1.
Introduction and Management Control Systems (CP)
Zimmerman (2017): Chapter 2
Chapter 2: The nature of costs
A. Opportunity costs
The concept of opportunity cost, is a powerful tool for
understanding the myriad cost terms and for structuring managerial
decisions. In addition, opportunity cost provides a benchmark
against which accounting-based cost numbers can be compared and
evaluated.
Definition: ”the benefit forgone as a result of choosing one course
of action rather than another.”
 The opportunity cost of a particular decision depends on the other
alternatives available. = Opportunity set: The alternative actions
comprise the opportunity set.
Characteristics:
- Opportunity costs are forward looking. They are the estimated
forgone benefits from actions that could, but will not, be undertaken
- In contrast, accounting is based on historical costs in general.
Historical costs are the resources expended for actions actually
undertaken.
Sunk costs are expenditures incurred in the past that cannot be
recovered. Remember that sunk costs are irrelevant for decision
making unless you are the one who sunk them. However, sunk costs
are not irrelevant as a control device. Holding managers responsible 4. Multiple Products
for past actions causes them to take more care in future decisions.  As we saw earlier, one limitation of cost–volume–profit
(p. 26)
B. Cost Variation
1. Fixed, Marginal, and Average Costs
Fixed costs are incurred when there is no production.
Marginal cost is the cost of producing one more unit.
Average cost per unit is calculated by dividing total cost by the
number of units produced.
Variable costs are the additional costs incurred when output is
expanded.
The relevant range encompasses the rates of output for which the
sum of fixed and variable costs closely approximates total cost.
C. Cost-Volumen-Profit Analysis
Once costs are classified into fixed/variable categories, managers
can perform cost– volume–profit analysis.
The contribution margin is the difference between the price and the
variable cost per copy.
1
3. Limitations of Cost–Volume– Profit Analysis
Cost–volume–profit analysis offers a useful place to start analyzing
business problems. It gives managers an ability to do sensitivity
analy- sis and ask simple what-if questions. And, as we saw in the
copier example, break-even analysis can prove useful for certain
types of decisions. However, several limitations of cost–volume–
profit analysis exist:
1. Price and variable cost per unit must not vary with
volume.
2. Cost–volume–profit is a single-period analysis. All
revenues and costs occur in the same time period.
3. Cost–volume–profit analysis assumes a single-product
firm. All fixed costs are incurred to produce a single
product. If the firm produces multiple products, and fixed
costs such as property taxes are incurred to produce
multiple products, then the break-even point or target
profit for any one of the products depends on the volume
of the other products. With multiple products and
common fixed costs, it is not meaningful to discuss the
break-even point for just one product.
Although these limitations are important, cost–volume–profit
analysis forces manag- ers to understand how costs and revenues
vary with changes in output. (p. 40)
analysis is that it applies only to firms making a single product.
 One way to overcome this limitation is to assume a constant
output mix of bundles with fixed proportions of the multiple
products. Then a break-even or a target profit number of bundles
can be calculated. See wine-bundle-example
5. Operating Leverage
 The higher a firm’s fixed costs, the higher its operating
leverage, which is the ratio of fixed costs to total costs.
 Operating leverage measures the sensitivity of profits to
changes in sales. (p. 42)
 Firms with low variable costs per unit can sustain larger short-
term price cuts when faced with increased competition.
D. Opportunity Costs versus Accounting Costs
The theoretically correct way to evaluate choices requires
estimating opportunity costs. Estimating opportunity costs requires
the decision maker to formulate all possible actions (the
opportunity set) and the forgone net receipts from each of those
alternatives so that the highest net cash flows from the set of
actions not undertaken can be calculated.
 Accounting-based costs are such a shortcut.
2. Calculating Break-Even and Target Profits
Break-even point occurs when total revenues equal costs.
Assumptions underlying break- even analysis are:
 Price does not vary with quantity.
 Variable cost per unit does not vary with quantity.
 Fixed costs are known.
 There is a single product (copies).
 All output is sold.
 Accounting systems record “costs” after making the decisions.
 Accounting costs are not forward-looking opportunity costs;
they look backward at the historical cost of the resources
consumed to produce the product. Accounting systems produce
accounting costs, not opportunity costs. However, accounting costs
often provide a reasonable approximation of opportunity costs.
1. Period versus Product Costs
 Product costs include all those accounting costs incurred to
manufacture a product.
 Period costs are those costs that are expensed in the period in
which they are incurred.

The profit-maximizing point of output occurs when marginal
revenue equals marginal cost (MC = MR).
Marginal revenue refers to the receipts from the last unit sold.
2. Direct Costs, Overhead Costs, and Opportunity Costs
 The accounting concepts of direct costs versus overhead costs
also illustrate the difference between opportunity and accounting
costs. Direct costs and overhead costs form the core of this book,
to which we will return in later chapters

E. Cost Estimation
1. Account Classification
2. Motion and Time Studies
COMMENT:
- Chapter 2, nature of costs = basic elements. Expected to be familiar and understand what the different
definitions mean, to the more complex opportunity costs, difference between accounting cost and opportunity
costs
- Chapter 4, organizational architecture = in depth description of the four phases - decision making vs decision
control.
Zimmerman (2017) …

Q2–1: The opportunity cost consists of the receipts from the most valuable forgone alternative when making a decision or choice among many
options.
Q2–2:
1. Opportunity costs are not necessarily the same as payments.
2. Opportunity costs are forward-looking.
3. Opportunity costs can be dated at the moment of final decision.
Q2–3: The $8,325 is an accurate estimate of the oppor- tunity cost if we can resell the material for that amount, or we can replace the material and the
future price is expected to be $8,325. In general, historical costs can be reasonably accurate estimates of opportunity costs if the current market price
has not changed and there is a ready market to buy and sell the material.

Q2–4: Sunk costs are costs incurred in the past that can- not be recovered and are, therefore, irrelevant for future decision making. An example of a
sunk cost is a firm’s purchase of 100 pounds of a material required in a one- time project. Sixty pounds are used in this project. The remaining 40
pounds have no market value. Using the opportunity cost concept, the historical cost of the remain- ing 40 pounds is sunk and irrelevant for future
uses of this material.

Q2–5: Avoidable costs are those costs that will not be incurred if an existing operation is closed or changed. Avoidable costs are the opportunity costs.
Unavoidable costs are costs that will continue to be incurred regardless of the decision.

2
Q2–6: Mixed costs are cost categories that cannot be classified as being purely fixed or purely variable. An example is utilities.
Q2–7: A step cost is a cost that is fixed over a given range of output level. For example, supervisory personnel cost is a step cost.
Q2–8: A fixed cost is a cost that does not vary with the number of units produced. Although fixed with respect to volume changes, fixed costs can still
be managed and reduced.
Q2–9: A variable cost is the additional cost incurred when output is expanded. Labor and materials are usu- ally two variable costs. A variable cost is
not necessarily a marginal cost. A marginal cost is the cost of the last unit produced, while variable cost is the portion of the total cost that varies with
the quantity produced. If the variable cost is linear, then marginal cost per unit equals variable cost per unit and is constant as volume changes. If vari-
able cost is not linear, marginal cost will be nonconstant.

Q2–10:
a. Price and variable cost per unit must not vary with volume.
b. It is a single-period analysis.
c. It assumes a single-product firm.

Q2–11: The major benefit of CVP analysis is that it forces managers to understand how costs and revenues vary with changes in output. Its limitations
include:
a. Price and variable cost must not vary with volume.
b. It is a single-period analysis (no time value of money).
c. It assumes a single-product firm.

Q2–12: Estimating opportunity costs requires the deci- sion maker to formulate all possible alternative actions and the forgone net receipts from those
actions. This is a costly and time-consuming process. Furthermore, the opportunity cost changes as the set of alternative actions changes.

Q2–13: Direct costs are those costs that are worth trac- ing to the unit being costed. Cost–benefit analysis requires one to determine whether tracing
the cost has a benefit greater than its costs.

Q2–14: Overhead costs include indirect labor and materials and other general manufacturing costs that can- not be directly traced to the units
produced. Overhead costs are usually allocated using a base that most closely approximates those factors that cause overhead to vary in the long run.

Q2–15: Period costs consist of all nonmanufacturing costs, including selling, distribution, general, and admin- istrative costs. Period costs are not
included in the cost of the products that are in inventory. Period costs are written off to the income statement when incurred.

Q2–16: Motion and time studies break each labor task down to its basic movements and then time each move- ment. These studies have two
objectives: (1) to estimate direct labor costs of a particular job and (2) to reduce these costs by redesigning the way employees perform or redesigning
the product to reduce labor input.

Zimmerman (2017): Chapter 4, Organizational Architecture

3
A. Basic Building Blocks
Before describing the general problem of how to motivate and
control behavior in orga- nizations (the economics of
organizations), this section first describes some underlying
concepts:
1. Self-interested behavior, team production, and agency
costs.
 One of the fundamental tenets of economics is that individuals
act in their self-interest to maximize their utility.
 The incentive to shirk in team production is called the free-rider
problem. Teams try to overcome the free-rider problem through the
use of team loyalty—pressure from other team members—and
through monitoring. Team production clearly has advantages, but it
also causes a variety of organizational problems, in particular the
free-rider problem
Principal-agent theory: When hired to do a task, agents
maximize their utility, which may or may not maximize the
principal’s utility. Agents’ pursuit of their self-interest instead of
the principal’s is called the principal–agent problem or simply the
agency problem.
Examples: employee theft of firm property,
 In general, agency problems arise because of information
asymmetries.
If the agent expects to leave the organization before the principal,
the agent will tend to focus on short-run actions. This leads to the
horizon problem: Managers expecting to leave the firm in the near
future place less weight than the principal on those consequences
that may occur after they leave
= To reduce agency costs such as employee theft and the free-
rider and horizon problems, firms incur costs. These costs
include hiring security guards to prevent theft, hiring super- visors
to monitor employees, installing accounting and reporting systems
to measure and reward output, and paying legal fees to enforce
compliance with contracts.
Two types of agency problems have been given specific names.
Adverse selection refers to the tendency of individuals with private
information about something that benefits them to make offers that
are detrimental to the trading partner
Moral hazard problems arise when an individual has an incentive
to deviate from the contract and take self-interested actions because
the other party has insufficient information to know if the contract
was honored. (p. 133).
Agents maximize their utility, not the principal’s. This problem is
commonly referred to as goal incongruence, which simply means
that individual agents have different goals from their principal.
2. Decision Rights and Rights Systems
4
B. Organizational Architecture
1. Three-Legged Stool
The firm cannot always use the external market’s price (even if
available) to guide internal transactions. More important, in the
absence of the discipline of the market, the parties to the firm must
design administrative devices to
(1) measure performance,
(2) reward performance, and
(3) partition decision rights.
 These three activities (called organizational architecture) are
performed automatically by markets but must be performed by
(costly) administrative devices inside the firm.
Performance evaluation can involve either objective or subjective
performance mea- sures or combinations of both. Objective criteria
include explicit, verifiable measures such as paying employees on
piece rates or sales. Subjective criteria focus on multiple hard-to-
measure factors. For example, subjective performance measures
include a variety of factors such as improving team spirit, getting
along with peers, meeting budgets and schedules, and affirmative
action hiring.
Besides measuring performance, organizations must reward
favorable performance and in some cases punish unwanted
behaviors (sometimes by firing employees). Agents meeting or
exceeding performance expectations are rewarded with pay
increases, bonuses, promotions, and perquisites. Superior
performance is rewarded with both monetary and nonmonetary
compensation. Monetary rewards involve salary, bonus, and
retirement ben- efits. Nonmonetary rewards include prestigious job
titles, better office location and fur- nishings, reserved parking
spaces, and country club memberships.
Another administrative device in firms is partitioning decision
rights. Within organizations, all decision rights initially reside with
the board of directors. The vast majority of these rights are assigned
to the chief executive officer (CEO), with the exception of the right
to replace the CEO and set his or her pay. The CEO retains some
rights and reassigns the rest to subordinates. This downward
cascading of decision rights within an organi- zation gives rise to
the familiar pyramid of hierarchies. Centralization and decentraliza-
tion revolve around the issues of partitioning decision rights
between higher versus lower levels of the organization and linking
knowledge and decision rights.
Ultimately, all organizations must construct three
systems that make up the firm’s organizational
architecture:
1) A system that measures performance.
2) A system that rewards and punishes performance.
3) A system that assigns decision rights.
 Like a three-legged stool: ”For the stool to remain level, all three
All economic resources or assets are bundles of decision rights with
respect to how they can or cannot be used.
 Decision rights over the firm’s assets are assigned to various
people within the firm who are then held accountable for the
results. If an individual is given decision-making authority over
some decision (such as setting the price of a particular product), we
say that person has the decision right for that product’s price.
 The question of whether the organization is centrally managed
or decentralized is an issue of decision right assignment.
 Employee empowerment is a term that means assigning more
decision rights to employees (i.e., decentralization). Accounting-
based budgets assign decision rights to make expendi- tures to
specific employees.
3. Role of Knowledge and Decision Making
Because knowledge is valuable in decision making, knowledge and
decision making are generally linked; the right to make the decision
and the knowledge to make it usually reside within the same
person.
 In fact, a key organizational architecture issue is whether and
how to link knowledge and decision rights.
 Ideally, knowledge and decision rights are linked, but they do
not always reside with the same person.
 Suppose it is very difficult to transfer knowledge and very
difficult to monitor the person with the knowledge. Moreover,
suppose large agency costs arise if the person with the knowledge
has the decision rights.
4. Markets versus Firms
5. Influence Costs
C. Accounting’s Role in the Organization’s
Architecture
 One way to limit agency costs is to separate the decision rights
to initiate and implement decisions (decision management) from
the ratifying and monitoring functions (decision control)
 Accounting systems play a very important role in monitoring as
part of the performance evaluation system. Accounting numbers are
probably more useful in decision monitoring and often least useful
in decision initiation and implementation
For decision management = managers want opportunity
costs
 Accounting data is critized for not being useful in
5
legs must balance. ” (p. 140).
 Though this sounds obvious, changing one system often
requires changing the other two systems.
= The internal accounting system is a significant part of the
performance measurement system. Changes are often made to this
system without regard to their impact on the performance-reward
and decision-assignment systems
 performance measurement systems generally use
financial and nonfinancial measures of performance.
 Nonfinancial metrics include percentage of on-time deliveries,
order completeness, excess inventory, employee turnover,
manufacturing quality, percentage of defects and units of scrap, and
customer complaints. (Financial indicators are collected and audited
by the firm’s accountants, whereas nonfinancial measures are more
likely to be self-reported. Therefore, financial measures are usually
more objective and less subject to managerial discretion.)
 Nonfinancial measures provide information for making
decisions. Financial measures of performance tend to be for
controlling behavior.
NB: Numerous performance measures dilute attention.
 Chapter 14 describes the Balanced Scorecard, and specifically
the problem of using multiple performance measures.
2. Decision Management versus Decision Control
Perhaps the most important mechanism for resolving agency
problems is a hierarchical structure that separates decision
management from decision control
 Decision management refers to those aspects of the decision
process in which the manager either initiates or implements a
decision. Decision control refers to those aspects of the decision
process whereby managers either ratify or monitor decisions.
 There is a separation of decision management from control.
Figure 4.1
To the extent financial measures are used for decision control
and nonfinancial measures are used for decision management,
the following implications arise:
1. Financial measures are not under the complete control of
the people being monitored (i.e., the operating managers).
2. Nonaccounting measures, such as customer complaints
and defect rates, are often more timely than accounting
measures.
3. Not every decision requires ratification or monitoring.
4. Operating managers tend to be dissatisfied with financial
measures for making operating decisions.
+ more.
 A number of specific internal accounting procedures, such as
decision management, but their usefulness for decision standard costs, budgeting, and cost allocations (described in later
control is often overlooked chapters), help reduce agency problems.

As a monitoring device, the accounting function is usually D. Example of Accounting’s Role: Executive
independent of operating managers whose performance the Compensation Contracts
accounting report is measuring.
 Since accounting reports bring subordinates’ performance to the - look up if necessary.
attention of their superiors, the reports should not be under the
control of the subordinates.

Zimmerman (2017) ….

According to Zimmerman (2020), the three legged stool of the organizational architecture should be balanced in the sense that
partitioning of decision right, performance measurement, and performance reward and punishment should be aligned.

One way to limit agency costs is to separate decision rights to initiate and implement decisions (decision management) from
the ratifying and monitoring functions (decision control).

Q4–1: Agency costs are the decline in value resulting from agents pursuing their own interests instead of the principal’s
interests. Differences among risk tolerances, working horizons, and excessive job perquisites all contribute to agency
costs. Agency costs also arise when agents seek to manage larger organizations, to increase either their job security or
their pay.

Q4–2: Agency costs are reduced by monitoring and bonding activities. Agency costs are limited by the existence of a
labor market for managers, competition from other firms, and the market for corporate control.

Q4–3: Goal incongruence means simply that agents and principals have different utility functions.
Q4–4: By restructuring the agent’s incentive scheme, the agent’s and principal’s objectives can be made more
congruent.

Q4–5: Because knowledge is valuable in decision making, the right to make a decision should reside with the person
who has the specific knowledge for the decision. Q4–6:

6
 a. Measuring performance.
b. Rewarding and punishing performance.
c. Partitioning decision rights to their highest-valued use.

Q4–7: Influence costs consist of the forgone opportunities arising from employees trying to affect decisions by
politicking and other potentially nonproductive influence activities. Influence costs arise when employees waste
valuable time trying to influence decisions.

Q4–8: The firm, defined as a locus of contracts, exists because each resource owner is better off contracting with the
firm than either contracting separately with all the resource owners individually or not contracting at all. Each resource
owner, by contracting with the firm, is implicitly contracting with all others contracted with the firm. The firm
economizes on repetitive contracting and transaction costs are reduced.

Q4–9: Decision management refers to those aspects of the decision process whereby the manager either initiates or
implements a decision (e.g., a supervisor requesting an additional employee to make her department run more
efficiently).
Decision control refers to those aspects of the decision process whereby managers either ratify or monitor decisions
(e.g., the supervisor’s boss ratifying the decision and allowing her to hire an additional employee).

Q4–10: All organizations must construct:

1. Systems that partition decision rights. Decision rights lie initially with the board of directors. The rights are
then assigned throughout the organization.
2. Systems that measure performance. The system developed must measure the performance of variables over
which the agent has been given decision rights.
3. Systems that reward and punish performance. The system must be matched to the performance variables being
measured.

Q4–11: The four steps in the decision process are:

1. Decision initiation—the beginning of the decision process. This step is usually performed by the person with
the specific knowledge; a decision management function.
2. Decision ratification—reviewing and approving the request; a decision control function.
3. Decision implementation—usually associated with the individual(s) who initiated the process; a decision
management function.
4. Decision monitoring—evaluating the implementation; a decision control function.

The separation of management and control helps reduce agency costs. The separation is structured so that the decision
makers do not measure their own performance.

Davila, A, Foster, G. & Oyon, D. (2009). Accounting and Control, Entrepreneurship and Innovation: Venturing into New Research
Opportunities
USE IF FOCUS ON INNOVATION AND Intro: The field of accounting and control has traditionally
ENTREPRENEURSHIP IN A CHANGING focused on established companies and stable settings. The
ENVIRONMENT purpose of accounting systems was to guide an organization

7
Davila et al. (2009) looks at management control systems towards meeting its pre-defined objectives.
in innovative/entrepreneurial settings.
Framework: “to look into innovation and control
Abstract: The relevance of accounting and control to entrepreneurship and from a strategy perspective”
innovation has become more salient over the last few years. The traditional
paradigm that identified accounting and control as nothing else but detrimental ”Based on the commonly used distinction between incremental
to these two aspects of management has been challenged both through new and radical innovation and between induced and autonomous
concepts and recent empirical evidence.
strategic actions, the framework identifies four potential types
of control systems that are distinct on various dimensions such
Purpose: This paper presents a review of this emerging literature. It examines as their purpose, sources of information, coordination needs, or
the theoretical concepts that are shaping these fields as well as the evidence
social and economic incentives.” (p. 301).
that is accumulating. It also presents a framework to structure the study of
management control systems in innovative settings and future opportunities for
research.

Conclusions:
The field of accounting and control has changed
significantly over the last decade.
Concepts such as interactive systems, dynamic capabilities, enabling
bureaucracies or adaptive routines provide the theoretical base to
explore the effect of control tools in entrepreneurial companies and
innovative settings
COMMENT:
An interesting paper, the link between mgmt control
and finance and the line of study. Mgmt control is
different from strategy courses --> but this article
tries to build a bridge between the literature. The
coer of this paper is how accounting actually can
hinder but also ___ innovation. The process -
hourglass process, 2x2 matrix where innovation is
discussed, type of innovation,
disruptive/incremental - what is the role of mgmt
accounting. Also a clear reference to Simons.

Davila, Foster & Oyon (2009) present a framework to examine management control systems for different
innovative settings.  “Innovation is not a monolithic phenomenon but various processes that coexist in parallel, each one requiring
different types of control systems.” (p. 284).
= Results ” The framework argues that incremental and radical innovation efforts require different manage- ment control systems. It also
argues that different systems are required to manage creativity coming from top management and creativity bubbling up from the rest of
the organization.” (p. 284)

“The original idea of management control systems (Anthony, 1965) viewed them as tools to implement goals coming out of the strategic
planning process (Ansoff, 1977).” (Davila, Foster & Ovon, p. 281).
 Thermosat metaphor has been used to illustrate this interpretation of control

Davila et al. (2009) argue that the traditional view of management control systems is at odds with the dynamic
nature of entrepreneurship and innovation.
 ”For the company to have any chance to grow and succeed, accounting and control within startup companies has to be limited to
bookkeeping under this view.” (p. 282).

Davila et al. (2009): Innovation and MCS: ”Innovation is associated with taking advantage of unexpected opportunities,
exceptions, new relationships, uncertain outputs, risk and the possibility of failure. Tools designed to eliminate variation and control
routine activities have little role in these settings. Traditional control tools encourage a command and control approach based on explicit
contracts, hierarchical organizations and extrinsic motivation. In fact, they are designed to eliminate innovation (an inefficient process
because of the likelihood of failure) and deliver pre-determined objectives as efficiently as possible.” (p.282). –> Researchers have
concluded that the role of management control systems should be kept to a minimum.
Simons, R. (1995). Control in the Age of Empowerment, Harvard Business Review
USE! GOOD CLASSIC EMPOWERMENT AND Beliefs Systems
CONTROL This control lever is used to communicate the tenets of

8

Introduction: One of the most difficult problems managers
face today is maintaining control, efficiency, and productivity
while still giving employees the freedom to be creative,
innovative and flexible. Giving employees too much
autonomy has led to disaster for many companies, including
such well-known names as Sears and Standard Chartered
Bank. In these companies and many others, employees had
enough independence that they were able to engage in and
mask underhanded, and sometimes illegal, activities. When
these deviant behaviors finally came to light, the companies
incurred substantial losses not only financially, but also in
internal company morale and external public relations.
One method of preventing these kinds of incidents is for
companies to revert to the “machinelike bureaucracies” of the
1950s and 60s. In these work environments, employees were
given very specific instructions on how to do their jobs and
then were watched constantly by superiors to ensure the
instructions were carried out properly.
In the modern corporate world, this method of managing
employees has all but been abandoned except in those
industries that lend themselves to standardization and
repetition of work activities (e.g., in casinos and on assembly
lines). In most industries, managers simply do not have time
to watch everyone all the time. They must find ways to
encourage employees to think for themselves, to create new
processes and methods, while still retaining enough control to
ensure that employee creativity will ultimately benefit and
improve the company.
There are four control levers or “systems” that
can aid managers in achieving the balance
between employee empowerment and effective
control:
1. Diagnostic control systems (allow
managers to ensure that important goals are
being achieved efficiently and effectively)
2. Beliefs systems (empower individuals and
encourage them to search for new opportunities.
They communicate core values and inspire all
participants to commit to the organization’s
purpose)
3. Boundary systems (establish the rules of the
9
corporate culture to every employee of the company. Beliefs
systems are generally broad and designed to appeal to many
different types of people working in many different
departments.
In order for beliefs systems to be an effective lever of control,
employees must be able to see key values and ethics being
upheld by those in supervisory and other top executive
positions. Senior management must be careful not to adopt a
particular belief or mission simply because it is in vogue to
do so at the time, but because it reflects the true nature and
value system of the company as a whole.
It is easier for employees to understand on an informal, innate
level the mission and credo of a company that operates in
only one industry, as did many companies in the past. As
companies grow more complex, however, it is becoming
more and more necessary to establish formal, written mission
statements and codes of ethics so that there can be no
mistaking where the company is going and how it is going to
get there.
Boundary Systems
This control lever is based on the idea that in an age of
empowered employees, it has become easier and more
effective to set the rules regarding what is inappropriate
rather than what is appropriate. The effect of this kind of
thinking is to allow employees to create and define new
solutions and methods within defined constraints. The
constraints are set by top management and are meant to steer
employees clear of certain industries, types of clients, etc.
They are also intended to focus employee efforts on areas
that have been determined to be best for the company, in
terms of profitability, productivity, efficiency, etc.
Boundary systems can be thought of in terms of “minimum
standards,” and can help to guard the good name of a
company, an asset that can be very difficult to rebuild once
damaged. Examples of these kinds of standards include
forbidding employees to discuss client matters outside the
office or with anyone not employed by the company
(sometimes including even spouses) and refusing to work on
projects or with clients deemed to be “undesirable.”
Many times a company will implement a boundary system
only after it has suffered a major crisis due to the lack of one.
It is important that companies begin to be proactive in
establishing boundaries before they are needed.
Boundary systems are the flipside of belief systems. They are
the “dark, cold constraints” to the “warm, positive,
 game and identify actions and pitfalls that
employees must avoid)
4. Interactive control systems (enable top-
level management to focus on strategic
uncertainties, to learn about threats and
opportunities as competitive conditions change,
and to respond proactively)
Diagnostic Control Systems
This control lever relies on quantitative data, statistical
analyses and variance analyses. Managers use these and other
numerical comparisons (e.g., actual to budget,
increases/decreases in overhead from month to month, etc.)
to periodically scan for anything unusual that might indicate
a potential problem.
Diagnostic systems can be very useful for detecting some
kinds of problems, but they can also induce employees and
even managers to behave unethically in order to meet some
kind of preset goal. Meeting the goal, no matter how it’s
done, ensures the numbers won’t fluctuate in a manner that
would draw negative attention to a particular department or
person.
Employee bonuses (and sometimes even employment, itself)
are often based on how well performance goals have been
met or exceeded, measured in quantitative terms. If the goals
are reasonable and attainable, the diagnostic system works
quite well. It enables managers to assign tasks and go on to
other things, releasing them from the leash of perpetual
surveillance. Empowered employees are free to complete
their work, under some but not undue pressure to meet a
deadline, productivity level, or other goal, and to do it in a
way that may be new or innovative.
However, when goals become unrealistic, empowered
employees may sometimes use their capacity for creativity to
manipulate the factors under their control in order not to fall
short of their manager’s expectations. Such manipulations
can only have very short-term positive effects and can very
possibly, depending on their magnitude, lead to long-run
disaster for the company.
BALANCING EMPOWERMENT AND CONTROL:
How they can support one another:
Example company: The senior managers who set the
company’s overall direction and strategy ensure that
they have adequate control of their far-flung operations
by using all four levers of control:
10
inspirational” tenets of belief systems.
Interactive Control Systems
The key to this control lever is the word “interactive.” In
order for this kind of control system to work, it is critical that
subordinates and supervisors maintain regular, face-to-face
contact. Management must be able to glean what is most
critical from all aspects of an organization’s operations so
that they can establish and maintain on a daily basis their
overall strategic plan for the company.
Companies use many different tools to accomplish this kind
of regular communication. One popular method of doing this
is to analyze data from reports that are frequently released
(for example, the Nielsen ratings), internally generated
productions reports, and professional journals.
Though this may seem somewhat like the diagnostic control
system discussed earlier, there are four important
characteristics which set the interactive control system apart:
1) the interactive system focuses on constantly changing data
of an overall strategic nature, 2) the strategic nature of the
data warrants attention from all levels of management on a
regular basis, 3) the data is best analyzed in a face-to-face
setting in groups that include all levels of employees, and 4)
the system itself stimulates these regular discussions.
Conclusion
Empowering employees is necessary for the
continuing health and improvement of most
companies. Using the four levers of control
discussed above in conjunction with one
another, managers can unleash the creative
potential of their subordinates without losing
overall control of their team and its objectives.
COMMENT:
Simons (1995) Milestone that is used in many of the
papers - be careful that the levers of control and BSC
are different - both are composed of four dimensions
and deal with mgmt control. Levers of control are one
level up --> meaning the levers control the strategy,
they have negative and positive effects, and the levers
 are needed in order for the managers to deal with all
1. To communicate core values, they rely on a beliefs the tools they have available eg. BSC (which is more in
system. The company has a set of core values that is the implementation than the actual strategy).
widely circulated, and these are also offset by clear
boundaries (boundary systems) e.g., to work in certain
countries or which types of projects are not profitable
and should be avoided
2. Managers gain still more control by using a variety of
diagnostic controls - among them profit plans, budgets, Final conclusion:
and goals and objectives. One of these are used
interactively (interactive control systems): the project  “Collectively, these four levers of control set in
management system focuses attention on the strategic motion powerful forces that reinforce one another. As
uncertainties that managers want everyone to monitor: organizations become more complex, managers will
The company’s reputation in trade, the shifting inevitably deal with increasing opportunity and
perceptions of customers, and the ideal skill mix competitive forces and decreasing time and attention.
required in various project teams. The new data are By using the control levers effectively, managers can be
used as a catalyst to force regular face-to-face confident that the benefits of innovation and creativity
discussions in which managers share information and are not achieved at the expense of control” (p. 88).
attempt to develop better ways to customize their
services and adjust their strategies in a changing
market.

According to Simons (1995) management control systems are ”[…] formal, information-based routines and procedures managers use to
maintain or alter patterns in organizational activities” (p. 5)

There are four control levers or “systems” that can aid managers in achieving the balance between employee empowerment and
effective control:

According to Simons (1995) the four levers of control aid managers in achieving the balance between employee empowerment and
effective control. The model created a paradigm shift as it identified interactive systems as tools to engage the organization in exploration
of strategic uncertainties, hereby developing a concept in the control literature whose purpose is to create – rather than eliminate – the
variation required for innovation.

and the role of management control systems as diagnostic systems to get the strategy implemented (Simons, 1995).

”Simons’ empirical work (1987, 1991, 1994) led to the development of the levers of control model (Simons, 1995). This model creates a
paradigm shift when it identifies interactive systems as tools to engage the organization in the exploration of strategic uncertainties; thus,
developing a concept in the control literature whose purpose is to create (rather than eliminate) the variation required for innovation. This
concept breaks with the traditional control paradigm and provides an argument for the relevance of control to innovation.” (Davila et al,
2009, p. 288)

The concept of interactive systems (Simons, 1995) has been associated with a formal process to review the existing business model and
identify its potential flaws. (Davila et al, 2009. p 299).

”Perhaps the scorecard can be seen as an embodiment of Simon’s (1995) interactive control systems; that is, it reports those measures
which senior managers have decided should be emphasized for a period of time.” (Otley, 1999, p. 376).

11
SYSTEM REVISION  accounting systems including performance measures!

VARIANCE ANALYSIS: 5. When variance analysis issued as an input to the performance

evaluation system in a budget, which of the following scenarios may be encountered?

A. Purchasing managers may buy lower quality materials to generate a favourable price variance
 Typical moral hazard problem, only evaluated on the price level, thus an incentive to lower
quality
B. If targets are set at easily achievable levels, some people will only do enough to meet them, but no more
 Agency problem - adverse selection
C. When labour efficiency is measured on a team or production cell basis, the free rider may take advantage
 Agency problem - Free rider problem
D. All of the above

12
 ELEMENTS THAT WILL COME UP IN THE EXAM; "If you read this situation from an agency literature
view"

13
 2. Responsibility Accounting and Transfer Pricing (CP)
Zimmerman, J. L. (2017). Accounting for Decision Making and Control, New York: McGraw Hill, Chapter 5.

Intro: This chapter discusses two additional examples of how
accounting systems can be applied to reduce agency problems:
responsibility accounting and transfer pricing.
 NB. This book focus on the use of accounting numbers as
performance measures, however, it is important to recognize that performance measured by EVA.
publicly traded firms also use their stock price as a performance
measure. (Stock prices are forward looking)
A. Responsibility Accounting
All but the smallest organizations are divided into subunits, each  Controllable costs are all costs affected by a manager’s decisions.
of which is granted decision rights and then evaluated based on
performance objectives for that subunit.
 Responsibility accounting begins with formal recognition of
these subunits as responsibility centers. A responsibility
accounting system is part of the performance evaluation system When goods are transferred from one profit (or investment) center to
used to measure the operating results of the responsibility center. another, an internal price (the transfer price) is assigned to the units
The decision rights assigned to a subunit categorize
the unit as a cost center, a profit center or an
investment center = Responsibility centers
 Each implies different decision rights and
accordingly different performance metrics
 See table 5.1 p. 163
1. Cost Centers
Cost center managers are assigned decision rights for
determining the mix of inputs (labor, outside services, and
materials) used to produce the output.
 Managers of cost centers are evaluated on their efficiency in
applying inputs to produce outputs
 Since they are not responsible for selling the final services or
products, they are not judged on revenues or profits!
 In addition to measuring the quantity of output, its quality
must be monitored effectively. If not, cost center managers who
are evaluated on costs can meet their targets by cutting quality.
Various objectives are used for evaluating cost center
performance:
- minimize costs for a given output
- maximize output for a given budget
Cost centers work most effectively if (1) the central managers
have a good understanding of the cost functions, can measure
quantity, and can set the profit-maximizing output level and
appropriate rewards; (2) the central managers can observe the
quality of the cost center’s output; and (3) the cost center
manager has specific knowledge of the optimal input mix.
4. Economic Value Added (EVA®)
Another measure of performance
 Second, many companies implementing EVA not only adopt
EVA as their perfor- mance measure but also link compensation to
5. Controllability Principle
Holding managers responsible for only those decisions for which
they have authority is called the controllability principle.
Uncontrollable costs are those that are not affected by the manager.
 Two drawbacks
B. Transfer Pricing
transferred.
 There are basically two main reasons for transfer pricing within
firms: international taxation and performance measurement of profit
and investment centers
1. International Taxation
When products are transferred overseas, the firm’s corporate tax
liability in both the export- ing and importing country is affected if
the firm files tax returns in both jurisdictions
 Firms can have two sets of transfer prices: one for taxes and one
for internal purposes. However, maintaining two such systems is
costly. Additional bookkeeping costs are incurred and are confusing
to users. In addition, some tax jurisdictions may argue that the
transfer prices used for internal purposes should also be used for
taxes, especially if they result in higher taxes than the transfer prices
used for taxes.
2. Economics of Transfer Pricing
Whenever responsibility centers transfer goods or services among
themselves, measuring their performance requires that a “transfer
price” be established for the goods and services exchanged
 NB: The choice of transfer pricing method does not merely
reallocate total company profits among business units; it also affects
the firm’s total profits.
 The transfer price that maximizes firm value is quite simple to
state: The optimal transfer price for a product or service is its
opportunity cost—it is the value forgone by not using the transferred
product in its next best alternative use. Unfortunately, as we will see,
this simple rule is often difficult to implement in practice.
Transfer pricing with perfect information
Transfer pricing with asymmetric information
 Look up p. 178 + 179

14
2. Profit Centers
Profit centers are often composed of several cost centers. Profit
center managers are given a fixed capital budget and have
decision rights for input mix, product mix, and selling prices (or
output quantities). Profit centers are most appropriate when the
knowledge required to make the product mix, quantity, pricing,
and quality decisions is specific to the division and costly to
transfer.
 Profit centers are usually evaluated on the difference between
actual and budgeted accounting profit for their division
Two complications when measuring profit centers’
profits:
1) How to price transfers of goods and services
between busines units (transfer pricing)
(2) Which corporate overhead costs to allocate to
business units)
3. Investment Centers
Investment centers are similar to profit centers. However, they
have additional decision rights for capital expenditures and are
evaluated on measures such as return on investment (ROI).
Investment centers are most appropriate when the manager of
the unit has specific knowledge about investment opportunities
as well as information relevant for making operating decisions
for the unit.
 Investment center managers do not have decision rights over
the quality of products they can sell and the market niches they
can enter
 … debasing the firm’s reputation (also called its brand-name
capital) p. 167
 Investment center performance can be measured in at least
three ways:
Net income: The simplest measure is accounting net income
generated by the investment center (revenues minus expenses)
(more p. 167).
Return on investment: Commonly used measure is return in
investment (ROI). ROI is the ratio of accounting net income
generated by the investment center divided by the total assets
invested in the investment center
 Other variants of ROI: ROA and RONA
 Whereas net income as an investment center performance
measure creates an overin- vestment problem, using ROI
typically creates an underinvestment problem. Managers have
incentives to reject profitable projects with ROIs below the mean  The trade-off between decision making and control discussed in
ROI for the division because accepting these projects lowers the Chapter 1 also applies to transfer prices
division’s overall RO + Horizon problem!
Residual income:
To overcome some of the incentive deficiencies of ROI, such as
over- or underinvesting, some firms use residual income to
15
3. Common Transfer Pricing Methods
 The correct transfer price is opportunity cost.  but
determining opportunity costs is difficult, in part because the
information necessary to calculate such costs resides with operating
managers who have incentives to distort it.
Market-based transfer prices
The standard transfer pricing rule offered by most textbooks is:
Given a competitive exter- nal market for the good, the product
should be transferred at the external market price. More p. 182.
Variable-cost transfer prices
If no external market for the intermediate good exists or if large
synergies that exist from internal production cause the market price
to be an inaccurate measure of opportunity cost, then variable
production cost may be the most effective alternative transfer price.
Full-cost transfer prices
The information and incentive problems described earlier can lead
the firm to select sim- ple, objective, hard-to-change transfer price
rules where responsibility center managers cannot easily game the
transfer price. Objective transfer pricing rules such as those based on
full accounting cost are often adopted primarily to avoid
unproductive disputes over measuring variable costs. Full cost
includes both direct materials and labor, as well as a charge for
overhead. Since full cost is the sum of fixed and variable cost, full
cost cannot be changed simply by reclassifying a fixed cost as a
variable cost.
Negotiated transfer prices
Transfer prices can be set by negotiation between Manufacturing and
Distribution. This method can result in transfer prices that
approximate opportunity cost because Manufac- turing will not agree
to a price that is below its opportunity cost and Distribution will not
pay a price that is above the product’s price elsewhere.
4. Reorganization: The Solution if All Else Fails
 If transfer pricing becomes sufficiently dysfunctional, reorganize
the firm.
RECAP:
No single method is best in all circumstances. Since each method has
its advantages and disadvantages, managers must choose the method
that trades off decision making, con- trol, and taxes given their
unique circumstances.
 Advantages and disadvantages can be seen in Table 5.1
Transfer Price. The cost charged by one segment of an organization
for a product or service supplied to another segment of the same
evaluate performance. organization.
Residual income measures divisional performance by
subtracting the opportunity cost of capital employed from
division profits
Zimmerman (2017)

Self-Study Problems page 189:

1. Tam Burger
A) Calculate ROI for both stores
B) Calculate RI (residual income)
C) Should they choose to expand?

2. Bioscience
A) Should international transfer be allowed?
B) What happens if transfer price is set at full cost? What if variable cost?
C) Analyze the various options
D) What are the opportunity costs

Q5–1: Responsibility accounting dictates that decision rights are linked with the specialized knowledge neces- sary to
exercise the decision rights and that the perfor- mance measurement system (e.g., the accounting system) measures the
performance of outcomes that depend on the decision rights assigned to agents.

Q5–2: The internal accounting system is most useful in decision monitoring and is an important part of the sepa- ration
of decision management and control. Accounting departments, being independent of operating manage- ment, are part
of the firm’s internal contracting system designed to reduce agency costs. Accounting reports are one measure of an
agent’s performance.

Q5–3: Responsibility centers differ in their assigned decision rights and their performance management system. • Cost
center. This center’s goal is either to maxi- mize output given a fixed amount of resources or to minimize input costs
given a fixed output. The performance measures are (1) actual versus bud- geted output and (2) actual versus budgeted
cost. If measured on total cost, the quality of the output may be a problem. If measured on average cost, the incentive to
increase inventory exists.
• Profit center. Profit centers are given a fixed amount of capital; they control pricing and the input mix. The
performance measure is the center’s budgeted versus actual profit. Managers have the incentive to build inventories and

16
 request more capital assets as long as they are not charged the opportunity cost of the assets.
• Investment center. Investment centers have all the decision rights of profit centers plus some control over the amount
of capital invested. The perfor- mance measure is either ROI or residual income. There are two problems with ROI.
First, ROI is not a measure of the center’s economic rate of return, creating a potential horizon problem. Second, man-
agers have the incentive to reject profitable projects if the expected ROI is less than the mean ROI for the center.
Residual income also has its shortcom- ings. Primarily, it too suffers from the horizon prob- lem. Residual income is an
absolute number and cannot be used to compare centers of different size.

Q5–4: EVA and residual income are based on the same formula. EVA might adjust accounting earnings, uses weighted-
average cost of capital, and links performance measurement (EVA) to compensation.

Q5–5: The controllability principle holds managers responsible for only those decisions they have the author- ity to
affect. One limitation is that while managers may have little control over the likelihood of some event, if they can
influence the costs (or benefits) of the event, they should still be held accountable. The second limitation is that the
performance of managers can often be better gauged by comparing it with the performance of others (relative
performance evaluation) even though the man- agers being evaluated may have no control over others’ performance.

Q5–6: All performance measurement schemes, includ- ing accounting-based schemes, are likely to produce mis- leading
results and induce dysfunctional behavior if used mechanically and in isolation from other measures. The second point
is that no system is perfect. The question to ask is this: Is the proposed system better than the next best alternative?

Q5–7:
a. International taxation.
b. Incentives and performance measurement of profit or investment centers.

Q5–8:
a. Market price: Given a competitive external mar- ket for the good, the transfer price is determined by the external
market price.
b. Variable cost: Transfer price is determined by the variable cost of manufacturing the good.
c. Full cost: Transfer price is determined by the full (fixed and variable) cost of manufacturing the good.
d. Negotiated price: A negotiated price is determined by negotiations between the purchasing and sell- ing divisions.

Q5–9: No. Changing transfer pricing methods does more than shift income among divisions. The method used can
change the profitability of the firm as a whole because the buying/selling division changes its scale of operations in
response to the transfer price.

Adams, L & Drtina, R. (2008). Transfer pricing for aligning divisional and corporate decisions

USE: LONG TERM GOALS IN The transfer pricing dilemma:

TRANSFERPRICING  Market-based price is the best
for that
IMPORTANT POINT:
”It is impossible to have a single transfer pricing
system that perfectly aligns long-term value
creation with short-run profit maximization.” (p.
Here is where the dilemma arises: ”If the manager of the selling division
makes the investment, he or she will recover cost but won’t increase
division profits. So, why should the manager invest when the benefits
go to others in the firm?”
 the source of conflict is the firm’s transfer price
 Economic theory offers guidelines for setting the correct

17
416)
transfer price to achieve the short-term objective; to
Abstract: maximize the current period profit
Discussions about transfer pricing normally presume the  But as we saw with the investing manager dilemma, the right
firm’s objective is to maximize profit while making the best transfer price for gen- erating profit may discourage a manager from
use of existing capacity. making the investment in the first place.

 Purpose: This article differs by exploring the impact of
transfer pricing on capital budget decisions. In decentralized
firms, decision authority for investment is assigned to
division managers whose capital budgets include revenues
from internal transfers. When a selling division is under
capacity, economic theory recommends a transfer price based
on differential cost. Here the seller generates sufficient
revenues to recoup operating costs, but not enough to recover
capital costs. Consequently, division managers will reject
some investments that otherwise would have increased
corporate shareholder value. Market-based transfer pricing
overcomes this conflict by allocating savings on inter-
company transactions to the selling division. However,
market transfer pricing may result in shortfalls to corporate
profit.
Nonetheless, we argue in favor of the use of transfer pricing
on the presumption that long-term value creation takes
precedence over short-term profit.
In this article, we explore the impact of transfer prices on the decision to
make capital investments and, by extension,
 we examine whether transfer prices for maximizing
short-term profits are consistent with long-term value
creation.
Long term goals = increasing shareholder value
 We are particularly interested in determining whether the chosen
transfer prices support long- term goal congruence between the division
and the corporate entity.
We find that whenever the transfer price is less than market price, long-
term goal congruence is jeopardized. On the other hand, a market
transfer price ensures that the division and corporate will both invest,
but it may result in lower short-term profits. Nonetheless, we
recommend market transfer prices on the presumption that long-term
value creation takes precedence.

Setting transfer prices for short-term profitability COMMENT:

One of the most frequently discussed objectives of a transfer
pricing system is ensuring goal congruence between the firm
and its divisions
 Typically, goal congruence in transfer pricing decisions
revolves around the short-term goal of maximizing profit to
the firm. (p.413)
In striving for goal congruence, the choice of a transfer price
focuses on two questions: 1) Buy internally versus buying
outside, 2) if internally, what is the correct price?
 Answering is depends on two circumstances
tied to use of existing capacity:
1) Full capacity = Market price
2) Under capacity = Differential costs to the seller;
the lower limit for transfer pricing
Adams et al. (2008): Not easy paper, use terms that can be
confusing --> but what is interesting is looking into the
main message, is summarizes when transfer prices can be
used and gives a different overview of choosing transfer
pricing. The common rule in the literature, is that MB
transfer price = long term value creation, however, I would
say that transfer pricing in that sense can have pros and
cons --> if asked to discuss which solution would be better,
then you would have quantitative exercise, but also
comment on this --> then USE THIS PAPER, on the goals
of the company/ long term goals = Market Base transfer
pricing, but there are problems with this

= As a general rule, the transfer price depends on each

division manager’s next best opportunity.

According to Adams and Drtina (2008) managers may encounter the transfer pricing dilemma: “If the manager of the
selling division makes the investment, he or she will recover cost but won’t increase division profits. So, why should the manager invest
when the benefits go to others in the firm?” (p. 411).

This is what Adams and Drtina (2008) describe as the conflict between optimizing short-term profit and long-term
shareholder value. The conflict occurs when the selling division operates below capacity.

18
Adams & Drtina (2008) emphasize that if the goal of a firm is creation of shareholder value, then long-term investment
should take precedence, thus all transfer pricing should be done using market-based prices.

Merchant, K. A. & Shields (1993). When and Why to Measure Costs Less Accurately to Improve Decision Making.
USE IF BIASES – and when in the decision making process they THESE BIASES are not related to the illegitimate
could be useful and when NOT purpose of deceiving external users of the information

Intro: there have been efforts to improve the architecture of
product cost accounting systems  but in many situations the
reporting and use of more accurate cost measurements is not in an
organization’s best interest!
Merchant & Shields (1993) use the term accuracy to encompass two
measurements categories, on one hand they focused on precision and
on the other, they focused from freedom from bias. A precise
measure is a measure that has no randomness or measurement noise.
An unbiased measure on the other hand is skewed neither upward
nor downwards from the true value. Although precision and lack of
bias are discipled measurement qualities, in some cases their
subversion (the lack of) can actually benefit an organization. In this
paper the authors argue that some managers in some organizations
deliberately and wisely add systematic bias to the cost of their
products and services to induce desirable responses
Merchant and Shields (1993) present three forms of less accurate cost
systems,
1) those with cost bias upwards,
2) those with cost bias downwards and
3) those with cost defined less precisely than it is possible.
Thus, creating a measurement noise with unknown directional biases.
They also discuss the pros and cons of these techniques, and of course
the biases in decisions that the others are referring to are different
from those in agency theory - meaning those are related to the
legitimated purpose of deceiving external users.
 The bias and imprecision the authors are referring to
are different: “they are totally legal biases and
imprecision that, in appropriate situations, improve
decision making and influence behaviour in positive
directions, with the consequence being better results.” P.
77.
Who should not use less accurate cost systems?
 These systems are not desirable for all firms!
 Situations where it should not be used: When a
strategy is being formulated:
“An important similarity among the examples of less
accurate cost systems we discussed is that the managers
of each of these firms had already formulated a
competitive strategy and were using their cost systems to
help implement the chosen strategy by directing and
motivating their employees in directions deemed to be
desirable. These cost systems were being used to
implement, not develop, competitive strategies” (p. 80)
 “On the other hand, when the strategy has already
been determined, implementing or using a less accurate
cost system can be preferable when implementation
success is increased by cost systems used to direct
employees’ attention, to help them learn, and to motivate
them. These purposes are not necessarily best served by
accurate costs”

Costs can deliberately be biased by management
Ø’Although precision and lack of bias are desirable
measurement qualities, in some cases their subversion can
actually benefit an organization’ (p. 76)
ØThe bias is infused in the calculation in the ratification
phase of decision making, not in implementation or
reward/monitoring.
ØNot illegitimate bias (not manipulation).
Merchant & Shields (1993): Interesting because it
represents a viewpoint; it suggests that sometimes
managers have an interest to …
Interesting arguments when needed to argue for the
completeness of the cost accounting measures - Eg.
This cost system hurt the company because it has
some elements missing, you can argue from this paper

 Bias serves strategy implementation (control) and not Less accurate cost systems are relevant in the "ratification:
strategy formulation (decision making). strategy implementation" - meaning in the decision control
phase, and not in the decision management meaning the
strategy formulation, initiation and implementation

19
 Merchant and Shields (1993)

3. Budgeting and Beyond Budgeting (CP)

Zimmerman, J. L. (2017). Accounting for Decision Making and Control, New York: McGraw Hill,
Chapter 6.
Intro: This chapter describes how budgeting is used for decision B. Trade-Off between Decision Management
making and to control conflicts of interest.
 A budget is management’s formal quantification of the operations and Decision Control
of an organization for a future period. It is an aggregate forecast of all
transactions expected to occur. 1.Communicating Specialized Knowledge versus Performance
Evaluation
 Budgets are an integral part of decision making by assembling  Budgeting systems perform several functions within firms,
knowledge and communicating it to the managers with the decision including decision management and decision control.
rights.

20
Budgets are developed using key planning assumptions or basic
estimating factors that are widely accepted forecasts of strategic
elements faced by the firm:
 Typical planning assumptions are product prices, unit sales,
foreign currency exchange rates, and external prices of key
inputs. Budgets help assemble and then communicate these
key planning assumptions.
Because budgeting performs such critical functions involving
decision management and decision control, it is ubiquitous—virtually budget figures that enhance their performance measure
all organizations prepare budgets.
A. Generic Budgeting Systems
1. Country club: This example illustrates the use of budgets to
assign decision rights and create incentives for employees to act in
the owners’ interests.
HOW THIS CONNECTS TO ORGANIZATIONAL
ARCHITECTURE: Chapter 4 described organizational architecture
as consisting of administrative sys- tems that assign decision rights
and evaluate and reward performance.
 The country club’s budgeting system illustrates how each of
these three administrative systems is used to reduce agency problems
at the club.:
1) Decision rights, which are initially held by the members, are
assigned to the board of directors.
 Notice the bottom-up nature of the budgeting process: The
operating managers submit their budgets to the board of directors,
who adjust the budgeted figures and recommend the budget to the
membership. The members then have final approval rights over the
budget.
2) Budgets are also a performance measurement system. Monthly
operating statements for each manager are prepared. The operating
statement is only one component of the club man- ager’s
performance. It shows whether the club manager met revenue and
expense targets.
 Another indication of the manager’s performance is
level of member satisfaction with the food and bar
operaton
3) Budget variances are indicators of whether managers are meeting
expectations and they are used in the performance reward system to
determine pay increases or, in the case of extremely unfavorable
variances, the need to terminate the responsible manager.
 Both negative if more than budget, but also can be negative if less
than budget ” On the other hand, favorable budget variances need not
indicate superior performance. If less was spent than was budgeted,
quality may have been sacrificed.”
21
In decision management, budgets serve to communicate specialized
knowledge about one part of the organization to another part,
thereby improving decision making. In decision control, budgets
are part of the performance measurement system. Because budgets
serve several purposes, trade-offs must be made when a budgeting
system is designed or changed. The budget becomes the benchmark
against which to judge actual performance.
 BUT if too much emphasis, then managers with
specialized knowledge will stop disclosing unbiased
forecasts of future events and will report conservative
2. Budget Ratcheting
Using historical data on past performance is a common mechanism
for setting next year’s budget. Unfortunately, it often leads to a
perverse incentive called the ratchet effect. The ratchet effect refers
to basing next year’s budget on this year’s actual performance.
 This “ratcheting up” of budgets causes employees to temper this
year’s better-than- budgeted performance to avoid being held to a
higher standard in future periods
 Causes dysfunctional behaviour and incentives to tamper with
the budgets
Why do firms ratchet up their budgets given the perverse
incentives induced?
One possible reason is that even more perverse incentives might
arise if they don’t.
= In summary, while the ratchet effect creates dysfunctional
behavior, the alternatives might prove more costly. In essence, one
agency problem is replaced with another one. Depending on the
particular situation, senior managers must choose the lesser of the
two evils.
3. Participative Budgeting
The trade-off between decision management and decision control is
often viewed as a trade-off between bottom-up and top-down
budgeting.
 Bottom-up budgeting, in which the person ultimately being
held responsible for meeting the target makes the initial budget
forecast, is called participative budgeting.
 Participative budgeting supposedly enhances the motivation of
the lower-level man- agers by getting them to accept the targets.
 Whether budgeting is bottom-up or top-down depends in part
on where the knowledge is located.
= Some experts argue the budget should be “tight” but achievable.
If budgets are too easily achieved, they provide little incentive to
expend extra effort. If budgets are unachiev- able, they provide
little motivation
4. New Approaches to Budgeting
The trade-off between decision management and decision control in
budgeting creates tension between the two roles, and these tensions
Bay View Country Club’s budget separates decision management
(decision initiation and implementation) from decision control
(decision ratification and monitoring):
1. Decision initiation (budget preparation) is done by the
operating managers.
2. Decision ratification (budget approval) is done by the board
and the members.
3. Decision implementation (operating decisions) is done by
the managers.
4. Decision monitoring (reviewing monthly operating
statements) is done directly by the board and indirectly by
the members.
2. Large Corporation
The previous example described budgeting primarily as a process by
which knowledge is assembled vertically, from both lower levels and
higher levels in the organization’s hier- archy. But budgeting is also
an important device for assembling specialized knowledge
horizontally within the firm. In a large, complex corporation, it is a
major challenge to disseminate specific knowledge.
 An important part of the budgeting process is sharing and
assembling knowledge about such key planning assumptions as unit
placements, prices, and copier return
 The corporate budgeting system is also a communication device
through which some of the specialized knowledge and key planning
assumptions are transmitted
Many budget systems involve a bottom-up, top-down
approach
 As the budget is passed from one level of the organization up to a
higher level, poten- tial bottlenecks are uncovered before they occur.
In summary, organizations use budgets to
1. Assign decision rights.
2. Communicate and coordinate information both vertically
and horizontally.
3. Set goals through negotiation and internal contracting.
4. Measureperformance.
C. Resolving Organizational Problems
As the two examples in section A illustrate, budgeting systems are an
administrative device used to resolve organizational problems. In
22
lead to criticism.
BUDGET CRITICISM: Budgets are criticized often because
they are time consuming to construct and add little value, are
developed and updated too infrequently. are based on unsupported
assumptions and guesswork, constrain responsiveness and act as a
barrier to change, are rarely strategically focused and often
contradictory, concentrate on cost reduction and not value creation,
encourage gaming and perverse behaviors, reinforce departmental
barriers rather than encourage knowledge- sharing, and make
people feel undervalued. (p. 230)
 The question is whether even more dysfunctional behavior
arises when budgets are not used.
Two different approaches are proposed to improve the
budgeting process:
1) One method involves building the budget in two distinct steps;
first lowest levels construct budgets in operational terms  next
step is develop financial plan based on the above
 This approach is more costly
2) A second approach to improve budgeting involves breaking the
so-called annual performance trap. This approach does not use
budgets as performance targets. Budgets are still constructed for
financial planning, but they are not used for performance
evaluation.
 Rather, firms use relative performance targets of other units or
firms and compare these peer-units’ performance to the actual
performance achieved by the unit being judged.
 This approach to improving the budget process decouples
financial planning, information communication, and coordination
(decision management) from performance evaluation and
performance rewards (decision control).
= No simple “one-size-fits-all” panacea exists for resolving the
conflict between deci- sion management versus decision control
when it comes to budgeting. Nor is such a solu- tion ever likely to
be found. Budgets perform both decision management and decision
control roles, and each firm must find the solution that best fits its
unique circumstances at that point in time. Budgeting processes
(and associated compensation schemes) evolve as the firm’s
circumstances change.
5. Managing the Trade-Off
To manage the trade-off between decision management and
decision control, many organizations put the chief executive officer
in charge of the budgeting process. Reasons include:
1) Signals important of the budgeting process, 2) CEO
has specialized knowledge and the overall view of the
firm
4. Static versus Flexible Budgets
All of the examples in this chapter so far have presented static
budgets, which do not vary with volume. Each line item is a fixed
amount. In contrast, a flexible budget is stated as a function of some
particular, these systems help (1) link knowledge with the decision
rights and (2) measure and reward performance.
1. Short-Run versus Long-Run Budgets
Long-run budgets are a key feature of the organization’s strategic
planning process.
 Strategic planning refers to the process whereby managers select
the firm’s overall objectives and the tactics to achieve them. It
involves deciding what markets to be in, what products to produce,
and what price-quality combinations to offer.
 In long-run budgets, the key planning assumptions involve what
markets to be in and what technologies to acquire.
 Long-run budgets are hardly ever used for decision control
(performance evaluation). Rather, long-run budgets are used
primarily for decision management
 Long-run budgets also reduce managers’ focus on short-term
performance.
2. Line-Item Budgets
Line-item budgets refer to budgets that authorize the manager to
spend only up to the specified amount on each line item.
 Because the manager cannot spend savings from one line item on
another line item without prior approval, the manager has less
incentive to look for savings. If next year’s line item is reduced by the
amount of the savings, managers have even less incentive to search
for savings.
 Line-item budgets reduce agency problems.
3. Budget Lapsing
Another common feature is budget lapsing, in which unspent funds do
not carry over to the next year. Budget lapsing creates incentives for
managers to spend all their budget. Otherwise, not only do managers
lose the benefits from the unspent funds, but next year’s budget may
be reduced by the amount of the underspending.
 Budgets that lapse provide tighter controls on managers than
budgets that do not lapse
 In addition, budgets that lapse reduce managers’ flexibility to
adjust to changing operating conditions.
 Without budget lapsing, managers could accumulate substantial
balances in their budgets.
= As in the case of budget ratcheting, the use of budget lapsing (or
not) involves a choice between two evils. Agency costs can not be
driven to zero; they can only be minimized.
KEY: An important lesson from this chapter is that whenever
budgets are used to evaluate managers’ performance and then to
compensate (or promote) them based on their performance relative to most of the organization. Basic description - also look at
the budget target, strong incentives are created for these managers to the appendix, here they describe the composition of a
game the system.
23
volume measure and is adjusted for changes in volume. Flexible
budgets provide different incentives than do static budgets.
 Flexible budgets are better than static budgets for gauging the
actual performance of a person or venture after controlling for
volume effects—assuming, of course, that the individual being
evaluated is not responsible for the volume changes.
 When should a firm or department use a static budget and when
should it use a flexible budget?
5. Incremental versus Zero- Based Budgets
Most organizations construct next year’s budget by starting with the
current year’s bud- get and adjusting each line item for expected
price and volume changes. Because most budgeting processes are
bottom up, where the detailed specialized knowledge resides,
lower-level managers submit a budget for next year by making
incremental changes in each line item.
 Under zero-based budgeting (ZBB), each line item in total must
be justified and reviewed annually. Departments must defend the
entire expenditure (or program expen- diture) each year, not just the
changes.
 In practice, ZBB is infrequently used.
SUMMARY:
Budgets perform a number of important functions:
1. Coordination of sales, production, marketing, finance, and so
forth.
2. Formulation of a profitable sales and production program.
3. Coordination of sales and production with all other activities of
the business.
4. Control of expenditures.
5. Formulation of a financial program including investment and
financing.
Appendix: Comprehensive Master Budget
Illustration
Chapter 6 discussed the important conceptual issues of budgeting. This
appendix illustrates how the various departments of a firm communicate
their specialized knowledge via a firmwide master budget. This example
demonstrates how various parts of the organization develop their budgets,
the importance of coordinating the volume of activity across the different
parts of the organization, and how budgets are then combined for the firm
as a whole.
1. Description of the Firm:
2. Overview of the Budgeting Process
3. Departmental Budgets
4. Master Firmwide Budget
COMMENT:
Zimmerman, chapter 6: Budgeting is a key element in
budget. In the exercise we also looked into the
operational budgets (do not expect huge exercise of
 this, but small ones like the ones in class)

Zimmerman (2017)

SELF STUDY PROBLEM 1:

a) Compute the production, packaging, distribution, advertising, and fixed overhead expenses for the various sales prices and
quantities in Table 1. Explain why GAMESS would not consider selling its adventure game for any price other than $44.

b) Actual data for the year are shown in Table 2. Calculate the budget variances.

SELF STUDY PROBLEM 2:

a. Calculate the processing, loan default, and overhead expenses for each possible interest rate.

b) Create an annual budgeted income statement for five-year loans and deposits for the Boat and Car Loan Department given a
savings interest rate of 4 percent. Remember to match supply and demand.

c) Table 2 shows the actual income statement for the Boat and Car Loan Department. Included are the actual loans and savings for
the same period. Calculate the variances and provide a possible explanation.

Q6–1: Budgets are developed using “key planning assumptions” or “basic estimating factors.”
Q6–2: Key planning assumptions represent those fac- tors that are to some extent beyond management control and that
set a limit on the overall activities of the firm. They must be forecast based on past experience, field estimates, and/or
statistical analysis.
Q6–3: A budget variance occurs when actual expenses do not match budgeted expenses exactly or when budgeted
revenues do not match actual revenues exactly.
Q6–4: Budgets are part of both. Most managers are evaluated in part on how well they are able to meet the budgeted
expectations of their department, division, and so on. Budget variances are indicators of whether managers are meeting
expectations. A large unfavorable variance may cause a manager to be demoted or lose his job.

Q6–5: Budgets provide:

a. A communication device involving both vertical and horizontal information transfers.
b. A negotiation and internal contracting procedure.
c. A role in the performance evaluation and reward system.
d. A role in partitioning decision rights.

24
Q6–6: Budgets separate decision management from decision control. Managers have the decision manage- ment rights
(i.e., budget preparation and operating deci- sions). The board of directors has the decision control rights (i.e., budget
review and approval and financial statement review).

Q6–7: The budgeting process serves as a communica- tion device in a large firm. The process gives manag- ers
incentives to share their specific knowledge, thus transmitting this knowledge vertically and horizon- tally throughout
the firm. Key planning assumptions are shared and developed in this process as well. The information-sharing process
also serves as a negotiation and contracting procedure between different subunits within the firm. Review of the prior
year’s budget is a part of this process, and therefore budgeting is part of the performance evaluation and reward and
punishment system. These processes partition decision rights within the firm.

Q6–8: This is just another example of the trade-off between decision making and control. The budget sys- tem transfers
specialized knowledge about key planning assumptions. However, if the budget is also used for con- trol and provides
incentives for meeting the budget, then managers will “shade” their forecasts to enhance their performance whenever
performance is measured by com- paring actual results with budget.

Q6–9: A bottom-up budgeting system means that lower levels in the organization prepare the initial bud- gets because
they have the specialized knowledge, and as the budget winds its way through the decision ratification process, higher
levels in the organization review the bud- get and bring to bear additional knowledge.

Q6–10: The ratchet effect refers to basing next year’s budget on this year’s actual performance if this year’s actual
performance exceeds this year’s budget. If, in this year actual performance falls short of budget, next year’s budget is
not reduced. Budget ratcheting causes employ- ees to reduce output this year to avoid being held to a higher standard in
future periods.

Q6–11: Participative budgeting occurs when the person ultimately held responsible for meeting the target makes the
initial budget forecast.

Q6–12: A short-run budget is a one-year budget. Like all budgets, it forces managers with specific knowledge to
communicate their forecasts and becomes the internal contract between the manager and the firm. A long-run budget
projects from 2 to 10 years into the future and is a key part of a firm’s strategic planning process. A short- run budget
involves both decision management and deci- sion control, while a long-run budget is primarily for decision
management.

Q6–13: Line-item budgets authorize a manager to spend only up to a specific amount on each line item. These budgets
are an extreme form of control; deci- sion rights to substitute resources are denied. The benefit of such control is a

25
 reduction of agency costs. The disadvantage of these budgets is that managers are disinclined to look for savings
because they cannot transfer the savings to another line item. If coming in under budget reduces the next year’s budget
for that line item, then the manager has no incentive to search for savings.

Q6–14: Budget lapsing provides tighter controls on managers than budgets that do not lapse. The primary pur- pose is to
prevent certain agency problems from occur- ring. The opportunity cost of lapsing budgets is usually less efficient
operations. Managers will devote time at year-end to ensure that the budget is fully spent, thereby protecting future
budget levels.

Q6–15: A static budget is a budget that does not change with volume, while a flexible budget changes with vol- ume.
The major reason for using flexible budgets is to better measure the actual performance of a person or entity after
controlling for volume effects, assuming that the person/entity being evaluated cannot control the vol- ume changes.
However, if a manager can influence the effect of the volume change, then it is unwise to shield the manager from the
volume changes.

Q6–16: With incremental budgeting, each lower- level manager submits a budget by making incremental changes to
each line item. Detailed explanations justify- ing the incremental changes are submitted and reviewed by the
organization. Base budgets are taken as given. Zero-based budgeting (ZBB) resets each line item in the budget to zero
and the entire amount must be justified. ZBB, in principle, maximizes firm value by identifying and eliminating
expenditures whose total costs are greater than total benefits, whereas inefficient base budgets can still exist with
incremental budgeting. However, ZBB often degenerates to incremental budgeting. The same justifications are
submitted to support the incremental changes. The volume of reports under ZBB is larger than under incremental
budgeting, causing senior managers to focus on changes.

Davila, A. & Wouters, M. (2005). Managing budget emphasis through the explicit design of
conditional budgetary slack
USE IF: BUDGET AND budgetary slack
Intro: Budgetary slack plays an important role in the functioning of
budgets in organizations. While theory has found negative as well as
positive elements associated with its presence, the empirical literature has
interpreted it as being dysfunctional to organizations.
Authors: In this paper, we present empirical evidence on how a
company purposefully budgeted additional financial resources with a
motivation intention to facilitate the managers’ task in achieving the goals
of the company.
Study: we examine how the company accepted more slack as the
demand on business processes increased and goals other than budget
targets––in particular, service quality––became harder to achieve. By
allowing this practice, headquarters made it clear to local managers that
product quality and service were at least as important as meeting budget
objectives. We also find that not only was budgetary slack purposefully
built during the budgeting process but also in the budgeting system itself
through the underlying cost accounting assumptions. The results of this
paper provide empirical evidence on the positive aspects of budgetary slack
and on the role of cost accounting models used in the budgeting system to
facilitate managerial work.
Introduction:
Budgets are probably the management tool most widely used in
organizations.
 A key variable that has traditionally been perceived as limiting
the effectiveness of budgets is budgetary bias (Lukka, 1988) and, in
particular one of its sub-components: budgetary slack
 The presence of budgetary slack makes budgets easier to attain
and empirical work has assumed that its presence is
dysfunctional––or even unethical and should be limited
The authors ”argue that even if budgetary slack has been presented
as dysfunctional in most of the empirical literature, in certain
settings––characterized by uncertainty and multiple goals––
budgetary slack can be beneficial to motivate the appropriate
behavior.” (p. 588)
The paper is among the first to present archival empirical evidence
on the purposeful use of budgetary slack to facilitate managerial
work.

This paper examines the positive effects of budgeting or rather how
some of the adverse effects of budgeting may be mitigated.
Not all is budgetary slack is positive, it has to be a
conditional budgetary slack
COMMENT:
Davila (2005): Addresses that slack is a clear problem -
agency problem. However, the company build…. Some
level of production above the target, middle managers
should have more costly resources…

26
Davila & Wouters (2005) describe
Hansen, S. C., Otley, D. T. & Van der Stede, W. A. (2003). Practice development in budgeting: an
overview and research perspective
USE IF: Critique of traditional budgeting + BEYOND
BUDGETING
Abstract: Practitioners propose two distinct approaches
to address what they believe are shortcomings of
traditional budgeting practices:
1) Advocates improving the budgeting process and
primarily focuses on the planning problems with
budgeting
2) Advocates abandoning the budget and primarily
focuses on the performance evaluation problems with
budgeting.
“The two conflicting developments illustrate that
firms face a critical decision regarding budgeting:
maintain it, improve it, or abandon it?” (p. 96).
PROBLEMS WITH BUDGETING IN PRACTICE
Critics: The main limitations of Budgeting
1. Budgets are time-consuming to put together.
2. Budgets constrain responsiveness and are often a barrier to
change
3. Budgets are rarely strategically focused and often
contradictory
4. Budgets add little value, especially given the time required to
prepare them
5. Budgets concentrate on cost reduction and not on value
creation
6. Budgets strengthen vertical command-and-control
7. Budgets do not reflect the emerging network structures that
organizations are adopting
8. Budgets encourage gaming and perverse behaviors;
9. Budgets are developed and updated too infrequently, usually
annually
10. Budgets are based on unsupported assumptions and
guesswork
11. Budgets reinforce departmental barriers rather than
encourage knowledge sharing
12. Budgets make people feel undervalued.
27
Introduction: “Budgeting is the cornerstone in the
management control process in nearly all organizations, but
despite its widespread use, it is far from perfect.” (p. 95)
 “Practitioners express concerns about using budgets for
planning and performance evaluation
 The practitioners argue that budgets impede the allocation
of organizational resources to their best uses and encourage
myopic decision making and other dysfunctional budget
games. They attribute these problems, in part, to traditional
budgeting’s financial, top-down, command-and-control
orientation as embedded in annual budget planning and
performance evaluation processes” (p. 95)
Two practice-led developments that illustrate
proposals to improve budgeting or to abandon it:
Improving = US-based, ABB group advocates
improving the budgeting system by marrying a more
complete, activity-based operational model with a
detailed financial model.
Abandon = European-based, BB Beyond Budgeting
group takes a more radical view and recommends a
two-stage approach. 1) Addresses the problems with
budgeting when they are used for performance
evaluation.
 “It suggest that traditional budgetary control that
combine planning and performance evaluation lead to
both poor planning and dysfunctional behavior.
Therefore, the BB-group recommend either radically
changing traditional budget-based performance
evaluations or completely eliminating the budget
process. The second stage of the BB-approach is to
radically decentralize the organization and empower
lower-level managers and employees.” (p. 98)
  These can be grouped by saying 1+4+9+10 related
to recurrent criticism that by the time budgets are
used their assumptions are usually outdated
 2+3+5+6+8 relate to another common criticism that
budgetary controls impose a vertical command and
control structure, centralized decisions making,
stifle initiatives, and focus on cost reduction rather
than value creation
 Finally, 7+11+12 reflect organizational and people
related budgeting issues
Conclusion:
“Critics have charged that planning and budgeting
systems are rife with politics and gameplaying;
generate only incremental changes vis-à-vis prior
period plans and budgets; are not responsive to rapidly
changing environments, impose a vertical command-
and-control structure, centralize decision making, and
stifle initiative; focus on cost reductions rather than
value creation; and are too costly for the few benefits
they produce” (p. 110).
COMMENT:
Hansen et al. (2003): Milestone in the literature -
explains the main movements in budgeting. Beyond
budgeting literature --> both relevant in smaller and
bigger companies. This paper gives you the main
points, and more importantly a critical assessment and
evaluation of budgeting
KEY – USE!
Hansen, Otley & Van der Stede (2003)
28
= “Although the ABB group has more of a planning
focus and the BB-group more of performance
evaluation focus, they share a common belief that
traditional budgeting is fundamentally mismatched to
today’s rapidly changing and uncertain environments”
(p. 98).
The Beyond Budgeting Approach
 The approach seeks to avoid the annual performance
trap; that involves dysfunctional behaviours that stem
from evaluating line managers vis-à-vis budget targets
that are set without reference to a credible (outside)
source and remain fixed for the next budget year.
 The literature is full of examples of managers’
inappropriate methods
 “To avoid these dysfunctional behaviours, the BB-
group proposes replacing rigid annual budget-based
performance evaluations with performance evaluation
based on relative performance contracts with hindsight” (p.
101).
 The group recommends that rewards be based on
subjective performance evaluations with an emphasis
on group rather than individual performance. The
objective is to engender a philosophy of doing what is
best for the firm in light of current circumstances and to
promote teamwork” (p. 102)
 “In addition, the BB-proposal also recommends
evaluating performance using various nonfinancial
measures that are aligned with strategic objectives. The
assumption is that by attaining appropriate levels of
performance on the measures included, the desired
financial performance and strategic objectives of the
organization will be achieved. This is similar to the
notion underlying balanced scorecard-type
performance measurement systems (Kaplan and
Notron, 1992)” (p. 102)
Critique BSC, p. 102.
Other researchers take a step further and suggest replacing budget-based performance evaluations with more emphasis on
non-financial performance measures – under the name ‘beyond budgeting’ (Hansen et al., 2003).

From assignment:
- Hansen, Otley & Van der Stede, W (2003) would support the argument and state that compensating the sales manager on
her ability to reach the new target would cause her to game the system. Essentially, the act of increasing the production to
the levels of the revised budget can potentially create dysfunctional behavior which, in the end, can have the consequences,
that shareholder value is not maximized.
- Other researchers take a step further and suggest replacing budget-based performance evaluations with more emphasis
on non- financial performance measures – under the name ‘beyond budgeting’ (Hansen, Otley & Van der Stede, 2003;
Sandalgaard & Bukh; 2014)
- The disadvantages of such subjective measures are that they may be difficult to compare over time, influence costs may be
high, and managers may neglect to take cost/benefit calculations into account (Hansen, Otley & Van der Stede, 2003)

From Sandalgaard: “However, the Beyond Budgeting literature leaves many questions unanswered. For example, why are budgets
still widely used if they are unsuitable for today’s business environment? In addition, the prominence of relative performance targets in the
Beyond Budgeting literature may affect the universal applicability of the model. In this regard, Hansen et al. (2003) point out that many
organizations might not have good relative performance data.” P. 410

”However, as Hansen et al. (2003) suggest, relative performance evaluation is not widely used, as firms often lack relevant internal
benchmarks.” (p. 412)

Sandalgaard N., & Bukh P. N. (2014). Beyond Budgeting and change: a case study
USE: More insights into Beyond Budgeting; for and against +
traditional budgeting against
Purpose – This paper aims to investigate reasons for going Beyond
Budgeting and the practical issues organizations face when they
change their management accounting system based on inspiration
from the Beyond Budgeting model.
KEY QUESTION = Are the Beyond Budgeting principles
universally adoptable or do certain circumstances hinder the
implementation of core Beyond Budgeting techniques?
Findings – The authors propose that many organizations that
change their management accounting system on the basis of
inspiration from Beyond Budgeting will maintain fixed budget
targets. Furthermore, the authors propose that even when the use of
budgets at the corporate level focuses on few line items, the
diagnostic use of budgeting at lower levels in the organization may
focus on a larger number of line items.
Why adopt Beyond Budgeting:
- Increasing environmental uncertainty is one of the main
arguments for abandoning traditional budgets
Hope and Fraser (2003) make three key arguments:
1) Budgeting is cumbersome and too expensive:
The costs associated with preparing and negotiating budgets, and
the costs of following-up on those budgets.
 In other words, if budgeting has lost its value due to changes in
the business environment and if the costs of running a budget
system have risen, then a change toward a more cost-effective way
of controlling organizations might be appropriate.
2) The extent of gaming has risen to unacceptable levels
The traditional budgets tend to become fixed performance
contracts; therefore subordinates will try to obtain the easiest goal
possible

3) Budgeting is out of kilter with the competitive

environment
Beyond budgeting = ” When an organization goes Beyond They argue that traditional budgeting was developed at a time when
Budgeting, it abandons the traditional budget in favor of a range of the business environment was more stable and less competitive than
techniques intended to make the organization more adaptive, and it

29
 it is today
adopts a radically decentralized way of managing” (Hope and
Fraser, 2003, in Sandalgaard & Bukh, 2013, p. 412). HOW to go Beyond Budgeting:
 Replace fixed budgets with relative performance
evaluation (see Svenska Handelsbanken)
Intro: “In recent years, consultants and practitioners have proposed
 Use of industry benchmarks (see Borealis)
the abandonment of traditional annual budgets in favor of a more
 Rolling forecasts
adaptive and radically decentralized management model known as
“Beyond Budgeting”.” (p. 409-410).

FoodCorp case study:

REASONS FOR GOING BEYOND BUDGETING:
- That budgets restrict organizations from adapting to rapidly
changing business environments and that budgeting is a costly
process
LACK OF BENCHMARKS AND NEED FOR
PREDICTABLE GOAL AHCHIEVEMENT
- The first hindrance for the implementation of the Beyond
Budgeting model in FoodCorp was the lack of internal benchmarks
for evaluating the performance of individual responsibility centers.
 Thus, going Beyond Budgeting by replacing fixed targets with
benchmarks is likely to be more suitable in organizations where
branch structures can be found (e.g. retail).
- A second hindrance for the implementation of the Beyond
Budgeting model in FoodCorp was the pressure to deliver the
budgeted payback every year to the owners/ suppliers.
COMMENT:
Sandalgaard & Bukh (2014): See it as an example of
beyond budgeting --> case tried it, where was the
problems and recistance came from. If asked to critize
to beyond budgeting - it gives good pros and cons!
 In case of increased environmental uncertainty
some form of Beyond Budgeting can be adopted
 In case of lack of internal benchmarks, fixed
aggregated top-down targets can be designed to
motivate new ways of thinking in managers.
Replacing fixed targets with benchmarks is likely to
be more suitable in organizations where branch
structures can be found (e.g. retail and banking).
 In organizations with specific ownership structures
(e.g. companies owned by private equity funds and
organizations in the public sector) budgets and fixed
targets are essential for spending approvals.
 Traditional variance analysis is likely to be
maintained. The lack of flexibility with regard to
the imposed targets is linked to an increased
flexibility in the way the set targets can be
achieved.
 Highly aggregated performance measures at
corporate level are accompanied by a
large number of line items in the budgets at the
lower levels of the organization.

USE FOR PROS AND CONS

Sandalgaard and Bukh (2014)

“Thus, our study indicates that Beyond Budgeting is not a standard solution and that Beyond Budgeting is not equally suitable in all kinds
of organizations and in all situations.” (p. 421).

ARGUE BOTH POSITIVE AND NEGATIVE SIDES OF BUDGETING:

Positive:
A. Assigns decision rights

30
B. Shares knowledge
Both vertically and horizontally
C. Forces planning
D. Measures Performance
Form of quantitative performance measuring

Negative: Hansen et al. (2003) argue for 12 limitations to budgeting + Sandalgaard

31
 4. Intellectual Capital Accounting
1. Knowledge of the various managerial technologies, their elements and principles; • IC model,
BSC (Balanced score card), Danish-IC model and IR-model (integrated reporting)

2. The ability to relate and compare the various managerial technologies; • Value drivers truth;
Intangible assets, Financial nonfinancial Measurement, Reporting, IC and Knowledge
management.

3. An understanding of the relevance of the various managerial technologies and their effect on
Organisational strategy; • Knowledge intensive companies, Creative companies & Human
depended companies.

4. The ability to reflect critically on the theories, their underlying assumptions and their
applications; • Knowledge is measurable, scalable, transferable, practical, useable,
renewable, valuable and managerial.

5. The capability to provide a reflected analysis of the pros and cons of the different theories,
concepts, and systems discussed in the course; • Knowledge into product, production
process, routines, culture evt.

6. The ability to properly apply the theories and concepts learned in the course to case
examples; • Systematic, Tivoli, Rambøll,

7. The capacity of presenting their thoughts and analysis in a well-structured and clear manner.
• Definitions, concepts, models, analysing, relevance and argumentation for the conclusion.

32
 Kaplan, R. S. and D. P. Norton (2004). The strategy map: guide to aligning intangible assets.
SKAL BRUGES
Intro: An organization's strategy describes how it
intends to create value for its shareholders, customers,
and citizens. All organizations today create sustainable
value from leveraging their intangible assets – human
capital; databases and information systems; responsive,
high-quality processes; customer relationships and
brands; innovation capabilities; and culture. Because an
organization's intangible assets may easily represent
more than 75 percent of its value, then its strategy
formulation and execution need to explicitly address
their mobilization and alignment.
The balanced scorecard is a performance measuring
system to quantify intangible assets and offers a
framework for describing strategies for creating value
from both tangible and intangible assets.
The four perspectives are intertwined and linked:
 They can view their strategic measures, not as performance
indicators in four independent perspectives, but as a series of cause-
and-effect linkages among objectives in the four balanced scorecard
33
Important elements: FOUR PERSPECTIVES:
Financial performance, a lag indicator, provides the ultimate
definition of an organization's success. Strategy describes how an
organization intends to create sustainable growth in shareholder
value.
Customer perspective
Success with targeted customers provides a principal component for
improved financial performance. In addition to measuring the
lagging outcome indicators of customer success, such as
satisfaction, retention, and growth, the customer perspective defines
the value proposition for targeted customer segments. Choosing the
customer value proposition is the central element of strategy.
Internal processes create and deliver the value proposition for
customers. The performance of internal processes is a leading
indicator of subsequent improvements in customer and financial
outcomes.
Learning and growth
Intangible assets are the ultimate source of sustainable value
creation. Learning and growth objectives describe how the people,
technology, and organization climate combine to support the
strategy. Improvements in learning and growth measures are lead
indicators for internal process, customer, and financial
performance.
perspectives.

STRATEGY MAPS: How organizations create value COMMENT:

Kaplan & Norton (2004): Interesting because in some
To facilitate discussions among executives about the linkages in the ways it covers performance measurements, but focuses
four balanced scorecard perspectives we use a general on intangible assets --> reminder in learning and
representation that we call a strategy map. growth there's intangible assets, but IT IS NOT THE
 In our experience, the strategy map, a visual representation of SAME AS HERE. The main difference IC literature
the linked components of an organization's strategy, is as big an
insight to executives as the balanced scorecard itself. distinctions between relational, organizational and
human capital --> this is the traditional way, however if
you think about the strategy map,
”The strategy map is based on five principles: strategy
balances contradictory forces; strategy is based on a
differentiated customer value proposition; value is
created through internal business processes; strategy
consists of simultaneous, complementary themes;
strategic alignment determines the value of intangible
assets. ''

Kaplan & Norton (2014)

Pros and cons of adopting a Balanced Score Card

Finally, when you present the BSC, please consider the causal linkages between perspectives. It was not explicitly
asked by the question, but it can be a bonus in the exam :).

Critique: The balance scorecard can be critized for its deviation from a single financial measure, e.g. ROI
or EVA, and instead focuses on the an array of measures of the balanced scorecard which may cause
management to reduce firm value.

From internet:

What is a BSC?

“The balanced scorecard retains traditional financial measures. But financial measures
tell the story of past events, an adequate story for industrial age companies for which
investments in long-term capabilities and customer relationships were not critical for
success. These financial measures are inadequate, however, for guiding and evaluating
the journey that information age companies must make to create future value through
investment in customers, suppliers, employees, processes, technology, and innovation.”

Simply put, The balanced scorecard is a fully integrated strategic management system. It
is a way of measuring performance across an organization to monitor progress and set
appropriate goals.

34
The balanced scorecard approach
To understand The balanced scorecard approach, it’s important to understand that it looks at business through four
distinct perspectives. These perspectives are:

Financial
The measurement of the organization’s success in terms of finances. This includes items like sales numbers, profit
margins, and return on investment (ROI). The financial measurements that are the most important will differ based on
the specific goals of the organization.

Customer
Looking at the organization from the viewpoint of a customer or stakeholder. This helps businesses understand what is
working with their customer base and make necessary adjustments. Some metrics to measure this might be the
number of tickets resolved, customer satisfaction surveys, and customer service calls.

Internal Processes
Examining the efficiency and quality of the organization’s performance internally. On the balanced scorecard, this
perspective helps organization leaders analyze how well internal systems and processes are working, or if something
could be improved/changed to increase profitability.

Organizational Capacity
Looking at what’s important to performance, from technology used to company culture to human capital and
infrastructure. All of these items force company leaders to look at items (that often get overlooked) and assess
how they are all serving the company as far as goal achievement goes.

Based on these four perspectives, organizations are meant to come up with key performance indicators (KPIs),
objectives, and targets they want to hit. There is also usually a data mining aspect as well, in which the
organization selects the exact data they want to have tracked and reported on.

ADVANTAGES:
1) Brings structure to business strategy, also provides a visual picture of strategy
2) Makes communication easier
3) Facilitates better alignment
4) Connect the individual worker to organizational goals

DISADVANTAGES
1) It must be tailored to the organization
2) It needs buy-in from leadership to be successful
3) It can get complicated  expensive and time consuming
4) It requires a lot of data
 If there are to many different objectives/performance measures, it is difficult for managers to know where to put
their efforts and focus

35
 Marr, B. et al (2003). Why do firms measure their intellectual capital? Journal of Intellectual Capital
USE if: If INTEGRATE non-financial metrics
Intro: A lot of research has focused on measuring and
reporting IC  but articles that have focused on the
measurement of IC differ in their reasons as to why
organizations should measure their IC
= The aim of this study is to shed light onto this
complex field, by segregating and explaining the
different rationales for the measurement of IC. (p. 442)
 A literature review enabled the authors to identify a
set of reasons that drive the measurement of IC:
” Those reasons include those that help develop, monitor or
manage a business from an internal perspective, as well as
externally driven reasons which focus on the ability to
communicate measures and results to external stakeholders.”
(p. 442).
Findings:
(1) a taxonomy of drivers as to why organizations measure
their IC;
(2) improved understanding of whether the extant research
lends any credence to the thesis that measuring IC delivers
business benefits; and
(3) finally recommendations as to a future research agenda.
Introduction:
 The research and published literature on measuring and
reporting intellectual capital (IC) is growing rapidly
 The literature in the area of IC measurement and the
number of measurement frameworks is continuously growing
as researchers attempt to develop metrics that inform strategy
formulation and implementation, improve disclosure,
benchmark performance, and predict future business
performance.
Five main reasons to why organizations are seeking to
measure IC:
(1) to help organizations formulate their strategy;
(2) assess strategy execution;
(3) assist in diversification and expansion decisions;
(4) use these as a basis for compensation; and finally
(5) to communicate measures to external stakeholders.
Conclusion:
In summary there is much stage 1 (building theories/raising
awareness) research and little stage 2 (theory testing).
 To date, we can be assured that awareness has been
achieved and academics as well as practitioners agree that IC
plays an important role in today’s organizations.
 The authors feel that the field of IC could run into danger
of losing credibility if researchers fail to produce more
research that tests the theories put forward, rather then further
adding to the large body of literature of theoretical
discussions and theory building

Marr (2003): Overview of IC tools, and how it evolved.

Interesting paper.

In the paper by Marr et al. (2003) the authors

Critique Balanced Scorecard: “However, correlations between measures have rarely been empirically proven and some
critics even doubt the assumption of causalities in widely implemented measurement systems such as the Balanced Scorecard
(Norreklit, 2000).” (p. 446).

Mouritsen, J. & H. T. Larsen (2005). The 2nd wave of knowledge management: The management control of knowledge
resources through intellectual capital formation.
USE IF: Danish model Introduction: The purpose of this paper is to analyse the
difficult, new, complex, ‘people-centred’, ‘fuzzy’ and

36
 intangible resource ‘knowledge’ in a management control
Intro: Through the 1990s, knowledge has become a phenomenon perspective and discuss how it is made manageable – how is
to be managed and intellectual capital information has been it a resource that managers develop, influence and orient
suggested to be medium for this ambition. towards corporate purposes?

The authors: In this paper, we propose a method to analyse (and

design) intellectual capital information so that it can be an input to
the management of knowledge resources. We use a distinction
between 1st and 2nd wave knowledge management to illustrate two
possible objects of knowledge management: the creative individual
and the network of knowledge resources. We suggest that
intellectual capital information is related to the management control
of knowledge resources where knowledge resources are related to
questions about economising, organising and modularising them. In
effect, intellectual capital information sees knowledge resources
from a management control perspective.
Mouritsen & Larsen (2005) is based on the Coloplast
example, shows how this was implemented. Interesting
because it gives the idea of knowledge management,
and what it means to have employees with
competences -what if they leave the company. How the
original japaneese literature

Mouritsen & Larsen (2005)

Busco, C. et al (2014). Leading Practices in Integrated Reporting, Strategic Finance, September

2014
USE: Sustainability focus + IR
Intro: Integrated Reporting (IR) is making the leap from
promising concept to powerful practice.
The authors provide a framework for Integrated Reporting
combined with Integrated Thinking.
The IIRC Integrated Reporting Framework:
Integrated Reporting results in a periodic, concise integrated report about
how an organization’s strategy, governance, performance, and prospects—in
the context of its external environment—lead to the creation of value in the
short, medium, and long term
 An IR is designed to benefit all stakeholders – including
employees, customers, suppliers, business part- ners, local communities,
regulators, and policy makers— interested in an organization’s ability to
create value over time.
The key objective of IR is to enhance accountability and stewardship with
respect to the broad base of tangible and intangible capitals and promote
understanding of their interdependencies.
Introduction:
 Competitiveness and sustainable growth are
fundamental goals for organizations
 But a paradigm shift is required if businesses intend to
contribute toward a more sustainable society. This change
calls for the introduction of an innovative perspective of
integrated management that’s able to combine multiple
dimensions of analysis and sustain—in practice—the
ongoing search for competitiveness.
A solution could be a combination of Integrated
Thinking and Integrated reporting:
 Integrated Thinking marks a change in the way in
which companies envisage, design, and run their business.
In parallel, IR provides an opportunity to understand
and question the business holistically: looking beyond the
financial representation to include an overview of
strategies, operations, risks and opportunities, future
outlook, governance, and more.

37
Representing value creation as capitals sengage with the company Financial capital
business model
The fundamental concepts of IR are represented by the capitals that an
organization uses and affects, as well as the process of creating value over
Manufacture capital
time. That value is embodied in the capitals—sometimes also referred to as
resources and relationships. Intellectual capital

As illustrated in the IR Framework, organizations depend on six different Human capital

types of capitals, which are stores of value that, in one form or another,
become inputs to an organization’s business model. They are: financial,
Social and relationship capital
manufactured, intellectual, human, social and relationship, and natural. The
IR Framework doesn’t require organizations to adopt them, so they should
be used as a benchmark to ensure an organization doesn’t overlook a capital Natural capital
that it uses or affects.
Busco et al. (2004) suggest the innovative combination of Integrated Thinking and Integrated Reporting in order to
contribute toward a more sustainable society while searching for competitiveness.

”One major difference between the BSC and ”IR” is there is no mention of natural capital in the BSC. The
environment is part of corporate governance in typical BSC strategy map (see Figure 1), but it is somewhat hidden”
(Massingham, 2019).

COMMENT: Busco et al (2014): Integrated reporting, interesting if also sustainability --> aims at integrating IC,
financial reporting and also sustainability reporting. Future of reporting.

NB: Moreover, I would mention the Intellectual capital literature as it is critical for the issue of
integrating non-financial metrics.

Balanced Score card:

38
The balance scorecard can be critized for its deviation from a single financial measure, e.g.
ROI or EVA, and instead focuses on the an array of measures of the balanced scorecard
which may cause management to reduce firm value.

39
 5. Management Accounting in a Changing Environment (CP)
Zimmerman, J. L. (2017). Accounting for Decision Making and Control, New York: McGraw Hill, Chapter 14.
Introduction:
 Many books on how to make organizations function
better with organizational innovations such as benchmarking, six
sigma, total quality management, reengineering, lean manufacturing,
the virtual corporation, downsizing, brainstorming, and corporate
culture

 Previous chapters of this book described and analyzed

management accounting sys- tems. Besides being used for both
decision making and control, these accounting systems support
external reporting for shareholders, taxes, and government
regulations.
 Thus, one of the central themes of this text is that trade-offs arise
when the accounting system is designed for multiple purposes.

= This book reinforces the importance of viewing the accounting

system as part of the firm’s organizational architecture.

A. Integrative Framework
 But with firms come agency problems because the employees
tend to care more about their own personal welfare than about the
owners’ welfare. Organizational architectures arise to control these
agency costs: Decision rights are partitioned and performance is
evaluated and rewarded. A critical task is linking the decision rights
with the knowledge required to make the decision. It may be easier to
transfer the decision rights to the person with the knowledge than to
transfer knowledge to the person with the decision rights.

See Figure 14.1 for overview of the determinants of

business strategy, organizational architecture, and firm
value
1. Organizational Architecture
 DECISION RIGHTS PARTITIONING
In order to make decisions (for either decision management or
control), managers require information.
 One would expect the information used for ratifying and
monitoring (control) to be qualitatively different from the information
used in initiation and imple- mentation (management). Decision
control information is likely to be more aggregate, less detailed, less
Figure 14.1
3. Environmental and Competitive Forces Affecting
Organizations
 the firm’s business strategy depends on technological
innovations and changes in market conditions
 A similar chain reaction is set off when market conditions
change. Increased global competition has forced many firms that
once enjoyed protected domestic markets to become more cost
competitiv
 Market conditions change for a variety of reasons, including
changes in government regulations and taxation policies
4. Implications
 Successful firms (and managers) will be those who adapt
quickly to changing markets and technologies. New profitable
investments will appear and some previously profitable
investments will become unprofitable. Successfully
implementing profitable projects requires organizational

40
timely, and less under the control of the manager being monitored
than is decision management information
 Whether decision rights are assigned higher up or lower down in
an organization is referred to as centralization–decentralization.
 Performance evaluation system
 which includes the accounting system. Besides using accounting-
based measures of performance, firms also develop nonaccounting-
based measures: the firm’s stock price, customer complaints, quality,
and percentage of deliveries on time.
 Performance reward system; compensation and
promotion policies
2. Business Strategy
 Each firm faces different investment opportunities, which are the
investment projects available to the firm today and in the future.1 The
investment projects available to and selected by the firm comprise its
business strategy.
 Business strategy affects the firm’s organizational architecture
because it determines the firm’s asset structure, its customer base, and
the nature of knowledge creation and dissemination within the firm.
 NOTICE TWO-WAY ARROW
B. Organizational Innovations and
Management Accounting
1. Total Quality Management (TQM)
 Quality is a major issue in both the profit and nonprofit sectors of
the economy.
 TQM seeks to improve all aspects of the company: its products,
processes, and services.
 While quality can be measured in many ways, the two most
common methods involve meeting customer expectations and
reducing defects. + MORE IF QUALITY IS FOCUS
2. Just-in-Time (JIT) Production
 In a JIT plant, production and demand are synchronized because
production does not start until an order is received. Products are
pulled through the plant by customer orders, rather than pushed
through by a master production schedule designed to keep the plant
operating at full capacity.
 Throughput time is the total time from when a product starts the
production process until it is ready for sale.
 BENEFITS + MORE IF QUALITY/production IS FOCUS
3. Six Sigma and Lean Production
 In the late 1990s and 2000s, six sigma came to replace TQM.
 Six sigma is a set of practices, first popularized by Motorola, to
systematically improve internal processes by eliminating defects and
hence the quality of products and services. The term “six sigma”
refers to the ability to produce products at defect levels below about
41
architectures that link decision rights and knowledge and that
create incentives for managers to use their knowledge to take
actions that capture the value in the investments undertaken.
 Senior managers are constantly trying to adapt to these
external shocks by modifying their business strategy and
organizational architecture
Three important implications:
1) First, before implementing an accounting or other
organizational change, it is important to understand what is
driving the change.
2) Second, a new accounting system should not be adopted
merely because other firms are doing so; they may be reacting to
a different set of external shocks.
3) Third, an accounting system should not be changed without
concurrent, consistent changes in the way decision rights are
partitioned, as well as in the perfor- mance reward systems. All
three parts of the organization’s architecture must be internally
consistent and coordinated.
4. Balanced Scorecard
 A balanced scorecard translates the strategy into a plan of
action that identifies specific objectives and performance drivers
to help determine if the organization is moving in the right
direction.
 In terms of Figure 14–1, the balanced scorecard is designed to
identify those key performance indicators used to focus
employees on those actions required to implement the firm’s
strategy.
 Most balanced scorecards combine both decision
management and decision control. Decision management is
provided by identifying the sequence of objectives and the key
performance indicators that allow the organization to achieve its
goals. The balanced scorecard also provides decision control by
establishing performance measures and targets for each objective.
It articulates the strategy of the organization and communicates
this strategy in a commonly understood language.
 SHORT TERM VS LONG TERM:
Many observers of corporate culture lament the emphasis on
short-term performance measures in corpora- tions. Quarterly
earnings announcements appear to have undue influence on the
actions of the managers of a corporation. Focusing on short-term
performance measures can reduce the value of the organization
because of a reluctance to invest in activities that benefit the
organization in the long run
 Examples: R&D, plant maintenance, employee training are
examples of expenditures that harm the short-term financial
measures, but benefit the organization in the long run.
 Assessing the balanced scorecard NB. P. 629.
three defects per million. + Lean production !!!
C. When Should the Internal Accounting
System Be Changed?
 There is no single ideal management accounting system.
 Because each firm has a unique business strategy, no two firms
will share the same organizational architecture or have the same
management accounting system. + INCLUDING TRADE-offs
Changing environment! Because firms are in a constant state of
flux, the accounting system must evolve
Sign that the internal accounting system is not
working well:
 One sign is dysfunctional behavior on the part of managers
because of poorly chosen performance measures. Managers will make
decisions to positively influence performance measures. If those
performance measures are not consistent with the goals of the
organiza- tion, management will make decisions that do not further
the organization’s goals.
 Another sign of problems with the accounting system is poor
operating decisions. If product mix and pricing decisions based on
management accounting are not adding to firm value, then the
accounting system is either providing inaccurate estimates of
opportunity costs and/or creating dysfunctional incentives.
Each organization must continually evaluate and improve its
management accounting system to meet the challenges of a changing
environment and a changing organization.
Zimmerman (2017)
Figge, F. et. al. (2002). The Sustainability Balanced Scorecard. Linking sustainability management to business strategy
42
COMMENT:
Zimmerman, chapter 14: Started from TQM, JIT
(basis of Lean production) and to BSC. Important
elements that are quite old/basic. But companies
build on these.
(NB: Definitions Glossary p. 680)
Six Sigma. A structured management approach that identifies
potential projects throughout the organization and then defines
the process improvement goals, measures the current process and
collects relevant data, analyzes the causal factors, determines that
all factors have been con- sidered, improves the process based
upon the analysis, and controls any variances before they result
in defects.
Throughput Time. The total time from when a prod- uct starts the
production process until it is ready for sale, including processing
time, time waiting to be moved or worked on, time spent in
transit, and inspection time. Also called cycle time.
Total Quality Management (TQM). A philosophy of continually
lowering costs and improving the provision of services and
products to customers.
SUMMARY:
 This text has emphasized the dual role of internal accounting
systems for decision making and control. Because the internal
accounting system is performing two separate roles (it is also
being used for taxes and financial reporting), trade-offs between
these roles must be made.
 In its decision-making role, the accounting system is the first
place managers turn to for help in estimating opportunity costs.
 However, accounting numbers are not forward-looking
opportunity costs. Accounting systems record historical costs,
which are backward looking.
Intro: The Balanced Scorecard of Kaplan and
Norton is a management tool that supports the
successful implementation of corporate
strategies.
The balanced scorecard: By linking operational and
non-financial corporate activities with causal
chains to the firm’s long-term strategy, the
Balanced Scorecard supports the alignment and
management of all corporate activities according
to their strategic relevance.
 The Balanced Scorecard makes it possible to
take into account non-monetary strategic success
factors that significantly impact the economic
success of a business
Main point: The Balanced Scorecard is thus a
promising starting-point to also incorporate
environmental and social aspects into the main
management system of a firm.
 This mix helps to overcome the shortcomings
of conventional approaches to environmental and
social management systems by integrating the
three pillars of sustainability into a single and
overarching strategic management tool.
The balanced scorecard approach
 The concept of the BSC is based on the assumption
that the efficient use of investment capital is no longer
the sole determinant for competitive advantages, but
increasingly soft factors such as intellectual capital,
knowledge creation or excellent customer orientation
become more important.
 As a reaction Kaplan and Norton suggested a new
performance measurement approach that focuses on
corporate strategy in four perspectives
 This BSC aims to make the contribution and the
transformation of soft factors and intangible assets
into long-term financial success explicit and thus
controllable.
 The purpose of a BSC is to formulate a hierarchic
system of strategic objectives in the four perspectives,
43
Introduction:
With the growing importance of environmental and
social issues many companies have implemented specific
environmental or social management systems during the
last decade. These systems have, however, rarely been
integrated with the general management system of a
firm.
 Thus, If firms are to achieve simultaneous
improvements of the economic, environmental and social
per- formance of businesses (strong contributions to
sustainability; Figge et al., 2001b), this lack of integration
turns out to be a major obstacle.
BSC: The Balanced Scorecard as a strategic management
tool claims to identify the major strategically relevant
issues of a business and to describe and depict the causal
contribution of those issues that contribute to a success-
ful achievement of a firm’s strategy
 Thus the BSC would be a good way to integrate
environmental and social management into the
general management of the firm
= CONCLUSION: Overall the SBSC provides a strong
tool for an integrated sustainability management. It helps
significantly to overcome the short- comings of the often
parallel approaches of environmental, social and
economic manage- ment systems implemented in the
past.
Different possible approaches of integrating
environmental and social aspects: Three options:
1) First, environmental and social aspects can be
integrated in the existing four standard perspectives.
 Environmental and social aspects can be subsumed
under the four existing BSC perspectives like all other
potential strategically relevant aspects  adding
environmental dimensions to the perspective, see
example such as environmental customer segment
2) Second, an additional perspective can be added to
take environmental and social aspects into account.
 The necessity for an additional non-market
perspective arises when environmental or social aspects
that cannot be reflected according to their strategic
relevance within the four standard BSC perspectives at
derived from the business strategy and aligned
towards the financial perspective. Based on such a
causal system of objectives, corresponding measures
are formulated in all four perspectives. Kaplan and
Norton basically distinguish between lagging and
leading indicators
Lagging indicators and long-term strategic objectives
are formulated for the strategic core issues of each
perspective derived from the strategy of the business
unit. Lagging indicators thus indicate whether the
strategic objectives in each perspective were achieved.
In contrast to the lagging indicators, the leading
indicators are very firm specific. They express the
specific competitive advantages of the firm and
represent how the results – reflected by the lagging
indicators – should be achieved. Based on the specific
strategy of the business unit, the key performance
drivers that have the greatest influence on the
achievement of the core strategic objectives (measured
by lagging indicators) are identified for every
perspective.
Finally: This enables an orientation of all business
resources and activities towards the conversion of the
strategy and a better communication of the strategy.
*MORE*
The process of formulating a sustainability balanced
scorecard:
The process has to meet these basic requirements:
1) Integration into business management
2) The process has to ensure that the SBSC formulated
is business unit specific
3) The environmental and social aspects must be
integrated according to their strategic relevance.
44
the same time significantly influence the firm’s success
from outside the market system.
3) Third, a specific environmental and/or social
scorecard can be formulated
 At this point, it is very important to note that a
derived environmental or social scorecard cannot be
developed parallel to the conventional scorecard
 THEREFORE, this not an independent alternative for
integration, but only an extension of the two above
variants
Difference between the two first: the difference lies
mainly in the characteristics of the strategically relevant
environmental and social aspects.
1) For those strategically relevant environmental or social
aspects that are already integrated in the market system
(e.g. environmental costs), it is fairly straightforward to
integrate them by means of appropriate leading or
lagging indicators into one of the four conventional
perspectives.
2) In contrast, if environmental and social aspects exert
their strategically relevant influence via mechanisms
acting in the firm’s non-market environment (e.g.
complaints of neighbour groups), then an additional,
non- market perspective is necessary.
If option no 2 : an additional non-market perspective: ”
We propose two fundamental conditions for the
introduction of an additional non-market perspective. In
order to justify the addition of a non- market perspective
(i) environmental and social aspects have to be
strategically relevant, i.e. they are either strategic core
aspects or performance drivers and (ii) it is not possible to
include these aspects appropriately, i.e. according to their
strategic relevance, into the four conventional
perspectives of the BSC (Figge et al., 2001a, 2001b). ”
Step 3: Strategic relevance, three stages
1) Aspects can represent strategic core issues, for which
lagging indicators have to be defined.
2) Performance drivers as represented by leading
indicators show how the results in each perspective,
reflected by the lagging indicators, are to be achieved.
3) Finally, environmental or social issues can also
represent hygienic factors, reflected by diagnostic
 indicators  Though these are not part of the BSC.

- REMEMBER: Therefore, every time one moves from

an upper level perspective to the next lower level
The result of the process of formulating an SBSC can be
perspective in the cascade it has to be ensured that
shown graphically by using a strategy map (Kaplan and
and shown explicitly how the lower level strategic
Norton, 2001).
core aspects and performance drivers contribute to
the achievement of the objectives in the higher level
perspective(s).
 This serves to establish the hierarchic cause-and-
effect chains that link all strategically relevant aspects
to the successful execution of the strategy
 The non-market perspective acts as a frame that
embeds the other perspectives.

Figge et al. (2002) argue that a lack of integration of environmental and social issues can turn into a major obstacle.

NB: Use Figge et al. to describe the BSC!!

”Kaplan and Norton also point out that the firm-specific formulation of a BSC may involve a renaming or adding
of perspectives (Kaplan and Norton, 1997, p. 33).”  Environmental and social perspective, could be a firm-
specific

COMMENT: Figge et al. (2002): BSC can be used to measure the IC and also the sustainability, how it can actually
be adapted.

Jordan, S. & Messner, M. (2012). Enabling control and the problem of incomplete performance indicators
USE: Performance indicators; both to measure Introduction:
Performance indicators are nowadays in widespread use in all kinds of organisations.
At times, they are com- bined to form integrated measurement systems which appear

45
performance but also as enablement of control
Intro: To which extent do managers care about the design characteristics
of performance indicators and other control systems?
This study: The paper examines this question with the help of the
framework of enabling and coercive control. Drawing upon data from a
longitudinal field study in a manufacturing organisation, we study
operational managers’ attitudes towards the incompleteness of performance
indicators.
Results: Managers are likely to perceive performance indicators as
enabling if the latter facilitate their actions without unduly constraining
them. This is true even for incomplete performance indicators as long as
managers can handle these indicators in a flexible way, treating them as
means rather than ends when carrying out their work. Our case also shows,
however, how a flexible use of indicators becomes more difficult to sustain
once top management signals an increased importance of the indicators.
Incompleteness then becomes a more pressing concern for managers. We
illuminate the various forms of top management sense-giving through
which such tightening of control is achieved and we show how they
translate into managers’ perception of the control system as being a
coercive rather than enabling one. Taken together, the findings of the
present paper add to our understanding of enabling and coercive forms of
control and also extend previous studies that have addressed the problem of
incomplete accounting information.
Conclusion:
 Performance indicators are used in many organisations to control and facilitate
managers’ decisions and actions. Not much is known, however, about the extent to
which managers actually care about the design characteristics of such indicators.
This paper focuses on this question and examines managers’ responses to
performance indicators when these are perceived as incomplete. It finds that such
incompleteness does not necessarily constitute a ‘‘problem’’ in the eyes of
managers. As long as a flexible handling of the control system is possible, such a
system can still be regarded as enabling despite its perceived incompleteness.
However, managers’ attitudes may change over time. More specifically, it reports
an increasing concern with the design of the control system in the case organisation
Jordan and Messner (2012)
Otley, D. (1999). Performance management: a framework for management control systems research
Intro: This paper proposes a framework for analysing the operation of A Framework for Performance Management (research) (Otley, 1999)
management control systems structured around five central issues. These
issues relate to objectives, strategies and plans for their attainment, target-
setting, incentive and reward structures and information feedback loops.
46
in the form of scorecards, dashboards, or measures trees (Kaplan & Norton).
 While the qualities and design characteristics of performance indicators, such as
their degree of completeness, accuracy, or precision, have been discussed in the
academic literature relatively little seems to be known about managers’ attitudes
towards the design characteristics of indicators.
NB: Accounting information – even if available in detailed form – provides only
for a limited understanding and handling of the complexity of organisa- tional life
and managers therefore tend not to rely ‘‘blindly’’ on such information.
Acknowledging that performance indicators can be used both to facilitate operational
managers’ activities and to allow for top management control, we examine in this
paper how operational managers’ attitudes towards performance indicators may
change over time and in response to a change in top management control.
Enabling and coercive control
 Managers reaction to the introduction of formal control
systems: According to these authors, formal systems will be re- ceived positively
if managers feel that the systems enable them to better master their work tasks. If, in
contrast, man- agers feel that formalisation is an attempt by top manage- ment to
coerce managers’ effort and compliance, then formal systems tend to be perceived in
a negative way.
Incompleteness and enabling control
 It is well established in the literature that accounting information usually does
not capture all the dimensions of performance considered relevant for an
organisation or manager
Jordan & Messner: Not easy to read, but give a good
basis to argue to what it means to have incomplete
performance measures. Enabling or constraining? Does
it motivate or the opposite? How these links to the
managers and top managers. Good elements to use in
arguments!
1) What are the key objectives that are central to the organization's overall
future success, and how does it go about evaluating its achievement for
each of these objectives? = OBJECTIVES
Their central focus is on the management of organizational performance.
Because the framework has been inductively developed, its application is
‘tested’ against three major systems of organizational control, namely
budgeting, economic value added and the balanced scorecard. In each
case, neglected areas of development are exposed and fruitful topics for
research identified. It is believed that the framework can usefully be
developed further by its use in analysing other instances of management
control systems practice, and that case- based, longitudinal studies provide
the best route to this end.
Introduction:
 Management accounting has tended to restrict itself to
considering only financial performance, and to use frameworks
and theories drawn primarily from the discipline of economics.
 Behavioural aspects of management accounting =
development of agency theory
The intention of this paper is to provide a perspective more
focused on the operation of overall control systems, and to do so
by looking beyond the measurement of performance to the
management of performance.
Management control systems
Management control systems provide information that is intended
to be useful to managers in performing their jobs and to assist
organizations in developing and maintaining viable patterns of
behaviour.
 Accounting measurement was stressed and non-financial
performance mea- sures were neglected.
The performance management framework
 It will be argued that there are five main sets of issues that
need to be addressed in developing a framework for managing
organizational performance that are represented as a set of
questions:
 (Organizations need to continually develop new
answers to them; this is because the context in which
the organization is set is constantly changing and new
strategies need to be develop to cope with new
operating environments”:
Economic value added (EVA)
 The first is a purely financial performance measure, Economic
Value Added [EVATM],I6 which it is argued can avoid some of the
performance measurement problems currently experi- enced with
other financial performance measures.
 Is an overall measure of financial performance that is
intended to focus managers’ minds on the delivery of
shareholder value
 As is well known, most measures of financial performance,
such as profit or return on investment, suffer from inherent defects
that may cause dysfunctional decision-making on the part of
managers.
 EVA is a little more than a new acronym for
residual income
47
2) What strategies and plans has the organization adopted and what are
the processes and activities that it has decided will be required for it to
successfully implement these? How does it assess the performance of
these activities? = STRATEGIES AND PLANS
3) What level of performance does the organization need to achieve in
each of the areas defined in the above two questions, and how does it go
about setting appropriate performance targets for them? = TARGETS
4) What rewards will managers (and other employees) gain by achieving
these performance targets (or, conversely, what penalties will they suffer
by failing to achieve them)? = REWARDS
5) What are the information flows (feedback and feed-forward loops) that
are necessary to enable the organization to learn from its experience, and
to adapt its current behaviour in the light of that experience? = FEEDBACK
Budgeting
 Budgeting has traditionally been a central plank of most
organizations’ control mechanisms, as it is one of the few techniques
capable of integrating the whole gamut of organizational activity
into a single coherent summary.
 NB COST CENTERS p. 370
 The budget focuses only on financial results and, worse, does not
necessarily pay sufficient attention to the means by which those
results are to be achieved.
= The process still represents the central coordinating
mechanism that most organizations have; it does not
need to be discarded lightyly, instead key areas must be
addressed
 See specific questions: e.g. better tied to achievement
of strategic goals, how to avoid distorting etc.
 The performance management framework thus flags up some
vital issues for studying and revising budgetary practice.
The balanced scorecard approach
Multi-dimensional approach to performance
measurement and management that is linked
specifically to organizational strategy;
 It suggests that as well as financial measures of performance)
attention should be paid to the requirements of customers, business
processes and longer-term sustainability
 A major strength of the balanced scorecard approach is the
emphasis it places on linking performance measures with business
unit strategy.
 From the perspective of this paper, the Balanced Scorecard
approach is clearly a stakeholder approach, and this represents one
of its major advantages.
 Reward structures are another major focus of the EVA
approach; The reason for using this method is explicitly
motivational and designed to avoid potentially dysfunctional short-
term behaviour. Stern Stewart thus recognize the potential
dysfunctional effects of short-term performance targets coupled
too closely to financial rewards, and have developed a scheme to
reduce the worst such effects.
= The EVA literature is therefore a good example of the
performance manage- ment framework being used in practice,
albeit to just a single over-arching measure of financial
performance.
 In summary, the approach has been well worked through, and
represents one of the most coherent performance management
systems currently on offer. Nevertheless, even under its own
assumptions concerning organizational objectives, it is clearly not
as comprehensive as it claims, and is particularly weak in
measuring and monitoring the means by which managers have
adopted to achieve their overall objectives.
 The topic of setting performance targets is not much discussed in
the balanced scorecard literature; Therefore, it does not specify how
trade-offs are to be made between the difference measures used.
= What becomes evident from this analysis is that the balanced
score- card is clearly a dynamic tool, the contents of which will
change over time as strategies develop and key success factors
change
 Lastly, this approach also makes it clear that the scorecard does
not stand in isolation; rather, it is underpinned by the traditional
measurement systems present in all organizations.
LINK TO SIMONS = ”Perhaps the scorecard can be seen as an
embodiment of Simon’s (1995) interactive control systems; that is, it
reports those measures which senior managers have decided should
be emphasized for a period of time.” (p. 376)
 The balanced scorecard is designed to be at the centre of an
organization’s control mechanisms to effectively deploy strategy
and to link operational practices with strategic intent. However, it
cannot stand alone and its links with more traditional control
systems need to be reviewed. + TRADITIONAL CONTROL IS
NEEDED

The Balanced Scorecard is thus a potentially powerful tool by which

senior mangers can be encouraged to address the fundamental issue
of effectively deploying an organization’s strategic intent.
Discussion:

See comparison of all three on p. 378

 A complete control system involves each of the five elements

identified both separately and in combination. Weaknesses in one
area can be, at least partly, compensated for by strengths in other
areas.

Conclusion: Although individual techniques of management

accounting and control have been studied individually within a
restricted context, they need also to be studied as part of a wider
organizational control system. The use of management accounting
and control systems can be fruitfully analysed from the framework
of performance measurement and performance management.

”As Otley (1999) points out, the new challenge in management control is the transition from measurement to management,
and a wholly parallel concern can be raised in relation to the measurements of knowledge found in intellectual capital
statements. How are they part of management control processes?” (Mouritsen & Larsen, 2005, p. 372).

”This agenda parallels Otley’s (1994, 1999, p. 364) suggestion that management control researchers should start ‘looking
beyond the measurement of performance to the management of performance’.” (M&L, 2005, p. 372)

48
COMMENT: Otley (1999): Milestone - compare different frameworks. Pros and cons of all of them, use them in
combination, gives you practical elements you can use to comment on these models.

Positive elements of financial indicators: SEE OTHER PEER EXAMPLES

Negative elements of financial indicator:
Why one should integrate non-financial metrics:

 “you argue that financial measures are defined by accountants and non financial measures are
usually self reported. Please be careful with this argument as this may be not correct if you don't
explain it fully. Moreover, you suggest that financial measures are less prone to the risk of
managerial discretion. I would argue that this is not incorrect, but it is also not always the case - you
can see this if you integrate the course texbook with the articles from the Syllabus: e.g. Merchant,
K. A. & Shields (1993). and Jordan, S. & Messner, M. (2012).”

CHAPTER 14: Zimmerman answers to cases:

14. SELF STUDY Example: Quality assurance programs  Six sigma

a. Prepare a cost-of-quality report that classifies each expense as being in one of four categories: appraisal, prevention, internal
failure, or external failure.
b. What conclusions can you draw from the data presented about Gilbert Foods’s six sigma program?

Q14–1: The firm’s business strategy is all the investment projects available to the firm today and into the future. The
business strategy arises from the nature of the business the firm is in and the amount and type of spending on R&D.

Q14–2: Business strategy affects the organizational structure in three ways. The types of investments affect the way
specialized knowledge is created and thus how decision rights are partitioned. The investments affect the physical asset

49
structure and how the firm must be organized for decision making and control of these assets. Finally, the investments
affect the type and nature of the customer base, which again causes the firm to adopt organizational structures to service
this customer base.
The organizational structure in turn affects the business strategy. The ability of the firm to generate profitable
investment ideas and implement them requires an organizational structure with incentives and controls conducive to
maximizing firm value.

Q14–3: Technological and market structure changes cause firms’ investment opportunities (strategy) to change. Some
previously profitable projects disappear and new profitable projects emerge. These changes in investment opportunities
prompt changes in organizational architecture.

Q14–4: Maybe. Other firms adopting organizational changes are often reacting to a change in either technology or
market conditions. Such changes should cause management to reexamine its firm’s policies. But to simply mimic the
other changes is not a good idea. Other firms have different investment opportunities and different organizational
architectures. They may be changing organizational policies not because of some change in technology or market
condition but because they realized their old system could be improved. Also, sometimes managers make mistakes and
adopt value-reducing organizational changes, which should certainly not be mimicked.

Q14–5:
a. High mean (e.g., Rolls-Royce versus Toyota).
b. Low variance (McDonald’s hamburgers versus local diner).
c. Larger number of options.
d. Meeting customer expectations.

Q14–6:
a. Knowledge of customer expectations.
b. Measures of actual realized value.
c. Weights to combine the various deviations from expectations.

Q14–7:

1. Prevention costs—incurred to eliminate defective units before they are produced.

2. Inspection costs—incurred to eliminate defective units before they are shipped.
3. Scrap/waste costs—the costs of defective units in manufacturing.
4. Failure costs—costs of returns, costs of warranty work, and opportunity cost of lost sales from reputation
effects.

50
Q14–8: JIT takes on many aspects of a process costing system; there are no batches or discrete jobs. Instead, separate
accounts, labor, and overhead are charged to a conversion costs account, and materials costs are charged to products.
Finished goods inventory is charged for conversion costs and for materials as units are completed. The materials charge
for completed units is backflushed, reducing the raw and in-process inventory account.

Q14–9: Decreasing throughputs has some dysfunctional aspects. Increased costs are incurred in factory redesign, setup
time reduction, and JIT delivery of raw material. Accounting systems focused on throughput time do not charge
managers for these costs. Consequently, managers measured on throughput will do things that may decrease throughput
but at the expense of firm profits.

Q14–10: The balanced scorecard seeks to better link the boxes in Figure 14–1 on business strategy and the performance
evaluation system. A balanced scorecard translates the strategy into a plan of action that identifies specific objectives
and performance drivers to help determine if the organization is moving in the right direction.

Q14–11: Balanced scorecards can be useful if they cause managers to identify the underlying value drivers that create
firm value and communicate these inside the firm. However, balanced scorecards have several drawbacks. First,
balanced scorecards ignore changes in other parts of the firm’s organizational architecture, such as decision rights
assignments and compensation plans. Changing just one leg of the three-legged stool can create dysfunctional results.
Second, telling managers to simultaneously maximize 20 balanced scorecard indicators provides no guidance as to the
relative trade-off among the indicators. It is an impossible task. You can only maximize one variable at a time. Third, if
their pay is based on multiple metrics, managers will choose those measures that are easiest to achieve and ignore more
difficult tasks. Fourth, by giving managers multiple criteria for measuring their success, the balanced scorecard reduces
their accountability for destroying shareholder value.

51
 6. Strategic Investment and Finance (CP)
The aim of the lecture is to introduce students to investment theory and discounting. Moreover,
this lecture will present the limitations of the traditional investment model and to discuss the
inclusion of strategic and dynamic perspectives in the investment calculations with a specific focus
on real options.

Hedegaard, O. & Hedegaard, M. (2015). Strategic Investment and Finance, DJØF Publishing Copenhagen, Chapters 1, 2, 3 and 4.
Chapter 1: Introduction to investment theory The objective of strategic investments: The
FOCUS: The meaning of capital budgeting and investment analysis
Intro: “In the business world, investments made are strategic decisions
which should add value, improve the company’s competitive position, and
maximize shareholders value. Strategic investment and capital budgeting
are critical to a corporation’s success and form an integral part of strategic
business planning and market positioning. This is because the analysis of
investment opportunities impacts most of the strategic business decision
which companies undertake” (p. 1)
Investments encompass an array of business decisions: from expansion of
production capacity, to development of new technologies, entrance into
new markets, mergers and acquisitions, investments in cost-saving
equipment, and others.
purpose is to add value to a company so that it achieves its
goals and increases shareholder wealth.
 Therefore, investments must be evaluated based on their
ability to generative positive future cash flows.
 HOWEVER, these are difficult to estimate on their own
(chapter 7), there’s no guarantee the project will progress as
planned, additionally, the company’s overall objectives will
be influenced by the demands of its various stakeholders,
making decision making even more complicated
= These stakeholders can have different
objectives as well as use different criteria to
evaluate

Focus of this book is on real strategic corporate investment in capital asset

projects, e.g., development of new products, new production equipment or
expansion into new markets.
 These come from the identification of investment opportunities, idea and
discussions within a company = Therefore, they are a combination of
creativity, business strategy, and investment calculations.

Investment projects can be classified in many ways:

- Replacement (to replace obsolete equipment)
- Cost reduction (to lower production costs by training employees,
replacing old equipment, or relocating production facilities to areas where
labor and raw materials are cheaper)
- Capacity expansion (to meet increased demand for the company’s
products)
- New product introduction and market expansion (to develop, produce, and
sell new product and/or enter new markets
- Government regulation (to comply with government requirements such as
health and safety regulations, environmental standards, or other legal
requirements)
- Welfare or social responsibility (to improve employees welfare or address
the social responsibility aspects of a company’s operations)
- Synergies (to achieve synergies on markets, in operations or through
knowledge sharing)
 Investments differ great in terms of risk and the amount of information
available prior to committing funds. There is a trade-off between
comprehensive investment analysis and higher evaluation costs = if routine
or if risky/costly investment the greater need for a comprehensive financial
analysis and complete info
Investment analysis
“Shareholders value is increased when an investment’s
expected future cash flows after being discounted back to
the present, exceed the initial cash outflow” (p. 3)
 Investment analysis therefore involves the estimating of
future cash flows over time and then discounting them back
to the investment’s starting point. This raises two
fundamental issues:
1) How to spread the cash flows properly over time,
and
2) How to make these cash flows comparable to each
other
Visualize expected future cash flows:

Another distinction: Interaction with other company initiatives 

52
independent investments can be accepted or rejected without regard to
others
 mutually exclusive investments – when one exclusive another
 contingent investments – when one is dependent upon a previous one
being undertaken
DEFINITIONS:
Investments are a series of cash flows which begin with cash outflows and
are followed by net cash inflows.
Financing is just the opposite; it has cash inflows followed by net cash
outflows, which typically take the form of interest and instalment payments.
Chapter 2: Discounting: Discounting is a finance tool which is used to
make cash flows generated at different points in time comparable to one
another = we need a discounting rate that reflects the cost of capital =
normally referred to as I,
 e.g., Interest rate 0.05 is equivalent to 5% per time period =5% p.a.
See excel sheet for calculations.
Compounded interest:
Compound interest formular: FVN = NPV0 · (1 + I)N
53
2) Discounting: Once we have defined time period and
estimated the net cash flow at the end of each one we need
to make them comparable. The discount rate, or costs of
capital is a reflection of different variables.
Evaluating investments (look up descriptions p. 6)
1) Net Present Value.
2) Annuity
3) Internal Rate of Return (IRR)
4) Payback Period
Discounting different amounts forth and back
in time:
To borrow or invest is a strategic long-term decision
that will typically result in a number of different cash
inflows and outflows staggered over more periods of
time.
Annuities
Financial investments versus real investments
“All of the above examples have been based on
financing structures rather than the cash flows
expected from investments in real assets. The is
by design in order to not complicate matters
unnecessarily while getting the fundamentals
laid out right. Compared to investments in real
assets, detailed calculations of net present value,
future value, and interest rates can be done with
much more accuracy when evaluating financial
investments. This is because cash flows from
investments in real assets generally are much
 more uncertain than financial investments and
require a much higher degree of professional
judgment to analyze.

The relative certainty of financial investments

vis-à-vis investments in real assets leads to an
important insight. It means that we should look
at investments in real assets from a different
perspective than we use of financial investments
because expected cash flows, the discount rate
and time horizon are typically much more
uncertainty for real investments, and therefore
carry greater risk and should be handled in a
more dynamic and strategic way than financial
investments.” (p. 21)

The following will have precisely this

perspective in mind.
Chapter 3: Capital budgeting

Intro: One of the most important and challenging aspects of

the capital budgeting process is turning economic and
technicalities of an investment strategy into a robust estimate
of future cash flows
= IMPORTANT to decide which factors to include in the
calculations
 Capital budgeting often involves different parts and units
of the business organisation; the sales and marketing team
estimate demand and prices, the production unit estimates on If different product categories: Their mix can be
cost and investments, finance = develops suggestions to analyzed by using the BCG matrix
financing structure and capital costs. = Highly cross
functional  The PLC curve and BCG matrix illustrate
how investment projects evolve through stages
“Finally, it is important not to get lost in the numbers; of varying cash flow requirements
projections are not reality. Before submitting a capital budget,
we need to step back and see if the projections make sense. For Cash flow estimation (p. 26)
instance, is it realistic to assume that a company will reach The strategic analysis lays the foundation for
12% annual growth in a mature industry characterized by
quantifying the scenarios into estimates of
over-capacity?” (p. 23)
the investment’s future cash flows. These can
Building investment scenario be structured by considering the following 5
Crucial first step: building the investment scenario that are elements
developed on the basis of coherent cash flow analysis and
estimates.  Important part of this process it to identify which 1) Capital expenditures/initial investment
factors and assumptions should be included and which (capex)
should not, valid arguments are important
Estimating the initial investment’s needs and
Classical tools can be used in the strategic analysis: A key part capital expenditures is a demanding task that
of the analysis is to develop a number of possible future requires a number of decisions to be made:

54
scenarios and consider them thoroughly, evaluating the
consequences for the investment project:
A roadmap for creating investment scenarios:
SWOT-analysis: Very solid strategic model that
comprehensively links together all the following strategic
tools and offers a good overview of external and internal
position and situation (p. 24)
PESTEL-model: Can be useful in creating a macro-level
overview of the factors influencing the investment decision. 
Can lead to Porter’s Five forces for an in-depth analysis of the
industry’s attractiveness, profitability and return on
investment
Internal analysis: The Product Life Cycle (PLC) tool is a
robust strategic method for determining where a firm’s
products fall within the development over time.
Chapter 4: Financial evaluation of investments
Evaluating single and alternative investments:
Single investments
“A single investment decision is one where an individual
project is being evaluated, and investor can either accept or
55
Capacity needs, economies of scale, investment
phases, new or used equipment/buildings, stock
requirements, re-investments, surrounding
infrastructure
2) Financing
Key elements: amount of debt compared to
equity, availability of various types of financing,
possibilities for refinancing, lending
environment, liquidity, effective cost of
capital /WACC
3) Sales
The estimation of sales is basically a question of
price and volumes; price optimization, Porters
five forces, market forms/competitive rivalry,
product life cycle, benchmarking, price/income
elasticities, market positioning
4) Expenditures
Cash flow estimates for operational expenditures
typically involve variable costs, semi-variable
costs, and fixed costs. Costing is linked to sales
estimation and usually reflects the following
factors: raw materials, packaging, salaries and
wages, energy, rent, repair and maintenance,
sales and marketing, distribution,
administration, royalties
5) Assumptions
Capital budgeting includes a listing of all the
underlying investment project assumptions that
influence actual cash flow: tax, depreciation,
credit periods, inventories, positive or negative
impact on sale of other products
 CASE EXAMPLE of THE ABOVE p. 28
Alternative investments
reject”
 The criteria for determining if an independent investment
is advantageous, is that the net present value is greater than 0.
 Investment theory typically uses three primary measures to
evaluate the profitability of an investment: 1) NPV, 2) Internal
rate of return (IRR), 3) Annuity

The net present value

The internal rate of return

Defined as: “The internal rate of return of an investment is the

rate of return which yields a net present value of precisely 0)
Hedegaard & Hedegaard (2015): Chapter 1-4 +
7-8, better than Zimmerman, but can also refer to
Zimmerman. First chapters = overview, remind
what the different elements are and how to
calculate and assess financial investment. There
won't be very difficult calculations.

Annuity

Hedegaard, O. & Hedegaard, M. (2015). Strategic Investment and Finance, DJØF Publishing Copenhagen, Chapters 7 and 8.
Chapter 7: Investment objectives and evaluation Investment objectives and evaluation:

Satisficing vs. Maximizing

The fundamentals of classical investment theory are
based on the assumption that all decision makers act
rationally and possess complete knowledge and
information about the various investing alternatives
at hand. The consequences of their actions and future
goals re fully known. This represents the so-called

56
“economic man” approach.

This premise is the basis of the shareholder value

perspective  combines concepts from Corporate
Finance and Corporate Strategy

Aside from the complexities involved in evaluating

investment strategies themselves, the needs and
objectives of the various stakeholder in and possibly
outside of a company must also be considered
 Stakeholder theory p. 2, Examples: CSR

The investment approach which seeks to reconcile
these factors is called the hehavioristic perspective.
Chapter 8: Real options: The inclusion of strategic
and dynamic perspectives in the investment
calculation
“A weakness of the traditional investment model is
that is considers the entire investment process as
static: operating decisions are assumed to be fixed in
advance and the investment’s calculation consists fo a
base case with known, predictable cash flows.
However, the world as a whole and the company
itself invariably change over time, often in dramatic
ways. The traditional model is therefore best suited to
“now-or-never” investments with known future cash
flows and passive investors who implement the
proposed investment project as originally planned”
(p. 5).
The table provides an overview of the investment
alternatives and helps in making the decision of which
one to choose. It is possible to extend the model further
by assigning weighs to the various parameters.
Division into phases
By separating investments into phases a company can
improve its use of the information it gathers;
 e.g., about market demand, competition, or cost
structure can lead to optimal decision about new
product’s introduction timing or the equipment capacity
needed to satisfy changing production schedules.
= Management can make wise investment decisions as a
real option provides a structure for a line of thought 
viewing investment as real options enables them to
respond strategically and proactively to business
opportunities in uncertain environments
 Real options are strategic tool; they combine financial
theory with strategy in a way that adds value for the firm

 By being flexible in the investment decisions and = The more volatile business environment, the more
implementation process = Therefore investment useful real options approach is
decisions is characterized by “real options” where the  also it is helpful as it gives potential for uncertain
decision maker has the right, but not the obligation, to cashflows (p. 7:12).
invest.
Real options in practice
Real options are therefore directly related to the A practical approach to assessing real options should be:
uncertainty inherent in investments and to the
firm’s strategic response to external changes in
its operating environment!
 Enables the company to adapt its approach
when faced with uncertain market conditions

= This is a key difference between the real

options approach and the traditional methods. EXAMPLES

57
Real options approach – focuses on companies and
the strategic investment decisions they make.
 They consist of opportunities and actions that the
firm’s management must identify and implement
= Real options represent a more strategic way of
thinking by the firm and form a link between strategic
planning and investment theory
Advantages:
- (Primary): Is that the investment’s risk can be
reduced and its value increased by allowing the
company to invest capital in a series of separate
phases.
= A way to compare two investment strategies! And
the analysis provides the basis for taking into account
future scenarios and the consequences.
The authors determine value of an investment
decisions or strategy as:
Value of traditional statistical investment calculation
+ value of real option
 The traditional method must be supplemented by
the value of an option whenever the company is faced
with a high-risk project or with many external
strategic factors
The authors do not dismiss the traditional method;
rather we supplement it with real option because a
company’s ability to alter its strategy in response to
new information can greatly enhance the investment’s
value.
Hedegaard & Hedegaard (2015) explain …
58
 One limitation of the traditional investment model is
that it often underestimates the value of projects with
strategic implication for the company. This is because the
ability to make follow-up investments in projects with
high growth potential cannot be factored in. With real
options, however, this growth and its value to the
company can be evaluated.
Deciding which of these actions are feasible and which
will have significant beneficial impact is therefore an
important part of using real options. Examples may
include the following:
 Price response to competitor actions, product changes,
speed of capacity expansions, market timing, synergies
and possible splitting/ restructuring of investment or
company
KEY POINTS:
1. The value of having real options depends on how well
a company can gather strategic information about a
project over time.
2) If an investment can be delayed, the ability to wait has
value + more
3. Real options are more valueable for project of higher
risk (volatility) + more
4. The value of real options depends on whether a firm
has an exclusive right to the options, or whether others
can use them + more.
Chapter 7+8 are focused on real-options, for the
simplicity - there could be exercise, but it won't be more
difficult that the ones in slide/or book. In the excel sheet
in the end, which is the maximum we can expect. More
focus on commenting!
 Christensen, C., Kaufman, S., & Shih, W. (2008). Innovation Killers. How Financial Tools Destroy Your Capacity to Do New
Things
Introduction: Why so many smart, hardworking managers in well-run 1. Misapplying Discounted Cash Flow
companies find it impossible to innovate successfully? and Net Present Value
- Though, the mathematics of discounting is logically
Foundings: Our investigations have uncovered a number of culprits: impecable, analysts commonly commit two errors that create
 These include paying too much attention to the company’s most an anti-innovation bias:
profitable customers (thereby leaving less-demanding customers at risk)
and creating new products that don’t help customers do the jobs they want
to do.
This is due to the misguided application of three financial-analysis tools
tools as an accomplice in the conspiracy against successful innovation. We
allege crimes against these suspects:
• The use of discounted cash flow (DCF) and net present value (NPV) to
evaluate investment opportunities causes managers to underestimate the
real returns and benefits of proceeding with investments in innovation.
• The way that fixed and sunk costs are considered when evaluating future
investments confers an unfair advantage on challengers and shackles
incumbent firms that attempt to respond to an attack.
• Theemphasis on earnings per share as the primary driver of share price
and hence of shareholder value creation, to the exclusion of almost
everything else, diverts resources away from investments whose payoff lies
beyond the im- mediate horizon. (p. 100).
Not bad tools and concepts  but the way they are commonly wielded in
evaluating investments creates a systematic bias against innovation!
 Instead, the authors “recommend alternative methods that can help
managers innovate with a much more astute eye for future value”
2. Using Fixed and Sunk Costs Unwisely
- When evaluating a future course of action, the argument goes, managers
should consider only the future or marginal cash outlays (either capital or
expense) that are required for an innovation investment, subtract those
outlays from the marginal cash that is likely to flow in, and discount the
resulting net flow to the present
 As with PDF and NPV “as long as the capabilities required for
yesterday’s success are adequate for tomorrow’s as well. When new
capabilities are required for future success, however, this margining on
fixed and sunk costs biases managers toward leveraging assets and
capabilities that are likely to become obsolete.”
= The argument that investment decisions should be based on marginal
costs is always correct. But when creating new capabilities is the issue, the
relevant marginal cost is actually the full cost of creating the new.
 Strategy and finance need to be integrated!!!
Definitions:
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1. To assume that the base case of not investing in the innovation – the
do-nothing scenario against which cash flows from the innovation are
compared – is that the present health of the company will persist
indefinitely into the future if the investment is not made.
 This is incorrect = ”For a better assessment of the innovation’s
value, the comparison should be between its projected
discounted cash flow and the more likely scenario of a decline in
performance in the absence of innovation investment.” = The
DCF Trap!
 ” It’s hard to accurately forecast the stream of cash from an investment
in innovation. It is even more difficult to forecast the extent to which a
firm’s financial performance may deteriorate in the absence of the
investment.” (p. 100)
2. The second set of problems with discounted cash flow calculations
relates to errors of estimation. Future cash flows, especially those generated
by disruptive investments, are difficult to predict.
 ”Arguably, a root cause of companies’ persistent underinvestment in
the innovations required to sustain long-term success is the indiscriminate
and oversimplified use of NPV as an analytical tool.” (p. 101)
3. Focusing Myopically on Earnings per Share
(Myopia = Nærsynethed, ”lack of foresight or intellectual insight.”)
- A third financial paradigm that leads established companies to
underinvest in innovation is the emphasis on earnings per share as the
primary driver of share price and hence of shareholder value creation.
 Pressure leads to focus on short-term stock performance and less
attention to the company’s long-term health – to the point they’re reluctant
to invest in innovations that don’t pay of immediately
Pressure is coming from principal-agent theory: conflict
of incentives
 ”That conflict of incentives has been taught so aggressively that the
compensation of most senior executives in publicly traded companies is
now heavily weighted away from sala- ries and toward packages that
reward improvements in share price. That in turn has led to an almost
singular focus on earnings per share and EPS growth as the metric for
corporate performance.” (p. 103)
 Furthermore, they are rewarded for going with the market’s short-
term model.
= We suggest that the principal-agent theory is obsolete in this context.
What we really have is an agent-agent problem, where the desires and
goals of the agent for the share owners compete with the desires and goals
of the agents running the company. The incentives are still misaligned, but
managers should not capitulate on the basis of an obsolete paradigm.
Processes That Support (or Sabotage) Innovation:
Fixed costs as those whose level is independent of the level of output;
typical fixed costs include general and administrative costs: salaries and
benefits, insurance, taxes, and so on. (Variable costs include things like
raw materials, commissions, and pay to temporary workers.)
Sunk costs are those portions of fixed costs that are irrevocably
committed, typically including in- vestments in buildings and capital
equipment and R&D costs.
Principal-agent theory – the doctrine that the interests of
shareholders (principals) aren’t aligned with those of managers (agents).
 (Without powerful financial incentives to focus the interests of principals and
agents on maximizing shareholder value, the thinking goes, agents will pursue other
agendas – and in the process, may neglect to pay enough attention to efficiencies or
squan- der capital investments on pet projects – at the expense of profits that ought
to accrue to the principals.)
Stage-gate innovation: Many marketers and engineers regard the stage-
gate development process with disdain. Why? Because the key decision
criteria at each gate are the size of projected revenues and profits from the
product and the associated risks.
Two serious drawbacks: 1) Teams know that the products
with the highest NPV gets pushed further. Difficult for
gatekeepers to judge if they are realistic.
2) The stage-gate system assumes that the proposed strategy is the right
strategy  this is not true, with new innovations it must emerge and then
be redefined
= ”The stage-gate system is not suited to the task of assess- ing
innovations whose purpose is to build new growth busi- nesses, but most
companies continue to follow it simply be- cause they see no alternative.”
(p. 105)

CONCLUSION: We keep rediscovering that the root reason for
established companies’ failure to innovate is that managers don’t have
good tools to help them understand markets, build brands, find customers,
select employees, organize teams, and develop strategy. Some of the tools
typically used for financial analysis, and decision making about
investments, distort the value, importance, and likelihood of success of
investments in innovation. There’s a better way for management teams to
grow their companies. But they will need the courage to challenge some of
the paradigms of financial analysis and the willingness to develop
alternative methodologies.
Discovery-driven planning: There are alternative systems
specifically designed to support intelligent investments in future growth.
See paper page 105 for full explanation.
 Today, processes like discovery-driven planning are more commonly
used in entrepreneurial settings than in the large corporations that
desperately need them.

Christensen, Kaufman, & Shih (2008) examine financial paradigms that lead established companies to underinvest in
innovation: 1) Misapplying Discounted Cash Flow and Net Present Value, 2) Using fixed and sunk cost unwisely, 3)
Focusing myopically on Earnings per Share.

*SKRIV LÆNGERE INTRO + KONCEPTER*

DCF = “The DCF Trap”

Formulas:
Compound interest formular:
FVN = NPV0 · (1 + I)N
- I is the interest rate
- N is periods of time
- NPV is the present value of future cash flows
- FV is the value of the cash flow calculated at time N

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Net income (NI) = Revenue – Incremental Costs – Depreciation

ROI: Another method for project evaluation is the accounting rate of return. A project’s accounting rate of
return, is also called return on investment:

(p. 106 Zimmerman)

Critique: A dollar of income received today is treated the same as a dollar of income received in the
future. The fact that these dollars are worth different amounts is ignored when accounting ROI is
computed. (Zimmerman, p. 107)

Return on Investment (ROI) = Current value of investment – Cost of Investment / Cost of

investment = (Cash flows from investment – initial investment) / initial investment

Residual Income (RI) = Net operating income - (Minimum required rate of return · Operating assets, t-1)

Residual income measures divisional performance by subtracting the opportunity cost of capital
employed from division profits

Net Present Value (NPV) = Summed net cash flow · (1 + I)-N

Present value of a cash flow stream:

(Zimmerman, p. 91)

IRR = The IRR method finds the interest rate that equates the initial outlay to the discounted future cash flows.

EVA: This formula is basically the same as residual income. EVA, like residual income, measures the total return after
deducting the cost of all capital employed by the division or firm. Even though the formula is the same as the residual
income formula, the two differ in a couple of ways. First, different accounting procedures are often used to calculate
“adjusted accounting earnings” than are used in reporting to shareholders

61
NPV og net income, ROI, EVA og residual income
Scenario evaluation

Broader issues to be considered when deciding on investment projects

Exam 2020
- Activity based costing (not an option)
- Budgets
- Performance assessment

Retake 2020
- Transfer + performance measurement
- Budgeting
- Financial analysis of investment projects

62
EXERCISE CLASSES:

1. Fixed costs + variable costs = operating income

1. Empowerment and let go of control (decision control and decision rights)

63
1. Opportunity costs – negative.

64
2. Performance indicators:

65
2. Tranfer pricing

66
2. Two divisions; transfer pricing

2. Transfer prices

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3. Budgets, purpose

69
3. Participative budgeting;

70
3. Zero-based budgeting

3. Budget lapsing and line-item

71
 4. Performance evaluation; advantages and disadvantages with new budgeting
system, recommendations
1. FLEXIBLE BUDGETS; variances

72
4. Design a balanced scorecard

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Previous exam:

Required:

1. a) Present an explanation of the responsibility accounting and budgeting system implemented at the
SA department. Your answer should include a discussion around the social implications of the way
the budget was created and operated in this setting.
2. b) Discuss the possible budget devices that could be implemented by public sector organisations in
general, and by the SA department in particular, to improve the budgeting system. You should also
present the advantages and disadvantages of the budget devices you present.

1. a) Evaluate the overall performance of FeedMe Diner. Which dimensions do you consider more
relevant and why?
2. b) Create a possible Balanced Scorecard for FeedMe Diner. Include any additional
information/metric that you consider relevant for the assessment of the performance of the
restaurant. Note: you are not expected to use (all) the metrics in the tables above.
3. c) Identify the Intellectual Capital (IC) components of FeedMe Diner and suggest to the owners the
best tool to report the restaurant’s IC externally. Motivate your answer by listing the possible ways
to report IC externally and their positive and negative aspects.

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