Chapter 22 – Control: The Management Control Environment

Management Control This chapter addresses the control process and the use of accounting information in that process. The activity “strategy formulation” develops strategies to attain an organization’s goals. Strategies change whenever a new opportunity or a new threat is perceived.

Management Control Process Process by which managers influence members of the organization to implement the organization’s strategies efficiently and effectively. Takes goals and strategies as given. Seeks to assure that the strategies are implemented. Includes planning.

Two Parts of Planning A statement of objectives. Resources required to achieve those objectives.

Goals and Objectives Terms often used interchangeably. Goals = broad, usually non-quantitative, long run plans relating to the organization as a whole. Objectives = more specific, often quantitative, shorter run plans for individual responsibility centers.

The Environment Four facets of the management control environment: Nature of organizations. Rules, guidelines and procedures that govern the actions of the organization’s members. The organization’s culture. External environment.

The Nature of Organizations Organization: a group of human beings who work together for one or more purposes. Managers or the management: Leaders who perform important tasks.

Tasks of Management Determining goals. Determining objectives to achieve the goals. Communicating goals and objectives. Determining tasks to be performed to achieve objectives. Coordination. Matching individuals to tasks. Motivating. Observing/monitoring employee performance. Taking corrective action as needed.

Organization hierarchy. = Layers of management with authority running from top to bottom. Optimal number of subordinates: (10?) Organization chart. Line units  their activities are associated with achieving the objectives of the organization. (They produce and market goods or services.) Staff units  exist to provide support services to other units and to the chief executive officer (CEO).

Rules, Guidelines, and Procedures Influence the way members behave. Written, or verbal; formal, or informal.

Culture Norms of behavior determined by: Tradition. External influences. Attitudes of senior management and the board of directors (BOD).

External Environment Everything outside of the organization itself. E.g., customers, suppliers, competitors, regulatory agencies.

Responsibility Accounting Involves a continuous flow of information that corresponds to the continuous flow of inputs into, and outputs from, an organization’s responsibility centers. Usage of various resources are measured directly in or converted to a monetary measure. Focuses on responsibility centers.

Full Cost Accounting Focuses on goods and services. Responsibility accounting is a different ways of slicing the same pie.

Responsibility Centers Commonly perform work related to several products. Inputs to a responsibility center are called cost elements or line items (on a department cost report). Costs have three different dimensions:

Dimensions of Costs Responsibility center. Where was cost incurred? Product dimension. For what output was the cost incurred? Cost element dimension. What type of resource was used?

Effectiveness and Efficiency Effectiveness = how well the responsibility center does its job. Efficiency = the amount of output per unit of input. Lower cost is more efficient.

Limitations of Actual costs Compared to Standard Not an accurate measure of efficiency for at least 2 reasons: Recorded costs are not precisely accurate measures of resources consumed. Standard are at best only approximate measures of what resource consumption ideally should have been in the circumstances prevailing.

Types of Responsibility Centers Important business goal: earn a satisfactory return on investment: ROI = (Revenues - Expenses) / Investment Leads to 4 types of responsibility centers: Revenue centers. Expense centers. Profit centers. Investment centers.

Revenue Center Responsible for outputs of center as measured in monetary terms (revenues). Not responsible for the costs of goods or services that the center sells. E.g., sales organization. Also responsible for selling expenses (e.g., travel, advertising, point-of-purchase displays, sales office salaries, rent).

Expense centers Responsible for expenses (i.e., the costs) incurred but does not measure its outputs in terms of revenues. E.g., production departments, staff units such as accounting.

Standard or Engineered Cost Center Expense center for which many of its cost elements have standard costs established. Differences between standard costs and actual costs are variances. E.g., production cost centers, fast food restaurants, and blood testing laboratories.

Discretionary Expense Center Also called managed cost center. Difficult to measure output in monetary terms. Production support and corporate staff. E.g., human resources, accounting, R&D.

Profit Centers Performance measured as difference between revenues and expenses. E.g., independent division of a company, factory that sells its output to the marketing division.

Advantage of Profit Center Encourages managers to act as if they are running their own business.

Criteria for Profit Center Involves extra record keeping. Only useful if manager influences both revenues, and costs. If senior management requires service performed by other responsibility center at no charge, than not a profit center, e.g., internal audit. If output is homogeneous (e.g., tons) no advantage to monetary measure of revenue. Multiple profit centers creates spirit of competition.

Transfer Prices Price at which goods or services are sold between responsibility centers within a company. Revenue for selling center and cost for the receiving center. 2 general types of transfer prices: Market based price. Cost based price.

Market-based transfer prices Based on price for same product between independent parties, i.e., a market price or, equivalently, an arm’s length price. Adjusted for quantifiable differences such as credit costs. Where available is widely used. Frequently not available.

Cost-Based Transfer Prices When no reliable market price is available. Cost plus a mark-up. If based on actual cost, little incentive to reduce costs.

Transfer Pricing Issues Negotiated by responsibility centers or set/arbitrated by top management. Should manager have freedom to use alternative source? Sub-optimization: maximize profits for a responsibility center may not maximize profit for the consolidated company.

Investment center Responsible for use of assets as well as profits. Expected to earn a satisfactory return on assets employed in the responsibility center.

Measures of Performance Return on investment = Profit/Investment assets = (net income) / (total assets). Residual income = Pre-interest profit – (Capital charge * investment)

Residual Income Residual income = economic value added = EVA = Income before taxes less a capital charge. Capital charge is calculated by applying a rate to the investment center’s assets or net assets.

Advantage of Residual Income over ROI Encourages managers make all investments whose return is greater than the capital cost rate.

Advantage of ROI over residual income: ROI measures are ratios that can be used to compare investment centers of different sizes. Residual income is an internal number that is not reported to shareholders and other outsiders.

Investment Center Issues Asset allocation between centers. How to value assets (e.g., historical cost or replacement cost). Most companies control investments in fixed assets using capital investment (i.e., capital budgeting) procedures addressed in Chapter 27. Managers focus their day-to-day efforts on managing current assets, particularly inventories and receivables.

Non-monetary measures Non-monetary as well as monetary objectives. E.g., Quality of goods or services, customer satisfaction. Management by objectives (MBO) and Balanced Scorecards in Chapter 24.