcomes or behaviors to participants, and are used to
evaluate their success in achieving these goals. It is generally believed that the
best performance measures for a particular function or business activity are
those linked to a firm’s strategy (Langfield-Smith, 1997, 219). Indeed, Griffin
1 and Page (1996) found that subjects rated those NPD performance measures as
most appropriate when they were related to new product or business strategy.
There is little evidence that strategy is used to guide the development of
performance measures used in NPD in practice. Several studies report that
between 45% and 60% of firms do not even measure NPD performance (Griffin,
1997a; Hertenstein & Platt, 1997, 2000; R&D Magazine, 1995). For those that
do measure performance, most use a combination of financial and non-
financial measures (Griffin & Page, 1996; Hertenstein & Platt, 1997, 2000).
Combinations of financial and non-financial performance measures are gener-
ally agreed to be most appropriate for performance measurement, and have been
found to be used in a variety of settings (Abernethy & Lillis, 1995; Cooper,
51
1996; Govindarajan, 1988, Hertenstein & Platt, 1998; Kaplan & Norton, 1992,
1993; Simons, 1987). Non-financial performance measures tend to be favored
by companies that pursue a growth strategy based on NPD and product
innovation (Ittner, Larcker & Rajan, 1997). Typical non-financial performance
metrics include assessment of customer satisfaction, product quality and time-
to-market (Griffin & Page, 1996; Hertenstein & Platt, 1997).
Moreover, Hertenstein and Platt (2000) report that product managers want
their firms to measure the extent to which product design is aligned with firm
strategy and the extent to which strategic goals are achieved. For example,
11 Lubove (1993) reported that Rubbermaid focused its growth strategy on NPD.
To achieve its strategic goal, Rubbermaid measured NPD success in part by
time-to-market in order to reduce opportunities for its competitors to create
“knock-off” designs.
Despite the apparent importance of performance measures as an MCS
mechanism to control NPD outcomes, Stivers, Covin, Hall, & Smalt (1998)
found a substantial gap between the rated importance of a performance dimen-
sion and its actual measurement and use, especially for non-financial
performance measures. Further Hertenstein and Platt (2000) report that a trou-
bling number of firms that measure NPD performance indicate that their
11 performance measures do not reflect their firm’s strategy. Moreover, Meyer,
Tertzakian, & Utterback, (1997) argue that most R&D performance measures
are based on single projects/products and have a short-term focus. That is,
companies tend to look at budget or time-to-market variances. They propose
measures that are longer-term and focus on product platforms or product lines.
Much research remains to be done in the area of firm strategy, MCS, and NPD
outcomes.
Summary of Literature Review
11 Based on this review of technical, marketing and management control litera-

ture regarding factors that differentiate successful from unsuccessful new
products, there is much to inform future research on the impact of accounting
participation, accounting information and analysis, and MCS on NPD outcomes.
Both theoretical and empirical work indicates that strategy is the context that
guides NPD personnel from all functions toward a successful outcome. Early
inclusion of personnel from key functions such as R&D, manufacturing and
marketing in the NPD process results in better outcomes than when their exper-
tise is called upon on an as-needed or sequential basis. Further, while committing
resources in key functional areas is necessary, it is not sufficient to insure new
product success. Firms also need to effectively integrate and coordinate the
functional perspectives, and to execute the functional tasks proficiently and at

the right time. To accomplish this, many firms have implemented a flexible
NPD process featuring defined stages following which senior managers review
progress and plans prior to a project moving on to the next stage.
Bringing Accounting Creativity and Value to NPD
From this review, we conclude that there are numerous opportunities for
management accountants to influence NPD outcomes and enhance the firm’s
1 performance. One set of opportunities derives from accountants’ participation
on NPD teams. Because one means by which new products are judged successful
is meeting expected profit goals, the NPD team must set appropriate target
product costs to guide design-related decisions. By participating on the NPD
team from the start, an accountant can proactively inform the team about the
financial implications of various design alternatives under consideration. An
accountant, more than other team member, has the expertise to understand the
financial nuances of a particular NPD project, and views the tasks of financial
analysis and financial planning as his/her primary focus in NPD. Through stead-
fast attention to product cost and other financial aspects of NPD, accountants
1 can help the team achieve higher returns.
Another set of opportunities embraces the development of appropriate
strategic controls. Through management accounting’s management communi-
cation and control responsibilities, management accountants can help senior
managers establish control mechanisms to communicate strategy to NPD teams
and then measure strategically important NPD outcomes. This includes insuring
that the firm has a well defined, documented NPD process, insuring that this
process has appropriate links to strategy both at early stages to provide appro-
priate strategic guidance to NPD and at stage-gate reviews to ensure that
consistency with strategy is achieved, and developing NPD performance
1 measures that reflect the firm’s strategy.
4. CONCEPTUAL FRAMEWORK
To guide future research on effective accounting participation in NPD, we have

developed a conceptual framework based on our review of the literature. The
conceptual framework explicitly integrates accounting with the two key NPD
functional areas, technical and marketing; the firm’s strategy provides an inte-
grating context, as shown in Fig. 1. The conceptual framework illustrates these
relationships and assumes that opportunities for accounting to contribute
creatively in NPD are realized.
53
11
11
Fig. 1. Conceptual Framework for Including the Accounting Function in NPD.
The framework diagramed in Fig. 1 can be positioned within a broader action-

11 oriented model linking strategy to firm performance via specific actions that
affect profitability. For example, in the Action-Profit Link (APL) model
proposed by Epstein, Kuman & Westbrook (2000), strategy is tied directly to
firm actions. The conceptual framework in Figure 1 is positioned between the
APL model’s firm strategy and specific actions driven by the strategy, as shown
in Fig. 2.
During NPD, choices about actions have not yet been made; thus the NPD
team effectively “models” the task-outcome-performance linkage for each
design under consideration to help select the optimal design. Each design
alternative reflects a commitment to a broad set of actions to be undertaken
with multiple future consequences or outcomes. For example, each design has
1
Creative Accounting? Wanted for New Product Development!

55
55
Fig. 2. Position of New Product Delvopment within Epstein, Kuman and Westbrook’s (2000) Action-Profit Link Model.
implications for product features, product quality, ease of use, ease of assembly,
manufacturing technology, capital investment, working capital requirements,
product cost structure, and ease of repair. Thus, NPD discussions are dynamic
and interactive as team members seek to realistically identify and evaluate
diverse future outcomes. Discussions require give and take among participants
as they trade off potential actions and outcomes in order to enhance expected
performance. Discussions benefit by the inclusion of individuals with varied
expertise related to the many aspects of the business that will be affected by
the team’s decisions. Each time the design is modified, the entire task-outcome-
11 performance model must be reexamined for all potential performance
consequences. Figures 1 and 2 represent key inputs to NPD as intersecting
circles to characterize the interactive nature of discussions that underlie
decisions reflected in the final design.
Two features of the framework in Fig. 1 tie together the diverse functional
perspectives in NPD teams: target cost and firm strategy. Target cost provides
concrete goals for technical product design, constraints on market-related
decisions, and critical input for financial feasibility analysis. Rather than
allowing “blue sky” discussions, target cost focuses participants on the specific
business challenge given to the team.
11 As shown in Fig. 1, target cost affects the technical staff’s goals regarding
functional and design aspects of the new product. For example, a higher target
cost allows the NPD team to design in more features or to utilize a more expen-
sive manufacturing process. Setting a tighter target cost challenges the NPD
team to rethink the goals and the design. They might discover a creative
solution to achieve the original goals at a lower cost, or they might conclude
that some features are not justified.
Target cost is also an important constraint for marketing due to the fixed
relationship between target cost and target price. As with the technical dimen-
sion, target cost (through its counterpart, target price) sets parameters on
11 expected sales volume and ultimately market share. Achieving market share
objectives depends on establishing a realistic, competitive price as well as on
marshalling adequate marketing resources and then proficiently executing
marketing and launch activities.
The lower circle in the conceptual framework diagram represents accounting’s
contributions, including financial analysis, or, “the business case;” target cost
is also a major element of the business case. Cooper (Cooper & de Brentani,
1991; Cooper & Edgett, 1996; Cooper & Kleinschmidt, 1986) and others
(Griffin, 1997a; Rochford & Rudelius, 1997) have included financial analysis
or the business case as a necessary and important step in the NPD process.
The business case describes in detail the product, market, estimated volume,
estimated market share, estimated revenue, estimated product cost, estimated

capital investment, and estimated marketing and development costs as well as
profitability and return on investment. The conceptual framework illustrates that
the decisions made by the NPD team on technical and marketing aspects of a
new product impact inputs to the financial analysis as well as the profitability
and return on investment results.
For example, if technical personnel on the NPD team cannot design the
desired features into the product at the target cost, they may turn to marketing
team members to discuss the impact of a higher target price on resulting market
1 share and volume estimates. Alternatively, they may discuss reducing the feature
set to keep within the cost target; fewer features may affect market share and
volume as well. These discussions should include accounting personnel who
can evaluate the financial implications of the price, cost, feature, and volume
interactions. Management accountants are especially well positioned to assess
trade-offs that must be made, such as trade-offs between fewer features/lower
cost and more features/higher cost or between product cost and time-to-market
(Hertenstein & Platt, 1999) or between product cost and development cost.
Management accountants can thus lift both technical and marketing personnel
out of their functional silos, enabling NPD to be more entrepreneurial, by
1 assessing the impact of decisions to change costs, prices, functionality and
features on the prospective product’s financial performance.
This conceptual framework assumes that opportunities for accountants to
contribute creatively to NPD are realized. Drawing from the literature review
above, this means specifically that accountants must be fully integrated into the
NPD process. Resources must be invested to involve accountants throughout
the NPD process. Accountants must be involved early, and they must possess
and proactively, proficiently exercise the financial skills and expertise that relate
to NPD. Further, resources must be invested so that accountants have access
to relevant models or modeling capabilities and financial information, especially
1 appropriate, detailed, firm-specific cost information.
These three dimensions of NPD – technical, marketing and accounting – are
guided by effective strategy. Thus, strategy, too, unifies NPD by providing an
integrative context for NPD activities and decisions as shown in Fig. 1. Without
this “glue,” the functional areas might not work toward the same goals or worse,
they may work at cross-purposes. Further, strategy can help define criteria used
to assess project progress at stage-gate reviews. Projects often are and should
be killed if key criteria are not met. Strategy also guides senior managers as
they prioritize potential development projects and determine the allocation of
resources, both in terms of personnel and financial resources to fund develop-
ment of selected projects.
57
This framework can be used to analyze a firm’s NPD performance, espe-

cially the contribution of accounting to NPD outcomes. Given empirical support
from research suggested in the section, A Guide to Future Research, below, the
framework can also be used to predict a firm’s NPD performance, and to guide
the integration of accounting and accountants into NPD in practice.
Before we proceed to develop testable hypotheses from the framework, we
want to illustrate its feasibility in practice. To do so, we have selected one of
our field research sites, Comptech Company,13 to illustrate how one company
has established a creative, proactive role for accountants in NPD like that
11 described by the conceptual framework. It illustrates accountants’ involvement
from the beginning of the NPD process, and shows accounting tools and infor-
mation accountants use. It describes the types of activities that accountants
engage in, such as working with rough designs to develop preliminary product
costs and financial analyses, helping the team assess the financial implications
of design alternatives, and developing financial models describing the effect of
the new product on customers and suppliers. It depicts the roles other NPD
team members count on accountants to play, such as “what if” analyses, and
maintaining objectivity to enhance project credibility at decision points in the
NPD process. As will become evident, the creative, proactive role that Comptech
11 has structured for management accountants is consistent with the conceptual
framework, and hence the research findings discussed above in the literature
review. It also strongly parallels the vision for management accountants that
the product developers at Duraprod articulated.
5. COMPTECH COMPANY14
Background
Products, Positioning, and Strategy

11 Comptech manufactures components for a consumer durable product and sells
their products to an original equipment manufacturer (OEM) market. Thus, they
have relatively few, large customers, each of which typically buys numerous
products from Comptech. Although product lines are long-lived, product designs
change annually. Over time, Comptech has evolved from supplying individual
components to supplying entire product systems comprising preassembled
groups of components to the OEMs.
The OEM market has experienced consistent, if not spectacular, growth over
the past several years and this growth is expected to continue. The market
supplying OEMs with components and systems is expected to grow even faster,
as OEMs push toward increased outsourcing. Also enhancing market growth
for component suppliers is their own push to provide high value features, and
their moves to global expansion. Although Comptech “originally had a
monopoly on their niche of products” in the OEM market, competition is
growing. OEMs are also becoming increasingly price sensitive, thus pushing
Comptech to reduce cost.
However, Comptech’s products have the potential to add value to the OEM’s
products. Comptech has recognized that in order to serve the OEMs well, they
not only have to meet the OEM’s stated needs, but to anticipate needs the
OEMs have yet to identify. Through technology and new product development
1 performance, they have helped increase the OEM’s pace of innovation. Thus,
Comptech has been attempting to design more value into its products, which
has increased costs. They are well aware that they have to increase value
sufficiently to justify raising prices to cover the cost increases.
As a result of this competitive market, cost is viewed as having very high
strategic priority at Comptech. Financial personnel, industrial designers, and
operations personnel have traditionally viewed product design, cost and quality
as “three key strategic goals that are part of a triad supporting each other.”
Performance
1 Financial data on Comptech are not publicly available, and for confidentiality
reasons Comptech declined to release specific financial data. However, those
interviewed consistently indicate that the company is growing significantly, and
is quite strong financially. Knowledgeable outsiders also consider the firm to
be financially strong, and they evaluate Comptech’s performance in new product
design and development as excellent.
Linking Corporate Strategy to NPD
Senior executives in NPD at Comptech are members of the corporate execu-

1 tive group that formulates the firm’s strategy. This creates a clear channel for
communicating the firm’s strategy to new product developers. Corporate
strategy is well defined in relation to the markets Comptech seeks to serve
and the product areas in which they want to participate. Further, corporate
strategy is also clear about Comptech’s desired technological approaches to
these products and markets. These strategic goals are effectively communi-
cated to NPD personnel. When interviewed about products they are developing,
NPD personnel consistently and spontaneously point out the relationship
between their products and the corporate strategy: “This product is especially
important because of Comptech’s goal to make X-products incorporating Y-
technologies.”
59
The Role of Accounting and Accountants in NPD
Management Accounting Resources on the NPD team

Each product line has one or more finance managers assigned to the product
line from the Finance Group. The finance manager works with the product
development team from the beginning. Very early in the process, beginning
with ideation, the finance manager develops very rough cost estimates. Although
the finance manager continues to report to the finance function, s/he is located
among the product developers. As one finance manager indicated:
11 Our work is early in the process; we are physically in the middle. The [product line] finance
people are physically in the middle of the . . . work areas. We work out there among them.
They come to us for stuff because we are right there.
Finance managers are assigned on a long-term basis to product lines and the
product development teams associated with those product lines. According to
a product designer,
Comptech strives for stability on its NPD teams. So, the [product line] finance manager
tends to stay on teams [for the product line]. [Thus,] they know the product almost as well
as the industrial designer or engineer, and they can talk knowledgeably and somewhat tech-
nically [about it.]
11
Finance Contributions to NPD: Timing, Expertise, and Proficiency
The finance team member’s role begins in the earliest stages of the NPD
process.15
Product line finance managers work on [product development] teams early in the process,
starting with advanced concepts. They develop quotes based on baseline sketches.
Product line finance managers provide early quotes that are competitive and credible. If the
team gets [approval to proceed], they help to set goals and articulate assumptions.
In “ideation,” the earliest stage of the product development process, product

11 developers at Comptech distinguish between generating ideas and evaluating
those ideas. During ideation, the team is involved in very advanced thinking
about product concepts. They brainstorm, generate ideas and increase the
number of alternatives under consideration. The product line finance manager
does not play a big role in idea-generation. However, after brainstorming, the
list of ideas must be narrowed before proceeding. Finance managers get more
heavily involved when product development teams are evaluating and priori-
tizing ideas, not just generating new ideas.
Product designers view cost information in these early product development
stages as enhancing designers’ creativity. Further, they believe that setting cost
targets insures that designers have opportunities to work on products that
actually make it to market. According to designers, designing products, which

are later rejected because they are too costly, is frustrating and demoralizing,
no matter how innovative and creative those products are.
Cost is a major part of the discussion. Cost needs to be a creative constraint. If we know
the cost up front, it is liberating. We get into trouble when we do “blue sky” brainstorming.
Often the output cannot be used. People at Comptech like to work on solving problems.
We need to have a good feel for the price point where the product will sell, so we get
competitive information from the marketing group. The first thing we want to do is derive
a target cost. How we get there is like fitting together puzzle pieces. We consider alterna-
tives that invoke cost competitive [manufacturing] processes to help reduce cost. We also
1 try to design in more value to increase the target cost.
Creativity and flexibility are crucial skills for finance personnel early in the
process. According to one product manager,
At an early stage in development, there is little certainty, little truth. “Financial analysis”
has to be very creative and flexible.
Others have observed that cost estimates in early ideation are very rough. Often
they are thought of as a range, for example, “cost target ± 5–10%.” According
to a product line finance manager,
1 We have an up-front financial model. The team, not the financial person, owns it. Product
design at an early stage is very, very fluid. The financial models must be flexible. The
designer might come in with a half dozen possibilities, “We could do it like this, or like
this, or like this . . .” The finance manager must mirror the same flexibility, perhaps through
multiple runs of the model, thus being able to respond, “And if we did, it would produce
financial results like this, or like this, or like this . . .” Our financial programs have “What
if?” tools built into them, and we continually do “What if?” analyses until we freeze the
design.
Because of the uncertainty associated with early stages of NPD, Comptech does
not hold product development personnel, especially product line finance
managers, responsible for these early estimates. Instead, anticipating that costs
1
will change, they have developed mechanisms for documenting and tracking
changes to product costs.
One interesting feature of our database system is that people document changes to the design
or [manufacturing] process. Along with the change, they indicate whether the change
increased or decreased the cost, whether the change was approved or not approved, and
whether it was internally initiated or [later, after customer acceptance] customer initiated.
Product development team members view the database documenting design and
cost changes as an important communication mechanism among the team
members, as well as a way to inform customers, following customer accep-
tance. This system also allows Comptech to see how customer requirement
61
changes relate to product cost changes, so prices can be adjusted if necessary

to achieve desired profit. They can also increase the product’s target cost as
they justify changes that add value.
Finance managers are expected to have much broader skills, and much
broader perspectives, than simply estimating product costs. According to a
product manager,
The finance person, early on in the project, needs to know the competitors, market shares,
and prices if there are comparable products. Further, if this is a product line where we have
to partner with firms in a related industry, the finance manager must understand that industry
11 as well.16 The selling team also needs support from the finance manager to justify the selling
price they want to negotiate. The finance manager needs to be part of the negotiation team.
One finance manager stated it was his job to “educate salespersons and help
them to deal with financial issues.” Finance managers as a group indicate that
they build financial models of the OEM’s operations to evaluate the effect of
incorporating a new component or system from Comptech into the OEM’s
product. Non-finance team members indicate this analysis provides arguments
and evidence for the selling team to use with OEM personnel, particularly OEM
financial personnel.
11 To meet these expectations, finance managers have to be experienced, and
they need tools and information to support their efforts. In addition to the finan-
cial models previously discussed, product line finance managers have access to
a database system containing all cost information needed to estimate a product
cost. The database has been created in the finance organization, but is now
viewed as a tool for product development. All product development team
members can access the database at any time to analyze the cost structure of
the product under development. Further, most product line finance managers
are former plant controllers, so they understand process costs associated with
manufacturing Comptech’s products.
11
Developing Product Cost Information in NPD
Estimating product cost is a highly collaborative effort. Purchasing provides
estimates of raw materials. Labor costs are estimated from labor rates provided
by plant controllers, and inputs on quantity of labor provided by operations in
conjunction with advanced manufacturing personnel who provided input on new
process issues. Capital costs for the product are similarly determined by oper-
ations, controllers, and advanced manufacturing. Product specific indirect
overhead costs are allocated using an activity-based costing (ABC) database,
and non-product specific overhead costs are facility driven, normally based on
square feet utilization.
Using Product Cost Information in NPD

Product development teams set their own product design goals, including desired
features, cost, and quality, based on competitive information and on customer
information supplied by the salesforce. At the milestone before the product
design is released into production, Comptech re-evaluates whether the product
has achieved the original goals; they must achieve baseline goals on all three
aspects, or the product has to be redesigned to achieve these goals.
The product line finance manager is considered accountable for the product
cost meeting the target. Further, the actual cost measured after the product goes
1 into production is compared to the cost estimated by the product development
team. Comptech tracks information on all projects back to the product line
finance manager who has participated on the NPD team, to see, overall, how
his/her projects have performed. This information is then used in annual reviews
of finance managers.
Credibility of NPD
NPD personnel believe that having product line finance managers on the NPD
team increases the credibility of the team’s proposals with senior management.
According to one product manager,
1
The finance manager has a balancing act to accomplish. On one hand, they need the respect
of the product development team. This requires that they have vision, and that they be some-
what of a risk taker. However, the risk is that they get too close to the product development
team. They must also have the respect and confidence of the finance group. Therefore, they
cannot just “go native,” but must be balanced and rigorous in their financial analysis.
A product line finance manager concurred, and indicated why it was so impor-
tant for this role to be filled by someone experienced in the financial area.
The finance manager makes a good financial model that the corporation believes in. This
gives credibility for the project. We have financial modeling programs. It would seem that
1 you could just give the program to the engineer and that they could plug in the data and
get the answer. But this is not the case. When they do the model, the finance person can
always look at it, and find something missing. There are two problems when someone else
does the model. First, it is not their primary interest. Their primary attention is on some
other aspect of the project. Second, they simply do not do these as often as we do. They
have not done as many, have not seen as many variations, have not come down the learning
curve. So it is a distinct advantage when the finance manager works with the team. You
get a better model. And you get more credibility for the project.
Creating Entrepreneurs
Finance managers also observe that, rather than stifling creativity, their pres-
ence on the team “makes others more entrepreneurial.” Suddenly, the work of
63
the non-finance team members is no longer just about “design” or “engineering,”

which can be isolated and territorial perspectives. Instead, with the finance
manager present on the NPD team, the attitude changes to, “I know the finan-
cial impacts of what I’m doing.” It provides a broader business orientation for
the team instead of a design orientation or a product engineering orientation.
Because they are able to consider the business implications of what they are
designing, the team feels more entrepreneurial. According to a product line
finance manager:
What surprised me about this position is how eager people on the product development
11 teams are to understand the financial impact of what they do. And how much they want to
do things to make it better. They care very much, and you just have to help them under-
stand.
Summary
Comptech illustrates key aspects of the conceptual framework. Accountants and
financial analyses are integrated into NPD from the beginning in a proactive,
creative and flexible way. The Comptech case makes a compelling argument,
consistent with research results from technology and marketing, that accounting
expertise and accounting data must play a role throughout the NPD process. It
11 certainly seems logical that a new product must achieve success on financial
as well as technical and marketing dimensions in order to be considered a
successful new product.
The Comptech field research not only demonstrates the characteristics
derived from the literature that have been proved to enhance NPD perfor-
mance, but in many ways, it also demonstrates the accomplishment of many
characteristics of the role for accounting and accountants envisioned by NPD
personnel at Duraprod. These aspects include early inclusion of the finance
person on the NPD team to facilitate greater focus on cost, more proactive,
creative, and flexible use of accounting data to model the effects of design
11 alternatives on the firm and end-users or customers, and facilitation of perfor-
mance measurement and accountability of NPD personnel for new product
performance.
We know from the research that not all firms integrate accounting and accoun-
tants into their NPD process as suggested by the conceptual framework. This
begs the question, “How would new product performance be affected if NPD
teams routinely included an accountant who could help the team evaluate the
financial feasibility and implications of various design alternatives more effec-
tively?” The need to systematically answer this and related questions leads us
to the future research required to better understand the role for accountants and
accounting information in NPD.
6. A GUIDE FOR FUTURE RESEARCH
The cases illustrated and the literature reviewed demonstrated that effectively
including accounting expertise in NPD will improve new product performance
just as effectively including marketing and technical expertise have been shown
to do. The following section develops testable hypotheses to guide future
research aimed at exploring this assertion. This research must address not only
whether effective accounting expertise and data increase new product perfor-
mance, it must also address what constitutes effective accounting expertise and
1 data, and how to most effectively incorporate it.
Table 3 presents hypotheses regarding the role that the accountant plays and
the influence of this role on the value of accounting contributions to NPD.
Team members who proactively contribute early in the NPD process may
enhance new product performance more than those who only respond to requests
later in the process. Table 4 presents hypotheses about the influence of the
accounting team member’s expertise on the value of accounting contributions.
Team members who have broad training and experience may enhance new
product performance more than those may whose training and experience is
narrower in scope.17 Finally, Table 5 presents hypotheses about the influence
1
Table 3. Hypotheses About the Relationship Between the Role of
Management Accountants and New Product Development Performance.
Enhances NPD Performance Does Not Enhance NPD Performance
The accountant: The accountant:

• Is involved early in the NPD process • Is involved later or at the end of the NPD
process
• Is proactive, suggests financial analyses • Is fairly passive, generally responds to
1 to be conducted, volunteers, provides requests for information or analyses
analyses without being asked
• Is comfortable with vague data, data • Wants greater certainty in the data, seeks to
that keep changing, rough analyses delay conducting analyses until the data are
more certain
• Is creative, adapts financial models • Uses standardized approaches or models.
and financial analyses to fit the situation
• Conducts financial analyses on the • Conducts financial analyses on the effect of
effect of decisions not only on the firm decisions primarily on the firm developing
developing the product, but also conducts the product.
financial analyses of the effect on
customers, distributors and/or suppliers.
65
Table 4. Hypotheses About the Relationship Between the Expertise of

Management Accountants and New Product Development Performance.
The accountant: The accountant:

• Is trained broadly, accounting/finance • Has narrower training, trained almost
training is augmented by broader exclusively to be an accountant
business training, for example, an MBA
• Has significant experience in operations • Has little or no experience in manufacturing
or manufacturing, for example, a former or operations
11 plant controller
• Has significant experience in non-financial • Has little or no experience in non-financial
functions other than operations functions other than operations
• Has expertise in financial modeling • Has little or no expertise in financial
modeling
Table 5. Hypotheses About the Relationship Between the Accounting/

Financial Data and Tools and New Product Development Performance.

11 The accountant: The accountant:
• Uses firm-specific data for NPD analyses • Uses generic data, such as those supplied
by CAD/CAM software suppliers, for NPD
analyses
• Can access most cost data needed to • Must request cost data needed to construct
construct product cost on-line product cost from various parts of the
organization, for example, from manufac
turing, tooling, purchasing.
• Has modeling capabilities, such as modeling • Does not have modeling capabilities to
programs, to assess the effect of decisions assess the effect of decisions about the
about the product on its financial performance product on its financial performance
11 • Has modeling capabilities that allow the • Does not have modeling capabilities that
NPD team to ask, “What if?” questions allow the NPD team to ask, “What if?”
questions
In the company: In the company:
• Most overhead data are available broken • Overhead data are not available broken
down by the activities involved in down by activities involved in manufac
manufacturing products, and the allocation turing products, and/or most overhead is
base (or cost driver) used to allocate allocated to products using the same base
activity costs to products were selected for or cost driver, for example, direct labor
their appropriateness to the activity
• Product cost data are accessible on-line • Product cost data cannot be easily accessed
by all NPD team members. by all members of the NPD team.
of financial data and tools available to the NPD team on the value of accounting
contributions. Detailed, firm-specific data and flexible models may enhance NPD
more than generic or aggregate data, or limited modeling capabilities.
Strategy has also been shown to be an important element of NPD, as it
focuses the NPD team on the highest valued opportunities, and helps team
members resolve differences in ways yielding higher returns to the company.
Since a key function of management control is strategy implementation, another
opportunity for management accountants to add value to NPD is by providing
effective strategic guidance to NPD through the discharge of their management
1 control responsibilities. We expect that effectively including strategic manage-
ment controls in NPD will increase new product performance. Research is
needed to address not only whether effectively including strategic management
controls in NPD increases new product performance, it must also address what
constitutes effective strategic management controls.
The cases and literature above suggest several hypotheses detailed in Table
6 about factors that may increase the value of strategic management controls
to NPD. Firms that have explicit steps for strategic planning and evaluation in
their formal NPD process may perform better than those who do not. Firms
that measure specific strategic goals or firms whose overall performance
1 measurement system reflects the key strategic goals of the firm may perform
better than those who do not.
7. SUMMARY AND CONCLUSION
NPD is important to firm success. Through NPD, firms enact their strategies
and substantially determine their financial performance. NPD has become an
important focus of management research, especially from the perspectives of
marketing and technical functions. However, NPD has been given little atten-
tion in the accounting literature. Without sound research, firms have little
1 guidance on how to structure accounting participation in NPD.
Initially, this paper presented a case illustrating the missed opportunities a
firm experiences when accountants play a limited role in NPD. This was
followed by a literature review regarding what is known about factors leading
to new product success. The review focused mainly on marketing and technical
literature, due to the lack of accounting literature in this area. However, even
the marketing and technical literature report that financial contributions, such
as up-front financial analysis and effective product costing, are factors that lead
to new product success. Key findings from the marketing and technical litera-
ture include: individuals from diverse functional areas must work together; those
individuals must be included early in the product development process; members
67
Table 6. Hypotheses About the Relationship Between Strategic

Management Controls and New Product Development Performance.
In the company: In the company:

• Senior NPD personnel participate in the • Senior NPD personnel do not participate
firm’s most senior strategy formulation in the firm’s most senior strategy formulation
group, committee, or task force. group, committee, or task force.
• The formal NPD process contains early • The formal NPD process does not contain
11 stages where strategy explicitly guides early stages where strategy explicitly guides
the search for new product ideas and the the search for new product ideas and the
design and development of new products. design and development of new products.
• Strategy is a key criterion in determining • Strategy is a not key criterion in
which new product concepts will proceed determining which new product concepts
from ideation into development. will proceed from ideation into development.
• Strategy is a key criterion used to • Strategy is not a key criterion used to
evaluate the product under review at evaluate the product under review at
stage-gate reviews. stage-gate reviews.
• Performance measures are used to • Performance measures do not reflect the
measure the achievement of key strategic firm’s key strategic goals.
11 goals.
• The alignment of product design and • The alignment of product design and
development with strategy is assessed. development with strategy is not assessed.
• Measures that assess the achievement • No incentives or rewards are based on
of key strategic goals and/or strategic measures that assess the achievement of key
alignment are used as criteria in awarding strategic goals and/or strategic alignment.
incentives and rewards.
of the NPD team must be proficient in functional skills related to product

11 development; and strategic guidance to direct the actions of diverse NPD
personnel is essential.
Next, we extend these findings to define a role for accountants in NPD and
we propose a model for effectively integrating accounting into NPD. Key
features of this model include: accountants who are involved early and
proactively on the NPD team, accountants who are broadly trained and expe-
rienced in business, accountants who are flexible and creative about financial
modeling and analysis, accountants who can access detailed, relevant, firm-
specific accounting data and who have available appropriate modeling tools,
accountants who can design appropriate controls to link strategy to NPD. We
then examine a field site illustrating many characteristics of this conceptual
framework. Finally, a set of testable hypotheses was derived from the model
to guide future research on what makes accountants effective and valuable in
NPD.
However, we not only need research on what constitutes an effective role
for accountants in NPD, we also need research to determine how to effectively
integrate accountants and financial analysis into NPD. In addition to a general
resistance to change, perceptions and stereotypes about accountants may lead
other team members to resist their participation. Accountants are often viewed
as bean counters who are narrowly focused and uncreative. Historical tension
1 between functional areas may make it difficult for other team members to accept
them.
Cultural constraints may also limit the accountants’ ability or willingness to
contribute effectively. As we saw at Duraprod, the strong culture compelling
accounting precision and holding accountants responsible for preliminary, rough
estimates constrained their ability to participate more fully.
Finally, accountants may need to develop new skills and expertise or they
may need to learn to apply their skills and expertise in new ways. Our
findings in this area parallel many of those of Siegel and Sorensen (1999) in
that accountants are increasingly expected to understand and implement
1 company strategy, to communicate with non-accountants, to participate on and
lead teams, and to spend more time analyzing information and participating in
decision making. Thus, they observe that accountants must be educated to
communicate well, to work on teams, to effectively demonstrate varied analyt-
ical skills, and to possess a solid understanding of how a business functions in
addition to a solid understanding of accounting. In addition to the skills and
expertise listed above, accountants involved in NPD require a solid under-
standing of the product development and launch process, expertise in
competitive analysis, the ability to work with vague, uncertain and changing
financial data, and a working understanding of their firm’s technologies and
1 manufacturing processes.
NOTES
1. Duraprod is an actual company. For reasons of confidentiality, the name of the
company has been disguised to protect the company’s identity. The case description is
based on field research, and the data, incidents and quotations are real. We selected
Duraprod as a research site based on an outside expert’s evaluation that it is successful
at designing and developing new products. We interviewed nine individuals at Duraprod
during a nine-month period. They represented varied functional areas; each was involved
in NPD. We conducted most interviews in person at Duraprod’s sites although we
conducted some follow-up interviews by telephone.
69
2. The term “management accountant” is becoming obsolete in practice (Siegel &

Sorensen, 1999; Williams & Hart, 1999). When we describe the field sites in this article
we adopt the terminology of our sites and refer to the management accountant as a
“finance person,” “finance team member” or “finance manager.”
3. The five interviewees were a product engineer, a manufacturing engineer, a finance
manager, an industrial designer, and a marketing person each involved in NPD.
4. The marketing manager, the industrial designer, and the manufacturing engineer
shared this view.
5. The four groups included solid performers (high on both dimensions), low impact
performers (high on profitability only), high impact technical winners (high on impact
only) and dogs (low on both dimensions).
11 6. Resource support included the dedication of necessary resources to achieve project
goals, adequate R&D budgets and allocation of necessary people to do the job.
7. There is evidence that other factors also play a part in determining whether or not
a new product will be successful, including supportive management [Cooper &
Kleinschmidt, 1995; Griffin, 1997a; Johne & Snelson, 1988; Lester, 1998; Maidique &
Zirger, 1984; Poolton & Barclay, 1998; Rothwell, 1992; Rothwell et al., 1974;
Rubenstein, Chakrabarti, O’Keefe, Souder & Young, 1976; Voss, 1985; Zirger &
Maidique, 1990], service [Cooper & de Brentani, 1991; Cooper & Edgett, 1996; Poolton
& Barclay, 1998; Rothwell, 1992] and the degree of synergy between company resources
and product needs or requirements [Cooper & de Brentani, 1991; Cooper & Edgett,
1996; Cooper & Kleinschmidt, 1993; Poolton & Barclay, 1998; Souder & Chakrabarti,
1978]. Among these, the role of supportive top management has been most widely inves-
11 tigated. These findings are robust, as they have been reported for samples across
industries as well as countries.
8. Marketing tasks include preliminary market assessment and studies, market research
(including correct product specifications), customer tests of prototypes, test marketing
and trial selling campaigns and finally the market launch.
9. The first- and second-rated reasons for new product failure were inadequate
marketing analysis and product defects.
10. The development costs for the big three U.S. automobile makers in 1994 ranged
from $490 to $750 per car, a relatively small percentage of total product cost of an
automobile (Harbour, 1995).
11. Empirical results concerning the significance of business/financial analysis on NPD
outcomes are mixed. Griffin (1997b) found that the business analysis stage positioned
11 in the middle of a NPD process was not significantly different between the more
successful compared to less successful innovators.
12. The number of stages presented has varied from 5 (Poolton & Barclay, 1998) to
13 (Cooper & Kleinschmidt, 1986).
13. Comptech Company is simply one example of how a firm might adapt the concep-
tual framework to practice. Other adaptations are possible, indeed, likely.
14. Comptech is an actual company. For reasons of confidentiality, the name of the
company has been disguised to protect the company’s identity. The case description is
based on field research, and the data, incidents and quotations are real. Similar to
Duraprod, we also selected Comptech as a research site based on an outside expert’s
evaluation that it is successful at designing and developing new products. We inter-
viewed ten individuals at Comptech during a two-year period. They represented varied
functional areas; each was involved in NPD. We conducted most interviews in person
at Comptech’s sites. Some interviews were conducted off-site at conferences, and follow-
up interviews were conducted by telephone.
15. Because Comptech sells its product to an OEM market, and not to end-users, a
significant portion of product development takes place after the product is “sold” to the
customer. The product development effort prior to sale to a customer can be thought of
as developing a working prototype. Following customer acceptance, the product is
customized and adapted to the specific customer’s requirements.
16. A finance manager indicated that, when partnering with related industries, it was
her job not only to do an industry analysis identifying the key competitors, their market
shares and prices, but also to analyze who would be a good partner, who was finan-
cially strong, and who was the lowest cost producer.
1 17. Sergenian and Bedard (1999) reported a similar finding in that breadth of
experience contributed to auditors’ ability to achieve good performance when they were
required to perform less routine, less structured tasks outside the domain of their
traditional, technical, attest function.
ACKNOWLEDGMENTS
We gratefully acknowledge the insightful comments of Jean Bedard, Germain

Böer, Anthony Hopwood, John Y. Lee, Mario Maletta, Alice Sapienza, and Jan
Shubert on earlier drafts of the manuscript.
1
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75
xii RUNNING HEAD

IMPLEMENTING COST-VOLUME-
PROFIT ANALYSIS USING AN
ACTIVITY-BASED COSTING SYSTEM
Robert C. Kee
ABSTRACT
This article mathematically models the relationship between a product’s

revenue and cost functions, where a product’s cost function is estimated
using activity-based costing. The resulting cost-volume-profit (CVP) model
may be used to determine the level of sales needed to break even and/or
earn a level of profit sufficient to justify the product’s production. The
article also illustrates how the CVP model may be used to determine the
rate of change in profitability with respect to a change in demand and
how this information may be used to understand the behavior of a product’s
profitability over the range of its potential market demand. The CVP model
is also used to demonstrate how to measure the change in profit for a
given change in one or more of a product’s underlying parameters. Finally,
the article illustrates how the financial implications of product and process
improvements stimulated through the use of ABC may be evaluated with
CVP analysis.

ISBN: 0-7623-0825-7
77
78 ROBERT C. KEE
INTRODUCTION
Cost-volume-profit (CVP) analysis models a product’s revenue and cost to
provide information for evaluating the economics of its production. Through a
set of simplifying assumptions, CVP analysis develops a set of equations to
represent a product’s cost and revenue functions. These equations reflect the
relationship between a product’s profitability with respect to its sales volume.
Analysis of the CVP model is used to determine the level of sales needed to
meet specific financial objectives, such as the sales required to break even and/or
11 earn a level of profit sufficient to justify the product’s production. Equally
important, it may be used to measure the change in a product’s profitability
with respect to variation in one or more of its underlying parameters. Based on
a product’s anticipated sales and the potential variation in its price, cost, and
demand, managers can evaluate whether it can meet specific financial objec-
tives, such as breaking even and earning a level of profitability that will enhance
the firm’s value. From this analysis, managers are able to determine which
products should be produced, which should be postponed, and which should be
deleted from further consideration.
CVP analysis is frequently criticized for its simplifying assumptions, such as
11 the deterministic and linearity of its cost and revenue functions. Equally impor-
tant, CVP analysis is often disparaged due to its focus on a single product and
single time period. However, as noted by Guidry, Horrigan and Craycraft (1998,
75), “Non-linear and stochastic CVP models involving multistage, multi-
product, multivariate, or multi-period frameworks are all possible, although a
single model embracing all of those extensions would seem a radical departure
from the whole point of CVP analysis, its basic simplicity.” Horngren, Foster
and Datar (2000) indicate that firms across a variety of industries have found
the simple CVP model to be helpful in strategic and long-run planning
decisions. However, Horngren Foster and Datar (2000) warn that, in situations
11 in which revenue and cost are better predicted by more complex assumptions,
managers should consider more sophisticated approaches to economic analysis.
CVP analysis was designed to be implemented within the framework of a
traditional cost accounting system. The fixed and variable categories of cost
and the linear relationship of variable cost to production volume in CVP analysis
reflect how expenditures are structured and assigned to products in a traditional
cost system. However, these systems allocate overhead based on volume-based
measures of activity that frequently bear little relationship to how overhead
resources are used in the production of the firm’s products. Consequently,
traditional cost accounting systems can lead to significant distortions in
measuring a product’s cost (Kaplan & Cooper, 1998). CVP analysis, based on
Implementing Cost-Volume-Profit Analysis 79
the assumptions of a traditional cost accounting system, fails to model the causal
relationship between a product and the cost of the overhead resources used in
its production. Equally important, the distortions introduced by a traditional cost
accounting system may affect the accuracy of CVP analysis and may lead to
suboptimal product mix decisions. These deficiencies of CVP analysis are not
an inherent limitation of the model, but rather its implementation within the
framework of a traditional cost accounting system.
Metzger (1993), Blocher, Chen and Lin (1999), and Hansen and Mowen
(2000) illustrate how CVP analysis may be implemented with ABC. In their
1 examples, the authors specify the number of batch-level activities that will be
used to produce a product. In effect, batch-level costs are treated as a fixed
cost. However, batch-level activities, such as set-up and purchasing, are gener-
ally performed to manufacture a specific number of units. This means that the
number of batch-level activities performed is a function of the quantity of the
product produced. The examples used by Metzger (1993), Blocher, Chen and
Lin (1999), and Hansen and Mowen (2000) were confined largely to computing
a product’s breakeven quantity. However, CVP analysis is used to produce a
variety of other information for evaluating a product’s profitability.
The purpose of this article is to mathematically model the relationship
1 between a product’s revenue and cost functions, where a product’s cost
function is estimated using ABC. Unlike Metzger (1993), Blocher, Chen and
Lin (1999), and Hansen and Mowen (2000), batch-level costs are treated as a
variable cost. Also, unlike Metzger (1993), Blocher, Chen and Lin (1999), and
Hansen and Mowen (2000), the article expands CVP analysis beyond the
breakeven point to the broader set of information needed to evaluate the
economic implications of producing a proposed product.
The remainder of the article is organized as follows. The next section
discusses ABC and the problematic aspects of evaluating a product’s prof-
itability with ABC. The following section develops the CVP model using an
1 activity-based costing system to represent a product’s cost function. The section
after that presents a numerical example to demonstrate how CVP analysis may
be implemented with ABC to measure a product’s economic attributes. The
final section presents a summary and suggestions for future research.
ACTIVITY-BASED COSTING AND

COST-VOLUME-PROFIT ANALYSIS
ABC differs from traditional cost accounting systems in two important respects.
First, it traces the cost of overhead resources to activities and from activities
to the products that consume their services (cost drivers) during production.
79
80 ROBERT C. KEE
Second, ABC traces overhead-related costs at the structural or hierarchal level

at which an activity’s services are used in the production process. For example,
many overhead resources are incurred at the unit, batch, product, and facility
levels of a firm’s operations (Cooper, 1990). The use of multiple cost drivers
and tracing costs at the structural level at which they are incurred enables ABC
to model the relationship between the resources consumed by production
activities and the products they are used to produce. ABC thereby provides a
more accurate estimate of the cost of the resources used to produce a product
as well as the cost of the individual activities used in its production.
11 ABC is an economic model of an organization’s production function (Kaplan,
1992) and provides a powerful framework for understanding and controlling its
costs. However, the goal of the firm is not to control costs but rather to create
value for its stockholders. Therefore, managers must simultaneously consider the
revenue and cost of production-related decisions to evaluate the firm’s
products. This is frequently accomplished by comparing a product’s price
relative to its unit cost and/or evaluating revenue and cost for a given level of
production. Both of these approaches to evaluating a product’s profitability with
ABC are problematic. Under ABC, the cost of unit-level activities is variable with
respect to production volume. Conversely, the cost of batch-level activities is vari-
11 able with respect to the number of batches produced and the cost of product-level
activities is variable with respect to the decision to produce the product. The costs
of facility-level activities relate to sustaining the firm’s operations and should not
be allocated to individual products (Kaplan & Cooper, 1998). Batch and product-
level costs are converted to unit-level costs by dividing batch-level costs by the
number of units in a batch activity and product-level costs by the product’s market
demand. Therefore, comparing a product’s price to its unit cost is implicitly
assuming a given level of production. Given an alternative level of production,
unit cost would change. Therefore, using a product’s price and unit cost for mea-
suring unit-level profitability and extrapolating to any level of production other
11 than that used to convert product-level cost to a unit cost is invalid. Conversely,
income computed from a product’s total revenue and total cost is a point estimate
of its profitability. Under ABC, profitability is not a linear function with respect
to unit sales volume. Therefore, extrapolating profitability outside the production
level used to compute a product’s profitability is inappropriate.
The role of CVP analysis is to jointly model a product’s revenue and cost func-
tions. Therefore, using CVP analysis with ABC represents a logical extension of
its use for supporting production-related decisions. While all costs are variable
under ABC, product-level cost represents a cost that will be incurred to produce
a product, independent of its production quantity. In effect, product-level costs
are similar to a fixed cost in evaluating whether a product should be produced.
Batch-level costs are incurred each time a batch activity, such as set-up or pur-
chasing, is performed. Batch-level activities result in a step-type cost function.
The aggregation of unit-, batch-, and product-level costs involved in a product’s
production creates a cost function that has discontinuities when batch-level activ-
ities are performed and is non-linear. Consequently, computing the level of sales
necessary to break even and earn a target profit is less tractable using ABC to
model costs than computing these metrics using CVP analysis with a traditional
cost accounting system.
1
COST-VOLUME-PROFIT MODEL DEVELOPMENT
To mathematically develop the CVP model based on an activity-based costing

system, the following notation will be used:
j = production activity index

Pi = price of Product i
Qi = quantity of Product i produced and sold
CU,j,i = cost of performing unit-level activity j to produce a unit of Product i
1 CB,j,i = cost of performing batch-level activity j to produce a batch of Product i
CL,j,i = cost of performing product-level activity j to produce Product i
Bj,i = number of batches required from activity j to produce Qi
bj,i = number of units in batch-level activity j
⌬ = difference operator
qi = difference interval for Product i, and
⌸i = Product i’s profit.
Under ABC, a product’s accounting income is defined as the difference between

its revenue and the cost of the resources used in its production.1 Using the prior
1 notation, this relationship may be stated:
⌸i = (Pi Qi) ⫺ (⌺jCU,j,i Qi + ⌺jCB,j,i Bj,i + ⌺jCL,j,i) (1)
In Eq. (1), revenue is represented by the term Pi Qi, while unit-, batch-,
and product-level costs are represented by ⌺jCU,j,i Qi, ⌺jCB,j,i Bj,i, and ⌺jCL,j,i,
respectively. Equation (1), like the traditional CVP model, reflects the inter-
relationships among a product’s cost, revenue, and profit with respect to sales
quantity. However, unlike the traditional CVP model, Eq. (1) reflects the
hierarchical structure at which cost are incurred as well as the causal relationship
between the demand on unit- and batch-level activities, services, or cost drivers
81
82 ROBERT C. KEE
and the quantity in which a product is produced. Equation (1) thereby provides
a more descriptive model of a product’s revenue and cost functions that deter-
mines the economics of its production and sales. Consequently, the CVP
relationship expressed in Eq. (1) enables managers to better estimate the finan-
cial consequences of product mix decisions. Equally important, Eq. (1) enables
mangers to simulate the effect upon a product’s profitability of variation in
its unit-, batch-, and product-level cost and price parameters. Finally, the CVP
relationship may be used to evaluate the economics of changes in batch
size and other operational attributes of a product’s production and marketing
11 activities.
Information frequently developed from CVP analysis to evaluate a proposed
product is the sales quantity needed to break even and that required to earn a
specific level of profitability. To estimate these two quantities, Eq. (1) may be
restated by factoring out Qi and rearranging its terms. The alternative expres-
sion for Eq. (1) may be written
Qi = (⌺jCB,j,i Bj,i + ⌺jCL,j,i + ⌸i) / (Pi ⫺ ⌺jCU,j,i) (2)
In Eq. (2), the breakeven quantity and the quantity needed to earn a specific
level of profitability is determined by replacing ⌸i with zero and the target level
11 of profit, respectively, and solving for Qi. However, solving for Qi is
problematic. Bj,i is restricted to integer values and is a function of the solution
to Eq. (2). Conversely, Qi in Eq. (2) is determined, in part, by the values of
Bj,i required to produce Qi. Consequently, Qi and Bj,i must be determined jointly
to solve Eq. (2).2 An approximate solution to Eq. (2) may be derived by
replacing Bj,i with the ratio Qi/bj,i. Therefore, Eq. (2) may be restated:
Qi = (⌺jCL,j,i + ⌸i) / (Pi ⫺ ⌺jCU,j,i ⫺ ⌺jCB,j,i/bj,i) (3)
While Eq. (3) is relatively easy to solve, the number of batch-level activities
required to produce Qi in Eq. (3) may have fractional values that are not possible
11 to implement in practice. Therefore, the solution to Eq. (3) is only a rough
estimate of the sales quantity needed to produce ⌸i. The non-integer batch-
level activities developed from Eq. (3) may be rounded up to the next highest
integer and then used as the estimated batch-level activities needed to solve Eq.
(2). To ensure that the solution to Eq. (2) is valid, the number of batch-level
activities required to produce Eq. (2)’s solution must be compared to the
estimated Bj,i used to derive its solution. If the estimated and actual Bj,i differ,
then the actual batch activities should be used as the estimated batch-level
activities and used to solve Eq. (2) again.3 This procedure should be repeated
until the estimated Bj,i used to solve Eq. (2) and the number of Bj,i needed to
implement its solution are the same.4
CVP ANALYSIS
A Numerical Example
To illustrate the analysis of a product’s CVP relationship using ABC data,

consider the example provided in Table 1. XYZ, Inc. is a medium-sized firm
with one unit-level activity, assembly, two batch-level activities, set-up and
purchasing, and one product-level activity, engineering. To facilitate discussion,
the number of support and production activities has been limited. However, the
1 principles and concepts discussed in the example are applicable to firms with
a larger number of support and production activities. XYZ, Inc.’s management
is evaluating the economics of manufacturing Product i. In Panel I, a cost driver
rate for the assembly activity was computed by dividing its expected cost of
$4,000,000 by its practical capacity of 500,000 machine hours. The cost driver
rate of $8/machine hour was then multiplied by the standard machine hours
needed to produce Product i to determine its assembly cost per unit. The costs
of batch-level activities, set-up and purchasing, are computed in Panel II. For
example, the cost driver rate for the set-up activity was derived by dividing its
expected cost of $800,000 by its practical capacity of 2,000 set-up hours. The
1 set-up cost per batch was computed by multiplying its cost driver rate of
$400/hour by the standard set-up hours per batch. The unit cost of the set-up
activity was then computed by dividing its batch-level cost by the number of
units in a batch. Purchasing costs per unit were computed in a similar manner.
The cost for the firm’s product-level activity, engineering, was computed by
dividing its expected cost of $3,000,000 by its practical capacity of 2,000 hours.
The cost per engineering hour of $1,500 was multiplied by the 400 hours
required to produce Product i and then divided by the product’s maximum
expected demand of 50,000 units to determine the engineering cost per unit of
$12.00.
1 In the last panel of Table 1, Panel IV, Product i’s activity-based cost is
computed. Direct material and labor costs were traced directly to Product i. The
costs of unit-, batch-, and product-level activities used to produce a unit of
Product i were taken from their computations in Panels I, II, and III, respec-
tively. Product i’s cost was subtracted from its price to determine its profit of
$21 per unit. Based on unit profitability, Product i appears to be relatively
profitable; i.e. it has a profit margin of 27%. However, the information in Panel
IV is insufficient to evaluate the financial consequences of manufacturing
Product i. ABC transforms the costs of all resources into a variable cost with
respect to the structural level at which they are consumed in the production
process. While batch- and product-level costs may be further transformed into
83
84 ROBERT C. KEE
Table 1. XYZ, Inc. Activity-Based Cost For Product i.
Panel I: Unit-Level Activity Assembly

Expected cost $4,000,000
Practical capacity in machine hours 500,000 hours
Activity-cost driver rate $8/hour
Activity-cost driver/unit 2 hours/unit
Cost per unit $16.00
Panel II: Batch-Level Activities Set-up Purchasing

Expected cost $800,000 $600,000
11 Practical capacity 2,000 hours 6,000 purchase orders
Activity-cost driver rate $400/hour $100/purchase order
Activity-cost driver/batch 2 set-up hours/batch 14 purchase orders/batch
Cost per batch $800 $1,400
Batch size 500 units 1,000 units
Cost per unit $1.60 $1.40
Panel III: Product-Level Activity Engineering

Expected cost $3,000,000
Practical capacity 2,000 hours
Activity-cost driver rate $1,500/hour
Activity-cost driver/product 400 hour
11 Cost per product $600,000
Maximum market demand 50,000 units
Cost per unit $12.00
Panel IV: Activity-Based Cost and Price

Direct material (4 lbs @ $5/lb) $20.00
Direct labor (0.5 DLH @ $12/DLH) $6.00
Assembly overhead $16.00
Unit-level cost $42.00
Batch-level cost
Set-up $1.60
11 Purchasing $1.40
Product-level cost
Engineering $12.00
Total activity-based cost $57.00
Price $78.00
Profit $21.00
Maximum market demand in units 50,000
a unit cost, they are not variable with respect to unit-production volume.
Consequently, the volume at which a product is produced plays an important
role in determining its profitability.
Sales Quantity Needed to Break Even and Earn a Target Profit
A starting point for evaluating the CVP relationship for Product i is to compute
the quantity needed to break even and earn a specific level of profitability. To
compute the breakeven quantity for Product i, its activity-based cost in Table
1 and ⌸i = 0 was entered into Eq. (3). This resulted in an approximate breakeven
point of 18,182 units that required 36.364 and 18.182 batches for the set-up
and purchasing activities, respectively. The non-integer set-up and purchasing
batches were then rounded up to 37 and 19, respectively. Next, the integer
1 number of batches for the set-up and purchasing activities, along with Product
i’s activity-based cost and ⌸i = 0, were entered into Eq. (2) to determine a
breakeven quantity of 18,228 units. The number of integer batches required to
produce 18,228 units was the same as the integer number of batches used in
its computation. Therefore, Product i’s breakeven quantity is 18,228 units.
To justify manufacturing a product, it must earn a profit sufficient to compen-
sate the firm for the resources committed to its production. Suppose the firm’s
target profitability for Product i is $400,000. To solve for the quantity of sales
needed to earn $400,000, activity-based costs from Table 1 and ⌸i = $400,000
were entered into Eq. (3). This resulted in an initial estimate of 30,303 units
1 that required 60.606 and 30.303 set-up and purchasing batches, respectively.
Then the non-integer number of set-up and purchasing batches was rounded up
to the next highest integer and entered into Eq. (2). This resulted in a solution
of 30,339 units. The number of set-up and purchasing batches needed to produce
30,339 units was the same as the estimated batches used in its computation.
Therefore, to earn a profit sufficient for the firm to manufacture Product i,
30,339 units must be sold.
Incremental Profit
1 To gain a broader perspective of the economics of producing Product i, the

rate of change in its profitability with respect to a change in its sales must be
determined. The rate of change in a product’s profit is the first derivative of
its accounting income with respect to its sales volume. In a traditional cost
accounting system, the first derivative of the CVP relationship is a product’s
contribution margin per unit. When a product’s costs are modeled with ABC,
its batch-level activities create a step-type cost and profit function. To
calculate the rate of change when a function is evaluated at discrete, rather
than continuous, values, a difference equation, rather than a derivative, is used.
Using a difference equation, the difference in profit for Eq. (1) over the interval
qi is:
85
86 ROBERT C. KEE
⌬ ⌸i = (Pi qi) ⫺ (⌺jCU,j,i qi + ⌺jCB,j,i qi /bj,i).5 (4)
The term ⌬ ⌸i represents the change in profit for a change in sales of volume
qi, where qi was chosen as the smallest quantity for which ⌬ ⌸i would be
uniform for any given value of Qi. This occurs when qi is the lowest common
denominator of the different batch sizes used to produce Product i. Since qi is
measured at the batch level and all costs are variable, ⌬ ⌸i is a batch-level
measure of Product i’s contribution margin.
For Product i, the lowest common denominator for its batch-level activities
11 is 1,000 units. The batch-level contribution margin, or ⌬ ⌸i, computed from
Eq. (4), with a difference interval of 1,000 units, is $33,000, or ($78/unit *
1,000 units) ⫺ ($42/unit * 1,000 units + $800 * 1,000 units/500 units + $1,400
* 1,000 units/1,000 units). Therefore, for every 1,000 additional (fewer) units
of Product i sold, accounting income will increase (decrease) by $33,000.
Product i’s accounting income is the multiple of the difference interval needed
to produce Qi units, times its batch-level contribution margin, less product-level
cost.6 For example, if Product i is produced, but the firm sold zero units, its
income would be (0 * $33,000) ⫺$600,000 or, ⫺$600,000. As sales increase,
the loss of ⫺$600,000 decreases by $33,000 for each additional 1,000 units
11 sold. The loss approaches zero at the breakeven quantity of 18,228 units. After
the breakeven point, profit increases at the rate of $33,000 for each additional
1,000 units sold past break even. As sales of Product i approaches its maximum
market demand, profit reaches its maximum value of $1,050,000, or (50 *
$33,000) ⫺ $600,000.
To view the relationship between profit and sales volume, a profit-volume
graph is given in Fig. 1. The horizontal and vertical axes of the graph depict
sales quantity and profit, respectively. The diagonal line in Fig. 1 reflects the
relationship between profit and sales, where profit was computed using Eq. (1)
with sales incremented in 1,000 units. Using Fig. 1, XYZ’s management can
11 visually examine the range of Product i’s profitability. Equally important, they
can visually identify the sales volume needed to break even as well as the sales
quantity needed to earn a specific level of income. Based on Product i’s expected
sales, the managers of XYZ, Inc. can then estimate its profitability and how far
sales would have to decline for the product to become unprofitable. In effect,
the profit-volume graph in Fig. 1 enables managers to visually evaluate much
of the quantitative information developed with Eqs (1) through (3).
In Fig. 1, profit appears to be a linear function with respect to sales volume.
This is the result of using the difference interval qi as the scale for representing
the relationship between profit and sales volume. However, on a unit basis, the
profit for Product i changes abruptly as each successive batch-level activity is
Profit-Volume Graph, Product i.

1
Fig. 1.
87
88 ROBERT C. KEE
performed. For example, after the first unit is produced, profit rises monotoni-
cally at Product i’s unit-level contribution margin of $36.00 per unit. However,
to produce Unit 501, an additional set-up activity is required at a cost of $800.
The profit for producing Unit 501 is ⫺$764, or its unit-level contribution of
$36 less set-up cost of $800. After Unit 501, profitability again rises monoto-
nically at the rate of $36 for each unit produced between Units 502 and 1,000.
However, Unit 1,001 requires additional purchasing and set-up activities that
result in profit declining $2,164, or the $36 contribution margin of Unit 1,001
less the cost of purchase and set-up activities of $1,400 and $800, respectively.
11 In a similar manner, the profit of Product i rises monotonically at $36 per unit,
except at odd multiples of 500 units plus 1, where it will decline $764 for an
additional set-up activity and at multiples of 1,000 units plus 1, where
profitability will decline $2,164 for the additional purchasing and set-up activ-
ities required to increase production. Therefore, the profit of Product i is a
discontinuous function that increases in a linear manner, except at production
levels where a batch-level activity is performed.
The significance of the discontinuities in Product i’s profit function means
that it would be uneconomical to produce the product in certain production
quantities throughout the range of its market demand. For example, to expand
11 production beyond an odd multiple of 500 units, a set-up must be incurred that
increases cost by $800. Therefore, it would be uneconomical to produce less
than the first 23 units of a new set-up batch since the contribution margin for
less than 23 units of a new batch is less than the additional set-up cost of $800.
Similarly, to expand production beyond a multiple of 1,000 units, purchasing
and accompanying set-up activities would be incurred that increase costs by
$2,200. It would, therefore, be uneconomical to produce less than the first 62
units of a new purchasing batch. Consequently, managers must understand and
incorporate the non-linear nature of a product’s profit function under ABC in
making production-related decisions.
11
Sensitivity Analysis
After computing a product’s profitability, CVP analysis may then be used to

measure its sensitivity to variation in one or more of its underlying parameters.
One of the major sources of variation is a change in a product’s sales demand.
CVP analysis uses the margin of safety and degree of operating leverage to
measure the impact upon a product’s net income to a change in its sales quan-
tity. A product’s margin of safety is the difference between its budgeted and
breakeven sales. For example, if the management of XYZ, Inc. expects sales
of Product i to be 36,000 units and budgets for this level of demand, projected
income would be $588,000. At budgeted sales, Product i’s margin of safety is

17,772 units, or 36,000 units less the breakeven quantity of 18,228 units.
Therefore, the sales of Product i could decline by 49% from its budgeted level
before the product would become unprofitable. The second metric, the degree
of operating leverage, measures the percentage change in profitability for a
percentage change in sales. The degree of operating leverage assumes a linear
cost function. Under ABC, a product’s cost function has discontinuities and is
non-linear. Therefore, the degree of operating leverage is inappropriate and
misleading for cost functions modeled with ABC. If operating leverage is
1 defined as the percentage change in profit for a change in sales quantity, it may
be used to assess the sensitivity of a product’s profitability to a change in
demand. The sales quantity used to compute the operating leverage must be
sufficiently large so that a product’s cost and profit functions are linear. The
smallest quantity for which cost and profit are linear is the lowest common
denominator of a product’s batch-level activities. Consequently, the operating
leverage for Product i at volume Qi for a change in demand of quantity qi may
be stated:
[(Pi qi) ⫺ (⌺jCU,j,i qi + ⌺jCB,j,i qi /bj,i)] ⫼ Qi /qi [(Pi qi) ⫺ (⌺jCU,j,i qi

1 + ⌺jCB,j,i qi /bj,i)] ⫺ ⌺jCL,j,i (5)
Equation (5) is Product i’s batch-level contribution margin divided by its

income, where income is the multiple of the difference interval needed to
produce Qi units, times Product i’s batch-level contribution margin, less its
product-level cost. For example, for Product i’s budgeted sales of 36,000, its
operating leverage is 5.61%, or $33,000 ⫼ [((36,000 units ⫼ 1,000 units)*
$33,000) ⫺ 600,000]. Therefore, for every 1,000 units sold above (below)
budgeted sales of 36,000 units, profit will increase (decrease) by 5.61%. Using
the margin of safety and operating leverage, managers can then evaluate the
1 risk of not breaking even and the sensitivity of Product i to variation from its
budgeted sales.
Another important aspect of sensitivity analysis is to evaluate the impact of
variation in price and cost parameters upon a product’s profitability. For example,
suppose the managers of XYZ, Inc. are concerned about the possibility of
competitors reducing the price for Product i by as much as 10%. To evaluate
the impact on Product i’s profitability to this potential action by competitors,
its price was reduced from $78 to $70.20. Then the new price and the cost
parameters listed in Table 1 were entered into Eqs (3) and (2), respectively, to
derive the new break even and quantity needed to earn a profit of $400,000. A
price reduction of 10% would increase the breakeven quantity from 18,228 to
89
90 ROBERT C. KEE
23,830 units and the quantity needed to earn a target profit of $400,000 from
30,339 units to 39,716 units. In effect, a 10% decrease in price would increase
both the break even and the quantity needed to earn a target profit of $400,000
by 31%. More importantly, the firm would be unable to earn its target profit of
$400,000 at its budgeted sales of 36,000 units. Analysis of Product i’s margin
of safety and operating leverage can be used to further evaluate the sensitivity
of its income to a 10% decrease in sales price. Similar analysis can be used to
evaluate the effect on Product i’s profitability to changes in its unit-, batch-, and
product-level costs.
11
Product and Process Improvement
Approximately 80% to 90% of a product’s life cycle cost is determined during

its development stage (Barfield, Raiborn & Kinney, 1998). Therefore, the
greatest potential for influencing a product’s cost and its resulting profitability
is before, rather than after, it has entered production. ABC provides a detailed
model of the firm’s support and production activities and how their services
and costs will be used in manufacturing a product. This information may be
integrated into CVP analysis to evaluate the economic implications of alterna-
11 tive product and process designs. For example, suppose the managers of Product
i are concerned about the potential impact of competitors decreasing their prices
for Product i and the adverse effect it would have upon the product’s
profitability. The engineers for Product i have proposed enhancing its quality
to mitigate the effect of a price decrease. This would require expanding
engineering resources from 400 to 480 hours to increase the product’s tech-
nical specifications and adding 20% more assembly and labor resources to
achieve the higher level of product quality. The firm’s marketing department
estimates that enhancing the quality of Product i would enable the firm to
increase its sales by 9,000 units and eliminate the impact of competitors
11 lowering their prices for Product i.
The proposed redesign of Product i changes its profit structure dramatically.
First, the additional assembly and labor resources increase unit-level cost by
$4.40 and decreases the batch-level contribution margin from $33,000 to
$28,600 per 1,000 units. Second, the additional engineering hours increase
product-level cost by $120,000. Third, product improvement will increase sales
by 9,000 units relative to what they would have been prior to product improve-
ment. The increases in the unit- and product-level costs increase the break even
from 18,228 to 25,228 units along with the quantity needed to earn the target
income of $400,000 from 30,339 to 39,215 units. The additional sales of 9,000
units increases budgeted sales from 36,000 to 45,000 units. However, the profit
on budgeted sales of 45,000 units for the product improvement is $567,000, or

$21,000 less than the profit on the budgeted sales of 36,000 units for the
original product. The sales quantity at which the firm would be indifferent
between product redesign and the original product is 31,227 units before and
40,227 units after the improvement; i.e. the sales after product improvement
will be 9,000 units higher than sales without the improvement.7 In effect,
improving Product i makes it more profitable below 40,227 units but less
profitable above this sales quantity. Consequently, XYZ’s management is
confronted with reduced profitability at budgeted sales of 45,000 units, but lower
1 susceptibility to the influence of competitors decreasing their prices for Product
i. Therefore, the managers of XYZ, Inc. must evaluate whether the reduction
in profitability for Product i’s budgeted sales with the proposed product improve-
ment is worth the reduction in its risk.
One of the other primary uses of ABC is to stimulate process improvement
(Swenson, 1995). Analysis of the individual activities and how their services
and costs are used in manufacturing a product can be used to identify activi-
ties where process improvement is needed and for identifying activities where
process improvement has the greatest potential for enhancing profitability. For
example, suppose the management of XYZ, Inc. is concerned about reducing
1 the cost of Product i. An analysis of Panel IV in Table 1 indicates that assembly
is the activity where the largest component of Product i’s cost is incurred. A
preliminary review of the assembly activity suggests that it can be streamlined
with the potential to reduce the machine hours used to manufacture Product i
by 25%. The cost of reconfiguring the assembly activity and retraining workers
to be more productive with the new process is estimated at $100,000. While
the reconfiguration of the assembly activity and workers’ training will benefit
other products, management insist that it be evaluated based on its financial
impact on Product i.
The proposed process improvement changes the mix of resources required
1 to manufacture Product i as well as the relationship between its profitability
and sales volume. The reduction in assembly time decreases unit-level cost for
manufacturing Product i by $4 while increasing its batch-level contribution
margin from $33,000 to $37,000 per 1,000 units. Conversely, assembly recon-
figuration and worker training will increase the product-level cost by $100,000.
The impact of these two changes increases the breakeven point from 18,182 to
18,925 units but reduces the quantity needed to earn a target profit of $400,000
from 30,339 to 29,750 units. The indifferent point between the firm’s current
production process and the proposed improvement is the additional product-
level cost of $100,000, divided by the decrease in unit-level cost of $4 per unit,
or 25,000 units. Since the indifference point is between the original breakeven
91
92 ROBERT C. KEE
point and the quantity needed to earn $400,000, the breakeven point for Product
i with the proposed process improvement will increase while the quantity needed
to generate a profit of $400,000 will decrease. The increase in the batch-level
contribution margin for process improvement means that income will increase
by $4,000 for each additional 1,000 units sold in excess of 25,000 units.
Therefore, the profit for budget sales of 36,000 units is expected to increase by
$44,000 to $632,000. Further analysis of Product i’s margin of safety and oper-
ating leverage can be used to evaluate the sensitivity of its profitability to the
proposed process improvement. Other proposals for improving the processes
11 used to manufacture Product i can be evaluated in a similar manner.
SUMMARY AND SUGGESTIONS FOR FUTURE

RESEARCH
The CVP relationship expressed in Eqs (1) through (3) represents an economic
model of a product’s revenue and cost functions. Using these equations,
managers can evaluate the range of a product’s profitability as well as identify
the sales quantities needed to meet specific financial objectives. The batch-level
contribution margin and operating leverage derived in Eqs (4) and (5) further
11 enables managers to understand the rate of change in a product’s profitability
with respect to a change in its sales demand. This information provides insights
into the behavior of profitability as sales change as well as the impact upon
earnings of sales deviating from budgeted levels. The economic model of a
product’s revenue and cost functions also provides a means for estimating the
change in profit for variation in one or more of its financial and operational
parameters. Finally, the CVP model offers a means for evaluating the financial
effects of product and process improvement alternatives identified with ABC.
This analysis enables managers to determine the most economical means of
designing and manufacturing a product. The CVP relationships expressed in
11 Eqs (1) through (5) provide a powerful analytical framework for evaluating the
economic attributes of production-related decisions.
The CVP model based on ABC in this article may be extended along several
potentially useful avenues. First, CVP analysis is typically implemented using
an accounting measure of profitability. However, one of the deficiencies of
accounting income is that it ignores the cost of capital. Consequently, the
CVP model should incorporate the cost of capital that will be committed to a
proposed product as a cost similar to the costs of other resources, such as
direct material, labor, and overhead. This enables managers to better estimate
the value created or destroyed from producing a product. Second, CVP analysis
incorporating ABC should be extended to evaluating multiple products. For
example, a new product may be produced that is part of a product line and
may complement and/or compete with one or more of these products. Under
these circumstances, a new product cannot be evaluated in isolation. Rather, it
should be considered as part of the larger product mix whose sales and costs
it affects and by which it is also affected. Finally, the CVP model based on
ABC should incorporate as many facility-level costs as possible. Facility-level
activities, such as accounting, human resource management, and information
systems, furnish services that are used indirectly in producing the firm’s
products. Consequently, their costs should be traced to products in the same
1 way as production-related activities, such as purchasing, set-up, and engineering
costs. CVP analysis of ABC that includes facility-level cost enables managers
to better understand the economics of producing the firm’s products and thereby
to make more efficient resource allocation decisions.
NOTES
1. Like most applications of CVP analysis, this article assumes that a product’s produc-
tion and sales are equivalent each period. Given the emphasis of management
philosophies, such as just-in time and theory of constraints, to minimize inventory, this
assumption is a realistic description of many firms’ operations today. The paper also
1 assumes that revenue is a linear function with respect to sales volume.
2. In computing break even using ABC, Metzger (1993), Blocher, Chen and Lin
(1999), and Hansen and Mowen (2000) make Bj,i in Eq. (2) a constant. Blocher, Chen
and Lin (1999) extend their analysis by evaluating the impact of varying the number of
units produced by a batch activity. They use an equation similar to Eq. (3) to compute
the breakeven quantity and then round non-integer batches up. While this simplifies the
computation of the breakeven quantity, it also introduces errors into its computation.
For example, the problem used by Blocher, Chen and Lin (1999) for a batch size of
100 units gives a breakeven quantity of 2,513 units. However, 2,515 units are needed
in their example to earn a profit of zero. While this error is trivial, as the number of
batch-level activities, the cost of batch-level activities relative to other cost, and differ-
ences in the batch sizes of batch-level activities increase, errors in computing break even
1 can become more substantial.
3. The recursive algorithm used to solve Eq. (2) relies on there being a unique set
of values denoted by Qi* and Bj,i* that satisfies the first-degree relationship expressed
in Eq. (2). If the estimated Bj,i used to solve Eq. (2) is less than Bj,i*, then the Bj,i
needed to implement the solution will be greater than the estimated Bj,i. The estimated
Bj,i cannot equal the actual Bj,i, by definition, nor can it be greater than the actual Bj,i
since this would preclude a solution. Conversely, if the estimated Bj,i used to solve Eq.
(2) is greater than Bj,i*, the actual Bj,i needed to implement the solution will be less
than the estimated Bj,i. The rationale for this is similar to the argument presented for
the case when the estimated Bj,i used to solve Eq. (2) is less than the Bj,i*. Consequently,
using the recursive algorithm with the Bj,i estimated from Eq. (3) to solve Eq. (2) will
result in a solution that converges to Qi* and Bj,i*.
93
94 ROBERT C. KEE
4. This step may be necessary when there is a significant difference in the sizes of
batch-level activities. However, even when there are significant differences in the sizes
of batch-level activities, the number of iterations required to solve Eq. (2) should be
minimal.
5. A difference equation is defined for the function y = f(x) as ⌬y = f(x + h) ⫺ f(x),
where ⌬ and h are the difference operator and difference interval, respectively. The
difference equation for Eq. (1) is ⌬⌸i = f(Qi + qi) ⫺ f(Qi), where qi was chosen as the
smallest quantity for which ⌬⌸i would be uniform for any given value of Qi. This occurs
when qi is the lowest common denominator of the different batch sizes used to produce
Product i. In order to take the difference equation, Bj,i was replaced with the equivalent
term Qi/bj,i. For a more in-depth discussion of difference equations, see Brand (1966) and
11 Goldberg (1958).
6. This formula requires that Qi is an integer multiple of qi. Otherwise, Eq. (1) should
be used to measure a product’s accounting income.
7. To solve for the indifference point, Qi and (Qi + 9,000) were defined as the sales
quantities before and after the proposed product improvement, respectively. Each sales
variable and its related price and cost data were entered into Eq. (1). At the indiffer-
ence point, the profit of each alternative is equivalent. Therefore, the profit equation for
each alternative was set equal to each other and solved for Qi. This resulted in a
solution of 31,227 units for Qi and 40,227 units for (Qi + 9,000).
REFERENCES
11
Barfield, J., Raiborn, C., & Kinney, M. (1998). Cost Accounting: Traditions and Innovations (3rd
ed.). Cincinnati, OH: South-Western College Publishing.
Blocher, E., Chen, K., & Lin, T. (1999). Cost Management: A Strategic Emphasis. Boston, MA:
Irwin McGraw-Hill.
Brand, L. (1966). Differential and Difference Equations. New York, NY: John Wiley & Sons, Inc.
Cooper, R. (1990). Cost classification in unit-based and activity-based manufacturing cost systems.
Journal of Cost Management, 4, 4–14.
Goldberg, S. (1958). Introduction to Difference Equations. New York, NY: John Wiley & Sons,
Inc.
Guidry, F., Horrigan, J., & Craycraft, C. (1998). CVP analysis: A new look. Journal of Managerial
Issues, 10(1), 74–85.
11 Hansen, D., & Mowen, M. (2000). Management Accounting (5th ed.). Cincinnati, OH: South-
Western College Publishing.
Horngren, C., Foster, G., & Datar, S. (2000). Cost Accounting: A Managerial Emphasis (10th ed.).
Upper Saddle River, NJ: Prentice Hall.
Kaplan, R. (1992). In defense of activity-based cost management: ABC models can play many
different roles to support a company’s operational improvement and customer satisfaction
programs. Management Accounting, 74(5), 58–63.
Kaplan, R., & Cooper, R. (1998). Cost & Effect: Using Integrated Cost Systems to Drive Profitability
and Performance. Boston, MA: Harvard Business School Press.
Metzger, L. (1993). The power to compete: The new math of precision management. National
Public Accountant, 38(5), 14–32.
Swenson, D. (1995). The benefits of activity-based cost management to the manufacturing industry.
Journal of Management Accounting Research, 7, 167–180.
AN EMPIRICAL STUDY OF THE
APPLICATION OF STRATEGIC
MANAGEMENT ACCOUNTING
TECHNIQUES
Karen S. Cravens and Chris Guilding
ABSTRACT
A resurgence of interest in management accounting has highlighted how

management accounting systems can be tailored to support strategic man-
agement (Langfield-Smith, 1997). Despite growing commentary concerned
with strategic management accounting (SMA) practice (Lord, 1996; Tomkins
& Carr, 1996), there exists little empirical evidence appraising the degree to
which individual SMA practices are applied. This study appraises the
frequency and perceived usefulness of SMA. An analysis of underlying themes
apparent in the SMA constructs is conducted together with an investigation
into dimensions of competitive strategy and organizational performance
relating to SMA application rates. Four underlying themes in SMA have been
identified: “costing”, “competitor accounting”, “strategic accounting” and
“brand value accounting”. Competitor accounting is a predominant theme in
the most widely used SMA practices. Firms following strategies of research
and development leadership or broad market coverage use SMA practices to
a relatively high degree. Evidence of a positive relationship between SMA
application and company performance is also presented.

ISBN: 0-7623-0825-7
95
96 KAREN S. CRAVENS AND CHRIS GUILDING
INTRODUCTION
Until relatively recently, there was a tendency to view the link between manage-
ment accounting and strategy as somewhat indirect and tenuous. Porter’s (1980,
1985) works typify this view as they depict management accounting as
concerned primarily with product or service cost determination. In fact, much
of the focus of management accounting illustrates a subservience to the rule-
based orientation of financial accounting where an emphasis on scorekeeping
and historical assessment predominates. The recent past reflects something of
11 a management accounting renaissance, however. Kaplan and Johnson (1987),
among others, highlight the misuse of management accounting and helped to
bring about a resurgence in the application of accounting to more strategic
issues (Johnson, 1992).
In light of this development, the paucity of empirical research concerned with
the use of strategically-oriented management accounting techniques is surprising.
The minimal extent to which researchers have modified their empirical inquiries
in the face of this changed management accounting orientation is evident from
Shields (1997) who notes the preponderance of management accounting research
oriented towards operational and short-term decisions. This apparent hesitancy on
11 the part of the management accounting research community provides the primary
motivation for this empirical study. The objectives of the study are:
(1) to appraise adoption rates of strategically-oriented management accounting
practices in the United States (U.S.);
(2) to assess U.S. practitioners’ perceptions of the extent to which strategically-
oriented management accounting practices could be helpful to their
organization;
(3) to explore for underlying factors in strategically-oriented management
accounting practices;
(4) to explore for associations between usage of strategically-oriented manage-
11
ment accounting practices and dimensions of competitive strategy; and
(5) to explore for associations between use of strategically-oriented manage-
ment accounting practices and perceived organizational performance.
The remainder of the paper is structured as follows. In the context of providing
an overview of strategic management accounting, the next section notes the
problematical nature of defining the construct. Following this, an outline of
management accounting techniques that may be classified as strategic manage-
ment accounting is provided. In subsequent sections, the research method is
described and then the results of the empirical study are presented. The
concluding section considers the implications of the study.
The Application of Strategic Management Accounting Techniques 97
WHAT IS STRATEGIC MANAGEMENT ACCOUNTING?

Shields (1997) notes the importance of a line of research investigating “conse-
quences of strategic ‘fit’ between management accounting mechanisms, strategy
variables, and other organizational design characteristics” (1997, 25). A valu-
able backdrop to this research theme is provided by Dent’s (1990) theoretical
review of: (1) the relationship between the management control system and
strategy; (2) how management accounting relates to the actual process of deci-
sion making in an organization; and (3) the effect that the management control
1 system might have on strategic change in an organization. Empirical studies
that fall into the “strategic fit” vein of contingency research noted by Shields
link various types of strategies to the design of control systems (e.g. Abernethy
& Guthrie, 1994; Archer & Otley, 1991; Govindarajan & Gupta, 1985;
Merchant, 1985; Simons, 1987).1 In these studies, the primary unit of analysis
was either the management control system or the management accounting
control system. This study adopts a less aggregated focus as we are not
concerned with the entire system, but with the individual techniques that
comprise strategic management accounting (SMA).
It should be acknowledged, however, that the particular interest shown in the
1 antecedents and implications of activity-based costing signifies that some
contingency research has been conducted at the level of a specific strategic
management accounting practice. Gosselin (1997) investigated the association
between strategy and organizational structure in terms of activity-based costing.
He found that strategy affects activity-based costing adoption as well as imple-
mentation. Chenhall and Langfield-Smith (1998) found that activity-based
costing ranked relatively low as a factor affecting organizational performance.
Ittner et al. (1997) also investigated activity-based costing by exploring the
revenue implications of activity-based cost hierarchies. They found that cost
hierarchies provided explanatory power for revenue changes.
1 In a manner analogous to the action-profit-linkage model developed by
Epstein et al. (2000), pursuit of this study’s fourth and fifth objectives can be
considered from a macro-perspective. Epstein et al. (2000) modelled the
relationship between corporate strategy and corporate profitability in terms of
firm actions that generate a delivered product or service that ultimately affects
consumer actions. Underlying this study’s fourth objective is the view that
dimensions of competitive strategy have the propensity to affect the adoption
of strategic management accounting practices; and underlying the fifth objec-
tive is the view that strategic management accounting adoption has the
propensity to affect organizational performance. Following the lead provided
by Epstein et al.’s action-profit-linkage model, these relationships are depicted
97
by the directional arrows linking the three boxes presented in the upper portion
of Fig. 1. These relationships have been explored in much of the “strategic fit”
literature commented upon by Shields (1997). The relative novelty of this study
becomes particularly apparent, however, when the way in which strategic
management accounting has been operationalized, which is noted in the lower
portion of Fig. 1, is considered. Rather than appraising strategic management
accounting as a holistic system, the perspective taken in this study has involved
an attempt to identify what particular practices may be seen to comprise strategic
management accounting. The lower portion of Fig. 1 also provides an overview
11 of the manner in which competitive strategy and organizational performance
have been operationalized.
Relative to the interest shown in the relationship between strategy and
management accounting, the absence of a literature concerned with distilling
what practices comprise SMA is striking. This may be partially attributable to
SMA being relatively under-defined (Tomkins & Carr, 1996). This problem
signifies that prior to considering what practices comprise SMA, attention needs
to be directed towards establishing what constitutes “SMA”.2 This issue relates
to the third objective of the study, which signifies that we are not only concerned
with the relationships depicted in the upper portion of Fig. 1, we are also
11 concerned with relationships between the variables operationalized as consti-
tuting strategic management accounting practice. Again, a parallel can be seen
with Epstein et al. (2000) who noted that while their model comprised groups
of variables, relationships between variables appearing within the same group-
ings can be expected.
Defining SMA is complicated by the ambiguous notion of strategy (Rumelt,
1979; Terreberry, 1968). While the division between tactical and strategic
dimensions of management is widely recognized (Mintzberg, 1988), Porter
(1996) believes that many activities that are identified as strategic would be
better classified as operational. This strategic versus operational orientation
11 clearly provides a problem when attempting to refine the notion of SMA.
Techniques classified as operational have been widely criticised for a focus on
“tactical, operational and short-term decisions” (Shields, 1997, 25) and an
inward-looking, cost minimisation orientation (Wilson, 1988). It would thus
appear appropriate to view SMA as encompassing those accounting techniques
contrasting with this orientation (i.e. techniques that have an externally-oriented
or long-term focus). This position is supported by work highlighting the external
and long-term orientation of strategy (Chandler, 1962; Mintzberg, 1988; Pearce
& Robinson, 1991; Stahl & Grigsby, 1991). Defining SMA in accordance with
its departure from conventional management accounting’s conventional internal
and cost minimization focus also represents the confluence of ideas apparent in
1
The Application of Strategic Management Accounting Techniques

99
Fig. 1. The Relationship Between Competitive Strategy, Strategic Management Accounting Application and Organizational
99
Performance.
the Bromwich (1990) and Simmonds (1981) commentaries which highlight the
external focus of SMA and also Wilson’s (1991) work which emphasises the
future focus of SMA.
WHAT TECHNIQUES COMPRISE STRATEGIC

MANAGEMENT ACCOUNTING?
Distillation of a set of techniques that comprise SMA is bound to involve a degree

of subjectivity. As just noted, in this study, we include only those practices
11 highlighting an external or future focus. Fifteen techniques have been identified
as qualifying as SMA practices according to these criteria. The practices
comprise the following: activity-based costing, attribute costing, benchmarking,
brand valuation budgeting and monitoring, competitor cost assessment,
competitive position monitoring, competitor performance appraisal, integrated
performance measurement, life cycle costing, quality costing, strategic costing,
strategic pricing, target costing and value chain costing. Guilding et al. (2000)
provide an international comparison of the relative usage of several of these
practices These practices have been operationalized using the definitions
provided in Appendix A which was included as a glossary within the body of
11 the questionnaire used for data collection.
Activity-based costing (management). The way in which activity-based costing

can serve to support strategic management is described by Palmer (1992) and
is evident in the work of Cooper and Kaplan (1988a; b) and Shank and
Govindarajan (1989). Activity-based costing is distinguished from conventional
approaches by a focus on activities as the fundamental cost objects (Cooper,
1991). Application of this costing philosophy has triggered accountability
attached to activities necessary to create a product or provide a service (Forrest,
1996). Case studies concerned with activity-based costing have highlighted how
11 the exercise can affect strategic decision making even though the process begins
with activities internal to the organization. With a more strategic focus, activity-
based costing can identify areas where competitive advantage can be secured.
Attribute costing. Bromwich (1990) provides a discussion of the benefits that can
arise from treating product attributes as cost objects. Product attributes are the
bundle of features accounting for a product’s appeal in the market place. It is
this marketing (or external) orientation of the cost object in question that
highlights why attribute costing may be considered as an example of SMA.
Attribute costing can forge a link between the accounting system and customer
perceptions. Attributes may include operating performance variables such as
reliability and warranty arrangements, the degree of finish and trim, as well as
service factors such as assurance of supply and after sales service. As a
consequence, attribute costing is a relatively dynamic form of costing that can
be conducted to provide information for a particular strategic decision. It can
help organizational deliberations concerned with how a particular “unique mix
of value” (Porter 1996, 64) can be delivered. Attribute costing can support
the various types of new positioning strategies (variety-based, needs-based,
or access-based) advocated by Porter (1996) in the pursuit of competitive
advantage.
1
Benchmarking. Benchmarking illustrates how an organization can improve
existing processes to a level necessary to yield strategic benefits in terms of
performance relative to competitors. There are various types of benchmarking
(Miller et al., 1992), but the most common type results in determining how
to improve a process by using an ideal often provided by sources external to
the firm.
Brand valuation budgeting and brand valuation monitoring. Brand valuation is

concerned with accounting recognition of a marketing asset that in most
1 commercial scenarios has a long life expectancy. This approach thus fosters a
long-term perspective in brand management (Aaker, 1991, 1996; Kapferer,
1992; Keller, 1993). Recognition of brand values by an accounting system
supports a perception of brand-related expenditure as an investment rather than
an expense. This novel accounting approach, which falls outside U.S. accepted
financial accounting standards, may be of particular significance in companies
with high marketing budgets. The output of marketing spending is rarely
accorded the status of a capitalized asset (Srivastava et al., 1998), and support
for such intangible marketing assets is likely to be under funded (Aaker &
Jacobsen, 1994; Guilding & Pike, 1990). Brand valuation can yield managerial
1 implications in terms of assisting management with budgeting (Guilding &
Moorhouse, 1992) and more strategic elements of brand management (Guilding
& Pike, 1994a, b). In particular, brand valuation has the potential to counter a
short-term focus and encourage more of a long-term or strategic approach in
brand management (Kapferer, 1992, 269; King, 1989). Slater et al. (1997)
discuss the importance of brand valuation in helping match the strategy of firms
characterized as “brand champions” to their control systems.
Competitive position monitoring. This technique involves appraising trends

with respect to sales, market share, volume and unit costs in terms of major
competitors (Simmonds, 1981). This externally-focused technique allows the
101
organization to assess its own position relative to main competitors and to

formulate strategy accordingly. Simmonds describes how this technique can be
used to identify situations such as increasing marketing expenditures to generate
an improved competitive position. Rather than indicating a stronger overall
position for the organization, the financial accounting depiction of this scenario
would indicate a decreased level of profitability. Simmonds believes that the
shortcoming of this depiction would be countered if the accountant also reported
the organization’s improved competitive position. In connection with data collec-
ted in New Zealand, Guilding (1999) found that competitive position monitoring
11 was the most widely used of competitor-focused accounting practices.
Competitor cost assessment. This practice differs from the above technique in
terms of a specific concentration on the cost structures of competitors. There
are many commentaries advocating competitor cost assessment as an accounting
technique that can provide a more complete appreciation of a competitor’s
strategic decision making environment (Bromwich, 1990; Jones, 1988; Porter,
1985; Simmonds, 1981; Ward, 1992). An improved understanding of the likely
actions of a competitor can improve management decision making on such
fundamental issues as what type of products or services can be provided and
11 how positioning strategies might be achieved (Porter, 1996).
Competitor performance appraisal. This practice differs from the two above
competitor-based approaches by an emphasis on the interpretation of published
financial statements (Moon & Bates 1993). Moon and Bates feel that the account-
ing literature concerned with competitor performance appraisal has ignored the
insight that can be gained with an appropriate analysis of financial statements.
They promote an analytical framework to be applied to published statements as
part of an assessment of competitors’ key sources of competitive advantage.
11 Integrated performance measurement. Cross and Lynch (1989) and Nanni et

al. (1992) refer to integrated performance measurement systems. Nanni et al.
view these measurement systems as concerned with acquiring “performance
knowledge and employing it operationally at every step in the strategic manage-
ment cycle” (1992, 9). Integrated performance measurement systems typically
focus on customer requirements and encompass non-financial measures. These
systems highlight market orientation as a means to achieve sustainable
competitive advantage (Narver & Slater, 1990). An example of an integrated
performance measurement system might involve all organizational departments
monitoring their achievements on factors critical to securing customer
satisfaction (e.g. quality, delivery, process time and cost). The operationalization
of these measures is dependent on the nature of the department’s activity.

Traditional management accounting approaches tend to adopt the same
financial measures in all departments. Actions prompted by such measurement
systems are not always consistent, however, with promoting a unified strategic
thrust. Nanni et al. (1992) claim that the implementation of an integrated perfor-
mance measurement system moves an organization’s departments closer to a
coordinated, strategic thrust.
Life cycle costing. This practice invokes a long-term accounting perspective as

1 it considers the total cost of a product or service from inception through to
maturity and decline (Berliner & Brimson, 1988; Shields & Young, 1991;
Susman 1991; Wilson 1991). Commentaries on this costing perspective under-
line linkages with strategy formulation and implementation and also note that
it might provide a useful counter to short-term management tendencies.
Quality costing. Quality assurance has developed dramatically as a strategically

significant dimension of competitive performance. Developing an accounting
system to appropriately support the pursuit of quality can be seen as a strategi-
cally oriented accounting action (Simpson & Muthler, 1987; Heagy, 1991; Carr
1 & Tyson, 1992). A widely-acknowledged perspective on quality costing involves
classifying and monitoring costs according to four categories: prevention,
appraisal, internal failure and external failure (Heagy 1991).
Strategic costing. Strategic costing, which is sometimes referred to as strategic

cost management, is included as a strategic management practice following
Shank and Govindarajan’s (1989) suggestion that managerial accounting has
progressed towards “strategic accounting” by means of strategic costing. This
type of costing is distinct from conventional inwardly-focused accounting
approaches due to the explicit consideration of strategy and the pursuit of long-
1 term competitive advantage in cost management (Grundy, 1996; Shank &
Govindarajan, 1988, 1989, 1991, 1992, 1993). Strategic costing recognizes
marketing concepts such as product positioning and market penetration, rather
than applying the conventional “relevant costing” approach which suffers from
a failure to recognize long-term marketing implications of the decision at hand.
Strategic pricing. Strategic pricing expands the conventional cost-based

accounting approach to pricing, with its internal and historical focus, by consid-
ering competitive and strategic issues relevant to the pricing decision from a
demand perspective (Jones, 1988; Simmonds, 1981, 1992). This practice
includes evaluating competitors’ reactions to price changes, price elasticities for
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consumers, market growth potential, and economies of scale and experience.

Foster and Gupta (1994) found that management accounting plays a key role
in pricing decisions and therefore the potential of strategic pricing should not
be underestimated.
Target costing. The basic concept of target costing involves producing a product
or service at a cost that achieves a specified level of target profit (Monden &
Hamada, 1991; Morgan, 1993; Sakurai, 1989). The strategic orientation of this
approach is evident from consumer and competitive factors implicit when deter-
11 mining the desired cost. Costs must be contained to allow a price to be set which
can yield a degree of market entry consistent with a target level of profitability.
Instead of internal factors driving the price charged (cost plus pricing) target
costing signifies that external factors are determining allowable cost levels.
Value chain costing. Porter (1985) developed the value chain model in his influ-
ential work on competitive advantage. This model involves viewing the series of
activities that occur between initial design of a product and its distribution to
consumers as comprising links in a chain. Shank and Govindarajan (1991, 1992)
augmented Porter’s work by considering the accounting implications arising
11 from adopting the value chain perspective. Value chain costing builds on the
value chain framework by analyzing how greater economies and efficiencies may
result along the various linkage points that comprise a particular organization’s
value chain. These points include both internal (inter-departmental) and external
(supplier as well as customer) links in the value chain.
RESEARCH METHOD
Sampling Procedures
11 Data were collected using a mailed questionnaire survey. An initial sample of

937 was drawn from Standard & Poor’s CD Disclosure of the largest U.S.
publicly-traded firms.3 The final sample was reduced to 920 firms due to
incorrect mailing addresses. Questionnaires were mailed by name to the
individual noted as “Chief Accountant”, “Controller”, “Chief Financial Officer”,
or “Treasurer” for each sample firm. Five individuals indicated a corporate
policy prohibiting completion of questionnaires, and these firms were removed
from the sample reducing the size to 915 firms (Pearce & Zahra, 1991). A
further eight individuals returned the questionnaires noting that they would not
respond. The first mailing resulted in 82 usable responses; the follow-up mailing
yielded 40 additional responses. Two of the questionnaires were received after
the data were analyzed and were not included. Thus, the overall usable response
rate was 13% (120/915).
To estimate possible non-response bias, Kolmogorov-Smirnoff tests were
conducted to investigate for differences in the responses provided by early and
late respondents (Armstrong & Overton, 1977). Significant differences (p < 0.05)
were not noted for any of the questions. While this suggests that non-response
bias is not a significant threat to the validity of the study, the potential of the data
being biased should be acknowledged. Accountants in firms that employ SMA
practices to a relatively high degree may be more likely to respond than those in
1 firms that employ SMA practices to a relatively low degree.
Variable Measurement
Measurement of the degree to which the various SMA practices were used was
achieved by posing the question: “To what extent does your organization use
the following practices?” Immediately following this question, the 15 SMA
practices were listed together with a Likert-type scale ranging from “1” (not at
all), to “7” (to a great extent). Similarly, to measure respondents’ perceptions
of the extent to which strategic management accounting practices could be
1 helpful to their organization, the following question was posed: “To what extent
do you believe the following practices could be helpful to your organization?”
Following this, the fifteen practices together with the same Likert-type scales
were provided.
With respect to competitive strategy, eight sub-dimensions based on Porter
(1985) have been identified. The eight sub-dimensions encompass importance
attached to research and development (R&D), product quality, product tech-
nology, product range, service quality, price level, advertising expenditure level,
and market coverage. Table 1 provides an overview of the eight measures and
also descriptive statistics pertaining to each.
1 Eight measures of organizational performance were selected comprising
two distinct benchmarks of achievement. With respect to the first benchmark,
respondents were asked: “Compared to your major competitor, how well has
your company performed in the following areas during the past 24 months?”
Immediately after this question, the following four dimensions of performance
were listed: sales volume, market share, profitability, and customer satisfaction
(Narver & Slater, 1990). Responses were recorded on a Likert-type scale ranging
from “1” (much worse) to “5” (much better). With respect to the second bench-
mark, the same question (combined with the same four performance dimensions)
was employed, except that the phrase “company/business objectives” was
inserted in place of “major competitor”.
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Table 1. Measures of Competitive Strategy – Descriptive Statistics.
Scale Used on Questionnaire Mean Std. Dev.
R&D Follower 1 2 3 4 5 R&D Leader 3.27 1.16

Low Product Quality 1 2 3 4 5 High Product Quality 4.28 0.70
Low Technology Products 1 2 3 4 5 High Technology Products 3.62 0.98
Narrow Range of Products 1 2 3 4 5 Broad Range of Products 3.58 1.07
KAREN S. CRAVENS AND CHRIS GUILDING

Low Quality Services 1 2 3 4 5 High Quality Services 4.36 0.79
Low Prices 1 2 3 4 5 High Prices 3.31 0.93
Low Advertising Expenditures 1 2 3 4 5 High Advertising Expenditures 2.76 1.01
Narrow Market Coverage 1 2 3 4 5 Broad Market Coverage 3.66 1.00
For each of these sub-dimensions of competitive strategy, respondents were asked to “Indicate the business strategy implemented by your company
to achieve an advantage over competitors (circle the number that most closely corresponds to your business strategy)”.
RESULTS
Table 2 presents the descriptive statistics for both the usage levels and perceived
usefulness of the fifteen SMA practices. The practices are presented in
descending order of usage, with means ranging from 4.93 (competitive posi-
tion monitoring) to 2.35 (brand value budgeting). Mean usage scores at or above
the midpoint of the scale are evident for six of the fifteen practices. A similar
ranking is evident with respect to the perceived usefulness of the practices.
However, mean scores are higher and only three practices record mean scores
1 below the mid-point of the measurement scale.4
Underlying Themes Within SMA
Recall that the third objective of the study concerned exploring for underlying
themes in strategic management accounting practices. In pursuit of this objec-
tive, a principal components factor analysis of the usage levels of the fifteen
practices was performed. Table 3 details the results of this analysis with four-
teen of the management accounting practices comprising four factors.
Benchmarking did not load on any of the factors. All of the eigenvalues are
1 above the suggested minimum of 1.0 (Sharma, 1996).
This analysis reveals a set of intuitively appealing underlying themes in the
SMA practices. The first factor appears to be closely associated to costing tech-
niques; the word “costing” appears in all of the items loading on this factor.
The second factor appears to be associated with competitor accounting; three
of the four items loading on this factor contain the word “competitor” or
“competitive”. The third factor may be viewed as relating to the notion of
strategic accounting; both items loading on this factor contain the word
“strategic”. The unifying theme in the fourth factor is brand value accounting.
When the underlying theme of the “costing factor” is considered, it would
1 appear that an inwardly-focused, rather than an outwardly-focused, theme
predominates. Costing is essentially an inwardly-focused activity. Close
examination of the operationalization of the SMA practices that load most
heavily on the costing factor supports this view (see Table 1).5 Further
interpretative insight into the nature of this result may be derived by drawing
on Porter’s (1996) dichotomization between management activity relating to
operational effectiveness and activity concerned with strategic positioning. In
the context of Porter’s dichotomy, it would appear that the costing factor is
more closely aligned with the promotion of operational effectiveness, rather
than a quest for competitive advantage through appropriate strategic positioning.
While achieving improvement in operational effectiveness is no doubt desirable,
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Table 2. Descriptive Statistics of Strategic Management Accounting Practices.
Use Perceived Usefulness
Components of Strategic Possible Actual Std. Actual Std.
Management Accounting Range* Range* Mean Dev. Range* Mean Dev.
Competitive position monitoring 1–7 1–7 4.93 1.66 1–7 5.79 1.38
Benchmarking 1–7 1–7 4.59 1.60 1–7 5.49 1.45
Competitor performance appraisal 1–7 1–7 4.50 1.75 1–7 5.44 1.64
Strategic pricing 1–7 1–7 4.36 1.96 1–7 5.75 1.40

Competitor cost assessment 1–7 1–7 4.09 1.77 1–7 5.41 1.46
Integrated performance measurement 1–7 1–7 4.00 1.75 1–7 5.37 1.59
Activity–based costing 1–7 1–7 3.54 1.85 1–7 5.03 1.74
Strategic costing 1–7 1–7 3.43 1.84 1–7 5.05 1.62
Target costing 1–7 1–7 3.19 1.84 1–7 4.81 1.86
Value chain costing 1–7 1–7 3.15 1.86 1–7 4.67 2.02
Quality costing 1–7 1–7 3.07 1.91 1–7 4.59 1.88
Monitoring brand values 1–7 1–7 2.88 1.86 1–7 3.97 1.84
Life cycle costing 1–7 1–7 2.73 1.76 1–7 4.44 1.92
Attribute costing 1–7 1–6 2.63 1.54 1–7 3.83 1.73
Brand value budgeting 1–7 1–7 2.35 1.68 1–7 3.94 1.91
* Scale where 1: low; 7: high.

1

Table 3. Factor Analysis of Management Accounting Practices.
Factor Label Description Factor Scores Cronbach Alpha Eigenvalue
Costing Activity-based costing 0.45746 0.7813 8.069795

Attribute costing 0.44454
Life cycle costing 0.64947
Quality costing 0.56056
Target costing 0.65468
Value chain costing 0.59799
Competitor Accounting Competitive position monitoring 0.67851 0.7627 5.897008
109
Competitor performance appraisal 0.61613

Competitor cost assessment 0.73163
Integrated performance measurement 0.50913 0.0001* 5.506750
Strategic Accounting Strategic costing 0.61135
Strategic pricing 0.82175
Brand Value Accounting Brand value budgeting 0.58789 0.0001* 4.745843
Monitoring brand values 0.95804
*(Pearson correlation p value)
109
such activity does not appear to be serving the type of differentiation that Porter
(1996) asserts is necessary for competitive strategy to be successful. “A
company can outperform rivals only if it can establish a difference that it can
preserve” (Porter, 1996, 62). For this reason, although the costing items referred
to in this study may exhibit more of a strategic orientation than conventional
management accounting practices, their strategic orientation may in reality be
limited.
Porter (1996) notes the frustration that many companies experience when
adopting management tools that increase efficiency but fail to generate an
11 increase in measurable profits. In contrast to strategic positioning, management
accounting practices that support operational effectiveness will assist manage-
ment in “performing similar activities better than rivals perform them” (Porter,
1996, 62). In a similar vein, Slater et al. (1997) comment on adapting control
systems to strategy and illustrate how measures such as product cost, scrap and
rework percentages are exceedingly narrow, even for firms competing on the
basis of operational efficiencies. More expansive measures are necessary. The
remaining three factors appear to be more expansive and closer to supporting
strategic positioning. Factor 2 (competitor accounting) specifically considers
strategic positioning through its focus on the competitive market. Competitor
11 accounting can be expected to yield information pertinent to firm deliberations
concerning how differentiation might be achieved. The inclusion of integrated
performance measurement in factor 2 may stem from the strong external orien-
tation that it exhibits in common with the competitor accounting items. The
distinctiveness of Factor 3 (strategic accounting) when compared to Factor 1 is
apparent from the former’s forward-looking and marketing orientation. Finally,
factor 4 (brand value accounting) also appears to have a strong forward-looking
and marketing orientation. “Value” is inextricably linked to a notion of the
future, and brands represent an example of an intangible marketing asset
(Guilding and Pike 1990).
11
SMA and Competitive Strategy
The fourth objective of the study concerns an exploration for associations between
usage of strategically-oriented management accounting practices and competitive
strategy. This exploration has been conducted by correlating the fifteen SMA
practices with the eight sub-dimensions of competitive strategy. Table 4 details all
significant (p < 0.10) Pearson correlations between the two variable sets.
Out of the 120 relationships examined, 27 are statistically significant (p <
0.10). With the exception of the relationship between value chain costing and
service quality, the correlation coefficient is positive in all of the statistically
1
1
Table 4. Pearson Product Moment Correlation Matrix for Management Accounting Practices and

Competitive Strategies.
PRACTICES COMPETITIVE STRATEGIES

R&D Product Product Product Service Price Advertising Market
Quality Technology Range Quality Level Level Coverage
Attribute costing 0.2001 0.1924 0.1581 0.1649

(0.0363) (0.0412) (0.0960) (0.0837)
Benchmarking 0.2103 0.1883
(0.0241) (0.0458)
Brand value budgeting 0.3003
(0.0015)
Competitive position 0.2502 0.01925 0.1576 0.2392 0.2356
monitoring (0.0081) (0.0402) (0.0956) (0.0115) (0.0124)
Competitor cost 0.2616
assessment (0.0055)
111
Competitor 0.1603 0.1562

performance appraisal (0.0943) (0.0984)
Integrated performance 0.1663
measurement (0.0796)
(0.0341)
Monitoring brand 0.2142 0.2640 0.2275
values (0.0275) (0.0065) (0.0202)
Quality costing 0.2570 0.2457 0.1792
(0.0075) (0.0100) (0.0348)
Strategic pricing 0.1816
(0.0576)
(0.0134)
Value chain costing -0.2309 0.2027
(0.0162) (0.0346)
Correlation coefficient; (p value at 0.10 or less)
111
Activity-based costing and strategic costing were not significantly related to any of the competitive strategy dimensions.
significant relationships. R&D leadership, which is significantly related to usage

of seven of the SMA practices is the sub-dimension of competitive strategy
exhibiting the strongest relationship with SMA. It is also the sole competitive
strategy associated with target costing usage and life cycle costing usage. The
normative literature concerned with target costing and also life cycle costing
highlights why these positive relationships with R&D leadership are to be
expected. R&D leaders would have a heightened awareness of the need to enter
the market at a price sufficient to provide targeted profits; in addition, they can
be expected to appreciate the need for adopting a long-term perspective when
11 justifying R&D expenditure. Both of these SMA practices are related to the oper-
ational effectiveness factor, and two other SMA practices that load on this factor
(attribute costing and quality costing) also exhibit statistically significant rela-
tionships with R&D leadership. It would appear that R&D leaders have a strong
product focus and an appreciation of benefits deriving from adopting a variety
of costing perspectives. It is also noteworthy that R&D leader firms have greater
recourse to use the three SMA practices containing the words “competitor” and
“competitive”. Again, this finding has intuitive appeal as firms with a large R&D
budget can be expected to experience a greater need for competitive analysis
in order to ensure such developmental expenditure is directed towards areas
11 providing the greatest promise for competitive differentiation. These firms would
have a high concern for the market launch of product prototypes and a need to
enter the market prior to the introduction of similar products by competitors.
Ranking closely behind R&D in terms of exhibiting a strong association with
SMA usage, is breadth of market coverage. This sub-dimension of competitive
strategy is significantly related to usage of six of the SMA practices. Related to
breadth of market coverage is breadth of product range. A company with a broad
product range can be expected to be seeking broad market coverage. Breadth of
product range exhibits statistically significant relationships with three SMA
practices, all of which are also related to market coverage. These SMA practices
11 are: attribute costing, monitoring brand values, and benchmarking. It is to be
expected that attribute costing would be of interest to this group of companies
as they need to plan and manage the diversity of attributes offered across their
portfolio of products. Monitoring brand values also affords a basis for compar-
ing across the product portfolio where there will be a heightened need to
determine how the marketing budget is to be allocated across the products.
Similarly, use of benchmarking as an additional tool for appraising product
performance appears an appropriate technique for this group of companies.
Two other competitive strategies, level of product technology and level of
advertising expenditure also exhibit statistically significant relationships with
three SMA practices. With respect to level of product technology, a positive
relationship exists with competitor position monitoring, competitor performance

appraisal and quality costing. These relationships appear to have strong
theoretical support. Jones (1988) notes a need for competitor accounting in high
technology industries. In addition, a high appreciation of the need for quality
control is to be expected in areas of high technology. Level of advertising
expenditure is the only dimension of competitive strategy exhibiting a signifi-
cant relationship with brand value budgeting. This competitive strategy is also
related to monitoring brand values. The literature on brand value accounting
notes the potential for high usage in the fast moving consumer goods industry
1 (Guilding & Pike, 1994a). A strong rationale for this finding exists as this is
an industry with a relatively high level of advertising expenditure. Brand
valuation techniques allow firms to estimate the current value of future bene-
fits created through advertising expenditures. Similarly, intuitive support for the
positive relationship between level of advertising and competitive position
monitoring is apparent as advertising plans need to be developed with due
regard to competitive differentiation considerations.
When Table 4 is considered from the perspective of the SMA practices, nine
of the practices exhibit a positive relationship with either one or two of the
competitive strategies. As eight relationships have been considered for each
1 SMA practice, the possibility that some of these statistically significant
relationships have resulted from chance alone should be acknowledged.6 Greater
importance may be attached to the four SMA practices found to be significantly
related to three or more of the competitive strategies: competitive position
monitoring, attribute costing, monitoring brand values and quality costing.
Usage of competitive position monitoring, which is positively related to five of
the competitive strategies, bears the strongest relationship with the dimensions
of competitive strategy appraised. Attribute costing also reveals a relatively high
association as it is positively related to four of the eight competitive strategies.
Activity-based costing and strategic costing are not significantly correlated with
1 any of the competitive strategies.
SMA and Organizational Performance
The final research objective concerns exploring for relationships between usage
of strategically-oriented management accounting practices and organizational
performance. Recall that eight dimensions of performance have been measured.
Table 5 details all significant (p < 0.10) Pearson correlations between the two
variable sets. Attribute costing and competitor cost assessment have not been
included in the body of this matrix as they have failed to exhibit a statistically
significant relationship with any of the performance variables.
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Table 5. Pearson Product Moment Correlation Matrix for Management Accounting Practices and
114
Organizational Performance.
PRACTICES: Performance compared to company objectives Performance compared to major competitor
Sales Market Share Profitability Cus. Sales Market share Profitability Cus.
Satisfaction Satisfaction
Activity-based costing -0.2799

(0.0027)
Benchmarking 0.2255 0.23902 0.1885
(0.0159) (0.0104) (0.0436)
Brand value budgeting 0.1798 0.1774 0.1807
(0.0602) (0.0626) (0.0577)
Competitive position 0.1884
monitoring (0.0438)
Competitor performance

appraisal 0.1769
(0.0609)
Integrated performance 0.1826
measurement (0.0556)
(0.0825)
Monitoring brand values 0.2255 0.2139 0.2194 0.2386 0.2619
(0.0207) (0.0293) (0.0239) (0.0138) (0.0067)
Quality costing 0.1612
(0.0925)
Strategic costing 0.1594 0.2463 0.1891
(0.0947) (0.0092) (0.0459)
Strategic pricing 0.2419 0.2343 0.2092 0.2561 0.1947
(0.0109) (0.0133) (0.0283) (0.0067) (0.0397)
(0.0123)
Value chain costing -0.2037
(0.0354)
Correlation coefficient; (p value at 0.10 or less)

Attribute costing and competitor cost assessment were not statistically significantly related to any of the performance variables.
Of the 120 relationships examined, 27 are statistically significant. With the

exception of the relationship between achieving customer satisfaction objectives
and use of two SMA practices (activity-based costing and value chain costing),
all of the statistically significant relationships are positive. This suggests that
higher company performance is associated with greater use of SMA. Particularly
noteworthy is the significant positive relationship between sales performance
relative to competitors and eight of the fifteen SMA practices. It could be that
this performance measure is also acting as a surrogate measure for company size
and that a positive relationship exists between company size and SMA usage.
1 This interpretation appears consistent with previous work that has found a
positive relationship between company size and accounting sophistication (Bruns
& Waterhouse, 1975; Merchant, 1981). Despite this observation, it should also
be noted that the achievement of internal sales objectives is significantly related
to four of the SMA practices, and that this suggests an underlying relationship
between sales performance and SMA usage. Three other measures of perfor-
mance also reveal statistically significant relationships with usage of four SMA
practices. These are market share and profitability achievements relative to
company objectives, and market share achievements relative to the competition.
When the correlation matrix is considered from the perspective of the SMA
1 practices, monitoring brand values and strategic pricing exhibit the greatest
relationship with the performance variables; each is significantly related to five
of the eight performance measures. Further support for the significance of brand
accounting derives from the finding that brand value budgeting is significantly
positively related to three of the eight performance measures. With respect to
the significance of strategic pricing, support for the importance of the “strategic
accounting” factor noted above stems from the finding that strategic costing is
positively related to three of the performance measures. Benchmarking, which
is positively related to three of the performance measures, is the only other
SMA practice to reveal a significant relationship with more than one measure
1 of performance.
CONCLUSIONS
Several contributions arise from this study. It is one of the first works that has
attempted to synthesize the practices that comprise SMA. Secondly, it provides
insight into the relative usage rates of SMA practices as well as practitioners’
perceptions of the degree to which these practices may further management in
their organizations. Thirdly, it has uncovered four underlying themes in the
SMA practices. Finally, it has uncovered associations between SMA usage rates
and dimensions of competitive strategy and performance.
115
With respect to the relative usage rates of the SMA practices, for six of the
practices, the mean usage rate is above the mid-point of the measurement scale
that ranged from “not at all” to “to a great extent”. Three of the top five ranking
practices contained the word “competitor” or “competitive”. This underlines the
importance of competitor accounting as a strategic management accounting tool.
Four of the least adopted management accounting practices scored below three
on the seven-point usage scale: brand value budgeting, attribute costing, life
cycle costing, and brand value monitoring. Brand valuation accounting is likely
to be less common in the U.S. relative to some other Western countries where
11 brand values can be capitalized on the published balance sheet (e.g. the U.K.
and Australia). Even for strongly branded companies, brand valuation does not
appear to be widespread in the U.S. (Davis, 1995; Cravens & Guilding, 1999).
The degree of attribute costing usage appears to be commensurate with the
minimal attention it has received in the literature. Life cycle costing has received
more extensive coverage in the literature, however, and further research
appraising reasons for the low level of application appears to be warranted. The
relative ranking of the perceived usefulness of the SMA practices largely paral-
lels the usage rate rankings. For each practice, the score on the perceived
usefulness measure was significantly higher than the usage rate score. This
11 finding represents a suggestion that many organizations may not be utilizing
the SMA practices to their full potential.
Four underlying themes have been uncovered by the factor analysis of usage
of the SMA practices. These factors have been labeled: “costing”, “competitor
accounting”, “strategic accounting” and “brand value accounting”. Though all
of the practices appraised in this study constitute a set of management
accounting practices with more of a strategic orientation than is the case with
conventional management accounting techniques, it appears that some may be
viewed as less strategic than others. Closer inspection of the way the six
practices loading on the “costing” factor have been operationalized reveals a
11 suggestion that they have an orientation that is more internally-focused than
externally-focused. In attempting to interpret this factor further, Porter’s (1996)
model that distinguishes between operational effectiveness management
activities and activities relating to developing sustainable competitive advan-
tage appears pertinent. The “costing” factor is likely to be more closely related
to operational effectiveness activities than activities supporting the pursuit of
sustainable competitive advantage. For this reason, we suggest that the six
practices loading on this factor have less of a strategic orientation than the
practices loading on the other three factors.
Use of Porter’s model in this manner highlights a broader significance, as
the results have implications for the way that the merits of accounting systems
are conceived. Porter (1996) provides a rationale as to why particular tools

adopted by companies, such as total quality management, have not led to the
type of improvements that translate to increased profitability. When evaluated
from this perspective, we are left to consider which management accounting
activities can make a truly strategic impact and affect profitability in any
discernible manner.
With respect to the relationship between SMA usage and competitive strategy,
strong support for the view that a relationship exists between SMA usage and
competitive strategy pursued has been provided. Of particular significance is a
1 strong relationship between R&D leadership and the usage of three of the four
practices loading on the “competitor accounting” SMA factor and four of the
six practices loading on the “costing” SMA factor. Breadth of market coverage
has also been found to bear a strong relationship with SMA usage. The most
significant SMA practices in relationships with competitive strategy were
competitive position monitoring, which is positively related to five competitive
strategies, and attribute costing which is positively related to four of the compet-
itive strategies. The pattern that emerges suggests that firms are employing SMA
practices with a specific goal in mind. This contingency theory conclusion is
perhaps to be expected at this stage of research into SMA application. These
1 findings can be seen to extend Guilding’s (1999) finding that competitor-focused
accounting adoption is related to strategic mission (operationalised using
Govindarajan and Gupta’s (1985) “build/harvest” measure) and competitive
strategy (operationalised using Miles and Snow’s (1978) “prospector/defender”
typology). Further case study research designed to uncover a richness of data
concerned with the exact manner of the application of SMA in the context of
specific competitive strategies is to be welcomed.
Strong support has also been found for the view that a relationship exists
between SMA usage and company performance. This underlines the importance
of further research into the application of SMA. The strongest relationships
1 with performance are evident with respect to usage of the two practices loading
on the “strategic accounting” SMA factor and also the two brand value
accounting practices. The finding is particularly noteworthy with respect to
brand value accounting as the brand value accounting practices exhibit rela-
tively low usage rates. This begs the following questions: could brand value
accounting be deserving of more usage, and is such usage of brand valuation
likely to remain relatively limited given the external reporting climate that
prohibits brand value capitalization in the U.S.? Also noteworthy is the finding
that not one of the six SMA practices loading on the costing factor exhibits a
relationship with more than one of the performance variables. This supports the
view that these techniques may be more akin to operational effectiveness than
117
strategic management, and that they are therefore unlikely to impart a discernible
impact on profitability.
The study’s findings should be interpreted in light of several limitations. In
addition to generally accepted limitations of survey research, a further problem
relates to the choice and operationalization of the fifteen SMA practices that
lie at the heart of the study. Others may, with justification, see an alternative
set of practices as constituting SMA. This problem is bound to persist, for even
though conventional management accounting practices have a longer history
than strategic management accounting practices, reference to any set of manage-
11 ment accounting textbooks will reveal a limited consensus on how a listing of
conventional management accounting practices may be achieved. Similarly, the
manner in which the fifteen appraised SMA practices have been operational-
ized necessitates the exercise of a degree of subjectivity. Due to the nascent
nature of the SMA literature, standardization of the way terms are used in prac-
tice is bound to be limited. While attention should be drawn to these limitations,
in a study concerned with socially under-defined constructs, there is little the
researcher can do to counter such problems.
NOTES
11
1. For an extensive review of this literature, see Langfield-Smith (1997).
2. Simmonds (1981) is generally accredited with the creation of the term “strategic
management accounting”. He defined it as “the provision and analysis of management
accounting data about a business and its competitors for use in developing and moni-
toring the business strategy” (1981, 26).
3. The sample was filtered by asset size which yields results similar to a filter by
sales (Hagerman & Zmijewski, 1979).
4. For each practice, the perceived merit score exceeded the usage level score (paired
t-test; p < 0.01).
5. Even for target costing (perhaps the one factor item with the greatest external orien-
tation), external orientation appears relatively muted compared to most items loading on
11 the other three factors.
6. Despite this comment, it should be noted that a two-tailed test of significance has been
employed and that several of the statistically significant relationships have considerable
intuitive appeal. For example, consider the positive relationship between integrated perfor-
mance measurement usage (which is oriented towards understanding customer needs and
the provision of customer satisfaction) and pursuing a high product quality strategy.
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11
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11
APPENDIX A
Operationalization of Strategic Management Accounting Practices:

Definitions provided to respondents as a glossary appended to survey
questionnaire
Activity-based costing (management)

An approach where costs are allocated to specific activities based on structural
and executional cost drivers such as scale, scope, learning, experience, tech-
1 nology, product complexity, etc.
Attribute costing
The costing of specific product attributes that appeal to customers. Attributes
costed may include: operating performance variables, reliability, warranty
arrangements, assurance of supply, and after sales service.
Benchmarking
The comparison of internal processes to an ideal standard.
1 Brand valuation (budgeting and monitoring)

The financial valuation of a brand through the assessment of brand strength
factors such as: leadership, stability, market, internationality, trend, support, and
protection combined with historical brand profits.
Competitive position monitoring

The analysis of competitor positions within the industry by assessing and moni-
toring trends in competitor sales, market share, volume, unit costs, and return
on sales. This information can provide a basis for the assessment of a
competitor’s market strategy.
1
Competitor cost assessment
The provision of a regularly scheduled update estimate of a competitor’s unit
cost.
Competitor performance appraisal

The numerical analysis of a competitor’s published statements as a part of an
assessment of a competitor’s key sources of competitive advantage.
123
Integrated performance measurement

A measurement system which focuses typically on acquiring performance
knowledge based on customer requirements and may encompass non-financial
measures. This measure involves departments monitoring those factors which
are critical to securing customer satisfaction.
Life cycle costing

The appraisal of costs based on the length of stages of a product or service’s
life. These stages may include design, introduction, growth, maturity, decline,
11 and eventually abandonment.
Quality costing
Quality costs are those costs associated with the creation, identification, repair,
and prevention of defects. These can be classified into three categories: preven-
tion, appraisal, and internal and external failure costs. Cost of quality reports
are produced for the purpose of directing management attention to prioritize
quality problems.
Strategic costing
11 The use of cost data based on strategic and marketing information to develop
and identify superior strategies that will produce a sustainable competitive
advantage.
Strategic pricing
The analysis of strategic factors in the pricing decision process. These factors
may include: competitor price reaction, elasticity, market growth, economies of
scale, and experience.
Target costing
11 A method used during product and process design that involves estimating a
cost calculated by subtracting a desired profit margin from an estimated (or
market-based) price to arrive at a desired production, engineering, or marketing
cost. The product is then designed to meet that cost.
Value chain costing

An activity-based approach where costs are allocated to activities required to
design, procure, produce, market, distribute, and service a product or service.
THE LONG-TERM STOCK RETURN
PERFORMANCE OF LEAN FIRMS
Kyungjoo Park and Cheong-Heon Yi
ABSTRACT
This study examines the long-term stock return performance of firms

adopting the lean system. It is hypothesized that stock returns for lean
firms are related to the magnitude of improvement in their operating perfor-
mance induced by lean adoption. The post-adoption period stock returns
for lean firms are compared with the pre-adoption period returns, the
CRSP value-weighted market index, and control firms’ returns to capture
the impact of lean adoption on stock prices. We document that the post-
adoption period stock return performances of lean firms show significant
improvement relative to the pre-adoption period returns, the CRSP value-
weighted market index and those of control firms. The higher stock returns
for lean firms are strongly associated with improvement of operating
performance resulting from lean adoption.
INTRODUCTION
Lean management has been one of the most popular management practices
among U.S. firms since the 1980s. To cope with competition at home and from
abroad, many firms drastically changed their operation methods by adopting the
lean system. The lean paradigm includes customer satisfaction, JIT, employee

ISBN: 0-7623-0825-7
125
126 KYUNGJOO PARK AND CHEONG-HEON YI
empowerment, and other organizational learning and improvement activities

(Lee, 1999). The underlying theme of the lean system is to practice continuous
improvement and elimination of waste in all phases of operations. There is
some anecdotal evidence documenting the effectiveness of lean adoption on
operating performance of firms. For example, a survey on the U.S. practitioners
by TBM Consulting Group of Durham reports that successful implementation
of the lean system improves customer relationships and sales growth attributed
to shorter lead times, lower costs, and better quality (Struebing, 1995).
Despite its popularity and some anecdotal evidence, there is still controversy
11 on the effectiveness of the lean program. Kaplan and Norton (1992) note that
improvement in operating performance and resource utilization due to the imple-
mentation of the lean management system is not always translated into better
financial performance. Results of prior empirical studies (Courtis, 1995; Huson
& Nanda, 1995; Inman & Mehra, 1993; Balakrishnan et al., 1996; Kinney &
Wempe, 1999) investigating the impact of JIT adoption on firm performance
are also mixed. For example, Balakrishnan et al. (1996) investigate changes in
return on assets (ROA) of 46 firms that disclosed JIT adoption and find no
impact of JIT adoption on ROA. On the other hand, Kinney and Wempe (1999)
show that JIT adoption improves profitability.
11 This study examines the impact of lean adoption on security return perfor-
mance. The contribution of our study is to provide clear evidence on the
effectiveness of the lean system using a stock performance measure and rigorous
research methods. We measure firm performance using stock returns in the
following reasons. First, stock prices (stock returns) are the best indicator of
firm value (change in firm value) in efficient markets since they unbiasedly
reflect all publicly available information on firms’ expected future cash flows.
Secondly, accounting variables used to construct operating performance
measures are contaminated by noise and bias due to rigidity in accounting rules
and managerial discretion, whereas stock returns are free from this kind of noise
11 and bias. Finally, although stock performance and operating performance are
in general positively related, the association of these two performance measures
is relatively weak. For example, Lev (1989) reports that the correlation between
return on assets (ROA) and stock returns is very low.
This study also adopts rigorous research methods compared with previous
studies. First, prior studies depend on firms’ public disclosures to identify lean
adopters, often resulting in relatively small samples since firms seldom publicly
disclose their implementation of the lean system. These studies might suffer
from sample selection bias because only successful firms tend to disclose their
adoption. In contrast, we identify a larger and relatively unbiased sample (92
lean firms and their adoption year) through telephone interviews. Second, we
The Long-Term Stock Return Performance of Lean Firms 127
employ the event study and control sample methods to provide compelling
evidence on the impact of lean adoption. We examine unexpected changes in
stock returns during a three-year period following the implementation of the
lean system relative to a three-year pre-adoption period stock returns. We assess
the effect of lean adoption on the stock return performance of lean firms (treat-
ment firms) using two benchmarks: (1) the CRSP value-weighted market index;
and (2) stock returns for control firms. Control firms are chosen on the basis
of the two-digit SIC code and firm size. Further, unlike many previous studies
relying on univariate analysis of operating performance, this study examines
1 cross-sectional associations between changes in operating performance of firms
and their stock returns to investigate whether improvements in operating perfor-
mance induced by the lean system are actually translated into better stock return
performance.
We find that firms implementing the lean system have higher stock returns
than the CRSP value-weighted market index or those of control firms. We also
find that the higher stock returns of lean firms are strongly associated with
improvements in operating performance induced by the lean system. Overall,
using a larger and unbiased sample and the event and control methodology,
this study provides clear evidence as to the positive lean adoption impact on
1 firms’ stock return performance.
The paper is organized as follows. In the next section, we develop hypotheses.
We then describe methodology for hypothesis testing and analyze empirical
findings. The last section concludes the study.
HYPOTHESES DEVELOPMENT
The lean system is effective in dealing with structural changes in business

environment (e.g. growing size, complexity, and high rates of labor unrest) and
international competition. Proponents of the lean paradigm argue that it will
1
replace both mass production and craft production, and that it will become a
standard global production system in the twenty-first century due to the universal
applicability and the endless possibility for improvement in firms’ operation. A
firm chooses to adopt a lean system if it expects that the adoption of the system
will lead to effective cost management and subsequently higher earnings. Since
changes in (or levels of) earnings are positively associated with stock returns
(Easton et al., 1991), we expect that lean firms outperform non-adopters with
respect to stock returns. Thus, the first hypothesis is:
H1: Lean firms, on average, have higher post-adoption stock returns than
non-adopters.
127
The impact of lean implementation on stock return is expected to vary across

firms, depending upon the magnitude of improvement in operating performance
resulting from the adoption of the lean system. One of the major benefits from
lean adoption is enhancement of operating performance. This improvement is
obtained through maximizing value-added activities and minimizing nonvalue-
added activities. As firms become lean, the proportion of nonvalue-added
activities decreases, providing an opportunity for cost reduction without
lowering quality of products or services to customers (Brimson, 1991). The
most direct effect of lean adoption on firms’ operations is a decrease in inven-
11 tory levels. The decreased inventories reduce inventory carrying charges,
insurance premiums, interest charges on inventory financing, inventory control
personnel, record-keeping costs, procurement activity costs, and inventory audit
costs (Waples & Norris, 1989).
The benefits of the lean system are more than reduced costs, including
employee empowerment, reduced space requirements, improved inventory
turnover, and less excessive rework (Ward et al., 1988). The lean system
improves quality awareness, and closely integrates R&D and downstream
activities with production. Thus, lean adoption is expected to improve assets
utilization. The better utilization of assets improves earnings and ROA because
11 of the reduced level of physical and dollar inventory and effective plant utiliza-
tion (Cheatham, 1989). The higher earnings would positively affect the stock
prices of lean firms.
Lean adoption, on the other hand, may have a negative impact on the stock
returns of lean firms. Successful implementation of the lean system may be
hindered by problems in institutional circumstances such as delayed JIT
delivery, reduced product diversity, inappropriately shortened product cycles,
rigid flexibility, limited automation, shortage of skilled blue-collar workers, and
decreased productivity and quality. Furthermore, significant new investments in
manufacturing facilities, inventory handling systems, and employee training for
11 lean program may have a negative impact on firms’ earnings and ROA
(Primrose, 1992), and subsequently on stock returns. Therefore, it is an empir-
ical question whether lean adoption will have a positive impact on stock returns.
We associate cross-sectional variations in the post-adoption stock returns for
lean firms with various operating performance measures to examine whether
improvement in operating performance through lean adoption leads to an
increase in stock return performance. To do so, we hypothesize:
H2: The stock price performance of lean firm is positively related to ROA
improvement subsequent to lean adoption.
We decompose ROA into profit margin and asset turnover:
H2a: The stock price performance of lean firm is positively related to profit
margin improvement subsequent to lean adoption.
H2b: The stock price performance of lean firm is positively related to total
asset turnover improvement subsequent to lean adoption.
H3: The stock price performance of lean firm is positively related to inven-
tory turnover improvement subsequent to lean adoption.
H4: The stock price performance of lean firm is positively related to fixed
asset turnover improvement subsequent to lean adoption.
H5: The stock price performance of lean firm is positively related to the
1 improvement in the ratio of inventory relative to sales subsequent to
lean adoption.
METHODOLOGY
Sample Design and Data
For the sample selection, the most difficult procedure is to identify lean adopters
and their adoption year because firms seldom publicly announce their decision
to employ the new management practice. In addition, it is unclear when firms
1 adopt the lean system since the whole units of a company rarely adopt the
system at the same time.
We identify lean firms and their adoption year through telephone interviews.1
All COMPUSTAT firms whose SIC codes are in the 3000–3800 range are
initially considered as potential lean firms since lean programs have been adopted
extensively among those industry groups. Manufacturing, purchasing or quality
assurance managers of each potential lean firm were contacted by telephone.
Questions were asked to determine whether a firm implements the lean system.
We used terms such as “just-in-time (JIT) production,” “continuous improvement
(kaizen) program,” “total quality management (TQM),” “lean production,” and
1 “customer satisfaction” to identify lean firms. We are able to identify 110 firms
whose manufacturing, purchasing, or quality assurance manager indicated the
adoption of lean programs during the period of 1980-95.2 We confirm the
credibility of each manager by the name, position, and telephone extension.
The initial 110 firms are then reduced to 92 treatment sample3 firms whose
financial data and monthly stock returns are available on the COMPUSTAT
tapes and the Center for Research in Security Prices (CRSP), respectively.
We translate the calendar year of lean adoption into the event time. For
example, if the respondent informs us that his/her firm had adopted lean produc-
tion in May 1990, then the year 1990 becomes the event year. The event year
is denoted as year 0.
129
Table 1. Distribution of the Adoption Year of Lean System.

Year of Adoption Number of Firms Cumulative percentage
1980 1 1.1
1983 1 2.2
1984 3 5.4
1985 5 10.9
1986 4 15.2
1987 6 21.7
1988 6 28.3
11 1989 14 43.5
1990 18 63
1991 9 72.8
1992 11 84.8
1993 7 92.4
1994 5 97.8
1995 2 100
Total 92
Table 1 reports the temporal distribution of lean adoption by our treatment

11 firms. The majority of firms (64.1%) adopted lean production from 1989 to
1993 of the sample period. The earliest adoption year was 1980. Until 1985,
few firms adopted a lean system.
Table 2 provides industry classification of 92 lean firms. Lean firms are
concentrated in electronics (34 firms), industrial machinery (27 firms), and motor
vehicles and accessories (14 firms) industries.
OPERATING PERFORMANCE MEASURES

We compare levels of and changes in the operating performance for our treat-
11 ment firms with those for control firms. Control firms are chosen on the basis of
Table 2. Industry Distribution of Lean Firms.

Two-digit SIC code Industrv Number of Firms
30 Rubber products 10
34 Fabricated metal products 7
35 Industrial machinery 27
36 Electronics 34
37 Motor vehicles and accessories 14
Total 92
the same industry and asset size. The fiscal year prior to the adoption year of the
lean system, year ⫺1, is used as the benchmark for the tests of changes in
operating performance between the post-adoption and pre-adoption period. In
addition, we compare treatment firms’ operating performance with industry
averages for each operating measure to test the robustness of the results. The
industry performance is computed using the contemporaneous mean performance
of all firms, excluding lean firms, in the same two-digit SIC code associated with
each lean firm. It should be pointed out that lean firms might be included in
industry matching group because our sample search was not exhaustive.
1 However, the possibility of lean firms being included in the industry comparison
group will reduce the power of our tests to find the success of lean adoption.
The definitions of operating performance measures are as follows:
(1) Return on Assets (ROA) = operating income before depreciation (OIBDP,

item 13)/ the average of beginning-of-period and end-of-period book value
of assets (item 6),
(2) Profit Margin = OIBDP (item 13)/ sales (item 12),
(3) Asset Turnover = sales (item 12)/ the average of beginning-of-period and
end-of-period book value of assets (item 6),
1 (4) Inventory Turnover = cost of goods sold (item 41)/ the average of begin-
ning-of-period and end-of-period of inventory (item 3),
(5) Fixed Asset Turnover = sales (item 12)/ the average of beginning-of-period
and end-of-period fixed assets (item 8),
(6) Total Inventory relative to Sales = inventory (item 3)/sales (item 12), where
all the items are obtained from the Compustat tape.
Panel A of Table 3 presents the mean4 operating performance measures for lean
firms three years before lean adoption (year ⫺3) to three years after lean adop-
tion. Panel A also reports changes in operating performance for lean firms from
year ⫺1 (one year before lean adoption) to year +1, +2, and +3. Panels B and
1 C report the paired differences in levels of and changes in operating perfor-
mance between lean firms and control firms and between lean firms and industry
benchmarks, respectively.
A clear trend is observable for all the performance measures in Panel A. All
seven ratios are on average deteriorating prior to lean adoption year, but
improves after adoption year. The mean ROA for lean firms falls from 15.4
from three years before adoption to 13% one year prior to adoption, but recovers
to 15.7 three years after adoption. In Panels B and C, lean firms also out-
perform their control firms and their industries, as the mean control-firm adjusted
and industry-adjusted ROAs are both statistically significant at the 1% level in
year +3.
131
Table 3. Mean Operating Performance Measures for Lean Firms, Control

Firms and Industry Benchmarks.
Panel A reports mean ratios for the 92 lean firms. Panel B reports the mean ratios for control firms.
Control firms are chosen on the basis of the same industry and asset size as those of lean firms.
Panel C reports industry mean ratios. Industry means are computed using the contemporaneous
mean performance of the firms in the same two-digit SIC code as each lean firms. The Compustat
data item for the variables are ROA(operating income before depreciation(OIBDP, item 13)/ the
average of beginning-of-period and end-of-period book value of assets (item 6)), profit
margin((OIBDP, item 13)/ sales (item 12)), total asset turnover ((sales, item 12)/ the average of
11 beginning-of-period and end-of-period book value of assets (item 6)), inventory turnover ((COGS,
item 41)/ the average of beginning-of-period and end-of-period of inventory (item 3)), fixed asset
turnover ((sales, item 12)/ the average of beginning-of-period and end-of-period fixed assets (item
8)), inventory/sales (item 3/item 12). The sample size varies from year to year depending on data
availability.
Total
Fiscal year Profit Asset Inventory Fixed Inventory/ Number of
relative to ROA Margin Turnover Turnover Asset Sales Firms
adoption Turnover
Panel A: Lean Firms*

11
⫺3 0.154 0.119 1.376 4.620 6.187 0.190 84
⫺2 0.143 0.113 1.337 4.308 6.400 0.209 85
⫺1 0.130 0.100 1.354 4.412 7.080 0.203 89
⫺0 0.123 0.096 1.339 4.588 6.544 0.197 92
⫺1 0.133 0.113 1.331 4.725 6.430 0.189 92
⫺2 0.150 0.114 1.373 4.939 6.680 0.185 89
⫺3 0.157 0.122 1.403 5.208 7.092 0.179 86
⫺1 to 1 0.001 0.011b ⫺0.018 0.322 ⫺0.632 ⫺0.013 89
⫺1 to 2 0.016a 0.010 0.011 0.674 ⫺0.404 ⫺0.016c 89
⫺1 to 3 0.022b 0.017 0.045 0.961c 0.116 ⫺0.021c 86
11 Panel B: Paired Difference between Lean Firms and Control Firms*
⫺3 ⫺0.002 0.018 ⫺0.066 ⫺0.167 ⫺2.508 0.010 84

⫺2 0.013 0.331 ⫺0.007 ⫺0.409 ⫺1.410 0 044c 85
⫺1 0.002 0.010 ⫺0.038 ⫺1.581 ⫺1.820 0.029 89
⫺0 0.004 0.014 ⫺0.041 ⫺1.838 ⫺1.153 0.012 92
⫺1 0.032 0.052b ⫺0.014 ⫺2.734 ⫺0.681 0.010 92
⫺2 0.032 0.023 0.016 ⫺1.028 ⫺0.620 0.010 89
⫺3 0.057 0.101 0.023 ⫺3.100 ⫺0.213 0.004 86
⫺1 to 1 0.029a 0.042b 0.028 ⫺0.832 1.183 ⫺0.020 89
⫺1 to 2 0.028 0.012 0.056 0.798b 1.388 ⫺0.016 89
⫺1 to 3 0.051b 0.091b 0.062 0.807 1.974 ⫺0.023 86
Table 3. Continued.
Panel C: Paired Difference between Lean Firms and Industry Benchmarks*
⫺3 0.014 0.011 0.013 0.561 1.396 0.031 84

⫺2 0.016a 0.016b 0.015 0.451a 0.856 0 030c 85
⫺1 0.002 0.000 0.028 0.429 1.395 0 033c 89
⫺0 ⫺0.000 0.001 0.021 0.524a 0.813 0.032c 92
⫺1 0.008 0.015 0.017 0.600b 0.647 0.025b 92
⫺2 0.022 0.016a 0.071 0 745c 0.801 0.022a 89
⫺3 0.025c 0.022c 0.103 0.896c 1.145 0.018 86
1 ⫺1 to 1 0.004 0.013 ⫺0.006 0.163 ⫺0.728 ⫺0.008 89
⫺1 to 2 0.016a 0.013 0 034 0 399b ⫺0.608 ⫺0.008 89
⫺1 to 3 0.018a 0.018 0.070 0.566 ⫺0.212 ⫺0.012 86
a
represents statistical significance at the 10% level.
b
c
* Significance levels are from one-tailed t-tests.
Results for profit margin are similar to the results reported for ROA, while
1 the mean control-firm adjusted and industry-adjusted asset turnovers are all
insignificant. Lean firms have improved inventory turnover absolutely and
relative to their industries. The mean inventory turnover for lean firms is 4.620
three years prior to adoption, but improves to 5.208 three years after adoption.
The mean industry-adjusted inventory turnovers are statistically significant at
the 1% level in years +2 and +3, while the mean control-firm adjusted inven-
tory turnovers are not significant in any year.
For fixed asset turnover, lean firms under-perform relative to their control
firms, but outperform relative to their industries, while both the mean control-
firm adjusted and industry-adjusted fixed asset turnovers are not statistically
1 significant. The ratios of total inventory to sales for lean firms relative to their
control firms and industries have improved, although not significant.
Results using the changes in operating performance show statistically signif-
icant improvements in ROA, profit margin, inventory turnover, and the ratio of
inventory to sales from the year prior to lean adoption to year +3. The mean
differences in the changes in the control-firm adjusted and industry-adjusted
ROAs from year ⫺1 to year +3 are both significant at the 5% and 10% levels,
respectively. The mean differences in the changes in the control-firm adjusted
and industry-adjusted profit margins from year ⫺1 to year +3 are both signifi-
cant at the 5% level. The results for inventory turnover and the ratio of inventory
to sales parallel those for profit margin and ROA, respectively. Overall, the
133
time-series patterns of the mean operating performances of lean firms show

improvements in the ratios of ROA, profit margin, inventory turnover, and the
ratio of inventory to sales over the post adoption period compared to those of
the control benchmarks. In the next section, we examine the stock performance
of lean firms.
STOCK RETURN PERFORMANCE
The Stock Return Performance of Lean Firms

11
We use the event study and control sample methodologies to measure the effect of
lean adoption on the stock return performance. We examine the stock return
performance for a three-year post-adoption period because it takes longer than a
year to see the benefits of lean adoption materialized. We measure the stock return
performance on a portfolio of lean firms by calculating the average annual returns
three years pre-adoption and post-adoption periods. We then compare the stock
return performance of a portfolio of lean firms with that of a control firm portfolio.
We compute the average annual arithmetic returns on a portfolio, r, as:
3 nt
11 1
r=
n 兺兺r ,
t=1 i=1 it
(1)
where rit is the annual return on firm i in year t, nt is the number of surviving
firms in year t, and n is the total number of firm-year observations. The annual
return on firm i in year t, rit, is computed as
12
rit = ⌸ (1 + Rim) ⫺1 (2)
m=1
11 where Rim is the monthly return on security i in month m. We then compare

the average annual return on lean firms during the three-year post-adoption
period with those of control benchmarks. Control benchmarks include the
average annual return on the CRSP value-weighted index and the average annual
return on matching firms during the post-adoption period. Each treatment firm
is matched with a matching firm by industry and total assets in year –1 (one-
year prior to lean adoption).
Table 4 reports the average annual return for each of the three post-adoption
event-years. The security performance of lean firms during year +1 through year
+3 is remarkable. In year two and year three, the average returns on lean firms
are 23.4% and 26.87%, respectively, whereas the counterparts of value weighted
Table 4. Post-Adoption Period Average Annual Returns for Lean Firms,

Control Firms, and CRSP Value-Weighted Market Index.
The adjusted annual return, rit, is computed as
12 12
= ⌸ (1 + Rim) ⫺ ⌸ (1 + E(Rim)),
m=1 m=1
where Rim is the monthly return on security i in month m and E(Rim) is a monthly market or
control-firm return (identically 0 in the raw returns). Control firms are chosen on the basis of the
same industry and asset size as those of lean firms.
1 Post-adoption Year
Year I (N = 92) Year 2 (N = 89) Year 3 (N = 86)
Lean Firms 18.20% 23.40% 26.87%

VW-Index 14.42% 14.28% 16.88%
Matching Firms 12.06% 11.56% 12.18%
Market-adjusted (VW-index) 3.78% 9 l l%b 9 98%b
Matching-firm adjusted 6.14% 11.84%b 14.69%b
b
* Significance levels are from one-tailed t-tests under the hypothesis that lean adoption improves
1 firms' security return performances.
(VW) market index are 14.28% and 16.88%, and matching firms are 11.56% and
12.18% respectively. The market-adjusted returns in each post-adoption period
are 3.78%, 9.11%, and 9.88%, respectively. The market-adjusted returns are
statistically significant at the 5% level for both year +2 and year +3. In addition,
the matching firm-adjusted returns are statistically different at the 5% level for
both year +2 and year +3. In summary, the test results in Table 4 clearly show
1 that the market is surprised by the post-adoption operating performance of lean
firms.
Table 5 reports summary statistics of the average annual returns, the average
market-adjusted returns, and the average matching-firm adjusted returns for lean
firms during three pre-adoption and post-adoption years. The average annual
return on lean firms is 22.80% during the post-adoption period, whereas the
average annual return is 13.45% during the pre-adoption period. The difference
is statistically significant at the 5% level. The market-adjusted and matching-
firm adjusted returns have also shown significant improvements, as the
differences of post-adoption and pre-adoption period average market-adjusted
returns and average matching-firm adjusted returns are statistically significant
135
Table 5. Average Annual and Market adjusted Returns on Lean Firms and
Control Firms during the Three Pre- and Past-Adoption Years of Lean System.
The average annual return on a portfolio is computed as
3 nt
1
r= 兺兺 r
n t=1 i=1 it
where rit is the annual return rit of firm i in year t, nt is the number of surviving firms in year t,
and n is the total number of firm-year observations. Matching firms are chosen on the basis of
the same industry and asset size. The sample size is 84.
11 Lean Firms Market adjusted Matching firm

adjusted
Mean Annual Returns during 13.45% ⫺0.2% ⫺6.54%

pre-adoption period (⫺3 to ⫺1)
Mean Annual Returns during 22.80% 7.5% 12.28%
post-adoption period (1 to 3)
Difference (post-adoption vs. 8 9%b 7 4%a l8 3%b
pre-adoption)
a
b
11 * Significance levels are from one-tailed t-tests under the hypothesis that lean adoption improves
firm performance.
at the 10% and 5% levels, respectively. Overall, the results of Table 5 show
that the long-term security return performance of lean firms is significantly
improved.
CROSS-SECTIONAL RELATIONS BETWEEN

OPERATING PERFORMANCE CHANGES AND STOCK
RETURNS
11
To examine cross-sectional associations between the operating performance
changes of lean firms and their stock returns, we use several measures of
(abnormal) long-term returns. In particular, we use (i) the three-year buy-and-
hold return, (ii) the difference of the post-adoption and pre-adoption period
buy-and-hold returns, (iii) the difference of the post-adoption and pre-adoption
period market-adjusted buy-and-hold returns, and (iv) the difference of the post-
adoption and pre-adoption period matching-firm adjusted buy-and-hold returns.
For each return metric, we run the following regression model:
Returnsi = ␣ + ␤k*⌬ in Operating Performanceik + ei (3)

where
⌬ in Operating Performanceik = operating performance measure k in the third
year after firm i’s lean adoption, minus mean
operating performance measure k during three
year pre-adoption period.
We consider six different operating performance measures – change in return
on assets (⌬ROA), change in profit margin (⌬PM), change in asset turnover
(⌬TURN), change in inventory turnover (⌬IT), change in fixed asset turnover
1 (⌬FT), and change in total inventory relative to sales (⌬INSA). We run cross-
sectional ordinary least squares regressions. The operating performance
coefficient, ␤k (k = 1, . . . , 6), estimates the impact of an improvement in each
operating performance measure on the stock return performance.
Table 6 reports the results of regression analysis to test the association
between excess stock returns and changes in operating performance. Panel A
shows regression results for the three-year buy-and-hold return. All the coeffi-
cients on operating performance measures, except change in fixed asset turnover
(⌬FT), are significant with expected signs. Furthermore, when the change in
ROA is decomposed into the change in profit margin and the change in asset
1 turnover, both operating measures are strongly associated with lean firms’ stock
return performances. When the components of asset turnover are included with
profit margin in the regression, only the change in profit margin remains statis-
tically significant. Results for other excess return metrics are similar to the
results reported for the three-year buy-and-hold return, although the results for
the difference of the post-adoption and pre-adoption period matching-firm
adjusted returns are relatively weak (Panels B, C, and D). Overall, the results
of Table 6 provide evidence that post-adoption period stock returns on lean
firms are strongly associated with improvements in operating performance
induced by lean adoption.
1
CONCLUSIONS
This paper examines the long-term stock return performance of 92 firms that
have adopted lean systems between 1980 and 1995. The effect of the lean
system on lean firms’ stock performance is measured by comparing the stock
returns on lean firms with two benchmarks. We show that the long-term stock
returns for lean firms outperform relative to the CRSP value-weighted index,
and the control firm returns. We also document that excess returns on lean firms
are strongly associated with the magnitude of operating performance improve-
ment resulting from lean adoption.
137
Table 6. Cross-sectional Regression Analysis of the Association between

Stock Returns and Changes in Operating Performance Improvements.
Regression results for 36-month buy-and-hold returns for lean adopters after lean adoption are
reported in Panel A. AROA is ROA in the third year following lean adoption, minus mean ROA
in year ⫺1, ⫺2 and ⫺3. APM is profit margin in the third year following lean adoption, minus
mean profit margin in year ⫺1, ⫺2 and ⫺3. ATURN is asset turnover in the third year following
lean adoption, minus mean asset turnover in year ⫺1, ⫺2 and ⫺3. AIT is inventory turnover in
the third year following lean adoption, minus mean inventory turnover in year ⫺1, ⫺2 and ⫺3.
AFT is fixed asset turnover in the third year following lean adoption, minus mean fixed asset
turnover in year ⫺1, ⫺2 and ⫺3. AINSA is total inventory/sales in the third year following lean
11 adoption, minus mean total inventory/sales in year ⫺1, ⫺2 and ⫺3. The next three panels report
regression results for different measures for excessive returns. Panel B reports results for the differ-
ence of the post-adoption and preadoption period returns for lean adopters. Panel C reports results
for the difference of the post-adoption and pre-adoption period market-adjusted returns. Panel D
reports results for the difference of the post-adoption and pre-adoption period matching-firm adjusted
returns. Post-adoption (pre-adoption) period returns are calculated over 36-month period after
(before) lean adoption. The sample size is 84.
Panel A: 36-month buy-and-hold returns for lean firms
Intercept 0.9lc 0.89c 0.92c 0.74c 0.95c 0.76c 0.85c 0.19

AROA (+)* l1.49c
11 APM (+) l3.65c 13.24c 11.11c
ATURN (+) 0.81b 0.60a
AIT (+) 0.23c 0.009
AFT (+) 0.03 0.006
AINSA (⫺) ⫺7.81b ⫺4.19
Adj. R2 39.4% 32.6% 3.9% 8.2% 1.0% 7.4% 34.7% 31.3%
F-stat. 47.8 35.9 3.9 7.4 1.7 6.7 20.1 9.57
Panel B: Difference of the post-adoption and pre-adoption period returns
Intercept 0.52b 0.54 0.55 0.33 0.59b 0.38 0.49b 0.36

AROA (+)* 10.86c
APM (+) 13.35c 12.81c 11.52c
11 ATURN (+) 0.83a 0.58
AIT (+) 0.27c 0.04
AFT (+) 0.04 0.02
AINSA (⫺) ⫺7.87b ⫺3.62
Adj. R2 25.1% 20.3% 2.6% 7.7% 2.2% 5.6% 21.2% 20.5%
F-stat. 26.5 20.3 3.0 7.3 2.7 5.5 11.2 5.9
Panel C: Difference of the post-adoption and pre-adoption period market-adjusted returns
Intercept 0 49b 0.51 0.53 0.29 0.56 0.33 0.46b 0.31

AROA (+)* 10.59c
APM (+) 13.29c 12 81c 11 26c
ATURN (+) 0.76 0.52
Table 6. Continued.
AIT (+) 0 28c 0.05
AFT (+) 0.04 0.01
AINSA (⫺) ⫺8.28b 4 00
Adj. R2 24.5% 20.7% 2.1% 8.7% 2.3% 6.6% 21.2% 21.7%
F-stat. 25.7 20.8 2.6 8.2 2.8 6.3 11.2 6.2
Panel D: Difference of the post-adoption and pre-adoption period matching-firm adjusted returns
Intercept 0.40a 0.34 0.33 0.13 0.35 ⫺0.00 0.35 ⫺0.01

1 AROA (+)* 5.61a
APM (+) 3.34 2.23 2.80
ATURN (+) 1.88 1.84
AIT (+) 0.22 0.06
AFT (+) 0.31 0.04a
AINSA (⫺) ⫺10.00a ⫺11.27a
Adj. R2 4.6% ⫺0.0% 14% 2.6% 2.7% 5.3% 12.5% 9.0%
F-stat. 3.0 0.5 8.0 2.1 2.2 3.4 4.0 2.0
* represents expected sign.

a
b
c
1 represents statistical significance at the 1% level.
Our study provides a clear evidence of the positive impact of the lean system
on the stock return performance. We use the event study methodology and
cross-sectional regression analysis to capture the effect of a lean system. The
sample of lean firms is identified through telephone interviews rather than mail
survey or public disclosure. Overall, our results reveal that there appears to be
a positive association between lean adoption and stock returns. However, the
generalization of the results should be cautious due to the limitations of the
study. For example, the self-selection bias may contaminate the results even if
we use the control sample method to mitigate the problem.
1
The results of the study raise some interesting questions. First, our lean firms
are limited to the manufacturing industry. An investigation of the effectiveness
of lean systems in the service industry deserves further research. Secondly,
our results are silent on the question of why some firms are successful with lean
implementation and others are not. Further research in this direction is called for.
NOTES
1. The sample data were borrowed from Lee and Park (2000)’s study.
2. The sample selection is not exhaustive because some of the managers are not
available for our interview.
139
3. The sample size varies from year to year depending on data availability.
4. We also examine (but do not report) the median performance for lean firms and
obtain very similar results to the mean results reported.
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THE RELATION BETWEEN CHIEF
EXECUTIVE COMPENSATION AND
FINANCIAL PERFORMANCE: THE
INFORMATION EFFECTS OF
DIVERSIFICATION
Leslie Kren
ABSTRACT
The objective of this research is to examine the effects of product-market

diversification on the relationship between chief executive (CEO)
compensation and financial performance. The results indicate that unre-
lated-diversified firms link chief executive compensation more strongly to
financial performance than firms that are undiversified or diversified into
related businesses. This relationship persists even after controls are
included for board monitoring, large outside shareholders, and CEO share-
holdings. Overall, these results are consistent with the assertion that the
organizational response to information asymmetry about CEO perfor-
mance, presumably caused by diversification, is a tighter linkage between
CEO compensation and financial performance. This is consistent with
Holmstrom’s (1979) proposition that, in a moral hazard setting, the prin-
cipal must rely on a second-best contract in which performance evaluation
is based on publicly observable outcomes when information about behavior

ISBN: 0-7623-0825-7
141
142 LESLIE KREN
is unavailable or too costly (Amihud & Lev, 1981). Correspondingly, where

it is more difficult for the board to obtain information on CEO behavior,
as in unrelated-diversified firms, financial performance is a more impor-
tant determinant of compensation.
INTRODUCTION
Executive compensation is one of the most controversial issues in U.S.

business. Instances of “excessive” executive compensation have been widely
11 reported in the popular press and have fostered the notion that executives are
paid exorbitant salaries regardless of their firm’s performance (Lublin, 1998).
Although academic research has usually found a positive association between
financial performance and executive compensation (Coughlin & Schmidt, 1985;
Murphy 1985), observers have also noted that the associations are modest and
explain little of the variance in compensation (Jensen & Murphy, 1990). The
lack of conclusive empirical evidence is particularly troublesome for regula-
tors, who have recently begun to focus on corporate governance reform. New
regulations are being considered by Congress, the Securities and Exchange
Commission, and the Internal Revenue Service.
11 This debate has also focused considerable research attention on the stew-
ardship role of accounting information and how it is used in performance
evaluation and compensation. In particular, accounting researchers have empir-
ically examined the effects of information asymmetry on compensation contract
design, employing agency theory models (Lambert & Larcker, 1987a; Clinch,
1991; Lanen & Larcker, 1992). In this context, the underlying premise has been
that a stronger relation should be present between executive compensation and
those financial performance measures (e.g. earnings) that are informative about
a manager’s performance (productive behavior) (Holmstrom, 1979). This
research has contributed to our understanding of how accounting and other
11 performance measures are selected and used.
The objective of this study is to extend this line of research by examining
the effects of product-market diversification on the relation between chief
executive (CEO) compensation and financial performance. Diversification was
selected for study because the informativeness of financial performance
measures about CEO performance is likely to be related to diversification. The
results of this study indicate that firms that have diversified into unrelated busi-
nesses implicitly link CEO compensation more strongly to financial performance
(return on common stock and especially return on assets) than firms that are
undiversified or diversified into related businesses. These findings persist even
after controls are included in the analysis for differences in board of director
The Relation Between Chief Executive Compensation and Financial Performance 143
composition, large outside shareholders, and CEO shareholdings. In addition, a

longitudinal within-firm analysis of a subset of the sample provides evidence
that the cross-sectional models are reasonably well-specified.
The next section provides a theoretical framework for analyzing the infor-
mation effects of diversification on compensation contracts. Subsequent sections
contain a description of the sample selection procedures and variable defini-
tions, a description of the results, including sensitivity analysis of the effects
of various organizational differences, and a time-series analysis of the perfor-
mance-compensation relation across diversification. The final section contains
1 a summary and conclusions.
RESEARCH HYPOTHESIS
An effective organizational control system achieves integration of owner and

manager interests (Fama & Jensen, 1983). Compensation contracts for managers,
whether written or not, play an important role in organizational control.
Holmstrom (1979) demonstrated that an optimal compensation contract depends
on direct observation of the agent’s productive behavior. If the agent’s behavior
cannot be observed, the principal must install a second-best (less efficient)
1 contract which depends on output (e.g. Shavell, 1979). Holmstrom (1979) also
concluded that the strength of the relation between compensation and an output
measure, or any performance measure, is determined by the informativeness of
the performance measure about agent behavior.
This premise has been used as the basis for prior research on the use of
financial and non-financial performance metrics in bonus plans and incentive
schemes. These studies have focused on the implicit link between compensa-
tion and various performance metrics. Firms rarely disclose the terms of explicit
compensation contracts. For example, researchers have expected to observe
incentives based on non-financial performance measures because non-financial
1 performance can be linked to subsequent financial performance and are an indi-
cator of managerial effort (Ittner et al., 1997). Ittner and Larcker (1998), for
example, documented the link between quality measures and executive compen-
sation and Banker et al. (2000) found that bonus plans based on customer
satisfaction in the hospitality industry could be linked to subsequent earnings
increases.
A series of studies have also employed Holmstrom’s (1979) results to examine
the relative usefulness of various financial performance measures and earnings
components in CEO compensation. Lambert and Larcker (1987a), for example,
proposed that accounting measures are less informative than stock market
measures about management’s performance in high-growth firms because
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144 LESLIE KREN
accounting measures lag stock market measures in reflecting investment

decisions in these firms. Consistent with their argument, they found evidence
that high-growth firms placed more weight on common stock return than return
on equity in executive compensation contracts. Clinch (1991) proposed a similar
lag in the ability of accounting results to reflect the value of research and devel-
opment (R&D) efforts. Thus, Clinch expected that accounting results would be
less informative than stock market results about management’s performance in
high R&D firms. Clinch, however, found evidence that both common stock
return and return on equity were more closely related to executive compensa-
11 tion for some high R&D firms compared to some low R&D firms. Along similar
lines, Lanen and Larcker (1992) predicted a positive relation between diversi-
fication by electric utilities into unregulated businesses and the incidence of
earnings-contingent compensation contracts for executives. They failed to find
confirming empirical evidence, however, perhaps, in part, because they
employed a rather imprecise measure of diversification. Citing the inconsisten-
cies of prior research, Gaver and Gaver (1998), expected to observe differential
weights in compensation contracts on earnings that were reported “above-
the-line” and ‘below-the-line’ (net of tax). Below-the-line components included
discontinued operations, extraordinary items, and accounting changes. Gaver
11 and Gaver expected that the latter are more informative about CEO effort and
thus would be more closely linked to CEO compensation. They found, however,
that gains are allowed to ‘flow through’ to CEO compensation but losses are
not, regardless of where they are reported. In a similar study, Kren and Leauby
(2000) report that executive compensation is shielded from the income-
decreasing effects of SFAS 106. Thus, prior empirical research examining the
premise that compensation should be linked to performance measures that are
more informative about management’s behavior has yielded inconclusive results.
Diversification is also likely to effect the informativeness of financial perfor-
mance measures in evaluating CEO performance, as discussed below. Thus,
11 diversification should allow a test of the general proposition that the explicit
weight placed on firm financial performance in CEO compensation is related
to the informativeness of financial performance about CEO performance.
Since strategic policies in undiversified (single-business) firms tend to be
stable or evolutionary and relatively narrowly focused, managerial efforts center
on stability and continuity (Kerr, 1985). The consequences of decisions must
be considered carefully because operating risk is not diversified across multiple
business domains and more opportunities arise for the board to be brought into
the decision-making process to evaluate strategic initiatives (Patton & Baker,
1987). In this setting, CEO decisions can be directly evaluated more easily and
financial performance measures are less informative because they provide less
incremental information about CEO performance. Moreover, in undiversified

firms, it is easier for the board to develop expertise in the firm’s particular busi-
ness which also facilitates effective monitoring of the CEO’s strategic decisions.
As argued by Simons (1987), rewarding efforts rather than results requires
access to more and better information about business environments, potential
opportunities and constraints, and the range of action alternatives available to
managers. Under this evaluation process, a weaker relation between CEO
compensation and financial performance will be observed because the CEO is
not penalized as severely for implementing strategies with poor performance
1 outcomes if these strategies appeared attractive at the outset and the CEO will
capture less benefit from unexpectedly good financial performance (Kerr &
Kren, 1992).
In contrast, diversified firms operate in many and potentially diverse domains,
so the board of directors is more likely to focus on the results of CEO deci-
sions in performance evaluation because the future period consequences of CEO
decisions and actions are more difficult to evaluate (Shleifer & Vishny, 1989).
As diversification increases, greater emphasis in the evaluation process must be
placed on financial performance because it is more informative about CEO
performance. Two dimension of product-market diversification have been
1 defined by organizational theorists: (1) the degree or the extent of diversifica-
tion, and (2) the relatedness of diversification (Dent, 1990; Keats, 1990). The
degree of diversification can be defined as the proportion of resources devoted
to a firm’s primary business. Relatedness can be defined as comparability or
similarity across a firm’s businesses (product-markets) (Ramanujam &
Varadarajan, 1989). In unrelated-diversified firms (conglomerates) when there
is even less interdependence among constituent business units than in firms that
have diversified into related-businesses, the CEO’s resource allocation decisions
are even less easily evaluated, ex ante, because of the uncertainty of dealing
with multiple external environments (Kerr, 1985). Thus, it is more difficult for
1 the board to monitor the CEO’s effort directly, and the board must increase its
reliance on financial performance measures, increasing the relative informa-
tiveness of financial performance measures. While both dimensions of
diversification will be examined in this study, because unrelated-diversified firms
(conglomerates) operate in dissimilar businesses, the relatedness dimension is
expected to be more closely associated with the informativeness of financial
performance measures. Stated as a hypothesis:
H1: The relation between CEO compensation and financial performance is

stronger for diversified firms (particularly unrelated-diversified) than for
undiversified firms.
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146 LESLIE KREN
Empirical exploration of this hypothesis is sensitive to several potential measure-

ment problems. First, diversification strategy and control procedures may be
selected simultaneously and alternate control mechanisms may be developed to
offset the information loss from diversification. This “simultaneity” problem is
common to research in this area and precludes causal inference because the
measured variables all arise from the same contracting process. For example,
shareholders of diversified firms may seek to offset information asymmetry by
improving board of director monitoring, perhaps by electing more outside
directors or more directors with compatible expertise (Fama & Jensen, 1983).
11 Thus, differences in board monitoring could confound the results if they are
systematically related to diversification. It is unlikely, however, that board
control can completely offset the information loss accompanying diversifica-
tion. In fact, Hoskisson, Hitt and Hill (1991) echo much of the management
science literature in arguing that loss of control is an “inevitable” consequence
of diversification (p. 310). Shleifer and Vishny (1989) also propose that
managers can counter disciplinary forces such as board monitoring by investing
in projects or diversifying into businesses that they can run more profitably than
their potential replacements (i.e. managerial entrenchment). To the extent that
board monitoring differences arise in anticipation of information asymmetries
11 resulting from diversification, any significant findings in this study will
represent a conservative test. The effects of monitoring by the board of
directors are explored later in the paper.
The second measurement problem is that the “seriousness” of the agency
problem (i.e. moral hazard) may be related to diversification. If incentives for
value-maximizing behavior arise from other sources beside compensation,
conflict of interest is reduced because the CEO’s interests align with the owner’s.
The presence of these other sources of incentives will confound the analysis if
they systematically vary with diversification. Measurement of other sources of
incentive requires estimates of the amount and composition of the CEO’s wealth
11 (Jensen & Murphy, 1990). Although obtaining estimates of total CEO wealth
is difficult, inside shareholdings can be measured. Inside shareholdings are prob-
ably the most important incentive component of total wealth since it is the
portion at risk with financial performance (Benston, 1985). While there seems
no a-priori reason to expect systematic differences in CEO shareholdings across
diversification, its effects are explored empirically below.
Finally, another measurement problem relates to the informativeness of
financial performance about CEO performance (productive behavior) across
diversification. Lambert and Larcker (1987a) identified several factors that
may affect the performance response coefficient, including characteristics of
the managerial labor market, personal attributes of the CEO, and the firm’s
production function. To the extent that these factors are omitted from the
analysis and are systematically related to diversification, spurious differences
in the performance response coefficient may be observed across diversification
levels. Development of effective empirical controls for these potentially
confounding factors is limited by measurement problems and lack of theory.
Ely (1991), however, argued that industry membership and organizational size
can proxy for “some” of these factors (p. 47). Ely also documented inter-industry
differences in the relation between compensation and various financial
performance measures, after controlling for size. Moreover, if these factors are
1 constant over time for a given firm but vary across firms at any point in time,
then a longitudinal analysis is more valid than a cross-sectional one. Indeed,
some previous research has focused on the time-series relation between perfor-
mance and compensation (Antle & Smith, 1986; Janakiraman, Lambert &
Larcker, 1992). Other research, however, suggests that a longitudinal approach
may be problematic. Lambert (1983), for example, argues that the performance-
compensation relation varies over time and Antle and Smith (1986) find
empirical evidence of temporal nonstationarity. The approach taken in this study
is explore both the effects of industry and size differences and to also under-
take a time-series analysis for some of the firms in the cross-sectional sample.
1
METHODOLOGY
Sample Selection
The sample includes 268 firms selected from the Fortune 500 Industrials, 50
Transportation, 50 Retail, and 100 Diversified Services. Since these listings
contain large firms, this would ensure adequate representation of diversified
firms. Two different observation periods were included in the analysis to reduce
period specific effects. A random sample of 161 firms from the 1989 listings
1 and 107 firms from the 1987 listings were retained in the final sample after
elimination of firms for which the proxy statement disclosed a CEO change (38
from the 1989 group and 28 from the 1987 group were deleted) or a signifi-
cant merger or acquisition (four in 1989 and four in 1987). A CEO change
may confound measures of compensation because a newly hired CEO can nego-
tiate initial contract terms that differ from his predecessor and contract terms
of the outgoing CEO may be altered by termination benefits (Coughlin &
Schmidt, 1985). Firms were eliminated for significant mergers or acquisitions
because these can cause disruptions in firm activities and may confound diver-
sification measures (Jensen & Ruback, 1983). A merger or acquisition was
considered significant if it was subject to a shareholder vote.
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148 LESLIE KREN
Variable Measurement
Measures of CEO Compensation

Total executive compensation includes cash, stock options, long-term compen-
sation (e.g. performance plans, restricted stock plans), assorted benefits (e.g.
pension plans), and changes in the value of firm-related claims. Researchers
have generally limited their attention to cash compensation (e.g. Lambert &
Larcker, 1987a), although some have attempted to estimate “total” compensa-
tion (e.g. Antle & Smith, 1986). The latter approach is hindered by vague and
11 ambiguous compensation data often found in proxy statements. Thus, estimating
total compensation involves some ad-hoc current value estimates of rather
difficult to interpret information (Antle & Smith, 1985). The approach taken in
this study is to use two components of compensation: cash (salary, cash bonus,
and deferred cash) and executive stock options. Stock options are included
because they have a significant economic value to the manager given any
positive probability of a stock price increase (Noreen & Wolfson, 1981). These
two components capture the majority of compensation, and are based on
relatively objective data. Mehran (1992), for example, finds that cash plus newly
granted stock options includes about 73% of “total” compensation for a recent
11 sample of large manufacturing firms. If the hypothesis is supported for these
compensation components, it seems unlikely that the effects are somehow offset
in the relatively small remaining portion of compensation. Inside shareholdings
are included in the model as an independent variable in subsequent cross-
sectional analysis.
Options are valued using the Black and Scholes (1973) option pricing model.1
Only currently awarded options are included to avoid the spurious correlation
resulting from the mechanical relation between previously granted options and
current financial performance. Ignoring previously granted stock options,
however, may underestimate the incentive effect of stock options. All compen-
11 sation measures are adjusted to 1987-constant dollars using the Consumer Price
Index. The results of subsequent analysis are reported separately for cash
compensation and cash plus stock options. The sample size was reduced to 183
firms for analyses of cash plus stock options because some firms did not disclose
complete option information.
In subsequent regression analyses, the change in the logarithm of compen-
sation (growth rate) is used as the dependent variable, as follows,
⌬ln(compensation) = ln(compensationt+1) ⫺ ln(compensationt), (1)
where t = 1987, 1989. This compensation measure is based on the assumption
that performance evaluation precedes changes in compensation. Thus, for the first
observation period, 1987 financial performance was used to predict the change
in CEO compensation from 1987 to 1988. For the second observation period,
1989 financial performance was used to predict the change in CEO compensa-
tion from 1989 to 1990. The change in compensation at the end of the year was
used because it represents the amount which could be based on current perfor-
mance when it is observed (up to the end of the current year) (Lambert & Larcker,
1987a). This compensation measure has been used in previous research (e.g.
Antle & Smith, 1986; Gibbons & Murphy, 1990), it is readily comparable to the
rates-of-return measures used to evaluate financial performance, and avoids
1 potential misspecification problems arising from using absolute compensation by
controlling for factors whose effect on the level of compensation is constant over
time (Lambert & Larcker, 1987b; Murphy, 1985, 1986). In contrast to the growth
rate, absolute compensation is likely to depend on factors other than performance.
For example, it seems reasonable that higher overall pay accompanies increased
scope of responsibility and financial impact in larger firms (Lambert & Larcker,
1987b). Moreover, making pay entirely contingent on performance would be
inefficient given a risk-averse manager. Thus, a measure of the change in com-
pensation should capture that portion of compensation provided in response to
financial performance rather than to scale of operations.
1
Measures of Financial Performance
Theory to identify optimal financial performance measures for empirical analysis
is not well developed. Prior research, guided by intuition and anecdotal
evidence, has focused on a variety of accounting and stock market-based perfor-
mance measures (Antle & Smith, 1986; Lambert & Larcker, 1987a).
Performance measures based on accounting or stock market results frequently
appear explicitly in proxy statements and are widely reported in the press as
measures of financial performance. In general, however, both accounting and
stock market measures have conceptual and methodological weaknesses as
1 measures of CEO performance. While accounting data may provide better infor-
mation than stock price for evaluating a CEO’s performance given accounting’s
stewardship role, accounting measures are subject to management manipulation
and may not correlate well with firm value. On the other hand, stock price
impounds the market’s estimate of the firm’s future financial condition, but it
is sensitive to numerous factors beyond the CEO’s control so it may be
inadequate indicator of CEO performance as well.
To avoid potential biases inherent in using either measure alone, both account-
ing-based and stock market-based measures of performance were used in this
study. Both measures are based on rates of return to facilitate comparisons to
each other, to previous research, and to the measure of compensation (change in
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150 LESLIE KREN
the logarithm of compensation). Stock market performance was measured as

return on common stock, defined as closing price at fiscal year-end plus divi-
dends divided by the closing price in the prior fiscal year-end. Accounting per-
formance was measured as return on assets (ROA), defined as income before tax,
extraordinary items and discontinued operations divided by average total assets.
Both measures are standardized to control for size differences. To control for
industry differences, both measures were adjusted for industry performance by
subtracting the value-weighted mean industry common stock return and ROA for
all other firms listed on Compustat in the same two-digit SIC industry as each
11 sample firm (Antle & Smith, 1986). The resulting rate-of-return performance
measures should not be sensitive to firm size or industry.2
Measures of Diversification
Data on diversification were gathered from historical segment-level financial
information contained on Compustat, which is reported in accordance with finan-
cial reporting requirements (AICPA, 1976). Each segment or line of business
is assigned a four-digit SIC code by Standard & Poors.
The degree of diversification was measured using the complement of the
specialization ratio, which is the ratio of the sales of the largest segment to the
11 total sales of the firm, as shown in (2). Larger values of this measure identify
more diversified firms.3
Degree of diversification = 1 – (sales of largest segment/
total firm sales) (2)
An objective measure of relatedness of diversification is not directly available
from prior research so one was developed for this study. The relatedness
measure is based on the sales-weighted pair-wise correlation of common stock
return for all two-digit SIC code businesses in which each firm operates. The
following procedure was used to calculate this measure. For each sample firm,
11 the correlation of quarterly returns for each pair of two-digit SIC codes was
calculated across all firms listed on Compustat (not including the sample firm)
for the previous five years. The resulting set of correlation coefficients were
then weighted by the sample firm’s sales in each two-digit SIC code pair to
provide the sales-weighted pair-wise correlation, as follows,
n⫺1 n n
relatedness = ⌺⌺ (Si + Sj)rij /(n⫺1)
I = 1 j = i+1
⌺ S,
i=1
i
(3)
where rij is the correlation of common stock return for industry i and j, Si and
Sj represents sales in industry i and j, respectively, and n is the number of
industries in which the firm operates. Unrelated diversification is reflected in a

correlation of 0 and related diversification is reflected in a correlation of 1.
Analogous to this measure, Morck et al. (1990) used the correlation of common
stock return to measure the relatedness of bidder and target firms in corporate
acquisitions (see also Weiss, 1992).
The magnitude of this measure should be inversely related to the difference
between SIC codes. To test whether this is the case, the pair-wise correlation
for all firms listed on Compustat with the same first digit of their primary SIC
code and with one digit difference in their SIC code were calculated. Firms
1 with the same first digit were found to have a median correlation of 0.683 (564
comparisons), while firms with one digit difference in their primary SIC code
were found to have a median correlation of 0.575 (1,050 comparisons). This
difference was statistically significant (p < 0.01) using a median test.
For subsequent analysis, three groups were created based on product-market
diversification. Group 1 contains undiversified firms (n = 114). These are firms
for which 95% or more of sales were from their core business (the largest
segment in which they operated). The remaining 154 diversified firms were split
into two subsamples at the median of the relatedness measure. Thus, group 2
contains related-diversified firms (n = 77), and unrelated-diversified firms are in
1 group 3 (n = 77).
Measures of Control Variables

To control for the measurement problems discussed above, control variables
are included in the analyses for proportion of outsiders on the board, board
shareholdings, outsider shareholdings (ownership dispersion), and CEO share-
holdings. The proportion of outsiders on the board are included because the
monitoring function is primarily the responsibility of outside directors who are
more independent of CEO influence (Weisbach, 1988). According to Fama and
Jensen (1983) outsiders have incentive to monitor management to maintain their
1 reputations as decision control experts and as directors of well-run companies.
The level of stock ownership by board members may also affect monitoring
efforts because board members with significant shareholdings have a direct
financial incentive to monitor managers and may have access to better evalua-
tive information (Kren & Kerr, 1997). A control for large outside shareholders
(ownership dispersion) is included because large outside shareholders are more
likely to engage in monitoring since they bear a relatively greater cost from
management’s non-value-maximizing behavior (Morck et al., 1990). Agrawal
and Mandelker (1990), for example, find a lower incidence of value-decreasing
antitakeover amendments in firms with large outside shareholders. In addition,
since CEOs with relatively large shareholdings bear a greater cost of their own
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152 LESLIE KREN
non-value-maximizing behavior, CEO ownership of shares may provide an

effective deterrent to behavior that reduces firm value. Lewellen et al., (1985),
for example, reported higher returns to firms making acquisitions when top
management had a larger equity share. To the extent that these factors are
systematically related to diversification, they may confound the results.
Outsiders are defined as board members who are not current or former managers
of the firm and board stock ownership is defined as the number of common
shares owned by the board (less the CEO’s shares) multiplied by the year-end
closing stock price and divided by market value of common equity. Outside
11 ownership (ownership dispersion) is measured as the proportion of market value
owned by the largest four shareholders. CEO stock ownership is measured as
proportion of market value owned by the CEO. Ownership and financial data
were gathered from proxy statements and Compustat, respectively.
Model Specification
Both cross-sectional and longitudinal analyses are provided to test the hypoth-
esis that CEO compensation is more strongly related to financial performance
for diversified firms than for undiversified firms. For the cross-sectional analysis,
11 the following regression model is used.
⌬ln(compensation) = ␤0 + ␤1(firm performance) + ␤2(Dundiversified)
+ ␤3(Drelated ⫺ diversified)
+ ␤4(Dundiversified ⫻ firm performance)
+ ␤5(Drelated-diversified ⫻ firm performance)
+ ⌺␤jCj (4)
In this model, Dundiversified is a dummy variable set to one if the firm is in the
11 undiversified group and zero otherwise, and Drelated-diversified is equivalently
defined. Thus, the coefficient of ␤1 is for the unrelated-diversified group, which
is the base case. Cj represents the vector of control variable described above.
The model was estimated separately for both financial performance measures,
common stock return and ROA.
Because the objective of this study was to examine the effects of informa-
tion asymmetry resulting from diversification on the link between financial
performance and compensation, it seems reasonable to look at the cross-sectional
relation, as done in model 1. However, pooling cross-sectionally requires a
homogeneity assumption within a diversification group of several factors that
affect compensation contract design, including, for example, characteristics of
the managerial labor market, personal attributes of the CEO, and the firm’s
production function (Lambert & Larcker, 1987a). To the extent that these factors
are omitted, specification errors can arise in the estimates of cross-sectional
regression models. It may be inappropriate to pool firms by diversification group
if the seriousness of the specification error is systematically related to diversi-
fication because it could lead to spurious differences in slope coefficients across
groups. A longitudinal within-firm analysis is appropriate to control for these
factors if they are constant for a given firm over time but vary across firms at
any point in time. Thus, a longitudinal analysis of the relations is also provided,
1 to assess the validity of the cross-sectional regression results.
RESULTS
Preliminary Analysis
Table 1 shows the distribution of sample firms by observation year, industry

(two-digit SIC code), and by diversification group. In total, 42 different two-
digit SIC codes are represented. The sample was biased toward larger firms;
for 20 industry-year combinations (136 sample firms), mean sample sales were
1 greater than mean industry sales using a two-sample t-test (p < 0.05). Industry
was defined as all other firms listed on Compustat in the same two-digit SIC
code as each sample firm. Since size and diversification are probably correlated
positively, this probably results in a larger proportion of diversified firms in the
sample. There seems no a-priori reason, however, to expect that this would bias
the conclusions. Nonetheless, all cross-sectional regression analyses reported
later in the paper were repeated with a control variable for size (ln(sales))
without any appreciable change in the conclusions (not separately reported).
This is not unexpected since both performance and compensation measures
should be independent of size differences.
1 Table 2 shows descriptive statistics for the measured variables in the study
for the total sample and also by diversification group. The last column shows
comparisons across groups using a Wilcoxon rank-sum test.
Differences in the degree and relatedness of diversification indicates that firms
in the unrelated-diversified group were not more diversified than the related-
diversified group, but the relatedness of diversification was significantly lower.
It seems evident, therefore, that degree and relatedness represent distinct
diversification dimensions. Firms can, and do, diversify without moving into
unrelated lines of business.
Comparison of firm size, measured as sales, indicates that the undiversified
group was smaller than the related-diversified group, but neither was different
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154 LESLIE KREN
Table 1. Sample Firms and Industries Classified by Observation Year and

by Diversification Group.
1987 1987/9 unrelated- unrelated-

Industry (SIC) firms firms diversified diversified diversified
Metal Mining (10) 1 0 0 1 0

Coal Mining (12) 0 1 0 1 0
Oil and Gas (13) 1 3 2 0 2
Nonmetallic (14) 0 1 0 0 1
Contractors (15) 1 3 0 2 2
11 Construction (16) 3 1 0 1 3
Food and Kindred (20) 6 9 10 3 2
Tobacco Products (21) 0 1 0 0 1
Textile Mill Prod. (22) 1 2 3 0 0
Apparel (23) 0 6 4 0 2
Lumber (24) 2 0 0 0 2
Furniture (25) 1 3 2 0 2
Paper (26) 6 12 5 9 4
Printing/Publishing (27) 5 6 3 8 0
Chemicals/Allied (28) 8 20 7 9 12
Petroleum and Coal (29) 4 10 4 1 9
Rubber (20) 3 1 2 1 1
Stone, Clay, Glass (32) 3 1 2 1 1
11 Primary Metal (33) 7 4 2 3 6
Fabricated Metal (34) 3 4 3 3 1
Industrial Mach.(35) 8 13 11 8 2
Electronic Equip. (36) 5 10 7 7 1
Transportation (37) 7 9 2 5 9
Instruments (38) 6 6 6 4 2
Misc. Manuf. (39) 0 1 1 0 0
Trucking (42) 2 3 5 0 0
Water Transp. (44) 1 2 2 0 1
Air Transp. (45) 4 3 7 0 0
Transp. Services (47) 0 1 0 0 1
Communications (48) 2 1 0 2 1
Wholesale-Durable (50) 0 1 1 0 0
11 Wholesale-Nondurable (51) 3 5 2 3 3
Building Materials (52) 1 0 1 0 0
Gen. Merchandise (53) 2 8 5 4 1
Food Stores (54) 3 2 5 0 0
Apparel (56) 1 1 2 0 0
Eating/Drinking (58) 0 1 0 0 1
Miscellaneous Retail (59) 1 2 2 0 1
Real Estate (65) 1 0 0 0 1
Business Services (73) 3 2 4 0 1
Motion Pictures (78) 1 0 0 0 1
Health Services (80) 0 1 1 0 0
Engineering Services (87) 1 1 1 1 0
Total 107 161 114 77 77
from the unrelated-diversified group. As noted above, however, including size

in subsequent regression analyses did not appreciably change the results. At
any rate, the results described below focus primarily on comparisons between
the unrelated-diversified and the other two groups.
Return on assets was cross-sectionally lower for unrelated-diversified firms
than for either of the other two groups (p < 0.05). Return on common stock
exhibited a similar pattern, although the difference was only marginally signif-
icant (p < 0.15). Research in organizational strategy has often found that
unrelated-diversified firms are the poorest performers, apparently because of a
1 lack of synergy, such as economies of scale (Datta et al., 1991). Morck et al.
(1990) also conclude that the market generally penalizes unrelated acquisitions
and Healy et al. (1992) find that postmerger cash flow performance of related
acquisitions is higher than for unrelated acquisitions. In addition, managers may
trade-off some returns to the extent that they diversify into unrelated businesses
to reduce compensation risk.
Both cash compensation and cash plus stock options was lower for the undi-
versified group compared to the other groups. This probably reflects size
differences (Lambert & Larcker, 1987b).
The mix of compensation was also different across groups. Stock option
1 awards as a proportion of total compensation was significantly lower for
undiversified firms than for the other two groups. This is consistent with attempts
by diversified firms to link compensation more strongly to financial perfor-
mance, since stock option value is explicitly a function of stock-market
performance. CEOs may also be more receptive (assign higher value) to stock
options from unrelated-diversified firms since their returns are less risky
(Lambert et al., 1991). Cash bonus as a proportion of total cash compensation
exhibited a similar pattern, but the differences are not statistically significant.
The pattern may be weaker for cash bonus because it is often tied not only to
achievement of firm-level outcomes but also to achievement of non-financial
1 performance objectives. These compensation mix differences are consistent with
the hypothesis that unrelated-diversified firms link compensation more strongly
to financial performance.
Cross-sectional differences in the proportion of stock options in compensation
may be related merely to performance differences, however, since better
performing firms may provide larger stock option awards. To check for this, the
proportion of cash bonus and stock options in compensation was recalculated after
splitting the sample into above and below the median sub-samples for common
stock return and return on assets. At both levels of performance, unrelated-
diversified firms consistently provided the highest proportion of compensation in
cash bonuses and stock options, although the differences were not statistically
155
156 LESLIE KREN
significant. As an additional check to determine whether these differences were

related to CEO stock ownership, the proportion of cash bonus and stock options
in compensation was recalculated after splitting the sample into above and below
the median for CEO shareholdings (as a proportion of firm market value). At both
levels of CEO shareholdings, the proportion of compensation paid as cash bonus
and stock options remained consistent with that shown in Table 2.
Descriptive statistics for the control variables are also shown in Table 2.
There were no significant differences across groups for the proportion of
outsiders on the board or stock ownership by the board. As found in previous
11 research, CEO shareholdings represent a significantly larger stake in the firm
than does annual compensation (Benston, 1985). Although not shown in the
table, the mean ratio of CEO stock ownership to cash compensation for the
entire sample was 50.7, which is comparable to previous research (Lambert &
Larcker, 1987a; Lewellen et al., 1987). The distribution is rather skewed,
however, the median is 7.7. CEO and outsider stock ownership shows varia-
tion across groups, suggesting that they should be included in the basic model.
Cross-Sectional Regression Analysis
11 The cross-sectional regression results for ROA as the performance measure are
shown in Table 3.4
Recall that the coefficient of ß1 is for the unrelated-diversified group, which
is the base case. For model 2 (including control variables) with ⌬ln(cash
compensation) as the dependent variable, the estimated coefficient for the unre-
lated-diversified group (the base case) is significant and positive (␤1 = 2.24;
p < 0.01), as expected. The coefficient on the interaction term for the undiver-
sified group (␤4 = ⫺2.81; p < 0.01) is significant and negative, indicating that
the coefficient estimate on ROA is significantly smaller for the undiversified
group than for the unrelated-diversified group. This is consistent with hypoth-
11 esis 1. Similarly, the coefficient on the interaction term for the related-diversified
group (␤5 = ⫺2.37; p < 0.05) is significant and negative, indicating that the coef-
ficient estimate on ROA is smaller for the related-diversified group than for the
unrelated-diversified group. This is also consistent with hypothesis 1.
A Chow test was also used to test for differences in coefficient estimates for
ROA on ⌬ln(cash compensation) across the three diversification groups. The
Chow test does not assume equal error term variances across the three groups.
The coefficient estimate for ROA on ∆ln(cash compensation) was significant
larger for the unrelated-diversified group than for the undiversified group
(p < 0.01) and the coefficient estimate for the unrelated-diversified group was
significantly larger than for the related-diversified group (p < 0.01). The Chow
Table 2. Means and Standard Deviations (in parentheses) for Measured

Variables for Sample Firms.
(1) (2) (3) difference

total unrelated- unrelated- across
sample diversified diversified diversified groupsa
(n = 268) (n = 114) (n = 77) (n = 77) (p < 0.05)
degree of diversificationb 0.189 0.002 0.323 0.334 1 < 2,1 < 3

(0.20) (0.01) (0.18) (0.15)
relatedness of diversification 0.837 0.980 0.845 0.619 1 > 2,1 > 3,2 > 3
1 (0.18) (0.09) (0.05) (0.13)
sales ($B) 4.477 4.371 4.853 4.256 1<2
(9.2) (11.1) (7.4) (7.6)
return on assetsd 0.063 0.068 0.068 0.052 1 > 3,2 > 3
(0.05) (0.06) (0.04) (0.05)
return on common stocke 0.155 0.161 0.190 0.110
(0.30) (0.32) (0.29) (0.30)
cash compensation (000s 824 763 872 865 1 < 2,1 < 3
(469.3) (527.9) (389.5) (444.9)
cash compensation plus 1,081 935 1,189 1,172 1 < 2,1 < 3
stock options (000s) (708.9) (704.1) (645.7) (752.3)
(n = 215) (n = 89) (n = 64) (n = 62)
1
stock options/(cash 0.207 0.164 0.244 0.233 1 < 2,1 < 3
compensation + (0.22) (0.21) (0.24) (0.21)
stock options) (n = 215) (n = 89) (n = 64) (n = 62)
Control variables
Proportion of outsiders 0.688 0.666 0.715 0.694
on the boardf (0.14) (0.16) (0.13) (0.13)
Board stock ownershipg 0.061 0.070 0.062 0.048
(0.11) (0.11) (0.13) (0.07)
CEO stock ownershiph 0.030 0.037 0.019 0.031 1>2
(0.075) (0.077) (0.056) (0.086)
outsider stock ownershipi 0.116 0.137 0.087 0.113 1>2
1 (0.145) (0.156) (0.135) (0.135)
a
Denotes significant difference (p < 0.05) using a Wilcoxon rank-sum test.
b
Complement of the specialization ratio, 1 - (sales of largest segment/total firm sales).
c
Sales-weighted, pair-wise correlation of common stock return for all two-digit SIC code busi-
nesses in which the firm operates.
d
Income before tax, extraordinary items and discontinued operations divided by average total assets.
e
Closing stock price plus dividends per share divided by the closing stock price in the previous period.
f
Outsiders are defined as board members who are not current or former managers.
g
Proportion of market value owned by board members (not including the CEO).
h
Proportion of market value owned by the CEO.
i
Proportion of market value owned by the four largest shareholders.
157
158 LESLIE KREN
Table 3. Cross-Sectional Regression Analysis of CEO Compensation on

Return on Assets and Diversification Strategy.
Dependent variable (t-statistics in parentheses;
base case is unrelated-diversified)
⌬ln(cash comp. +
⌬ln(cash comp.) stock options)
(n = 268) (n = 183)
model 1 model 2 model 3 model 4

11
Intercept ␤0 0.021 ⫺0.041 ⫺0.056 ⫺0.131
(0.62) (⫺0.43) (⫺0.94) (⫺0.70)
Return on assetsa ␤1 2.67 2.24 0.968 0.756
(4.11***) (3.19***) (0.88) (0.64)
Dundiversifiedb ␤2 ⫺0.004 0.014 0.153 0.172
(⫺0.08) (0.33) (1.94*) (2.15**)
Drelated-diversifiedc ␤3 0.016 0.019 0.121 0.104
(0.34) (0.42) (1.36) (1.15)
Dundiversified ⫻ ␤4 ⫺2.46 ⫺2.81 ⫺1.70 ⫺2.21
return on assets (⫺2.97***) (⫺3.33***) (⫺1.15) (⫺1.48)
Drelated-diversified ⫻
return on assets ␤5 ⫺2.90 ⫺2.37 ⫺3.56 ⫺1.07
11
(⫺2.86***) (⫺2.23**) (⫺1.96*) (⫺0.54)
Control variables
Proportion of outsiders ␤6 0.105 0.132
on the boardd (0.83) (0.53)
Board stock ownershipe ␤7 ⫺0.135 ⫺0.341
(⫺0.75) (⫺1.13)
CEO stock ownershipf ␤8 ⫺0.375 0.370
(⫺1.54) (⫺0.89)
outsider stock ownershipg ␤9 ⫺0.036 0.037
(⫺0.29) (0.16)
R-square 0.06 0.06 0.05 0.05
11 F-statistic 3.59*** 1.99** 1.75 1.09
a
b
Dummy variable set to 1 for undiversified firms and 0 otherwise.
c
Dummy variable set to 1 for related-diversified firms and 0 otherwise.
d
e
f
g
Proportion of market value owned by the largest four shareholders.
*p < 0.10; **p < 0.05; ***p < 0.01.
test also indicated that the coefficient estimate for ROA for the undiversified
group was not statistically different from the related-diversified group. Thus,
the results of the Chow test were consistent with those reported in Table 3 for
⌬ln(cash compensation).
Overall, these results are consistent with the hypothesis that unrelated-diver-
sified link CEO cash compensation more strongly to ROA. Moreover, the
relatedness dimension of diversification has the most significant effect on the
relation between ROA and cash compensation.
The nature of the interaction between diversification and ROA as they
1 effect ⌬ln(cash compensation) is illustrated graphically in the interaction plot
shown in Fig. 1. Endpoints on the plot represent predicted values for ⌬ln(cash
Fig. 1. Interactive Effects of Return on Assets and Diversification Strategy on

⌬ln(CEO Cash Compensation).
159
160 LESLIE KREN
Table 4. Cross-Sectional Regression Analysis of CEO Compensation on

Return on Common Stock and Diversification Strategy.
Dependent variable (t-statistics in parentheses;

base case is unrelated-diversified)
⌬ln(cash comp.
⌬ln(cash comp.) + stock options)
(n = 268) (n = 183)
model 1 model 2 model 3 model 4

11
Intercept ␤0 0.025 0.038 ⫺0.025 ⫺0.055
(0.75) (0.39) (⫺0.41) (⫺0.29)
Return on common ␤1 0.372 0.342 0.348 0.489
stocka (3.79***) (2.90***) (1.95*) (2.33**)
Dundiversifiedb ␤2 0.002 ⫺0.003 1.116 0.074
(0.04) (⫺0.07) (1.45) (0.86)
Drelated-diversifiedc ␤3 0.006 ⫺0.005 0.073 0.056
(0.13) (⫺0.10) (0.80) (0.59)
Dundiversified ⫻ ␤4 ⫺0.211 ⫺0.205 ⫺0.506 ⫺0.641
return on common (⫺1.71*) (⫺1.41) (⫺2.16*) (⫺2.40**)
stock
11 Drelated-diversified ⫻ ␤5 ⫺0.201 ⫺0.275 ⫺0.090 ⫺0.198
return on common stock (⫺1.31) (⫺1.69*) (⫺0.32) (⫺0.68)
Control variables
Proportion of outsiders ␤6 0.044 0.126
on the boardd (0.35) (0.52)
Board stock ownershipe ␤7 ⫺0.139 ⫺0.240
(⫺0.78) (⫺0.80)
CEO stock ownershipf ␤8 ⫺0.404 ⫺0.327
(⫺1.67) (⫺0.80)
outsider stock
ownershipg ␤9 ⫺0.096 ⫺0.021
11 (⫺0.77) (⫺0.09)
R-square 0.08 0.06 0.06 0.08
F-statistic 4.39** 1.94** 2.11 1.71*
a
Closing stock price plus dividends per share divided by the closing stock price in the previous
period.
b
Dummy variable set to 1 for undiversified firms and 0 otherwise.
c
Dummy variable set to 1 for related-diversified firms and 0 otherwise.
d
e
f
g
Proportion of market value owned by the largest four shareholders.
*p < 0.10; **p < 0.05; ***p < 0.01.
compensation) using the first and third quartile values of ROA in the regression
equation reported in Table 3 at the indicated levels of diversification. The
plot shows that the relation between performance and compensation is the
largest for unrelated-diversified firms. For the other two groups, differences in
performance are associated with smaller differences in compensation.
The results for ⌬ln(cash+stock options) with ROA as the financial performance
measure are also shown in Table 3. These results do not support hypothesis 1.
There is a significant negative estimate for the interaction term for the related-
diversified group (␤5 = ⫺3.56; p < 0.10) for model 3 (without control variables).
1 The estimate is negative, consistent with hypothesis 1, but it disappears when the
control variables are included (model 4). Lack of support for the hypothesis for
⌬ln(cash + stock options) may result from a poorly specified regression model
for this compensation measure. Previous research has proposed that stock option
awards are used to provide motivation in future periods rather than as a reward
for past performance (Murphy, 1985). In fact, deep out-of-the-money options are
often reissued at a lower exercise price (presumably to recapture their motiva-
tional effect) and some evidence indicates that stock option awards are more
often made early in executives’ careers (Mehran, 1992).
Cross-sectional regression results for common stock return as the performance
1 measure are shown in Table 4.5 As before, the coefficient of ␤1 is for the unre-
lated-diversified group, which is the base case. ␤1 is significant and positive in
all four models, as expected.
For ⌬ln(cash compensation) as the dependent variable in model 2 (with
control variables), the interaction coefficient for the related-diversified group
(␤5 = ⫺0.275; p < 0.10) is significant and negative, indicating that the coeffi-
cient estimate on common stock return is smaller for the related-diversified
group than for the unrelated-diversified group. However, the coefficient
estimate on common stock return is not significantly different for unrelated-
diversified group compared to the undiversified group (␤4 = ⫺0.205; p = ns).
1 This provides partial support for hypothesis 1.
The results for ⌬ln(cash+stock options) with common stock return as the finan-
cial performance measure are also shown in Table 4. In model 4 (with control
variables), the interaction coefficient for the undiversified group (␤4 = ⫺ 0.641;
p < 0.05) is significant and negative, indicating that the coefficient estimate on
common stock return is smaller for the undiversified group than for the unre-
lated-diversified group. However, the coefficient estimate on common stock
return is not significantly different for related-diversified group compared to the
unrelated-diversified group. This again provides partial support for hypothesis 1.
A Chow test was again used to test for differences in coefficient estimates
for ROA on ⌬ln(cash compensation) across the three diversification groups.
161
162 LESLIE KREN
The results of the Chow test were consistent with those reported in Table 4.
Overall, these results provide only mixed support for the hypothesis that unre-
lated-diversified firms link CEO cash compensation more strongly to ROA.
Some ad-hoc evidence consistent with these regression results was obtained
using a questionnaire survey of the CEOs in this study. Sixty-two usable
responses were received (23%). The following three questions were included:
(1) Does the board use qualitative criteria rather than objective (financial) criteria
to evaluate your performance?, (2) To what extent are you rewarded for making
the right decisions, regardless of the outcome, and (3) What percentage of
11 periodic increases in your cash compensation is subjectively determined, rather
than determined using objective criteria (such as financial results)? Questions
one and two used seven-point response scales anchored with: 1 – to a very
small extent; 7 – to a great extent. The third question asked respondents to
circle a percentage. The correlations of the questionnaire items with the propor-
tion of cash bonus and stock options in compensation all had the expected sign
and were statistically significant. Q1 was significantly correlated with the
proportion of cash bonus (r = ⫺0.48; p < 0.05); Q3 was significantly correlated
with the proportion of stock options (r = ⫺0.31; p < 0.05); and Q2 was signif-
icantly correlated with both the proportion of cash bonus (r = ⫺0.51; p < 0.05)
11 and proportion of stock options (r = ⫺0.31; p < 0.05). These findings support
the proposition that stock options and cash bonus are used more often by boards
that apply objective performance criteria. The questionnaire was administered
in spring of 1991 so there may have been some CEO attrition in the interim.
Longitudinal Analysis
The purpose of this section is to describe the results of a longitudinal analysis

of a subsample of the firms in this study. Developing a longitudinal sample
was limited because only seven years of historical segment-level financial data
11 is available from Compustat. To ensure at least seven time-series observations
per firm, only the firms from the cross-sectional sample for which compensa-
tion data was gathered for 1990 were included. Historical compensation data
was obtained from the annual CEO compensation surveys published in Fortune.
Only cash compensation is available from the Fortune surveys. After elimi-
nating firms with incomplete compensation and segment data, a sample of 88
firms remained. As a final step, firms that changed diversification group during
the seven-year observation period were eliminated, leaving a final sample of
49 firms (343 firm-years). Firms that changed diversification category were
excluded because it was not clear how to analyze these changes. Control system
(contracting) changes are likely to be evolutionary and it is not clear whether
Table 5. Descriptive Statistics for Longitudinal (Spearman) Rank-Order

Correlations Between Executive Compensation and Return on Common Stock
and ROA by Diversification Group (343 Firm-Year Observations).
total unrelated- unrelated-
sample diversified diversified diversified
(n = 49) (n = 21) (n = 13) (n = 15)
Panel A: return on assets:a

median 0.214 0.107 0.142 0.429
mean 0.133 0.007 0.102 0.336
1 std. dev. 0.407 0.473 0.564 0.322
Q1b ⫺0.214 ⫺0.429 ⫺0.179 0.036
Q3 0.464 0.393 0.393 0.571
% positive 69.4 61.9 61.5 86.7
Panel B: return on common stock:c
median 0.000 ⫺0.214 ⫺0.214 0.143
mean ⫺0.084 ⫺0.148 ⫺0.154 0.067
std. dev. 0.407 0.455 0.417 0.296
Q1b ⫺0.429 ⫺0.571 ⫺0.428 0.000
Q3 0.179 0.214 0.000 0.250
% positive 51.0 38.1 38.5 80.0
1
a
b
Q1 is the first quartile and Q3 is the third quartile.
c
Closing stock price plus dividends per share divided by the closing stock price in the previous
period.
they precede or follow changes in diversification. Moreover, as described below,

sample sizes for diversification changes were relatively small.
Diversification remained quite stable over this time period for this sample.
The mean (median) number of changes in diversification for the 85 firms was
1 0.66 (0.00). After excluding the 49 firms that made no changes, the mean
(median) number of changes for the remaining firms was 1.6 (1.0). The change
process could also be characterized as evolutionary; only five (6%) firms
changed more than one diversification group from one year to the next.
The relation between performance and cash compensation was measured
using the Spearman (rank-order) correlation between the two variables by firm
over the seven years between 1984 and 1990. Distribution statistics of these
nonparametric correlations are shown in Table 5. Panel A shows the results for
ROA. The highest correlations were found for unrelated-diversified firms,
consistent with the hypothesis. In addition, the unrelated-diversified group had
the highest percentage of positive correlations. A Wilcoxon test indicated the
163
164 LESLIE KREN
correlations for the unrelated-diversified group were marginally larger than for
the undiversified group (p < 0.15). Similar results are shown for common stock
return in panel B of Table 10. Again, a Wilcoxon test indicated that the
correlations for the unrelated-diversified group were larger than for the
undiversified group (p < 0.03). Overall, these results support the conclusions
from the cross-sectional models.
SUMMARY AND CONCLUSION
11 Evidence is provided using 268 Fortune 500 firms to support the hypothesis
that unrelated-diversified firms link CEO compensation more strongly to finan-
cial performance than firms that are undiversified or diversified into related
businesses. Consistent results were also obtained from a longitudinal analysis
of a subset of the firms.
Overall, these results are consistent with arguments that the organizational
response to information asymmetry about CEO performance, caused presum-
ably by diversification, should be a tighter linkage between CEO compensation
and financial performance measures. This is consistent with Holmstrom’s (1979)
proposition that, in a moral hazard setting, the principal must rely on a second-
11 best contract in which performance evaluation is based on publicly observable
outcomes when information about behavior is unavailable or too costly (Amihud
& Lev, 1981). Correspondingly, where monitoring CEO behavior is more diffi-
cult for the board, as in unrelated-diversified firms, financial performance
measures are a more important determinant of compensation. It is interesting
to note that if unrelated diversification reflects attempts by managers to diver-
sify their firm’s lines of business to diversify their own compensation risk, as
has been often suggested (e.g. Amihud & Lev, 1981), then these efforts appear
to be undone by boards in unrelated-diversified firms by linking compensation
more strongly to financial performance (increasing compensation risk).
11 Previous research examining the effects of diversification on firm value has
generally found that diversification reduces firm value (Comment & Jarrel,
1994). Berger and Ofek (1995), for example, found that diversified firms were
undervalued compared to single-business firms. They concluded that diversifi-
cation represents a “. . . suboptimal managerial strategy . . .” and they
questioned the efficacy of control mechanisms in diversified firms. The results
in this study contradict Berger and Ofek’s conclusions by providing evidence
that control systems differ across diversification and are consistent with norma-
tive agency theory arguments that CEO cash compensation should be linked
more closely to ROA in (particularly unrelated) diversified firms when direct
monitoring of CEO behavior is more difficult.
These results are stronger for ROA than for common stock return. This may
be a consequence of a CEO’s ability to hedge compensation risk through market
transactions, or the relative informativeness of disaggregate accounting infor-
mation. The latter reason suggests that accounting measures provide information
beyond that found in stock price (Antle & Smith, 1986). One explanation for
why the results were more consistent with the hypothesis for ROA than for
common stock return may be related to the disaggregate nature of accounting
information relative to stock price (which may be particularly valuable for
compensation administrators in a diversified firm). Some research has already
1 examined ways that earnings components are used to motivate specific manage-
ment actions that increase shareholder wealth (Bushman & Indjejikian, 1993;
Lambert, 1993). Kim and Suh (1993), for example, argued that the informa-
tiveness of earnings relative to other performance measures defines earnings’
role in compensation contracting. Earnings provide evaluators with incremental
information about management’s’ input (effort) that is unavailable from stock
price. Dechow and Sloan (1991) found that the growth in research and devel-
opment expenditures was significantly depressed during a CEO’s final years in
office, consistent with the existence of this “horizon problem.” They concluded
that earnings-based incentives encourage managers to focus on short-term
1 performance. This study’s results suggest that firm characteristics (i.e. diversi-
fication) should be included in positive theory accounting models.
These results hold even after controlling for differences in the proportion of
outsiders on the board of directors, or differences in shareholdings by the board,
outsiders or by the CEO. These factors seem to be independent of diversifica-
tion effects. Thus, one could conjecture that diversification is one of several
sources of information asymmetry that affects the seriousness of the moral
hazard problem.
In addition to those identified above, important shortcomings in this study
(and this line of research) include the inability to measure total changes in CEO
1 wealth. This may be a serious omission since CEOs may make attempts to
diversify their total portfolio to offset firm-specific risk. These attempts may be
anticipated by compensation system designers and result in altered contract
terms. Another problem relates to the effect of multi-period contracting. Lambert
[1983] demonstrates, using a multi-period model, that the agent’s performance
over the entire employment history can be used to diversify some of the uncer-
tainty surrounding the agent’s behavior. This suggests that a CEO’s reputation
impacts the relationship between behavior, firm performance and compensation
[Murphy, 1986]. Along these lines, long-term incentives (beyond stock options)
were not studied and yet may provide additional perspectives on compensation
system design.
165
166 LESLIE KREN
ACKNOWLEDGMENTS
The author gratefully acknowledges helpful comments by Jeffrey Kerr, Paul

Kimmel, Michael Schadewald, Terry Warfield, Arthur Warga, and the
Accounting Research Workshops at the University of Wisconsin-Milwaukee
and Lehigh University on earlier drafts of this paper.
NOTES
11 1. The Black-Scholes model probably overstates executive stock option value because
executive stock options are contingent on employment, they are strictly non marketable,
and the model’s assumption of a constant variance for the stock price can be readily vio-
lated through managers’ actions (Noreen & Wolfson, 1981). To provide a lower bound
on stock option value, options were also valued using the lesser of zero or the difference
between the year-end market price of the underlying stock and the exercise price of the
option (Benston, 1985; Lewellen et al., 1987). This valuation was highly correlated with
the Black-Scholes value (r = 0.70, p < 0.00), however, and the substantive results were
similar so only the Black-Scholes model results are reported in the paper.
2. In addition to the reported performance measures, the cross-sectional regression
analyses were replicated using: (1) raw common stock return and ROA, (2) raw common
stock return and ROA less the value-weighted return of all firms listed on Compustat,
11 and (3) risk-adjusted common stock return and ROA calculated by subtracting the
average common stock return and ROA for all other firms on Compustat with the same
(market) beta as each sample firm. Except for minor differences, these alternate perfor-
mance measures produced conclusions consistent with those reported.
3. The analysis was also repeated using an entropy (Herfindahl-type) measure proposed
by Jacquemin and Berry (1979) and used in several subsequent studies
n
Degree of diversification = ⌺Pi ⫻ ln(1/Pi),
i=1
where Pi is defined as the proportion of the ith segment’s sales to total sales. This measure
provides a weighted average of the proportionate share of sales from each segment, with
the weight being the logarithm of the inverse of each segment’s proportionate share. This
11 measure is intended to incorporate both the number of segments in which the firm operates
and the relative importance of each segment’s sales in total sales (Palepu, 1985). For this
sample, the correlation between the two measures was very high (r = 0.96; p < 0.00)
and comparable results were obtained using either measure so only the results using the
simple measure in equation 2 is reported in the paper.
4. There was no evidence of heteroscedasticity for any of the subsequent formula-
tions of this regression model based on a White’s test (Ramanathan, 1989), so ordinary
least squares was used. Also, even though a Shapiro-Wilk statistic indicated some depar-
tures from normality for some of the models’ regression residuals, it was not severe
since 90% of the standardized residuals invariably fell between plus and minus 1.64 and
the medians of the distributions were close to zero (Neter & Wasserman, 1974).
5. The magnitude of the coefficients shown in table 4 are not directly comparable to
previous studies. Therefore, to check the consistency of this sample, the results of a
simple regression of common stock return on ⌬ln(cash compensation) was compared to

Gibbons and Murphy (1990) who reported a slope coefficient of 0.1562 (their Table 1)
for the same model for a large cross-section of CEOs. The regression for this sample
produced a similar slope coefficient of 0.1685 (t = 2.897; p < 0.01).
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169
xii RUNNING HEAD

PARTICIPATIVE BUDGETING AND
PERFORMANCE: A STATE OF THE
ART REVIEW AND RE-ANALYSIS
Peter Chalos and Margaret Poon
ABSTRACT
Despite numerous empirical studies, a theoretical paradigm of participative

budgeting and performance is lacking. A multiplicity of explanatory
variables examining budgetary performance has generally yielded mixed
results and low explanatory power. This state of the art re-analysis
contributed to the resolution of these issues in several ways. First, based
upon an exhaustive review of participative budgeting and performance
studies, a more parsimonious set of budget constructs was developed.
Confirmatory factor analysis yielded two managerial and two
organizational constructs that were both theoretically appealing and
methodologically reliable. These included budgetary goals, incentives,
socialization, and learning. Second, a regression of these constructs with
budget participation explained significantly more performance variance
than prior studies. Results suggested the interaction between participation
and goals contributed positively to performance while incentive effects
had a significant performance effect independently of participation. A
post hoc structural equation analysis also found managerial learning to

ISBN: 0-7623-0825-7
171
172 PETER CHALOS AND MARGARET POON
be an influential mediating variable between budget participation and

performance. These findings offer a theoretical and methodological
re-interpretation of the mixed results previously found between budget
participation and performance and suggest areas for future research.
INTRODUCTION
Participative budgeting is one of the most exhaustively researched areas of

management accounting. Recent studies (Lau & Buckland, 2000; Perez &
11 Robson, 1999) continue to explore participative budgeting variables. Yet the
cumulative results of these not inconsiderable efforts have been decidedly
mixed. Budgetary participation has been found to be positively associated with
performance outcomes as often as not (Dunk & Nouri, 1998; Shields & Shields,
1998). The sheer diversity of variables used in this research has hindered the
development of a theoretical framework. Both the indeterminate direction and
sizable magnitude of variance in the findings suggest a fundamental
misunderstanding of the moderating relationship between participation, budget
variables and performance. A meta-analysis of budgetary participation
concluded: “A significant portion of the variance in participative budgeting
11 studies remains unexplained. There is little evidence that methodological
moderators have contributed to these inconsistencies. Researchers should
proceed to analyze summary theoretical moderators identified in the literature”
(emphasis added, Greenberg et al., 1994, 136).
This study contributed to the resolution of these issues. First, given recent
criticism of a lack of a theoretical framework in participative budgeting (Shields
& Shields, 1998; Russell, 1996; Greenberg et al., 1994), a state of the art review
of all of the variables previously explored in explaining the linkage between
participative budgeting and performance was undertaken. Based upon these
findings, a reduced set of constructs was developed. Factor analysis confirmed
11 two individual and two organizational constructs that were both intuitively
appealing and methodologically reliable. These included individual budgetary
goals and incentives, and organizational socialization and learning. A regression
of these constructs upon performance explained significantly more of the
variance than prior studies. The results suggested that the significant statistical
interactions frequently found between participation and budget moderators on
performance were primarily attributable to individual budget goal emphasis,
while incentives affected performance independently of participation. In
addition, a post hoc structural equation analysis indicated that organizational
learning was a significant mediating rather than moderating variable between
budget participation and performance.
Participative Budgeting and Performance 173
STATE OF THE ART
Performance is the most frequently reported and statistically significantly

dependent variable associated with participation. In our state of the art review,
we categorized studies of participative budgeting and performance according
to: (i) budget variable; (ii) budget construct; (iii) method; (iv) construct
reliability; (v) significance of budget variable interaction with budget
participation upon performance; (vi) significance of budget variable main
effect upon performance; and (vii) R2 of the model. These results are summa-
1 rized in Appendix A and are discussed below in the context of each budgetary
construct.
Budget Goals
Goal theory predictions have been consistently supported in empirical studies,

making it one of the most robust findings in psychology (Locke & Latham,
1990). From a goal theory perspective, participation’s effect on performance
occurs by increasing the salience of and commitment to specific and challeng-
1 ing budget goals. This process operates by increasing the level of perceived
control and accountability an individual feels relative to a goal, thereby enhanc-
ing the influence of the goal on behavior. Particularly noteworthy is that the
effect of performance incentives is not included in goal theory. Evidence indi-
cates that incentives operate independently of goal setting effects (Locke &
Latham, 1990).
In studies of budgeting, a significant literature has focused on the relationship
between managerial goals, participation and performance. As can be seen in
Appendix A, these studies include goal setting, difficulty, importance and
accountability. Our analysis revealed numerous studies that examined the
1 relationship between participation and aspects of individual goal setting. Kren
(1990) found that subordinate performance was marginally maximized in settings
in which difficult goals were coupled with budget participation to build budget
commitment. Chow (1983) also found that both goal level and managerial par-
ticipation in goal level setting marginally affected performance. In examining
task difficulty, Mia (1989) and Brownell and Dunk (1991) both found that budget
participation significantly decreased the perception of task difficulty and
improved performance. When budget participation increased as task difficulty
increased, performance was high. Performance was low when participation was
not commensurate with the perceived level of task difficulty. When task diffi-
culty was high, budget participation served an important information exchange
173
role. Most recently, using a survey instrument (Otley, 1978; Hopwood, 1972)
designed to measure the importance of the budget, Lau and Buckland (2000)
found that participation alone decreased performance for Norwegian managers
but that budget participation interacted positively with goal difficulty. The
authors attributed this to the importance of high participation in Norway. A
similar result was found in Singapore (Lau & Tan, 1998).
The importance attached to budget goals has been examined in numerous
studies. Dunk (1993, 1990) found strong evidence of interaction between bud-
getary importance and participation on performance and positive budgetary
11 importance main effects as well. These cumulative results suggest that
emphasizing budgetary goals without managerial participation adversely affects
performance.
Another frequently examined goal variable is accountability. Managers are
generally held accountable for budgetary goals over which they have control.
Absent accountability, goals become less structured and meaningful.
Responsibility accounting encourages goal directed behavior. Brownell (1983)
and Tiller (1983) have argued that lack of budget accountability interacts with
budget participation to adversely affect performance. Brownell (1983) found that
when managers were held accountable for unfavorable variances, a significant
11 negative main effect upon performance resulted, but that participation led to a
significant positive interaction upon performance. Tiller (1983) also found a pos-
itive interactive effect between budget participation and decentralized account-
ability on performance. When subjects were less accountable (i.e. low decision
responsibility) in setting budget goals, performance was significantly lower under
budget participation than when subjects were more accountable (i.e. high deci-
sion responsibility).
The above studies on the relationship of individual budgetary goals and
participation upon performance strongly suggest a positive interaction between
goal characteristics and budget participation. All of the studies found a positive
11 interaction between budget participation and goal related variables upon
performance, while less than half found positive main effects (see Appendix A).
Budget participation in setting goals appears to increase managerial motivation,
improve goal clarity, induce identification with the budget and increase com-
mitment to achieving the budget. Goal setting, difficulty, importance and con-
trollability are speculated to represent with statistical reliability a goal construct
that interacts with managerial budget participation in affecting performance. It is
hypothesized that:
Hypothesis 1. Budget participation interacts positively with a goal construct

to affect performance.
Performance Incentives
Dunk and Nouri (1998) provide evidence that pay schemes motivate managers
to maximize budget performance. Incentive effects upon performance are firmly
rooted in the economics literature. Agency theory stresses the motivational
aspects of incentives in aligning principal-agent interests, but rarely admits agent
participation in the design of such incentives. Economic incentives and related
perquisites are viewed as motivators of performance, independently of
managerial participation. In a budgeting context, Brownell and McIness (1986,
1 589) argue that: “(pay or bonus) valence of an external outcome . . . does not
depend on whether it is participatively set.” Numerous studies of participative
budgeting and incentives have examined the effect of monetary rewards,
resource allocations, performance evaluation, scope of managerial authority and
budget fairness upon performance. These studies have confirmed the effect of
incentives upon performance and failed to confirm hypothesized interactions of
budget participation and incentives upon performance.
Reward allocation has been examined in several studies. In a laboratory
experiment, Chow (1983) found that budget incentives exerted a significant
main effect upon subject performance, independently of budget participation.
1 Shields and Young (1993) in a managerial survey also found a strong and
significant main effect of incentives upon subject performance. In neither case
did subject participation exert a significant interaction effect with incentives
upon performance. Aranya (1990) measured the effect of managerial resource
incentives upon performance. Survey results indicated a marginally significant
positive main effect and a negative interaction of resource allocation with
participation upon performance. High performance was associated with low
participation–high resources. Aranya (1990, 75) concluded that “reward systems
that do not motivate participants to set high performance standards may result
in decreasing effort under conditions of high participation – high resources”.
1 Chalos and Haka (1989) found no significant interaction between relative
managerial performance incentives and budget participation upon performance,
but did find a positive main effect on performance. Dunk (1990) also found a
significant and positive main effect as well as a negative interaction between
performance incentives and budget participation upon performance. Irrespective
of whether budget participation and performance incentives were high or low,
performance was low. In other words, admitting budget participation in the
performance incentive process lowered performance, irrespective of the
evaluation (Dunk, 1990).
Chenhall (1986) found that budget participation exerted a positive interaction
with performance authority upon performance. A positive main effect was also
175
found. Two recent studies (Lindquist, 1995; Magner et al., 1995) examined the
implications of the fairness of economic incentives, such as pay schemes,
relative to budget participation and their effects upon managerial performance.
Less fair budgets were presumed to adversely affect managerial attitude and
performance. Participation was hypothesized to mitigate this effect. Lindquist
(1995) found no interactive effects between fairness and budget participation,
but did find a main fairness effect upon performance. Magner et al. (1995)
however found a significant negative interaction in addition to a positive main
effect. Low buget participation increased performance more than high budget
11 participation overall.
Together, the above studies on the relationship of managerial incentives to
performance are remarkably consistent. The results strongly suggest that budget
participation is not a positive incentive moderator. Four studies found a significant
negative interaction between budget participation and incentives upon perfor-
mance, while four studies found no significant interaction effects. There is little
evidence to suggest that budget participation in the design of incentives positively
affects performance. On the contrary, several studies suggest a decrement in
performance. By contrast, incentives per se were found to exert a significant pos-
itive effect upon performance in all of the studies (Appendix A). Based upon the
11 above findings, we hypothesize that rewards, resources, performance incentives
and fairness represent a managerial incentive construct. It is hypothesized that:
Hypothesis 2. Incentives exert a positive main effect upon performance,

independently of budget participation.
Budgetary Socialization
An organizational climate exists within which the budgetary process operates.

Hofstede (1991, 181) defines budgetary culture “as the manifestation of behavior
11 evolving from the shared values of the organization”. These values are rein-
forced through organizational socialization practices. Numerous dimensions of
budgetary socialization have been examined, including the resolution of orga-
nizational conflicts, role ambiguity, transmission of culture and task uncertainty.
Several studies have examined budgetary conflicts. Most recently, Perez and
Robson (1999) examined the “organizational hypocrisies of the budget
participation process” in a case study, concluding that the ritual of budget
negotiation and performance persists within a broader political and cultural
process of legitimization. Mia (1988) found a positive interaction between
budget participation and organizational conflicts. Managers with a less favor-
able organizational attitude towards budgetary conflicts performed significantly
worse than managers participating in the budget with a more positive organi-
zational outlook. Brownell (1983) found budget participation to interact strongly
with organizational climate, including such aspects as trust, respect and proce-
dures.
Employee role is another aspect of budget socialization. Role ambiguity
involves the expectations associated with a managerial role and the ascribed
organizational methods of fulfilling these expectations. Chenhall and Brownell
(1988) found that role ambiguity was moderated by budget participation in
influencing performance. In a recent study of budget socialization, Nouri and
1 Parker (1998) found that budget participation increased organizational
commitment. A related study of budget culture (O’Connor, 1995) found that
power distance moderated the effect of participative budgeting on performance
by decreasing role ambiguity. Another aspect of budgetary socialization includes
the specification of task procedures and the sequence of steps used to guide
task performance. These specifications reduce budget uncertainty. Brownell and
Dunk (1991) found no significant main or interactive effect between budget
participation and task uncertainty.
All but one of the above studies involving aspects of budgetary socialization
found insignificant main effects and, with one exception, positive interactions
1 of participation with budgetary socialization variables upon performance
(Appendix A). Accordingly, it is posited that resolution of budget conflicts,
reduction of role ambiguity, reinforcement of budget culture and reduction of
budgetary uncertainty represent a budgetary socialization construct that interacts
with budget participation to affect performance. It is hypothesized that:
Hypothesis 3. Budget participation interacts positively with budgetary

socialization to affect performance.
Budgetary Learning
1
An interactive learning process of periodic planning, measurement, and feedback
characterizes many budgetary systems. “Goals are determined. Environmental
information is coded, stored and subsequently retrieved. Deviations of actual
outcomes from predetermined goals are recorded for corrective actions”
(Flamholtz et al., 1985, 39). The emphasis on routines and the ecology of learning
closely resembles paradigms of individual learning. But budgetary learning,
whether tacit or formalized, may not provide access to stored information and may
vary in the emphasis placed on formal routines. For example, goals and feedback
are strongly conditioned by the environment in which the firm operates. In uncer-
tain environments, firms face challenges implementing budgetary systems
177
designed to promote routine organizational learning. Khandwalla (1972) was one

of the first researchers to emphasize the importance of environmental competition
on the firm’s budgetary system. Otley (1980) also concluded that budgetary
systems were strongly influenced by the firm’s environment.
Numerous studies of participative budgeting have examined the importance
of budget learning with feedback, information sharing and uncertainty reduction.
Magner et al. (1996) tested a model of cognitive budgetary participation through
a main effects structural model and found that participation enhanced budget
quality which in turn affected budget utilization. Senge (1990) stressed the
11 notion of shared mental models for budgetary improvements. Organizational
learning is viewed as increasing an organization’s capacity to take effective
actions; to improve actions through better knowledge and understanding; and
to discover patterns and rules for better future decision making. Den Hertog
and Wielinga (1992) found a trend towards cross-functional teams and flatter
information sharing, designed to facilitate budget participation and
organizational learning. Results of field research clearly indicate the importance
of organizational learning in budgeting.
Recent evidence from the accounting literature emphasizes the importance of
budgetary feedback in organizational learning. The organization learns by
11 comparing reported results to budgeted goals. Divisional sales and production
reports are examples of such feedback. Periodically, budget analysts issue
summary financial control reports. Examples include production variances for
cost centers and divisional contribution margins for profit centers. Other
applications include project management reports such as path analysis for
production scheduling; profit planning systems for lines of business which report
actual to forecast revenues and expenses; revenue budgets which analyze market
share, volume, price, etc.; reports used to monitor competition; and human
resource planning budgets (Simons, 1995, 108).
The organization learns by comparing reported results to budgeted goals at
11 each reporting level. This vertical cybernetic loop constitutes budgetary learning
in its simplest form. Using a simulated approach to feedback learning, Ouksel
et al. (1997) examined alternative organizational learning conditions relative to
both accuracy and speed of learning, finding strong feedback effects in learning.
Agents learned to distinguish past patterns to improve future decisions under
alternative feedback structures.
Information sharing is a key component in organizational learning. Shields and
Shields (1998) found information sharing to be a main reason for participative
budgeting and suggested its importance in organizational learning. Dunk (1995)
found a significant main effect and a marginal statistical interaction between
information sharing and budget participation on performance. Kren (1992)
examined the mediating rather than moderating role of information between par-
ticipative budgeting and performance. He found a strong effect of budget partici-
pation on information and a strong main effect of information on performance.
Contingency theorists have argued that environmental uncertainty impacts
budgetary learning (Carley, 1992; Bourgeois, 1985; Galbraith, 1977). As
environmental uncertainty increases, information needs increase. Govindarajan
(1986) found that greater budget participation improved managerial performance
in high environmental uncertainty situations and hampered performance in low
uncertainty situations. Brownell (1985) also found a significant interaction
1 between budget participation and environmental uncertainty upon performance.
Budget participation was more efficient in uncertain research and development
environments than in marketing. Participation reduced and resolved some of
the environmental uncertainty affecting performance. Most recently, Hassel and
Cunningham (1996) found that performance was affected by a significant
interaction between budget participation, environmental uncertainty and reliance
on budget controls.
Studies analyzing facets of budgetary learning suggest strong interaction and
main effects upon performance. Five of the six studies that reported statistical
results found a positive main effect of organizational learning variables upon
1 performance, while all three of the studies that investigated interactions with
budget participation also found significant results. One study reported mediating
effects in which participation affected learning, which in turn increased
performance. It is hypothesized that:
Hypothesis 4. Budgetary learning interacts positively with participation and

has a main effect on performance.
RESEARCH METHODS
1 Respondent Sample
Data for the study were collected through a questionnaire administered to

marketing managers listed in a national business directory of publicly traded
firms. Prior to survey mailing, all firms were contacted by telephone in order to
invite their participation and to ensure that their managers held budgetary
responsibility. In return for their participation, managers were provided with sum-
mary results of the survey. Questionnaires were mailed to 200 randomly selected
division managers across as many firms that agreed to participate in the study.
A total of 108 responses were received, of which 15 were deleted because
of missing data. This left a useable response rate of 93 questionnaires (46.5%)
179
which compares favorably with other budgeting studies. Descriptive statistics

of the respondents indicated the mean age to be 32.45 years (standard deviation
= 6.19 years) with an average tenure of 4.20 years (standard deviation = 3.70)
at their respective firms. Sixty-four of the respondents (71.1%) were male and
45 (50.6%) classified themselves as mid-level regional marketing managers,
with the remainder approximately equally divided between vice-presidents and
area managers. As the questionnaires were anonymous, no data on industry type
or size of firm was requested.
11 Instrument
Of the reported participative budgeting and performance studies, over one half
used Mahoney’s measure of performance. The remainder used a mix of financial
performance metrics and self-ratings of performance in which no single measure
predominated. Given that this study was empirically grounded in prior research
and that Mahoney’s metric was the most commonly reported measure of
performance, this metric was employed. Using a 7 point Likert scale, managers
were asked to rate themselves on eight dimensions. These included planning,
investigating, coordinating, evaluating, supervising, staffing, negotiating, and
11 representing (see Appendix B). An overall measure of performance was also
included to cross-validate the summative score of the eight dimensions of
performance provided by the respondents.
Budget participation was defined as the manager’s degree of influence on the
budget. As employed in most studies of participative budgeting, Milani’s (1975)
participation measure was used (see Appendix B). While alternative measures
have been used (Hofstede, 1967; Aranya, 1990), Milani’s measure dominates
the literature. To enable comparisons across studies, Milani’s measure was
adopted. This measured subjects’ involvement in the budget; revisions of the
budget by the supervisor; unsolicited managerial opinions regarding the budget;
11 managerial influence on the budget; budget contribution; and solicited budget
opinions. An overall measure of budget participation was constructed by
summing responses to these items.
The methods and test instruments used to examine each of the independent
variables in participative budgeting studies were dissimilar. Appendix A
categorizes each of these studies by method. Frequently, different methodologies
were used across studies to examine the same independent variable. Not only
did the methods differ by variable but, when surveys were used as a
methodology, so did the survey instrument. The survey studies examining
information sharing, for example, all used different test instruments. It was not
possible in the present survey study to replicate either experimental
manipulations or the diverse set of survey instruments of the same variable used
across prior studies. Instead, the verbal designation of the construct as reported
by the author of each study was the designation used.
As discussed above in the context of the literature, the individual goal
emphasis construct included questionnaire items asking respondents to rate (1
= strongly disagree; 7 = strongly agree) the importance of goal setting, difficulty,
importance and accountability in the budget process. The incentive variable
included monetary rewards, resource allocations, performance evaluation,
budgetary authority and budget fairness. The budgetary socialization construct
1 comprised resolution of budget conflicts, role ambiguity, budget culture and
reduction of budget uncertainty. The organizational learning construct included
the importance of organizational learning, budget feedback, information sharing
and planning for environmental uncertainty (Appendix B).
Countermeasures to Validity Threats
Several measures were taken to mitigate threats to response bias and survey
reliability. First, debriefing analysis of variable responses relative to respondent
characteristics was done. Second, t-tests were performed on each of the 17 item
1 responses relative to the midpoint of the scale in order to assess the statistical
significance of the relative (un)importance attributed to each variable by survey
respondents. Third, Cronbach alpha coefficients (1951) were calculated for each
construct in order to corroborate the hypothesized construct reliability and to
compare it against reported alphas from previous survey studies of the same
variable. Fourth, Harman’s (1967) single factor test was performed across survey
items. If a substantial amount of common method variance exists in the data,
a single factor will emerge when all variables are entered simultaneously.
Results of eigenvalue loadings from a rotated varimax factor solution of the
data were compiled for all the constructs. Additional validity threats included
1 common method bias attributable to single source survey respondents, that is
managers, not superiors, evaluated their own performance. A recent method-
ological meta-analysis of common method bias in participative budgeting
(Greenberg et al., 1994, 133) concluded that “any differences between common
methods and multiple methods partition is simply due to statistical artifacts and
not due to underlying differences in the data gathering procedures”. Finally, the
methodological approach used in this study (survey) might not be representative
of some of the other approaches (namely experimentation). Again, Greenberg
et al. (1994, 136) reported that “survey results were not significantly different
from experimental results”. Together, these measures and empirical findings
provide some assurance against threats to validity.
181
ANALYSIS AND RESULTS
Reliability Checks
One hundred and eight survey responses were coded, 15 of which were deleted
because of missing data. This left 93 observations for analysis. Descriptive
statistics of the questionnaire responses are shown in Table 1. The correlation
matrix of all variables is included in Table 2. With one exception, t-tests on
mean responses to the budget variables were all significantly (p < 0.05) above
11 the midpoint of the Likert scale, an indication of the budgetary importance of
the variables to the subject respondents. To test for possible respondent effects,
ANOVAS were run on the debriefing variables. None of the variables was
statistically significant relative to any of the survey variables.
Results indicated that the performance construct had an alpha reliability
coefficient of 0.83, above the minimum of 0.60 normally considered to be accept-
able, and with a single factor with an eigenvalue above unity. The overall per-
formance scaled metric correlated highly with the summative score (R2 = 0.87;
Table 1. Survey Descriptive Statistics (n = 93).

11
Variable Mean Std. Dev. Min. Max.
Definition of Manager’s Budgetary Role* (1) 4.10 1.30 1 7

Difficulty of Budget Goals (2) 5.10 1.04 2 7
Allocation of Monetary Rewards (3) 4.20 1.25 1 7
Reduction of Budget Uncertainty (4) 4.50 1.24 1 7
Budget Information Sharing (5) 5.14 1.16 1 7
Budget Goal Setting (6) 5.47 1.06 2 7
Budgetary Authority (7) 4.35 1.24 1 7
Learning During the Budget Process (8) 5.33 1.09 2 7
Justification of Budget Fairness (9) 4.67 1.18 2 7
11 Resolution of Budget Conflicts (10) 4.30 1.24 1 7
Planning for Environmental Uncertainty (11) 5.95 0.83 3 7
Allocation of Budget Resources (12) 5.39 1.10 2 7
Performance Evaluation (13) 4.67 1.18 2 7
Reinforcement of Budgetary Culture (14) 4.27 1.24 1 7
Budgetary Accountability (15) 5.40 0.86 3 7
Importance of Budget Goals (16) 5.33 1.00 3 7
Budgetary Feedback (17) 5.58 0.99 3 7
Budgetary Participation (Summative) 3.70 2.03 1 7

Budgetary Performance (Summative) 4.45 1.35 1 7
* The only variable that was not significantly different from the Likert scale midpoint @ p < 0.01.
1
Participative Budgeting and Performance

Table 2. Correlation Matrix of Budget Variables.1
Questionnaire Budget Variables 1
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17
1 0.361 0.345 0.221 0.206 0.424 0.358 0.128 0.294 0.508 0.480 0.308 0.189 0.425 0.264 0.480 0.208
2 0.428 0.251 0.097 0.443 0.300 0.157 0.290 0.291 0.354 0.337 0.218 0.478 0.348 0.401 0.357
3 0.330 0.148 0.249 0.434 0.344 0.347 0.321 0.302 0.296 0.397 0.427 0.225 0.249 0.381
4 0.393 0.164 0.189 0.484 0.199 0.074 0.103 0.253 0.213 0.125 0.196 0.267 0.503
5 0.143 0.102 0.027 0.188 0.111 0.162 0.161 0.247 0.132 0.155 0.152 0.140
183
6 0.230 0.179 0.198 0.246 0.243 0.275 0.185 0.317 0.389 0.551 0.288
7 0.148 0.584 0.389 0.287 0.357 0.224 0.427 0.300 0.230 0.277
8 0.124 0.151 0.124 0.301 0.129 0.131 0.233 0.452 0.683
9 0.304 0.287 0.248 0.347 0.351 0.239 0.322 0.183
10 0.589 0.270 0.154 0.465 0.284 0.397 0.212
11 0.264 0.138 0.435 0.388 0.320 0.199
12 0.377 0.375 0.461 0.305 0.311
13 0.176 0.396 0.345 0.153
14 0.407 0.479 0.240
15 0.353 0.365
16 0.448
17
1
See Table 1 variable identifiers
183
11
11
11
184
Table 3. Rotated Factor Loadings of Budget Variables.
Factor 1 Factor 2 Factor 3 Factor 4 Factor 5
Variable Budgetary Budget Goals Performance Budgetary Information
Socialization Incentives Learning Sharing
Resolution of Budget Conflicts 0.809 0.086 0.201 0.094 ⫺0.026

Reduction of Budget Uncertainty 0.765 0.225 0.097 0.028 0.096
Definition of Manager's Budgetary Role 0.649 0.277 0.134 0.066 0.265
Reinforcement of Budgetary Culture 0.607 0.358 0.284 0.091 ⫺0.067
Budget Goal Setting 0.198 0.774 0.025 0.092 0.094
Difficulty of Budget Goals 0.234 0.676 0.126 0.193 0.096
Importance of Budget Goals 0.272 0.592 0.139 0.383 0.013
PETER CHALOS AND MARGARET POON

Budgetary Accountability 0.253 0.560 0.329 0.085 ⫺0.079
Budgetary Authority 0.312 ⫺0.041 0.755 0.186 ⫺0.020
Justification of Budget Fairness 0.222 0.021 0.706 0.096 0.165
Performance Evaluation ⫺0.124 0.310 0.643 ⫺0.049 0.237
Allocation of Budget Resources 0.152 0.357 0.542 0.190 ⫺0.030
Allocation of Monetary Rewards 0.224 0.226 0.437 0.297 0.149
Learning During the Budget Process 0.034 0.106 0.104 0.902 ⫺0.085
Budgetary Feedback 0.090 0.264 0.139 0.820 0.036
Planning for Environmental Uncertainty 0.035 0.062 0.141 0.652 0.359
Budget Information Sharing 0.122 0.069 0.127 ⫺0.007 0.880
Eigenvalues 5.830 1.758 1.299 1.099 1.050
Cronbach’s Alpha of Factor Variables 0.786 0.750 0.737 0.789 1.000
Cumulative Percentage of Variance 34.3% 44.1% 52.3% 58.7% 64.9%
p < 0.05). The participation construct had an alpha reliability coefficient of 0.76
and a single factor with an eigenvalue greater than one.
Construct Validity
Responses to the budgeting variables were factor analyzed. The confirmatory

varimax-rotated factor solution retained five factors with eigenvalues greater
than one. With the exception of information sharing, all of the construct loadings
were as hypothesized. Together, these factors explained 64.9% of the variance
1 (see Table 3). The overall Kaiser’s measure of sampling adequacy was 0.77.
The factor loadings were all above the rule of thumb of 0.40, and all factors
had alpha reliability coefficients above 0.70. Table 3 includes the factor
loadings, eigenvalues and alpha coefficients for all factors. Factor 1,
organizational budgetary socialization (eigenvalue = 5.83), included resolution
of budget conflicts, reduction of budget uncertainty, resolution of budget role
ambiguity and place and reinforcement of budget culture, as theorized. An alpha
check of the raw scores of factor 1 variables yielded 0.79.
The second factor, individual goals (eigenvalue = 1.76), included goal setting
importance, determination of goal difficulty, communicating the importance of
1 budgetary goals, and accountability for budget goals. These variables confirmed
the goal construct, as theoretically hypothesized. A Cronbach alpha of the raw
scores of factor 2 variables yielded 0.75.
The third factor, performance incentives (eigenvalue = 1.29), included
delineation of budget authority, justification of budget fairness, performance
evaluation, resource allocation, and allocation of monetary rewards. This factor
included all of the variables theoretically linked to individual incentives. A
Cronbach alpha of the raw scores of factor three variables yielded 0.74,
indicating construct reliability for the managerial incentive factor.
The fourth factor (eigenvalue = 1.099) represented budgetary learning. Factor
1 loadings included the importance of organizational learning, budgetary feedback
and planning for environmental uncertainty. A Cronbach alpha of 0.79 was
found for this construct. Contrary to theoretical speculation, information sharing
did not load on the organizational learning construct. Instead, a final factor
represented information sharing (eigenvalue = 1.05).
Model Fit and Tests of Hypotheses
A correlation matrix of the factor scores is included in Table 4. The orthogonal

factors were by definition uncorrelated. An OLS model of the raw factor
variables was employed to test the hypothesized main incentive and learning
185
Table 4. Factor Correlation Matrix.

BP P F1 F2 F3 F4 F5
BP
P 0.174
F1 0.053 0.039
F2 ⫺0.075 0.135 0.000
F3 ⫺0.099 0.367* 0.000 0.000
F4 0.315* 0.427* 0.000 0.000 0.000
F5 0.028 ⫺0.087 0.000 0.000 0.000 0.000
11
BP = Budget Participation
P = Performance
F1 = Budgetary Socialization
F2 = Budget Goals
F3 = Performance Incentives
F4 = Budgetary Learning
F5 = Information Sharing
*Significant @ p < 0.01.
effects and the interactive effects of participation on goals, socialization, and

11 learning:
Y = ␤0 + ␤1 x1 + . . . ␤6 x6 + ␤7⫻7 . . . 11 x1⭈x2 . . . 6 + 苲
e (1)
Y represented managerial performance; x1 participation; x2 budget goals; x3
incentives; x4 socialization; x5 budget learning and x6 information sharing. The
results of the regression model are summarized in Table 5.
To determine the incremental effect of budget participation in the model, a
stepwise regression was performed. The main effects were run in stage one and
the interaction terms were added in stage two. As indicated in Table 5, the
main effect model was significant (R 2 = 0.36; F = 3.25; p < 0.00), but the full
11 regression explained a significantly larger proportion of managerial performance
(R = 0.47; F = 4.99; p < 0.000). The explanatory power of the interactive model
exceeded prior studies (mean R2 = 0.184; max. R2 = 0.380 (Appendix A)).
Hypothesis one posited that budget participation positively interacted with
goal emphasis to affect performance. The interaction was significant with the
expected sign (t = 1.79; p < 0.05; 1 tailed), corroborating hypothesis one. As
goal difficulty increased, budget participation had a positive effect upon
performance. Without participation, imposed budgetary goals significantly
lowered performance (t = 1.67; p < 0.05; 1 tailed).
Hypothesis two tested whether the coefficient indicated a significant main
incentive effect upon managerial performance. The coefficient was significant
Table 5. OLS Regression Results of Raw Factors on Performance.

Variable Coefficient Value Std. Error t p
Intercept ␤0 35.137 3.043 11.550 0.000

Participation ␤1 0.251 0.116 2.167 0.034
Budgetary
Socialization ␤2 1.527 4.112 0.371 0.712
Budget Goals ␤3 ⫺5.295 3.171 ⫺1.670 0.100
Performance Incentives ␤4 6.837 3.216 2.126 0.038
Budgetary Learning ␤5 6.171 3.114 1.982 0.048
1 Information Sharing ␤6 ⫺4.002 2.896 ⫺1.382 0.172
Participation ⫻ ␤7 -0.034 0.148 0.235 0.815
Budgetary
Socialization
Participation ⫻ ␤8 0.228 0.127 1.789 0.079
Budget Goals
Participation ⫻ ␤9 ⫺0.167 0.120 ⫺1.392 0.169
Performance Incentives
Participation ⫻ ␤10 0.349 0.160 2.179 0.033
Budgetary Learning
Participation ⫻ ␤11 0.126 0.118 1.064 0.291
Information Sharing
1
R2 = 0.474; F11,61 = 4.987 (p < 0.000); (R2 = 0.363 main effects model only).
(t = 2.13; p < 0.05), corroborating hypothesis two. Performance incentives

exerted a significant positive effect upon performance and an insignificant
interaction with participation, as hypothesized.
Hypothesis three posited that participation would interact positively with
budgetary socialization. The interaction term of socialization and participation
was not significant. Nor was the main effect significant. Hypothesis four
1 predicted a positive interactive effect of participation and organizational learning
on performance and a positive main effect of learning on performance. Results
indicated a significant interaction between budget participation and
organizational learning (t = 2.18; p < 0.05). A main learning effect on
performance was also found (t = 1.98; p < 0.05), confirming hypothesis four.
Post Hoc Structural Equation Analysis
As a further check on the methodological validity of the OLS model, a mediating

model was examined. Participation was viewed as an antecedent to the budget
factors (Shields & Young, 1993; Kren, 1992; Mia, 1988; Brownell & McIness,
187
11
11
11
188
Fig. 1. Path Model of Mediating Variables.
1986). As shown in Fig. 1, participation was hypothesized to affect performance,

mediated by the effect of budgetary factors. These factors were considered to
be endogenous to the budget process and causally dependent upon participation.
EQS, a path analysis software package, was run treating the budget factors
as mediating variables between budget participation and performance. Each path
coefficient, pij, indicates the impact of variable j in explaining the variance in
variable i. The values of the path coefficients can be interpreted in units of
standard deviation. For example, the path coefficient of p31 = 0.136 in Fig. 1
indicates that for every standard deviation increase in participation, the data
1 predicted a performance increase of 0.136 standard deviations in performance.
A series of regressions were performed to estimate the path coefficients as
follows:
Z2i . . . m = p2i . . . m1Z1 (2)
Z3 = p31Z1 + p32i . . . mZ2i . . . m (3)
Z1 represented budget participation; Z2i . . . m the budget factors, and Z3

performance. Each variable was standardized to a mean of zero and a standard
deviation of one. The path coefficients were used to decompose the total
1 relationship between two variables into direct and indirect effects. The total
relationship was measured with the zero order correlation coefficient, rij:
r12i . . . m = p2i . . . m1 (4)
r2i . . . m3 = p32i . . . m + p31r12i . . . m (5)
r13 = p31 + p32i . . . m r12i . . . m (6)

Subscripts 1 and 3 refer to budget participation and performance respectively.
Subscript 2i . . . m refer to the budget factors. The first term on the right hand side
1 of all equations is an estimate of the direct effect or path coefficient of the variable
in question. The second term is an estimate of the indirect effect, or in the absence
of an indirect effect, it is an estimate of the spurious effects. Equation (5) allows
a decomposition of the total relationship between budget factors and performance
into a direct effect and a spurious effect. The spurious effect results from partici-
pation, which is a common antecedent to both budget factors and performance.
Equation (6) allows decomposition of the total relationship between participation
and performance into a direct effect and indirect effect through budget factors.
The results of estimating Eqs (2) and (3) are shown in Fig. 1 and Table 6.
The path p31 = 0.13 represents the relationship between budget participation and
performance. This was not significant (t = 1.34; p > 0.05). However, when the
189
Table 6. Results of Path Analysis.
Dependent Variable Path Coefficient Estimate t-statistic

Link to: (Fig. 1)
Budget Factors to P2i1 0.053 0.468

Budget Participation P2j1 ⫺0.075 ⫺0.668
(see Eq. 2) P2k1 ⫺0.099 ⫺0.879
P2l1 0.316 2.941*
P2m1 0.028 0.806
11 Performance to Budget Factors P32I 0.092 0.927

(see Eq. 3) P32j ⫺0.031 ⫺0.306
P32k 0.405 4.061**
P32l 0.410 4.034**
P32m ⫺0.139 ⫺1.397
Performance to Participation P31 0.136 1.340

(see Eq. 3)
For equation (2) P2l1, R2 = 0.092 (F = 8.643**); For equation (3), R2 = 0.363 (F = 3.25**)
*Significant at p < 0.01
**Significant at p < 0.001
Bentler-Bonnett Normed Fit Index = 0.955; ␹2 = 1.934.
11
mediating budget variables were considered, the path model resulted in a signif-
icant and strong explanatory fit (Bentler-Bonnet normed fit index NFI = 0.95;
␹2 = 1.93). In other words, budget participation per se had an insignificant effect
on performance, but significant combined direct and indirect effects through the
mediating factors.
Three path coefficients were significant: budget participation to organizational
learning, p2l1 = 0.31 (t = 2.94; p < 0.01); incentives to performance, p32k = 0.40
(t = 4.06; p < 0.001); and learning to performance, p32l = 0.41 (t = 4.03; p <
11 0.001). Consistent with the main effects of the OLS regression, incentives and
learning exerted significant effects upon performance. Per equation (2) budget
participation per se provided relatively little explanatory power (R2 = 0.09;
F = 8.64; p < 0.001). Equation (3) however provided strong explanatory power
(R2 = 0.36; F = 3.25; p < 0.001), as previously reported, due to the effects of
incentives and organizational learning on performance.
In Table 7, the direct effect of budget participation on budget factors shows a
significant effect of participation on learning (Eq. 4), suggesting a mediating
rather than moderating learning effect. None of the other path coefficients
between participation and budget factors, as expected, was significant, confirming
the fact that the significant OLS interaction effect found between participation and
Table 7. Decomposition of Path Analysis.

Dependent Variable Path Total Effect Direct Effect Indirect/
Link to: Coefficient Rij pij Spurious
(Fig. 1) Effect
Budget Factor to P2i1 0.053 0.053

Budget Participation P2j1 ⫺0.075 ⫺0.075
(see Eq. 4) P2k1 ⫺0.099 ⫺0.099
P2l1 0.316 0.316
P2m1 0.028 0.028
1 Performance to P32I 0.099 0.092 0.007a
Budget Factors P32j ⫺0.041 ⫺0.031 ⫺0.010
(see Eq. 5) P32k 0.392 0.405 ⫺0.013
P32l 0.453 0.410 0.043
P32m ⫺0.135 ⫺0.139 0.004
Performance to P31 0.223 0.136 0.0875b
Participation
(see Eq. 6)
a
Spurious Effect.
b
Indirect Effect.
1
goals on performance (H1) was correctly specified. The direct effect of the budget
factors on performance is also included in Table 7 (equation 5). This is statistically
equivalent to a main effect only OLS regression of budget factors upon
performance. The indirect effect of participation on performance through
organizational learning was assessed by p32lr12l in equation (6). Eliminating
spurious effects, this value was equal to 0.41*0.31 = 0.13. In other words, the
indirect effect of participation on performance through organizational learning
contributed as much to performance as participation directly.
The model was re-run with the five factors as antecedents to budget
1 participation. This served as a check of the temporal order between participation
and the mediating variables. The Bentler-Bonett normed fit index (NFI = 0.28)
indicated a very weak fit of the data. Neither budget participation nor any of
the factor coefficients were significant, suggesting that budget factors were not
causal antecedents to participation and that the full interactive OLS model was
correctly specified.
DISCUSSION
The results of this re-analysis of the state of the art literature clarified several
unresolved participative budgeting issues. First, the multiplicity of variables
191
examined in previous studies was more parsimoniously modeled without loss

of generality to include two managerial and two organizational constructs. These
included individual goals and incentives and organizational learning and
socialization. These constructs explained significantly more of the performance
variance than found in prior budgeting studies.
Second, budget participation empowered managers, which increased goal
commitment and positively affected performance. Imposed goals decreased
performance. However, the interactive effect of participation in the design of
individual incentives, so often advanced as a reason for participative budgeting,
11 was not confirmed. To the contrary, our results suggested that managerial
involvement in incentive design marginally lowered performance. Rather, a
main incentive effect upon performance was noted. This finding corroborates
the intuition for and empirical prevalence of budgetary “pay for performance”
incentives, such as bonuses and stock options. Our findings suggest that
independently of budgetary participation, incentive contracting issues are
extremely important in understanding the relationship to performance.
Third, although budgetary socialization has been proposed as an important
interactive variable with participation in the literature, our findings were
inconclusive. While the budget may serve an organizational acculturation
11 purpose, our results did not reflect this effect. Perhaps our factor analysis did
not successfully capture a meaningful budgetary socialization construct.
Finally, our findings indicate that interactive participation effects are in some
cases mis-specified. One of the most interesting findings of this study was the
strong positive mediating effect of learning between budget participation and
performance. Recent fieldwork (Simons, 1995; Den Hertog & Wielinga, 1992;
Senge, 1990) and theoretical simulations of organizational learning (Ouksel
et al., 1997; Carley, 1992) attest to the importance of organizational learning.
Carley (1992) characterized the learning process as a feedback loop in which
actual results are recorded and compared to budget. Environmental uncertainty
11 and feedback play a key role in her model. Managerial participation leads to
organizational learning. Learning occurs as past deviations are used to reduce
future environmental forecast error – i.e. the organization learns from its mistakes.
Our results confirm the intuition of this characterization of organizational
learning in a budget context. Budget systems are designed to activate learning
across a range of management activities. The environment facing the firm has
a significant impact on budgetary uncertainty. Current corporate environmental
concerns include operating budgets, capital budgets (i.e. investments),
productivity measures, new product development, activity analysis, target
costing, and process reengineering to name only a few. Forecast accuracy is
particularly important for budgetary profit projections, capital budgeting cash
flow estimates and target cost projections. Budgetary participation activates

learning needed in monitoring these investments. In each of these areas, financial
and non-financial goals are determined. Actual performance is measured relative
to these goals as managers learn through feedback. Institutional memory of
events can then be captured and transferred to new budget teams in order to
mitigate risks associated with future environmental uncertainties.
The considerable body of work relating environmental predictability to budget
systems has been summarized in such work as Galbraith (1977), Mintzberg
(1979) and Pfeffer (1982) but has yet to be incorporated into budgeting research.
1 In today’s rapidly changing technological environment, speed of organizational
learning is a vital consideration in budgetary planning. The value chain from
product development through customer delivery is very time dependent, as
product development times and life cycles decrease. The clear implication for
budget systems is the ascendancy of the learning organization, in terms of both
accuracy and speed.
To date, research in the role of organizational learning in budgeting remains
limited to a few studies. Future research should examine how budget
participation affects organizational learning as a function of the predictive
characteristics of budgetary information under alternative information structures.
1 These information structures include lateral as opposed to vertical information
flows, increasingly found under flatter team organizational structures. The role
of budgeting under wider spans of control found in newly downsized
organizations is an intriguing question. The optimal dissemination of budgetary
information across sub-units should also be explored. The examination of
antecedents to budgeting would be a worthwhile extension to such models.
Organizational learning and incentive issues are two increasingly important
budgeting issues for consideration in future research.
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11
11
1
Participative Budgeting and Performance

APPENDIX A
Prior Research: Main Effect and Budget Variable Interaction with Participation on Performance.
Construct: Model Interaction Main Effect Methodology2 Source
Questionnaire Item1 (R2) (p-value) (p-value)
Budget Goals (␣ = 0.750)

Goal Importance 0.301 < 0.10 < 0.10 Survey Dunk, 1993
0.320 < 0.01 < 0.05 Survey Dunk, 1990
Goal Setting 0.215 < 0.10 n.s. Experiment Kren, 1990
– < 0.10 < 0.10 Experiment Chow, 1983
Difficulty of Budget Goals 0.138 < 0.05 n.s. Survey (␣ = 0.75) Mia, 1989
0.231 < 0.05 < 0.10 (neg.) Survey Lau and Buckland, 2000
197
0.167 < 0.05 < 0.01 Survey Lau and Tan, 1998
0.223 < 0.01 n.s Survey Brownell and Dunk, 1991
Budget Accountability 0.052 < 0.10 < 0.10 (neg.) Survey Brownell, 1983
– < 0.10 < 0.01 Experiment Tiller, 1983
Performance Incentives (␣ = 0.737)

Allocation of Monetary Rewards – – – Review Dunk and Nouri, 1998
– n.s. < 0.01 Experiment Chow, 1983
0.102 n.s. < 0.05 Survey (␣ = 0.93) Shields and Young, 1993
Allocation of Resources 0.191 < 0.01 (neg.) < 0.10 Survey (␣ = 0.72) Aranya, 1990
Performance Evaluation 0.111 < 0.05 (neg.) < 0.01 Survey Dunk, 1990
– n.s. < 0.10 Experiment Chalos and Haka, 1989
Budgetary Authority 0.244 < 0.01 < 0.05 Survey (␣ = 0.87) Chenhall, 1986
Justification of Budget Fairness 0.368 < 0.01 (neg.) < 0.01 Survey (␣ = 0.72) Magner et al., 1995
– n.s. < 0.01 Experiment Lindquist, 1995
197
11
11
11
198
Prior Research: Main Effect and Budget Variable Interaction with Participation on Performance Continued.
Construct: Model Interaction Main Effect Methodology2 Source
Questionnaire Item1 (R2) (p-value) (p-value)
Budgetary Socialization (␣ = 0.786)

Resolution of Budget Conflicts – – – Field Study Perez and Robson, 1999
– < 0.01 n.s. Survey (␣ = 0.90) Brownell, 1983
0.131 < 0.05 n.s. Survey (␣ = 0.61) Mia, 1988
Definition of Manager’s Budget
Role 0.274 < 0.01 < 0.01 (neg.) Survey (␣ = 0.87)
Budgetary Culture 0.184 < 0.05 < 0.05 Survey Nouri and Parker, 1998
0.080 < 0.10 n.s. Survey (␣ = 0.90) O’Connor, 1995
Reduction of Budget Uncertainty 0.276 n.s. n.s. Survey (␣ = 0.76) Brownell and Dunk, 1991
Budgetary Learning (␣ = 0.789)

Learning During the Budget – – – Field Study Senge, 1990
Process – – – Field Study Den Hertog and Wielinga,
1992
0.241 – 0.01 Survey Magner et.al., 1996
Budgetary Feedback – – – Field Study Simons, 1995
– – <0.01 Simulation Ouksel et al., 1996
Budget Information Sharing 0.191 < 0.10 <0.05 Survey (␣ = 0.79) Dunk, 1995
– – – Survey Shields and Shields, 1998
0.218 – <0.05 Survey (␣ = 0.72) Kren, 1992
Planning for Environmental 0.080 < 0.05 n.s. Survey Brownell, 1985
Uncertainty 0.103 < 0.01 <0.05 Survey (␣ = 0.75) Govindarajan, 1986
0.240 < 0.05 – Survey Hassell and Cunningham,
1996
1
a represents the reliability coefficient found in the present study.
2
a represents the reliability coefficient for survey instruments when reported in other studies.
APPENDIX B
Questionnaire
Managerial Performance
A. Effective managerial performance may be considered to depend in part on the following activ-
ities. For each activity, please rate your recent performance by circling the appropriate
number from 1 (very low) to 7 (very high).
1 Below Average
Above Average
Performance
1. Planning: Determining goals, policies 1 2 3 4 5 6 7
and courses of action, work scheduling,
setting up procedures, programming
2. Investigating: Collecting and preparing 1 2 3 4 5 6 7
information for records, reports and
accounts, measuring output, inventorying,
job analysis
3. Coordinating: Exchanging information 1 2 3 4 5 6 7
with people in your organization in order
1 to relate and adjust programs, advising and
liaison with other personnel
4. Evaluating: Assessment and appraisal of 1 2 3 4 5 6 7
proposals, reported or observed performance,
employee appraisals, judging output records,
judging financial reports, product inspection
5. Supervising: Directing, leading and 1 2 3 4 5 6 7
developing personnel, training and explaining
work rules to subordinates, assigning work
and handling complaints
6. Staffing: Maintaining the work force of 1 2 3 4 5 6 7
your organization, recruiting, interviewing
1 and selecting new employees, placing,
promoting and transferring employees
7. Negotiating: Purchasing, selling or 1 2 3 4 5 6 7
contracting for goods and/or services,
contacting suppliers, dealing with sales
representatives
8. Representing: Attending conventions, 1 2 3 4 5 6 7
consultation with other firms, business club
meetings, public speeches, community drives,
advancing the general interests of your
organization
9. Overall Performance 1 2 3 4 5 6 7
199
Role of the Budget

B. Based on your experience, please rate the importance of the following in the budget process.
Please use the following scale:
1 = Strongly Disagree (SD) 5 = Slightly Agree

2 = Disagree 6 = Agree
3 = Slightly Agree 7 = Strongly Agree (SA)
4 = Neutral (N)
SD N SA
11 1. Definition of Manager’s Budgetary Role 1 2 3 4 5 6 7

2. Difficulty of Budget Goals 1 2 3 4 5 6 7
3. Allocation of Monetary Rewards 1 2 3 4 5 6 7
4. Reduction of Budget Uncertainty 1 2 3 4 5 6 7
5. Budget Information Sharing 1 2 3 4 5 6 7
6. Budget Goal Setting 1 2 3 4 5 6 7
7. Budgetary Authority 1 2 3 4 5 6 7
8. Learning During the Budget Process 1 2 3 4 5 6 7
9. Justification of Budget Fairness 1 2 3 4 5 6 7
10. Resolution of Budget Conflicts 1 2 3 4 5 6 7
11. Planning for Environmental Uncertainty 1 2 3 4 5 6 7
12. Allocation of Budget Resources 1 2 3 4 5 6 7
11 13. Performance Evaluation 1 2 3 4 5 6 7
14. Reinforcement of Budgetary Culture 1 2 3 4 5 6 7
15. Budgetary Accountability 1 2 3 4 5 6 7
16. Importance of Budget Goals 1 2 3 4 5 6 7
17. Budgetary Feedback 1 2 3 4 5 6 7
Budget Participation
C. The following items can be used to describe the role which you play in the development
of the budget. Please circle the appropriate number on a scale of 1 to 7 for each item.
1. Which category below best describes your activity when the budget is being set? I am
11 involved in setting:
None of the Budget All of the
Budget
1 2 3 4 5 6 7
2. Which category below best describes the reasoning provided by your superior/supervisor
when budget revisions are made? The reasoning is:
Very arbitrary and/or Very sound and/or

illogical logical
1 2 3 4 5 6 7
3. How often do you state your requests, opinions and/or suggestions about the budget to your
superior/supervisor without being asked?
Never Very frequently
1 2 3 4 5 6 7
4. How much influence do you feel you have on the final budget?
None Very much
1 2 3 4 5 6 7
5. How do you view your contribution to the budget? My contribution is:

Very important Very unimportant
1 1 2 3 4 5 6 7
6. How often does your superior/supervisor seek your requests, opinions and/or suggestions
when the budget is being set?
Never Very frequently
1 2 3 4 5 6 7
Individual Information
D. Number of Years in Present Position ______.
Management Title ________________________________.
1 Budgetary Responsibility for _____________________________________.
Age ______.
Sex ______.
201
xii RUNNING HEAD

INTERACTIVE EFFECTS OF
STRATEGIC AND COST
MANAGEMENT SYSTEMS ON
MANAGERIAL PERFORMANCE
Andreas I. Nicolaou
ABSTRACT
This study examines the effect of the interaction between a firm’s cost
management system and its strategic systems on a financial manager’s
performance in carrying out tasks related to cost management. The use of
cost management systems assists in implementing a firm’s specific
manufacturing strategy, as defined by the use of modern systems of just-
in-time production and electronic data interchange. The specific strategic
systems used by a firm, therefore, influence the design of cost management
systems, which support strategic and operational decisions. A financial
manager’s satisfaction with the extent of decision support is hypothesized
to be influenced by the extent to which a firm’s cost management system
complements decision requirements that are determined by a firm’s specific
manufacturing strategy. During the empirical study, an extensive sample
selection process was carried out in order to identify organizations that
were users of just-in-time manufacturing techniques as well as electronic
data interchange systems. The results were, in general, supportive of the
hypothesized relationships. These results offer significant implications,

ISBN: 0-7623-0825-7
203
204 ANDREAS I. NICOLAOU
which support the view that system design issues should be explicitly
considered in models where it is sought to identify performance outcomes
due to the introduction of specific manufacturing techniques. Suggestions
for future research are also made which could extend the concepts and
relationships presented here.
INTRODUCTION
Recent developments in manufacturing technology and advances in the potential

11 information processing capability of organizations enhance the importance of
designing information systems that support decisions in environments where the
required flow of information occurs in a primarily lateral fashion. Requirements
for lateral information processing are often created by new technological and
production arrangements, where the relative efficiency and sustainable
competitiveness of manufacturing operations are critical for an organization’s
success in its value chain (Dertouzos et al., 1989; Hayes et al., 1988). Lateral
information processing, as opposed to vertical information flows, impose system
design requirements that influence decision support and performance.
The use of modern technologies by manufacturing organizations has made
11 necessary the examination of relationships between a firm’s strategy and the
design of information systems for cost control and cost management. Other
accounting studies in this area (Abernethy & Lillis, 1995; Langfield-Smith,
1997) have shown the importance of examining specific operational or
manufacturing-level strategies in such relationships. The manufacturing strategy
adopted by a firm can significantly influence the effective management of costs
and the design of cost management systems (CMS) that provide decision support
and assist in implementing a firm’s strategy. The use of a CMS is defined in
this study as a computer-based system that provides cost information used in
strategic decisions, including sourcing, product pricing and mix, and customer
11 profitability decisions, as well as in operating decisions, including process
improvement, product design, and performance measurement and evaluation
decisions (Swenson, 1995).
The use of just-in-time (JIT) manufacturing techniques and electronic data
interchange (EDI) systems that allow for the electronic exchange of accounting
and production data among trading partners, are two notable developments that
assist in a firm’s operational ability to respond to demands of the new
manufacturing environments. While prior studies have examined the success of
use of JIT systems with inconclusive results (e.g. Balakrishnan et al., 1996),
this study introduces system design issues in explaining the relationship of JIT
and EDI systems use with the extent of decision support in organizations and
Interactive Effects of Strategic and Cost Management Systems 205
the effect on managerial performance. The use of a cost management system

to effectively support a firm’s information needs in strategic and operational
decision making is prerequisite for a firm’s ability to attain desired objectives
in its value chain. As a result, a manager’s perceptions of personal performance
could serve as a surrogate measure for the effectiveness of decision support
provided by the CMS. The primary purpose of this study, therefore, is to
examine the relationship between a financial manager’s perceived self-
performance and the extent of use of the CMS to support strategic and
operational decision needs that are necessary for the implementation of such
1 operational strategies as just-in-time and electronic data interchange systems.
The strategic and operational decision needs, which are considered in this
study, capture the range of decisions that are required for the effective
implementation of a firm’s specific manufacturing strategy. The use of JIT and
EDI systems represents a significant dimension of a firm’s manufacturing
strategy and is an important concept that is examined in this research. These
systems might influence the coordinated management of information flows
relative to a firm’s value chain, or “strategic cost management.” The emphasis
on the strategic management of costs has gained ground in past research
(Bromwich, 1990; Shank & Govindarajan, 1992; Simons, 1990) and the results
1 of this study demonstrate that this is an important issue in modern manufacturing
organizations. A manager’s satisfaction with the performance of a cost
management system is significantly influenced by the design of the CMS to
support decisions and promote the coordination and control of activities in
modern manufacturing environments.
The remainder of the paper is organized as follows. In the next section,
pertinent research that relates to individual components of the research model
is reviewed. The theoretical framework is developed and the major research
hypothesis for the study is advanced. The study’s research method is presented
next, followed by a presentation of the empirical findings. The paper concludes
1 with a discussion of the findings and with suggestions for future research.
THEORETICAL FRAMEWORK
The research model for the study posits that perceptions of managerial
performance will depend on the degree of fit between the use of JIT and EDI
technologies and the scope of use of a CMS. The term “CMS performance
satisfaction” is employed to indicate the extent to which a financial manager
believes that his or her personal performance is enhanced by the use of
information provided by the CMS. As a concept, therefore, the term “CMS
performance satisfaction” relates to how well does the system supports strategic
205
and operational decisions, with regard to the implementation of a firm’s specific

manufacturing strategy. The discussion that follows is organized around the
major components of the research model, and presents theoretical arguments
that are used to advance the research hypothesis for the study.
Use of JIT and EDI Systems as Components of Manufacturing Strategy
Prior research in production/operations management (Skinner, 1969, 1985;

Swamidass & Newell, 1987; Wheelwright, 1984) has distinguished between the
11 content and process of manufacturing strategy. Manufacturing strategy content
refers to specific dimensions which comprise the strategy, that is, “[t]he distinc-
tive competencies of the manufacturing function employed in the pursuit of com-
petitive advantage” (Swamidass & Newell, 1987, p. 510). This research considers
the use of JIT production and EDI systems as specific competencies that promote
relative competitive advantage and help attain strategic objectives in a manufac-
turing environment. The process aspect of manufacturing strategy encompasses
the set of organizational arrangements that allow for its successful implementa-
tion. The resultant process that allows an organization to effectively implement its
strategy is defined in this research in terms of a firm’s cost management system
11 and, specifically, through the process of its use in making managerial decisions.
The use of JIT production and EDI systems affects the degree of competency
of a firm in dealing with its suppliers and customers in its value chain. For
example, enhanced flexibility in just-in-time manufacturing may allow a firm
to respond more effectively to market and technological uncertainties (Hayes
& Wheelwright, 1984; Hayes et al., 1988). The use of JIT helps free up
managers’ time from managing inventories so that they could attend to such
issues as the management of product quality and manufacturing efficiency. Use
of JIT systems facilitates relationships with a few trading partners with which
longer-term relationships can be established (Kaplan & Atkinson, 1989, p. 416;
11 Morris & Hollman, 1988). In such a system, uncertainty in deliveries can be
reduced when trading partners link their computer systems so that production
orders, invoices, payments, et cetera, are done automatically. Successful JIT
implementation, therefore, would depend greatly on reliable and efficient
communication with trading partners. This can be achieved through EDI
(Banerjee & Golhar, 1993; Srinivasan et al., 1994). EDI systems are
interorganizational systems that facilitate communication and information
sharing between two or more organizations by providing a highly efficient and
error-free electronic information link (Bakos, 1991). Different organizations that
rely on each other for the procurement of critical resources may be subject to
resource dependencies, as there might exist asymmetries in the control of those
resources (Pfeffer & Salancik, 1978). In such situations, the use of EDI systems
and the integration of interorganizational information processed by those
systems with internal accounting information systems, can provide significant
benefits to the organization in terms of improved coordination and control of
internal activities (Miller & Vollman, 1985; Nicolaou, 2000). Similarly, the use
of JIT systems can provide significant benefits for internal process efficiency
and control. The implementation of these systems, however, creates information
needs that are necessary for making appropriate strategic and operational
decisions in such environments. These decision needs could be met through the
1 use of a firm’s cost management system. The following section discusses the
concept of decision support through the scope of use of cost management
systems and advances the research hypothesis for the study.
Scope of Use of Cost Management Systems
Prior accounting studies that examined issues relating to the design of control
processes in organizations were motivated by Anthony’s (1965) definition of
management control as “the process by which managers ensure that resources are
obtained and used effectively and efficiently in the accomplishment of
1 organizational objectives.” This paper adopts the view that systems for cost
management assume a wider scope in terms of the information they process and
have an expanded role with regard to possible uses of their information outputs
than traditional systems for management control. In modern manufacturing orga-
nizations, cost management systems inevitably are part of the overall organiza-
tional infrastructure (cf. Nanni et al., 1992), that is, they form part of an
arrangement of information processing systems and automation capabilities that
allow improved responses to demands for increased quality, reduced costs, and
on-time delivery (Information Infrastructure Task Force: Committee on
Applications & Technology, 1994; Hayes et al., 1988). Cost management
1 systems, therefore, would support coordination among different activities,
functions, or among different organizations involved in a firm’s value chain (cf.
Porter, 1985). In a normative statement about the effectiveness of such systems,
Nanni et al. (1992) suggest that, “. . . for management accounting systems to be
effective, they must continuously evolve with other parts of the infrastructure”
(p. 5), that is, they must be consistent with other complementary policies and
procedures of the organization that facilitate organizational actions. As a result, a
manager’s satisfaction with the performance of an organization’s CMS, will
reflect how well is the CMS designed to support specific requirements relating to
a firm’s strategic and operational decision needs that are necessary for the
implementation of manufacturing strategy.
207
The use of EDI systems helps coordinate the procurement of resources and
delivery of finished products with internal production activities. In addition, the
use of EDI systems promotes quality, performance measurement, and the control
of costs throughout the supply, production and delivery processes. The use of
JIT systems also entails significant changes in the production process. JIT
systems affect manufacturing performance through their effects on efficiency
and improved manufacturing control. Better scheduling of production within
the factory allows the procurement of materials and assembly and manufacture
of parts and components just before they are needed. Nevertheless, it is difficult
11 to establish such performance relationships without considering the system that
will support the need for a continuous flow of required materials, a smooth
supply chain, or identification of areas for process improvement and perfor-
mance assessment throughout the production and delivery processes.
A financial manager’s satisfaction with CMS performance, therefore, will
depend on the complementarity between the use of JIT and EDI systems and the
scope of use of the CMS to support strategic and operational decision needs. The
notion of complementarity or, fit, between these two sets of concepts implies that
successful implementation of a firm’s manufacturing strategy requires a simulta-
neous shift in the design and scope of use of the cost management system.
11 Milgrom and Roberts (1990, 1995) have exemplified the meaning and application
of complementary relationships, especially as applied in modern manufacturing.
In their analysis, complemetarities represent synergies among different elements
of an organization’s strategy and structure (Milgrom & Roberts, 1995). The
successful adoption and implementation of a firm’s manufacturing strategy, there-
fore, is not a marginal decision (Milgrom & Roberts, 1990). As a result, the use of
JIT and EDI systems which is not consistent with design changes in a firm’s CMS
may not allow reduction in decision uncertainty and realization of potential
benefits. The following research hypothesis is therefore advanced:
H1: A manager’s satisfaction with the performance of a CMS will be
11
positively associated with the extent of complementarity between the use of
JIT/EDI systems and the scope of use of CMS to support strategic and oper-
ational decisions.
RESEARCH METHOD
Sample Selection
The study design requires the collection of data from manufacturing organizations
that have adopted EDI systems and JIT manufacturing techniques. To identify
firms that have adopted JIT manufacturing, a comprehensive search was per-
formed on the text of annual reports and/or 10-K filings of all manufacturing firms
in the United States. For this purpose, a keyword search was performed on the
SEC Online database during the time period from 1987 to 1995. The SEC Online
database was chosen for this task since it includes the text of annual reports and
10-K filings, that is, president’s letter and management discussion and analysis, in
an electronic format for multiple years. Following Balakrishnan et al. (1996),
these keywords were used to search for JIT adopter firms: “just in time,” “JIT,”
“pull system,” “continuous flow manufacturing,” and “zero inventories.” A total
1 of 1,650 records (annual reports and/or 10-K filings) were identified in the string
search. After eliminating multiple-year and/or multiple-report disclosures for the
same firm, reports that did not indicate JIT adoption, as well as reports that either
related to non-U.S. firms or to adoption of JIT in foreign operations only, a total
of 341 firms remained in the sample.
The researcher determined the extent of JIT use for the 341 firms by
evaluating the text in the reports. The objective was to generate a measure of
JIT use that possessed face validity with regard to the actual use of JIT as
discussed in the annual reports. Two levels of JIT use were identified: (a)
significant use of JIT in the production process, and (b) use of JIT in the delivery
1 process only. These levels are further discussed in the section on measurement
below. This phase divided the sample into 191 firms that had used JIT in the
production process and 150 firms that had used JIT in the delivery process only.
In addition, a total of 105 firms with JIT production (or 55%) were also users
of EDI systems, while 98 firms with JIT delivery (or 65%) were also using
EDI systems. EDI user firms were identified through a manual search in the
1995 EDI Yellow Pages Directory.
In order to identify the different operating divisions and/or subsidiary
companies in which JIT was implemented, in addition to possible JIT adoption
in the parent company operations, the management discussion in each of the
1 annual reports and/or 10-K filings for all 341 firms was further scrutinized. This
was a critical part of sample selection since data about manufacturing strategy
and its associated constructs were necessary to be collected from those operating
units instead of corporate centers that were not directly involved in
manufacturing operations. The process of identifying divisions and subsidiary
companies of large corporations, which were initially identified in the sample
of 341 firms, was facilitated by a simultaneous cross-reference between the
management discussion in the annual reports and/or 10-K filings and the
“Ultimate Parent Index” in Volume 3 of the Standard & Poor’s Register of
Corporations. This whole process resulted in the selection of a final sample of
604 organizations, including 251 whole companies which were part of the initial
209
sample of 341 firms extracted from SEC Online and were not further divided
into other operating divisions, 199 manufacturing divisions of larger
corporations, and 154 subsidiary companies involved in manufacturing. This
final step in sample selection ensured that all organizations in the sample were
directly involved in manufacturing operations and were users of JIT
manufacturing techniques.
Data Collection
11 A mail survey was employed to collect information about the constructs of

interest. Mail surveys enable researchers to survey a large sample of the
population while it preserves the anonymity of the respondents. Two potential
problems might be encountered when using mail surveys to collect data: (a)
low response rates, and (b) nonresponse bias. To insure for the first risk, the
Total Design Method was used (Dillman, 1978). Specific analyses were
conducted to assess nonresponse bias. Before mailing the research instrument
to organizations in the sample, the instrument was evaluated by expert panels.
These included both faculty members and an individual from the target
population that possessed similar characteristics with the target respondents, as
11 suggested by Dillman (1978, pp. 155–158). The revised instrument and a cover
letter were mailed to each organization in the sample for completion by the
financial controller or chief financial officer, that is, the officer who has primary
responsibility for product costing, planning, and control decisions.
Nonrespondents were followed-up with two additional mailings.
The final response rate from all mailings was 20%. A total number of 107
useable responses were received. Five additional responses were considered
unusable due to the organizational position of the person completing the
questionnaire, for example, marketing manager, or because it was evident that
responses did not refer to manufacturing operations. Of the 604 mailed
11 questionnaires, 26 were returned as undelivered, while 17 respondents denied
response due to time pressures and another 14 denied response due to company
policy not to participate in mail surveys. Of the 107 useable responses, 62 firms
were adopters of JIT production techniques, while 45 firms adopted JIT in the
delivery area only. In addition, 74 firms had adopted EDI systems. Table 1
presents descriptive characteristics for the 107 firms.
Tests for non-response bias were performed to determine: (a) whether the
distribution of the 604 organizations in the response (n = 112) or nonresponse
(n = 492) categories was independent of available demographic characteristics
(gross revenue and number of employees), and (b) whether early and late
respondents provided significantly different responses. Chi-square tests indicated
Table 1. Sample Characteristics for the 107 Responding Organizations.

Standard Range
Mean Deviation Minimum Maximum
Size:
- Number of employees 1,547 1,478 45 7,300
- Revenue (gross sales in millions of $) 258.5 341.4 6 2,100
- Length of tenure of respondent in their 7.1 5.1
current position (years)
- Length of use of CMSs (years) 16.6 8.2
1
no significant differences in the two demographic characteristics. The

Hotelling’s T2 statistic also indicated no significant differences in the
multivariate means of early versus late respondents.
Measurement of Research Variables
CMS Performance Satisfaction (CMS-PERF)

A manager’s satisfaction with the performance of a cost management system
1 relates to how well does the system support the manager’s tasks. The measure
of “CMS Performance Satisfaction” employed in this paper actually accom-
plished its measurement objective by asking respondents to consider the impact
of their organizations’ CMS on their own personal performance. A number of
areas of personal performance were listed and each respondent evaluated the
extent of impact of their CMS on each performance dimension, using a seven-
point Likert scale, anchored from “extremely negative impact” to “extremely
positive impact,” with an end-point of “no-impact.” Different areas of personal
performance are identified in a traditional measure of managerial performance
developed by Mahoney et al. (1965). The original measure of managerial
1 performance has been used successfully in many accounting studies (e.g.
Brownell, 1982, 1985; Chong, 1996; Gul, 1991; Gul & Chia, 1994).
In this study, four areas of performance (planning, investigating, coordinating
and evaluating) plus an overall item, included in the original instrument, were
measured. The need in the present study was to select a scale that would provide
a measure of the extent to which the system impacts a financial manager’s
personal performance in carrying out tasks of managerial planning,
investigating, coordinating, and evaluating. These tasks (i.e. areas of managerial
performance) are closely related to the problems of product costing, planning,
coordination, and control, which are often faced by financial managers in
manufacturing organizations. The “CMS performance satisfaction” instrument
211
Table 2. Response Scales.

Panel A: CMS Performance Satisfaction
Please rate the impact of your organization’s CMS on your own personal performance in each
of the following areas:
a. Planning.
b. Investigating.
c. Coordinating.
d. Evaluating.
e. Overall Performance.
11
Source: Mahoney et al. (1965).
Responses were measured on seven-point Likert scale with “extremely negative impact” (-3) and
“extremely positive impact” (+3) endpoints and a mid-point of “no impact.”
Panel B: CMS Scope
Information from our existing CMS is used to support the following types of decisions:
a. make or buy decisions for component parts.
b. product pricing decisions.
c. decisions to discontinue existing products.
d. decisions relating to post-manufacturing, customer-related costs.
e. identification of areas for process improvements.
11
f. product design decisions.
g. performance measurement and evaluation decisions.
Source: Swenson (1995)
Responses on each item measured actual use or non-use (yes/no) of CMS to support each
decision.
Panel C: Scale Measuring EDI Use
Scope of EDI Use
Extent of use of EDI in the following areas:
a. procurement.
11
b. shipping/distribution.
c. production planning.
d. accounts receivable.
e. accounts payable.
f. payments (financial EDI).
Intensity of EDI Use
1. Extent of total customers linked by EDI.
2. Extent of total suppliers linked by EDI.
3. Extent of total external transactions converted to EDI.
Responses were measured on five-point scale with “none” and “very large extent” endpoints.
For those organizations not users of EDI, all of the above items were scored as zero.
employed here, therefore, possesses face validity with regard to the measurement
objective. The whole instrument used in this study is presented in Panel A of
Table 2.
CMS Scope (CMS-SCOPE)

The scope of a CMS is expressed in terms of its use in order to support strategic
and operational decision needs. Brinker (1992) discusses CMS scope in terms
of coordinating a set of activities that are necessary for meeting customer
demands in addition to maintaining an organization’s own economic viability.
1 Cooper and Kaplan (1991) also identify such activities as those required for
product pricing, product design, customer service, process improvements, while
also meeting traditional performance measurement and evaluation needs. The
coordination of these activities produces information that can support strategic
and operational decisions and therefore assists in the implementation of
manufacturing strategy relating to those decisions. As a result, CMS scope is
an important concept that reflects the use of information in a number of decision
areas or activities of the organization. The actual measurement reflected the
scope of use of a CMS in the seven different areas that were identified by
Swenson (1995) to represent strategic and operational decision needs. Panel B
1 of Table 2 presents the individual items used to accomplish this measurement.
Use of JIT Manufacturing Techniques

Based on the interpretation of actual JIT use in organizations, as described in
the text of annual reports, two different levels of JIT were defined in this study:
(a) “JIT Production,” that is, use of JIT manufacturing techniques which required
significant changes in the production process, and (b) “JIT Delivery,” that is,
adoption of JIT as a way of inventory management in the delivery process with
no significant changes in the production process itself.
As Kaplan and Atkinson (1989) emphasize, there is a need to distinguish
1 between; (a) firms with significant use of JIT in production, and (b) firms which
adopt JIT narrowly for inventory management only. Adoption of JIT production
can lead to significant operational benefits, where the organization can improve
quality and reduce non-value-added time thus becoming more responsive to
customers, in addition to financing benefits, that is, improved inventory turns.
When JIT is primarily adopted as a means of inventory management without
having any significant effect on the manufacturing process, the inventory cost
that may be saved due to JIT adoption is forced back to suppliers without
reducing the total systems cost for inventory and production. Both Kaplan and
Atkinson (1989) and Foster and Horngren (1987) distinguish between firms with
JIT production and JIT purchasing. Nevertheless, the two processes can also be
213
used in a complementary fashion. The review of annual reports of manufacturing

firms that was performed in the sample selection phase of this study, has revealed
that most firms are by now much more mature in their use of JIT in production
and in only a few instances there was mention of JIT for purchasing only.
There were, however, abundant instances of “supplier” firms, which use a
“JIT Delivery” system. A JIT Delivery system would be the direct counterpart
of a JIT purchasing system of a customer organization. As a result, adoption
of a JIT Delivery system would in many cases be forced by major customers
(often a requirement for continuing doing business with a supplier). In addition,
11 larger customer organizations would tend to displace their costs to smaller
suppliers by often requiring them to hold excess inventories in order to be able
to meet unexpected shifts in demand. The adoption of “JIT Delivery” would
thus tend to be qualitatively different from the adoption of “JIT Production.”
These two concepts are therefore distinguished in the present study. In terms
of measurement, the researcher evaluated descriptions in annual reports
(president’s letter and management discussion) and classified firms into the two
categories. A binary code was used, with “1” assigned to instances of “JIT
Production,” while instances of “JIT Delivery” were coded as “0.” A similar
categorization methodology to identify firms adopting a JIT system was also
11 used in prior studies, as in the one by Balakrishnan et al. (1996). Appendix I
presents excerpts from annual reports which provide representative examples
of the “JIT Production” classification, while Appendix II provides examples of
the “JIT Delivery” classification.
Use of EDI Systems

EDI systems are interorganizational systems that assist in reducing uncertainty
with regard to organizational decisions for coordination and control. The use
of those systems helps coordinate the procurement of resources and delivery of
finished products with the internal production activities of the firm. In addition,
11 control issues that might relate to performance measurement, cost control, and
monitoring of product quality, can be more effectively resolved through the use
of EDI systems.
The reduction in decision uncertainty is assumed to increase with the broader
scope and greater intensity of EDI use. As a result, nine items were developed
in this study in order to measure the extent of EDI use, as shown in Panel C
of Table 2. Six of those items measure EDI use for procurement, shipping/
distribution, production planning, accounts receivable, accounts payable and
payments. Prior studies by Premkumar et al. (1994) and Premkumar and
Ramamurthy (1995), have also used similar statements with regard to the “extent
of use” of EDI in a number of areas. Iacovou et al. (1995) have also used an
item concerning the “variety of applications interconnected through EDI,” while

Bensaou and Venkatraman (1995) provide a direct measure of the “scope of
EDI use,” by summing dichotomous responses on six items measuring whether
EDI is used or not used in several areas. The other three items that are shown
in Panel C of Table 3 measure the extent of use of EDI for exchanging
information with customers, suppliers, and with regard to the total external
transactions of the firm. Bensaou and Venkatraman (1995) have also measured,
in a similar fashion, the number of specific documents that are exchanged
electronically with trading partners. Premkumar and Ramamurthy (1995), as
1 well as Iacovou et al. (1995), also provide measures of an organization’s
intensity of external electronic connectivity.
The Model
The research hypothesis makes predictions about the extent of complementarity

or degree of fit between the use of JIT and EDI systems which define the
context of a firm’s manufacturing strategy and the extent of use of a CMS
which relates to system design in response to requirements that result from that
strategy. The conceptualization of fit between the two sets of variables implies
1 that an interaction exists between them (Drazin & Van de Ven, 1985).
Moderated regression analysis (Arnold, 1982; Zedeck, 1971) was employed in
order to provide a direct test of the relationship implied by the research
hypothesis.
In accordance with the predictions made in H1, the moderated regression
analysis (MRA) model provides a test of the statistical hypothesis as to whether
the form of the relationship between CMS performance satisfaction and CMS
scope is moderated by the use of JIT and EDI systems. The following series
of ordinary least squares models are therefore developed:
1 CMS⫺PERF = a + b1 CMS⫺SCOPE + e (1)

Research hypothesis H1 predicts that the form of the relationship represented
by Eq. (1) is a function of the use of both JIT and EDI systems. That is, the
slope parameter in Eq. (1) is a function of JIT and EDI system use. As a result,
Eq. (1) can be modified as follows:
CMS⫺PERF = a + (b1+b2 JIT ⫻ EDI) CMS⫺SCOPE + e (2)
Equation (2) can further be rewritten as follows:
CMS⫺PERF = a + b1 CMS⫺SCOPE + b2 CMS–SCOPE ⫻

JIT ⫻ EDI + e
215
The model specified in Eq. (3) therefore provides a complete specification of

the relationships stated in the research hypothesis. As a result, Eq. (3) will be
used to provide a direct test of the research hypothesis.
RESULTS
Reliability and Validity of Measures
All measures were tested for validity and reliability. Construct validity,
11 including both convergent and discriminant validity, was tested primarily
through principal component analysis. Since no prior results were available
regarding the reliability and validity for most of the scales used here, the use
of an exploratory rather than confirmatory method for validity testing was
deemed appropriate (Anderson & Gerbing, 1988). Examining the internal
consistency of the measures tested reliability. Cronbach’s alpha coefficient
was computed and compared to desired standards of reliability (Nunnally, 1978,
pp. 245–246).
Principal component analysis on the set of items comprising the scale of
CMS-PERF, resulted in a single factor solution, explaining 72% of the total
11 variance, as determined by the scree test, Bartlett’s ␹2 test on the number of
factors, and the eigenvalue-greater-than-one rule (Gorsuch, 1983). The Cronbach
a coefficient was equal to 0.90, which is well above acceptable levels. The
factorial structure of the nine items comprising the EDI use scale was composed
of three factors, explaining 77% of the total variance. The three factors were
interpreted as EDI use in procurement (EDI-PROC; Cronbach ␣ = 0.83), in
shipping (EDI-SHIP; Cronbach ␣ = 0.81) and in accounting/finance (EDI-
ACCT; Cronbach ␣ = 0.82). All scales, therefore, exhibited satisfactory levels
of convergent validity and reliability. For two observations in the study, there
were missing data on the EDI variables. Following Little (1992), a conditional
11 mean imputation was performed for the missing data using the regression
method. This was done before the principal component analysis. Table 3
presents the results of the principal component analysis on the EDI scale.
The CMS-SCOPE scale identifies different areas of CMS use. As a result,
the collection of those items listed on Panel B of Table 2 is not assumed to
measure a latent construct of CMS with error, but rather is assumed to measure
different aspects of CMS scope (cf. Gordon & Smith, 1992). The use of factor
analysis in the case of CMS-SCOPE was therefore not considered appropriate.
All scales also exhibited satisfactory levels of discriminant validity, or the
degree to which measures of different concepts are distinct. Correlations among
different items of the same construct are much larger than correlations between
Table 3. Principal Component Analysis on EDI Scale.
Component 1: Component 2: Component 3:

EDI use in EDI use in EDI use in
Procurement Shipping Accounting
Process Process Process Communality
Eigenvalue (before rotation) 4.40 1.42 1.11 6.93 (total)

Proportion of variance explained 0.49 0.16 0.12
Cumulative variance explained 0.49 0.65 0.77
1 Item Loadings*
(Rotated Factor Pattern):
- Extent of use of EDI in:

a. procurement 0.89 0.09 0.16 0.83
b. shipping/distribution 0.10 0.89 0.19 0.84
c. production planning 0.37 0.64 0.11 0.56
d. accounts receivable 0.17 0.37 0.71 0.67
e. accounts payable 0.41 0.03 0.84 0.87
f. payments (financial EDI) 0.11 0.14 0.86 0.77
- Extent of customers linked by EDI 0.13 0.91 0.13 0.86
- Extent of suppliers linked by EDI 0.89 0.06 0.27 0.87
- External transactions converted to EDI 0.58 0.45 0.33 0.66
1
* Item loadings in bold represent items retained to measure each component.
items loading on different constructs. In addition, the confidence interval (±

two standard errors) around the correlation estimate between each pair of
constructs did not include the value of one. Table 4 presents descriptive statistics
for all the variables measured in this study, while Table 5 summarizes the results
on internal consistency and also presents Pearson product-moment correlation
coefficients.
The correlation coefficients shown on Table 5 demonstrate that there is a
1 direct significant relationship between CMS-PERF and CMS-SCOPE (r = 0.23;
p < 0.01), while the simple correlations between CMS-PERF and all other vari-
ables are not significant. This result provides some preliminary support for the
model tested, since the use of JIT and EDI systems should have a contingent,
not a direct effect on CMS-PERF, the dependent variable.
Results on Hypothesis Testing
The research hypothesis is tested by estimating the regression model of CMS

performance satisfaction on the interaction between CMS scope and the use of
JIT/EDI systems. These results are shown in Table 6.
217
Table 4. Descriptive Statistics (N = 107).
Number Scale
of Scoring Range of
Scale Standard Range Observations
Scale Items Mean Deviation Min. Max. Min. Max.
CMS-PERF 5 0.83 0.87 ⫺3 3 ⫺2 3

CMS-SCOPE 7 4.51 1.65 1 7 1 7
JIT 1 0.58 0.50 0 1 0 1
EDI-PROC 3 1.45 1.13 0 5 0 4
11 EDI-SHIP 3 1.72 1.41 0 5 0 5
EDI-ACCT 3 1.44 1.24 0 5 0 5
A goodness-of-fit test was also performed on the error terms of the regres-
sion model estimated (Neter et al., 1985), where no significant deviations from
normality were indicated.
The research hypothesis was predicting that the fit or interaction between the
use of JIT/EDI systems and CMS scope will be positively associated with the
managers’ satisfaction of CMS performance. This hypothesis was partially
supported by the data. The estimated coefficient of interaction between CMS
11 Scope, JIT use, and use of EDI in procurement was significant (t(102) = 2.93,
p < 0.01) and the direction of the effect was as expected. The coefficient is
positive, indicating that the complementary use of CMS to support decision
requirements in cases of JIT use and use of EDI in procurement, is associated
with a higher level of managers’ satisfaction with their cost management
systems. However, the joint use of JIT and EDI in shipping and in accounting
did not exhibit a significant moderating influence on the relationship between
the scope of use of a CMS and a manager’s performance.
Table 5. Pearson Product-Moment Correlations and Cronbach ␣ Coefficients.

11 Variables 1 2 3 4 5 6
1. CMS-PERF 0.90†
2. CMS-SCOPE 0.23** 0.64
3. JIT 0.08 0.24** N/A
4. EDI-PROC 0.09 0.07 0.19* 0.83
5. EDI-SHIP 0.03 0.07 0.20* 0.83*** 0.81
6. EDI-ACCT 0.04 0.11 0.11 0.82*** 0.78*** 0.82
* Significant at the 0.05 level.

** Significant at the 0.01 level.
*** Significant at the 0.001 level.
†
Entries on the diagonal are Cronbach a coefficients of internal scale consistency.
Table 6. Regression Model of CMS Performance Satisfaction on CMS

Scope and its Interaction with JIT and EDI Use.
Independent Parameter Standardized
Variable Estimate t-statistic Coefficient
Intercept 1.41 1.17

CMS-SCOPE 0.84 2.52** 0.55
CMS-SCOPE * JIT * EDI-PROC 0.86 2.93** 0.75
CMS-SCOPE * JIT * EDI-SHIP ⫺0.16 ⫺1.15 ⫺0.31
CMS-SCOPE * JIT * EDI-ACCT ⫺0.19 ⫺1.11 ⫺0.31
1
Model F(4,102) = 3.99** Model R2 = 0.13 Adjusted R2 = 0.11
* Significant at the 0.05 level.
** Significant at the 0.01 level.
*** Significant at the 0.001 level.
The incremental meaningfulness and significance of the explanatory power

of the expanded model with the three interactions, as presented in Table 6, was
also compared vis-à-vis the explanatory power of a more restricted model where
CMS Scope was the only explanatory variable. The resulting F statistic (Fisher,
1 1970) was highly significant (F3,102 = 4.35; p < 0.01), indicating that the
expanded model that includes the interactive terms explains a significantly
greater proportion of the variance in the dependent variable.
Additional tests were performed to avoid the risk that the hypothesis was
tested on the same sample that was used to estimate system fit. These results
were found to be robust in a random split of the sample where half of the
responses (n = 54) were used for estimation purposes and a hold out sample
(n = 53) was used for hypothesis testing. The results were also found to be
robust in a median split of the sample, where the estimation sample was formed
by those responses with scores on CMS-PERF that were above the median
1 score (n = 49). In a further test, organizational size (defined as the logarithm
of the number of employees) was entered into the estimation equation with no
significant changes to the results.
DISCUSSIONS, LIMITATIONS AND CONCLUSIONS
This study examined the use of JIT and EDI systems as dimensions of a firm’s
manufacturing strategy. The research hypothesis advanced in the study provided
an empirical test of the relationship between the use of these technologies and
cost management. The use of a CMS to support strategic and operational
decisions, as required for the implementation of manufacturing strategy, served
219
as a motivation for the research hypothesis and is further discussed here with
regard to the importance of the results and the overall contributions of the study.
The results provide support for the notion that a financial manager’s
satisfaction with the performance of a CMS can be a valid indicator of how
well is the CMS designed to support strategic and operational decision needs
that are necessary for the implementation of a firm’s manufacturing strategy.
The concept of complementarity or, fit, that was used to advance the research
hypothesis of this study, was supported by the data. Both the theoretical
arguments and empirical results support the view that a manager’s personal
11 performance is directly associated with the use of the CMS that supports his
or her investigation, evaluation, coordination, and planning needs. The
managers’ satisfaction with the performance of their CMSs, in turn, was shown
to be contingent on the extent to which the CMS can support these decision
needs in a context where the organization uses JIT production and EDI in the
procurement area. The use of EDI in procurement along with the use of JIT
production, therefore, significantly affect decision requirements that need to be
satisfied through the use of a CMS. CMS design, as a result, represents an
important construct in the successful implementation of manufacturing strategy.
An implication of this result is that an important reason some firms do not
11 realize the expected benefits from their use of JIT and EDI systems, may be
due to their reliance on inappropriate cost management systems which do not
address decision needs that are complementary to those required by their
manufacturing strategy. The inconclusive results reported in prior accounting
studies examining such relations could thus be due to their lack of attention to
system design as an important factor that influences the realization of potential
performance outcomes. Future research might expand on these concepts to
examine potential benefits that might be realized by complementary changes in
CMS design that are motivated by changes in an organization’s specific
manufacturing strategy. Such benefits might relate, for example, to the financial
11 success of business organizations.
Like all studies, the current study also has its limitations due to the
methodology employed. For example, the study measured all research variables
at a single point in time and used correlational analysis. This approach limits
statements about causation. Use of summated responses to questionnaire items
that appear on the same instrument always entails some risks. Responses could
be biased because of the common method used for the collection of all data.
Though care was taken to extensively validate these data through psychometric
analyses, which have not indicated any violations of scale validity, this criticism
of the survey method can never be completely ignored and should be taken
into account. Non-response has been a problem in the data collection phase of
this study. Nevertheless, all tests for nonresponse bias have provided satisfactory
results.
Although this study has relied on perceptual measures of CMS effectiveness,
future research, as mentioned before, could examine the effects of accounting
system design choices on quantifiable measures of firm performance. Extant
research (e.g. Balakrishnan et al., 1996) has not provided conclusive evidence
about the extent of financial benefits to firms adopting JIT systems. Although
the present study has focused on the issue of successful implementation of
manufacturing strategy, a future study could focus on firm performance issues.
1 Future research could also examine the effect of the external organizational
environment on the relationship between CMS scope and the use of JIT and
EDI systems. The development of interorganizational relationships, which are
uniquely related to the use of these systems, entail a number of issues for cost
management which could be the subject of future research endeavors.
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Wheelwright, S. C. (1984). Manufacturing strategy: Defining the missing link. Strategic
1 Management Journal, 5, 77–91.
Zedeck, S. (1971). Problems with the use of “moderator” variables. Psychological Bulletin, 76(4),
295–310.
223
APPENDIX I
JIT Production Descriptions
Primary SIC: 3950

Size: Number of Employees: 1500; Revenue (Gross Sales): $191 million.
The Company utilizes just-in-time inventory techniques. In recent years the
Company completed a restructuring program designed, in part, to reduce
11 worldwide product costs by streamlining the manufacturing process and
converting to a just-in-time mode of operation, and to eliminate excess
manufacturing capacity. In addition, a new integrated business system has been
implemented to help monitor and control costs more effectively.
Primary SIC: 3679

There is renewed commitment to 100% quality performance through the
application of Just-In-Time (JIT) manufacturing techniques. JIT is customer-
oriented. It presupposes a superior quality level and a commitment to continual
11 improvement throughout the organization. JIT alters the way manufacturing has
traditionally been done by attacking surplus inventory as the major impediment
to the movement of material through the factory. Any inventory not immediately
needed for the next manufacturing step is considered wasteful because it requires
the unproductive use of labor, space, equipment, and energy, and impedes the
ability to respond to changes in customer orders. By reducing the number of
items being worked on at each station to the ultimate ideal of 1, JIT significantly
lowers manufacturing costs, smoothes the transition to new schedules, and
self-generates an insistence upon quality materials and workmanship throughout
the production process.
11
Primary SIC: 3824
In the manufacturing area, product-shipping performance is at the highest level
in the company’s history. The improved turnaround time is a result of the
company’s continuous flow manufacturing processes that produce quality
products with dramatically shortened lead times. In addition to their regular
responsibilities, many XYZ Division employees and managers participated in
teams for the implementation of the new business system and the introduction
of the new continuous flow manufacturing system in the plants.
APPENDIX II
JIT Delivery Descriptions
Primary SIC: 3751

The Company has developed successful relationships with mass merchandisers
1 by providing a low cost product that management believes is differentiated from
the competition based on superior features, and by supplying just-in-time
inventory with proven reliability. All of the Company’s businesses are extremely
competitive. [The Company] competes primarily on the basis of just-in-time
delivery, production innovation, consistent quality control and price. The loss
of, or a material reduction in, business from [a few major] customers could
adversely affect the Company’s business (emphasis added).
Primary SIC: 3310

1 The Company produces to customer order rather than for inventory. Although
some blanket orders are taken for periods of up to one year, such blanket orders
represent a projection of anticipated customer requirements and do not become
firm orders until the customer calls for delivery of specified quantities of
particular products at specified times. The Company is therefore required to
maintain a substantial inventory of raw materials to meet the short lead times
and just-in-time delivery requirements of many of its customers. Customers
typically place firm orders for delivery within two to three weeks. The
Company’s largest customer is General Motors Corporation purchasing through
various decentralized divisions and subsidiaries. The loss of this customer’s
1 business in the aggregate would have a material adverse effect on the Company
(emphasis added).
Primary SIC: 3089

The Company also participates in “KAN BAN” and other “pull” based Just-
In-Time delivery programs with several of its customers. These programs require
varying levels of finished goods inventories. These factors combined have
increased the Company’s levels of finished goods and raw material inventories.
225
xii RUNNING HEAD

THE ROLE OF QUALITY COST
INFORMATION IN DECISION
MAKING: AN EXPERIMENTAL
INVESTIGATION OF PRICING
DECISIONS
Asokan Anandarajan and Chantal Viger
ABSTRACT
Many authors in the academic literature have noted that, despite

recognizing its importance, a significant number of companies still do not
attempt to identify, measure, and accumulate quality costs. This is due to
a perception that the costs of implementation far outweigh the benefits.
We postulate that, if the presentation of quality cost information
significantly changes decision making, then it has benefit. We examine
whether presentation of quality cost information influences the decisions
of management. A between-subjects experiment was conducted by mailing
case studies to fourteen hundred Marketing managers in the United States.
The managers were randomly assigned to one of three experimental groups
in which a number of variables including the presentation of quality cost
information were manipulated. Each manager received a case study with
four randomly assigned pricing scenarios and a questionnaire. A split-plot
factorial design was used to examine the responses. The results indicated

ISBN: 0-7623-0825-7
227
228 ASOKAN ANANDARAJAN AND CHANTAL VIGER
that pricing decisions were influenced not only by the identification of

quality costs but also by the extent of their controllability. Moreover, the
extent to which quality cost information influenced the pricing decision
was moderated by the level of competition, buyers’ sensitivity to price
variation and market competition.
INTRODUCTION
Japanese firms have shocked the industrial nations by focusing on a dual strategy
11 of high quality products and competitive prices. Juran and Gryna (1993) note
that, in order to compete, U.S. firms have attempted to improve the quality of
their corporate products. As a result quality indicators have become essential
to accurately measure quality at both financial and operational levels. They note
that it is crucial for organizations to monitor performance in many non-
financial areas as well. For many companies quality is a pivotal component or
measure of non-financial performance. In the manufacturing sector in particular
product quality has become a key factor in determining a firm’s success or
failure in the global market place. Advanced, highly reliable manufacturing
methods have made it possible to achieve very high standards of product quality.
11 As a result, more and more firms are making product quality a pivotal
component of their competitive strategy.
Schaffer and Thomson (1992), Dale and Lightburn (1992), Noci (1995), and
Youngdahl and Kellog (1997), among others, claim that quality is one of the
most critical success factors for organizations. These authors note that firms
can enhance competitive advantage, especially against low cost competitors,
only if they are able to implement quality-based strategies. These authors also
observe that despite this emphasis, many quality-based initiatives have failed.
One reason attributed for this is the lack of accounting numbers that could
facilitate decision making. Today traditional accounting systems are criticized
11 and said to be irrelevant in helping companies evaluate quality (Albright &
Roth, 1992, Diallo et al., 1995).1 Ebrahimpour (1986), and Bowman (1994)
observe that, to improve the competitive position of the firm and enhance the
firm’s profits, companies must analyze and utilize information on the costs
related to quality.
Costs relating to quality management (hereafter referred to as quality costs)
can be very useful if they can be obtained accurately. Ebrahimpour notes that
quality costs could be used in one or more of the following ways:
• A measurement tool to evaluate the overall effectiveness of the firm’s quality
programs.
The Role of Quality Cost Information in Decision Making 229
• A tool to indicate the when, the where, and the how of the quality
improvement programs.
• A technique to estimate the amount of the effort between the various quality
activities.
The Institute of Management Accountants recognizing the problem of

inadequate accounting strongly recommends the integration of quality costs into
existing management reporting and measurement systems. Many writers have
given support to the IMA and argued theoretically for the provision of quality
1 cost information to managers (Diallo et al., 1995; Ebrahimpour, 1986; Garrison
& Noreen, 2000). In particular it has been stated that quality cost information
may influence a variety of decisions including quality-program implementation
decisions and strategic pricing decisions among others. In the light of this,
measuring and reporting on quality costs are especially important. Many authors
in the academic literature have noted, however, that despite recognizing its
importance many companies still do not attempt to identify, measure, and
accumulate quality costs (Garrison & Noreen, 2000; Juran & Gryna, 1993;
Kumar & Fitzroy, 1998). This is due to a perception that the costs of attempting
to identify, measure, and accumulate quality costs far outweigh the benefits.
1 Research in this area has been limited because of the difficulties in attempting
to surrogate for and measure the benefits of incorporating quality versus the
costs of implementing it.
In this study we conduct an experiment involving Marketing managers. We
examine whether quality cost information affects the pricing decisions of
management. We focus on pricing decisions because of their importance i.e.
their influence on both the level of sales a firm accomplishes and the revenue
it earns (McCarthy & Perreault, 1990). If information on quality costs
significantly influences the pricing decisions of managers, it provides
corroboration that firms must attempt to identify and integrate quality costs into
1 traditional accounting systems. Since the pricing decision is a function of many
factors including information about costs, buyers’ price sensitivity, and level
and nature of competition, one cannot examine the influence of quality costs
without incorporating and controlling for these factors. Consequently, the
influence of quality cost information is examined at different levels of
competition and buyers’ sensitivity to price variations.
OBJECTIVE OF THE STUDY
The objective of this research is to examine if, and the extent to which, quality
cost information affects the pricing decisions of management. In essence, this
229
study provides experimental evidence about managers’ reactions to quality cost

information.
BACKGROUND ON QUALITY COSTS
Juran and Gryna (1993) identify two types of quality, namely, quality of design
and quality of conformance (see Fig. 1). Quality of design is defined as “a func-
tion of a product’s specifications”, while quality of conformance is defined as
“a measure of how a product meets its requirements or specifications”. Quality
11 costs, by definition, refer to the quality of conformance. Quality costs are “the
costs incurred because actual quality may, or does not, conform to designed
quality” (Morse, 1983; Morse & Poston, 1986). As shown in Fig. 2, quality
costs can be segregated into four categories: prevention costs, appraisal costs,
internal failure costs, and external failure costs. First, a company incurs preven-
tion and appraisal costs because possible poor quality of conformance may
occur. Second, a company experiences failure costs when definite poor quality
of conformance has occurred.
As illustrated in Fig. 2, the nature of the quality costs and the time at which
they occur determine the category they belong to. Prevention costs aim to
11 prevent the occurrence of errors and defects before production begins, while
appraisal costs seek to identify defective materials and products during
production. Once the production is completed, a number of costs can occur:
11
Fig. 1. Different types of Quality.

Fig. 2. Categories of Quality Costs.
internal failure costs occur when a product is identified as defective before being
shipped to customers while external failure costs occur if a defective product
is found after the product is sold to the market. Examples of each types of
quality costs are presented in Fig. 3. In addition to the costs shown in Fig. 3,
a company could face hidden quality costs (for instance, loss of customers),
which are not accounted in today’s accounting systems.
1 The relationship between the different categories of quality costs is illustrated
in Fig. 4. As the figure indicates, the more a company invests in prevention
and appraisal costs, the less it will incur internal and external failure costs.
(This is because the level of product conformity increases with the increase in
prevention and appraisal costs.) Similarly, the less a company invests in
prevention and appraisal costs, the more it will incur in internal and external
failure costs, because the level of product conformity decreases with the
decrease in prevention and appraisal costs.
It is generally postulated that, as the total costs of quality decreases, higher
quality (quality is referred in Fig. 4 as the percentage of products conforming
to their specifications) should result.
231
11
11
Fig. 3. Examples of Quality Costs. (Adapted from IMA, 1993).
LITERATURE REVIEW
Initial research primarily emphasized the beneficial effects of quality. Quality

was shown to be correlated with return on investment and increasing market
11 share (Buzzel & Wiersema, 1981a, b; Jacobson & Aaker, 1987; Philips et al.,
1983). Initial research also focused on if, how, and the extent to which quality
costs were used within traditional accounting systems. Kumar and Fitzroy (1998)
summarized these studies succinctly. They reviewed surveys cited from the U.K.
(Allen & Oakland, 1988), Japan (Kano, 1986), Australia (Sohal et al., 1992),
India (Sarkar, 1990), Germany (Vocht, 1984) and New Zealand (Stephenson,
1986). They found that, during the period of the respective studies, very few
firms broke down quality cost into prevention, appraisal, internal and external
failures or attempted to provide figures for these.
Subsequent research focused on the role and importance of quality cost
information within the “paradigm shift” of practicing Total Quality Management
Fig. 4. Modern model for Optimum Quality Costs. (Adapted from Juran et al., 1998).
(TQM). In the accounting field research on quality has focused on the

categorization of quality costs. The seminal research in this area initially focused
on how to initiate a system of quality costing within TQM (Juran, 1974).
Subsequently, other researchers developed models that facilitated the
incorporation of quality costs within traditional accounting systems. In
particular, many models are presented in the literature that examine the
1 relationship between prevention and appraisal costs to determine the minimum
cost of quality (COQ) point. Sandoval-Chavez and Beruvides (1998), for
example, developed an empirical model to express COQ as a function of two
main components: traditional prevention-appraisal failure and opportunity
losses. Bowman (1994) developed a model that included the costs of inventory.
Another group of studies consisted of longitudinal investigations within
selected firms that had adopted a system to incorporate quality cost information.
Keogh, Atkins, and Dalrymple (1998), and Goulden and Rawlins (1997)
conducted longitudinal studies of unnamed companies during a time of change
to TQM and summarized the benefit. Carr (1995) did a similar study with Xerox
and showed how Xerox saved more than $200 million when it applied cost of
233
quality principles to its U.S Sales and Marketing Group, a service business.
Poston (1996) detailed the development and evolution of a comprehensive
quality cost system at the Union Pacific Railroad Company.
In this study we examine the information content of quality cost information
in traditional accounting reports with specific reference to Marketing managers.
Quality cost reports are assumed to have information content if such reports
significantly influence the pricing decisions of Marketing managers.
METHODOLOGY
11
A quasi-experiment was selected to investigate whether decision-makers were
affected by the identification of quality cost information and the controllability
of those costs. This methodology was chosen because the variables could be
manipulated. When variables are manipulated, information can be obtained by
mail, survey, or interviews. A mail survey was selected because it facilitated
the selection of a much larger sample. A mail survey also has the advantage
of eliminating “experimental artifacts”. A further advantage is that it provides
subjects with flexibility in terms of response time.
In the quasi-experiment subjects were asked to communicate their pricing
11 decisions about fictitious products. Four different products were given to each
participant. These products differed on buyers’ price sensitivity and level of
competition. As previously mentioned, these variables were chosen because they
influence pricing decisions and enhance the perceived realism of the case study.
The design of the experiment is shown in Fig. 5 while the experimental package
that characterizes each group is presented in Fig. 6.
Subjects were assigned to one of three experimental groups and received
written case scenarios relating to a fictitious manufacturing company. All
subjects in experimental group 1 received a set of information excluding quality
11
Fig. 5. Experimental Design.

Fig. 6. Experimental Package per Group.
cost information. These subjects were then requested to establish a selling price
for each of the four hypothetical products.
Subjects in group 2 received a set of information that included quality cost
information. Moreover, subjects received educational information on quality costs
to rule out ignorance as a possible cause of non-reaction to quality cost informa-
tion. Thus, subjects in group 2 established selling prices for hypothetical products
1 based on accounting cost information that included information on quality costs.
Subjects in group 3 received the information given to subjects in group 2
(set of information that includes quality cost information and educational
information on quality cost information). In addition they also got a management
statement of the controllability of quality costs. Subjects then established their
pricing decisions based on the information given to them.
The subjects’ responses were analyzed in order to determine whether the
identification of quality costs by itself and its controllability affected the pricing
decision of subjects. Because pricing decisions were nested within subjects, this
study used a split-plot factorial design. The corresponding ANOVA table is
presented in Table 1.
235
Table 1. ANOVA – Split Plot Design.

Sums of Degrees of Description for Relationship of Interest
Squares Freedom
WHOLE PLOT
Between Blocks
Q q⫺1 Quality cost information

C c⫺1 Controllability of quality costs
Error-between p1 + p2 + p3⫺3 Error-between block
11 block QxC
SPLIT-PLOT
Within Block
S s⫺1 Buyers' price sensitivity
SxQ (s⫺1)(q⫺1) Buyers' price sensitivity ⫻ quality cost information
SxC (s⫺1)(c⫺1) Buyers' price sensitivity ⫻ controllability of quality
costs
L l⫺1 Level of competition
LxQ (l⫺1)(q⫺1) Level of competition ⫻ quality cost information
LxC (l⫺1)(c⫺1) Level of competition ⫻ controllability of quality costs
LxS (l⫺1)(s⫺1) Level of competition ⫻ buyers' price sensitivity
LxSxQ (l⫺1)(s⫺1)
11 (q-1) Level of competition ⫻ buyers' price sensitivity ⫻
quality cost information
LxSxC (l⫺1)(s⫺1)
(c-1) Level of competition ⫻ buyers' price sensitivity ⫻
controllability of quality costs
Error within p1 + p2 + p3⫺12
subjects
Total p1 + p2 + p3⫺1
A score Dij in a split-plot factorial design is a composite that is equal to the

following terms in the experimental design model:
11
Dqcsl = ␮ + Qq + Cc + (qc(i) + Ss + Ll + SQsq + SCsc + LQlq + LClc
+ LSls + LSQlsq + LSClsc + gqc(sl(i))
where:
Dqcsl = absolute percent change in pricing
␮ = the overall mean
from the whole plot:
Qq = the effect of treatment “quality cost information” at level q
and is subject to the restriction GQq=0.
Qq = ⫺1 when no quality cost information is provided
Qq = 1 when quality cost information is provided;
Cc = the effect of treatment “controllability of quality cost information”

at level c and is subject to the restriction GCc= 0.
Cc = ⫺1 when no management statement is provided
Cc = 1 when a management statement is provided
qc(i) is the between error
from the split-plot:
Ss = the effect of “buyers’ price sensitivity” at level s
Ss=-1 when buyers are not very sensitive
Ss= 1 when buyers are extremely sensitive
1 Ll = the effect of factor “level of competition” at level l
Ll= ⫺1 when the market is moderately competitive
Ll= 1 when the market is highly competitive
SQsq, SCsc, LQlq, LClc, LSls, LSQlsq, LSClsc are all interaction effects
of the above factors
gqc(sl(i)) is the within-error term.
Subjects
The subjects selected in this study were marketing managers. The latter were
the preferred subjects because marketing management have traditionally been
1
responsible for setting the prices that reflect “acceptable values to consumers
and producers” (McCarthy & Perreault, 1990, p. 3). Marketing managers in the
United States were sampled from Alvin. B. Zeller’s mailing list which provides
an exhaustive listing of marketing executives in this country. Fourteen hundred
marketing managers across the United States were contacted to solicit their
participation in this study. Each manager was randomly assigned to one of three
experimental groups that differed on whether or not quality cost information
was provided, and on whether or not management statement on the control-
lability of quality costs was provided. Each manager received a case study
including a presentation letter, a case study with four randomly assigned pricing
1
scenarios, a questionnaire and a pre-stamped envelope. Eighty-nine managers
responded to the mailed questionnaire representing an overall response rate of
6.4% while the usable response rate was about 5.6%.2
Research Instrument
Subjects in all three experimental groups were asked to set the selling price of
four products using information about the product. Subjects were given
information concerning three variables which are recognized to be important in
pricing decisions: buyers’ price sensitivity, nature of competition, and product
unit cost. Moreover, selected subjects also received information on quality costs
237
as a component of product unit cost. The case scenario was intended to reveal
relevant information, while not overloading the subject and hindering the
response rate. The information that was provided included:
Company history: Name of the company

Products made
Prior product prices
Prior product mix
Position of the firm in the industry
11 Market share held
Product costing Information: Unit product cost
Level of competition: (Highly or moderately
competitive)
Buyers’ price sensitivity
Quality cost information (received by
selected participants only)
Industry Information: Narrative description of production activities
The Independent Variables

11
Testing the impact of quality cost information necessitated the comparison of
the decision made with and without the information. Consequently, the
independent variable of quality cost information was dichotomous; quality cost
information was provided for one group but not for the others. Similarly, the
second independent variable, the controllability of quality costs by management,
was dichotomous; a management statement of the controllability of quality costs
was provided for one group but not for the others.
Pricing is influenced by multiple factors of which some are internal to the
company, while others are external to the company (McCarthy & Perreault,
11 1990). According to Nagle (1987), managers must focus on the product costing,
level of competition and buyers’ price sensitivity when establishing a price.
Product costing information was provided to managers either with or without
quality cost information. Moreover, two additional independent variables,
buyers’ price sensitivity and level of competition, was used and manipulated.
Because the direct measurement of price sensitivity is impractical for most
pricing problems, buyers’ price sensitivity was verbally and dichotomously
defined: buyers were stated to be either extremely sensitive or not very sensitive
to any price variation. Finally, the level of competition (or number of firms)
was considered and described as highly competitive or moderately competitive.
We also incorporated a series of variables that were not manipulated.3
The Dependent Variable
The dependent variable used was the “absolute” percent change in price for
each case.4 That is, the dependent variable measured the impact of the inde-
pendent variables on pricing decisions. The steps below present the method
used to calculate the dependent variable’s value, hereafter referred to as Di.
1. Each subject set four pricing decisions, hereafter referred as Pj.
Product Pricing Decision (Pj)
#A Pa
1
#B Pb
#C Pc
#D Pd
2. Calculation of the absolute percent change in price (Di).
Product Initial Pricing Percent Absolute percent

pricing decision change Change in
(provided in (provided by In price price
case study) PI subject) Pj %I = (Pj 2 Pj)/Pi Di = |%I|
1 #A Pia Pa %a Da=|%a|
#B Pib Pb %b Db=|%b|
#C Pic Pc %c Dc=|%c|
#D Pid Pd %d Dd=|%d|
As mentioned earlier, the “absolute percent change in price” was preferred in

order to facilitate the analysis of results. Thus, the larger the value of D, the
greater the effect of the independent variable on pricing. In contrast, the smaller
the value of D, the lesser the effect of the independent variable on pricing.
1 HYPOTHESES
The main effects and interaction effects of quality cost information, controlla-
bility of these costs, buyers’ price sensitivity and level of competition were
measured by examining the impact on the pricing decision, “D” defined above.
The hypothesized effects are now discussed.
The primary variable of interest was quality cost information. It was expected
that managers who received quality cost information (Groups 2 and 3), would
adjust their pricing decision more than those managers who did not received qual-
ity cost information (Group 1). This is because managers who receive quality cost
information would be able to impute the cost reduction specifically to quality costs.
239
Consequently, the following hypothesis (presented in its alternative form) has been
formulated to test the impact of quality cost information on the pricing decision:
H1: The price adjustment (D) by managers who receive quality cost infor-
mation will be significantly greater from the price adjustment by managers
who do not receive quality cost information.
It is expected that managers who are informed about the controllability of a cost
are more likely to consider the variation of this cost in their decision. A cost is con-
trollable if it is subject to the influence of a given manager of a given responsibil-
11 ity center for a given time span (Garrison & Noreen, 2000). Because managers can
expect to limit costs to their reduced and controlled level, it was hypothesized that
managers who are informed (Group 3) of the controllability of quality costs would
adjust their pricing decisions more when those costs were reduced. On the other
hand, managers who were not informed of the controllability of quality costs
(Groups 1 and 2) might also reduce their pricing decisions, but not as significantly
as they would if they were informed of the controllability of quality costs.
Therefore, the following hypothesis (presented in its alternate form) was tested.
H2: The price adjustment (D) by managers who are informed of the control-
lability of quality costs is significantly greater from the price adjustment by
11
managers who are not informed of the controllability of quality costs.
Economic theory suggests that any increase (decrease) in price, ceteris paribus,
will lead to lower (higher) sales volumes. It is expected that managers would
adjust their pricing decisions more when buyers are sensitive to price variation.
The hypothesis (presented in its alternate form) is as follows:
H3: Managers’ price adjustment (D) is significantly greater when buyers are
extremely price sensitive than when they are less sensitive to price.
Nagle (1987) noted that the degree of industry competition may influence price
11 setting. Managers may be more conservative in their pricing actions when an
industry constitutes a lesser number of firms. In contrast, managers may be less
conservative and more aggressive in their pricing behavior when an industry is
represented by many firms. Therefore, the hypothesis (presented in its alternate
form) is as follows:
H4: Managers’ price adjustment (D) is greater in an extremely competitive
market than in a moderately competitive market.
We also examine the influence of two-level and three-level interactions on the
pricing decision. These hypotheses (all presented in alternate form) are as
follows:
H5: The impact of quality cost information on pricing decisions does vary
with the level of the buyers’ price sensitivity.
H6 : The impact of controllability of quality costs on pricing decisions does

vary with the level of buyers’ price sensitivity.
with the level of competition.
H8: The impact of buyers’ price sensitivity on pricing decisions does vary
1
H9: The impact of buyers’ price sensitivity on pricing decisions does vary
with the levels of both competition and buyers’ price sensitivity.
H11: The impact of controllability of quality costs on pricing decisions does

vary with the level of both competition and buyers’ price sensitivity.
1
Data compilation
Subjects were asked to record their responses on a questionnaire that was

returned to the researcher. The statistical model examined the main and
interaction effects of four variables: quality cost information (provided or not
provided to participants), controllability of quality cost (management statement
provided or not provided to participants), buyers’ price sensitivity (extremely
or not very price sensitive) and level of competition (moderately or highly
competitive). We tested the main and interaction effects of the independent
1 variables discussed above on pricing decisions. However, since preliminary tests
showed that experimental groups were different in terms of firm size and
educational background, the model also partialled out the effects of two
covariates (i.e. firm size and education). The results of the split plot model with
two covariates are shown in Table 2.
RESULTS
Quality Cost Information (Quality)

Subjects who received quality cost information (group 2 and 3) reduced their
pricing decisions by 7.72% while those who did not receive it (group 1) reduced
241
Table 2. Summary of Results of the Split Plot

with two Covariates.
Independent Variable Hypothesis F Statistics p value Expectation

met
Quality Cost
Information (Quality) H1a 3.23 0.03805** Yes
Management Statement
on Controllability (Control) H2a 5.70 0.00975*** Yes
Buyer's Price Sensitivity (Buyer) H3a 30.77 0.0001*** Yes
11 Level of Competition H4a 13.87 0.0001*** Yes
Quality*Buyer H5a 0.29 0.5916 No
Control*Buyer H6a 0.90 0.3427 No
Quality*Competition H7a 4.22 0.0413** Yes
Control*Competition H8a 3.84 0.0512* Yes
Buyer*Competition H9a 0.03 0.8531 No
Quality*Buyer
*Competition H10a 3.50 0.0625* Yes
Control*Buyer
*Competition H11a 0.02 0.9010 No
***Significant at alpha 0.01.

11 **Significant at alpha 0.05.
*Significant at alpha 0.10.
their pricing decisions by 5.93%. The results indicate that the null hypothesis
(H1) can be rejected. The price adjustment of managers who received quality
cost information is significantly greater than the price adjustment by managers
who do not receive quality cost information (p-value of 0.03805). This result
corroborates the view held by several researchers (Besterfield, 1979; Crosby,
1984; Ebrahimpour, 1986; Juran, 1974) who postulated that quality cost
information would be relevant in making pricing decisions.
11
Management Statement on Controllability (Control)
The group who received the management statement on the controllability of
quality costs reduced their prices by 8.85% while the group who did not receive
it reduced their prices by 6.67%. The results indicate that the null hypothesis
(H2) can be rejected. The price adjustment by managers who were informed
of the controllability of quality costs was greater than the price adjustment by
managers who were not informed of the controllability of quality costs (p-value
of 0.00975). The results imply that managers are more sensitive to the variation
of quality costs as the uncertainty surrounding those costs diminishes, i.e, as
the source of variation is explained or controlled.
Buyers’ Price Sensitivity (Buyer)

Prices were reduced by 6.12% when buyers were not very sensitive while they
were reduced by 7.83% when buyers were extremely price sensitive. The results
indicate that the null hypothesis (H3) can be rejected. The price adjustment by
managers was significantly greater when buyers were extremely price sensitive
than when buyers were not very sensitive (p-value of 0.0001). These results
confirmed the expectation that as buyers’ sensitivity increases, managers reduce
their prices in order to increase their firm’s market share.
1 Level of Competition
Prices were reduced by 6.39% when the market was moderately competitive
while they were reduced by 7.54% when the market was extremely competitive.
The results indicate that the null hypothesis (H4) can be rejected. The price
adjustment by managers was significantly greater in an extremely competitive
market than in a moderately competitive market (p-value of 0.0001). These
results confirm the expectations of Monroe and Della Bitta (1978) and Nagle
(1987) that the degree of industry competition influences price setting.
Interactions
1 The two level interactions quality*buyer (H5), control*buyer (H6), and buyer*
competition (H9) were not significant with p-values of 0.5916, 0.3427, and
0.8531 respectively. The two level interaction quality*competition (H7) had a
p-value of 0.0413. Thus, the null hypothesis is rejected. This interaction,
(illustrated in Fig. 7), indicates that the impact of quality cost information on
pricing decisions was not the same at different levels of competition. The impact
of quality cost information is particularly accentuated in an extremely compet-
itive market.
The two level interaction controllability*competition (H8) has a p-value of
0.0512. It was found earlier that managers tended to be more aggressive
1 (cooperative) in their pricing behavior as the number of firms in an industry
increased (decreased). The interaction controllability*competition is illustrated
in Fig. 8. The marginally significant interaction indicates that the impact of
the management statement on the controllability of quality costs on pricing
decisions is not the same at the different levels of competition. As shown
in the figure, the impact of the management statement on the control-
lability of quality costs is particularly accentuated in an extremely competitive
market.
The three-level interaction quality*buyer*competition was marginally signif-
icant with an F-statistic of 3.50 (p-value of 0.0625). The three-level interaction,
illustrated in Fig. 9, indicates that the effect of quality cost information was
243
11
Fig. 7. Interaction between Quality Cost Information and Level of Competition.
not the same across the levels of both buyers’ price sensitivity to price variation
11 and market competition.
In summary, the results empirically demonstrate the importance and influence
of quality cost information on management decision-making. In addition, they
proved that pricing decisions are influenced not only by the identification of
quality costs but also by their controllability. Moreover, it was proven that the
extent to which quality cost information affected the pricing decision was not
the same across the level of competition: the impact increased as the level of
competition increased. Likewise, the extent to which controllability of quality
costs affects the pricing decision was not the same across the levels of
competition: the impact increased as the level of competition increased. Finally,
11 the effect of quality cost information was not the same across the levels of both
buyers’ price sensitivity to price variation and market competition.
DISCUSSION
This paper investigated whether an information system incorporating quality

cost information leads to different pricing decisions relative to the traditional
information systems. Overall we tested the main and interaction effects of
quality cost information, controllability of quality costs, level of competition
and buyers’ price sensitivity on managers’ pricing decisions after partialling out
the effects of firms size and educational background. The latter two variables
Fig. 8. Interaction between Controllability of Quality Cost and Level of Competition.

1
were added as covariates in the model, because the comparison of personal
characteristics between experimental groups indicated that these groups were
different in terms of firm size and educational background. The objective of
integrating covariates was to ensure that those traits did not alter the significance
of the results.
Our results empirically demonstrated the importance and influence of quality
cost information on management decision-making. The results also indicated
that pricing decisions were influenced not only the identification of quality costs
but also by their controllability. In addition, our results confirmed the impact
1 of buyers’ price sensitivity and the level of competition on pricing decisions.
Moreover, our findings indicated that the extent to which quality cost
information affected pricing decisions was not the same across levels of
competition: the impact increased as the level of competition increased.
Likewise, the extent to which controllability of quality costs affected the pricing
decision was not the same across levels of competition: the impact increased
as the level of competition increased. Finally, the effect of quality cost infor-
mation was not the same across levels of both buyers’ price sensitivity to price
variation and level of competition. In conclusion, after taking account of the
moderating effects of certain variables, the finding that quality cost information
significantly influences pricing decisions is an indication that the time and effort
245
11
11
Fig. 9. Interaction between Quality Cost Information*Buyers’ Price

Sensitivity*Level of Competition.
required to implement and incorporate quality costs within traditional accounting

reports may be well justified.
11
LIMITATIONS
The results of this research are subject to certain limitations. It is possible that
some accuracy in representing the managerial and manufacturing environment
has been sacrificed in the development of the case materials. This is due to
time constraint and the likely threat of extraneous variables in the model. In
practice, managers are free to choose the information they prefer. As a
consequence, the results of the proposed study differ from managers’ decision
making in a real situation. Future research would show the effects of such
sacrifices. It is also possible that this study may not be generalizable beyond:
(1) the choice of subjects, (2) the tasks used in the experiment, and (3) the
specific information used.
Prior studies that focused on pricing decisions had used students to surrogate
for marketing managers. In contrast, this study enhanced the external validity
of the results vis-à-vis prior studies by surveying marketing managers. A
limitation arose from this choice. That is, a relatively low response rate was
obtained from the mail survey. The overall response rate was about 6.4%, while
the usable response rate was about 5.6%. Although the bias of non-response
has been ruled out from the statistical analysis, a bias remains because of the
1 low response rate.
Finally, in this study, pricing decisions were seen through a traditional
perspective which assumes that costs set the floor for the price that company
can charge for its products. This study assumed that target costing was not used
as a pricing tool.
NOTES
1. Diallo et al. (1995) criticized traditional costing methods for focusing only on
costs incurred in the production of the defective or unacceptable parts or products.
1 That is, the production or rework cost (direct material, direct labor, and manufacturing
overhead) of the units not meeting quality control standards is considered a loss.
Loss is divided into categories of normal or abnormal. Many prevailing accounting
systems report the abnormal loss only as feedback for control and corrective action.
This, according to these authors is totally inadequate.
2. Before performing the statistical analysis, tests on the non-response bias was
carried out to ensure that early respondents were not statistically different from late
respondents in terms of personal characteristics.
3. The unmanipulated variables were:
• Industry demand: demand in the industry was defined as fairly flat i.e. the demand
was limited to replacement demand.
1 • Position in the product’s life cycle: products had reached their maturity stage in
their life.
• Strategic focus: the company focused on a cost leadership strategy.
• Position of the firm in the industry: the company held the 4th position in the
market with a 10% market share for each product market. However, the market
share had declined for the second consecutive year.
4. All prices were expected to be reduced given the level of unmanipulated
variables (see endnote 3) and because the case study presented a forecasted cost
savings for each product. In addition, the case study specifically stated that the
objective of the firm was to increase the market share of each product. If the price
was reduced then the “percent change in price” became negative. Consequently, the
absolute value of the% change in price was preferred in order to facilitate the analysis
of results.
247
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249
xii RUNNING HEAD

RISK PERCEPTION AND HANDLING
IN CAPITAL INVESTMENT:
AN EMPIRICAL STUDY OF SENIOR
EXECUTIVES IN HONG KONG
Simon S. M. Ho and Lloyd Yang
ABSTRACT
This study examines the risk perception and risk handling practices of 105
senior Hong Kong executives in strategic capital investment decisions. In
addition, the relationships between various risk handling practices and
firm characteristics are explored. Overall, the findings indicate that
executives tend to perceive chance events as causal and seek ways to
control risk. There is a tendency to attach less importance to the proba-
bility of loss than to the potential amount of loss. Executives prefer a
relatively simple intuitive risk analysis approach with a primary focus on
‘total project’ risk. After analyzing the risk, executives tend to reduce the
pure risk components by tightening project control, operating contingency
plans in the event of need, and diversifying the risk by setting up joint
ventures. The typical pattern of a risk-return trade-off decision involves
making a single value estimate of the risk-adjusted discount rate, along-
side a payback calculation as a rough indication of risk, combined with
management judgement based on experience and intuition. It is clear,
however, that executives will continue to rely on more than one risk

ISBN: 0-7623-0825-7
251
252 SIMON S. M. HO AND LLOYD YANG
method for investment decisions. The implications for theory and practice
are discussed.
INTRODUCTION
The purpose of this paper is to report findings from a study of the conceptions
of risk and risk handling approaches held by executives in an international
business centre. Unlike ‘pure’ risks usually discussed in the field of safety
management (where there is usually no element of potential gain, i.e. the
11 potential outcomes are ‘loss’ or ‘no loss’), managers with entrepreneurial talents
take certain strategic (or speculative) risks in expectation of higher returns
(unless otherwise specified, the term ‘risk’ in this paper refers to ‘strategic
risk’). The role of risk taking in business decision making is well acknowledged
by executives in all types of corporations and is a natural part of business
activities (Peters & Waterman, 1982; Baird & Thomas, 1985; Porter, 1990).
The handling of risk is also well recognized as an important, but often complex
task in reaching effective capital investment decisions. Researchers in the field
of business strategy put much effort in incorporating risk in the modelling of
corporate strategy (Bettis, 1982; Bowman, 1982; March & Swanson, 1984;
11 Bromwich & Bhimani, 1991). Bierman (1986), Pike (1996), Freeman and
Hobbes (1991) and Harris and Raviv (1996) found in their surveys that the
challenges of handling risk considerations were perceived to be one of the most
prominent problems in capital investment decisions among U.S., U.K. and
Australian multinational firms.
The past decade has therefore seen an increasing interest in the
conceptualization, analysis and assessment of risk. Recently, there have been
several lines of development in the accounting, finance and decision-making
literature that attempt to offer scientific solutions to complex ‘risk’ problems,
despite the view that risk is a multi-attribute phenomenon and risk handling
11 process is a multi-dimensional organizational decision process. For instance,
management scientists have been primarily concerned with techniques and
probabilistic models to capture the essence of project risk and displaying it in
a form usable to managers making risk-return trade-off decisions. Authors in
finance have focused mainly on the establishment of a proper discount rate to
adjust for future and uncertain cash flows for compensation. On the other hand,
economists and decision analysts have been most concerned with the utility
theory aspect of investment decisions and with the development of a method
by which decision-makers’ risk preferences may be reflected. Early empirical
research, using utility-based models, suggested that risk is measured by return
distribution attributes such as variance and skewness (Cooley, 1977). In additon,
Risk Perception and Handling in Capital Investment 253
empirical evidence suggests that decision makers do not treat probabilities and
outcomes in the multiplicative manner assumed by most economic and statistical
models (Slovic, 1967; Camerer, 1994).
In more recent years, Hirst and Baxter (1993) and Gordon, Loeb and Stark
(1990) have investigated the choice process and the role of information in capital
budgeting, while Dixit and Pindyck (1995) suggested the options approach to
capital investment. Stewart (1994) and others tried to overcome the limitations
of the return on investment (ROI) measure in capital investment by using the
economic value added (EVA) measure (originally called residual income)
1 requiring the capital charge be subtracted from net income before taxes.
However, very few companies use it extensively for measuring project
performance (Kaplan & Atkinson, 1998) and its associated problems should be
further addressed (e.g. adjusting financial accounting practices) to improve its
usefulness. Building upon Kahneman and Tversky’s (1979, 1992) prospect
theory for information choice, Loomes and Sugden (1982, 1998) offers an
alternative which allows a decision-maker’s capacity to anticipate feelings of
regret and rejoicing in capital investment. The model yields a range of
predictions very consistent with choice phenomena that have defied conventional
explanation.
1 Yet we know very little about how executives really perceive and handle
risk, and why some firms are more effective than others in managing risky
investments. These extensive efforts in developing various risk measurement
and analysis approaches in capital budgeting may be inadequate if a good
understanding of how executives perceive and handle risk in capital budgeting
is lacking. Given the theoretical and practical importance attached to risk
handling, it is also surprising that relatively little empirical research has been
conducted on how executives actually perceive and handle risk in strategic
capital investment decisions.
A psychometric paradigm for studying perceived pure risk has been
1 well-documented in the literature (e.g. Slovic, Fischoff & Liechtenstein, 1986;
Slovic, Kraus, Lappe & Majors, 1991; Yates, Zhu, Ronis, Wang, Shinotsuka
& Toda, 1989). These studies show people make judgements about the current
riskiness of diverse hazards and then relate these judgements to several
characteristics that have been shown to account for their perceptions. Cognitive
research shows that due to limitations of human information processing
capabilities, individuals rely heavily on heuristics to facilitate decision making
and are subject to “framing effects”. These may tend to focus decision-makers’
attention on non-probabilistic risk attributes (Kahneman & Tversky, 1992;
March & Shapira, 1992; Hogarth & Kunreuther, 1995). Lopes (1987) believes
that risk must be related to the loss of what one values. Although such research
253
has been found useful in managing public health and safety risks, its contribution
to the understanding of strategic risk taking is very little.
The few available works on strategic risk perception held by managers,
indicates that the theoretical perspectives do not fit well with practising
managers’ conceptions of risk, and have largely concentrated on general, rather
than decision-specific issues (Shapira, 1986; March & Shapira, 1987;
MacCrimmon & Wehrung, 1986; Yates, 1992). The existing knowledge on risk
handling practices in capital investment, mostly collected and reported as a part
of broader-based capital budgeting surveys (e.g. Klammer & Walker, 1991;
11 Klammer, Koch & Wilner, 1991; Ho & Pike, 1991; Freeman & Hobbes, 1991;
Cooper, Cornick & Redmon, 1992; Drury, 1993; Sangster, 1993; Cheng, Kite
& Radtke, 1994; Chen, 1995; Pike, 1996; Cornick & Dardenne, 1997),
inevitably provides only a very limited view of risk management and its related
problems. In addition, organizational changes and the fast growth in
management education over the past two decades, fuelled by the expansion of
information technology, may have changed the perception and practice of some
executives.
Since little empirical evidence is available, the aim of this paper is to report
findings from a study of the conceptions of risk and risk handling approaches
11 held by executives in one of the major international business and financial
centers – Hong Kong. On risk perceptions and measures the purpose is to see
if possible to identify a common set of risk attributes. On risk handling, the
study was based on an integrated model of strategic risk handling (Ho, 1990)
which links the different dimensions of the risk process. This model suggests
that all corporate investment decisions in practice should go through a series
of steps in a logical sequence. The process first requires risk identification, then
risk analysis/measurement, pure risk reduction, and lastly, risk evaluation –
subsequent incorporation in the final project decision process. After the
measurement of risk at both project and portfolio level, a decision maker needs
11 to judge whether some or all of the inherent pure risks can/should be avoided,
reduced, tolerated or accepted. If the project is still perceived as too risky after
reduction (for example, in terms of maximum possible loss), it would probably
be more likely to be rejected. Otherwise, the decision maker then has to make
a risk-return trade-off decision and decide to what extent the residual risks
(largely probabilistic) can be accepted or compensated with a higher return.
Finally, the manager must make an overall judgement about the project(s), and
ultimately make an accept/reject decision. This integrated model is very useful
in exploring the risk handling practices of executives in capital budgeting
decisions and will be the main framework for designing the current study
instrument.
In sum, the current study sought to answer the following questions:

(1) What do executives understand by the term ‘risk’ in capital investment
decisions? How do these perceptions differ from theory and prescribed
models?
(2) How executives perceive the importance of different quantitative risk
measures?
(3) To what extent do executives analyze risk in different levels of capital
budgeting decisions (i.e. from single project risk to portfolio risk)?
(4) To what extent do executives use different risk reduction methods for
1
reducing ‘pure’ risk components?
(5) To what extent do executives use different risk-adjustment techniques for
the residual risk?
Using subjects in Hong Kong could further provide a test of the theory in a
different national setting. Hong Kong has been ranked by the World Economic
Forum in Davos, Switzerland as the third most competitive city in the world
and by the Washington-based Heritage Foundation as the world’s freest
economy in 1997. Hong Kong is one of the major business and finance centres
in the world with a large population of entrepreneurial business leaders. Since
1 Hong Kong is poised to play a key role in global business in the next century,
the findings in the current study should be useful in enhancing our knowledge
about executives’ attitudes and concerns about risk and improving the
effectiveness of risk handling efforts in other similar economies. The ‘risk’
problem is particularly significant for fast-growing economies (such as
South-East Asia countries) which are now facing rapid socio-economic and
political changes.
RESEARCH METHODOLOGY AND DESIGN
1 Mainly based on relevant previous studies and supplemented by findings from

ten executive interviews, a survey questionnaire was designed and refined. The
pilot-tested questionnaires, consisting of a mixture of open and closed
Likert-type questions, were distributed to named ‘finance directors’ in the largest
500 companies (in terms of number of employees) listed in The Key Decision
Makers in Hong Kong Businesses.
After two follow-ups the whole process resulted in responses from 120
companies, 105 being usable for this study (an actual response rate of 21%).
Additional comments given by some respondents on the survey questionnaires
provided further insights. Follow-up telephone interviews with selected
respondents were carried out to seek clarification on certain issues and obtain
255
a more detailed picture of certain aspects of risk handling in the capital

budgeting process.
In order to establish the reliability and validity of the data obtained, all refusal
letters were analyzed. The major reasons of not participating in the survey were
“lack of time” and “company policy not to answer questionnaires.” This finding
implies that those who failed to respond would not necessarily have different
risk practices from the executives who did respond. In addition, the measures
of three corporate characteristics (i.e. number of employees, net fixed asset and
annual capital expenditure) and three risk handling variables from the last 40
11 questionnaires received were compared with the results of the first 40 in order
to check for any possible bias. This split-half technique, introduced by
Oppenheim (1966), indicated no significant difference (alpha = 0.05) between
early and late responding firms, thus suggesting that non-response bias was
minimal in the data collected.
The distribution of the sample firms presented by industrial sector, size and age
also suggests that the respondents were fairly representative of the population (see
Tables 1 and 2). Almost all respondents were senior executives and were well-
versed in various aspects of strategic investment decisions. About 53.6% of the
respondents were below the age of 40 and another 46.4% aged between 40–45.
11 Following the format of the questionnaire, the major findings are presented
in the remaining five sections dealing with:
• Perception of Risk
• Usefulness of Risk Measures
• Scope of Risk Analysis
• Pure Risk Reduction and Control
• Adjusting Risk for Project Decision
Chi-square analyses indicated no significant associations between industrial
sectors and risk handling practices. Bivariate correlational analyses were
11
Table 1. Industrial Breakdown of Respondents.
Industry Number of Respondents Percentage of Total
Manufacturing 29 28
Property 26 25
Utility/Transportation 3 3
Financial 14 13
Trading 17 16
Others 16 15
Total 105 100
Table 2. Profile of Respondent Firms.

Attributes Mean
Fixed Asset (HK$000) 2,515,891

Capital Expenditure (HK$000) 351,576
Employee Number 2,809
Firm Age 29.62
conducted to examine any significant associations between four major firm

1 characteristics (i.e. employee size, net fixed assets, level of capital expenditure
and firm age) asked in the questionnaire and all risk handling practices. Only
the significant associations with visible patterns will be highlighted in later
relevant sections.
RESULTS
Perception of Strategic Risk
In order to obtain some non-directed responses about capital investment risk

1 attributes, respondents were first asked an open-end question: “What do you
understand by the term ‘risk’ in capital investment decisions?” As expected the
responses to this open-end question were varied. The most frequently-used
words/phrases used were (in order of frequency): possibility, uncertainty/not
certain (in key assumptions, events or outcomes) (35 responses), not meeting
target (32 responses), deviations (31 responses), difficulty in control (28
responses), unpredictability (28 responses), loss (26 responses), and undesirable
outcomes (22 responses). Less than 10% of the respondents in fact viewed risk
from the ‘quantification’ or ‘measurement’ perspectives. The probabilistic terms
such as ‘expected value’ or ‘variance’ were only mentioned a few times,
1 regardless of the directions of outcomes.
Respondents tended to perceive risk more from the sources/causes of
uncertainty/risk perspective than about the possible outcomes. About 38% of
respondents were explicitly concerned with ‘downside’ or negative outcomes
alone when viewing risk (versus 4% who focused on positive outcomes only).
The remaining 58% did not mention the direction of the outcomes. These results
are somewhat different from Petty et al. (1975) findings in the U.S. suggesting
a preoccupation (over 80%) with downside risk.
Overall, the managers saw risk in a less precise way than it appears in finance
theory. In particular, there was little inclination to equate the risk of a project
with a statistical measure (e.g. variance) or to perceive risk from the market
257
portfolio perspective. Risk is more related to the potential loss of a large amount
o0r an investment return below target. Many of the respondents view risk to
be characterized by a variety of attributes which may not include probabilities.
They tended to perceive risk events to be causal and sought ways to control or
eliminate these ‘sources’ or ‘causes’ of ‘risks’ (vs. attributes of risk). These
findings are somewhat in contrast to the traditional risk theory which assumes
‘risk’ as mainly a chance or probabilistic event (e.g. Rowe, 1977; Yates, 1992).
They also suggest that decision makers are loss-averse as opposed to risk averse
which are consistent with other studies (e.g. Shapira, 1995).
11
Usefulness of Risk Measures
In classical decision and finance theory, risk is most commonly conceived as

a probabilistic distribution of possible outcomes and their values, likelihood and
variations. Six alternative measures of risk were identified from the literature:
(a) expected value of return
(b) probability of loss
(c) maximum amount of potential loss
(d) variance
11
(e) semi-variance (variance of negative or positive outcomes only)
Markowitz (1959) rejected the first three as unsuitable. He preferred the semi-
variance measure to variance for theoretical reasons, but chose the variance
measure because of its familiarity and ease of computation. Mao (1970) argued
that managers tend to be preoccupied with the downside risk, and in particular
the risk of failure and bankruptcy. Supported by field evidence in eight American
companies, he suggested that semi-variance is a better measure and is more
consistent with this concept of investment risk than ordinary variance. However,
these findings are pretty dated and it is not known whether they are still valid
11 today.
Despite the arguments for viewing ‘risk’ as a ‘hazard’ or ‘danger of loss’
and measuring risk as ‘semi-variance’, modern finance theory advocates the
definition of ‘risk’ as the dispersion of returns; i.e. with possible deviations
(both positive and negative) from the ‘expected return’. The larger the variance,
the larger is the risk. Finance theory assumes that investors are holding a port-
folio of assets (projects or securities), so that the risk of failure on one individual
asset is balanced by the possibility of success on another. The use of variability
as a measure of risk assumes that positive and negative deviations from the
mean merit equal attention and well-diversified investors are concerned more
with the overall (portfolio) risk and return than a single project’s performance.
If returns are normally distributed, finance theory further suggests that

executives can compare the alternative investment on the basis of their mean
(expected value) and variance. Various risk analysis methods (e.g. decision tree,
covariance analysis, Hertz-type simulation, capital asset pricing method, etc.)
have been developed from these assumptions and probabilistic decision rules
(Pike & Ho, 1991). Risk analysis is based on a formal and comprehensive
evaluation of the uncertainties associated with critical project variables and their
probabilities before any mean-variance or risk-return trade-off decision is made.
To what extent executives actually measure risk and make risk-return trade-off
1 decisions in this way is not known.
The respondents in the current study were asked to indicate to what extent
(1 = never, 4 = very often) they found the different risk measures useful in
making corporate investment decisions (see Table 3). Among the various risk
measures, ‘expected value’ was ranked as the most useful measure (mean =
3.46). This finding is in sharp contrast to Shapira (1986) and March and Shapira
(1987) who found that it is the magnitude of outcome (i.e. in terms of dollar
amount) that defines risk for managers rather than expected value. Although all
respondents indicated that they were familiar with ‘expected value’ and 93%
of them found this measure useful or very useful, it is not certain how many
1 of them really understood it in the statistical sense (i.e. the product of
probabilities and outcomes) as prescribed in the textbooks. Discussions with
some executives revealed that the statistical term ‘expected value’ caused
confusion, since it does not represent the outcomes which are really ‘expected’,
‘required’ or ‘desired’.
Ninety-one percent of respondents found the measure of ‘maximum amount
of potential loss’ useful or very useful (mean = 3.33), while only 84.6% found
the ‘probability of loss’ useful or very useful (mean = 3.01). This therefore
indicates that more executives felt that risk could be better defined in term of
1 Table 3. Usefulness of Risk Measures.
Measure Not Not Very Mean

Familiar Useful Useful
With At All
1 2 3 4
(%)
1. Expected Value of Return 0.0 0.0 6.7 41.0 52.4 3.457

2. Max. Amount of Potential Loss 0.0 0.0 8.7 49.5 41.7 3.330
3. Probability of Loss 2.9 3.8 8.7 57.7 26.9 3.019
4. Variance from Expected Return 1.0 3.8 13.5 58.7 23.1 2.990
5. Semi-variance 42.4 7.1 25.3 23.2 2.0 1.354
259
potential amount to lose (or expected to be lost) than in terms of probability

of loss. This is fairly consistent with March and Shapira’s (1987) findings that
risk is not primarily perceived as a probability concept and the magnitudes of
possible bad outcomes seemed more salient to the executives surveyed.
There was also much less inclination to equate the risk of a project with the
variance (or semi-variance) of the probability distribution of possible outcomes
(or loss). Table 3 shows that executives felt that risk could better be defined
in terms of variance (mean = 2.99) than in terms of semi-variance (mean = 1.35).
Executives were least familiar with the ‘semi-variance’ measure (with 42.4%
11 indicating ‘not familiar with’). These results again offer little support for the
contention for using semi-variance as a measure of risk.
None of the firm characteristics was significantly associated with the perceived
usefulness of any risk measures. In an effort to determine the extent to which firms
use a variety of risk measures in their investment decision process, a series of
bivariate correlational analyses were conducted among the measures (see Table
4). With the exception of ‘expected value of return’ by ‘semi-variance’, ‘amount
of potential loss’ and ‘probability of loss’, all other correlation measures were pos-
itively significant at the 0.05 level. Overall, the findings indicate that financial
executives do not rely too much on precise statistical risk measures in making
11 investment decisions. Also, these executives tended to use several key values to
assess the risky situation instead of using one single summary statistic grounded
in probability concepts. This may suggest that they are simply being realistic and
the use of several measures are quite appropriate in a world of uncertainty.
On a 10-point scale question (ranging from ‘mainly subjectively/intuitively’
to ‘mainly formally/quantitatively’), executives were further asked how the risks
of capital projects were usually assessed or analyzed in their companies. It was
found that among the 105 executives who responded, 89 (63%) tended to use
more quantitative methods, while the remaining 52 (37%) applied more intuitive
11 Table 4. Inter-relationships Among Risk Measures.

Measure 1 2 3 4
1. Expected Value of Return

2. Max. Amount of Potential Loss 0.037
3. Probability of Loss 0.063 0.458***
4. Variance from Expected Return 0.369*** 0.230 0.227*
5. Semi-variance 0.229 0.385*** 0.316* 0.671***
* significant at 0.05 level.

** significant at 0.01 level.
*** significant at 0.005 level.
approaches in assessing risky projects. This is consistent with Ho and Pike’s

(1991) U.K. findings which indicated that although actual practices of firms
still lagged well behind the theoretically-prescribed probabilistic risk analysis
approach, there has been a continuing trend towards greater sophistication of
risk handling. Nevertheless, interview results reflected that simple intuitive
approaches have not tended to be replaced by the more quantitative advanced
ones, but are used to supplement risk analysis. Furthermore, moving toward
theoretically prescribed risk analysis approaches should not automatically be
considered greater sophistication.
1
Scope of Risk Analysis
Theory suggests that firms should differentiate between types of risks. Scope
or level of risk analysis conducted within firms ranges from single project risk
(i.e. the variability in the capital project’s cash flows) to portfolio risk (i.e. the
variability in a firm’s or a shareholder’s portfolio returns). At the project level,
firms may analyze the risk of each project individually or collectively on a
group basis. Potential dependencies (joint probabilities) between uncertainty
factors should also be considered when project risk is measured. Even if
1 individual risks are known, their combined effect should also be considered.
The acceptance of a new project may change the overall risk of a company as
well as the risk of its portfolio of investment projects. Thus, risk can be analyzed
within a single project, division, total firm, or investment portfolio context.
These different aspects of risk analysis provide complementary perspectives and
criteria for making capital investment decisions.
In the current study, respondents were asked to what extent (1 = never, 4 =
very often) they incorporated each of the listed aspects of investment risk in
their decision process. Table 5 reveals that managers most frequently assessed
the risk of each project or project class individually (mean = 3.305). The second
1
Table 5. Scope of Risk Analysis.
Never Very Often
Aspect 1 2 3 4 Mean
(%)
1. Risk of each project in isolation 2.9 12.4 36.2 48.6 3.305

2. Effect on company over-all risk/profitability 0.9 9.5 47.6 41.0 3.276
3. Effect on other projects risks/returns 2.9 30.5 41.0 25.7 2.895
4. Relationships among projects 2.9 31.4 43.8 21.9 2.848
5. Relationship among different risk factors 4.8 27.6 42.9 24.8 2.876
6. Effect on shareholder’s portfolio 14.4 26.9 30.8 27.9 2.721
261
most popular response was the ‘effect of project risk on corporate overall
risk/return’ (mean = 3.276). ‘Effect on other projects’ risk/return’ (mean =
2.895) and ‘relationship among various risk factors’ (mean = 2.876) were found
to be lower in use in the sample firms and only 58% of the respondents analyzed
‘the effect of project risk on the shareholders’ portfolio’ (mean = 2.721).
Correlational analyses conducted between each aspect of risk analysis and
other firm characteristics suggest no significant relationships. Table 6 shows the
bivariate correlations among the extent of different aspects of risk analysis.
With the exception of ‘risk of each project in isolation’ by ‘effect of the project
11 risk on other projects’ risk/return’, ‘effect of each project risk on company
overall risk/profitability’, and ‘effect of the project risk on shareholders
portfolio’, all other relationships were positively significant at the 0.05 level.
These indicate that, although some firms conduct a variety of analyses, firms
conducting individual project risk analysis extensively do not necessarily tend
to carry out other aspects of risk analysis.
Overall, these results suggest that executives are still more concerned with
evaluating total project risk than with focusing on portfolio risk. However, total
project risk analysis could be considered to be a prerequisite to the successful
application of market portfolio risk analysis (Hull, 1980). Hertz and Thomas
11 (1983) stress the importance of using all different levels of risk analysis and
having any conflicting results discussed among decision makers before reaching
a decision. Indeed, the need to develop flexible, multi-level, interactive decision
processes using various risk perspectives has become increasingly evident.
Pure Risk Reduction and Control
Effective handling of risk requires its identification, measurement and

subsequent incorporation in the project decision model. After the measurement
11 Table 6. Interrelationships among Scope of Risk Analysis.
Measure 1 2 3 4
1. Risk of each project in isolation

2. Effect on company over-all risk/profitability 0.087
3. Effect on other project risk/return ⫺0.097 0.330***
4. Relationship among different risk factors 0.215* 0.475*** 0.316***
5. Effect on shareholder's portfolio 0.102 0.434*** 0.2505** 0.362***

and analysis of investment risk, managers having a high concern for total risk
need to judge whether some or all projects should be avoided, reduced, or
tolerated. If some of the non-speculative risks are unacceptable, risk-reduction
methods are needed to protect against unfavourable outcomes, which could
range from complete catastrophes to less serious occurrences.
Respondents were therefore further asked to rate the extent (1 = never, 4 =
very often) to which they used various methods commonly prescribed in the
literature for reducing ‘pure’ risk components. Table 7 shows the percentage
usage of each method. The five most popular risk-reduction methods were
1 ‘maintain tighter project control’ (mean = 3.490), ‘operate contingency plan’
(mean = 3), ‘diversify the risk’ (e.g. joint venture) (mean = 2.941),
‘product/market diversification’ (mean = 2.892), and ‘change to a group deci-
sion’ (mean = 2.882). Less popular techniques included, ‘modify policies and
staffing of the company’ (mean = 2.693), ‘delay the decision’ (mean = 2.683),
‘subtract critical parts of the project to outside contactors’ (mean = 2.53) and
Table 7. Risk Reduction Approaches.
Never Very
Often Significant
1 Method 1 2 3 4 Mean Correlations
(%)
1. Tighter control of 1.0 4.9 38.2 55.9 3.490 2 ,5
project implementation
2. Operate contingency 3.9 17.6 52.9 25.5 3.000 1,8,5
plan in the event of need
3. Diversify the risk 2.9 19.6 57.8 19.6 2.941 4 ,11
(e.g. joint venture)
4. Product or market 2.9 25.5 51.0 20.6 2.892 6,11
diversification
5. Change to a group 7.8 23.5 41.2 27.5 2.882 1,2,4,5,6
decision
1
6. Modify policies & 6.7 32.4 41.0 16.2 2.693 4,5,8
staffing of the company
7. Delay the decision 5.4 26.9 63.4 5.0 2.683 12
8. Subcontract critical 15.0 32.0 38.0 15.0 2.530 2,6,9
parts to outsiders
9. Acquire commercial 16.8 35.6 35.6 11.9 2.441 5,8,12
insurance coverage
10. Secure material/market 14.9 40.8 31.7 12.9 2.426 11,12
by vertical integration
11. Deal with competitors 18.4 44.7 28.2 8.7 2.272 2,3,4,5,10,12
12. Delegate the 29.4 46.1 23.5 1.0 1.961 7,9,10,11
decision to others
263
‘acquire commercial insurance coverage’ (mean = 2.441). Very few executives

used methods such as ‘secure material/market by vertical integration’, ‘deal
with competitors’, or ‘delegate the decision to others’.
Bivariate correlational statistics indicate that level of capital expenditure and
firm age was significantly correlated with ‘delegate the decision to others’
(positively) and ‘product/market diversification’ (negatively) respectively (alpha
= 0.05). Respondent age was also significantly and negatively related to both
‘acquire commercial insurance coverage’ and ‘secure material supply and/or
product market via vertical integration’. As shown in the last column of Table
11 7, each risk reduction method was significantly correlated with at least one
other method. In particular, ‘deal with competitor’ was significantly correlated
with six other risk reduction methods.
While diversification of investment risk is well established in the finance
literature as a primary means of reducing firm-specific risk, the results of this
survey indicate only a moderate preference for using diversification strategy as
a primary tool for risk reduction. Discussions with executives revealed that there
are other risks associated with becoming a diversified company and that some
young companies are more preoccupied with growth than with stable earnings.
11 Adjusting Risk for Project Decision
From both theoretical and intuitive perspectives, investors taking a greater risk
should be compensated with greater returns or, alternatively, more stringent
requirements should be placed on higher risk projects (e.g. shortening the
payback period). Respondents were asked to indicate the extent to which they
use the various risk adjustment techniques listed.
As shown in Table 8, ‘shorten required payback’ was used most frequently
(mean = 3.0), either individually or with other techniques. This is not surprising
since this technique is easy to use and emphasises liquidity. This finding
11 contrasts with the much higher reliance on internal rate of return in Australia
and the U.S. During interviews, many executives expressed the opinion that a
shorter payback period means earlier and surer recovery of investments. In a
certain sense payback adjustments achieve a ‘no loss’ situation faster, with
fewer uncertainties and usually with more cash receipts at an earlier stage of
the project. Certainly, there are also some concerns about whether treating
shareholder wealth maximization as of secondary importance would lead
managers to use the payback method more (Pike, 1985; Kee & Bublitz, 1988).
All of these are important considerations for practising managers. Moreover
to be able to breakeven, which is a very important criterion for evaluating
projects, tells some managers’ egos that another battle has been won in the
Table 8. Risk Adjustment Methods.

Never Very Often
Method 1 2 3 4 Mean
(%)
1. Shorten required payback 4.9 18.4 48.5 28.2 3.000

period
2. Raise discount rate/required 5.9 29.4 42.2 22.5 2.814
ROR intuitively
3. Adjust estimated cash 7.8 23.5 53.9 14.7 2.755
1 flows subjectively
4. Adjust estimated cash flows 18.6 36.3 34.3 10.8 2.373
for cost of risk premium (e.g.insurance)
5. Raise discount rate/required ROR 17.5 37.9 35.0 9.7 2.369
using quantitative methods (e.g.CAPM)
corporate world, especially if there is no strong emphasis on quantified amount

of profit.
The next most popular methods of adjusting risk were to ‘raise discount
rate/required rate of return intuitively’ (mean = 2.814) and ‘adjust estimated
1 cash flows subjectively’ (mean = 2.755). ‘Adjust estimated cash flows for costs
of risk premium’ (mean = 2.373) and ‘raise discount rate/required rate of return
using quantitative methods (e.g. capital asset pricing model or simulation)’
(mean = 2.369) were the techniques least frequently employed by the respon-
dents. However, as indicated by some experts (e.g. Kaplan & Atkinson, 1998),
the return of return measure suffers from some defects such as rejecting projects
which will earn below the division’s average ROI but are still above the
divisional cost of capital. Although EVA is an improved measure of ROI,
according to interview findings, it is seldom used by Hong Kong executives.
The common use of ‘adjust discount rate intuitively’ is probably due to the
1 fact that this method is more accurate and consistent with the DCF evaluation
framework than adjusting estimated cash flows. However, a question immedi-
ately arises as to the way in which the risk premium is determined within these
firms. For example, does the risk premium vary with the type or size of a
project? Although an adjustment of the discount rate is desirable, estimating
the adjustment correctly is equally important. Discussion with executives further
revealed that firms employed different methods to determine the risk premium.
Some simply added a risk premium to the market riskless rate; others relied on
their recent earnings or growth performance; and only a few used the capital
asset pricing model (CAPM) to estimate the required discount rate. Nevertheless,
although the CAPM was used in some firms to assist in determining their overall
265
cost of capital, few firms used it to incorporate project risk due to the difficulty
in determining a beta for similar projects. It seems that in a large proportion
of the firms, the size of the discount rate adjustment is usually a matter of
managerial judgement and depends on experiences with other similar
investments, and on the risk-taking attitude of the decision maker. These findings
basically agree with U.S. surveys which show that there is little agreement in
practice on how to determine the cost of capital (Baker, 1987).
This study finds, on the whole, a much higher usage of ‘shorten required
payback’ method in Hong Kong than in other countries as indicated in
11 previous studies (e.g. Klammer et al., 1991, Ho & Pike, 1991). Shortening
payback is far less popular in the U.S. than in Hong Kong (see e.g. Gitman
& Mercurio, 1982). In addition, both the current study in Hong Kong and Ho
and Pike’s (1991) study in the U.K. found that the risk adjustment of discount
rate is the more favoured technique, while risk adjustment of cash flow is
adopted more by American managers (see Gitman & Mercurio, 1982;
Klammer, 1991).
Correlational analyses in Table 9 show that ‘raise discount rate/required ROR
using quantitative techniques’ is significantly influenced by firm age with older
firms using it more frequently (alpha = 0.05). Except for the relationship between
11 ‘adjust cash flows subjectively’ and ‘shorten required payback period’ and ‘raise
discount rate /required ROR using quantitative techniques’ respectively, all other
interrelationships between the various risk adjustment methods were significant at
the 0.05 level. This indicates that firms frequently employ several risk adjustment
techniques either on the same project or on different projects.
Table 9. Interrelationships Among Risk Adjustment Methods.
Measure 1 2 3 4
11 1. Shorten required payback period

2. Raise discount rate/required ROR 0.268**
intuitively
3. Adjust estimated cash flows 0.087 0.2667**
subjectively
4. Adjust estimated cash flows for cost 0.192* 0.2813** 0.398***
of risk premium (e.g. insurance)-
5. Raise discount rate/required ROR 0.231* 0.248* -0.073 0.343***
using quantitative methods (e.g. CAPM)

SUMMARY AND CONCLUSION
This paper has examined senior financial executives’ preferences for handling
risk and uncertainty within a capital budgeting context, based on a survey
conducted on 105 of the largest firms in Hong Kong and supplemented by
executive interviews. The findings indicate that executives tend to perceive risk
in an imprecise way and view risky chance events as causal by seeking ways
to control them. There is a tendency to consider the probability of loss less
important than the potential amount of loss. There is also much less inclination
1 to equate the risk of a project with the variance (or semi-variance) of the
probability distribution of possible outcomes (or loss). The findings show that
perceived risk in capital investment is a multi-attribute phenomenon. The
principle risk attributes appear to be uncertainty (lack of knowledge and
information), possibility of a below-target return, the possibility of a large loss,
the decision makers’ perceived control.
The processes that led to risk-return trade-off decisions are somewhat
different from the classical decision making model. Executives prefer relatively
simple and intuitive risk analysis approach with a primary focus on ‘total
project’ risk. After analyzing the risk, executives tend to reduce the pure risk
1 components by tightening project control, operating contingency plans, and
diversifying risk by setting up joint ventures. It was also found that the processes
that lead to the risk-return trade-off decisions are somewhat different from the
classical decision making model. The typical pattern involves making a single
value estimate of risk-adjusted discount rate, alongside a payback calculation
as a rough indication of risk, combined with management judgement based on
experience and intuition. It is clear, however, that executives will continue to
rely on more than one risk handling method for investment decisions.
One important contribution of this study is the substantial descriptive evidence
provided on the current risk handling practices in large firms. These findings
1 may encourage executives to re-evaluate and improve their own risk handling
practice in the light of the revealed practices and problems of others. Given the
wealth of theoretical literature relative to risk analysis and the absence of
information describing the real world practice and impacts, this study offers a
more comprehensive empirical database for further research in this field.
These findings have implications not only for understanding investment
decision making processes in organizations, but also for the further development
and modification of normative risk handling approaches in capital budgeting con-
texts. If we wish to encourage (or inhibit) executives conducting sophisticated
risk analyses or to take more strategic risk, we probably need to restructure our
conceptual framework of risk to match managerial perceptions. Future research
267
should examine to what extent the different perceived risk attributes can explain
returns of investment project better than do standard deviation of returns. Also,
more research should investigate more carefully the role of behavioural,
organizational and cultural variables in risk handling process.
ACKNOWLEDGMENTS
The authors would like to thank the Business Administration Panel of the
Research Committee, The Chinese University of Hong Kong, for funding this
11 research project. They also express their gratitude to Mr. Derek Chau for his
assistance in data analysis. All correspondence regarding this paper should be
sent to the first author.
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APPENDIX
Sample Responses to Question on Perceptions of Risk in Capital Investment

1. The possibility of facing tangible and intangible loss.
2. Expected business risks and uncertain market risk.
3. In case of failure, the loss to the firm.
4. Uncertain factors to be incurred during the investment process.
5. The undesirable consequences to investors.
1 6. It is not possible to separate risk and uncertainties of long-term
investments.
7. The differences between expected target and potential outcomes.
8. The potential downsides due to future uncertain factors.
9. The possibility of potential loss.
10. The uncertainties in an investment project.
11. Risk and returns are hand in hand, return is also the price of risk.
12. Difficult to control foreign exchange fluctuations.
13. Lack of knowledge about the new market.
14. The difference from the expected target.
1 15. Should always reduce and avoid risk.
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xii RUNNING HEAD

A FRAMEWORK FOR EXAMINING
THE USE OF STRATEGIC CONTROLS
TO IMPLEMENT STRATEGY
Russ Kershaw
ABSTRACT
Interest in the relationship between a firm’s competitive strategy and its

use of strategic controls has increased in recent years. Unlike traditional
control systems, strategic controls are explicitly linked to the firm’s
competitive strategy to encourage strategy implementation. Researchers
have proposed that aligning performance measures and reward systems
with strategic goals can motivate management behavior that is consistent
with the firm’s strategy. However, much of this research is based on
intuitive arguments or has used a cross-sectional approach, which does
not provide a basis for determining causality. The purpose of this paper
is to summarize research that has investigated the use of strategic controls
to implement strategy. Studies examining the use of economic incentives
and performance measures to encourage strategy implementation are
reviewed. Contemporary approaches to performance measurement (e.g.
The Action-Profit-Linkage model and the Balanced Scorecard) are also
discussed. Based on this discussion, a framework that identifies the key
linkages between firm strategy and managers’ actions is developed. The
framework focuses on the critical characteristics of performance

ISBN: 0-7623-0825-7
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274 RUSS KERSHAW
measurement systems that impact management behavior and ultimately

strategy implementation. Directions for future research to examine the
model’s proposed linkages and applicability are also discussed.
INTRODUCTION
The dynamic nature of the current business environment has increased interest
in the relationship between a firm’s use of strategic controls and its competitive
strategy (Langfield-Smith, 1997). Unlike traditional controls, which focus on
11 short-term, financial measures of performance, strategic controls emphasize both
non-financial and financial measures that support the firm’s mission and strategy
(Ittner & Larcker, 1997; Stahl & Grigsby, 1992; Goold & Quinn, 1990).
Researchers have suggested that the alignment of performance measures and
incentive systems with strategic goals can motivate managers to take actions that
are consistent with firm strategy (e.g. Govindarajan & Shank, 1995; Simons,
1990; Dent, 1990). Recent normative and practitioner-oriented studies assert that
performance measurement systems should be customized to support the focus of
the firm’s strategy (e.g. Epstein et al., 2000, Kaplan & Norton, 1996; Simons,
1995; Meyer, 1994; Nanni et al., 1992). However, much of this research is based
11 on intuitive arguments and is not supported by empirical evidence (Langfield-
Smith, 1997). In addition, determining the nature of the causal linkages between
the use of strategic controls and management behavior has been precluded
because prior research has been primarily survey-based (Fisher, 1995).
Young and Selto (1993) suggest that agency theory (Baiman, 1990) constructs
may provide the basis for a framework to examine the relationships among a
firm’s strategy, its use of strategic controls, and managers’ efforts to achieve
strategic objectives. Agency theory describes how managers’ actions are
influenced by economic incentives and performance-related information.
Feltham and Xie (1994) suggest that incentives must be based on measures that
11 are congruent with firm strategy to motivate managers to allocate their efforts
in a strategically desirable way. In addition, using performance measures that
are influenced by events beyond managers’ control may not induce the desired
effort allocations. Feltham and Xie (1994) predict that measures that are highly
responsive to managers’ efforts will motivate managers to expend more
goal-related effort than those that are only slightly responsive.
The purpose of this paper is to briefly summarize research that has examined
the use of strategic controls to implement strategy. In particular, studies that
have examined the use of performance measures and economic incentives to
promote strategy implementation are reviewed. Traditional research approaches
to investigating these issues are also discussed relative to more contemporary
A Framework for Examining the Use of Strategic Controls to Implement Strategy 275
performance measurement system methodologies (e.g. The Action-Profit-

Linkage (APL) model – Epstein et al., 2000; The Balance Scorecard – Kaplan
& Norton, 1996). Based on this review and discussion, a framework for
understanding the use of strategic controls to implement strategy is developed.
The model identifies the key linkages between the firm’s overall mission and
strategy and managers’ actions at the local level. The framework also highlights
the critical characteristics of performance measurement systems that drive
managers’ effort decisions, which ultimately affects strategy implementation. In
addition to a description of the model, a brief illustration is provided to
1 demonstrate the model’s relationships. Finally, suggestions for future research
to investigate the model’s proposed linkages and applicability are discussed.
Strategic Controls
The primary function of strategic controls is to motivate members of the firm

to behave in a manner that is consistent with the firm’s goals and strategies
(Schendel & Hofer, 1979). It has been suggested that strategic controls differ
from traditional controls along several dimensions (e.g. Ittner & Larcker, 1997;
Stahl & Grigsby, 1992; Goold & Quinn, 1990). For instance, strategic controls
1 formally consider non-financial measures of performance that can impact
long-term financial performance. Traditional controls typically focus on
short-term financial measures of performance. When strategic controls are used,
both financial and non-financial objectives are usually derived through an
external benchmarking process and therefore based on competitive standards.
On the other hand, financial objectives and budget goals are typically derived
internally, based on the firm’s historical performance, when traditional controls
are employed. In summary, unlike traditional control mechanisms, strategic
controls are explicitly linked to a firm’s competitive strategy since they are
designed to encourage strategy implementation.
1 Various strategic control mechanisms can be employed to encourage the
implementation of a firm’s competitive strategy (Flamholtz, 1996; Goold &
Quinn, 1993). The alignment of performance measures and economic incentives
with the firms’ strategic goals are typically cited as effective strategic controls
(e.g. Govindarajan & Shank, 1995; Stahl & Grigsby, 1992; Goold & Quinn,
1990). Merchant (1998) notes that choosing performance measures that are
congruent with firm strategy and operational goals is crucial for promoting
strategy implementation. Performance measures direct attention and managers
can be expected to devote effort to improve measures whether or not they are
congruent with the organization’s objectives. When multiple measures are used
to evaluate performance, attaching relative weightings to each measure can focus
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276 RUSS KERSHAW
managers’ efforts on the firm’s strategic priorities. If measures are not properly
defined or the wrong importance weightings are used, managers’ efforts may
be misdirected.
Economic incentives can be linked to the appropriate performance measures
to further influence managers’ actions and support the organization’s goal
prioritization. Incentives that are contingent on congruent performance measures
will motivate managers to take actions that are designed to achieve the firm’s
specified objectives. Merchant (1998) also notes that the effectiveness of a
measure in motivating the desired actions is inversely related to the extent that
11 it is influenced by uncontrollable factors. Performance measures that are highly
influenced by events that are beyond managers’ control increases the ambiguity
of achieving the desired outcome, which reduces managers’ motivation to take
the required actions.
Weisenfeld and Killough (1992) examined the behavioral impacts of
performance reports and conclude that firm performance should be enhanced
if: (1) the reports accurately represent managers’ efforts, and (2) incentives are
linked to managers’ performance. In a field study of a manufacturing firm that
had recently implemented a contemporary quality strategy, Young and Selto
(1993) examined these predictions. Despite the adoption of new quality
11 measures, they found low levels of motivation toward improving product quality
on the part of the firm’s production personnel. Young and Selto also report that
no economic incentives were provided to encourage quality improvements. In
addition, production personnel did not understand how their efforts affected the
new quality measures. Consequently, managers tended to ignore these measures
when assessing worker performance. Young and Selto contend that the firm
had not appropriately implemented strategic controls to motivate strategy
implementation. Further, they suggest that agency theory concepts may provide
a theoretical basis for examining this issue.
11 Agency Theory Research
According to Baiman (1982), agency theory describes how relationships among

principals and agents are thought to be affected by economic incentives and
the availability of information. Of particular interest is the agency relationship
between the firm’s senior management (the principal) and mid-level managers
(the agent) who are hired to implement the firm’s objectives and strategies
(Kaplan & Atkinson, 1998; Ch. 13). Both the principal and the agent are
assumed to behave in accordance with their self-interests. The principal’s
interests are assumed to be consistent with the firm’s goals, but the agent’s
interests may conflict with these goals. Accordingly, agency theory explicitly
acknowledges the potential for goal conflict, which can result in behavior that
is dysfunctional relative to the firm’s objectives.
Eisenhardt (1989) indicates that one method for preventing dysfunctional
behavior is for the principal to provide agents with economic incentives
that are based on surrogate measures of behavior (performance measures). It
is argued that such incentives can motivate agents to put forth the desired
level of effort by imposing financial risk on agents and aligning their inter-
ests with those of the firm (e.g. Fama, 1980; Shavell, 1979; Demski &
Feltham, 1978). However, most agency models assume that the measures used
1 to indicate performance are congruent with the firm’s objectives. Feltham and
Xie (1994) argue that the performance measure, on which incentives are based,
must correspond with the firm’s goals in order to motivate agents to allocate
effort across assigned tasks in a desirable manner. Agents are expected to
focus their efforts on activities that support incentive-based measures whether
or not the measures are congruent with the firm’s strategy and stated objec-
tives.
Although the empirical investigation of agency theory constructs has been
limited (Kren & Liao, 1988), some accounting research has examined the
behavioral effects of economic incentives (e.g. Kershaw & Harrell, 1999;
1 Harrell & Tuttle, 1997; Dillard & Fisher, 1990; Waller & Chow, 1985; Chow,
1983). The findings from these studies demonstrate that economic rewards
can influence work-related behavior. However, this line of research has
not investigated the impact of incentives on managers’ effort allocation
decisions in a multi-task setting when multiple performance measures are used.
In the current business environment, managers often must decide how to
allocate their efforts among various activities in the presence of multiple
performance indicators. Understanding how firms can use incentives to
promote strategy implementation in such a setting, is fertile ground for future
research.
1 Some recent cross-sectional, research (Ittner & Larcker, 1997, 1995; Banker,
et al., 1993; Daniel & Reitsperger, 1992, 1991) indicates a positive relationship
between the use of quality performance measures to evaluate production
managers and the adoption of quality-based strategies. For instance, Ittner and
Larcker (1997) report a greater emphasis placed on quality performance in
determining management compensation in firm’s following a differentiation
strategy based on quality. However, Ittner and Larcker do not find a
corresponding improvement in performance for these firms. They suggest that
these results may be caused by the use of quality measures that are poor
indicators of the desired outcomes, which may not appropriately motivate
managers to focus their efforts on improving quality.
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278 RUSS KERSHAW
Several agency models (e.g. Baiman, 1982; Holmstrom, 1979; Shavell, 1979)
have investigated the implications of measuring performance using imperfect
surrogates of behavior. Shavell (1979) defines an imperfect surrogate of behavior
as a performance measure that is influenced by events other than agents’ efforts.
Baiman (1982) suggests that a performance indicator that is influenced by events
beyond agents’ control may not induce the desired behavior. Holmstrom (1979)
argues that when there is a reliable relationship between the productive
inputs supplied by agents and outcomes, the use of performance-based incentives
will be most effective. Feltham and Xie (1994) predict higher levels of effort
11 toward all activities that affect a performance measure that is responsive to agents’
efforts. As the responsiveness of a measure decreases, uncertainty in relation to
achieving the desired outcome increases, which reduces agents’ motivation to
exert effort.
Kershaw and Harrell (1999) empirically examined this issue and report higher
levels of effort toward goal-related activities when the performance measure was
responsive versus unresponsive to their subjects efforts. However, their study
examined the effects of performance measure responsiveness when only a single
measure was used. In contemporary business settings multiple performance
indicators, which are related to a set of prioritized strategic objectives, are often
11 present. In this setting, managers can be expected to allocate more effort toward
the goals with highly responsive performance measures. This implies that when a
measure for a high priority goal is only slightly responsive and a measure for a
lower priority goal is highly responsive, managers may allocate more effort to the
lower priority goal than to the high priority goal. These arguments suggest an
interaction between a firm’s strategic objectives and the responsiveness of the
performance indicators used to measure them.
Kershaw and Harrell (1999) observe a responsiveness effect when economic
incentives were provided (performance-based bonus) and when they were not
(flat salary). They suggest that the use of responsive measures may affect
11 managers’ goal directed efforts to the same degree as economic incentives and
may act as a substitute for providing performance-based rewards. As discussed
previously, providing rewards for improvements in a performance measure are
predicted to motivate managers to allocate more effort toward the rewarded
goal. However, if the rewarded measure is only slightly responsive to managers’
efforts, outcome uncertainty increases and managers are expected to allocate
less effort toward the rewarded goal. Conversely, an un-rewarded performance
measure that is highly responsive should motivate managers to allocate more
effort toward the un-rewarded goal. This discussion suggests possible interac-
tions between a firm’s use of economic incentives and the responsiveness of
the indicators used to measure performance.
Contemporary Performance Measurement Approaches
Several practitioner oriented and normative studies (e.g. Epstein, et al., 2000;
Kaplan & Norton, 1996; Meyer, 1994; Nanni et al., 1992) argue that the goal
of performance measurement should be to encourage implementation of the
firm’s competitive strategy. Regardless of the firm’s strategy, multiple
performance measures are assumed to be required since they direct attention
and can motivate managers to allocate their efforts in a strategically desirable
way. Key aspects of these contemporary approaches to performance
1 measurement include choosing a balanced set of measures and understanding
the causal relationships among the measures chosen.
For instance, the Balanced Scorecard (Kaplan & Norton, 1996) suggests that
firms develop a set of performance measures that balances; financial with
non-financial measures, short-term with long-term measures, objective with
subjective measures, and external with internal measures. Further, Epstein, et
al. (2000) develop the Action-Profit-Linkage (APL) model, which provides an
integrative framework for assessing the profit impact of managers’ actions.
The main purpose of contemporary approaches to performance measurement
like the Balanced Scorecard and APL model is to link managers’ behavior to
1 the organization’s mission and strategy. This is accomplished by translating an
organization’s strategy into a collection of objectives and performance measures.
In the Balanced Scorecard for instance, objectives and measures are derived
from four perspectives: financial, customer, internal business processes, and
learning and growth. Performance measures from the financial perspective are
usually associated with profitability (e.g. operating income, return on invested
capital, market share). Customer satisfaction, customer retention, and on-time
delivery are measures from the customer perspective that indicate how well
firms are delivering value to their customers. Measuring quality, cost, time to
market, and response time would help firms evaluate their execution of key
1 internal business processes that impact what customers’ value. Indicators from
the learning and growth perspective (e.g. employee skill level, training
availability, employee satisfaction) attempt to measure firms’ ability to excel at
key business processes. Performance measures from each of these perspectives
should be linked in a chain of cause and effect relationships that conveys the
organization’s mission and strategy. The goal is to make an organization’s
mission and objectives transparent in order to guide managers’ actions toward
implementing the firm’s strategy.
The Action-Profit-Linkage model is a framework for identifying the key
drivers of profitability that is derived from the literature in accounting, human
resource management, marketing, and operations. The model’s focus is on
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linking managers’ actions to the profitability of the firm. The proposed

framework states that managers take actions based on the firm’s strategy, which
will affect various aspects of the company’s products and services. The firm’s
product and service offerings will impact customers’ perceptions, attitudes and
overt purchasing behavior. Customers’ reaction to the company’s products and
services will predictably affect the firm’s revenue stream. When the revenue
impact is combined with the cost of managers’ actions the linkage between those
actions and corporate profitability is complete. The model also provides for a
feedback linkage between corporate profitability and the firm’s business strategy.
11 Langfield-Smith (1997) suggests that since many of these contemporary
approaches to performance measurement are based on intuitive arguments or
theoretical frameworks, empirical research is required. Although it is assumed
that a set of performance measures can influence managers to align their efforts
with a firm’s strategic goals, many aspects of these approaches are unspecified.
For instance, what is the proper balance among short-term and long-term
measures given various strategies? How much emphasis should be placed on
specific measures at different management levels? How should economic incen-
tives be linked to the prescribed set of performance measures? Given a firm’s
set of strategic priorities, how will the responsiveness of each measure affect
11 managers’ effort allocation among multiple objectives?
Fisher (1998, 1995) notes that much of the empirical research that has
examined the relationship between firm strategy and the use of management
controls has used a contingency theory framework. Contingency theory suggests
that the use of management control systems is contingent upon the firm’s
circumstances and organizational setting. A firm’s competitive strategy and
mission is one of the contingent factors that can influence the effectiveness of
management controls. However, the typical cross-sectional approach used in
these studies provides the basis for correlation among strategy, management
controls, and firm performance, but does not help determine causality.
11 Given the call for empirical research to examine the linkages among strategy,
managers’ actions, and firm performance it might be useful to establish a
framework for understanding the use of strategic controls to implement strategy.
A model that identifies the key linkages between a firm’s overall mission and
strategy and managers’ actions at the local level could help guide future research
efforts. Such a framework would need to identify the key characteristics of
performance measurement systems that affect managers’ effort allocation
decisions. The actions chosen by individual managers ultimately affect firm
profitability, which in the end is the true measure of an organization’s strategy
and its implementation. A framework for understanding the use of strategic
controls to implement strategy is developed in the next section.
Fig. 1. Strategic Control Framework.
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282 RUSS KERSHAW
Strategic Control Framework
The strategic control framework shown in Fig. 1 is a model that identifies the
process by which a firm or business segment links its mission and strategic
objectives to managers’ actions. The day-to-day efforts and decisions of
managers throughout the firm will impact how effectively the company’s
strategy is implemented as measured by firm profitability. Given the critical
nature of the linkage between managers’ actions and strategy implementation,
the model focuses on the key characteristics of the company’s performance
11 measurement system. Prior research indicates that performance measures direct
attention and affect managers’ behavior. The framework highlights important
factors that affect how well the chosen performance measures motivate
managers to take actions that are consistent with the firm’s strategic objectives.
Many firms establish broad mission statements to communicate the
company’s basic values, core beliefs and overall strategic direction. Mission
statements often identify the firm’s key target markets and primary products or
services and usually express long-term, high level objectives. The intent is to
provide inspiration and motivate a company’s managers to achieve the goals
outlined in the mission statement. However, a firm’s overall strategy as
11 described in its mission statement is usually too general to provide operational
guidance to managers in the organization. Kaplan and Norton (1996) tell the
story of how the CEO of an undersea construction company guided senior
managers to develop a motivational mission statement. This process lasted
several months, after which the mission statement was distributed throughout
the company. Soon thereafter, the CEO received a phone call from a manager
on a drilling platform in the North Sea. The manager said the following to the
CEO. “I want you to know that I believe in the mission statement. I want to
act in accordance with the mission statement. I’m here with a customer. What
am I supposed to do? How should I be behaving each day, over the life of the
11 project, to deliver on our mission statement?” In this and many other companies,
the words in the mission statement and the actions required to implement them
on a day-to-day basis are not properly linked.
Before managers can be expected to take actions that are consistent with the
firm’s mission, the organization’s strategy has to be translated into more specific
objectives and performance measures. Transforming the company’s mission
statement into specific outcomes the firm desires and the drivers of those
outcomes provides guidance for managers’ actions and effort allocations. An
important element of identifying more detailed operational goals is to establish
a prioritized set of objectives that is consistent with the firm’s strategy. For
example, the primary focus of a cost leadership strategy is to reduce the firms
cost of products and services relative to competitors (Porter, 1980). The adoption
of a cost leadership strategy implies that production management should focus
their efforts on activities aimed at reducing the cost of products manufactured.
However, the adoption of such a strategy does not imply that managers should
ignore quality, since a reasonable level of quality is usually required. Under a
cost leadership strategy, production management’s top priority may be to
produce low cost products but improving product quality might be identified
as a secondary goal. By explicitly prioritizing objectives at an operational level,
firms can guide managers to allocate their efforts across activities in a
1 strategically desirable manner.
Once the firm’s mission has been translated into a set of prioritized goals at
an operational level, indicators of performance for each objective need to be
identified. Choosing the right set of performance measures is critical in linking
firm strategy to managers’ actions because what is measured is what gets done
(Kaplan & Norton, 1992). A set of performance measures influences effort
allocation because it focuses managers’ attention on the consequences of the
actions they take. In choosing indicators of performance several factors
can affect how well the chosen measures influence managers to take actions
that are consistent with the firm’s strategic objectives. These factors include:
1 (1) congruence, (2) responsiveness, (3) measurability, and (4) use of incentives.
Congruent performance indicators are those that measure the dimensions of
performance that are consistent with firm strategy. If the dimensions of
performance are not congruent with operational objectives the measures can
motivate managers to take inappropriate actions. Using agency theory as a basis,
Feltham and Xie (1994) argue that performance measures must correspond with
the firm’s goals in order to motivate agents to allocate effort across activities
in a desirable manner. Managers are expected to focus their efforts on activities
that support measures whether or not the measures are congruent with the firm’s
stated objectives. For example, production managers can add value by the timely
1 delivery of high quality, low cost products. To ensure that production managers
act in a strategically desirable manner, the firm needs to choose the dimension
of performance (delivery time, quality, cost) that is congruent with their strategy.
If all three dimensions of performance are measured then the company needs
to explicitly identify importance weightings to encourage proper effort
allocation. Using a set of incongruent performance measures or performance
weightings can induce actions that are not consistent with firm strategy.
As suggested by agency theory, performance measure responsiveness
indicates the extent to which a measure is influenced by events beyond
managers’ control. For instance, Feltham and Xie (1994) suggest that managers
will focus their efforts on activities that improve more responsive performance
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measures. Merchant (1998) notes that if measures are affected by uncontrollable

factors that can not be isolated and eliminated the measures will not motivate
strategically desirable behavior. When unresponsive measures are used, proper
actions on the part of managers may not necessarily result in the desired outcome
and improper actions may be obscured. For example, production managers are
often evaluated based on their ability to reduce product cost by taking actions
to improve productivity. However, uncontrollable factors such as product design,
raw material cost, and market demand can significantly affect the production
manager’s ability to reduce cost through productivity improvements. If the
11 uncontrollable effects on product cost are unfavorable and not easily segregated,
managers’ extensive efforts to improve efficiency may not result in lower costs.
As a result, managers’ performance may be evaluated as unsatisfactory, which
will not motivate future productivity improvement actions. This aspect of
establishing a set of performance measures is highlighted in the strategic control
framework as a feedback loop between managers’ actions and the impact of
those actions on measures. Using measures that are responsive to managers’
efforts can act as a reinforcing mechanism for future actions. On the other hand,
use of unresponsive measures can negatively impact managers’ future actions
to achieve strategic objectives.
11 A third factor that can affect how well a set of performance measures
motivates managers to take strategically desirable actions is how effectively the
desired outcomes can be measured. Merchant (1998) suggests that measures
should be precise, objective, timely, and understandable in order to appropriately
influence managers’ actions. It is difficult to precisely measure some aspects of
performance (e.g. customer satisfaction, employee development). The use of
imprecise measures can lead to performance misevaluation, which can result in
a de-motivating effect similar to when unresponsive measures are used. An
objective measure is one that is free from bias. When measures are self-reported
or can be determined using various measurement methods objectivity could be
11 low. Use of such measures may not motivate managers to take appropriate
actions since the effects of those actions can be obscured in the measurement
process. The time lag between managers’ efforts and the measurement of results
should be short. If there is a significant delay in measuring performance the
motivational effect of the measure is diminished. Finally, for managers to take
appropriate actions, they need to understand what actions will influence the
chosen measures. For example, Young and Selto (1993) report that since a
company’s managers did not understand how their actions affected new quality
measures they tended to ignore them. In summary, the level of precision,
objectivity, timeliness and understandability used to measure performance will
impact managers’ motivation to take strategically desired actions.
Finally, agency theory argues that economic incentives can motivate managers
to take the desired actions by imposing financial risk on them and aligning their
interests with those of the firm. Empirical research (e.g. Kershaw & Harrell,
1999; Harrell & Tuttle, 1997; Dillard & Fisher, 1990; Waller & Chow, 1985;
Chow, 1983) demonstrate that economic incentives can influence work-related
behavior. However, managers often must decide how to allocate their efforts
among various activities in the presence of multiple performance indicators. In
a manufacturing setting for instance, production managers are often faced with
decisions related to improving quality, reducing costs, or decreasing delivery
1 time. Linking incentives to measures of quality, cost or delivery time are
expected to influence managers to take actions that are consistent with the
incentives. To ensure that production managers act in a strategically desirable
manner, the firm needs to link incentives to the measures that are compatible
with its strategy. If each performance dimension is important then the company’s
incentive system needs to be structured according to the importance weightings
assigned to the performance measures. Since performance-based incentives are
expected to influence managers’ actions regardless of strategy, it is important
that they be aligned with the firm’s strategic priorities.
To illustrate the linkages in the strategic control framework a brief example
1 is provided in Fig. 2. Consider the Midwest Manufacturing Company, a fictitious
manufacturer of telecommunications equipment. The company has developed a
corporate strategy based on a differentiation approach, which is to provide
customers with higher quality products and services than those offered by its
competitors. The Ohio Plant manufactures several key components that are used
in the company’s equipment. The plant’s managers are instructed that the plant’s
primary goal is to produce high quality components and its secondary goal is
to maintain reasonable product costs. The company’s management control
system reports two measures for the Ohio plant; (1) the defect rate, and (2)
cost per unit.
1 Managers at the plant will take actions to improve product quality and reduce
cost based on the factors discussed previously that affect performance measure
effectiveness. As shown in Fig. 2, it appears that the importance weightings
placed on the two measures at the plant are congruent with the firm’s strategy
and objectives. However, are the defect rate and cost per unit measures
responsive to managers’ efforts to improve them? Can they be measured in a
precise, objective, and timely manner. Do the plant’s managers understand how
their actions will affect the defect rate and cost per unit? Finally, does the
company link any portion of managers’ compensation to improvements in the
performance measures, and if so, are the incentives consistent with the strategy?
Answers to these questions will determine how well the measures influence
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11
11
11
Fig. 2. Midwest Manufacturing Company.
the plant’s managers to take actions that are compatible with the firm’s
quality-based strategy. Ultimately, the day-to-day efforts and decisions of
managers at the plant will impact how effectively the company’s strategy is
implemented as measured by corporate profitability.
The linkage between performance measurement and managers’ actions is an

important aspect of strategy implementation. As a result, the strategic control
framework outlined here, focuses on the key characteristics of the firm’s
performance measurement system that affect management behavior. The
framework highlights factors that affect how well the chosen performance
measures motivate managers to take strategically desirable actions. How these
factors interact to influence managers’ efforts to implement firm strategy is a rich
area for future research. In the following section suggestions for future research
to investigate the framework’s proposed linkages and applicability are discussed.
1
Direction for Future Research
While the strategic control framework provides a useful model for examining
the linkages among firm strategy, managers’ actions and company performance,
additional research is needed. Researchers have argued that organizations need
to use strategic controls in order to encourage managers to implement their
firm’s competitive strategy. For instance, linking economic incentives to
appropriate performance measures is usually cited as an effective method for
motivating managers to act in a strategically desirable manner. Some empirical
1 agency theory research has demonstrated that economic incentives can influence
work-related behavior. However, since this research has focused on the impact
of incentives in single task settings, future studies could investigate their effects
on managers’ effort allocations across multiple tasks. In addition, future research
could examine how various incentive schemes affect managers’ decisions when
multiple performance measures are used.
There is limited empirical support for the proposition that managers will exert
higher levels of effort toward improving performance indicators that are more
responsive to their efforts. However, not much is known about how managers
will allocate their efforts to achieve a set of prioritized objectives given multiple
1 performance measures and varying levels of responsiveness. For instance, future
research could investigate how the responsiveness of lower priority objectives
can affect managers’ efforts to achieve higher priority goals. In addition, future
studies could examine how a firm’s use of economic incentives interacts with
the responsiveness of multiple performance indicators. An additional avenue
for further study would be to explore the substitutability of performance measure
responsiveness and the use of economic incentives.
Similarly, gaining a better understanding of how the various aspects of
performance indicator measurability interact with the use of incentives could
help guide the development of strategic controls. For example, future research
could examine how varying degrees of performance measure precision,
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objectivity, timeliness and understandability interacts with incentives to affect

managers’ actions. Additionally, future studies could investigate the interactive
effects among the different measurability factors in a multiple task setting. For
instance, understanding how the precision level of indicators interacts with the
time lag between managers’ efforts and the measurement of results could be
useful to the design of performance measurement systems. Examining how the
positive motivational effects of using precise measures interact with the negative
effects of a lengthy delay in results would help managers make tradeoffs when
choosing performance measures.
11 Given the lack of empirical support for many of the contemporary approaches
to performance measurement (e.g. Action-Profit-Linkage model, Balanced
Scorecard), several research opportunities exist. For instance, an issue worth
examining is the appropriate balance among short and long-term measures when
different competitive strategies are used. In addition, research that investigates
how the level of emphasis placed on different types of performance measures
(e.g. financial vs. non-financial) affects performance under various strategies
would be useful. Research that examined these issues at different management
levels would also provide guidance as to how firms should structure their
performance measurement system. Additionally, the impact of linking various
11 economic incentive schemes to a balanced set of performance measures would
be an area worth examining.
Most contingency theory research has examined the relationship between
strategy and management controls without considering possible conflicts with
other contingent factors (e.g. technology, firm size, market conditions). Gaining
a better understanding of how other contingent variables that may conflict
with a firm’s competitive strategy affect manager’s behavior would be useful.
The typical cross-sectional approach used in contingency studies precludes the
determination of whether causal relationships exist among a firm’s strategy,
management control system, and performance. Experimental and time-series
11 approaches would help determine whether causal relationships exist among these
variables. In general, empirical research that examines how strategic controls
can be used to influence managers to implement a firm’s strategy is a fertile
area for study.
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11

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xii RUNNING HEAD

Volumes 1–9: Advances in Management Accounting

ADVANCES IN MANAGEMENT ACCOUNTING VOLUME 10

ELSEVIER SCIENCE Ltd

LIST OF CONTRIBUTORS vii

EDITORIAL POLICY AND

1 THE IMPACT OF WORK TEAMS ON PERFORMANCE:

CREATIVE ACCOUNTING? WANTED FOR

AN EMPIRICAL STUDY OF THE APPLICATION

THE LONG-TERM STOCK RETURN PERFORMANCE

THE RELATION BETWEEN CHIEF EXECUTIVE

PARTICIPATIVE BUDGETING AND PERFORMANCE:

11 INTERACTIVE EFFECTS OF STRATEGIC AND

THE ROLE OF QUALITY COST INFORMATION

11 RISK PERCEPTION AND HANDLING IN CAPITAL

A FRAMEWORK FOR EXAMINING THE USE OF

Asokan Anandarajan School of Management

Karen S. Cravens School of Accounting

Chris Guilding School of Accounting and Finance

Julie H. Hertenstein Accounting Group

Simon S. M. Ho School of Accountancy

Robert C. Kee Culverhouse School of Accountancy

Leslie Kren School of Business Administration

Andreas I. Nicolaou Department of Accounting and MIS

Kyungjoo Park Department of Accountancy

Marjorie B. Platt Accounting Group

Margaret Poon Department of Accountancy

Priscilla S. Wisner Thunderbird, The American Graduate

Lloyd Yang School of Accountancy

Cheong-Heon Yi Department of Accountancy

Thomas L. Albright K. J. Euske

Grant W. Newton Fredelle Spiegel

STATEMENT OF PURPOSE AND

Advances in Management Accounting is to be an annual publication of quality

This Page Intentionally Left Blank

EDITORIAL POLICY AND MANUSCRIPT

1 3. Manuscripts should include on a separate lead page an abstract not exceeding

4. Topical headings and subheadings should be used. Main headings in the

6. In order to be assured of anonymous review, authors should not identify

7. Manuscripts currently under review by other publications should not be

conference of a professional association and “State of the Art” papers are

8. Four copies of each manuscript should be submitted to John Y. Lee at the

9. A submission fee of $25.00, made payable to Advances in Management

12. Inquires concerning Advances in Management Accounting may be directed

Marc J. Epstein John Y. Lee

This volume of Advances in Management Accounting begins with an article by

relative to the pre-adoption period returns, the CRSP value-weighted market

The impact of implementing work teams on corporate performance gener-

Advances in Management Accounting, Volume 10, pages 1–28.

study contributes to the body of research linking firm actions to performance

LITERATURE REVIEW OF WORK TEAMS AND

Sociotechnical theories of organizational behavior contend that teams form a

Teaming is promoted as a key driver of improving quality, by creating a cross-

Empirical studies of teaming and quality outcomes have produced mixed

customer satisfaction in service industry teams. No significant relationships were

METHODS AND ANALYSES

Research Setting and Methods

Table 1. Demographic Data.

Full Scale 1.000 0.796* 0.688* 0.884***