TOPIC 3

DESIGNING
MANAGEMENT
CONTROL
SYSTEMS
 Process of working within
organization structures/constraints

How to design an effective MCS

LECTURE Factors influencing MCS Design

OUTLINE
Identification of responsibility
centers

Development of performance
measures and Balanced Scorecard
 Types of
Organizations

• A functional structure
• In which each manager is responsible for a
specified function such as production or
marketing.
• A business unit structure
• In which business unit managers are
responsible for most the activities of their
particular unit, and the business unit functions
as a semi-independent part of the company
• A matrix structure
• In which functional units have dual
responsibilities
 Functional Organizations

CEO

Staff

Manufacturing Marketing
Manager Manager

Staff Staff

Manager Manager Manager Manager Manager Manager

Plant 1 Plant 2 Plant 3 Region A Region B Region C
 Functional Organizations
ADVANTAGES DISADVANTAGES
1. There is no unambiguous way
• The efficiency of determining the
effectiveness of the separate
functional managers

2. A dispute between managers

of different functions can be
resolved only at the top, even
though it may have originated
at a much lower
organizational level.

3. Functional structures are

inadequate for a firm with
diversified products and
markets
 Business Unit Organizations
CEO

Staff

Manager Manager Manager

Business Unit X Business Unit Y Business Unit Z

Staff Staff Staff

Marketing Marketing Marketing

Plant Manager Plant Manager Plant Manager
Manager Manager Manager

A business unit, also called a division, is responsible for

all the functions involved in producing and marketing a
specified product line.
 Business Unit Organizations
ADVANTAGES
1. Provides a training ground in
general management. The
business unit manager should
demonstrate the same
entrepreneurial spirit that
characterizes the CEO of an
independent company.
2. Its manager may make
sounder production and
marketing decisions than
headquarters might, and unit
as a whole can react to new
threats or opportunities more
quickly
DISADVANTAGES
1. Each business unit staff may
duplicate some work that in
a functional organization is
done at headquarters.
2. The disputes between
functional specialists in a
functional organization may
be replaced by disputes
between business units in a
business unit organization.
 Matrix Organizations

CEO

Staff

Function A Project X
Manager Manager

Function B Project Y
Manager Manager

Function C Project Z
Manager Manager
 DESIGN AN EFFECTIVE MCS

Technical Relevance of the Scope of the system

considerations information
Accurate Must be
Timely comprehensive and
include all activities
Consistent across value chain of
Flexible the organisation.
 DESIGN AN EFFECTIVE MCS

• Who is interested in evaluating

Consider 3 aspects of MCS the performance of organization?
• What is being evaluated?
• When is the performance
evaluation is done?

• Planning
Elements of MCS • Coordinating
• Communication
• Evaluation
• Decision making
THE COMPONENT OF MCS
• FORMAL MCS • INFORMAL MCS

• Rules, procedures, policies,

performance measures,
incentive plans.
• E.g.: MAS, Quality system,
HR system, info on
recruitment, training,
absenteeism, info on
revenues, costs and income.
• Shared values, loyalties,
mutual commitments
among member of
organization.
• Slogan that reinforce values
and loyalties…
KEY DESIGN CRITERIA FOR EFFECTIVE MCS
The MCS must:

permit clear links from planned organization

purpose to operational activity.

be able to assist managers both when planning

purpose & when controlling its achievement.

Enable a manager who so wishes to ascertain

exactly what output is expected of him & by whom
 DESIGNING CONTROL SYSTEMS
• Two basic questions:
• What is desired ?
• What is likely to happen ?

• If what is likely is different from what is desired, then two basic MCS-
design questions must be addressed:
• What controls should be used ?
• How tightly should each be applied ?
 WHAT IS DESIRED ?

Start Identify Identify

Start from objectives Identify the key Identify the key

and strategies actions (KA) results (KR)
• They should be • i.e., actions that must be • i.e., the few key areas
important guides to the performed to provide where things must go
actions that the greatest probability right for the business to
are expected, especially of success. flourish.
if they are specific.
WHAT IS LIKELY TO HAPPEN?

Do employees understand
what they are expected to Are they properly Are they able to fulfil their
do (key actions) or to motivated? desired roles?
accomplish (key results)?
• lack of direction • lack of motivation • personal limitations

The discrepancy between what is desired and what is

likely will determine the choice and the tightness of the
management control systems.
 EVOLUTION OF CONTROL SYSTEM

• As firms grow, their controls evolve usually towards:

• Increased formalization of procedures
– for action accountability purposes

and/or

• Development of more elaborate information systems

– for results control purposes.
CONTROL AND “GOOD” CONTROL

“Good control” is said to take place when there is

A high probability that the firm’s A low probability that major
objectives will be achieved; unpleasant surprises will occur.

In this respect, tight control is “good” because it provides

a high degree of certainty that people will act as the
organization wishes (assuming away harmful side-effects).
 Tight ACTION controls
•Behavioral constraints
–Physical
•Extra protection usually costs more.
–Administrative
•Restricting decision making to higher organizational levels provides tighter controls if:
–Higher-level personnel can be expected to make more reliable decisions;
–Those who do not have authority cannot violate the constraints.
• Preaction reviews
–Become tighter if the reviews are frequent, detailed, and performed by diligent, knowledgeable persons.

• Action Accountability
–The amount of tightness of control generated by action accountability depends on:
•The definition of (un)desirable actions
–Definitions must be specific, yet complete;
»e.g., “act professionally” vs. “obtain three competing bids before releasing a purchase order”
–Definitions must be understood and accepted.
•The effectiveness of the action-tracking system
–Employees should feel that their actions are noticed, and noticed relatively quickly.
•The reinforcement provided
–i.e., the significance of the rewards or punishments.
 Tight RESULT controls
The achievement of tight results controls depends on:
–The definitions of the desired results areas
•Congruence and completeness
–Choosing measurable performance dimensions that reflect an organization’s “true” objectives;
–e.g., Number of visitors for the success of a museum?
Number of patents for the success of R&D-departments?
Annual profits for a firm with significant growth prospects?
•Specificity
–Disaggregation and quantification;
–e.g., “keep customers happy” vs. “less than 1 pct. customer complaints.”
–The performance measures
–precision (amount of “noise”)
–objectivity (freedom of “bias”)
–timeliness (“lag” between occurrence and measurement)
–understandability

–The reinforcements provided

•Are the links between results and rewards:
–Direct (no ambiguity)
–Definite (no excuses)
 Tight PERSONNEL controls
• The tightness of personnel controls depends a great deal on the
overlap between individual and organizational objectives.
• Selection and training ?

• Cultural controls are often more powerful and stable

• Strong company cultures.
BEHAVIORAL CONSIDERATIONS

Embedding the Using a mix of short and

organization’s ethical long-term qualitative and
code of conduct into quantitative
MCS design performance measures

Developing an
Empowering employees
appropriate incentive
to be involved in decision
system to reward
making and MCS design
performance
 IMPACT OF MCS ON BEHAVIOR

Many managers try to implement new systems without considering the

behavioral implications and consequences of a MCS

Negative consequences:

Goal congruence may not
Motivation could be low
occur
Employees may be
encouraged to engage in
dysfunctional behavior
• Eg: data manipulation,
gaming, budget slack etc
MOTIVATION FACTORS ON MCS

In addition to fostering When designing jobs and

ethical behavior, a central specific tasks, system
issue in MCS design is how designers should consider
to motivate appropriate the following three
behavior at work dimensions of motivation:

Persistenc
Direction Intensity
e
 GOAL 
CONGRUENCE ON MCS

The alignment of goals occurs as

employees:
Goal congruence - the
- Perform their jobs well and are
organization and its
helping to achieve
employees align their organizational objectives, and
respective goals
- Are attaining their individual
goals at the same time
 RESPONSIBILITY CENTERS

A responsibility
A responsibility Responsibility accounting is part
center is an accounting begins of the performance
organization unit with formal evaluation system
that is headed by a recognition of the used to measure
manager who is subunits as the operating
responsible for its responsibility results of the
activities. centers. responsibility
center.
 DECENTRALIZATION AND
RESPONSIBILITY CENTERS

• A company is organized along lines of responsibility. Most

companies use a more flattened hierarchy that emphasizes
teams.
• Firms with multiple responsibility centers choose one of two
decision-making approaches to manage their diverse and
complex activities: centralized or decentralized.
CENTRALIZATION vs
DECENTRALIZATION
 TYPE OF RESPONSIBILITY
CENTERS
– Cost center: Manager is responsible only for costs.

– Revenue center: Manager is responsible only for

sales, or revenue.

– Profit center: Manager is responsible for both

revenues and costs.

– Investment center: Manager is responsible for

revenues, costs, and investments.
 • Output, and only
output, is measured
• Measurement is
normally in monetary
Revenue terms
• Typically,
Center sales/marketing
– Cannot set price
– Have no control
over costs
 • Inputs, and only inputs, are
measured
• Measurement is normally in
monetary terms
• Two types
Cost – Engineered expense centers
• Optimal relationship
Center between inputs and
outputs
– Discretionary expense
centers
• Optimal relationship
cannot be established
between inputs and
outputs
 • Both inputs and outputs are
measured
• Measurement is in
monetary terms
• Inputs are related to
Profit outputs
• Two conditions must be met
Center to create a profit center
– Relevant information
must be available
– Effectiveness of
managers decisions must
be measurable
 • Financial evaluation
must measure
– Income generated
– Effective use of center’s
Investment assets
• Performance
Centers measures
– Return on investment
(ROI)
– Residual income (RI)
– Economic value added
(EVA)
 TRANSFER PRICING

• In decentralized organizations, the output of one division is used as the

input of another.
– The value of the transferred good is revenue to the selling division
and cost to the buying division.
• This value, or internal price, is called the transfer price.
– Transfer price is the price charged for a component by the selling
division to the buying division of the same company.
• The strategic objectives of international TP are:
1. Taxation-related objectives
2. Internal management-oriented objectives
3. International or operational objectives
 IMPACT OF TRANSFER PRICING ON
DIVISIONS AND THE FIRM AS A WHOLE

• When one division of a company sells to another division, both divisions as

well as the company as a whole are affected.
• The price charged for the transferred good affects both
– the costs of the buying division
– the revenues of the selling division
• Thus, the profits of both divisions, as well as the evaluation and
compensation of their managers, are affected by the transfer price.
• Since profit-based performance measures of the two divisions are affected,
transfer pricing often can be an emotionally charged issue.
• The next exhibit illustrates the effect of the transfer price on two divisions of
a company.
• Division A wants the transfer price to be as high as possible while Division C
prefers it to be as low a as possible.
IMPACT OF TRANSFER PRICING ON DIVISIONS
AND THE FIRM AS A WHOLE
DEVELOPMENT OF PERFORMANCE
MEASURES
Designing PMS

• Traditional PMS
• Contemporary PMS

Performance dimension

Performance indicator/measure
 DEVELOPMENT OF
PERFORMANCE MEASURES

• Implementing performance indicators:

– Recognizing the need for enhanced performance indicators.
– Ensuring top management support and commitment
– Creating an implementation team
– Developing a business performance model
– Understanding the goals and strategies of the firms
– Defining the critical success factors
– Assessing the current PMS
– Determining which measures to eliminate
– Developing the performance indicator architecture
– Establishing the underlying technology
– Reevaluating performance evaluation and the reward system
– Ensuring continual improvement
PERFORMANCE OBJECTIVES AND SMART MODEL

Specific Is it clear exactly what the employee will do?

Is it clearly defined and understood both by employee

Measurable  and by manager or supervisor how success will be
measured? (Survey results, activity report, project
completion, etc.)

Attainable Is it realistic to expect completion of this Objective as it

is written?

Does completion of this Objective support the goals of

Relevant the department, division or institution, and is it within
the scope of the position?

Time bound Does the Objective include a specific date for

completion?
 THE BALANCED SCORECARD

• The Balanced Scorecard (BSC) provides a system for measuring and

managing all aspects of a company’s performance.
• The scorecard balances traditional financial measures of success,
such as profits and return on capital, with non-financial measures of
the drivers of future financial performance.
• The Balanced Scorecard measures organizational performance
across different perspectives.
 THE BALANCED SCORECARD –
THE PERSPECTIVE

– The financial perspective describes the economic consequences

of actions taken in the other three perspectives.
– The customer perspective defines the customer and market
segments in which the business unit will compete.
– The internal business process perspective describes the internal
processes needed to provide value for customers and owners.
– The learning and growth perspective defines the capabilities
that an organization needs to create long-term growth and
improvement.
THE END OF TOPIC
3