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1 Notes For students doing Maths for Economists AND CFR2 who have a clash - HUMSS 144 11:00 – 13:00 Fridays 2 Feb & 16 Feb only Coursework: Post name &

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Presentation on theme: "1 Notes For students doing Maths for Economists AND CFR2 who have a clash - HUMSS 144 11:00 – 13:00 Fridays 2 Feb & 16 Feb only Coursework: Post name &"— Presentation transcript:

1 1 Notes For students doing Maths for Economists AND CFR2 who have a clash - HUMSS 144 11:00 – 13:00 Fridays 2 Feb & 16 Feb only Coursework: Post name & members on Blackboard by 5pm otherwise 5% lost Group time next Tuesday in this theatre – OPTIONAL but lecturer on hand to help

2 2 Management Control Systems January 23 rd 2007

3 3 Lecture objectives Describe the relationship between planning and control and distinguish between feed forward and feedback controls. Discuss the limitations of traditional budgetary planning and control systems in a modern business environment and assess the alternatives to traditional systems Examine the effect of behavioural issues on budgetary planning and control systems

4 4 Different types of controls Action (or behavioural) controls Personnel and cultural (or clan and social) controls Results (or output controls) Action (or behavioural) controls –Behavioural constraints –Preaction reviews –Action accountability –Focus should be on prevention rather than detection –controls

5 5 Different types of controls Social, personnel and cultural controls –Social controls involve selection of people who have been socialized into adopting particular norms of behaviour. –Personnel controls build on employees natural tendencies to control themselves (Emphasis is on selection, training and job design). –Cultural controls represent a set of values, social norms and beliefs that are shared by members of an organization and that influence their actions. –In recent years there has been a greater emphasis on cultural controls in the form of employee empowerment.

6 6 Different types of controls Results or output controls The focus is on reporting information about the outcomes of work effort. Results controls involve the following stages: –Establishing performance measures that minimize undesirable behaviour. –Establishing performance targets. –Measuring performance. –Providing rewards or punishments.

7 7 Cybernetic control systems Results controls resemble a cybernetic (mechanical) control system. Cybernetic systems involve feedback controls (actions after the events) but ideally control should be based on control actions before the events. A cybernetic control system

8 8 Harmful side-effects of controls Occurs when controls motivate employees to engage in behaviour that is not organizationally desirable (i.e. system leads to a lack of goal congruence). Results controls: –Encourages individuals to focus only on what is measured, regardless of whether it is organizationally desirable –Focuses mainly on quantifiable and easily measurable items. –Subject to data manipulation. –Can lead to negative attitudes towards the control system. Action controls: –May discourage creativity Cultural controls: Lack of goal congruence where group goals do not coincide with firm goals

9 9 The measurement reward process with imperfect measures

10 10 Advantages and disadvantages of different types of controls Personnel/cultural controls: –Few harmful side-effects –Inexpensive to operate –Appropriate only in certain circumstances Action controls: –Direct link between control mechanism and the action. –Measurement problems do not apply. –Not feasible where cause-and-effect relationships are not well understood or easily observable. –Best suited to stable situations. Results controls: –Can be applied where knowledge of what actions are desirable is lacking. –Focus is on outcomes (individual autonomy is not restricted).

11 11 Management accounting control systems (MACS) Tend to be the predominant controls in most organizations because: –Monetary measure provides a means of aggregating results from dissimilar activities. –Profitability and liquidity are essential for company survival. –Financial measures enable a common decision rule to be applied. –Measuring results in financial terms enables managers to be given more autonomy.

12 12 Responsibility accounting Responsibility accounting is a fundamental part of the MACS. Four types of responsibility centres: –Cost or expense centres (Two types: standard cost centres and discretionary cost centres). –Revenue centres –Profit centres –Investment centres

13 13 The nature of MACS Two core elements: –Formal planning processes (e.g. budgeting and longterm planning) for establishing performance expectations. –Responsibility accounting Responsibility accounting assigns differences from the performance target to the individual who is accountable for the responsibility centre. Process involves: –Setting performance targets. –Measuring performance. –Comparing performance against target. –Analysing variances and taking remedial actions. Responsibility accounting is implemented by issuing performance reports Issues that must be addressed by responsibility accounting include: Distinguishing between controllable and noncontrollable items (i.e. the controllability principle). Determining how challenging the targets should be. Determining how much influence managers should have in the setting of targets.

14 14 A typical performance report

15 15 The controllability principle Principle advocates that it is appropriate to charge to a responsibility centre only those costs that can be influenced by the manager of the responsibility centre. Implemented by either eliminating uncontrollables or reporting controllable and uncontrollable items separately. Types of uncontrollable factors: Economic and competitive factors (Because managers can respond to some of these changes most MACS do not shield managers completely from them). Acts of nature (Managers normally protected from them). Interdependencies where outcomes are affected by other units within the organization: –Pooled interdependencies –Sequential interdependencies –Reciprocal interdependencies –Adjustments for the distorting effects of uncontrollables can be made either before or after the measurement period.

16 16 Prior and Post Adjustments Adjustments before the measurement period: –Specify which budget line items are uncontrollable (eliminate or report separately in performance report). –Insurance Adjustments after the measurement period: –Variance analysis –Flexible performance standards (e.g. flexible budgeting and ex post budget adjustments) –Relative performance evaluations –Subjective performance evaluations

17 17 An example of flexible budgeting Static budgets are prepared for a single, planned level of activity. Performance evaluation is difficult when actual activity differs from the planned level of activity. With a flexible budget you can –Estimate costs at different activity levels –Compare actual outcomes to expectations when output levels are known

18 18 Flexible budgeting To flex a budget for different activity levels, we need to know how costs behave with changes in activity levels –Total variable costs change in direct proportion to changes in activity –Total fixed costs remain unchanged within the relevant range

19 19 Flexible budgeting Advantages –Flexible budgets show revenues and expenses that should have occurred at the actual level of activity Flexible budgets may be prepared for any activity level in the relevant range –Flexible budgets reveal variances due to good cost control or lack of cost control –Ensures that managers are accountable for the conditions applying during the period and not those envisaged when the budget was set

20 20 Budget techniques Flexible budgets A simple example.. Output (units) 90 120 £ £ Revenue9001,200 Variable costs450 600 Variable overheads 90 120 Fixed overheads300 300 Total costs8401,020 Profit 60 180

21 21 Preparing the flexible budget From this we can see that certain costs clearly vary with levels of output. Obviously fixed costs dont. By calculating the relationship between variable costs and output (as output drives the budget) We can calculate expected costs/revenues for any output level

22 22 Preparing the flexible budget Clearly the relationships are (at a given level) Revenue £900/90 = £10 per unit Variable costs £450/90 = £5 per unit Variable overheads £90/90 = £1 per unit

23 23 Preparing the flexible budget Output (units)135 Revenue135 X £10 =1,350 Variable costs135 X £5 = 675 Variable overheads135 X £1= 135 Fixed overheads £300 300 Total costs1,110 Profit 240

24 24 But what if there are semi- variable costs? There may be instances when the relationship between outputs and inputs is not clear Some costs may be part fixed and part variable High-Low technique

25 25 High-Low method difference Output90 12030 £ £ £ Revenue9001,200300 Variable costs450 600150 Variable overheads435 480 45 Total costs8851,080 Profit 15 120

26 26 High-Low method Compare costs/revenues at 2 levels of output Divide cost/revenue change by change in output For Revenue and variable costs £10 & £5 relationship still holds Overheads are semi-variable Therefore change can only be attributed to variable element

27 27 High-Low method Therefore change = 45/30 = £1.50 per unit At output 90 units Variable element = 90 X £1.50 = 135 So Fixed element = 435 – 135 = 300 To confirm, at 120 units of output Variable element = 120 X £1.50 = 180 So Fixed element = 480 – 180 = 300

28 28 Budget at different output level At (say) 100 units of output budget = Revenue (100 X £10)£1,000 Variable costs (100 X £5)£ 500 Overheads (£300 + 100 X £1.50) £ 450 Total costs£ 950 Profit£ 50

29 29 Guidelines for applying the controllability principle Price and quantity of service controllable = Controllable expense Quantity controllable but not price = Manager accountable for difference between (actual quantity × budgeted price) and (budgeted quantity × budgeted price) Quantity and price not controllable = Non- controllable expense General principle = Hold managers accountable for performance areas to which you want them to pay attention

30 30 Determining how challenging the targets should be A clearly defined quantitative goal is likely to motivate higher levels of performance. Level of budget difficulty should be related to task uncertainty. Targets must be accepted to motivate managers to achieve higher levels of performance. Literature identifies a theoretical relationship between budget difficulty, aspiration levels and performance Hypothesized relationships suggest that budget level that motivates best performance is unlikely to be achieved most of the time ( do not adopt a punitive approach for adverse variances)

31 31 The effect of budget difficulty on performance (Source: Otley (1987))

32 32 The effect of budget levels on aspiration and performance (Source: Hofstede (1968))

33 33 Arguments in favour of setting highly achievable budgets Conflict between planning and motivational purposes. Psychological benefits (e.g. achievement and self-esteem). Shields managers from adverse impact of environmental changes. Alleviates harmful side-effects of controls.

34 34 Determining how much influence managers should have in setting standards Advantages of participation in the setting of performance standards: –Targets more likely to be accepted –Reduces the information asymmetry gap –Reduces negative attitudes and dysfunctional behaviour Empirical studies provide conflicting evidence on the effectiveness of participation. Factors influencing the effectiveness of participation: –Personality variables: Authoritarianism Locus of control – Work situation –Job difficulty Limitations on the positive effects of participation: –Budgetee has the opportunity to negotiate lower targets. –Depends on personality traits and work situation. –A top down approach may be preferable where a large number of similar units exist.

35 35 Side effects of using accounting information for performance evaluation Hopwood observed three different styles of managerial use of accounting information for performance evaluation: –A budget-constrained style –A profit-conscious style –A non-accounting style

36 36 Hopwoods findings

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