Principles of Management Control Systems

Principles of
Management Control
Systems
ICFAI UNIVERSITY
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Principles of
Management Control
Systems
ICFAI Center for Management Research
Road # 3, Banjara Hills, Hyderabad – 500 034
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ISBN 81-7881-995-3
Ref. No. PMCS/A 01 2K6 31
For any clarification regarding this book, the students may please write to ICFAI
giving the above reference number, and page number.
While every possible care has been taken in preparing this book, ICFAI welcomes
suggestions from students for improvement in future editions.
 The Institute of Chartered Financial Analysts of India, January 2006.
All rights reserved.
No part of this publication may be reproduced, stored in a retrieval system, used in a
spreadsheet, or transmitted in any form or by any means – electronic, mechanical,
photocopying or otherwise – without prior permission in writing from Institute of
Chartered Financial Analysts of India.
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Contents
PART I: AN OVERVIEW OF MANAGEMENT CONTROL SYSTEMS
Chapter 1 Introduction to Management Control Systems 3
Chapter 2 Approaches to Management Control Systems 15
Chapter 3 Designing Management Control Systems 28
Chapter 4 Key Success Variables as Control Indicators 42
PART II: MANAGEMENT CONTROL ENVIRONMENT
Chapter 5 Organizing for Adaptive Control 57
Chapter 6 Autonomy and Responsibility 71
Chapter 7 Transfer Pricing 87
PART III: MANAGEMENT CONTROL PROCESSES
Chapter 8 Strategic Planning and Programming 99
Chapter 9 Budget as an Instrument of Control 114
PART IV: MANAGEMENT CONTROL TOOLS
Chapter 10 Reward Systems 139
Chapter 11 Management Control of Operations 152
Chapter 12 Continuous Process Improvement Methods 163
PART V: MANAGERIAL COSTING
Chapter 13 Strategic Cost Management 177
Chapter 14 Auditing 185
Chapter 15 Audit of Management Functions 208
PART VI: MANAGEMENT CONTROL IN SPECIFIC SITUATIONS
Chapter 16 Control in Multinational Corporations 221
Chapter 17 Control in Nonprofit Organizations 234
Chapter 18 Control in Service Organizations 242
Chapter 19 Management Control of Projects 258
PART VII: MANAGEMENT CONTROL AND EMERGING AREAS
Chapter 20 Control in the Age of Empowerment 279
Chapter 21 Management Control and Ethical Issues 287
Glossary 295
Bibliography 301
Index 304
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Detailed Contents
PART I: AN OVERVIEW OF MANAGEMENT CONTROL
SYSTEMS
Chapter 1: Introduction to Management Control Systems: Importance of
Control Systems: Elements of a Control System – Nature of Management
Control Systems: Important Features of Management Control Systems,
Management Control Process, Characteristics of a Good Management Control
System, Distinction between Strategy Formulation, Management Control and
Task Control – Types of Management Control Systems: Formal Control
System, Informal Control System – Subsystems and Components of
Management Control Systems: Formal Control Process, Informal Control
Process
Chapter 2: Approaches to Management Control Systems: Cybernetic
Approach to Management Control Systems: Characteristics of a Cybernetic
System, Cybernetic Paradigm and the Control Process, Designing
Management Controls, Control Process Hierarchy – Contingency Approach to
Management Control Systems: The Need for the Contingency Approach –
Strategy and Control Systems: Corporate Strategy, Business Unit Strategy
Chapter 3: Designing Management Control Systems: Steps in Designing
Management Control Systems: Choice of Controls, Tightness of Controls –
Factors Influencing the Design of Management Control Systems: Managerial
Styles and the Design of Control Systems: Corporate Culture and Design of
Control Systems, Decentralization and Design of Control Systems,
Organizational Slack and Design of Control Systems, Stakeholder Controls
and Design of Control Systems, Communication Structures and Control
Process – Establishing a Customer-Focussed Total Quality Culture:
Implementing Total Quality Management – Impact of Information
Technology on Control Systems Design: Providing Information for
Operational and Strategic Decision Making
Chapter 4: Key Success Variables as Control Indicators: Concept of Key
Variables - Identifying Key Variables: Input Variables, Production Variables,
Marketing Variables, Asset Management Variables, Sources of Key Variables,
Types of Key Variables – Key Success Variables and the Control Paradigm:
Dynamics of the Control Process, Identifying Key Variables –
Comprehensive Performance Indicators: Limitations of Indicators – Key
Variables in Selected Industries: Insurance Industry, Hotel Industry, Sugar
Industry, Management Training Institute, Power Industry
PART II: MANAGEMENT CONTROL ENVIRONMENT
Chapter 5: Organizing for Adaptive Control: Strategy, Structure and
Control – Decentralization Vs Centralization – Response of Structure to
Strategy: Evolution of the Matrix Structure: Project Organizations, Product
Organizations, Service Organizations, The Matrix Structure and the
Multinational Firm – Evaluation of the Control Factors in Organizational
Design: Matrix Versus Functional – Controller’s Organization – Adaptive
Organization: The Need for Adaptive Organization, Adaptive Controls that
Support the Adaptive Organization
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Chapter 6: Autonomy and Responsibility: Divisional Autonomy:
Management Style and Process, Responsibility Structure, Measurement of
Reward Systems – Responsibility Structure: Overall Effectiveness Measures:
Return on Investment (ROI) – Responsibility Centers: Nature of
Responsibility Centers, Types of Responsibility Centers – Performance
Measurement of Decentralized Operations: Measuring Divisional Operations
– Inter Profit Center Relations: Setting Transfer Prices
Chapter 7: Transfer Pricing: Objectives of Transfer Pricing – Principles of
Transfer Pricing: Goal Congruence – Methods of Calculating Transfer Price:
Market-Based Pricing Method, Cost-Based Pricing Method, Negotiated
Pricing Method – Upstream Fixed Costs and Profits: Two Step Pricing, Profit
Sharing, Two Sets of Prices – Administration of Transfer Prices: Negotiation
– Arbitration and Conflict Resolution, Product Classification
PART III MANAGEMENT CONTROL PROCESSES
Chapter 8: Strategic Planning and Programming: Elements of Strategy –
Characteristics of Strategic Planning: Benefits of Strategic Planning,
Organizational Relationships, Top Management Style – Strategic Planning
Process: Reviewing and Updating the Strategic Plan, Deciding on
Assumptions and Guidelines, First Iteration of the Strategic Plan, Analysis,
Second Iteration of the Strategic Plan, Final Review and Approval –
Analyzing Proposed New Programs: Rules, Avoiding Manipulation,
Acquaintance to Planning Models, Organizing for Analysis – Analyzing
Ongoing Programs: Analysis, Activity Based Costing, Expense Center – The
Programming Process: Bower's Model of the Investment Decision-Making
Process. Parameters of the Programming Process, Mutually Supportive
Management Systems for the Implementation of Strategy through
Programming Decisions, Formal Programming Procedures
Chapter 9: Budget as an Instrument of Control: Need for Budgeting –
Forecasting, Budgeting and Strategic Planning – Budgeting Process and
Control: Budget Preparation Process, Budgetary Control, Behavioral
Dimensions of Budgeting – Master Budget: Steps in the Preparation of the
Master Budget, Budget Balance Sheet – Zero Based Budgeting: The ZBB
Process, ZBB Vs Traditional Budgeting, Implementing Issues, Advantages
and Disadvantages of ZBB – Performance Budgeting: Steps in the
Implementation of Performance Budgeting, Performance Budgeting Vs
Traditional Budgeting – Participative Budgeting – Variance Analysis for
Control Actions: Revenue Variances, Expense Variances, Summary of
Variances, Limitations of Variance Analysis
PART IV: MANAGEMENT CONTROL TOOLS
Chapter 10: Reward Systems: Purpose of Reward Systems:– Components of
Incentive Compensation Plans – CEO Compensation – Incentives for Business
Unit Managers: Size of Bonus Relative to Salary, Cutoff Levels, Bonus Basis,
Performance Criteria, Benchmarks for Comparison – Balanced Scorecard –
Design Considerations: Rewards Integrated with MSSM (Mutually Supportive
Systems Model), Attainability, Formal Rewards, Informal Rewards – Agency
Theory: Concepts of Agency Theory
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Chapter 11: Management Control of Operations: Information used in
control of operations: Informal Information, Formal Information, Non
Financial Information – Just-In-Time Techniques: Advantages of Just-In-Time
Techniques, Implications for Management Control – Total Quality
Management: Consequences of Poor Quality, Total Quality Management
Approach, Implications for Management Control – Computer Integrated
Manufacturing – Decision Support Systems: Nature of Decision Support
Systems. Implications for Management Control
Chapter 12: Continuous Process Improvement Methods: Target Costing:
Planning Stage, Development Stage, Production Stage, Benefits of Target
Costing – Benchmarking and Benchtrending: Planning Phase, Analysis
Phase, Benchtrending, Process Benchtrending – Quality Improvements:
Process Quality Teaming – Activity-Based Costing: Traditional Costing vs
Activity Based Costing (ABC)
PART V: MANAGERIAL COSTING
Chapter 13: Strategic Cost Management: Evolution of Strategic Cost
Management: Strategic Measures of Success – Three Key Themes of Strategic
Cost Management: Value Chain Analysis, Cost Driver Analysis, Strategic
Positioning Analysis – Strategic Management and Strategic Cost Analysis
Chapter 14: Auditing: Benefits of Audit: Identify Opportunities for
Improvement, Reality Check, Identify Outdated Strategies, Increase
Management’s Ability to Address Concerns, Enhances Teamwork, Increase
Commitment to Change – Limitations of Audit – Timing of an Audit – Audit
Process: Staffing the Audit Team, Creating an Audit Project Plan, Laying the
Ground Work for the Audit, Analyzing Audit Results, Sharing Audit Results,
Writing Audit Reports, Dealing with Resistance to Audit Recommendations,
Building an Ongoing Audit Program – Audit Tools and Techniques: Budget,
Timing, Projectability, Geography, Surveys, Questionnaires, Focus Groups,
Interviews, Direct Observation – Management Audit: Objective of a
Management Audit, Development of Management Audit, Benefits of
Management Audits, Types of Management Audit, Organizing the
Management Audit, Conditions for Successful Management Audit – Internal
Audit: Need for Internal Auditing – Financial and Cost Audit – Social
Audit: Social Accounting versus Social Audit, Definition of Social Audit,
Features of Social Audit, Approaches to Social Audit, Types of Social Audit –
Audit Evidence: Persuasive, Relevant, Unbiased, Objective – Auditing for
Continuous Improvement
Chapter 15: Audit of Management Functions: Audit of the Purchasing
Function: Purchasing Procedure, Characteristics of an Effective Purchase
Department – Purchase Audit Areas – Human Resource Audit: Conducting an
HR Audit – Research and Development Activities Audit: Evaluation of R&D
Activities – Production Audit: Characteristics of a Good Manufacturing Audit
– Marketing Audit: Characteristics of Marketing Audit – Sales Audit:
Approaches to Sales Audit, Conducting a Sales Audit, Characteristics of a
Sales Auditor, Process of Collecting Data During Sales Audit
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PART VI: MANAGEMENT CONTROL IN SPECIFIC
SITUATIONS
Chapter 16: Control in Multinational Corporations: Types of Controls
Used By MNCs: Personal Controls, Output Controls, Cultural Controls,
Result Controls, Bureaucratic Controls – Concept of Strategic Control:
Headquarters-Subsidiary Environment, Impact of Global Competition, Impact
of Host Government Demands, Impact of Joint Ventures – Factors Affecting
Control Systems in MNCs: Cultural Differences Across Countries,
Differences in Business Environment – Analysis of Foreign Investment
Projects by MNCs: Taxes on Income from Foreign Investment Projects,
Political Risks, Economic Risks, Exchange Rate Risk – Transfer Pricing in
MNCs: Situation 1-Paying Some Tax, Situation 2-Inflating Profits, Situation
3-Paying No Tax, Situation 4-Getting Tax Rebates, Tax Avoidance Inflates
Profits, Methods of Transfer Pricing – Control of Foreign Affiliates: Currency
Translation, Budgeting for Foreign Affiliates
Chapter 17: Control in Nonprofit Organizations: Mission of Nonprofit
Organizations – Key Characteristics of Nonprofit Organizations: Atmosphere
of “Scarcity”, Bias towards Informality, Participation and Consensus, Dual
Bottom Lines: Mission and Financial, Difficulty in Assessing Program
Outcomes, Governing Board with both Oversight and Supporting Roles,
Mixed Skill Levels of Staff, Participation of Volunteers – Designing Control
Systems for Nonprofit Organizations – Employee Characteristics and
Organizational Culture: Rewards, Performance Measurement, Fund
Accounting, Programming and Budget Preparation
Chapter 18: Control in Service Organizations: Control in Professional
Organizations: Characteristics of Professional Organizations, Control
Systems in Professional Organizations – Control in Government
Organizations: Political Influences, Public Information, Attitude towards
Clients, Management Compensation – Control Systems in Government
Organizations: Strategic Planning, Performance Measurement – Control in
Financial Service Organizations: General Characteristics of Commercial
Banks, Regulatory Capital, New Products, Management Control Implications,
Basle Committee Principles on Banking, General Characteristics of Insurance
Companies – Control in Securities Firms: Management Control Implications
Chapter 19: Management Control of Projects: Differences between the
Control of Projects and the Control of Ongoing Activities: Single Objective,
Focus on Projects, Need for Trade-offs, Less Reliable Performance Standards,
Frequent Changes in Plan, Difference in Rhythm, Environmental Influence –
Project Planning: Planning Process, Nature of Project Plan, Project Scope,
Project Schedule, Project Cost, Project Scheduling – Project Control:
Objectives of Project Control, Control as a Function of Management –
Reporting for Control: Effective Reporting System, Types of Project Reports
– Project Team and Matrix Structure: Matrix Structure – Project Audits:
Levels of Audit – Project Evaluation: Evaluation of Performance, Evaluation
of Results
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PART VII: MANAGEMENT CONTROL AND EMERGING
AREAS
Chapter 20: Control in the Age of Empowerment: Balancing
Empowerment and Control: Diagnostic Control Systems, Belief Systems,
Boundary Systems, Interactive Control Systems – Control Systems and
Conflict Resolution: Conflicts in the Planning Subsystem, Conflicts in the
Measuring Subsystem, Conflicts in the Recording Subsystem, Conflicts in the
Appraisal Subsystem, Conflicts in the Reporting Subsystem, Conflicts in the
Subsystem for Remedial Action – Framework for Conflict Resolution
Chapter 21: Management Control and Ethical Issues: Identifying Control-
Related Ethical Issues: Creating Budgetary Slack, Responding to Flawed
Control Indicators, Managing Earnings, Using Excessively Tight Control
Measures – Designing Control Systems to Regulate Ethical Conduct:
Cybernetic Control Process for Developing an Ethics Program – Control
System Supporting the Ethics Program: Management Style and Culture,
Infrastructure, Rewards, Coordination and Integration – The Ethical Principle
of Fairness In the Design of Control Systems
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PART I:
AN OVERVIEW OF MANAGEMENT
CONTROL SYSTEMS
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Chapter 1
Introduction to Management
Control Systems
In this chapter we will discuss:
• Importance of Control Systems
• Nature of Management Control Systems
• Types of Management Control Systems
• Subsystems and Components of Management Control Systems
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Principles of Management Control Systems
In 2001, Enron Corp., the global energy giant, collapsed in one of the largest
cases of bankruptcy filing in U.S. corporate history. Tyco International, a
diversified manufacturing and service company, had to abandon plans to split
into four parts, because of doubts about its accounting practices. The stunning
news that WorldCom, the telecom giant, had artificially inflated its earnings
by $3.8 billion rocked the corporate world and shook investors’ confidence in
stock markets. WorldCom's accounting irregularities involved the deliberate
mis-recording of expenses as capital expenditures, in order to inflate its cash
flows. The accounting irregularities included transfers between internal
accounts of $3.06 billion in 2001 and $797 million in the first quarter of 2002.
As these examples illustrate, the absence or malfunctioning of control systems
can lead to huge losses, and even to corporate bankruptcy. Defective products
and poor coordination between departments also arise due to weak control
systems.
This chapter focuses on the importance of control systems, the nature of
management control systems, types of management control systems, and the
subsystems and components of management control systems.
IMPORTANCE OF CONTROL SYSTEMS
A control system is a set of formal and informal systems to assist the
management in steering the organization towards its goals. Controls help in
guiding employees effectively towards the accomplishment of the
organization’s goals. Establishing a control system in an environment of
distributed accountability, reengineered processes, and local autonomy and
empowerment is a challenging task.
The control process in any organization can be undertaken at three levels.
These are: the strategic level, the management level, and the operational level.
Each type of control occurs primarily at one of the three distinct levels of the
organizational hierarchy.
• Strategic control deals primarily with the broad questions of domain
definition, direction setting, expression of the organization’s purpose, and
other issues that impact the organization's long-term survival. Strategic
control overlaps to some extent with the process of strategy formulation.
Strategic control also deals with issues relating to general company
objectives and the implementation and monitoring of progress.
• Management control deals with effective resource utilization, the state of
competitiveness of the unit, and the translation of corporate goals into
business unit objectives.
• Operational control is primarily concerned with efficiency issues.
Occurring at very specific functional or sub-departmental levels of the
organizational hierarchy, this mode of control generally conforms to
traditional control models. The time horizon of control is very short, the
benchmarks are known and well defined, and the outcomes are tangible
and easily measurable.
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Introduction to Management Control Systems
It is important to recognize that the three levels of control are not mutually
exclusive. They represent a nested arrangement. If the control process does
not identify and deal appropriately with a problem occurring at a lower level,
the problem worsens. The problem then gets kicked up to a higher level of
control. This can be illustrated through the example of Kimberly-Clark in
Exhibit 1.1. In extreme cases, when the issue gets more complicated,
threatening the organization’s survival, the problem needs to be handled from
the highest levels, in terms of strategic control.
Increased control in an organization will result in reduced creativity and
entrepreneurship. Hence it is important for organizations to establish the trade-
off between the amount of control and the level of freedom for employees, and
to choose the right mix of controls.
Elements of a Control System
Any control system has four important elements. They are a detector or
sensor, an assessor, an effector and a communications network, as can be seen
in Figure 1.1. The detector analyzes the situation that is being controlled. An
assessor helps in comparing the actual results with the standard or expected
results. An effector is used to reduce the gap between the actual and the
Exhibit 1.1
Management Control at Kimberly-Clark
Kimberly-Clark, the manufacturer of household and health products, is an example
of a company that mixed up operational and management control issues. The
company has a good reputation as a manufacturer of household and health
products. Since 1950s, it also started selling cigarette paper and sheets of pressed,
reconstituted tobacco-to-tobacco companies for use in cigarettes. The tobacco
reconstitution process used by Kimberly-Clark enabled tobacco companies to
manipulate nicotine levels in cigarettes.
The state of West Virginia in the US alleged that Kimberly-Clark conspired with
cigarette companies to deceive the public about the hazards of smoking. When the
company realized that its tobacco business was becoming a legal and financial
liability, it spun off the tobacco unit.
At the operational control level, the company did not ascertain whether the
advertisements claiming that the tobacco reconstitution process allows nicotine
levels to be adjusted to a smoker’s individual requirement was indeed misleading.
At the management control level, the company did not act immediately once
smoking related illness became common. The strategic control failure was not
making a conscious determination whether the tobacco business was consistent
with the company's mission and values. If the tobacco business was consistent
with the mission and values, the company then needed to follow up by instituting
proper operational and management control systems that protected the
organization against legal liability.
Adapted from Veliyath, Raj; Hermanson, Heather M. “Organizational control systems:
Matching controls with Organizational levels” Review of Business, Winter97, Vol. 18
Issue 2, p2.
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standard result. The communication network transmits information between
the detector, the assessor and the effector.
The process of control usually involves four important steps. They are:
• Identifying the goals or objectives,
• Implementing the programs or policies,
• Measuring and comparing outcomes against targets, and
• Analyzing whether the achieved targets are in accordance with the goals
or objectives.
NATURE OF MANAGEMENT CONTROL SYSTEMS
The role of the management is to organize, plan, integrate and interrelate
organizational activities to achieve organizational objectives. The achievement
of these activities is facilitated by management control systems. A
management control system is designed to assist managers in planning and
controlling the activities of the organization. A management control system is
the means by which senior managers ensure that subordinate managers,
efficiently and effectively, strive to attain the company's objectives. According
to Anthony, Dearden and Govindarajan1
(1992), management control is “the
process by which managers ensure that resources are used effectively and
efficiently in the accomplishment of the organization's objectives”.
If the management monitors the activities of the business units frequently,
then it is exercising tight control. Limited monitoring of the business units’
activities can be termed as loose control. The difference between tight and
loose control thus relates to the degree to which the management monitors the
1
Robert N Anthony and Vijay Govindarajan, Management Control Systems, Eight Edition
Irwin Publications.
Figure 1.1 Elements of the Control Process
Control
device
2. Assessor. Comparison
with standard
1. Detector. Observed
information about what is
happening
Entity being
controlled
3. Effector. Behavior
altering communication,
if needed
Source: Robert N.Anthony, Govindarajan, Management Control Systems, (USA: Irwin, 1995) 5.
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activities of a unit. When there is tight control by the management, there is
extensive involvement of the management in the day-to-day operations of the
business unit. The budget is considered a binding constraint with a strong
emphasis on meeting the budgeted targets. Deviations from the budget are
generally not considered acceptable. Loose control is characterized by limited
involvement by the management in day-to-day operations. Under loose
control, the budget is regarded more as a tool for planning and communication
than as a binding commitment.
Management control systems involve a number of activities in an
organization, including:
• Planning the future course of action
• Coordinating and communicating the various activities of the organization
to different departments
• Evaluating information and deciding the various activities; and finally,
• Influencing people to work in accordance with the goals of the
organization.
Important Features of Management Control Systems
Nature of decisions
Management control decisions are based on the framework established by the
organization's strategies. Management control decisions also take into account
the quantity and quality of resources available. Within the constraints of the
available resources and the policies of the organization, a manager should be
able to implement activities that are best suited for a particular business unit.
Decisions are made at the highest level, but their actual implementation may
require some time. For instance, employees need time to adapt to a new
technology.
Decisions are systematic and rhythmic
Decisions in management control process are systematic and rhythmic i.e.
they are in accordance with the strategies and procedures laid down by the top
management. Plans developed for a unit must encompass the whole
organization, and the plans for each of the organization’s units must be
coordinated with one another, so that there is a balance between different
activities. For example, operations and distribution should be balanced with
the sales program.
Strategy implementation tool
Management control helps an organization to move towards its strategic
objectives. It is an important vehicle for the execution of strategy. Figure 1.2
explains how strategies are implemented through management controls,
organizational structures, human resource management, and culture. Effective
execution can take place with the help of an efficient organizational structure,
human resource management and culture. All these are influenced by the
system of management control, and hence it is an important aspect of strategy
implementation.
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Behavioral considerations
People are important assets for an organization. Without the cooperation of the
employees, managers cannot implement their decisions. To manage people
effectively, control systems are required for the following three reasons- lack
of direction, motivational problems and personal limitations.
Poor performance in organizations can be attributed to lack of direction
among employees. Giving employees the required support and direction to
accomplish organizational goals is one of the important functions of
management control systems.
Motivation is important to help employees perform to their full potential.
Most of the organization’s problems occur because individual goals and
organizational goals do not match. This results in demotivated performance by
the employees. At the managerial level too, lack of motivation will result in
employees taking decisions that are harmful to the organization. The decisions
may be made in order to advance the personal interests of the employees
involved. In extreme cases, this could lead to employee fraud and theft. In IT
companies, computer-related crime can result in huge losses for the
organization. Hence, there is a need to control such behavior in an
organization.
Another behavioral problem that can have serious consequences for an
organization is personal limitations. In spite of high motivation to perform,
certain employees may be unable to perform because of their personal
limitations. These limitations are specific to individuals, and could also be
because of inadequate training, lack of knowledge or information, and
inexperience. Job design also plays an important role in performance. Some
jobs are designed in a manner that creates stress. This can lead to accidents
and errors in decision-making. Training plays an important role in reducing
Figure 1.2Framework for Strategy Implementation
Implementation mechanisms
Management
Controls
Organization
Structure
Culture
Human Resource
ManagementStrategy
Performance
Source: Robert N Anthony and Vijay Govindrajan, Management Control Systems (USA:
Irwin, 1995) 11.
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the severity of limitations at the individual level. Finding effective tools for
control of such limitations is an important part of control systems.
Management Control Process
The management control process involves three interrelated activities –
communication, motivation and evaluation. First, it involves communication
between the superior and the subordinates. Communication helps the
subordinates understand the goals of the organization. The superior should
make sure that the subordinates understand what the organization expects of
them. Second, for the subordinates to put in their best efforts to achieve
organizational goals, they have to be motivated. It is the responsibility of the
superior to motivate the subordinates. Finally, for effective performance,
superiors should evaluate the work of the subordinates and give them
feedback periodically. It is essential for the superior to evaluate the
performance of subordinates without any bias.
Characteristics of a Good Management Control System
A good management control system ensures success for an organization. Good
management control here implies that the goals of the organization are clearly
communicated to the employees, and that the employee is confident about
performing his tasks well. For example, good inventory control means that
employees have information about the quantity of inventory present and its
availability at different locations. An organization does not usually have
perfect control. For perfect control all the employees should be working in the
best possible way. But this is not always possible as employee behavior is not
stable. Good control can be achieved in the following ways:
Future-oriented
Planning is always oriented to the future. The organization should be focused
on the future. Employees should be encouraged to be flexible so as to respond
effectively to change.
Clear Objective
Good control cannot be established unless the multiple objectives of a
particular task are considered separately. For example, to assess the control
system relating to production, all major performance parameters like
efficiency, quality and asset management, have to be measured.
Minimum control losses
Control devices are costly and not always economically feasible. So, control
devices should be put in place only when the economic benefits exceed the
costs. The difference between the performance that is theoretically possible
and one that can be reasonably expected is called “control loss.” An
organization achieves optimal performance when control losses are
minimized.
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Distinction between Strategy Formulation, Management Control and Task
Control
It is important to analyze the differences between management control and
other types of control. Management control needs to be distinguished clearly
from strategy formulation and from task control. While strategy formulation
takes place at the highest level in an organization, task control takes place at
the individual level. Management control lies at the middle level between
strategy formulation and task control. Figure 1.3 explains the distinction
between strategy formulation, management control and task control.
Distinction between strategy formulation and management control
Strategy formulation takes place at the highest level of the management and
involves formulation of new strategies, whereas management control involves
implementation of these policies. Strategy formulation takes place in
accordance with situations, both internal and external to the organization.
Hence, strategy formulation may not always follow a clearly defined system.
The management control process takes place in a systematic manner, and
involves managers and staff at all levels in the organization. Strategy
formulation usually involves only those at the highest level of the
organization. There may be changes in one or a few strategies, while others
remain unaffected. In contrast, the management control process involves the
whole organization, and changes affect all the parts since they are linked with
one another. Therefore, a high level of coordination is required.
Task control vs. management control
Task control involves the control of individual tasks. These tasks are carried
out according to the rules and regulations laid down by the management
Figure 1.3 General Relationship among Planning and Control Functions
Activity Nature of
End product
Strategy formulation
Goals, strategies and
policies
Management control
Implementation of
Strategies
Task control
Efficient and effective
performance of
individual tasks
Source: Robert N.Anthony, Govindarajan, Management Control Systems, (USA: Irwin,
1995) 9.
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control process. Usually the techniques in operations research and
management science focus on task control. The information important for task
control in an organization is usually quantitative in nature e.g. the number of
items ordered by the customers, the components used in manufacturing the
products, the number of man-hours used in a particular process, etc. The
devices used for task control include programmable machine tools, process
control computers and robots. In task control, each task requires a different
task control system (a production control system is different from a cash
management system).
Thus, it can be concluded that task control is quantitative in nature whereas
management control is oriented towards behavior. In task control, in some
cases, such as automated processes, employees may not be involved; in other
cases, there may be interaction between a manager and a worker. Management
control involves interaction between two managers or between a superior and
subordinate.
TYPES OF MANAGEMENT CONTROL SYSTEMS
Control systems in an organization fall under two broad areas: formal and
informal. Formal controls are laid out in writing by the management, whereas
informal controls arise as a result of employees’ behavior. Examples of formal
controls are plans, budgets, regulations and quotas. Informal controls include
group norms and organizational culture. Formal controls are framed by the
managers, whereas informal controls often originate with employees and are
affected by general socio-cultural factors.
Formal Control System
Formal control systems are written, management-initiated mechanisms that
influence the behavior of employees in achieving the organization’s goals.
Formal controls can be classified into three types, based on the nature of
management intervention. They are:
Input controls
These are the actions taken by the company before a planned activity is
implemented. These measures help the company to select the right way to
undertake the activity. Input controls include selection criteria, recruitment
and training programs, manpower allotments, strategic plans and resource
allocations.
Process controls
Process controls involve tracking certain variables and taking corrective action
whenever there is any deviation from specified parameters in the variables.
The control action takes place before the process of transformation is
completed and the output is produced. Process control is exercised when the
firm attempts to influence the ongoing activity to achieve the desired ends.
The control is applied to the behavior or activities rather than the end results.
For example, under a feed-forward system of inventory control, the factors
that affect inventory levels of finished goods, such as the rate of sales or
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dispatch delays, are tracked. When the sales begin to decline or there is a
dispatch bottleneck, this information is fed forward, and the level of the
finished goods inventory is controlled by reducing production. Thus, the
inventory levels are prevented from exceeding required levels. Alternatively,
the managers may realize that the original standards for sales or dispatch
delays are no longer appropriate and must be revised. This again feeds into a
loop, which leads to the inventory objectives or plans being updated. Process
control can also be illustrated using the example of a salesperson’s job. The
management may direct the salesperson to follow certain procedures for new
market development, but may not hold the salesperson responsible for the
extent of new business generated i.e. the end result. In such a case, process
control has been exercised.
Output controls
Output control is exercised when performance standards are set and
monitored, and the results are evaluated. Output control takes place when the
control activity is based on the comparison of actual and planned outcomes.
Such controls are applicable when it is easy and inexpensive to measure the
output and when there are few elements of uncertainty. In this type of control,
the management expects the employee to perform in a result-oriented way, as
it believes that the employee has the requisite knowledge to undertake the
activities required, in a suitable manner, and to complete the assigned task
without management intervention.
Informal Control System
These are unwritten, typically worker-initiated mechanisms that influence the
behavior of individuals or groups in business units. There are three types of
informal controls. They are:
Self-control
It deals with the establishment of the personal objectives by the individual,
monitoring their attainment and adjusting the behavior in the organization to
attain the goals. Self-control can be beneficial to an organization if the
organization’s goals are in congruence with the individual’s goals. But if the
goals do not match then the performance of the employee can suffer.
Social controls
Social control refers to the prevailing social perspectives and patterns of
interpersonal interactions within subgroups in the firm. In this type of control,
an organization establishes certain standards, monitors conformity with the
standard and takes action when deviations occur. Social control arises out of
the internalization of values and mutual commitment towards some common
goals.
Cultural controls
According to William G Ouchi, culture is “the broader values and normative
patterns that guide worker behavior within the entire organization.” Cultural
control can be realized by norms of social interaction, and stories, rituals and
legends relating to the organization.
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SUBSYSTEMS AND COMPONENTS OF MANAGEMENT CONTROL
SYSTEMS
The subsystems and components of control systems can be discussed on the
basis of formal and informal processes.
Formal Control Process
The formal control process has two dimensions- formal planning and formal
reporting.
Formal planning process
The formal planning process has two dimensions: strategic planning and
operations planning. In most organizations there are two budgets- one for
operations and one for strategy; and, there are two sets of reports - one for
strategic projects and one for operating activities. The formal planning and
control process should support the style and culture of the organization, and
should be supported by the infrastructure, the rewards, and the communication
systems in the organization.
A strategic planning system is necessary to assist the organization in the
planning and control of projects. It helps the organization to decide its goals
and objectives, and key strategies. An operational planning system undertakes
activities that are short term in nature.
Formal reporting process
Detailed reports help the organization to assess the progress of its strategic and
operational planning. Monthly, quarterly or yearly reports help the
organization to analyze its performance periodically, and to decide on the next
set of programs to be undertaken.
Although planning and reporting appear to be two distinct processes, there
should be a certain degree of integration. Strategic programs are funded out of
current operations and grow out of current activities. Further, strategic plans
and programs have a great impact on current operations and so, these strategic
plans should be adjusted from time to time in line with their effect on
operations.
Informal Control Process
Management decisions are based upon experience, intuition and feeling.
Informal control processes are formed as a result of interaction between
people. The informal control process helps in the development of new goals
and objectives. There are a number of mechanisms for control through
informal systems. One mechanism is the use of ad hoc teams to solve
problems, improve productivity and achieve organizational change. Informal
teams usually consist of cross-organizational groups which work in
coordination to solve problems related to a particular client, product or
market. Informal communication systems evolve as people develop work
relationships. Informal communication is helpful in supporting the key values
of the organization. Fostering informal communication is critical to the
development and maintenance of effective informal controls.
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Informal rewards and recognition are conferred upon the key team members
within the informal system. The respect an individual is shown is an informal
reward for performance. Communication systems are not highly guarded in
informal systems.
SUMMARY
The purpose of control is to ensure that an organization meets desired
objectives and that individual members behave in a manner consistent with
organizational objectives. In recent times, several companies have lost billions
of dollars because the necessary controls were absent. Management control
systems are considered essential for the successful attainment of corporate
objectives. It is the means by which senior managers effectively and
efficiently strive to attain company's objectives. Any control system in an
organization has four important elements that help in synchronizing the
organization’s various activities. They are – the detector (which provides
information about the situation), the assessor (for comparison with
benchmarked standards), the effector (which tries to bridge the gap between
the actual situation and the standard required), and finally, the communication
systems (that help in passing the information between the other three
elements). Control systems can be divided into formal and informal controls.
Formal control systems can be classified as input controls, process controls
and output controls. Informal control systems can be classified into self-
control, social control and cultural control. A clear corporate strategy,
corporate structure, well-defined centers of responsibility, and reliable
information centers are essential for management control systems to be
successful. A good management control system is oriented towards the future,
has clear objectives, and minimizes control losses. It is important to analyze
the distinction between strategy formulation, task control and management
control. Strategy formulation takes place at the higher level of the
management, and task control involves the control of individual tasks.
Management control lies at the intermediate level between the levels of
strategy formulation and task control. It helps in the implementation of the
desired strategies.
The subsystems and components of control systems can also be divided on the
basis of their use in formal and informal systems. Managerial style and
organizational culture play an important role in determining which
components are used, and whether the formal or informal processes are
dominant.
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Chapter 2
Approaches to Management
Control Systems
• Cybernetic Approach to Management Control Systems
• Contingency Approach to Management Control Systems
• Strategy and Control Systems
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In the introductory chapter, we discussed the importance of controls in
achieving organizational objectives. In addition to the amount of control, the
appropriate mix of controls should be used to maintain the right balance in an
organization. In this chapter, we discuss the various approaches to the
implementation of management controls. Organizations are complex
structures; hence, there is a need to design controls for them to function
effectively. The cybernetic approach helps us to understand the elements and
design of the control process in an organization. The contingency approach to
management control systems provides a potential explanation for the
bewildering variety of management control systems actually practiced.
Strategies at the corporate and business unit levels have a bearing on the form
and structure of control systems in an organization.
CYBERNETIC APPROACH TO MANAGEMENT CONTROL SYSTEMS
Cybernetics has its origin in the Greek work ‘Kybernetes’ which means
“steersman.” A steersman is a person who directs the movement of the ship
along the planned course or direction. In the 1940s, Norbert Weiner coined the
term cybernetics. According to his definition, cybernetics is the study of “the
entire field of control and communication theory, whether in the machine or
the animal”. Cybernetics deals with the self-regulating principles in a variety
of systems ranging from the human biological system to machine systems.
The human brain is a complex structure that helps in regulating the body
functions and helps the body perform complex activities. Organizations too
are complex, as they are made up of different individuals. Cybernetics has
been applied in such diverse fields as radar control, animal genetics,
inferential automation, cryptography and deciphering, automatic machine tool
control, language translation, teaching machines, artificial intelligence and
robotics. Due to its broad applicability, it has been popular with general
systems theorists as a unifying theory of self-regulation.
Characteristics of a Cybernetic System
The following are the characteristics of a cybernetic system:
Complex structures
There are number of heterogeneous interacting components in a cybernetic
system, making it complex.
Mutual interaction
The various components of a cybernetic system interact in a way that creates
multiple interactions within and among the subsystems.
Complementary
In cybernetic systems multiple interactions take place as a result of multiple
processes and structures. There are a number of subsystems which interact;
and hence, there is a need for multiple levels of analysis which complement
one another.
Evolvability
Cybernetic systems tend to evolve and grow in an opportunistic manner, rather
than being designed and planned in an optimal manner.
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Approaches to Management Control Systems
Constructivity
Cybernetic systems are constructive. They increase in size and complexity by
building on their existing characteristics and also developing new traits.
Cybernetic Paradigm and the Control Process
The cybernetic paradigm devised by Griesinger in the late 1970s helps in
designing the control process in an organization. The cybernetic paradigm not
only helps in capturing the essential elements of the repetitive control process
(refer Figure 2.1), but also does it economically. The essential elements of the
repetitive control process are the following:
• Setting goals and performance measures
• Measuring achievement
• Comparing achievement with the results
• Computing the variances resulting from the preceding comparison
• Reporting the variances
• Identifying the causes of the variation
• Taking the required action to eliminate the variances in the future
• Follow-up to ensure that the goals are met.
All goal-oriented controls reflect the basic elements of the cybernetic
paradigm. The paradigm begins with the assumption that decisions are made
because of the interaction between the decision maker and the external
environment. The manager of each business unit scans the external
environment for data that could be useful for the organization. The
mechanisms through which managers collect data are called sensors. Sensors
can collect data through formal methods like reports, or through informal
Figure 2.1: The Cybernetic Paradigm of the Control Process
Environment
Feedback
Goals
Perception
Behavior
Choice
Value
Premises
Comparator
Factual
Premises
Source: Joseph A Maciariello and Calvin J Kirby, Management Control Systems, (USA:
Prentice-Hall, Inc, Second edition) 42.
Behavioral
Repertoire
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methods like interactions with the members of the organization. Sensors can
be used to collect data with regard to both the internal and external
performance of the business unit. Based on the data collected, the manager
builds up certain assumptions about the external environment and the present
performance of the unit. These assumptions are a starting point for the
analysis and are termed as ‘factual premises’. Factual premises are formed on
the basis of perceptions, which are affected by past experiences,
organizational goals and personal goals.
The next step involves comparing the factual premises with the organizational
goals and performance measures. When there is difference between the
decision maker’s assumptions (value premises) and the assumptions made
about the environment (factual premises), then every possible step is taken to
bridge the gap. This is done with the help of a comparator that analyzes the
difference between performance as measured and performance information
desired. When there is a shortfall in performance, the decision maker searches
for a course of action that will help to cover the shortfall; this is referred to as
behavioral choice. Choice of behavior could involve selecting a solution on
the basis of previous experiences. In case there is more than one alternative
solution to the problem, the feasible alternative with the highest subjective
utility is chosen. In case no suitable alternative is found, the decision maker
expands his search for a viable option. After an appropriate method is found to
cover the shortfall, the next step is the implementation process.
The implementation process starts with the manager (effector) acting as an
agent for change by implementing the desired controls. After implementation,
the next step is to get the required feedback to determine the effects of the
action. This feedback helps the manager to judge whether the chosen behavior
or action has helped move towards the desired performance. If the feedback is
positive, this action can be selected again when similar situations arise in the
future. The feedback also helps in assessing whether the goals set are being
achieved. If the goals are not achieved, the manager has to go through the
whole process again. Hence all goal-oriented controls reflect the basic
elements of a cybernetic paradigm. To achieve goals, organizations need to
design effective individual controls for each activity.
Designing Management Controls
There are many issues to keep in mind while designing controls for an
activity:
• The process of establishing controls should be seen as a constructive
exercise that will help in enhancing the performance of the employees.
The standards set should be challenging, but at the same time, attainable.
• The objectives should be measurable to enable evaluation of performance.
• Controls should focus on the objectives and key results of an activity.
There should be a restricted number of objectives.
• There should not be too much focus on easily measurable factors and
short-run variables. Attention should be paid to all the important
variables in a balanced fashion.
• Responsibility for results should rest with a single individual to avoid
duplication of work.
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• To get the desired results, it is important to compare the actual
performance with the desired results. Comparing actual performance with
the desired results could be useful for setting controls for the next year.
• When establishing controls, the factors that could be hampering the work
process, such as stress, tiredness at work and absenteeism, should be
identified. Good feedback is an indication of the quality of the control
process. Early predictors, can help organizations to improve their
performance.
• It is advisable to take a sample of the variables to be controlled. This can
be done statistically or through observation.
• An acceptable range of variation for the value of each variable should be
established.
• While preparing reports there should be exceptions to desired results and
these should be promptly reported to the person responsible for the
reports.
• The severity of the problem should be determined by analyzing the cause
of the problem and then corrective action should be taken. The results of
these actions have to be monitored and compared to the expected values.
• A system of controls requires judgment and insight by those establishing
them and interpreting results.
Control Process Hierarchy
The control process in an organization involves the relationship between the
superior and the subordinates. The relationship can be termed as a means-end
relationship because the superior communicates the goals of the organization
to the subordinates, who, in turn, devise strategies to achieve those ends. The
goals of the subordinates should be congruent to the goals of the superior.
Congruency in goals can be achieved through negotiation, and depends on the
style of management and the communication process in the organization. The
hierarchy of the control process can be illustrated with an example. In a
hierarchical organization with decentralized decision-making and authority,
the control process begins with the superior meeting the subordinates and
negotiating goals, objectives and targets for the next year. After the goals are
finalized, the performance is tracked at periodic intervals. The superior and
subordinates review the overall performance. In areas where performance has
been unsatisfactory, they try to find the reasons for the unsatisfactory
performance. Once the reasons are identified, a plan of correction is prepared.
This plan is prepared on the basis of past corrective actions and the current
performance. Thus the targets and course of action for the next year are set.
The same process is carried out throughout the organization. A reward system
based upon the performance of the employees is designed. First, managers
decide on the targets they want to give their subordinates. Next, there is
negotiation between the superior and the subordinates with regard to the
targets. At this stage, it can be analyzed whether the subordinates’ objectives
are in congruence with the objectives of the superior. All the targets should be
specific and measurable. There should be a limited number of targets, so that
they can be managed well. The targets should cover qualitative variables
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(employee training and development, and new product development) as well
as quantitative variables.
To summarize, the goal-oriented control process follows the cybernetic
paradigm and involves planning, decision-making and controls. It operates
through a hierarchy of control, and its main purpose is the attainment of
organizational goals and objectives.
CONTINGENCY APPROACH TO MANAGEMENT CONTROL SYSTEMS
Contingency theory is based on the premise that the design and use of control
systems is contingent upon the particular context of the organizational setting
in which the controls operate. Contingency theory was propounded in
response to the universalistic approach that argues that there is an optimal
scheme for control design which is applicable in all settings and firms. In
contrast, contingency theory states that the appropriateness of different control
systems depends on the business setting. Contingency approach is an
extension of scientific management theory The theory also states that the
appropriateness of different control systems depends on the setting of the
business.
The term ‘contingency’ implies that the structure and process are contingent
on various external and internal factors. Prior to the contingency theory, the
classical theory developed by management scientists like Fayol, Burns and
Stalker, and Lussato assumed that people were motivated by economic
rewards. It also assumed division of labor based on specialization, and the
delegation of routine tasks to subordinates by hierarchical superiors.
Contingency theory focuses on the interaction between the organization and
its environment. It is assumed that the organization ‘imports’ energy and
resources from the environment, and converts them into goods, services and
by-products. The goods, services, and by-products are then 'exported’ to the
environment, thus changing the environmental circumstances in which the
organization operates.
The Need for the Contingency Approach
Factors such as technology, organizational structure and the environment have
led to the emergence of contingency formulations in control systems.
Technology
It has long been recognized that technology influences the design of control
systems. New computer systems enable companies to respond to changes in
the environment and refashion corporate policies rapidly. Revision of plans
and estimates and new incentive programs can be worked out quickly and
passed on to the workforce rapidly. Technology can help managers to use
resources more effectively, and to collect data for strategic and operational
decision-making. The increased use of technology has brought in new control
systems that can help managers identify specific problems in administration or
factory operations. The contingency approach is able to utilize the new
technology very effectively in control systems.
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Organizational structure
A modern organization’s structure should be such that it can cope with a high
degree of uncertainty, as new tasks are constantly incorporated into the
production or work process. An ‘organic1
' organizational structure adapts
easily to unstable conditions in rapidly changing environments. As a business
grows, the work of the management increases, and the organization’s structure
becomes more complicated as new tasks or lines of production are added. The
management control system for such organizations is complex. The
contingency approach helps in designing a control system that meets the
demands of complex organizational structures.
Environment
In order to survive, organizations have to adapt to the demands of their
environment. Management controls in an organization are greatly influenced
by the type of competition faced by the firm. The contingency approach helps
to develop a highly sophisticated control system in line with the intensity of
competition the firm faces.
Contingency theory greatly expanded the scope strategy and management
control. It emphasizes the “fit” between external environmental factors and the
internal resources of the organization. It analyzes the components of the
organization, its structure and cultural setting, and its ability to adapt to
technological and structural changes.
Fisher2
(1998) developed an approach to contingency theory and management
control by reviewing- contingency theory, management control systems and
firm outcomes. He suggested that the assumptions that underlie contingency
theory are too narrow. Fisher's approach focuses not only on the unique,
characteristics of control systems, but also on the environment in which some
control systems have a better fit. Fisher points out that the contingency
approach has enabled researchers to develop generalizations about control
systems relative to business and organizational settings. By studying
contingency factors in different business settings, Fisher identified five
contingent control variables: uncertainty; technology and interdependence;
industry, firm and unit variables; competitive strategy; and mission and
observability factors. These factors can be either external or internal to the
organization, and can affect organizational outcomes, performance, resource
allocation and distribution of rewards.
He suggested potential research areas in contingency control that include:
causal relationships of multiple variables; study of control systems in relation
to other organizational aspects; human resources policies and cultural systems.
These also included non-financial factors such as cycle time, lead time,
frequency of orders and production performance factors. The financial factors
included budgeting and standard cost systems. Fisher suggested new
directions in contingency control research that would move from financial to
operational and production control factors critical to organizational
1
The organic organization is structured to encourage flexibility and change. The structure also
motivates and creates a rewarding work environment.
2
Fisher, Joseph G "Contingency theory, management control systems and firm outcomes: Past
results and future direction." Behavioral Research in Accounting 1998 Supplement, Vol. 10,
p47
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performance. For example, the contingency approach could be used to explain
variations in the adoption of just-in-time and activity-based costing methods in
different organizations.
STRATEGY AND CONTROL SYSTEMS
According to Kenneth R Andrews, “strategy is a process by which senior
executives evaluate company's strengths and weaknesses in light of the
opportunities and threats present in the environment, and decide on a product
market that fits the company's distinctive competencies with environmental
opportunities.” Organizations usually treat strategy and control as distinct
organizational functions. Strategies are developed first, as managers study
their current and potential role in the environment and determine the
appropriate response. Controls are designed to help organizations to achieve
their goals. An organization can gain competitive advantage by integrating the
usually separate functions of strategy and control. Management control
systems are the tools which help in the effective implementation of strategy. It
is important to analyze the different kinds of strategies, as control systems can
be designed based on the types of strategies.
Strategies can be considered at two levels in an organization. There are
strategies for the organization as a whole (corporate strategy) and strategies
for each business unit (business unit strategy). For the formulation of
corporate strategy, an organization should consider the suitability of the area
of business for the firm, and the mission or purpose of each business unit. This
analysis will help the firm decide whether to divest or retain a particular
business, and the amount of resources to allocate for each business. At the
level of the business unit, a firm has to analyze the business unit’s mission,
and the steps it should take to accomplish the mission. Corporate strategy is a
guide to the individual business units, helping them to function in accordance
with the organization goals and strategies.
Corporate Strategy
Corporate strategy relates to the firm as a whole. Corporate strategy involves
making plans regarding where and how the firm can compete in an industry.
At the level of corporate strategy, controls refer to the mechanism by which
corporate executives influence the strategic direction of the firm and the level
of achievement of the firm's objectives. Corporate strategy and controls should
be integrated in order to keep employee behavior in congruence with
managerial goals.
An organization has a well-aligned structure, it will not function effectively
without a control system in place. The organizational structure of a firm refers
to its hierarchies and reporting patterns. For the effective functioning of the
structure, appropriate control systems are needed. Since planning and control
requirements are different for different corporate strategies, they need to be
designed in accordance with the corporate strategies. For example, in the
electronics business, channels of communication and transfer of competencies
across various business units are critical for effective functioning, and
therefore the various departments are interdependent. In such companies, the
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corporate level managers need to have wide range of control across various
departments. Managers should also have extensive knowledge about the
various departments and their work processes.
Control systems can be framed according to the class into which a company
fits. Companies can be classified into three categories: a single business firm
operating in one line of business; a firm which has undertaken diversification
into businesses that are related to one another; and, a firm which has
diversified into businesses that are not related to one another, (except in being
owned and managed by a common concern.) Corporate strategies of firms are
distinctly different in firms with different levels of diversification. Firms can
be classified into three categories based on the extent and type of
diversification undertaken by them.
Single business firm: The firm concentrates on a single business. For example,
Apple Computers pursues a single business strategy of manufacturing
computers.
Related diversification: The firm has diversified into businesses that are
related to one another and have a common set of core competencies.
Unrelated diversification: The firm operates in different areas of business
which are unrelated to one another. The only common link between them is
that they are managed and financed by a common concern.
Control systems will differ on the basis of corporate strategy with regard to
diversification.
• More diversification requires that the managers at the corporate level
should have a wide range of expertise and knowledge relating to the
various activities of the firm. Management control in diversified firms is
often difficult. .
• Single business firms and firms with related diversification are based on
company-wide core competencies. Hence it is important to have good
channels of communication that can allow interdependence among the
different units.
• In the case of undiversified firms, there is comparatively less
interdependence among various units. As a firm becomes more
diversified, control systems should be altered to foster better cooperation
among the diverse units and to encourage their entrepreneurial spirit.
There are specific activities that need to be considered when designing a
control system for different corporate strategies
Strategic planning: Conglomerate businesses usually use vertical strategic
plans i.e. the different business units prepare strategic plans, which are
reviewed by the senior management. Strategic planning systems for
diversified business units are usually both horizontal and vertical. The
horizontal process involves the preparation of a plan on behalf of each unit or
group by an executive, with synergistic inputs from the different business
units of the organization. The managers of the individual business units
identify the various linkages to other business units so that they can synergize
their operations. These interdependent units also require joint strategic plans.
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The strategic plans of the individual business units are often circulated among
the various business units as this helps in getting feedback.
Budgeting: In a single business firm, the chief executive can control the
budgeting operations through informal methods and personal intervention. In a
conglomerate, it is not possible to rely on informal interpersonal relationships,
and the chief executive officer may is unlikely to be able to control all the
budgeting activities in all the businesses. Hence, business unit managers have
greater influence in developing their product/market environments.
Incentives and compensation: The plan for employee incentives and
compensation in organizations varies according to the level of diversification
of the organization. In the case of conglomerates, bonus is usually formula-
based. Formula-based plans are not usually popular in highly interdependent
firms as their performance is based on the decisions and actions of other units.
In a single business firm, bonus is determined on the basis of subjective
factors such as the performance of the business. In the case of a business unit
manager, the bonus is tied to the performance of the particular unit rather than
the profitability of the whole firm. In the case of single business firms and
those with related diversification, the compensation is usually tied to the
performance of the unit and also the performance of the whole firm. Linking
incentives to the overall performance of the organization helps to increase
teamwork and interdependencies.
Business Unit Strategy
Diversified companies segment themselves into business units and assign
different strategies to different business units. Such companies do not have a
standardized approach for all their business units, but develop separate
strategies for each business. Business unit strategy deals with creating and
maintaining competitive advantage in all the businesses the company operates
in. Business unit strategy for an organization has two interrelated aspects:
mission and competitive advantage.
Mission
A mission statement is a broad organizational goal, based on planning
premises, which justifies an organization’s existence. There should be
congruence between the mission statement of the organization and the controls
being used. Management control systems help the manager to make decisions
on the trade-off between the short term and the long term. In a diversified
business, the primary task of the CEO is to make basic decisions on the
businesses to undertake, the resources to deploy in each, and the integration of
the multiple businesses to make them most effective. There are various
planning models that help managers at the corporate level to allocate resources
among different businesses. These models of planning also help in identifying
the missions of individual business units. The focus of all the planning
decisions are based on certain factors:
• Concentrating on the internal and external factors of the business that
determine the attractiveness of the market opportunities available to
business units.
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• The competitive ability of the business unit is likely to vary from one unit
to another. So a firm has to emphasize on the performance of each
business unit before allocating resources.
• The attractiveness of the industry in which a unit is operating is likely to
vary. Hence it has to be considered when allocating resources.
Two of the planning approaches most widely used are the Boston Consulting
Group's two-by-two growth share matrix and General Electric Company’s
three-by-three industry attractiveness-business strength matrix. While the
models differ on the methodologies adopted, they have the same set of
missions for a business unit to choose from: Build, Hold, Harvest and Divest.
The company should have a clear idea of the type of mission the business
units have chosen, as this will help in deciding on the control systems to be
used.
Build: This mission indicates that the business unit’s goal is to increase its
market share, even at the expense of short-term earnings and cash flow. A
business unit following this mission is typically a resource user due to the
heavy investment required to build a competitive position. Business units with
low market share in high growth industries typically pursue a ‘build’ mission.
Hold: This strategic mission aims to protect the business unit's market share
and competitive position. The cash outflows, for a business unit following this
mission, would usually be approximately equal to cash inflows. Typically,
businesses with high market share in high growth industries pursue a ‘hold’
mission.
Harvest: This mission has the goal of maximizing short-term earnings and
cash flow, even at the expense of market share. A business unit following such
a mission would be a resource provider in that it generates more cash than that
required for further investment. Typically, businesses with high market share
in low growth industries pursue a ‘harvest’ mission.
Divest: This strategic mission indicates a decision to withdraw from the
business either through a process of slow liquidation or outright sale.
Typically, business units with low market share in low growth industries are
divested.
The missions discussed above should not be used in a mechanistic manner.
They have to be combined with creativity, innovation and initiative by the
managers for effective control systems.
Thus while framing control systems a manager has to be aware of the mission
adopted by each of its business units. The form and structure of a control
system affects business units with different missions. Strategic planning,
budgeting, and the incentive/compensation system are the main aspects
determining the form and structure of the control system.
Strategic planning process: Strategic planning needs to be designed keeping
in mind the environment in which the company operates. In an environment
where there are greater uncertainties, strategic planning assumes more
importance. For this reason, the process of strategic planning is more critical
for 'build' business units than for ‘harvest’ business units. A ‘build’ mission is
usually undertaken in the growth stage of the product life cycle, and the
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objective of the ‘build’ mission is to increase the market share. Increasing a
company’s market share involves uncertainty, particularly with regard to
competitors, for ‘build’ units.
Budgeting: Budgeting involves deciding on the allocation of resources and
targets of each business unit. Budget revisions are more likely in the case of
‘build’ units than for ‘harvest’ units because of frequent changes in the market
environment of ‘build’ units. 'Build' managers, however, usually have greater
influence on the formulation of budgets, and other important management
decisions. For ‘harvest’ units, the environment is usually stable, and so inputs
from managers of ‘harvest’ units are less essential.
Incentive compensation system: When several elements enter into the design
of an incentive compensation system for business units. Managers have to
decide on the size of incentive bonus payments, the measures of performance
to be considered for incentive bonuses ( sales volume, product development,
return on investment etc.), the criteria on the basis of which subjective
judgments are to be made, the frequency of incentive payments (annual,
monthly, biennial), etc. The mission of the business unit influences the type of
incentive package formulated. In many firms, the completion of riskier
projects is rewarded by higher compensation. Managers in ‘build’ units are
therefore likely to have higher incentive payments than managers in ‘harvest’
units. Performance may be measured either over the short term or the long
term. If a firm links incentives to performance in terms of profits, cash flows
and returns on investment, it is said to have a short-term focus, whereas if it
links incentives to performance in terms of market share, new product
development and development of human resources, it is said to have a long-
term focus.
Competitive advantage of a business unit
In order to accomplish its mission, every business unit should develop a
competitive advantage. In order to identify its competitive advantage, a
business unit should analyze the competitive structure of the industry in which
it plans to operate. Porter’s Five Forces Model analyzes the competitive
structure of an industry on the basis of the following factors:
• Intensity of rivalry among the existing players
• Bargaining power of the buyers
• Bargaining power of the suppliers
• Threat from substitutes
• Threat of new entrants
An understanding of these factors, can help a business unit to frame generic
strategies through which it can respond to the opportunities in the external
environment. Alternative generic strategies may be developed in terms of:
Low Cost: The primary focus of this strategy is to achieve low cost relative to
competitors. Cost leadership can be achieved through economies of scale in
production, learning curve effects, tight cost control and cost minimization in
areas such as research and development, service, sales force, or advertising.
Differentiation: The goal of this strategy is to differentiate the product of the
business unit, in order to create a product that is perceived by customers as
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unique. Differentiation may be based on brand loyalty, customer service,
dealer network, product design and features, and product technology.
Focus: This strategy requires the business unit to focus on a particular buyer
group, segment of the product line, or geographic market. The focus strategy
helps the unit to achieve core competency by narrowing its market segment.
Additional considerations: Although a firm should adopt different controls for
its units, there are some problems associated with this strategy. The external
environment of a business unit changes over time and shifts in strategy may be
required. If a control system is over-committed to a single strategy or level of
diversification, it may become difficult for the manager to shift to a new
strategy.
Secondly, the control system should be appropriate for both the mission and
the competitive advantage of the firm. Trying to design a control system that
fits both may result in conflict. In such situations, the manager has to decide
whether to give priority to the firm’s mission or to its competitive advantage.
SUMMARY
The cybernetic approach to management control systems helps in analyzing
complex activities in an organization. The cybernetic paradigm helps to
manage the repetitive control process in an organization. Contingency theory
was propounded in response to the universalistic approach that argues that
there is an optimal scheme for control design, which applies in all settings and
firms. Changes in technology, organizational structure and the need to adapt to
the environment of the industry have contributed to the emergence of
contingency formulations in control systems. Management control systems are
tools that help in effective implementation of strategy. Hence, it is important
to understand the types of strategies firms use in respect of diversification and
how control systems can be devised for each strategy. Strategies can be
considered at two levels: the corporate level and the level of the business unit.
Corporate strategy relates to the whole organization and involves decisions on
where to compete and how to compete. Strategies at the corporate level can be
differentiated on the basis of the level of diversification undertaken by the
firm i.e., whether it is a single business firm, a firm with related diversification
or a firm with unrelated diversification. Business unit strategies deal with
creating and maintaining competitive advantage in all the areas of business in
which the company operates. Business unit strategy has two interrelated
aspects: mission and competitive advantage. The business unit’s mission
could be: to build, to hold, to harvest or to divest; while it can develop its
competitive advantage in terms of low cost, differentiation or focus.
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Chapter 3
Designing Management
Control Systems
• Steps in Designing MCS
• Factors Influencing the Design of MCS
• Establishing a Customer Focused Total Quality Culture
• Impact of Information Technology on Control Systems design
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Designing Management Control Systems
A management control system is a set of interrelated communication
structures that facilitate processing of information and coordination between
different parts of an organization. Control systems help in the effective
implementation of an organization’s strategy. The subsystems and
components of management control systems should be mutually supportive so
that organizational goals can be achieved. When the subsystems are properly
designed, they provide a basis for an organizational control system. The
control systems should be designed in such a way that they reflect the goals
and strategies of the organization. It is also important to design control
systems in such a way that they contribute to the effective implementation of
the organization's strategies. This chapter deals with the steps involved in
designing control systems, factors that influence the design of management
control systems, the relationship between the style, culture and design of
control systems, establishing a customer-focussed total quality culture and the
impact of information technology on control systems design.
STEPS IN DESIGNING MCS
Designing control systems requires an understanding of what the organization
wants from each employee individually. This involves identifying the role of
each individual from the chief executive officer to each employee at the
lowest organizational level in achieving organizational goals. MCS cannot be
designed without an understanding of the key actions being controlled. Since
the purpose of a control system is to influence actions, identifying the desired
actions is important. An organization must find out what knowledge and
information it requires to control employees’ actions. Another way to
understand what has to be controlled is to identify the key actions (KAs). KAs
differ from firm to firm, and from individual to individual. For lower level
employees, such as the production line workers, KAs are easy to identify,
because they are routinized and mechanical. KAs of higher level employees
which involve identification of problems, team building and making
investment decisions may not be easily understood as they need professional
judgment. It is not easy to judge whether the actions taken are appropriate
without close monitoring done by someone who has equal or higher
professional knowledge. Most companies have standard sets of actions for
employees who prepare investment proposals, business plans, and give
justifications for recruitment decisions. These are called action controls.
Role demands can also be identified through the Key Results (KRs). Key
results are the areas which are important for the growth of an organization.
Examples are sales performance, customer orders received etc., Key results
change according to the prevailing internal and external environment of an
organization.
The step that follows the understanding of role demands involves
understanding the likely actions or results of the role demands. If the analysis
shows that what is desired is not different from what is likely, then it can be
concluded that the company has an effective management control system. If
the analysis shows a difference between the two, then the reasons would have
to be investigated. The reason may be lack of direction, motivational problems
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or personal limitations. Depending on the severity of the situation, different
controls should be applied.
Choice of Controls
The choice of controls depends on the severity of the problem. Control
mechanisms can be selected from feasible alternatives (that would provide the
maximum benefits). While analyzing these alternatives, managers should first
consider personal or cultural control, as these have very few consequences and
are less costly to implement. Usually in small organizations, most problems
are solved by implementing cultural and personal controls. However, these
controls work only when employees have clearly defined roles, understand
their goals and expected performance levels. Choices among the various
actions and results control depend on the advantages and disadvantages each
control has in a particular setting.
Action controls
These are controls that work on the standard sets of procedures. The
advantages of action controls are:
• They are directly linked to the task being performed.
• They direct managerial attention towards the actions being taken within
the firm.
• Their application in an organization is uniform in nature and hence they
aid in organizational coordination.
• Since these controls work on a standard set of actions, they act as a
knowledge repository and guide the implementation process even when
key managers leave the organization.
• In a positive sense, these controls are means for attaining efficiency, as
they are a key element in the bureaucratic form of organization.
These controls also have their own disadvantages:
• Action controls are useful only for highly routinized jobs.
• This type of control does not foster creativity and innovation among
employees, as employees have to follow rigid rules.
• Since these controls do not encourage creativity, employees tend to quit
their jobs.
• Because of the rigidity of rules, companies have difficulty in adapting to
the changing external business environment.
Result controls
These are used to control the behavior of employees. These are effective in
addressing motivational problems. They inform employees about what is
expected of them and what they should do in order to produce the desired
results. Results control can be established by first defining the dimensions on
which the control has to be set. The dimensions could be either customer
satisfaction or product profitability. The next step involves measuring
performance based on these dimensions. Setting performance targets and
providing adequate incentives to encourage employees to perform effectively
is the final step. The advantages of results control are the following:
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• These controls are feasible, and provide effective control even where
knowledge as to what actions are desirable is lacking.
• Result control provides on-the-job training and also provides employees
an opportunity to learn from their mistakes.
• Result control results in motivating employees, and commitment towards
the job as it gives employees greater autonomy to perform their task.
The disadvantages of result controls are these:
• Often the controllable results that the organization desires and the
performance of the individual cannot be measured effectively.
• Any problem that arises as a result of this control is attributed to the
employee’s mistake.
Result controls and action controls are the major elements of management
control systems in all organizations. After the choice of controls the next
decision relates to the tightness of controls.
Tightness of Controls
Whether the control should be tight or loose depends on how the organization
perceives the following issues-the benefits of tight controls, the costs incurred
due to tight controls, and the side effects of tight controls, if any. Some
organizations prefer tight control in areas that are most critical to their
success. Some forms of tight controls are costly to implement, require a
significant amount of the top management's time, and requires new
information systems, measuring equipment or extensive studies to gather
useful information. All these may add to organization's expenditure. Finally, it
is necessary to know whether there are any harmful effects of the control
being used. For example, if the environment in which the employees are
working is unpredictable, then tight controls will not work, as employees need
autonomy to take actions. As tight controls limit adaptability, employees will
find it difficult to adjust to changing environment.
The best control method would be a combination of tight and loose controls -
an environment where autonomy, entrepreneurship and innovation are
encouraged, and, at the same time, employees share a set of rigid values.
FACTORS INFLUENCING THE DESIGN OF MCS
The design of control systems is influenced by a number of factors:
managerial style, corporate culture, organization structure, organizational
slack, stakeholders’ control and communication structures.
Management style and corporate culture play an important role in designing
the control system. While management style is related to the individual
manager's whereas corporate culture relates to the overall organizational
concept. In fact management style and corporate culture are related to one
another. The style of a manager influences the style of other managers in the
organization and upon the culture of an organization. Culture consists of
shared values and norms of the organization and this influences the prevailing
style of the management. Hence management style and culture are
intertwined.
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Managerial Styles and the Design of Control Systems
Managers differ in their styles of managing employees. The different styles
have an impact on the design of the control systems. If the control systems are
not designed with the managerial style in mind, then conflicts might arise
between organizational goals and managerial styles. The different managerial
styles that influence the design of control systems are external control, internal
control and mixed control.
External control
External control works on the premise that subordinates can be motivated
through rewards. This style is authoritative and mechanical as the
organizational goals are set by the top management. Exhibit 3.1 shows the
prominence of external control style in ITT. The style also establishes that to
achieve the goals it is necessary to
• Set difficult goals so that the employees need to stretch themselves.
• Form strict regulations so that employees are not able to manipulate their
tasks.
• Embed adequate incentives in the performance assessment systems, so
that employees are motivated to perform.
This type of control has its advantages and disadvantages. On the positive
side
Exhibit 3.1
External Control Style at ITT
Harold Geneen, manager with ITT, adapted an external control style during his tenure as
a manager. He was accessible to his subordinates and developed a controller
organization. The line managers were supervised by a large staff. Whenever problems
arose, task forces were set-up to solve the problems. The movement of inventory,
payables and receivables were checked by the corporate controller. Geneen developed a
control system for ITT with the following characteristics.
• Infrastructure - a highly refined formal system of goals and controls
• Rewards - Bonuses were used to motivate the employees for better performance.
Bonuses were 30% or more of salary. Managers were paid 12% more than the
market rate. This resulted in intense competition among employees.
• Communication and integration - Geneen spent the equivalent of three months per
year in meetings to solve problems. These meetings helped the employees to build a
cordial relationship among themselves and with their boss.
• Control process - A control process was used in order to assist managers to submit
their report to the top managers found the environment too tensed up to develop and
succeed. Further, his style did not encourage innovation.
Geneen’s style was not free of problems. There were some significant costs associated
with this style. The managers found the environment too tensed up to develop and
succeed. Further, his style did not encourage innovation.
Adapted from Joseph A. Maciariello and Calvin J. Kirby, Management Control Systems (New
Jersey: Prentice Hall Inc., 1994).
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• Subordinates may be motivated to perform, as rewards are directly linked
to performance.
• Because of high control executed by the top management, superior will be
able to monitor subordinates work and there would be no manipulations.
The disadvantages of this type of control are:
• Employees will not have any commitment towards the organization. They
will perform only to obtain rewards and benefits.
• Employees will concentrate only on one aspect of their job and ignore the
rest. An employee may concentrate on increasing the sales volume, and
ignore customer service.
• Only the positive outcomes of a particular task would be informed to the
higher authorities. The negative information about it will be withheld,
fearing deduction in incentives.
• Employees will invest all of their potential in their area of work and
ignore other aspects that are important for the well-being of an
organization as a whole.
Internal control
This style works on the premise that subordinates will be motivated and
committed to the organization if they are involved in the decision making
process. United Airlines has achieved success by adopting this style (refer
exhibit 3.2). The style assumes that employees will experience a sense of
achievement, recognition and self-esteem if they are involved in the decision-
making process. The following are strategies that are important to implement
internal control style:
Exhibit 3.2
Internal Control Style at United Airlines
Ed Carlson, former CEO of United Airlines, used the internal control style. His style
led to the design of a control system with the following characteristics.
• Infrastructure- Personal participation was encouraged. Carlson placed his
confidence in the trustworthiness and motives of managers. He developed profit
centers only after extensive consultation. Small staff was employed and task forces
were used to solve problems.
• Rewards - Bonuses were paid in relation to performance against plan.
• Communication and Integration - Carlson emphasized teamwork in problem
solving. He used the concept of personal communication extensively in order to
knit the organization together.
• Control process - Reports were focused on people. Commitments started at the
lower level of the hierarchical structure. Managers were held responsible for their
commitments. Carlson's style too was not free from problems. It was extremely
difficult to implement the participative style in an organization as big as United
Airlines.
Adapted from Joseph A. Maciariello and Calvin J. Kirby, Management Control Systems (New
Jersey: Prentice Hall Inc., 1994).
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• The management style should be participatory in nature as the employees
are involved in the process of decision making. The emphasis here is not
so much on achieving the goals, but on how well they are set.
• Strategies are designed to solve problems jointly, and not to blame a
particular individual for its occurrence. When an employee's performance
moves in an undesired direction, the subordinates and managers meet to
identify the reasons for this and to develop appropriate solutions to the
problem. Thus this system works in a positive direction to analyze
problems at an early stage.
• Rewards in this system are not based on one or two specific measures of
performance, but on accountability of the overall performance. This
management style does not punish an employee for his past actions, but
intends to improve his performance in the future.
The advantages of the internal control style are the following:
• It inspires high levels of commitment and motivation in the employees.
Since the employees also take part in the decision-making process they are
more focussed on achieving the targets.
• This type of control encourages accountability towards the work and an
open work atmosphere. Employees are free to give their feedback on
managerial decisions.
This style has certain disadvantages too. They are:
• It exercises loose control within the organization. In this situation
managers will have less control over their subordinates.
• The information provided in this control is basically meant for identifying
the problems and suggesting corrective action. Hence it does not work as
an evaluation tool for rewarding employees.
• Employees, who are not willing to participate in this kind of management
may not perform well.
Mixed control
The two types of control discussed above have their own advantages and
disadvantages. Hence a manager has to carefully analyze the benefits of each
style and carefully choose the style that would be most beneficial for the
organization. The characteristics of mixed control style of Litton industries are
shown in exhibit 3.3. Sometimes a manager has to balance both types of
control styles in the organization. In doing so, he has to consider four
important issues. They are:
Congruency between control and managerial style: In order to choose the type
of control to be adopted for the organization, a manager has to first analyze his
style of management. If his style is participatory in nature, than internal
control would be a better. If it is authoritative, then adopting the internal
control style would not work, as the subordinates may not be used to putting
forward their views during the decision-making. They may not be in a position
to set realistic goals. Hence, there is a need for congruency between the
managerial style and the control style.
Analyzing the climate, structure and reward system of the organization: All
these factors determine employee behavior. For example, if employees are
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