Chapter 9

Management Control Systems and

Responsibility Accounting

LEARNING OBJECTIVES:
When your students have finished studying this chapter, they should be able to:

1. Describe the relationship of management control systems to organizational goals.

2. Use responsibility accounting to define an organizational subunit as a cost center, a

profit center, or an investment center.

3. Compare financial and nonfinancial performance, and explain why planning and
control systems should consider both.

4. Explain the importance of evaluating performance and how it impacts motivation,

goal congruence, and employee effort.

5. Prepare segment income statements for evaluating profit and investment centers
using contribution margin and controllable-cost concepts.

6. Measure performance against quality, cycle time, and productivity objectives.

7. Describe the difficulties of management control in service and nonprofit

organizations.

1
CHAPTER 9: OVERVIEW

This chapter covers the role of management control systems in assisting in managing
organizations. The concept of responsibility accounting is explained and illustrated
including discussions of financial and nonfinancial measures of performance for different
types of responsibility centers.

Section One: Defines management control systems and discusses how they are related
to organizational goals, subgoals, and objectives. The balance of goals,
subgoals, and objectives is also examined.

Section Two: Considers the items that affect the design of a management control
system. These include existing organizational constraints, the kinds and
types of responsibility centers in place, the costs and benefits of a
particular design, and motivational factors.

Section Three: Addresses the concept of controllability over costs and its impact on the
measurement of financial performance. The contribution margin income
statement is enhanced due to the identification of costs that are and are not
controllable by managers of operating segments.

Section Four: Covers nonfinancial measures of performance such as control of quality,

cycle times, and productivity. Measurement of these features of
operations can help managers reach their long-term profitability goals and
may dissuade managers from taking an ill-advised short-term focus.

Section Five: Looks at management control systems in service, government, and

nonprofit organizations. Reasons for difficulties in implementing
management control systems in these settings are given. However, proper
training and motivation towards meeting organizational goals are cited as
keys to successful management control.

Section Six: Discusses the future of management control systems. As the organizations
and environment for which management control systems are developed
change, changes in the systems must be made. Principles to guide the
redesign of management control systems are provided.

2
CHAPTER 9: ASSIGNMENTS
COGNITIVE EXERCISES

28 Management Control Systems and Innovation

29 Municipal Responsibility Accounting
30 Control Systems and Organizational Behavior
31 Control Systems and the Production Function of the Value Chain

EXERCISES

32 Key Performance Indicators

33 Responsibility for Stable Employment Policy
34 Salesclerk’s Compensation Plan
35 Common Measures on a Balanced Scorecard
36 Goals and Objectives at Foundation Health Systems (Business First)
37 Performance Evaluation
38 Quality Theories Compared
39 Quality Control Chart
40 Cycle-Time Reporting

PROBLEMS

41 Multiple Goals and Profitability

42 Responsibility Accounting, Profit Centers, and Contribution Approach
43 Incentives in Former Soviet Union
44 Balanced Scorecard
45 Productivity
46 Productivity Measurement

CASES

47 Trade-Offs Among Objectives

48 Relationship between Strategy and Key Success Factors, Learning
Culture, and General Electric
49 Quality Programs, Strategic Initiatives, and General Electric
50 Review of Chapters 1-9

COLLABORATIVE EXERCISES

51 Goals, Objectives, and Performance Measures

52 Internet Exercise - Proctor and Gamble (http://www.pg.com)

3
CHAPTER 9: OUTLINE
I. Management Control Systems

The foundation for control is the planning process. The outcome of planning
provides the basis for control. Management Control System (MCS) - a logical
integration of management accounting tools to gather and report data and to evaluate
performance. See EXHIBIT 9-1 for the components of a MCS. The purposes of a
MCS are:

1. clearly communicate the organization’s goals.

2. ensure that every manager and employee understands the specific actions
required of him/her to achieve organizational goals.
3. communicate results of actions across the organization.
4. ensure that the MCS adjusts to changes in the environment.

A. Management Control Systems and Organizational Goals {L. O. 1}

A well-designed MCS aids and coordinates the process of making decisions
and motivates individuals throughout the organization to work toward the
same goals. It also coordinates forecasting revenue- and cost-driver levels,
budgeting, measuring and evaluating performance.

See EXHIBIT 9-2 for a description of the process of setting goals, objectives,
and performance measures. Overall company goals, objectives, and
performance measures are set by top management, not changed often, and
reviewed on a periodic basis (usually once a year). Goals answer the
question, “What do we want to achieve?” However, goals without measures
do not motivate managers. Targets for goals are specific quantified levels of
the measures.

Goals and measures are often too vague to provide guidance. Therefore,
critical processes and critical success factors are used. Critical Processes -
series of related activities that directly affect the achievement of
organizational goals (e.g., the goal “exceed guest expectations” would have
“produce and deliver services” as a critical process). Critical Success
Factors - actions that must be done well in order to drive the organization
towards its goals (e.g., timeliness is a critical success factor for the produce
and deliver services process and is measured by check-in time, check-out
time, and response time to guest requests). Managers often face trade-off
decisions with measures.

4
II. Designing Management Control Systems

A. Identifying Responsibility Centers {L. O. 2}

Responsibility Center - a set of activities assigned to a manager, a group of
managers, or a group of employees.

An effective MCS gives each lower-level manager responsibility for a group

of activities and objectives and then reports on

1. the results of activities

2. the manager's influence on those results
3. effects of uncontrollable events

Responsibility Accounting - identifies what parts of the organization have

primary responsibility for each objective, develops performance measures and
targets to achieve, and designs reports of these measures by organization
subunit, or responsibility center.

Responsibility centers usually are classified according to their financial

responsibility.

1. Cost Centers

Cost Center - a responsibility center in which a manager is

accountable for costs only (e.g., accounting department). Its financial
responsibilities are to control and report costs only.

2. Profit Centers

Profit Center - responsibility for controlling costs (or expenses) as

well as revenues (e.g., marketing department). Nonprofit
organizations whose goal is to break even are also considered profit
centers since they have responsibilities for both revenues and costs.

3. Investment Centers

Investment Center - success is measured not only by its income but

also by relating that income to its invested capital, as in a ratio of
income to the value of the capital employed. This term is not widely
used in practice. Instead, these responsibility centers are typically
referred to simply as profit centers.

5
6
B. Development of Measures of Performance {L. O. 3}
Both financial and nonfinancial measures of performance are important in
achieving an organization's objectives. Common to good performance
measures are that they will:

• Relate to the goals of the organization

• Balance long-term and short-term concerns
• Reflect the management of key actions and activities
• Be affected by actions of managers and employees
• Be readily understood by employees
• Be used in evaluating and rewarding managers and employees
• Be reasonably objective and easily measured
• Be used consistently and regularly

Consideration of nonfinancial measures of performance can improve

operational control. These nonfinancial measures may be more timely, and
more easily understood and closely affected by employees at lower levels of
the organization, where the product is made or services are rendered.
Activities are now stressed that drive revenues and costs, instead of
explaining the financial measures after the activity has occurred. The effects
of nonfinancial measures of performance typically are not seen in the
financial measures until considerable ground is lost. Financial measures are
lagging indicators that arrive too late to help prevent problems and ensure the
organization’s health.

C. Monitoring and Reporting Results and the Balanced Scorecard

Balanced Scorecard - performance measurement and reporting system that

strikes a balance between financial and operating measures, links
performance to rewards, and gives explicit recognition to the diversity of
stakeholder interests. Line managers can understand the numbers presented
due to the use of nonfinancial measures. The balanced scorecard focuses on
performance measures from across the spectrum of the organization. This
enhances the learning process because managers are made aware of the
results of actions and how these actions are linked to the organizational goals
(see EXHIBIT 9-3 and 9-4).

D. Weighing of Costs and Benefits

Designers of a MCS must also weigh the costs and benefits of various
alternatives. These are often difficult to measure, and both may become
apparent only after experimentation or use.

7
8
 E. Motivation of Employees to Achieve Goal Congruence and Exert
Managerial Effort Through Rewards {L. O. 4}
To achieve maximum benefits at minimum costs, a MCS must foster goal
congruence and managerial effort. Goal Congruence - individuals and
groups aiming at the same organizational goals. It occurs when employees,
working in their perceived best interest, make decisions that meet the overall
goals of the organization. Managerial Effort - exertion toward a goal or
objective. Effort means not only working faster, but working better (i.e.,
more efficient and effective).

Incentives must be incorporated in the MCS to encourage goal congruent

behavior and managerial and employee effort. Performance evaluation along
with bonuses tied to the achievement of objectives may help in this area.
Motivation - aiming for some selected goal together with the resulting drive
(effort) that creates action toward that goal.

III. Controllability and Measurement of Financial Performance

MCS often distinguish between controllable and uncontrollable events and between
controllable and uncontrollable costs. Usually, responsibility center managers are in
the best position to explain their center's results even if the managers had little
influence over them.

Uncontrollable Cost - cannot be affected by the management of a responsibility

center within a given time span. Controllable Costs - influenced by a manager's
decision and actions. Costs that are completely uncontrollable tell nothing about a
manager's decisions and actions because, by definition, nothing the manager does
will affect the costs. Uncontrollable costs should be ignored in evaluating a
manager's performance, while controllable costs should be used. Activity-based
costing is helping companies to identify controllable costs.

A. Contribution Margin {L. O. 5}

Many organizations combine the contribution approach to measuring income
with responsibility accounting (i.e., report by cost behavior as well as by
degrees of controllability). Line a of EXHIBIT 9-5 gives the contribution
margin for each of the various segments of Barleycorn.

9
B. Contribution Controllable by Segment Managers

Line b in EXHIBIT 9-5 gives the contribution controllable by segment

managers. Managers of the various segments may have control over certain
advertising, sales promotion, salespersons' salaries, management consulting,
training and supervision costs that are deducted from the segment
contribution margin to yield the contribution controllable by segment
managers. When service department costs are allocated, charges are made for
division headquarters, or store depreciation or lease costs are determined. No
easy answers exist regarding if, and how much of, these costs are controllable
by segment managers.

C. Contribution by Segments

Fixed expenses (e.g., depreciation, property taxes, insurance, and perhaps the
segment manager's salary) are not under the control of the segment manager.
These costs are deducted from the contribution controllable by segment
managers to give the contribution by segments. Line c in EXHIBIT 9-5
shows segment contributions for Barleycorn, Inc., which approximate the
financial performance of the segments, as distinguished from the financial
performance of its manager, which is measured in line b.

D. Unallocated Costs

Central corporate costs (e.g., top management and some corporate-level

services, such as legal and taxation) are frequently not allocated to segments
unless a persuasive cause and effect, or activity-based justification for
allocating such costs exists - see before line d in EXHIBIT 9-5.

10
IV. Nonfinancial Measures of Performance {L. O. 6}
A. Control of Quality

Quality Control - the effort to ensure that products and services perform to
customer requirements. In the traditional approach to maintaining the desired
level of quality in the U.S., companies inspected completed products, and
rejected or reworked those that failed inspection. Due to the expense of
inspection, only a sample of products was tested. The production process was
judged to be in control as long as the number of defective products did not
exceed an acceptable quality level. This meant that some defective products
could still make their way to customers.

Due to competitive pressures, and seeing the success of Japanese products,

U.S. companies have learned that the traditional approach is extremely costly.
The resources consumed in making and detecting defective parts are a waste,
and considerable rework may be necessary to correct the defects. It is also
very costly to repair products in use by customers or to win back a dissatisfied
customer. Quality Cost Report - displays the financial impact in quality.
See EXHIBIT 9-6 for Eastside Manufacturing Company’s quality cost
report. There are four categories of quality costs:

1. Prevention - costs incurred to prevent the production of defective

products or deliver substandard services, including engineering
analyses to improve product design for better manufacturing,
improvements in production processes, increased quality of material
inputs, and programs to train personnel

2. Appraisal - costs incurred to identify defective products or services

including inspection and testing

3. Internal Failure - costs of defective components, and final products

or services that are scrapped or reworked

4. External Failure - costs caused by delivery of defective products or

services to customers, such as field repairs, returns, and warranty
expenses

The costs stated in reports typically understate the true quality costs since lost
sales are not included due to measurement difficulty.

TEACHING TIP: Internet Site – see the following for quality:

http://www.aicpa.org/cefm/ma/index.htm
(Customer Service and Quality)

11
12
 In recent years, more companies are taking the total quality management
(TQM) approach to quality control. Total Quality Management -
concentrates on the prevention of defects and on customer satisfaction and is
the application of quality principles to all of the organization’s endeavors to
satisfy customers. The TQM approach is based on the assumption that the
cost of quality is minimized when a firm achieves high quality levels. TQM
delegates the responsibilities for many management functions to employees.
For it to be successful, employees must be very well trained in the process,
the product or service, and the use of quality-control information.

In TQM, employees are trained to prepare, interpret, and act on quality-

control charts, like that shown in EXHIBIT 9-7. Quality-Control Chart -
statistical plot of measures of various product dimensions or attributes. The
plot helps to detect process deviations before the process generates defects
and identifies excess variation in product dimensions or attributes that should
be addressed by process or design engineers.

B. Control of Cycle Time

Cycle Time (or Throughput Time) - the time taken to complete a product or
service, or any of the components of a product or service. It is a summary
measure of manufacturing efficiency and effectiveness, and is an important
cost driver. The longer a product or service is in process, the more costs are
consumed. Lowering cycle time requires smooth running processes and high
quality, and also creates increased flexibility and quicker reactions to
customer needs. As cycle time is decreased, quality problems become
apparent throughout the process and must be solved if quality is to improve.
Decreasing cycle time also results in bringing products or services more
quickly to customers, a service customer’s value. The use of barcoding can
be used to measure cycle times. Reports for cycle times, such as that in
EXHIBIT 9-8, can be prepared to alert managers' attentions to cycle-time
problem areas.

C. Control of Productivity

Productivity - a measure of outputs divided by inputs. The fewer inputs

needed to produce a given output, the more productive the organization.
Companies differ as to which measures of input are most important
depending on whether they are labor-intensive, machine-intensive, or
material-intensive organizations. Examples of different types of productivity
ratios are given in EXHIBIT 9-9.

13
 D. Choice of Productivity Measures.

The productivity measures companies choose to manage depend on the

behaviors desired. Those emphasized by top management receive the most
attention. Sometimes myopic attention to one or a few measures comes at the
expense of others, resulting in the endangerment of the long-run profitability
of a firm. Rather than specify productivity goals, managers may concentrate
their control on the more fundamental activities of quality and service. Then
the productivity measures can be used to monitor the actual benefits of
improvements in these activities.

E. Productivity Measures Over Time.

Be careful in comparing productivity measures over time because process

changes or inflation can make them misleading.

V. Management Control Systems in Service, Government, and Nonprofit

Organizations {L. O. 7}
Service, government, and nonprofit organizations have more difficulty implementing
management control systems than do manufacturing firms because their outputs are
more difficult to measure. Nonprofit and governmental agencies have the additional
problem of not having a financial "bottom line" as an objective. Also, many people
in nonprofit organizations seek their positions for reasons other than monetary
rewards (e.g., the desire to help improve conditions in underdeveloped countries).
There are six reasons why control systems will probably not be as highly developed
in nonprofit organizations as they are in profit-seeking firms.

1. Organizational goals are less clear and multiple which requires difficult
tradeoffs.
2. Professionals dominate and have been less receptive to the installation and
improvement of formal control system.
3. Measurements are more difficult because there is no profit measure and there
are a lot of discretionary fixed costs, which makes the relationships of inputs
to outputs difficult to specify and measure.
4. There is less competitive pressure to improve management control systems.
5. The role of budgeting is often more a matter of playing bargaining games
with sources of funding than it is rigorous planning.
6. Motivations and incentives of individuals differ from those in for-profit
organizations.

TEACHING TIP: Internet Site – see the following for governmental agency cost
accounting:
http://www.va.gov/cfo/pubs/costguide

14
VI. Future of Management Control Systems

Certain management control principles that can guide the redesign of systems to
meet new management needs follow:

1. Always expect that individuals will be pulled in the direction of their own
self-interest.

2. Design incentives so those individuals who pursue their own self-interests are
also achieving the organization's objectives. When multiple objectives are
present, multiple incentives are appropriate.

3. Evaluate actual performance based on expected or planned performance,

revised, if possible, for actual output achieved.

4. Consider nonfinancial performance just as important as financial

performance.

5. Array performance measures across the entire value chain of the company.

6. Periodically review the success of the management control system. Are

objectives being met? Does meeting the objectives mean that subgoals and
goals are being met too? Do individuals have, understand, and use the
management control information effectively?

7. Learn from management control successes (and failures) of competitors

around the world. Despite cultural differences, human behavior is remarkably
similar. Successful applications of new technology and management controls
may be observed in the performance of others.

15
CHAPTER 9: TRANSPARENCY MASTERS

The following exhibits are reproduced as transparency masters at the end of this manual:

Exhibit 9-1 The Management Control System

Exhibit 9-3 The Components of a Successful Organization and Measures of

Achievement.

Exhibit 9-4 Balanced Scorecard for Luxury Suites Hotels

Exhibit 9-5 Barleycorn, Inc.’s Contribution Approach: Model Income Statement,

by Segments (thousands of dollars)

Exhibit 9-6 Eastside Manufacturing Company’s Quality Cost Report (thousands of

dollars)

Exhibit 9-7 Eastside Manufacturing Company’s Quality Control Chart

Exhibit 9-8 Eastside Manufacturing Company’s Cycle Time Report for the Second
Week of May, 20X1

Exhibit 9-9 Measures of Productivity

16
CHAPTER 9: Quiz/Demonstration Exercises
Learning Objective 1

1. A management control system is distinguished from a purely accounting system by

a. its focus on motivation and evaluation of performance consistent with the

organization's goals.
b. its focus on organizational goals and objectives.
c. its focus on internal management decision making.
d. all of the above.

2. Which of the following affects all components of a management control system?

a. feeback.
b. progress measurement.
c. learning.
d. a., b., c.
e. a., c.

Learning Objective 2

3. Which of the following responsibility centers does not have accountability for
revenues?

a. investment centers
b. Cost centers
c. profit centers
d. None of the above

4. Which of the following is an example of a cost center?

a. a division
b. a subsidiary
c. a plant
d. an accounting department

17
Learning Objective 3

5. Good performance measures will not:

a. be readily understood
b. be easily measured
c. be used to evaluate managers
d. be concerned with only long-term goals

6. Which of the following is a financial measure?

a. number of defects
b. number of customer complaints
c. amount of wasted materials by employee
d. required return on investments

Learning Objective 4

7. In order to encourage goal-congruent behavior and to motivate managerial effort, a

management control system must include

a. ultimatums from top management regarding the accomplishment of short-run

profitability without regard to long-run consequences.
b. organizational goals that are not rewarded by the performance evaluation and
incentive structure of the firm.
c. a performance evaluation and incentive structure inconsistent with the
organization's goals.
d. none of these

8. A management control system must foster:

a. goal congruence
b. managerial effort
c. individuality
d. a., b.
e. b., c.

18
Learning Objective 5

9. In a segment income statement prepared using the contribution margin format, the
key measure that is used to evaluate managers of the segments is

a. contribution margin.
b. contribution by segments.
c. unallocated costs.
d. contribution controllable by segment managers.

10. An example of an uncontrollable cost to a raw materials supervisor is:

a. quality costs
b. ordering errors
c. information system support cost
d. shipping costs

Learning Objective 6

11. A quality cost report details the various costs of maintaining and selling quality
products to customers and includes the following four categories:

a. Promotion, detention, suspension, and retention

b. Recision, derision, provision, and sedition
c. Prevention, appraisal, internal failure, and external failure
d. Elevation, degradation, normalization, and interpretation

12. An example of an external failure cost is:

a. warranty costs.
b. scrap costs.
c. a decrease in the quality of material inputs.
d. inspections costs.

13. In order for a company to improve its productivity, it must

a. produce more outputs for the level of inputs used.

b. produce fewer outputs for the level of inputs used.
c. use more inputs to produce the same level of output.
d. use more inputs to produce fewer outputs.

19
Learning Objective 7

14. Service and nonprofit organizations have more difficulty in implementing

management control systems than do manufacturing firms because

a. they have no goals.

b. their outputs are more difficult to measure.
c. they are concerned with the satisfaction of their customers.
d. their managers are less sophisticated and do not understand the purpose and
use of management control systems.

15. Service and nonprofit organizations differ from profit-seeking organizations

because service and nonprofit organizations:

a. organizational goals and objectives are more easily determined

b. discretionary costs are usually small
c. less competitive pressure is exerted from other nonprofit organizations
d. budgeting is less of a bargaining game

20
CHAPTER 9: Solutions to Quiz/Demonstration Exercises

1. [d] 2. [e] 3. [b] 4. [d] 5. [d] 6. [d]

7. [d] 8. [d] 9. [d] 10. [c] 11. [c] 12. [a]

13. [a] 14. [b] 15. [c]

21
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23
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