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MODULE 3: MANAGEMENT ACCOUNTING AND ORGANISATIONAL CONTROL Lecture 1 - Management Control, Budgeting and Responsibility Accounting READING 1: Review of Literature on Controls & Accountability (Merchant & Otley, 2006) The Domain of Management Control Systems
* Control: things managers do to ensure that their organisations perform well
* Management Control System is designed to help an organisation adapt to the environment in which it is set and to deliver the key results desired by stakeholder groups
* Generic Management Process: (1) Setting objectives (2) Deciding on preferred strategies for achieving those objectives (3) Implementing those strategies while (4) Making sure that nothing, or as little as possible, goes wrong Control Concepts and Frameworks
* Anthony (1965) - First discussion of management control; divided control in 3 topics: (1) Strategic planning: Future oriented - sets overall strategy (2) Management control: Ensuring resources obtained to meet organisational objectives (3) Operational control: Control processes heavily dependent on situation
* Otley (1999) - Descriptive framework based around 5 questions: (1) What are the key objectives that are central to the organisation's overall futures success, and how does it go about evaluating its achievement for each objective?
(2) What strategies and plans has the organisation adopted and what are the processes and activities that it has decided will be required for to successfully implement them?
How does it assess and measure performance of these activities?
(3) What level of performance does the organisation need to achieve in each area defined in (1) and (2), how does it go about setting appropriate performance targets?
(4) What reward will managers gain by achieving these performance targets?
(5) What are the information flows that are necessary to enable the organisation to learn from its experience, and adapt in light of experience?
What have We Learned about Accountability-Oriented Control Systems?
* Some control systems intended to hold individuals accountable for their actions or for the results they or their organisations produce i.e. individuals are rewarded (punished) when good (bad) things happen
* Individuals aware of what is expected of them - expectations can be implicit or explicit 7 most important accountability issues:
5.1 What makes a good performance measure?
* Can distinguish between market measures, financial summary measures, disaggregated financial measures and non-financial measures
* Various evaluation criteria - congruence, informativeness, objectivity, timeliness
* Good measures reflect progress toward achievement of organisation's objectives (i.e congruence, but sometimes informativeness or signal-to-noise ratio)
* Congruence measured by correlation by 'true' performance (difficult to measure - proxied by stock returns) and measure used for control purposes
* Generally low correlation found (~0.2) - development of new techniques e.g. EVA, economic profit, cash flow ROI
* Development in combining measures (e.g. balanced scorecard) - intuitive but testing in early stages (which measures to use? how to measure? weighting?)
* Performance measurement even more difficult in NGOs (not profit-seeking)
* Should managers be accountable for one measure (maximum autonomy, cheap) or multiple (complex - expensive, but easier to understand bottom line)?
5.2 Why are managers generally held accountable for more than they can control?
Controllability principle: hold people accountable only for what they can control
* To increase controllability:
- Before measurement, design responsibility structures to match performance measures with managers' level of authority (i.e. sales people responsible for sales)
- Buy insurance to transfer risk to third parties
- After measurement, use MA tools (variance analysis, flexible budgets etc.)
* In practice, managers often held accountable for thing they cannot control, 2 causes: (1) Difficult to separate uncontrollable and controllable effects on performance measures (2) While some factors are uncontrollable, firms want managers to respond to them
* Should controllability principle be influenceability principle (i.e. held accountable if can materially influence effect of a factor on performance even if factor itself is uncontrollable)
5.3 Are performance target necessary? And, if so, what makes a good one?
* Small number of performance targets that are challenging, but not impossible
* Practical problem of how to combine motivational targets with realistic planning numbers
* In most organisations, budgets set at level that is frequently achieved, although argued that they can still encompass stretch budgets
* Most cited weaknesses of budgetary control by Beyond Budgeting: (1) Constrain responsiveness - barrier to change (2) Rarely strategically focused - ofter contradictory (3) Add little value, especially given time needed to prepare them (4) Concentrate on cost reduction, not value creation (5) Strengthen vertical command and control (6) Do not reflect emerging network structures, which organisations are adopting (7) Encourage 'gaming' and perverse behaviours (8) Develop and updated too infrequently (9) Based on unsupported assumptions and guess-work (10) Reinforce departmental barriers rather than encourage knowledge sharing (11) Make people feel undervalued
Argued many of these problems mitigated by adopting new principle controls:
- Removing emphasis on preset targets replacing them with benchmarked ones (e.g. league tables)
- Remove reliance on arbitrary performance targets that are set for a fixed period months in advance, instead use relative performance targets that are continually updated in light of changing conditions; evaluate performance with hindsight
5.4 What Do We Know about Choices of Styles of Accountability
* Distinction between interactive and diagnostic use (Simons, 1995):
- 5 dimensions for interactive use (Bisbe et al 2005): (1) Intensive use by top managers (2) Intensive use by operating managers (3) Face-to-face challenge/debate (4) Focus on strategic uncertainties (5) Noninvasive, facilitating, inspirational involvement
* Budget Constrained vs Profit Conscious (Hopwood, 1972)
- i.e. ST approach characterised by a rigid insistence by senior managers that targets should be attained in the current period vs LT approach that might condone ST failure to attain target if it could be demonstrated that performance might be better over LT
5.5 What are the Key Incentive System Design Issues; What Do We Know about Them?
* All firms use some form of incentive system but do they work?
- Kohn (1999): Reward and punishment product only temporary compliance - intrinsic rewards more powerful and enduring
* What incentives should be provided?
- Varies depending on employees values, age etc.
- Cash generally highly valued so often money used as form of incentive
* Incentive system issues often relate to timing i.e. motivation enhanced when rewarded frequently but difficult to accurate sense of performance in ST
* Difficult to operationalise pay/performance relationship (where should floor and cap be?)
* Contingency relationship between multiple incentives e.g. if no promotion opportunities how does this effect design of bonus plan?
* How to make choices in different settings? Based on strategy, resources, uncertainty in operating environment, country?
5.6 How and Why do Control Systems Differ in Different Settings
* Appropriate control arrangements depends on context within which system is operating
- O'Clock & Devine (2003): Control systems built on foundation of shared values and assumption (i.e. depends on culture)
* Recursive relationship between culture and control which makes it difficult to predict what the consequences of control system changes are likely to be
5.7 How do We Recognise Progress (Positive Innovation) from Fads?
* Only possible to tell after the fact e.g. human resource accounting; at present time cannot tell if EVA, balance scorecards, beyond budgeting etc. are fads Conclusion
* MCS literature rich and varied (multiple frameworks, paradigms etc.)
* MCS field may be relative incomplete in state of development compared to other fields of accounting - not a problem but an opportunity
* Progress has been and is being made
READING 2: Codman & Shurtleff, Inc: Planning & Control System (HBS Case Study) Current Problems: (1) Currency issues i.e. deterioration of USD/EUR (2) Unfavourable mix variance (3) Higher than anticipated start-up costs - unfavourable mix variance
* Subsidiary of J&J - initial clash between J&J orientation by medical speciality and Codman product oriented mission
* Supplies hospitals and surgeons worldwide with products for surgery
* Changing environment from demand for high quality products to low costs products due to introduction of DRG costing - increased push for technological innovation to lower cost Relationship with J&J
* Compromised of 155 autonomous subsidiaries
* Managed on decentralised basis - subsidiaries act as integral, autonomous operations
* Senior policy & decision making group was Executive Committee
* BUs organised in sectors based firstly on products and secondarily on geographic markets 5 & 10 Year Plans
* Each subsidiary responsibly for preparing own plans and strategies i.e. operate as sum of strategic plans; no corporate strategy
* Each company annually prepares a 5 and 10 year plan consisting of estimated unit sales volume, estimated sales revenue, estimated NI, estimated ROI with narrative description
* Planning horizon focus on 2 years and remain fixed over 5 year period
* Plan presented to representative from J&J at annual review where assumptions/strategies/
* When approved summarised into two-page memorandum sent to CEO of J&J and presented to Executive Committee Financial Planning at J&J
* Used annual budgets for upcoming operating year and a second year forecast - revenue/
expenses budgeted by month, selected BS items budgeted to reflect year-end targets
* Developed bottom-up using (1) 5 & 10 Year Plans (2) 2nd Year Forecast from Prior Year
* Individual budgets consolidated by Information and Control Department - large focus on previous 2nd year forecasts to re-examine strategic plans
* After revenues & expenses budgeted, contingency expense budgeted depending on perceived uncertainty
* Similar approval process to 5 & 10 year plans i.e. presented to J&J representative, when approved presented to Executive Committee Budget Revisions & Reviews
* Budget performance monitored closely - weekly figures send to J&J rep, monthly management report prepared and formally revised 3 times a year by Executive Committee Corporate View of Planning & Control Process
* J&J President: Generally optimistic planning, no penalty for failure, encourage healthy conflict, focusing on managing LT i.e. no ST bonus plans
* Executive Committee Member: System focuses on finding & correcting problems
* Corporate Controller: Believes committee never dictates/changes proposals, only challenges ideas - individual realises forecast is not good enough; process cascades down J&J
READING 3: Management & Cost Accounting Chapter 14 (Bhimani et al, 2012) Budget & Responsibility Accounting Organisational Structure & Responsibility
* Organisational Structure: Arrangement of lines of responsibility within the entity - can be organised by business function (BP), regions (Diageo), product group (Norsk Hydro)
* Managers of individual groups have decision-making authority concerning all functions
* Organisation must co-ordinate efforts of employees i.e. assign responsibility to mangers who are accountable for actions in planning & controlling human & physical resources
* Responsibility Centre: Part, segment or subunit of an organisation whose manager is accountable for a specified set of activity (higher the manager, broader the RC); 4 types: (1) Cost centre - manager accountable for cost (2) Revenue centre - manager accountable for revenue (3) Profit centre - manager accountable for R&C (4) Investment centre - manager accountable for investments, R&C
* Responsibility Accounting: System which measures the plans (budgets) and action (results) of each responsibility centre; affect behaviour as can be held accountable
* Budgets & responsibility accounting can provide systematic help for managers e.g. through variances to pinpoint fault for operating problems
* Variance helpful in 4 ways: (1) Early warnings (2) Performance valuation (3) Evaluating strategy (4) Communicating the goals of the organisation Responsibility & Controllability
* Controllability: Degree of influence that a specific manager has over costs, revenues and other items in questions
* Controllable Cost: Any cost that is primarily subject to the influence of a given manager of a given responsibility centre for a given time span
* Responsibility accounting systems either exclude all uncontrollable cost from manager's performance or segregate uncontrollable costs from controllable ones
* Controllability can be difficult to pinpoint as: (1) Few costs clearly under sole influence of one manager (2) Will long enough time span, all costs will come under somebody's control but more reports focus on period of year or less - can inherit problems from predecessors Emphasis on Information and Behaviour
* Managers should avoid overemphasising controllability - should focus on information and knowledge not control i.e. who is the person who can tell us most about the specific item in questions, regardless of that person's ability to exert personal control?
* Performance reports for responsibility centres may include uncontrollable items because approach could change behaviour in direction of to management desires
Criticisms of Traditional Budgeting and Proposals for Change
READING 4: Scenario Budgeting - Integrating Risk & Performance (Palermo & Van der Stede, 2007)
* Performance goes through cycles - unrealistic to expect single target to fit all scenarios
* Target setting flexible enough to incorporate uncertainty - moves with business conditions
* Challenge of adjusting targets without unintended negative effects on motivation/mistrust for 'reneging' by resetting targets - paper argues achieved through scenario budgeting
Scenario Budgeting - What Is It?
Similar to standard management-by-expectation approach with 2 key differences:
* Planning - Firm undertakes strategic risk analysis to identify risks linked to 'key strategic drivers' used to define alternative scenarios with different targets for each scenario
Process is not fixated on single number, relieving undue stress on managers
* Performance Evaluation - Allows for variance analysis between expected and actual planning assumptions made around 'strategic drivers', as well as variance analysis between actual and expected performance
- If planning carried out credibly initially, then given scenario should be sufficiently close to reality to allow it to become the new base for comparison of actual performance
* Allows for: (1) Flexibility - Makes companies comfortable with multiple possible outcomes (2) Motivation - Reduces destructive stress while still requiring managers to perform against plan What Good Does It Do? Why Bother
* Most useful when uncertainty is high - encourages managers to plan rather than deal with problems at they come
* Different from 'flexible' budgets as scenario budgeting tries to anticipate possibly changing circumstances - awareness of possible risks help shape risks
* Better than traditional fixed budgets, as managers are hesitant to suggest target changes especially if too easy - results in unrealised potential
* However could argue managers would not find tougher targets reasonable even in scenario budgeting but targets only change if planning assumptions change - not reneging with benefit of hindsight but adjusting in planned manner
* Only need to be as complex as company desires - implies at least 2 scenarios but doesn't have to be dozens - must narrow down key strategic drivers!!
Scenario budgeting allows for planned flexibility while maintaining the motivational effects of targets - helps business navigate more effectively through uncertainty
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