1. © 2014 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

2. PowerPoint Authors: Susan Coomer Galbreath, Ph.D., CPA Charles W. Caldwell, D.B.A., CMA Jon A. Booker, Ph.D., CPA, CIA Cynthia J. Rooney, Ph.D., CPA Copyright © 2014 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Fundamentals of Management Control Systems Chapter 12

3. 12-3 Alignment of Managerial and Organizational Interests LO 12-1 Explain the role of a management control system. A management control system is designed to help managers make decisions that will increase the organization’s performance. The purpose of the management control system is to align more closely the interests of the manager and the interests of the organization.

4. 12-4 Decentralized Organizations LO 12-2 Identify the advantages and disadvantages of decentralization. Decentralization is the delegation of decision-making authority to subordinates in the organization’s name. When authority is decentralized, a superior, whom we call a principal, delegates duties to a subordinate, whom we call an agent. We find principal-agent relationships in many settings.

5. 12-5 Decentralized Organizations Some organizations are very centralized; few decisions are delegated. The military is a good example of centralized authority. At the other extreme are highly decentralized companies in which decisions are delegated to divisional and departmental managers. In many conglomerates, operating decisions are made in the field; corporate headquarters is, in effect, a holding company. Good decisions require good information. In large organizations, especially those that are geographically dispersed, much of the information needed to make the decision is local; that is, it is specific to the local conditions. Supporting some local variations can capitalize on local knowledge and allow franchisees to earn more than would otherwise be possible. Local knowledge is knowledge about these local conditions. LO 12-1

6. 12-6 Advantages of Decentralization Some of these advantages follow: Better use of local knowledge. As companies grow, more and more local knowledge needs to be processed in order to manage the business. Faster response. Local managers can react to a changing environment more quickly than top management can. With centralized decision making, delays occur while information is transmitted to decision makers. Wiser use of top management’s time. Just as local managers have better information about local conditions, top managers have better knowledge about strategic issues and industry trends. Reduction of problems to manageable size. The complexity of problems that humans can solve has limits. Even with the aid of computers, some problems are too complex to be solved by central management. Training, evaluation, and motivation of local managers. Decentralization allows managers to receive on-the-job training in decision making. Top management can observe the outcome of local managers’ decisions and evaluate their potential for advancement. Some of these advantages follow: Better use of local knowledge. As companies grow, more and more local knowledge needs to be processed in order to manage the business. Faster response. Local managers can react to a changing environment more quickly than top management can. With centralized decision making, delays occur while information is transmitted to decision makers. Wiser use of top management’s time. Just as local managers have better information about local conditions, top managers have better knowledge about strategic issues and industry trends. Reduction of problems to manageable size. The complexity of problems that humans can solve has limits. Even with the aid of computers, some problems are too complex to be solved by central management. Training, evaluation, and motivation of local managers. Decentralization allows managers to receive on-the-job training in decision making. Top management can observe the outcome of local managers’ decisions and evaluate their potential for advancement. LO 12-1

7. 12-7 Disadvantages of Decentralization Decentralization has many disadvantages as well. The major disadvantage is that local managers can make decisions that are not in the best interests of the organization’s top managers and the owners (shareholders). A second cost of decentralization is administrative duplication. A third cost of decentralization is the possibility of poor decisions based on incomplete information. A company must weigh the costs and benefits of decentralization and decide on an economically optimal level. One can assume that the disadvantages of decentralization for highly centralized organizations outweigh the advantages while the reverse is true for decentralized companies. LO 12-1

8. 12-8 Framework for Evaluating Management Control Systems LO 12-3 Describe and explain the basic framework for management control systems. Once an organization has decided to decentralize, it is important to develop a system to reduce the impact of dysfunctional decision making. This system is called a management control system, which is the structure and procedures that the principals (owners) use to influence agents (managers) of the organization to implement the organization’s strategies.

9. 12-9 Elements of a Management Control System Delegated decision authority. Performance evaluation and measurement systems. Compensation and reward systems. LO 12-3

10. 12-10 Balancing the Elements An effective, well-functioning management control system balances these three elements and defines them consistently. You are the manager of a newspaper stand that is par of a national company. The goal of the organization is to make money (or at least sell newspapers). As the newspaper stand manager, you can affect that by making good decisions about the number of papers to order. The purpose of the management control system is to influence you to make decisions that further the organization’s goal. However, because the performance measure is completely independent of your decisions, it cannot motivate you to make better decisions. The three elements are not consistent; that is, they are not balanced. LO 12-3

11. 12-11 Responsibility Accounting LO 12-4 Explain the relation between organization structure and responsibility centers. Responsibility accounting reports revenues and costs at the level within the organization having the related responsibility.

12. 12-12 Cost Centers Managers of cost centers are responsible for the cost of an activity for which a well defined relationship exists between inputs and outputs. Cost centers often are found in manufacturing operations where inputs, such as direct materials and direct labor, can be specified for each output. The production departments of manufacturing plants are examples of cost centers. LO 12-4

13. 12-13 Discretionary Cost Centers When managers are held responsible for costs but the input-output relationship is not well specified, a discretionary cost center is established. Legal, accounting, R&D, advertising, and many other administrative and marketing departments are usually discretionary cost centers LO 12-4

14. 12-14 Revenue Centers Managers of revenue centers typically are responsible for selling a product. Consequently, the manager is held responsible for sales price or sales activity variances. An example of a revenue center is the sportswear department of a large department store for which the manager is responsible for merchandise sales. LO 12-4

15. 12-15 Profit Centers LO 12-4

16. 12-16 Investment Centers Managers of investment centers have responsibility for profits and investment in assets. These managers have relatively large amounts of money with which to make capital budgeting and other decisions affecting the use of assets. Investment centers are evaluated using some measure of profit related to the invested assets in the center. LO 12-4

17. 12-17 Responsibility Centers and Organization Structure Group a vice president – Investment centers Division vice president – Profit centers Staff managers – Discretionary cost centers Plant managers – Cost centers District sales managers – Revenue centers a Group refers to a group of divisions. LO 12-4

18. 12-18 Measuring Performance Total goal congruence exists when all members of an organization have incentives to perform in the common interest. This occurs when the group acts as a team in pursuit of a mutually agreed-upon objective. Individual goal congruence occurs when an individual’s personal goals are congruent with organizational goals. In most business settings, however, personal goals and organizational goals differ. Performance evaluation and incentive systems are designed to encourage employees to behave as if their goals were congruent with organization goals. This results in behavioral congruence; that is, an individual behaves in the best interests of the organization regardless of his or her own goals. LO 12-4

19. 12-19 Evaluating Performance LO 12-5 Understand how managers evaluate performance. A company often is tempted to compare the performance of its centers and even to encourage competition among them. As you will see, the problems inherent in performance measurement complicate such comparisons. In addition, the various centers can be in very different businesses. It is very difficult to compare the performance of a manufacturing center with the performance of a center that provides a consulting service and has a relatively small investment base. Investment centers operating in different countries face different risks. When comparing the performance of investment centers, all such differences should be considered.

20. 12-20 Compensation Systems An effective management control system provides the appropriate incentives for the manager to make decisions in the organization’s best interests. The compensation system has to reward the manager for measured performance to provide sufficient incentives to influence the manager’s decisions. We can classify the compensation into two categories: fixed compensation and contingent compensation. Fixed compensation is paid to the manager independent of measured performance. A good example of fixed compensation is salary. Contingent compensation is the amount of compensation that is paid based on measured performance. An example of contingent compensation is the commission paid to the sales staff. An effective management control system provides the appropriate incentives for the manager to make decisions in the organization’s best interests. The compensation system has to reward the manager for measured performance to provide sufficient incentives to influence the manager’s decisions. We can classify the compensation into two categories: fixed compensation and contingent compensation. Fixed compensation is paid to the manager independent of measured performance. A good example of fixed compensation is salary. Contingent compensation is the amount of compensation that is paid based on measured performance. An example of contingent compensation is the commission paid to the sales staff. LO 12-5

21. 12-21 Performance Evaluation Systems Incentives LO 12-7 Understand the potential link between incentives and illegal or unethical behavior. Fundamental questions regarding a performance measurement system: 1. Does the measure reflect the results of those actions that improve the organization’s performance? 2. What actions might managers be taking that improve reported performance but are actually detrimental to organizational performance? LO 12-6

22. 12-22 What Pressures Can Lead to Unethical Behavior? Unrealistic budget pressures, particularly for short-term results. These pressures occur when headquarters arbitrarily determines profit objectives and budgets without considering actual conditions. Financial pressure resulting from bonus plans that depend on short-term economic performance. This pressure is particularly acute when the bonus is a significant component of the individual’s total compensation.

23. 12-23 Internal Controls LO 12-8 Understand how internal controls can help protect assets. Effectiveness and efficiency of operations Reliability of financial reporting Compliance with applicable laws and regulations Companies set up internal control systems to deal with problems such as financial fraud. At a general level, internal controls provide management with reasonable assurances that their company’s assets are protected and the company’s accounting is reliable. More specifically, internal control is a process designed to provide reasonable assurance that an organization will achieve its objectives in the following categories:

24. 12-24 Internal Controls U.S. Congress passed the Sarbanes-Oxley Act of 2002 (SOX) in response to a large number of business and accounting scandals that came to light in 2001 and 2002. These included the large frauds and subsequent bankruptcies of Enron and WorldCom. SOX will likely cause improvements in the internal controls—and the documentation of internal controls—in many organizations. However, these benefits come at a cost. An open question is: Do the benefits justify the costs of investing in better internal controls? LO 12-8

25. 12-25 Internal Controls Companies use many types of internal controls besides separation of duties. Here are some examples. 1.Setting limits on the amount of expenditures (for example, no more than $100 per person for an expense account dinner). 2.Requiring management authorization for the use of a company’s assets (for example, use of a company car). 3.Reconciling various sets of books (for example, reconciling accounts receivable with the collections of cash from customers). 4.Prohibiting particular activities or behavior (for example, prohibiting a company’s purchasing agents from accepting gifts from present and prospective vendors). 5.Rotating personnel and requiring employees to take vacations (for example, requiring the person who reconciles bank statements with the company’s cash accounts to rotate duties so someone else can check that the cash on the books is actually in the bank). Companies use many types of internal controls besides separation of duties. Here are some examples. 1.Setting limits on the amount of expenditures (for example, no more than $100 per person for an expense account dinner). 2.Requiring management authorization for the use of a company’s assets (for example, use of a company car). 3.Reconciling various sets of books (for example, reconciling accounts receivable with the collections of cash from customers). 4.Prohibiting particular activities or behavior (for example, prohibiting a company’s purchasing agents from accepting gifts from present and prospective vendors). 5.Rotating personnel and requiring employees to take vacations (for example, requiring the person who reconciles bank statements with the company’s cash accounts to rotate duties so someone else can check that the cash on the books is actually in the bank). LO 12-8

26. 12-26 End of Chapter 12