Management Accounting Practice and Research Related to Vertical Hierarchies within Organizations

Kenneth A. Merchant University of Southern California EIASM, December 2006

What is a vertical hierarchy?

Organization built on series of superior/subordinate relationships Headquarters/divisions/departments
Functional Divisionalized Geographical

Critical problems in vertical hierarchies

The organizational coordination problem The management control/agency/motivation problem

Primary control alternatives in vertical hierarchies

Direct supervision (monitoring) Bureaucracy (rules and procedures) Meritocracy (autonomy plus accountability

Creating a meritocracy is generally the preferred alternative

Encourage coordinated actions. Energize the workforce. Stimulate learning, creativity/innovation and continuous improvement.

Management accounting in meritocracies

Long history
E.g., DuPont, General Motors, GE

Centralized control with decentralized authority Responsibility accounting

E.g., Solomons (1965)

Virtually all corporations of at least minimal size

Create financial plans/budgets Measure financial and operational performance monthly Use responsibility accounting Provide rewards based on financial performance (typically annually)

So is best practice well established?

Not exactly

Among the things we dont know

1. Why so heavy an emphasis on summary financial measures of performance when it is known that these measures provide poor indications of value creation?

What we want (in for-profit organiations)

Measures that go up when value is created and down when value is destroyed.

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What weve got

Correlation between annual accounting earnings and annual value creation .20

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Lots of financial measurement alternatives

Profit measures (e.g., PAT, PBT, operating income, EBITDA, OIBDA) Return measures (e.g., ROE, ROC, ROI, RONA, RAROC, CFROI) Residual measures (e.g., residual income, EVA, economic profit)

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Summary financial measures: unsolved questions

Which measures work best in which settings? Can the measures be improved? Are there roles for financial measures even if they do not reflect value changes well?

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Correlations between accounting earnings and value creation

One year Two years Five years Ten years .22 .39 .57 .79

Source: Easton et al, JAR, 1992.

Should firms just extend the measurement horizon?

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Among the things we dont know (cont.)

2. How best to link market, financial and nonfinancial measures of performance? Lots of frameworks for Integrated Performance Measurement Systems
Balanced Scorecard Tableau de Bord Performance Prism Intellectual Capital Navigator SMART (Strategic Measurement and Reporting Technique) EFQM (European Foundation for Quality Managements Excellence Model)

(Or more generally, MBO/CSF)

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Measurement issues when using a combination of measures

How to test the assumed causal linkages? How many measures is enough? How should the measures be weighted in importance? (What is balance?) What to do when measures have interactive or non-linear effects on overall performance?
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An example of a non-linear relationship

Relationship between Satisfaction and Forthcoming Year's Profit
5-Month Survey
400000

300000

200000

100000 .6 .7 .8 .9 1.0

Satisfaction with Customer Service

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We must understand better

The different purposes of performance measurement systems.
Does some combination of the major categories say it all? attention directing, problem solving, decision facilitating and/or decision influencing Difference between a dashboard and an objective function? Difference between a complete objective function and an optimally designed incentive system?

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Among the things we dont know (cont.)

3. Why do so many organizations base performance-dependent rewards on corporate performance even though few employees can have a material effect on overall corporate performance?

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Among the things we dont know (cont.)

4. Can budgeting be improved, or is it really pass?

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Among the things we dont know (cont.)

5. Why is the typical bonus formula so complex?
For example:
Organizational level of performance Objective function Performance contingencies Shape of the reward function

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Shape of a typical short-term bonus function

Rewards

Results
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Among the things we dont know (cont.)

6. Why dont firms use truthinducing incentive systems?

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Among the things we dont know (cont.)

7. Why are systems sometimes dramatically different across settings
Individual contingencies and combinations of them Management style

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Among the variances in practice that are difficult to explain

Differences in use of punishments Differences in tolerance for use of subjectivity in performance evaluations Differences in implementation of the controllability principle

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Differences in application of the controllability principle

1. One companys philosophy: No tolerance for any excuses.
President: We dont pay for effort. We pay for results.

2. Most(?) companies protect managers from some bad luck but reward them for virtually all good luck.

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An important, poorly understood contingencynational setting

Performance-dependent incentives for department managers in automobile retailers:
U.S. (n = 433) % earning formula bonus 64.3% Size of formula bonus (% salary) 54.6% Primary performance measure=profit 94.0% Formula bonus floor and cap 1.6%

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Cross-national differences in reward systems (cont.)

Performance-dependent incentives for department managers in automobile retailers, U.S. vs. Netherlands:
U.S. Netherlands (n = 433) (n = 145) % earning formula bonus 64.3% Size of formula bonus (% salary) 54.6% Primary perf. measure=profit 94.0% Formula bonus floor and cap 1.6% 10.3% 8.6% 15.4% 23.1%

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Among the things we dont know (cont.)

8. More generally, what are the motivations of people in the hierarchy? We know that its often not:
a. Value maximization; e.g., superiors encourage subordinates to create slack. b. Pure self-interest; e.g., many people try to do the right things even at personal cost.
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Conclusion
There is a lot yet to be learned, even in this very mature area of management accounting.

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