ICFAI - Principles of Management Control Systems

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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
The Institute of Chartered Financial Analysts of India, January 2006.

All rights reserved.
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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.
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.
Contents
PART I: AN OVERVIEW OF MANAGEMENT CONTROL SYSTEMS
Chapter 1
Introduction to Management Control Systems
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

Organizing for Adaptive Control
57
Chapter 6
Autonomy and Responsibility
71
Chapter 7
Transfer Pricing
87
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Chapter 5
20
PART III: MANAGEMENT CONTROL PROCESSES

Strategic Planning and Programming
Chapter 9
Budget as an Instrument of Control
99
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PART IV: MANAGEMENT CONTROL TOOLS

Reward Systems
Chapter 11
Management Control of Operations
152
Chapter 12
Continuous Process Improvement Methods
163
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Chapter 10
139
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PART V: MANAGERIAL COSTING
Strategic Cost Management
177
Chapter 14
Auditing
185
Audit of Management Functions
208
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Chapter 15
Chapter 13
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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
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
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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
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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 Controllers Organization Adaptive
Organization: The Need for Adaptive Organization, Adaptive Controls that
Support the Adaptive Organization
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
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PART III MANAGEMENT CONTROL PROCESSES
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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
PART V: MANAGERIAL COSTING
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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)
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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
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Chapter 14: Auditing: Benefits of Audit: Identify Opportunities for

Improvement,
Reality Check, Identify Outdated Strategies, Increase
Managements 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
PART VI: MANAGEMENT

SITUATIONS
CONTROL
IN
SPECIFIC
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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
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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
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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
PART VII: MANAGEMENT CONTROL AND EMERGING

AREAS
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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 ControlRelated 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
Chapter 1
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Control Systems
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Introduction to Management
In this chapter we will discuss:
Importance of Control Systems
Nature of Management Control Systems
Types of Management Control Systems
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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.
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IMPORTANCE OF CONTROL SYSTEMS
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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.
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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
organizations goals. Establishing a control system in an environment of
distributed accountability, reengineered processes, and local autonomy and
empowerment is a challenging task.
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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 organizations 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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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.
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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 smokers 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.
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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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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 organizations 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 tradeoff 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
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Figure 1.1 Elements of the Control Process

Control
device
2. Assessor. Comparison
with standard
1.
Detector.
Observed
information about what is
happening
3. Effector. Behavior
altering communication,
if needed
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Entity being
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Source: Robert N.Anthony, Govindarajan, Management Control Systems, (USA: Irwin, 1995) 5.
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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.
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NATURE OF MANAGEMENT CONTROL SYSTEMS
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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.
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.
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Important Features of Management Control Systems
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Nature of decisions
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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.
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Decisions are systematic and rhythmic
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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 organizations 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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Figure 1.2Framework for Strategy Implementation

Implementation mechanisms
Management
Controls
Organization
Structure
Strategy
Human Resource
Management
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Culture
Performance
Behavioral considerations
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Source: Robert N Anthony and Vijay Govindrajan, Management Control Systems (USA:
Irwin, 1995) 11.
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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.
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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.
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Motivation is important to help employees perform to their full potential.

Most of the organizations 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
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
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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.
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Characteristics of a Good Management Control System
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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
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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.
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
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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.
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Task control vs. management control
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Task control involves the control of individual tasks. These tasks are carried
out according to the rules and regulations laid down by the management
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Figure 1.3 General Relationship among Planning and Control Functions
Strategy formulation
Nature of
End product
Goals, strategies and
policies
Management control
Implementation of
Strategies
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Activity
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).
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TYPES OF MANAGEMENT CONTROL SYSTEMS
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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.
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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.
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Formal Control System
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Formal control systems are written, management-initiated mechanisms that

influence the behavior of employees in achieving the organizations goals.
Formal controls can be classified into three types, based on the nature of
management intervention. They are:
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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 salespersons 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
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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.
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Informal Control System
Self-control
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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:
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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
organizations goals are in congruence with the individuals 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
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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.
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Formal reporting process
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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.
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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.
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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
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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
organizations 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 selfcontrol, 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
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Control Systems
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Approaches to Management
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.
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CYBERNETIC APPROACH TO MANAGEMENT CONTROL SYSTEMS
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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.
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Characteristics of a Cybernetic System
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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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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
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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
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Figure 2.1: The Cybernetic Paradigm of the Control Process

Goals
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Environment
Feedback
Factual
Premises
Perception
Value
Premises
Comparator
Behavior
Choice
Behavioral
Repertoire
Source: Joseph A Maciariello and Calvin J Kirby, Management Control Systems, (USA:
Prentice-Hall, Inc, Second edition) 42.
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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 makers 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.
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Designing Management Controls

There are many issues to keep in mind while designing controls for an
activity:
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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.
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.
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Control Process Hierarchy
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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
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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.
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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.
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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 organizations 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 organizations 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
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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.
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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
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The organic organization is structured to encourage flexibility and change. The structure also
motivates and creates a rewarding work environment.
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
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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.
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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 units 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
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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.
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Single business firm: The firm concentrates on a single business. For example,
Apple Computers pursues a single business strategy of manufacturing
computers.
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Related diversification: The firm has diversified into businesses that are
related to one another and have a common set of core competencies.
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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.
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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.
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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 formulabased. 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
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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.
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A mission statement is a broad organizational goal, based on planning

premises, which justifies an organizations 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:
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Concentrating on the internal and external factors of the business that

determine the attractiveness of the market opportunities available to
business units.
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 Companys
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.
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Build: This mission indicates that the business units 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.
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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.
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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.
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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

companys market share involves uncertainty, particularly with regard to
competitors, for build units.
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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 longterm focus.
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Competitive advantage of a business unit
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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. Porters 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
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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.
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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 firms mission or to its competitive advantage.
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SUMMARY
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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 units 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
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Designing Management
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Control Systems
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Steps in Designing MCS
Factors Influencing the Design of MCS
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Establishing a Customer Focused Total Quality Culture
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Impact of Information Technology on Control Systems design
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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 organizations 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.
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STEPS IN DESIGNING MCS
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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.
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Action controls
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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.
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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.
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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.
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Any problem that arises as a result of this control is attributed to the

employees 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.
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Tightness of Controls
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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
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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.
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This type of control has its advantages and disadvantages. On the positive
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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.
Geneens 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.
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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 decisionmaking process. The following are strategies that are important to implement
internal control style:
Exhibit 3.2
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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.
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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:
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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.
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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.
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Mixed control
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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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Exhibit 3.3
Mixed Control Style at Litton Industries
Roy Ash, co-founder and president of Litton industries, made use of the mixed control
style. His style consisted of the following characteristics:
Infrastructure - For a diversified organization like Litton, the appropriate approach
to decision making and problem solving should be that of an analytical type. Roy
Ash used the same approach. He chose people who possessed strong analytical
powers and strategic skills.
Rewards Roy Ash selected only the best people and made sure that they were
given their dues they deserved.
Communication & integration - Roy Ash arranged numerous small meetings in

order to communicate with people more frequently.
Control process - Though the financial plan at Litton was presented yearly, it was
updated monthly and quarterly. Performance reports against plan and cash flow
statements were prepared weekly. The numerical reports were fewer in number.
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control system, then there will be no congruence of goals.
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Reliability of job performance measures: In some organizations control

systems clearly indicate the performance measures that have to be
implemented in the organization. But some control styles do not indicate the
performance of the employees clearly. For example, an external control
system cannot be implemented if employee's performance is not measured
precisely. This requires loose and more internally oriented organizational
control.
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Individual differences among subordinates: It is usually assumed that a

manager has a clear understanding of the nature of all the employees and their
needs. Some employees may be willing to take part in the decision-making
process while others may not be interested in it. A manager should consider all
these factors while finalizing his choice of control system for the organization.
It may be difficult for a manager to consider all the factors discussed above.
Therefore, the manager should sequentially prioritize his decisions.
Firstly, a manager needs to question himself about the managerial style he

uses, the strategy of the organization, the accuracy and reliability of the
performance measures and the willingness of the subordinates to
participate in the decision-making process.
The best way for a manager to choose the most appropriate control style is
to use the decision tree approach.
Also, a manager should consider the trade-off for different styles that can
be applied to a particular situation. This trade-off has to be prepared by
weighing the desirable and undesirable effects that a control system can
have on some subordinates.
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Just as an organizational strategy is important for the implementation of

organizational plans, a control system and the way it is implemented play an
important role in making an organization and its employees more productive.
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Management control is the process by which an organization ensures that its

sub-units act in a coordinated and cooperative fashion so that more resources
could be obtained and optimally allocated in order to achieve the
organization's goals. Corporate culture consists of shared values, common
perceptions and common premises that the members of an organization use to
achieve goals. Organizational culture influences several basic premises of an
organization and, hence, has a major influence on the organizational goals.
Thus, while designing management control systems, the heads of an
organization should take its culture into consideration. Bureaucracies, markets
and clans are three types of corporate control mechanisms that exist in varying
degrees in different organizations. Bureaucracies follow strict formal rules,
procedures and directives. It has clearly defined roles for each member of the
organization. The most important component of a market-based approach is
creating incentives to motivate performance. In the case of the clan control
mechanism, the organization depends on values and beliefs to boost
performance. Values and beliefs are conveyed to the employees at all levels,
initially through recruitment and socialization process and subsequently
through training and development.
Corporate Culture and Design of Control Systems
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Corporate culture helps in the overall coordination of all the activities of an

organization. In an organization when the goals and values are shared by the
individual members, problems are minimized and a sense of group loyalty
prevails. For example, IBM has designed the following belief system for its
employees.
Respect for the individual
Customer service
Dedication to work towards excellence
Decentralized business
Total quality management
Empowerment of people
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Employees should also be rewarded appropriately for understanding and

implementing the suggestions proposed by the management and achieving
new goals. Sometimes, as a result of resistance from the leader certain changes
are prevented from being implemented. In such cases, it is better to change the
leader. After the change has been implemented, it is important to extend it on
to other sub-systems of the control system.
Impact of corporate culture upon control system
Culture becomes an important asset of an organization when it is properly
imbibed in an organization. Conversely, it is a liability when it adapts poorly
to the environmental needs of the organization. The strength of culture
depends on the following three factors:
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The assumptions made by the organization
The clarity of the assumptions and
How well they are shared within the organization.
A control system must be so designed that it fits the existing culture of the
organization. This can be done by stressing on the values that the management
wants its employees to follow and rewarding them for achieving goals based
on these values. In order to foster desirable values in an organization, the
subsystems and components of its formal control systems should be so
changed as to inculcate these values.
Decentralization and Design of Control Systems
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It is necessary for every organization to decentralize the decision-making

authority, so that sub-goals can be set. In this way, every decision-maker is
made responsible only for a small portion of the overall organizational
objective. Decentralization ensures that the decision-maker arrives at the right
decision by making use of sufficient information. However, decision-makers
should find ways to deal with the complexity in the organizational
environment even when the information available to them is limited.
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The purpose of a control system is to knit the subunits of an organization

together. Without a centralized control system, it would be difficult to bring
this about. There what is important for an organization is not whether it should
be decentralized or not, but to what extent it should be decentralized.
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Organizational Slack and Design of Control Systems
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Cyert and March define organizational slack as the disparity between the
resources available to the organization and the payments required to maintain
the coalition. Organizational slack occurs when an organization underexploits its environment. This under exploitation results in higher salaries,
wages and perquisites than necessary to carry out the goals and objectives of
the firm. Dividends may be higher than necessary to maintain the confidence
of shareholders. But, in terms of management control systems, slack acts as a
cushion against changing the business environment and provides resources for
innovation and adaptation in various areas.
Stakeholder Controls and Design of Control Systems

The stakeholders of an organization include investors, customers, employees,
suppliers and the public. It is necessary for the organization to determine the
goals and objectives, performance measures of each of the above categories. A
functional organizational structure is designed keeping these goals in view and
then managerial controls are designed for departments of the organization.
Based on the relationships and the goals, organizations exercise control over
stakeholders. The analysis of stakeholder relationships begins with identifying
all the stakeholders. The next step is to distinguish the most important
stakeholders. This group consists of stakeholders who are highly influential,
powerful insofar as the organization's decision-making process is concerned.
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The next step is the analysis of the inducements that can be offered to the
stakeholders. Inducements can include material rewards, power, distinction
and participation in the activities of the organization. Next, the contribution
for a particular stakeholder has to be analyzed. Contributions include capital,
revenue, performance and community support. Finally, the competition for a
particular stakeholder is analyzed. All these steps help the company in
identifying crucial stakeholder variables that help in monitoring and
influencing the control process.
Communication Structures and Control Process
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The formal and informal communication within an organization include

meetings, day-to-day contacts among managers, body language etc. All these
formal and informal communication are crucial in understanding and
improving the control process. Let us discuss how communication structures
support control process with the help of information systems.
The first element of the information system is a formal or informal process,
which scans the environment in which an organizational subunit operates.
After this the organization requires a planning process. The planning stage is
the most crucial of all, as it involves four sub-processes namely strategic
planning, business planning, long range planning and operations planning. All
these processes would remain incomplete without proper communication
across various levels of the organizational hierarchy. Feedback is necessary
after the completion of each stage (environmental scanning, planning). The
feedback is compiled in the form of a report. This is followed by decisionmaking procedures and implementing them.
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ESTABLISHING A CUSTOMER-FOCUSED TOTAL QUALITY CULTURE
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Organizations in the present-day competitive environment need to concentrate

on customer satisfaction. In markets that offer a number of options to buyers,
companies can place themselves in an advantageous position by concentrating
on customer-focused total quality culture. While, on one hand, organizations
have to respond to the needs of the customer, on the other hand, they have to
increase their efficiency to compete with others in the business. Total quality
management ensures that organizations attain the required levels of efficiency
targets as well as satisfy customers. Thus, TQM can be described as a system
that emphasizes customer satisfaction and commitment to continual
improvement of its services and products to meet the needs of existing and
potential customers, through empowerment and active involvement of all the
staff.
Control is an integral part of any business. Lack of structured and formal
quality assurance and control training adversely affects the progress of the
quality improvement program.
TQM follows a cybernetic paradigm in solving problems:
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First, the top management makes (clear to the rest of the employees) the
key philosophical principles of TQM.
The top management then sets up a company wide quality improvement

program. This program consists of a quality improvement team which is
formed according to the mission and targets of the organization. The main
task of the team is to communicate the various philosophies and charter
subunit teams in a hierarchical fashion.
The next step involves each team coming up with ideas about products
and services that need to be launched. It also involves covering
manufacturing products according to the expectations of the consumers.
Implementing Total Quality Management
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Implementing TQM is a long process. It may take as many as seven years to

complete the process. It is the responsibility of the top management to
implement TQM. The top management should search for expert trainers and
organize TQM training programs for the different teams within the
organization. The teams should be encouraged to work towards the
improvement of TQM objectives. This encouragement may assume the form
of rewards and recognition given to the employees for good work. Middle
management should ensure that the environment needed for the
implementation of TQM is easily susceptible to changes and continuous
improvement. Figure 3.1 shows the importance of formal and informal
systems necessary to support a TQM program. The subsystems and
components of a control system should be so designed as to help a TQM
program achieve customer satisfaction.
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IMPACT OF INFORMATION TECHNOLOGY ON CONTROL SYSTEMS

DESIGN
Information technology has benefitted traditional control systems1 in many

ways.
Data can be managed more easily, and at a reasonable cost.
The various departments of the organization can work towards achieving

the organization's goals and collaborate for fast decision-making.
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Data can be collected for strategic and operating decisions.

With the help of the new spreadsheet technology, the budgeting process of a
company can be speeded up, and the quality of the budgets can be improved.
New technology also ensures that managers update the budgets. Data
architectures2 help companies adapt to regulatory or other environmental
changes.
In production facilities, information technology is increasingly being used for
speeding up the control process. Prior to the advent of information technology,
any faults in the production process could not be detected until there was some
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William J Burns, Jr. and F. Warren McFarlan Information technology puts power in control
systems Harvard Business Review, Sep/Oct87, Vol. 65 Issue 5, p 89.
Data architecture gives the desirable features of the corporate database, such as an integrated,
well-formed business view, while overcoming the practical difficulties like customer, order,
sales, etc. and the systems in which they appear.
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Figure 3.1: Management Systems for Total Quality

STYLE & CULTURE
Style
Participative/teamwork
Values
Strong customer focus
Continuous
improvement
Innovation as a value
Trust
INFRASTRUCTURE
SBUs
Problem solving teams
Responsibility for
quality distributed
throughout
Staff support for
quality methodology
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CONTROL PROCESS
Statistical quality control
Informal active planning
Competitive benchmarking
Activity-based costing
Target costing
Other performance measures
Customer satisfaction
measures
Vendor measurements
Cost of quality measurements
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REWARDS
Based on quality
performance
Recognition programs
Consistent throughout
organization
Skepticism tolerated
Cynicism rejected
COORDINATION
AND INTEGRATION
Training in TQM
Problem solving tools
Employee involvement
Open and candid
communication
Source: Joseph A. Maciariello and Calvin J. Kirby, Management Control Systems (New
Jersey: Prentice Hall Inc., 1994) 136.
major breakdown. But with the new technologies even a slight change can be
detected. Information technology can also help a company align its control
and sales-incentive measures. New inventory tracking systems can help
companies update account balances, monitor inventory and alert
manufacturers and suppliers for upcoming requirements.
As control systems operate all the areas of an organization, any change in
them requires changes to be made in the overall structures and strategies of the
organization. Therefore, managers should take the right decisions in choosing
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what type of technology requirements the organization needs. Technology

should be used for making work easier rather than indulging in complex and
expensive systems such as costly data, storage systems.
Providing Information for Operational and Strategic Decision Making

The decline in the cost of information processing led to the rise of ABC
(activity based costing) systems. These systems provide accurate cost data for
the operational and strategic decisions in an organization. The availability of
an electronic equipment, called the optical scanning equipment, has improved
the efficiency of inventory control techniques. This equipment is also used to
conduct market research by noting customers demand patterns.
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SUMMARY
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Designing control systems require an understanding of what the organization

wants from each of its employees. This involves identifying the role of each
individual from the chief executive officer to the employees at the lowest
hierarchical level in achieving organizational goals. While designing a control
system, it is necessary that the managerial style and the culture of the
organization should be clearly analyzed. There are three types of managerial
control systems namely external control, internal control and mixed control.
External control is authoritative and mechanical, as the organizational goals
are set by the top management. This style works on the premise that
subordinates will be motivated and committed to the organization if they are
involved in all aspects of decision making. In the case of the mixed control
style, the manager analyzes the benefits of each style and carefully chooses
the one that would benefit the organization the most. The control process
includes the essential elements of planning, decision-making and control.
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Decentralization ensures that the decision-maker arrives at right decision with

the help of sufficient information. Organization slack occurs when the
organization under exploits its resources. In such cases, the organization
incurs extra costs in all its functional operations.
Stakeholders are the essence of an organization and it is the duty of every
organization to identify key stakeholders variables and monitor their
performance. The designer of a control system designer should make use of
communication structures to coordinate various activities of the organization.
TQM ensures customer satisfaction and commitment to the continual
improvement of the organizations services and products to meet the needs of
existing and potential customers, through empowerment and active
involvement of the staff. Subsystems and components of control systems
should be designed to assist TQM in achieving customer satisfaction. New
technology has benefitted control systems in a number of ways by helping
companies manage data easily.
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Chapter 4
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Key Success Variables as
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Control Indicators
Concept of Key Variables
Identifying Key Variables
Key Success Variables and the Control Paradigm
Comprehensive Performance Indicators
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Key Variables in Selected Industries
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CONCEPT OF KEY VARIABLES
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A key variable is a significant indicator of business activity, whose sudden

and unpredictable change warrants immediate action by management. Key
variables are also referred to as key success factors as they help in explaining
the success or failure of the organization. A small change in a key variable
will have a significant impact on the performance of the organization. The
nature of the task, the technology and the environment in which the
organization operates are the factors which greatly influence the identification
of key variables. An important function of key variables is that they indicate to
the management the necessity for prompt action. A manager should identify a
few variables that are crucial to the attainment of strategy, goals and
objectives of an organization. Once they have been identified, the manager
can rely on these key variables to monitor business activities and alert the
organization to the changes in the business environment that could
significantly affect the attainment of management goals. The top management
should analyze the reasons for significant changes in key variables
continually. Some examples of key variables are profitability, market position,
productivity and employee attitude. This chapter looks at the importance of
key variables for organizations, the identification of key variables, and the
types of key variables.
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A key variable is a significant indicator of business activity. Any change in its

value is expected to have an impact on the performance of the organization. It
is the responsibility of every organization to identify key variables as they are
indicators as to the likely success or failure of the business. The nature of key
variables differs from organization to organization depending on the nature of
the task, the technology and the environment of the organization. Key
variables have certain characteristics that help the manager to identify them.
However, the actual selection of key variables requires a thorough
understanding of the business, its operating environment and management
goals. The management can identify key variables either for the whole
organization or for the major centers of responsibility. Although key variables
differ from business to business, they have certain characteristics in common:
They are important in explaining the success or failure of the business

unit. A key variable can be identified by analyzing those strategic factors
which directly influence the attainment of management goals. The
questions to be asked are: What is the organization trying to achieve, and
what factors will cause the organization to achieve or not achieve these
goals?
Key variables require examination and in-depth evaluation. At the stage of

in-depth evaluation, the manager has to make a subjective judgment as to
whether each factor identified is important in explaining the success or
failure of attaining management goals. Sometimes it may be necessary to
reassess the factors that affect the attainment of goals. For example, a
hospital may be particularly concerned about the quality of its services.
Factors measuring the number of patients seen by the clinic staff per hour
may indicate the staff is over- or under-utilized, but would provide no
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Exhibit 4.1
Identifying Key Variables
Identifying strategic factors influencing the managerial goal
Accept or reject the above factors
In-depth examination of each factor
Select measurable factors or replace the factors that are not measurable
Identifying factors that are volatile
Identifying the predictable variables
The final step is determining whether appropriate management action is

taking place when significant change occurs in a key variable
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Source: ICFAI Center for Management Research.
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information on the quality of the services provided. A more appropriate

factor may be the number of appointment cancellations.
They must be measurable, either directly or via a surrogate or substitute.
For example, client satisfaction for a non-profit counseling center cannot
be measured directly, but a surrogate such as number of follow-up
appointments or cancellations, can be selected as a key variable.
Key variables are volatile; they can change rapidly for reasons often
beyond the control of the manager.
Changes in key variables are not easily predictable. The choice of key
variables requires the manager to make a subjective judgment. A long and
exacting test to determine the volatility of each factor is not necessary, but
the factors selected for further consideration as key variables should be
more volatile than those rejected.
Management action is required when a significant change occurs in any

key variable. The manager should select as many key variables as required
to run the business, possibly two or three, but no more than six. If too
many key variables are selected, the significance of each one is
diminished.
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Predictable variables are of little use as key variables. Obviously, if an

event can be predicted with a degree of certainty, then appropriate
management action can easily be taken. Thus, a variable that tells the
management something already known or readily predictable is of little
value.
IDENTIFYING KEY VARIABLES

The most common method of identifying key variables is the input-throughoutput model. The input variables are related to raw material, the throughput
variables to production, processing and manufacturing, and the output
variables to marketing.
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A generalized list of key variables is given below. However, every

organization will have to identify the key variables relevant to it for itself.
Input Variables
Key input variables could include the following:
Raw material availability
This is an important key variable; its absence leads to lower capacity
utilization. Organizations find it difficult to recover their fixed costs, when
raw materials are not readily available. Inability to procure raw material may
even lead to the closure of the organization.
Raw material quality
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The quality of the raw material is critical for the quality of the end product,
and for the profitability of the firm. The quality of raw materials is tested
through simple sampling techniques. As payment for a product is made on the
basis of quality, the maintenance of quality becomes crucial.
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Raw material costs
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The management needs to keep a close watch on raw material costs,

particularly when they constitute a large percentage of the total cost.
Production Variables
Capacity utilization
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The key variables related to production are:
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Capacity utilization is an important variable and is affected by either

marketing variables or procurement variables. For example, in the dairy
industry, capacity utilization is affected by milk products sold or by milk
procured. Capacity utilization reflects the ability of the production staff to
schedule and plan what to produce, how much to produce and when to
produce. In service-oriented organizations, it is necessary to decide on the
appropriate measures to indicate the utilization of resources. For example, in
movie theaters and hotels, percentage of occupancy is an indicator of capacity
utilization.
Losses
Another key variable related to production is the percentage of spoilage and
wastage in process of manufacturing the product. In manufacturing industries,
the management should monitor the yield percentage closely.
Quality control
The quality of the product is important for all organizations. Most
organizations aim at a zero-defect state. It is necessary to identify the
measures of quality. The number of complaints from customers and the
quantity of goods returned are usually good indicators of quality.
Maintenance
Maintenance of equipment is crucial to ensure smooth production and better
capacity utilization. Maintenance can be categorized as preventive
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maintenance and breakdown maintenance. The number and percentage of

productive hours lost due to maintenance may be selected as a key variable.
Costs
It is essential to control costs as they have a significant impact on profits.
Appropriate measures indicating the impact of costs should be developed.
Delivery
Timely delivery is critically important in certain situations. Delays in delivery
systems need managerial attention. For example, the production department of
a dairy industry has to ensure that the distribution department gets the milk on
time.
Marketing Variables
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Marketing variables are of crucial importance in a competitive economy.

Some important marketing variables are:
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Order book position
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The order book position is important for organizations that undertake

manufacturing based on orders. It helps the marketing department to decide
the planning schedules for marketing and distribution.
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Market share
The market share of a company indicates its performance and its competitive
strength. This variable helps the company to monitor its performance.
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Institutional sales
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If institutional sales comprise a significant part of total sales, the number of

orders received from institutional buyers is a key variable. A decline in
institutional sales is a signal of trouble in the marketing area.
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Asset Management Variables

The management of fixed and current assets is important for an organization.
Asset turnover
The asset turnover denotes the relationship between the total assets in an
organization and sales volume. A decrease in asset turnover is not a good sign
for the organization and needs immediate managerial attention.
Working capital turnover
The efficiency of management of working capital is indicated by the working
capital turnover. The inventory turnover and accounts receivables turnover can
also help in the analysis of working capital. A low inventory turnover
indicates building up of inventory an indication that something is seriously
wrong in inventory management.
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Sources of Key Variables

Key variables arise on the basis of:
Industry characteristics
In a given industry, there are certain general requirements for success, which
apply to all the firms. In the insurance industry, for example, the basic
requirement for the success of a firm is a positive investment performance.
Similarly, in the hotel industry, the occupancy rate is the criterion for success.
Environmental factors
The economic and the political climate are the major environmental factors
which determine key variables. For example, publishers who depend on the
postal services are affected by postal rates.
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Competitive strategy
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The strategy that a company adopts usually determines the variables that must
be monitored and emphasized. An organization that follows a low-cost
strategy will require an analysis of the product cost structure.
Stakeholders
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customers, executives, suppliers or creditors, may also be considered as key
variables.
Types of Key Variables
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In an organization with a function-based structure, every manager can identify

one or a few key variables related to the function of the unit. A key variable
for an operations manager, for example, is the quality of goods produced.
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Key variables can be classified broadly into the following categories: strategy,
structural, process and environmental. According to a framework prepared by
Samuel Paul1 there is a positive relationship between the key variables and the
organizational performance. Performance of an organization improves if there
is congruence between the different variables.
Strategy variables refer to the long-term choices concerning the programs,
goals, policies, and action plans that are formulated by an organization. The
structural variables can be studied in terms of the structure of the organization:
centralized or decentralized form of organization, and the organizational
autonomy. Structural variables thus represent the organizational arrangements
and the distribution of authority and relationships. Process variables refer to
the processes that influence the behavior of the employees towards the
achievement or organizational goals. Some examples of process variables are
the participation, monitoring and control, human resource development, and
motivation. Environmental variables help in understanding the scope, diversity
and uncertainty relating to an organization. For example, scope in terms of
marketing refers to the area that is being covered by the organization. The
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Samuel Paul, Managing Development Programmes: Westview Press, Colorado, 1982, p. 104
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scope of the environment also depends on whether the firm is well diversified
or deals in a single commodity. In the case of the former, the scope is broader
as the interaction between the organization and the environment is complex.
When all these variables are perfectly aligned then an organization can
achieve congruence of its performance with its goals.
KEY SUCCESS VARIABLES AND THE CONTROL PARADIGM
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The control system should be designed to fit in with the hierarchical structure
of an organization. Control experts should weigh the pros and cons of
different organizational structures. Through decentralization, the management
gives autonomy to the managers of the various units of the organization.
Responsibility centers are set up to coordinate and control various activities.
Each responsibility center has its own goals and strategies. The control
system designers should design the control systems in a way that helps
managers to achieve their units goals without conflicting with the overall
organizational goals. This can be understood more clearly by analyzing the
dynamics of the control process.
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Dynamics of the Control Process
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After identifying the key success variables of a firm, it is important to examine

the dynamics of the control system. A control system has two sets of dynamic
interactions: reinforcing interactions and balancing interactions. The
interactions can be seen as cause and effect relationships in organizations.
They are usually circular i.e. the last reaction links back to the initial action,
and are called causal loops. As an example, let us consider three employees
A, B and C. If A expresses confidence in Bs performance at work, he shows
trust and respect for B. This motivates B to perform even more effectively
towards the achievement of the organizations goals. Bs performance is then
noticed by C. If C commends Bs performance to A, it is a positive
reinforcement and is called a reinforcing causal loop. Causal loops may also
be negative, as will happen if there is reduction in trust between A, B and C.
This also results in a reinforcing circle but in a downward direction.
According to systems theory, a change in one variable causes changes in the
secondary variables. For example, if A expresses lack of trust in B, this would
be a reinforcing feedback in the downward direction. But if C has a positive
opinion of Bs performance and commends his work to A, this checks the
downward spiral and acts as a balancing force. The feedback of C with regard
to B is a secondary effect. The above example indicates the importance of
secondary effects. When one subsystem or element is changed in an
organization, there are influences on a number of other subsystems. These are
called secondary effects. When a reinforcing process is set into motion, it too
has secondary effects that may slow down the process of the work. Delays in
the control process may occur for the following reasons:
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When the management overreacts to a problem.
When the management is faced with a complex problem that it is unable

to solve, the gap between performance and expectations is reduced. This
results in a lower level of performance that can delay the work process.
A dominant team member can block informal planning efforts by bringing

in his own solution to a new problem to be solved. This may increase the
time taken for planning and further delay the whole process.
The above dynamic control problems can be minimized by creating an

organization which learns the type of organization termed as an adaptive
organization by Senge and Kirby. An organization that is open to new ideas
and encourages employee creativity and continuous learning can be termed as
a learning or adaptive organization. A participative management style
supports a learning organization.
The dynamics of controlling a management team
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A newly formed team must develop a shared vision for its goals or objectives.
It must also assess the current situation in terms of vision. The team must
gather information to understand the current situation and then take
appropriate action. By implementing decisions and getting feedback, members
work on common goals and strategies that are aligned with the needs and
vision of the organization.
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A study undertaken by Kirby shows that a reinforcing system of informal

activities enables successful teams to achieve their goals. The key findings of
the study are:
Table 4.1 Key Variables Used in Certain Industries

Key Variable
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Industry
Accounting firm
Billed hours/Available hours

Paid seats/Capacity seats
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Airline
Acceptance/Offers made
Number of appointments
Number of cancellations
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Counseling center
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College
Fuel cost/Miles flown
Electrical utility
KWH sold
Health clinic
Customer contacts per day
Hospital
Beds occupied/Available beds
Leasing company
Number of transactions
Magazine
Renewals/ Subscription expired
Professional organization
Meeting attendance/Total members
Restaurant
Labor
cost/Revenue,
cost/Revenue
Retail store
Gross margin by departments
Telephone company
Access minutes of use
Raw
food
Source: Henry Wichmann. Jr et al key variables as a management tool, CMA

Magazine, March 1990, p23.
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Successful teams have a culture of trust and openness.
The leaders of successful teams develop certain preconceived premises

about the best way to perform any given action.
The group has a shared vision about the objectives to be achieved, and
uses free interchange of ideas to promote better ways of achieving the
targets.
Further, this sharing of ideas leads to improvement in performance and

creates an environment that increases team learning. Providing the right
feedback also increases the level of trust and openness in the teams.
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Identifying Key Variables An Example
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This level of trust and openness reduces the gap between current performance
and the goals of the team members. This is referred to as creative tension.
When employees are able to perform effectively in order to fill the
performance gaps, the situation is said to be one of creative tension.
Sometimes team members are unable to achieve the organizational goals
because of distractions on account of their ambiguous roles. This referred to as
emotional tension. The matrix structure usually has this role ambiguity
because of the competing and often ambiguous instructions given to program
participants by program and functional managers. The way in which teams
respond to such ambiguous situations separates the excellent from mediocre
teams.
Roger Hall identified five key variables for a publishing company:

The annual subscription rate.
The advertising rates of the publisher
The annual expenditure incurred for the promotion of subscriptions (i.e.

advertising the magazine).
Annual expenditure for the promotion of the magazine.
The size of the magazine i.e. number of pages per issue.
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Hall found four critical relationships in the interaction between a magazine

publishing firm and the environment. The first relationship specified the
demand for advertising pages as a function of the price or rate charged
advertisers per thousand of paid circulation. Hall found a negative relationship
between advertisement page sales and price. The second relationship was
related to the demand for regular subscription. The demand for regular
subscription was related to the number of trial subscriptions and regular
subscriptions that were expiring which created a potential for renewal, the size
of the magazine, and the rate charged to annual subscribers. The third
relationship was concerned with the sales of trial subscriptions. This was a
function of promotional expenditure and magazine size. The fourth
relationship related to the total cost of producing the magazine. This was a
function of the size of the magazine i.e. number of pages delivered to the
readers.
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Implications for the control structure

Important parameters on which the control structure is to be based include:
Efficiency and effectiveness
Economies of scale
Coordination
Assignment of responsibility for profit
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For an effective control system, a divisional structure with departments

divided on the basis of function, is preferred. In a publishing firm, the
divisional structure depicted in Figure 4.1 may be adopted. For a publishing
firm, the quality of editing is crucial. The editor, thus, has a significant
influence on the quality variable, as well as on the long-term future of the
business. The control structure put in place depends to a great extent on the
divisional structure of an organization. Each success factor is assigned as a
goal for a specific responsibility center. Thus, all the responsibility centers
together contribute to the achievement of all the goals of the firm.
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Figure 4.1: Organization Chart for a Magazine Firm
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Publisher
Circulation
manager
Distribution
manager
Production
manager
Advertising
manager
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Source: Joseph A. Maciariello and Calvin J. Kirby, Management Control Systems (New Jersey: Prentice
Hall Inc., 1994) 87.
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The hierarchical structure of an organization makes it possible to process all

the information pertaining to key success factors in order to make business
decisions. Through decentralization, the management gives a degree of
autonomy in decision making to subordinates.
The designers of the control system establish critical success factors that help
managers achieve the goals of their sub-units. Each unit and sub-unit of the
hierarchical structure should coordinate and control the various key success
factors in pursuit of the overall goals of the firm.
COMPREHENSIVE PERFORMANCE INDICATORS

Every organization needs to identify the variables that influence its success at
each level so that it can monitor and predict the values of key variables. The
main idea of monitoring the performance of key variables at each level of the
organization is to push them to the desired level and, if that is not possible, to
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react to the performance of the key variables so as to compensate

appropriately. Key variables should be identified at each level and for each
responsibility center of the organization.
The measurement of key variables is not free from problems. One danger is
that of concentrating on the variables that are easy to measure. Variables
which are difficult to measure but which are important to the achievement of
long-term goals are often ignored. For example, firms often emphasize shortrun profits and encourage managers to produce good numbers (production in
term of quantity), regardless of the long-term effects on the business. This
results in the reduction of expenses on research & development, maintenance,
and employee development which may not affect the performance in the
short-run, but play a significant role in the accomplishment of long-term
goals.
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A number of precautions have to be taken with regard to the measurement of

performance in any responsibility center. First, the variables that are measured
should correspond with the goals and objectives of the organization. Second,
only those variables that are crucial should be measured, and they should be
measured even if they are qualitative. Key success factors should not be
omitted from the control system because they are qualitative. Third, the
measurement of the factors should be developed in such a way that the
measures taken in the short term take account of both short-term objectives
and long-term goals.
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The process for measurement of key performance variables can be observed

by looking at the case of General Electric. General Electric divided the task of
measuring key success factors in the company into three sub-projects which
involved developing performance measures for each of the companys
departments. The exercise focused on:
Measuring the whole department as an economic entity.
Measuring the functional departments such as marketing, finance etc.
Measuring the performance of the management of the departments.
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On the basis of the above measures, the principles for the control program at
GE were formulated. The principles focused on providing:
Factual knowledge to support judgment in the performance appraisal of

departments.
Performance information for both short-run as well as long-term goals.
The minimum number of measures for use at each level of the

organization.
GE developed the following performance measures for each of its

departments:
1) Short-term profitability
2) Market share
3) Productivity
4) Product leadership
5) Personnel development
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6) Employee attitude
7) Public responsibility
8) Balance between short-range objectives and long-range goals
Limitations of Indicators
Indicators are used to understand an organizations current state of affairs and
for initiating corrective action. However, there has to be consensus on what
the indicator really means and conveys.
Performance indicators have the following limitations:
(a) The absence of consensus among managers on the use of indicators
(b) Problems encountered during the measurement of indicators
(c) Lack of clear specification of the unit of measurement
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(d) Lack of consistent information leading to incorrect conclusions.
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KEY VARIABLES IN SELECTED INDUSTRIES
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These limitations can be overcome by developing systematic and scientific

methods to improve the quality of the data on which decision-making is based.
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Given below are important critical variables in various industries. They

illustrate how key variables or key success factors play an important role in
day-to-day operations.
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Insurance Industry
Number of claims settled in a given period of time and number of claims

outstanding
Number of policies processed in a given period of time
Growth rate in insurance business with respect to each policy
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Hotel Industry
Room occupancy rate
Number of complaints by customers
Amount of food wasted in the restaurant
Percentage of revenue contributed by the restaurant
Percentage of absenteeism among employees
Sugar Industry
Price of sugar sold in the open market
Transport cost per ton of cane
Fuel cost per kilogram of sugar

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Number of production days lost
Support price by government
Management Training Institute
Number of students appearing for an entrance examination
Percentage of absenteeism among students
Number of research projects undertaken and completed
Time spent by faculty on teaching and research
Time spent on management development programs
Power Industry
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The inputs for a power industry are coal and water. The output variables
include transmission losses. The key variables include the following:
Quantity and quality of coal
Availability of wagons for transportation of coal
Availability of water
Capacity utilization
Preventive and breakdown maintenance
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SUMMARY
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Key variables are those variables to which the goals, strategies and objectives
of the management are most sensitive. Every organization should identify the
key factors which are important for its success.
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The most common method of identifying key variables is the input-throughoutput model. The input variables are related to raw materials and other
inputs, the throughput variables to production, processing, manufacturing, and
the output variables to marketing. Key variables arise on the basis of: industry
characteristics, competitive strategy, environmental factors, stakeholders and
significant functions. The nature of key variables varies from organization to
organization depending upon the nature of the task, the technology used, and
the environment in which the organization operates. Key variables can be
classified broadly as strategy, structural, process and environmental. The
control system should be designed to fit in with the hierarchical structure
established by an organization. Control experts should weigh the pros and
cons of having different organizational structures. Through decentralization,
the management gives autonomy and empowers the managers of the various
units. Responsibility centers are set up by firms to coordinate and control
various activities.
Every organization needs to identify the variables that influence its success at
each level so that it can monitor and predict the values of key variables. This
is done with the help of performance indicators. The main purpose of
monitoring the performance of key variables at each level of the organization
is to direct them towards the desired levels, and if that is not possible, to take
appropriate compensatory action.
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PART II:
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MANAGEMENT CONTROL
ENVIRONMENT
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Chapter 5
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Organizing for Adaptive
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Control
Strategy, Structure and Control
Decentralization Vs Centralization
Response of Structure to Strategy: Evolution of the Matrix

Structure
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Evaluation of the Control Factors in Organizational Design
Controllers Organization
Adaptive Organization.
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For effective implementation of organizational goals, it is necessary to design

the elements of control system infrastructure (such as organization structure,
responsibility centers, rewards and performance measures) which are mutually
supportive and adaptive. An organizational structure should be designed in
such a way that it facilitates information processing and communications.
In this chapter, we will discuss the infrastructural aspects important for an
organizational design. We will also discuss the influence of strategy on
organizational structure and control requirements; the evolution of
multidivisional structures in response to the changes in control requirements;
the importance and organization of the controller's function and the
characteristics of an adaptive organization.
STRATEGY, STRUCTURE AND CONTROL
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With the rapid changes in business environment, organizations have adopted

multidivisional structures. Multidivisional structures are decentralized
structures where the divisional managers have a fair degree of autonomy in
decision making and are held accountable for the functioning of the firm in
terms of profits achieved or assets utilized. Decentralized multidivisional
structures improve the managers ability to evaluate the performance of
enterprises.
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DECENTRALIZATION VS CENTRALIZATION
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As organizations grow in size, decentralization of operations becomes a

critical requirement. Decentralization in the broadest sense means delegation
of authority to the lowest feasible level of decision making within a
framework of predetermined responsibilities and clearly set goals. The
advantages of organizational decentralization are:
As analysis of trade-offs among cost, revenue and investment involves
lower levels of management, information processing becomes simpler.
It allows closer control and supervision of subordinates within the

division.
Since managers are empowered to take decisions, they are motivated to

perform better keeping in mind the goals and strategies of the
organization.
It helps evaluate overall performance of the various organizational units of

the business.
It also ensures that managers are given right environment and autonomy,
wherein they are trained to make the right decisions.
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One factor which affects decentralization to a large extent is the development

of control techniques. A manager cannot delegate authority without having
some way of knowing whether it will be used properly or not. Improvements
in statistical devices, use of accounting controls and computers have helped
managers to develop better control.
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This type of organizational structure should be used only when the company is
in a position to support functional groups on a continuous basis. Companies
managing projects for shorter durations cannot have a decentralized structure
as this structure best works when the project is large enough to support on a
permanent basis that can achieve technical excellence and economies of scale.
However, short duration projects also require the excellence and scale
economies of the functional organization and coordination and control of the
decentralized organization.
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Coordination and control problems in a decentralized organization can be

achieved, if the management has projects that are large enough to support a
permanent functional organization and at the same time allow for economies
of scale in the functional organization. This structure will work to achieve the
coordination and control required to complete the project and also keep in
view the technical excellence and scale economies of the functional
organization. In some organizations, decentralization is sometimes associated
with dysfunctional performance which results in incremental costs. If the
incremental benefits are more than costs involved, the organization maintains
a decentralized structure. But if the incremental costs exceed the incremental
benefits, the organization reverts to a centralized structure.
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Centralization pertains to geographic concentration or it may refer to

concentration of specialized activities, generally in one department.
Centralization restricts the delegation of decision-making authority. In a
centralized structure, the overall decision-making power is vested with the top
management. When there are few homogenous markets, it is easier to plan,
administer and coordinate functional departmental activities, and hence
greater the advantage of centralization.
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RESPONSE OF STRUCTURE TO STRATEGY: EVOLUTION OF THE

MATRIX STRUCTURE
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The matrix structure fulfils the requirements for control and functional
excellence required in organizations. A matrix organizational form is a mixed
organizational form in which normal hierarchy is overlayed by some form
of lateral authority, influence or communication. There are two chains of
command, one along functional lines and other along project lines. The matrix
structure evolved in response to needs of organizations that pursue high
technology projects, provide complex products and services and have
operations in different countries. Organizations pursuing high technology
products need to maintain a high degree of technical excellence in multiple
disciplines. This can be possible only by having an organizational structure
that has a high degree of technical excellence in multiple disciplines. This
requires high division of labor and specialization. To utilize each speciality
fully, there must be a number of projects where the specialized talents can be
employed. Thus, a company will be managing multiple projects
simultaneously. The coordination and control cannot be achieved with the
functional organizational structure. The incremental benefits of a matrix
organization are motivation and coordination. The matrix is an example for a
structural change following strategy to improve control.
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The matrix organization helps avoid coordination problems that arise during
the handling of complex programs. This is because the matrix structure places
total responsibility in the hands of the manager whose task is to devise plans
and coordinate and integrate the activities of the organization. This helps
maintain a balance among performance, cost and time variables.
In the matrix structure, managers not only achieve the goals and objectives of
the project, but also share the resources economically among the various
departments for the achievement of the goals and objectives. The matrix form
of organization may be appropriate when many interactions between the
functions are necessary or desirable. The matrix organization is extensively
being used in the management of the defense projects and projects that require
complex activities.
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The form an organization chooses depends on its costs and benefits, economic
and control factors. Control systems help calculate the net benefits of each of
the three designs (decentralized, centralized and matrix) on a qualitative basis
and adopt the best one. The design that is selected should promote
communication, cooperation, teamwork, motivation and performance.
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Project Organizations
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There are short-term as well as long-term benefits for each project. They vary
according to the time, cost and quality. Hence cost, quality and schedule are
the key variables for any project. A matrix structure helps an organization to
achieve agreed upon performance with respect to cost, quality and time
variables. The matrix structure for a project organization can be explained
with the help of a matrix (refer exhibit 5.1). The various functions are
represented in rows and the programs undertaken are represented in columns.
The total functional output for any period of time is found in the last column.
It also lists contributions of each function. In most organizations, the outputs
are identified in the columns of the matrix and the inputs are identified in the
rows of the matrix (refer exhibit 5.1). Though the product manager assumes
responsibility for the delivery of the product in a matrix structure, he does not
have a direct control over the functional organizations. Generally, in
organizations there are two separate authorities to set goals and direct the
work necessary to achieve the goals i.e. knowledge based authority and
resource based authority. This sometimes leads to confusion as there is no
unity of command. This problem can be resolved to a great extent in a matrix
organization where in practice there is a formal and informal relationship
among program and functional which leads to distribution of authority and
responsibility.
Product Organizations
For developing complex products, organizations require closer coordination
among the various functional departments. Product managers are responsible
for the planning and coordination of the functional efforts required to
introduce new products, modify existing products and make changes to the
advertising programs of any existing products (refer exhibit 5.2). The matrix
structure allows for such coordination. The matrix structure can also be used
for the introducing new products as well as monitoring ongoing projects. It
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Exhibit 5.1
The Structure of a Matrix Organization
Program Functions
Program 1
Program 2
Program 3
Total
functional
output
Engineering
Procurement
Quality Assurance
Manufacturing
Program Management
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Total Program
Requirements
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Source: Joseph A. Maciariello and Calvin J. Kirby, Management Control Systems (New
Jersey: Prentice Hall Inc., 1994) 151.
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can be applied to a product based organization when an organization has too

many products to manage, when the products require coordination among
specialized disciplines, and when the market size is too small to justify
separate divisions for each product. The application of the matrix structure
and the control process for the management of products is known as product
control system. The matrix structure in a product organization enables
economies of scale in each discipline and also provides total management of
each product. This ensures high level of efficiency and coordination.
Service Organizations
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Service organizations require employees who are highly skilled in a number of

areas. The services offered require close cooperation among the various units.
Thus, the structure should be designed in such a way that it leads to
cooperation and better control of various activities. The matrix structure may
be appropriate for service organizations.
The application of matrix structure in a service organization can be best
illustrated by taking an example of the tourism industry. In the tourism
industry, business agencies and communities can define their overall
objectives and monitor their progress. The objectives should provide guidance
for all decisions including finance, personnel and marketing. The success of
the tourism industry depends on creating an atmosphere where in employees
can provide good customer service. This requires close coordination between
the various departments like hospitality and guest relations, quality control,
personnel selling, customer service etc. Customers can also be served best by
providing information through local offices. The matrix structure can be very
useful for meeting the desired needs of customers and in providing
coordination between the various departments of the organization. As in
product management, the functional groups can provide each local office with
information and resources. These local offices should have resources and
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Exhibit 5.2
Product Matrix Organization
General
Manager
Controller
Treasurer
Product
Research
Manager
Advertising
Manager
Sales
Manager
Manager of
Products
Production
Manager
Personnel
Manager
Product
Manager B
Product
Manager C
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Market
Research
Manager
Other Staff
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Source: Joseph A. Maciariello and Calvin J. Kirby, Management Control Systems (New Jersey:
Prentice Hall Inc., 1994) 153.
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plans to market, plan and control client services in a given area. The structure
is designed in such a way that the functional personnel report directly to the
functional managers, while the local office managers hire the services of
functional resources in a manner identical to that of product or project
managers.
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The Matrix Structure and the Multinational Firm

It is difficult to coordinate in a multinational (MNC) firm as compared to
domestic product organization. This is mainly due to two reasons. Firstly, in
an MNC, there is greater geographical dispersion among the various units of
the enterprise. Secondly, since each division of an MNC is responsible for the
sale and sometimes production of all the companys products in the given area
of the world, little attention can be given to the development, introduction and
coordination of a given product for the company as a whole. Due to these
factors, the importance of matrix structure in an MNC has increased greatly.
Design of organization structure in an MNC is based on the combination of
the market area and the product rather than on the product and function. The
products and market area are important for the multinational firm as these two
conditions can help a firm earn profits by exporting the products even though
transportation costs and trade barriers exist. However, it is not always
appropriate to apply a matrix structure. For example if an organization is using
a standard product design and management focuses mostly on developing a
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better market for the product. A functional organization is better suitable for
the same. On the other hand, if an MNC has a worldwide market for the
products, the management needs to devote time for the development of the
product. These conditions do not occur frequently in multinational
organizations as the market characteristics as well as basic labor costs are
different for most products in various parts of the world and it becomes
necessary to differentiate the various markets. Thus, the matrix structure helps
in providing a dual structure for managing both the product and market
dimension.
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The structure consists of a product manager who is responsible for a particular

product and an area manager who is responsible for a given geographical area.
The product manager is responsible for bringing in profits of a particular
product on a world wide basis, but he has no authority over the functional
disciplines employed on the product. The area manager has the authority and
responsibility of maintaining the overall profitability of his division and
control over the functional personnel assigned to that division. Product
managers are concerned with current business and technological
developments of their product in a particular area. Using their expertise and
knowledge, they help the area managers to implement technical and business
programs for improving the profitability of their product line on a worldwide
basis. The product manager also communicates the benefits of the product to
the various area managers and tries to reduce bottlenecks among the various
area divisions.
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Products differ in their key variables while some products require emphasis on
marketing others require emphasis on engineering or production. The product
manager should therefore ensure that, product lines get the required attention
from the different divisions. Moreover, the product manager has to make sure
that resources are allocated according to the profitability of the product.
Sometimes he or she may have to drop a product in one division and expand
its sales in another division. Most importantly, when there are rapid
technological changes the product manager has to forecast such changes and
incorporate them into the product in each division.
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For a matrix organization in a multinational firm, it is necessary that there are

behavioral adjustments between the area manager and the product manager.
Project based organizations therefore, use teams for accomplishing of
organizational goals.
EVALUATION OF THE CONTROL FACTORS IN ORGANIZATIONAL

DESIGN
The activities of an organization can be managed by using three types of
organizational designs: centralized, decentralized and matrix.
In a centralized organization, the authority for all products, projects and
services rests with the top management. In a decentralized organization, a
division, department or a group is held responsible for the decision it takes.
These units are allowed to design their own management policies and have
complete authority over the functional organization.
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A matrix structure or a hybrid structure incorporates the advantages of both

the above mentioned forms and a new structure is then designed.
Organizations should choose a design structure that is likely to benefit them
the most. Each design must be evaluated on the basis of efficiency and
coordination. The best form is the one which operates at minimum cost per
unit of output.
Matrix Versus Functional

While managing complex programs, an organization may face several
coordination problems. A matrix organization helps avoid such problems as
the total responsibility for the project lies in the hands of a manager who
coordinates and integrates the multiple functions within the organization. He
ensures that proper balance is maintained among the costs, performance and
time variables.
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The incremental cost of a matrix organization is more than that of a functional

organization. This is due to two reasons. Firstly, the organization incurs costs
as result of additional layer of management for managing each program.
Secondly, difficulties are created by separating responsibility for a program
from the authority to direct the work necessary to carry out program goals.
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organizational problems occur. Some of these have been mentioned below.
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Problems in the implementation of the matrix structure
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Difference in orientation: The main aim of any program manager is to

maintain a balance among performance, cost and time requirements of the
program. The priorities of a functional manager are different from that of a
program manager. The functional manager can emphasize on quality and
competence norms while ignoring the goals of the program. Thus, there is a
need to design reward structures and financial controls for both project and
functional organizations. If there are tensions between the program and the
functional managers work it will result in conflict in the workplace, thereby,
making it very difficult to achieve the organizational goals. Thus, reward
structures can be used for balancing short and long run goals and objectives by
rewarding functional work that also helps achieve program goals. The reward
structure for programs and functional organizations should reflect a balance
between the short and long run profits.
Diffuse responsibility: In a matrix structure, it is difficult to clearly demarcate

the responsibility for a given activity. This is because program managers have
program responsibility under the matrix structure, while functional managers
have technical responsibility and when problems develop it becomes difficult
to isolate responsibility. As the responsibility is distributed between the
program and functional personnel, it becomes very difficult to administer
systems of accountability. This in turn, could lead to greater instances of
conflict. Conflicts usually arise while resolving technical and cost problems
and assigning the priorities to various programs.
Program personnel in temporary assignments: Unlike the functional
personnel assigned to a permanent organizational unit the project structure is
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temporary and functions according to the availability of the projects. After the
project is accomplished the team is disbanded. The primary aim of a program
manager is to complete the project on time. After the completion of the short
term projects the staff is temporarily left without any projects. In such a
situation the functional personnel will hesitate to take up the program
responsibility and program office personnel may attempt to increase the
duration of the program artificially at the expense of the program goals, thus
increasing, the costs of the organization. This problem becomes severe during
adverse economic periods. The actual costs incurred as a result of these
potential organizational problems depends upon the ability of the program and
personnel managers to build effective informal relationships and design goal
congruent reward structures. In addition there is also a need to design reward
systems that promote high quality functional performance.
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CONTROLLERS ORGANIZATION
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A person who is responsible for designing and implementing the management

control system is called the controller. A controller plays an important role in
design and operations of the control system. The main responsibilities of a
controller are:
To design the control system
To prepare financial reports and statements for the clear understanding of

shareholders and external parties
To develop internal auditing systems for the control of the physical and
monetary assets of the firm.
To conduct educative sessions and create awareness among employees

about the matters relating to the controller's function.
To advice the management on the financial implications of decisions

under consideration. To provide functional supervision and training for
employees in each of the divisions of the corporation.
To analyze program and budget proposals and bring together the various
segments of an organization under a single organizational budget.
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The advisory and control systems suggest a direct reporting relationship of

divisional controllers to divisional general managers since these are very
important staff functions performed by the controller. In a matrix
organizational structure, the divisional controller has to report to two persons.
He has to give functional accountability to the corporate controller and
operational accountability to the general manager of the division. These create
several problems as in a matrix organization structure. These tensions must be
resolved in a manner similar to those of the matrix organization. An empirical
study of control functions in large multidivisional US corporations conducted
by Vijay Sathe1 indicates that the degree of involvement of the controller in
managerial functions depends on the following variables.
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Controller Involvement in Management. Englewood Cliffs, N.J.: Prentice Hall, 1982
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The financial orientation of the company, emphasis on financial goals, and

the management of its businesses using a portfolio approach.
The importance the organization places upon planning, programming,

budgeting and reporting.
The importance the organization gives to development of the controller

and the employees assisting him.
The extent to which the controller is involved in the business decisions.
The working capital management of the company. The management

development strategy the organization adopts in terms of developing the
controllers function.
Some of the characteristics essential for a good controller have been specified
below:
Personal energy and motivation
Personal integrity and professional commitment
Accounting knowledge and analytical skill
Understanding business problems and recommending actions that are

required to run the business successfully
Ability to judge and grasp information that is important for an

organization
Building effective interpersonnel relationships and being flexible in

meeting managements demands.
Ability to analyze managements actions and plans and not hesitate to

question managements plans and actions.
Recognizing the responsibility towards the division as well as corporate

management.
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ADAPTIVE ORGANIZATION
To face the challenges posed by the rapidly changing environment,
organizations need to develop adaptability, and modify their structure at
regular intervals. The rapid environmental changes have made it imperative
for organizations to gain a global perspective, speed up the decision making
process and realign resources rapidly. An organization which is not adaptive
to environmental changes will become inefficient in due course of time.
The Need for Adaptive Organization

It is not very easy for an organization to adapt to environmental changes. An
organization needs to steer its resources and realign them to meet the changes.
Moreover, the culture, and the organizational structure need to be reorganized
in accordance with the changes. Let us examine the factors which create the
need for an adaptive organization.
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Environmental factors
In order to adapt itself to environmental changes, an organization has to speed
up the decision-making process, gather large amounts of data that support
decisions, and implement the decision at the right time. The organization
should also be able to realign resources in order to meet these changes.
Moreover, as mentioned earlier, the organizational structure should be
designed in such a way that it can adjust to various environmental changes.
Mintzberg in 1979 stated that, Environmental factors are contingency factors
in the design of organizational structure. While the organization is influenced
by environmental changes, these changes are influenced by certain other
factors that are discussed below:
Environmental uncertainty
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Organizations become more informal in response to environmental

uncertainty. Ad hoc teams are developed to cope with uncertainty and to meet
the changing needs of the organization. Verbal communication is encouraged
so that people can understand the environment better and respond to changes
accordingly.
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Environmental complexity
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Complexity in the environment may sometimes affect the market in which the
organization operates as well as the competition prevailing in the market. Due
to this complexity management may choose to decentralize into focused
market segments to fully understand smaller market niches.
Environmental diversity
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The market is divided into different segments on the basis of customers,

products and geographical locations. This diversity helps the organization to
develop various business units in each segment.
Environmental hostility
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When the organization is faced with hostility e.g. adverse political changes,
the top management decides to centralize decision making. Efforts are made
to gather information at the earliest and take suitable action.
The control systems designer analyzes these four environmental factors,
before taking a decision on redesigning the organizational structure to achieve
control.
Adaptive Controls that Support the Adaptive Organization

In the adaptive organization, the control mechanism is more implicit. Every
organization tries to instill its own values in its employees through its training
programs. In nonprofessional organizations, such an adaptive model can be
instituted through extensive acculturation, socialization and training programs.
This is traditionally practiced in Japanese firms. The adaptive organization
requires high levels of awareness, skill, and integrity within the work group.
Given the high degree of employee empowerment today, even one poorly
trained or disruptive employee can cause significant damage to an
organization. The effectiveness of these controls also may be limited by the
subjectivity of the control measures used by workplace politics.
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The informal and formal adaptive control for organizations are shown in
exhibits 5.3 and 5.4 respectively. The culture of an organization should be
such that it should emphasize global awareness, change and opportunistic
actions, continuous learning, and flexibility to adjust and accept new
assignments. On the formal side, the infrastructure should be characterized by
organization structures that can be easily formed and dissolved, the use of ad
hoc teams and projects and the use of worldwide purchasing. The planning
and control processes should focus on the organizations vision, strategy,
information systems, information flows and other formal procedures. The
reward system should be designed in such a way that it helps the organization
to achieve excellence in an uncertain environment.
Exhibit 5.3
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Informal Control for Adaptive Organization

Infrastructure
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Management style and

culture
Global operating perspective
Opportunistic action oriented
Change oriented
Lifelong learning
Agility in new assignments
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Expert emergent roles for

local cultures and markets
Acceptance of temporary
assignments
Informal control process
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Verbal informal actions

Use of multidisciplinary
teams for problem solving
Rewards
Coordinating and integration
Based on peer recognition for

the adaptive values of the
organization
Use of personal travel for

managers to become familiar
with worldwide conditions
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Exhibit 5.4
Formal Control for Adaptive Organization

Infrastructure
Management style and culture
Organization structure
Easily formed and dissolved
Use of adhoc Teams
Widespread use of outsourcing
Rewards
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Coordinating and integration

Use of management rotation on
a global basis
Use of multidisciplinary teams
for accomplishing specific
objectives
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Emphasize ability to achieve

excellence in uncertain
environments
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Formal control process

Clear company vision
Integrated information systems
Rapid response times for
information flows
Accurate worldwide reporting
Simple and rapid authorization
procedures
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Widespread use of teams
Global operating perspective

Opportunistic action oriented
Change oriented
Lifelong learning
Agility in new assignments
The emergent roles for local cultures and markets, temporary assignments,
constitute the informal infrastructure. The planning and control processes
should focus on informal actions to solve problems. The coordination
mechanisms should facilitate training of managers in order to help them adapt
to worldwide conditions.
SUMMARY
This chapter examines the role of control systems in designing the
infrastructure of an organization. With companies expanding, it has become
important to develop organization structures that support complex
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multimarket, multidivisional corporations. The matrix structure has proved

very useful for product organizations, service organizations and multinational
firms. Three organizational designs have been identified which are used to
manage the activities in an organization. They are: a centralized organization,
a decentralized organization and a matrix structure.
The role of the controller in relation to the design and operation of the control
system has also been discussed. A divisional controller in a matrix
organization has both functional and operating accountability. For a controller
to function effectively, there is a need for technical competence, business
judgment and communications skills.
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Due to the rapidly changing environment, there is a need to develop

organizations which can adapt themselves to these changes.
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Chapter 6
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Responsibility
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Autonomy and

Divisional Autonomy
Responsibility Structure
Responsibility Centers
Performance Measurement of Decentralized Operations
Inter Profit Center Relations
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An organization uses a number of structural elements to influence the

behavior of managers. These elements interact with the formal control process
to influence managerial behavior. These elements play an important role in
influencing the autonomy of managers at the divisional control level, of an
organization and also influence the way managerial performance is measured
and evaluated. This chapter focuses on the autonomy of managers at the
divisional level and the determinants of such autonomy. Such autonomy can
be categorized into three divisions- management style and process,
responsibility structure and reward systems.
DIVISIONAL AUTONOMY
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With most organizations operating in dynamic and highly competitive

markets, it is important for the top management to decide on the right kind of
autonomy to be given to the managers. Organizations today require flexibility,
innovation and creativity. Thus, it becomes all the more important for the top
management to decide on the levels of autonomy. The top management must
decide upon the level of decentralization of decision-making. To do this, the
top management should design a tool to help it attain congruence between the
levels of autonomy it wants to sanction to its subordinates and the extent of
autonomy that subordinates expect to get. Vancil1 developed a design tool that
helps the management to communicate the desired levels of autonomy. This
tool helps the management in designing structures and processes to achieve
the appropriate levels of autonomy. In this context, it is important to discuss
the variables that influence autonomy in an organization. The variables
discussed in the Exhibit 6.1 can be grouped into:
Management style and process
Responsibility structure
Measurement of reward systems
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Management Style and Processes
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Management style plays an important role in influencing the behavior of the

employees in an organization. Managers have different notions about how a
companys business can be run. They need to decide whether it can be run in a
centralized manner or by striking a balance between centralized control and
decentralized action. All these constitute management style and process. There
are a number of personal variables that influence the level of autonomy that a
corporate manager can sanction a subordinate. These include:
The level of involvement of the corporate managers in the business
The interactions of the corporate managers with other managers
The level of trust and confidence of the manager in the ability of the
subordinates
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Vancil, Richard F., Decentralization: Ambiguity by Design. Homewood, III: Dow Jones
Irwin, 1979.
Exhibit 6.1
A Theory of Decentralized Management
DIVERSIFICATION
STRATEGY
Breadth of Lines of Business
CORPORATE MANAGERS
Philosophy and Style
BUSINESS
STRATEGY
Definition of Market
Segments
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Intended by Corporate
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MANAGEMENT PROCESS
Policies and Procedures
RESPONSIBILITY
STRUCTURE
Custody of
Physical Resources
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Perceived by
Profit Center
Manager
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COST AND ASSET

ASSIGNMENT
For Shared Resources
MEASUREMENT
METHODS
For Assigned Costs
and Assets
REWARDS
Physical and
tangible
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Source: R F Vancil , Decentralization:Managerial Ambiguity by Design,( Dow Jones-Irwin,

Homewood Illinios, 1979) 128.
Management style influences the decentralization process in an

organization. The companys plans, budgets, meetings, performance
reviews, etc., are influenced by the managers style.
Management policies and procedures

Policies and procedures help managers decide the way in which decisions are
to be made. They help in maintaining uniform behavior among profit center
managers with regard to certain decisions.
Diversification strategy
According to Vancil, there is a fair relationship between the diversification
strategy that the management chooses and the autonomy of the profit center
managers. In firms that run a single business, the managers autonomy seem to
be restricted, whereas in firms that grow by acquiring or introducing unrelated
businesses, the extent of autonomy is high. When a firm runs a single
business, all its functions are centralized which leads to the sharing of
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resources and, thus, to restricted autonomy. When a firm runs a number of

unrelated businesses into unrelated businesses, there is not much synergy
between the various businesses and only a few resources are shared. This
leads to more managerial autonomy.
Business strategy
Business strategy is the strategy to be followed in each division of the
organization. The kind of business strategy chosen by the management
influences autonomy in the organization. For example, a cost strategy leads to
less autonomy as there is usually centralization of resources.
The four variables discussed above-management style, processes,
diversification strategy and business strategy have a major influence on the
autonomy of profit center managers. They constitute the first line of
influence that the top managers have over profit center managers.
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Responsibility Structure
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The responsibility structure represents the physical, human and financial

resources that are entrusted to the profit center manager. These resources
represent the functional authority of the project center manager, and the
resources in the custody of a manager influences his/her decision-making
authority. Responsibility structure can be considered the second line of
influence that the top management has over profit center managers. The
responsibility structure and types of responsibility centers will be discussed in
detail later in this chapter.
Measurement and Reward Systems
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Cost and asset assignments convey to the division manager those items of cost
and investment that the manager should be concerned about.
Measurement methods show how much concerned the divisional managers
should be about the costs and assets assigned. These methods help in
allocating resources according to the requirement of a particular division. The
common methods of measurement are proration, negotiation and metering.
Proration refers to allocating resources based on standard rules of the
organization. Negotiating and metering give the managers more autonomy in
deciding upon the quality and quantity of resources they use.
The reward system is determined on the basis of the performance of a
particular center. The amount and method of allocating bonuses depends on
the managers autonomy. Rewards given to managers are either tangible or
intangible. Tangible rewards include financial and related compensation.
Intangible rewards include power, status, and the feeling of accomplishment.
While responsibility structures are the second line of influence that the top
management has over the profit center manager, the measurement and reward
system constitute the third line of influence.
RESPONSIBILITY STRUCTURE
The responsibility structure of an organization consists of responsibility
centers and related performance measurement systems. These responsibility
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centers work towards the achievement of the organizational goals. This

hierarchical placement of the responsibility center helps the top management
to ensure that decisions made in one part of the organization are congruent
with decisions made in other parts. The responsibility structure includes an
accounting system. A responsibility accounting system helps managers to
record the plans and performances of the center for which the manager is
accountable. The measurement of the performance of a responsibility center is
done through cost, profit, revenue, investment and quality goals set by the
organization. There are three different methods of measuring the performance
of a responsibility center. They are:
The efficiency measure
The process measure
Effectiveness measure
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The efficiency measure measures performance in terms of inputs received

over a specified period of time for a given level of output. The process
measure pertains to the production process, and the effectiveness measure
gauges the output of the organization in terms of its goals and objectives. The
above mentioned methods of performance evaluation help in assessing the
progress of each subunit, and this is done with those variables for which the
manager has reasonable amount of control in mind.
Overall Effectiveness Measures: Return on Investment (ROI)
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The most important objective of a firm is to achieve a good return on

investment. The logic behind the hierarchy of responsibility centers and the
responsibility accounting system is to make all the decentralized subunits of
an organization responsible for various elements of ROI. The performance of
responsibility centers in an organization is based on cost, quality, revenue and
investment.
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Donaldson Brown of General Motors divided ROI into a number of elements

for easy understanding. These elements are helpful in establishing
performance measures for various subunits of a division that are goal
congruent and would have an influence over the performance measures.
ROI= Net profit/invested capital
ROI can be divided into two components- net profit, which is a percentage of
the sales revenue, and the turnover of investments in relation to the sales
revenue.
Profit margin = net profit/sales revenue
Investment turnover = sales revenue/invested capital
Exhibits 6.2 and 6.3 show the computation of profit margin and investment
turnover.
RESPONSIBILITY CENTERS
Responsibility center is a unit or function of an organization headed by a
manager who is directly responsible for its performance. In a responsibility
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Exhibit 6.2
Computation of profit margin
sales revenue
cost of goods sold
net profit =
operating expenses =
+
period expenses
+
other expenses
income taxes
Profit margin =
sales revenue
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Prentice-Hall Inc, Second edition) 194.
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center, the accounting system generates information on the basis of

managerial responsibility, allowing that information to be used directly in
motivating and controlling the action of each manager in charge of a
responsibility center.
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Responsibility centers can be assigned very narrowly or broadly in terms of

the activities that senior management decides to assign to a particular
manager. But the type of responsibility center specifically defines the primary
objective of the decisions required when managing the assigned activity. For
example, as a cost center, a manager would focus on reducing costs in relation
to a standard cost or budget, and would not be concerned about the profit
margins of the various products or the implications of these decisions on the
company's profitability. However, in designating this center as a cost center,
the senior management should have already decided that the profit
implications would be controlled by another part of the entire system.
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Nature of Responsibility Centers
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Every organization has its goals determined, and the management decides
upon the strategies to accomplish these goals. Responsibility centers help in
implementing these strategies. As an organization is a collagium of
responsibility centers, the ability of its responsibility centers to meet their
objectives help an organization to achieve its goals. Every responsibility
center uses inputs (material, labor, etc.) and needs working capital, equipment
and other assets to function effectively. The responsibility center produces
outputs which are classified as goods and services and hence they can be
measured, whereas in human resources, transportation, accounting and
administration, the output is services that cannot be measured.
Measurement of inputs and outputs
It is easy to identify the monetary costs of physical quantities. The amount of
money is calculated by multiplying the physical quantity by a price unit of
quantity. Therefore, the inputs of a responsibility center are referred to as
costs. While the costs of inputs can be easily measured, outputs are not so easy
to measure.
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Exhibit 6.3
Computation of Investment Turnover
sales revenue
current assets
+
invested capital =
fixed assets
+
Investment turnover =
other assets
+
other liabilities
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Prentice-Hall Inc, Second edition) 194.
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The performance of a responsibility center can be judged by using the

effectiveness and efficiency criteria. Efficiency is the ratio of outputs and
inputs. These measures are usually used on a comparative basis. If there are
two responsibility centers, A and B, responsibility center A would be
considered more efficient than responsibility center B if it uses less resources
than B but has the same output, or if it uses the same amount of resources, but
produces more output. If both the centers are found to be performing up to the
companys expectations, the center that shows the lower costs is considered
more efficient.
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The effectiveness of the unit is decided on the basis of a units outputs and its
objectives. The greater the contribution of the outputs to the accomplishment
of the organizational objectives, the more effective is the unit. A unit should
be both effective and efficient to contribute to the achievement of these goals.
The companys overall profit can be considered as the base for measuring
effectiveness and efficiency.
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Types of Responsibility Centers

According to the nature of monetary inputs and outputs, responsibility centers
can be classified into the following:
Revenue centers
Revenue centers are those organizational units in which outputs are measured
in monetary terms. These centers are marketing organizations and they are not
directly responsible for profits. Revenue centers are also called expense
centers, as the revenue center managers are held responsible for expenses
incurred by the unit. The main objective of revenue centers is to maximize
revenues. For example, a marketing organization is a sales revenue center.
Such a center is devoted to increasing the revenue, and assumes no
responsibility for production. In this center, the manager is responsible for the
level of revenue or outputs of a center, measured in monetary terms, but is not
responsible for the costs of the goods or services that the center offers.
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Expense centers
In expense centers, inputs or expenses are measured in monetary terms
whereas the outputs are not measured in monetary terms. There are two types
of expense centers-engineered expense centers and discretionary expense
centers. There are two types of cost involved in engineered expense centers
and discretionary expense centers respectively-engineered costs and
discretionary costs. Engineered costs are costs that can be estimated to a
reasonable extent by the management. Examples are direct labor and direct
material. Discretionary costs, on the other hand, are costs that cannot be
estimated by the management.
Engineered expense centers
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In these centers, inputs or expenses are measured in monetary terms and

outputs are measured in physical terms. These centers are usually found in the
manufacturing units that use a standard cost system. There are certain
responsibility centers within administrative and support departments that
actually are engineered expense centers. In these centers, the cost of the
product is determined by multiplying the output of each unit with its standard
cost. Its efficiency is measured by comparing the actual cost with the standard
cost.
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In discretionary expense centers, the output cannot be measured in monetary

terms. Discretionary expense centers include administrative and support units
like legal, accounting, industrial and public relations units. Here, the
efficiency is not the difference between budgeted and actual expense, but the
difference between the budgeted input and actual input. In discretionary
expense centers the management decides on certain policies that should
govern the company's operation. These relate to the amount of money that
should be spent on R&D, financial planning, public relations, etc. The
decisions related to such activities depend on the way a company operates.
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Control characteristics for expense centers
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The management control systems for expense centers are discussed, taking
into consideration factors like budget preparation, cost variability, financial
control and measurement of performance.
Budget preparation: The decisions regarding the budget of expenses for a
discretionary expense center is different from that for an engineered expense
center. In engineered expense centers, the costs are determined by the
management, taking into view the operating budget required to perform the
task effectively in the future. However, in a discretionary expense center, the
principal task is to decide on the magnitude of the job that has to be
performed. These tasks are of two types-continuing and special. Continuing
tasks take place year after year (like financial statements) while special tasks
are one-time tasks, for example, developing a profit budgeting system for a
newly acquired division.
Management by objectives is a useful technique in preparing budgets for a
discretionary expense center. Management by objectives is a technique where
the objectives of performance are jointly determined by subordinates and their
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superiors. The progress towards these objectives is periodically reviewed and

the rewards are allocated on the basis of performance. Another method used to
understand the appropriate level of spending in a discretionary expense center
is sensitivity analysis. According to this technique, the budget has a section
which explains the activities that can be undertaken if the budget is increased.
Sensitivity analysis is mostly not taken by companies as they think that it is
important for a manager to prepare the possible budget for accomplishing
activities that should be undertaken.
Cost variability: The costs, in a discretionary expense center, tend to vary
from one year to another according to the volume. However, these are not
influenced by short-term fluctuations in volume within a year. In engineered
expense centers, costs vary with short-term fluctuations in volumes.
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Financial control: The financial control in a discretionary expense center is

different from that in an engineered expense center. Here, the operating costs
are minimized by setting a standard for the costs and comparing the actual
costs with this standard. In discretionary expense centers, costs are controlled
by determining the tasks that have to be undertaken and the amount of effort
that is required for each task. Financial control is, hence, determined at the
planning stage.
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Measurement of performance: The financial performance report of a

discretionary expense center does not help in evaluating the efficiency of the
manager, whereas in engineered expense centers the financial report helps in
evaluating the efficiency of the manager. If the two centers are not properly
distinguished, the management may consider the performance report of a
discretionary center as an indication of its efficiency.
Administrative and support centers
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Administrative centers include the senior corporate management, the business

unit management and the managers responsible for their staff units. Support
centers provide services to other responsibility centers.
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Problems related to control in administrative and support centers include

difficulty in measuring output, as they basically provide service and advice to
the responsibility centers. Therefore, it becomes difficult to set cost standards.
Hence, their performance cannot be branded as efficient or inefficient.
Secondly there is lack of congruence between goals of staff units and
responsibility centers. The suggestions that staff departments may provide
regarding the development of systems, programs or functions may be too
costly when one thinks of the additional profits that these would generate. The
severity of the problems is also related to the organizational level. At the
operational level, the staff activity is controlled by the plant manager, and at
the business unit level, by the business unit manager. When compared to the
plant level, there is more discretion of tasks at the business unit level. Support
centers charge a particular price for the services they provide to other
responsibility centers.
Budget preparation: The budget for a support center consists of expenses, and
is prepared by comparing with the current years actuals. This budget consists
of the following components- the basic costs of running a center (for which
there is no need of management decisions), costs incurred by the discretionary
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activities of the center, and a section containing proposed increases in budget

(other than those related to inflation).
Research and development centers
Control problems in research and development: The problems in research
and development are:
Difficulty in measuring quality: The inputs for an R&D activity can be
measured whereas the outputs are difficult to measure. For R&D activities, the
time taken for a particular research cannot be estimated as it may take months
or sometimes years for a particular activity. Also the output is difficult to
measure because of its technical nature.
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Lack of goal congruence: As in administrative centers, goal congruency is

lacking in R&D centers, too. Conflict may arise between the research manager
and the business unit manager. The research manager may want to build the
best research and development center, no matter what the expense be, while it
may not be possible for the company to afford it. Also, the researchers may
not have sufficient knowledge about the business, in some cases.
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The research and development costs cannot be controlled on a year-to-year

basis because a research project may take years to show results and the
organization would have to bear the cost of the project for that period of time,
mainly the cost on labor.
Marketing centers
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There are two types of marketing activities in every organization: order filling
(logistics) and order getting. Order getting is an actual marketing activity.
Order filling activities include transferring goods from the company to the
customer, and receiving the appropriate pay from the customer. These are
mostly engineered expense centers. Order getting activities include test
marketing, training sales force, advertising, sales promotion, etc. Though the
output of a marketing organization can be measured, it is difficult to evaluate
the marketing effort, as the marketing department has no control over
economic conditions or competitors actions. These actions may be different
from what was expected when the sales budgets were established. In such
situations, it is difficult to achieve management control. Also, it becomes
difficult to measure the efficiency and effectiveness of these costs.
Profit centers
When financial performance of a responsibility center is measured in terms of
the organizations profit, then it is called a profit center. In a profit center,
performance is measured in terms of the numerical difference between
revenues (outputs) and expenditure (inputs). A profit center is given the
responsibility of earning profits. It is involved in the manufacture and sale of
outputs, and it measures how well the center is doing economically. The profit
center also determines the efficiency of the manager in charge of the center.
A profit center helps in motivating managers to perform well in areas they
control and also encourages managers to take initiatives. The profit center
helps the organization to make the best use of specialized market knowledge
of the divisional managers, and entrusts the local managers the responsibility
of tradeoffs.
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Profit centers have been used as a major management control tool. The major
advantages of profit centers are:
These help in increasing the speed of making operating decisions as they

do not have to be referred to corporate headquarters.
As the decision-making authority lies with the managers they can make
better decisions related to the task they are performing, because they can
understand the nature of the work better.
Since profit centers make their day-to-day decisions themselves

headquarters can concentrate on broader issues of the organization.
Managers are motivated to perform more effectively, as they are

responsible for increasing the profit of their unit.
Managers use their imagination, take initiatives to perform more

effectively, to increase the profit of their unit.
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However, there are certain difficulties associated with the creation of profit
centers. The management cannot have considerable control over the different
profit centers when decisions are centralized. The top management has to
depend on management control reports which may not be as effective as the
personal knowledge of an operation. There may be no place for competent
general managers in a functional organization because of lack of opportunities
for them to develop creative management skills.
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Organizational units compete with one another, and this may, sometimes,
result in conflict between different centers and reduction in cooperation
between different units and sharing of resources.
Types of profit centers
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Functional units can be classified as different types of profit centers. A multibusiness company can be divided into independent profit generating units such
as marketing, finance, manufacturing etc. The decisions regarding whether a
particular functional unit can be a profit center depends on the responsibility
center manager's ability to influence, if not control, other activities that affect
the company's bottom line. The different types of profit centers are discussed
below:
Marketing: A marketing activity becomes a profit center if it is charged with
the cost of the products sold. A marketing activity can be given the
responsibility of making profit when the marketing manager has the authority
to make principal cost/revenue trade off in terms of marketing a product,
spending on sales promotion, the appropriate time for this expenditure and on
which media to spend.
Manufacturing: This is an expense center and the management of activities
here is based on performance against standard costs and overhead budgets.
Problems in measurement may occur because of inadequate quality control,
shipping of inferior quality products, and so on, to obtain standard cost credit.
At times, there may arise the need to accommodate an order in-between
production schedules, and the manufacturing managers may be reluctant to
interrupt these schedules. In manufacturing units, when performance is
measured against standards, there may be no incentives for manufacturing
products that are difficult to produce. These factors may demotivate the
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managers, and eventually, they may not try to improve standards. Hence,
while measuring the performance of manufacturing activities against standard
costs, it is important to take into consideration quality control, production
scheduling and the make or buy decisions.
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Measuring profitability: Profitability measurements in a profit center can be of

two types-management performance and economic performance. Management
performance focuses on the managers performance while economic
performance relates to how well a profit center is performing as an economic
entity. Management performance is a measure used for planning, controlling
and coordinating the day-to-day activities of the profit center. The
performance measures of profit centers can be different and hence, the
necessary purpose for the information should not be obtained from a single set
of data. For example, the management performance report can show excellent
performance of a profit center manager. But the economic and competitive
forces for that particular report can show poor economic performance. As a
result, the center may run into losses and may even have to close shop.
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Types of profitability measures: The parameters that can be used for

measuring the profitability of a profit center are contribution margin, direct
profit, controllable profit, income before taxes and net income.
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Contribution margin: This performance measure is used on the premise that,

since fixed expenses are not controllable by the manager, the focus should rest
on maximizing the difference between revenues and variable expenses. The
problems of using contribution margin is that since many of the centers
expenses may vary according to the discretion of the profit center manager,
focus on the contribution margin tends to direct the attention of the profit
center manager away from the goals of the center.
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Direct profit: This measure helps in understanding the contribution of the

profit center to the general overhead profit of the corporation. It encompasses
all the expenses directly incurred by profit centers or related to profit centers,
irrespective of whether the expenses are controllable by the profit center
manager. However, it does not include corporate expenses.
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Controllable profit: The headquarters expenses in an organization can be

divided into two categories-controllable and uncontrollable. Controllable
expenses include expenses that are controlled by the business unit manager.
The advantage of including such costs in the measurement system is that the
profit will be calculated after the deduction of expenses that can be influenced
by the profit center manager. Hence, these are controllable profits. As
uncontrollable headquarters expenses are taken into consideration while
calculating controllable profits, controllable profits cannot be compared
directly with published data or with trade association data, which report the
profits of other companies in the industry.
Income before taxes: In this method, all corporate overhead profit is allocated
to the profit center. The amount of expense incurred by each profit center
forms the basis of allocation of profit. Such allotment has its own drawbacks.
Firstly, the costs in departments like finance, and HR are not controllable by
the profit center and hence, profit centers should not be held accountable for
such costs. Also, it is difficult to quantify the amount that has been spent on
human resources in each profit center.
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However there are certain advantages in allocating costs.

Corporate service units often have a tendency to spend lavishly to make their
units as excellent as possible without paying due attention to the value they
create for the company. Once such costs are allocated to profit centers, the
profit center managers will try to keep a check on the expenditure.
The performance of profit centers is easily comparable to that of competitors
performance who pay for similar services.
Since the profit center can earn profit only when it has recovered all its costs,
including allocated corporate overhead costs, the profit center manager will be
motivated to make long-term marketing decisions such as pricing, product
mix, and so on, because the center will have to recover its share of corporate
overhead costs.
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For profit centers to function with the allocated costs in mind, it is important
that they are allocated budgeted costs, and not actual costs. This ensures that
the profit center managers will perform without complaining about the
arbitrariness of the allocated costs, since there would be no variances in the
allocated overheads in the performance reports.
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Net income: The performance is measured by taking into consideration the net
income after the payment of taxes. The disadvantage of using this method is
that many decisions that have an impact on the income taxes are made at
headquarters, and profit center managers should not be judged by these
decisions. If the income after tax payment is constant percentage of the
income before tax payment, then there would be no need to measure
performance based on this method. This method would be useful if profit
centers influence decisions like installing credit policies or disposing of
equipment. This method is also useful to motivate the manager to minimize
taxes in case the taxable income differs from income, as measured by using
generally accepted accounting principles.
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The performance of profit centers can be measured by comparing actual

results with one or more of the measures discussed above with budgeted
amounts. In addition, data on competitors and industry provide a good
crosscheck on the appropriateness of the budget.
Investment centers
An investment center has control over sales revenues and operating costs, and
the assets used to generate profit. An investment unit manager must be in a
position to influence the size of the investment and profit variables. An
investment center is a measure of economic performance, and it analyzes all
elements of profit and investment. The objective of this center is to maximize
profit, given the amount of investment required to generate the profit.
Cost centers
The objective of cost center is to minimize the variance between standard
costs and actual costs. A cost center is a production or service function,
activity or item of equipment the costs of which may be attributed to cost
units. Cost centers are basically related to costs, and not to the revenues or
assets and liabilities of the organization. A cost center is a separate
organizational unit for which separate cost allocation is done. A cost center
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forms the basis for building up cost records for cost measurements, budgeting
and control. From a functional point of view, a cost center is a production cost
center (where only production is undertaken like a assembly department), a
service cost center (offering service to production departments like personnel,
accounting etc.,) or an ancillary manufacturing center (producing packing
materials).
PERFORMANCE MEASUREMENT OF DECENTRALIZED OPERATIONS
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When a control system designer plans to measure the performance of a

decentralized operation, a number of difficulties are encountered, especially in
a multidivisional company. The main issues involved in the measurement of
the performance with regard to interdivisional transactions are measuring
profit and investment performance and setting transfer prices for interdivisional transactions. The techniques for measuring performance discussed
below like ROI performance measurement, transfer pricing are all suitable for
formal organizations. In informal organizations like a clan-based one,
companies rely more on informal control mechanisms. The emphasis here is
more on teamwork.
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The methods used to measure a divisional operation are based on the

responsibility structure and the cost and asset assignments of the firm.
ROI- (Return on Investment) as a measurement of performance
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The objective of any firm is to achieve satisfactory returns on investment.

Elements such as cost, quality, revenue and investment are assigned to a
responsibility center in appropriate amounts, and these elements are used to
calculate the ROI.
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The design of measurement systems and financial performance of a firm is

based on the principles of ROI. ROI is an important organizational issue. Each
responsibility center should contribute to the ROI. The contribution of each
center of an organization to ROI depends on allocation of resources to the
center manager. Hence, ROI is an important investment criterion for the
responsibility centers.
To calculate the ROI of an investment center, it is important to define the
revenue, expense and investment allocated to the center. Expenses can be
assigned through cost assignment methods. Investment can be assigned,
depending on the assets to be assigned and the methods of measuring the
assets. When a firm applies a budgeted ROI figure to a responsibility center to
determine expected profits, the divisional manager uses that figure as a
criterion for investing in assets. These investments are made keeping in mind
the ROI budgeted figure. The ROI measure is important as it helps in
establishing corporate objectives and helps the managers to work towards
achieving the organizational goals and investment projects that are appropriate
for the firm.
The cybernetic paradigm helps in understanding the usage of ROI. When a
firm functions within the goals of the organization in mind, and attains a
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certain level of return on the total book value of the investment, then the
managers of the investment centers can be made responsible for ROI as
computed in the divisional income statement and the balance sheet.
INTER PROFIT CENTER RELATIONS

Responsibility centers differ from one another in their activities and
performance. It is necessary to integrate the activities of the different
responsibility centers. The performance measurement system should be so
designed as to encourage the divisional managers to act in the best interest of
the company.
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One major problem encountered during the measurement of the performance

of a division is the determination of prices for goods and services that are
transferred between divisions. This is referred to as the problem of transfer
pricing.
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The problem of transfer pricing arises when the business conducts transactions
with each other. One solution to this problem is to stop business transactions
among the divisions. However, this solution has some disadvantages. If the
business transaction between the divisions are eliminated, the organization
would have to forgo certain benefits, such as economies of scale in
manufacturing and management.
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Setting Transfer Prices
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Transfer price is defined as the value of transfer of services between two or

more profit centers. The transfer pricing system enables the management to
enjoy the benefits of centralization and decentralization. Transfer prices are
not set by the corporate staff; they are negotiated by the divisions among
themselves. The process of determining transfer prices is governed by two
criteria-goal congruence and fairness.
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Goal congruence
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A transfer price is said to be goal congruent if the buying and selling divisions
make decisions regarding the price and quantity of transfers, which would
have been the same if they were made by the central management.
Fairness in setting transfer prices
This means that the profit center gives the divisional managers the required
autonomy to pursue their objectives. In a profit center, where each division
operates almost as an independent company, one of the most important
decisions that the managers need to take concerns the pricing of products
manufactured by the division. The buying division usually negotiates with the
selling division to decide upon an appropriate price. However, disagreements
between divisions on transfer prices is a common occurrence.
A transfer pricing system is said to be efficient if it encourages managers to
pursue decentralization of autonomy and, at the same time, not forgo the
benefits of centralization. It should allow the divisional managers to achieve
the goals and objectives of the organization and at the same time these goals
should be in congruence with the organizational goals.
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SUMMARY
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Assigning the right kind of autonomy and responsibility to employees will

result in creative ideas. But a manager should be able to strike the right
balance between autonomy and control. To understand autonomy, it is
important to identify the variables that influence autonomy. They can be
grouped under three heads: Management style and process, responsibility
structure and reward systems. Management style, policies and procedures,
diversification and business strategy fall in the first group. Reward systems are
designed on the basis of the manager's ability to manage costs and
investments. Responsibility structure consists of responsibility centers and
related performance measurement systems. Responsibility structure
establishes the physical, human and financial resources that are entrusted to
the profit center manager. The availability of resources influences the
decision-making authority of the responsibility center managers.
Responsibility centers can be classified into revenue centers, expense centers,
profit centers, investment centers and cost centers. Revenue center are mainly
responsible for raising the revenue, and assume no responsibility for profits. In
expense centers, inputs are measured in monetary terms, whereas outputs
cannot be easily quantified. There are two types of expense centers:
Engineered expense centers and discretionary expense centers.
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In profit centers, financial performance is measured in terms of the numerical

difference between revenues and expenditures. An investment center is a
measure of economic performance and it analyzes all elements of profit and
investments. Cost centers are supposed to minimize the variance between
standard costs and actual costs. When divisional autonomy is provided to
centers, it becomes important to measure the performance of decentralized
operations. Factors ROI, are important for measuring performance. Managing
inter-profit center relations is a major task in an organization. It is necessary to
integrate the activities of the different responsibility centers so that they work
towards the accomplishment of the goals of the organization.
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Transfer Pricing
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Chapter 7
Objectives of Transfer Pricing
Principle of Transfer Pricing
Methods of Calculating Transfer price
Upstream Fixed Costs and Profits
Administration of Transfer Prices
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When an organization has a decentralized structure, it has several separate

profit centers1. Goods and services are transferred internally from one profit
center to another, before the final product/service is brought to the market.
Companies find it useful to account for the value of goods and services
exchanged, even if the exchange is only internal and does not involve the
market at all. This helps the company to assess the contribution of each of the
profit centers separately. To help in such assessment, a mechanism called
transfer pricing has been developed. Transfer pricing helps to determine the
value of goods and services transferred before calculating the profits of the
company. A transfer price is defined as the price that is assumed to have been
charged by one part of a company for products and services it provides to
another part of the same company, in order to calculate each division's profit
and loss separately. In this chapter we will discuss the objectives of transfer
pricing, various methods of transfer pricing and ways of administering these
prices.
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OBJECTIVES OF TRANSFER PRICING
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The main objective of transfer pricing is proper distribution of revenue

between profit centers. If two or more profit centers are jointly responsible for
product development and marketing, then the resulting profit has to be shared
between the profit centers. Some other objectives of transfer pricing are:
Providing relevant information to the profit centers regarding the trade-off
between costs and revenues of the company.
Inducing goal-congruent decisions, i.e., decisions that improve the profits

of business units and also improve the profits of the company (this is
discussed in detail below).
Helping to measure the economic performance of profit centers.
Minimizing tax liability.
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PRINCIPLE OF TRANSFER PRICING

The fundamental principle of transfer pricing is that the transfer price should
be similar to the price that would be charged if the product were sold to
outside customers or purchased from outside vendors.2
Goal Congruence
While designing the mechanism for transfer pricing, the interests of profit
centers should neither supersede the interests of the overall organization, nor
should there be a clash of interests between the organization and its profit
centers. In other words, there should be goal congruency between profit
centers and parent organization. Some of the prerequisites for achieving goal
congruency are:
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The concept and functioning of profit centers has been discussed in chapter 6.
Management Control Systems by Anthony and Govindarajan, 8th edition, Irwin Publications.
Transfer Pricing
Competent people
Good organizational atmosphere
Details of market prices
Freedom to source
Availability of information
Scope for negotiation
Competent people
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Organizations need managers who can balance long-term and short-term

goals. Managers are often accused of sacrificing long-term gains for shortterm profits. This approach can prove disastrous for the organization. Transfer
pricing can be misused for manipulating profits, and this gives a wrong picture
of the position of the company. Hence, organizations should have competent
people skilled at negotiation and arbitration, who are capable of determining
the appropriate transfer prices. This makes goal congruency possible.
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Good atmosphere
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Details of market prices
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In order to achieve goal congruency, managers of profit centers, especially the

buying profit centers, should ensure that the transfer prices charged by the
selling profit centers are just. This will create an atmosphere of trust between
selling profit center and buying profit centers.
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When a product is transferred from one profit center to another, the normal
market price for the identical product can be taken as the basis for establishing
the transfer price. The market price should reflect the same conditions in terms
of quantity, quality, time for delivery, etc. as characterize the product to which
the transfer price applies. The market price can be adjusted to reflect savings
due to lower expenses on advertising and marketing as the product is sold
within the company.
Freedom to source
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Managers of selling profit centers should be given freedom to sell their goods
in the external market, while managers of buying profit centers should be
allowed to buy their goods from the external market. Thus the market
becomes the main determinant of the transfer price.
Availability of information
Managers should be fully aware of market conditions and should have all the
necessary information available to them, before they take any decision. For
example, managers should be aware of the alternatives available and the
relevant costs of and revenues derivable from each alternative.
Scope for negotiation
There must be a mechanism for negotiating contracts, and managers who take
transfer pricing decisions should be trained in negotiation.
If all the above conditions are met, then companies can devise a mechanism
for transfer pricing based on the market price. But quite often these conditions
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are not fulfilled, and it becomes difficult to achieve goal congruency. Some
situations that are not favorable for achieving goal congruency are:
Limited markets
Excess or shortage of capacity in the industry
Limited markets
Markets for buying and selling the goods of the profit centers may be either
very small or nonexistent. Some of the reasons for this are:
Firstly, the profit center may have spare internal capacity, but may not wish to
make any external sales. Secondly, if the company is the sole producer of a
differentiated product then outside capacity does not exist. Thirdly, a company
that has invested heavily in facilities will not want to source goods from
outside unless the selling price in the market is as low as its own variable cost.
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Excess or shortage of industry capacity
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Sourcing constraints
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There may be situation of excess capacity or shortage of capacity in the

industry. The selling profit center does not sell in the outside market when
there is excess capacity in the industry. The buying profit center may purchase
from outside vendors even though there is capacity available inside the
company. Thus the company, as a whole, may not be optimizing its profits. In
a situation of insufficient capacity in the industry, the buying profit center may
be unable to obtain products it needs from the external market, whereas the
selling profit center is able to make profits by selling the product in the
external market. This situation occurs when demand is high and industry
capacity is low. Here also, the company, as a whole, may not be able to
optimize profits.
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When there is an excess or shortage of industrial capacity, the sourcing

decisions taken by the company are vital. A company may allow its buying
profit center to buy goods from outside, if the profit center is getting a better
deal in terms of quality, price and service. In the same way, a selling profit
center may be allowed to sell its products in the open market if it gets a better
profit by selling in the market. Whatever be the case, the management should
not get bogged down by pressures within the company and should try to take
decisions that optimize the profit of the company.
METHODS OF CALCULATING TRANSFER PRICE

Methods used for calculating the transfer price differ from company to
company. Companies should evaluate all the methods before adopting one that
is most suitable for them. The following criteria should be used to evaluate the
methods for calculating transfer price.
Goal congruence: As already discussed, transfer prices should balance
between goals of enterprise as a whole and its profit centers.
Rationality: Transfer prices should not interfere with the process by which the
buying center manager rationally strives to minimize costs and the selling
center manager rationally strives to maximize revenues.
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Transfer Pricing
Autonomy: Each profit center manager should be free to satisfy his centers
needs either internally or externally at the best possible price.
Performance evaluation: Transfer pricing should aid in objective evaluation
of the activities of the profit center. It should be used as a tool for making
proper decisions. It should also aid in appraisal of managerial performance
and of the enterprise as a whole.
The three methods of calculating transfer price that are used commonly are:
Market-based pricing method
Cost-based pricing method
Negotiated pricing method
Market-Based Pricing Method
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Companies that use this method price the goods and services they transfer
between their profit centers at a price equal to that prevailing for those goods
and services in the open market. This is similar to arms length pricing as
intracompany transfers are priced the same as those for external customers.
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Market-based pricing method has two main advantages for a company. Firstly,
business units can operate as independent profit centers with the managers of
these units being responsible for their own performance as well as that of the
business unit. When managers are made responsible for performance of the
business unit, it increases their motivation and it also becomes easier for the
headquarters to assess the actual operating performance of its business units.
Secondly, tax and customs authorities favor the market price method because
it is more transparent and they can crosscheck the price details provided by the
company by comparing them with market prices on that date.
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In practice, however, the use of a market price as a benchmark is difficult

because often there is no competitive market which can provide a comparable
price. For some types of complex capital equipment, an external market may
not exist at all. In some cases, prices may be distorted by monopoly elements.
Moreover, a definitive market price may be difficult to determine because of
variance in prices from one market to another due to changes in exchange
rates, transportation costs, local taxes and tariffs etc. In addition, a company
may set its selling price depending on the supply and demand conditions
prevalent in a specific market. In sum, these factors mean that a unique market
price for companies to follow does not always exist.
Cost-Based Pricing Method

The cost-based pricing method calculates transfer price on the basis of the cost
of a good or service. The cost of a good or service is available in the cost
accounting records of the company. This method is generally accepted by the
tax and customs authorities since it provides some indication that the transfer
price approximates the real cost of item. Cost-based approaches are, however,
not as transparent as they may appear. A company can easily manipulate its
cost accounts to alter the magnitude of the transfer price.
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Companies that adopt the cost-based transfer pricing method have to choose
between alternative approaches, which are listed below:
Actual costs approach
Standard costs approach
Variable costs approach
Marginal costs approach
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Apart from this, companies also have to decide on the treatment of fixed costs,
and research and development costs. These issues can prove problematic for
the company that adopts a cost-based transfer pricing method. Cost-based
methods usually create difficulties for the selling profit center, as their
incentive to be cost-effective may fall, if they know that they can recover
increased costs simply by raising the transfer price. Without an incentive to
produce efficiently, the transfer price may erode the competitiveness of the
final product in the market place.
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Negotiated Pricing Method
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In this approach, buying and selling business units freely negotiate a mutually
acceptable transfer price. Since each unit is responsible for its own
performance, this will encourage cost minimization and encourage the parties
to seek a transfer price which yields them an appropriate profit return.
However the tax authorities have their reservations about this method because
companies that use this method have greater scope of manipulating transfer
prices, to minimize their tax liability.
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UPSTREAM FIXED COSTS AND PROFITS
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A typical transfer pricing problem is encountered in oil companies, paper

companies and other integrated companies in which raw material is extracted
and processed further for production of the final product. In such companies,
in the absence of proper transfer pricing, the division that sells the final
product to outside customers may not be aware of the fixed costs involved in
the internal purchase price. For example, an oil company has three divisions:
the crude oil division, the refinery division and the sales division. The final
product of the company, say petroleum, is sold by the sales division, but
before this, the crude oil division sells its crude to the refinery division, from
where it is sent to the sales division. In this situation, the sales division may
underestimate the costs (particularly the fixed costs) incurred during
extraction and processing. So, it might sell the final product at a price that is
not sufficient to recover fixed costs. Due to this company may incur losses and
there can be a conflict between the two divisions.
In order to tackle these kind of problems, companies should adopt following
methods.
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Two step pricing

Profit sharing
Two sets of prices
Transfer Pricing
Two Step Pricing

Two step pricing involves charging for the product being transferred twice.
First, the product is priced on the basis of the variable cost incurred in
producing it. At the second stage of pricing, the fixed costs that are incurred
because of certain special facilities used for production are also included. The
sum of these two charges constitutes the transfer price for the product.
Profit Sharing
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Under this method, the product is transferred to the marketing unit at the
standard variable cost. After the product is finally sold, the business units
share the profit earned. But, this method may lead to disagreements over the
way the profit is divided between the two profit centers. Sometimes, senior
management has to intervene to settle these disputes. As the profits between
units are divided arbitrarily, it does not reflect accurately the profitability of
each segment. Also, as the manufacturing unit's contribution depends on the
marketing unit's ability to sell and the actual selling price, this may be treated
as unfair by the manufacturing unit.
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Two Sets of Prices
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Under this method, revenue is credited to the manufacturing unit at the market
sales price and the buying unit is charged for the total standard costs. The
difference between the outside sales price and the standard cost is charged to
the parent companys account. These charges are later eliminated while
drawing consolidated financial statements. This method is used when there are
frequent conflicts between the buying and selling units and they cannot be
resolved by any method.
The disadvantages of this method are:
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1. It is difficult to maintain an additional book each time a transfer of good is

made.
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2. It motivates the managers to concentrate only on internal transfers (where

they are assured of a good markup) at the expense of outside sales.
ADMINISTRATION OF TRANSFER PRICES

Implementing transfer pricing involves long negotiations between heads of
various units, classification of products, and arbitration and conflict resolution
in case conflicts arise.
Negotiation
Business units of companies negotiate among themselves before taking
decisions pertaining to transfer prices. The headquarters does not involve itself
in formulating transfer prices and leaves it to the line managers of the
respective units to establish the buying and selling prices. There are two
reasons for this. Firstly, the line managers of the business units may feel
powerless if they are denied any say in the transfer prices, and this may affect
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their motivation. Secondly, if the profits of business units are poor then the
unit managers may argue that it is due the arbitrariness in setting transfer
prices by the headquarters.
Arbitration and Conflict Resolution

There may be times when business units are not be able to reach an agreement
on transfer price easily. In such situations, business units should follow a set
procedure for arbitrating disputes relating to transfer price. The responsibility
for arbitration rests with the parent company. It may assign a single executive
who can talk to the business unit managers and arrive at an agreement over the
price. Alternatively, a committee may be formed with the following
responsibilities: to settle transfer price disputes, to review sourcing changes,
and to change the transfer price rules whenever necessary.
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Organizations can have a formal or informal system of arbitration to

administer the transfer price mechanism and to resolve the conflicts. In a
formal system of arbitration, both the parties submit a written case to the
arbitrator, who reviews it and decides the price. In an informal system of
arbitration, most of the presentations are oral.
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Irrespective of the formality of the arbitration and the process of conflict

resolution in an organization, the goal is to make the system of transfer pricing
system effective. The management can use any one of the following ways to
resolve the conflicts: forcing, smoothing, bargaining, and problem solving.
Forcing and smoothing reflect conflict avoidance, whereas bargaining and
problem solving indicate conflict resolution.
Product Classification
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Sourcing and transfer pricing are greatly affected by the number of

intracompany transfers and the availability of markets and market prices. The
larger the number of intracompany transfers and the less the availability of
market prices, the greater the need for more formal transfer pricing rules. If
market prices are readily available, the headquarters can play a vital role in
making sourcing decisions. In some companies, products are classified into
various categories to help in determining transfer prices. For example, a
company can divide its product portfolio into two classes before taking
transfer pricing decisions.
Class I products may include all those products whose transfer price the senior
management at the headquarters would like to control.
Class II products may include those products that can be produced outside the
company without disrupting the normal workflow. These products are small
in volume and are transferred at market prices.
SUMMARY
A transfer price is defined as the price that is assumed to have been charged
by one part of a company for products and services it provides to another part
of the same company, in order to calculate each division's profit and loss
separately. The main objective of transfer pricing is to aid in the proper
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Transfer Pricing
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distribution of revenue between profit centers. While designing transfer

pricing systems, organizations should aim at goal congruency. Some of the
factors which help in achieving goal congruency are: competent people, good
atmosphere, freedom to source, market price details, availability of
information, and scope for negotiation. Some factors that hamper achievement
of goal congruency are: limited markets, excess or shortage of industry
capacity, and sourcing constraints. Companies use three methods for
establishing transfer prices. They are the market-based pricing method, the
cost-based pricing method, and the negotiated pricing method. Integrated
companies can use two-step pricing, profit sharing or two sets of prices in
order to overcome problems related to upstream fixed costs. Implementation
of transfer prices is more difficult than formulating them. Companies need to
engage in negotiations, provide mechanisms for arbitration, and classify their
products, to overcome problems that can arise during implementation of
transfer prices.
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PART III:
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MANAGEMENT CONTROL
PROCESSES
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Chapter 8
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Programming
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Strategic Planning and

Elements of Strategy
Characteristics of Strategic Planning
Strategic Planning Process
Analyzing Proposed New Programs
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Analyzing Ongoing Programs
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The Programming Process
Strategic planning involves long-term planning, and is usually undertaken by

the top management. Strategic planning is the process of deciding on the
programs that the organization will undertake and the amount of resources that
will be allocated to each program in the next few years.
For strategic planning to be effective, it should be accompanied by an
appropriate organizational structure, an effective management information
system, a budgeting system and a reward system. Decisions regarding
strategic planning influence the physical, financial and organizational
framework within which the relevant operations are carried out. The
programming process is an organizational process for making long-term
resource allocation decisions. This chapter examines in detail the significance
of strategic planning, the strategic planning process and the programming
process.
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ELEMENTS OF STRATEGY
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According to Yavitz1 and Newman, there are four elements of strategydomain sought, differential advantage, strategic thrusts and targeted results.
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The domain sought relates to analyzing the environment in which the

organization is functioning. It addresses issues related to the changing needs
of the business activity, the changes in the business environment, changes in
the customers perception regarding the companys products and best
practices to deal with competition. All these relate to the domain in which the
organization operates. Benchmarking is considered an important tool for
comparing the companys products with those of its competitors.
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Differential advantage relates to identifying the strengths and weaknesses of

different businesses, improving upon the strengths and overcoming the
weaknesses.
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After an organization analyzes the domain and differential advantage, the next
step is to plan the strategies required to achieve the goals. This involves issues
related to costs, marketing new products and services, planning the training
and development strategies required for the staff to work in congruence with
the organizational goals.
The last stage involves analyzing performance. To know whether an
organization is moving in the right direction, it is important to measure at
regular intervals the actual results against expected results.
CHARACTERISTICS OF STRATEGIC PLANNING

Strategic planning is the first step in the management control process. The
difference between strategy formulation and strategy planning is this: Strategy
formulation is the process of deciding on new strategies, whereas strategic
planning is the process of deciding on how to implement these strategies.
Strategy formulation essentially involves deciding on the goals of the
1
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Yavitz, Boris and William H Newman, Strategy in action: The execution, politics and
payoff of business planning, New York: The Free Press, 1982.
organization, whereas strategy planning is concerned with developing

programs to implement these goals effectively and efficiently. Strategic
planning is systematic; it is usually done annually with prescribed procedures
and timetables. Strategy formulation is unsystematic and depends on the
threats or opportunities that the environment offers.
Benefits of Strategic Planning

1. Strategic planning takes into consideration the changing business
environment which is a foundation for organizational change.
2. It helps in identifying and analyzing the internal business culture and
evaluating its impact on the companys performance.
3. It helps in analyzing available opportunities and potential threats.
4. It helps in allocating resources to the most beneficial activities.
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5. It helps managers set realistic objectives that are demanding, and yet
attainable.
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6. It helps in identifying poor performing areas and eliminating them.
7. It helps in obtaining better information for decision making.
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8. It helps in developing a frame of reference for budgets and short-range

operating plans.
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9. It helps in bringing about coordination of internal activities and thereby

enhances the organization's growth.
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In short, strategic planning provides a road map of the company's target, and
how to reach it.
Organizational Relationships
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An important purpose of strategic planning is to improve communication

between the corporate and business unit executives, and arrive at a mutually
agreed upon set of objectives and plans. In some organizations, the controller
organization is involved in preparing the strategic plans while in others, there
is a separate planning staff. In organizations where the controller of the
organization is involved in the preparation of strategic plans, the plans may
not be as successful as other organizations. Analytical skills and broad outlook
may not exist in the controller organization. Such organizations may be
suitable for fine-tuning the annual budget and analyzing the variances between
actual and budgeted costs. Even in organizations that have a separate strategic
planning staff, disseminating guidelines and assembling and bringing together
the budgeted numbers are done by the controller organization.
The staff at the headquarters should facilitate the strategic planning process,
but should not intervene too strongly. They must ensure that the process runs
smoothly but should not make program decisions themselves. This encourages
business unit managers to freely put forward their views in the decisionmaking process.
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Top Management Style

The way strategic planning is conducted depends largely on the chief
executive officers style. Some CEOs prefer to make decisions without a
formal system. If the controller of such companies attempts to introduce a
formal system, it is not likely to succeed. In some companies, the senior
executives may prefer an extensive formal analysis and documentation of the
plan, and hence, the plan is very elaborate. Thus, in designing the system, it is
important that the senior managements style be clearly diagnosed and the
strategic plan be prepared accordingly.
STRATEGIC PLANNING PROCESS

The strategic planning process involves the following steps:
Reviewing and updating the previous years strategic plan.
Deciding on assumptions and guidelines for the plan.
First iteration of the new strategic plan
Analysis
Second iteration of the new strategic plan
Review and approval
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Reviewing and Updating the Strategic Plan
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This involves reviewing and updating the strategic plan that was prepared in
the previous year. Reviewing and updating takes place every year when the
strategic plan is prepared, depending on the decisions the management takes.
There is no fixed time limit set for this review. The updating of these plans is
done with the help of a computer program. These programs help in
incorporating the decisions on revenues, expenses, capital expenditures and
cash flow. Updating is usually taken up by the planning staff. The
management is involved, only if there are uncertainties or ambiguities in the
program decisions.
Deciding on Assumptions and Guidelines

This step involves making broad assumptions about growth in the gross
domestic product, cyclical movements, the rate of general inflation, labor
rates, prices of important raw materials, selling prices, market conditions, and
the government legislation, in each of the countries in which the company
operates. All these assumptions are examined and updated with the latest
information. This process of updating has implications on revenues, expenses
and cash flows of the existing operating facilities. It shows the amount of new
capital that is available from the retained earnings and new financing. All
these data are clearly analyzed so that it is currently valid (for the present
year) and the amounts are extended for another year. This updating provides a
rough estimation for the senior management to decide about the key
guidelines that are to be observed in planning and for designing of these
methods for achieving these objectives. The objectives are presented
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separately for each product line and are expressed as sales revenue, or as a
profit percentage or a return on capital employed. There also are guidelines
regarding wage and salary hikes, new or discontinued product lines and selling
prices. At this stage, basically the views of the senior management are
presented.
To present these objectives to the business unit managers, most companies
hold meetings between the corporate and business unit managers. Such
meetings continue for several days, and help all business unit managers in the
organization know one another. These meetings are held far away from office
premises, to avoid distractions.
First Iteration of the Strategic Plan
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After the assumptions and guidelines have been framed, the business units
prepare the first iteration of the strategic plan. Most of the initial
documentation and analytical work is done by the members of the business
unit. After this, a final decision is taken by the business unit managers. The
staff at the headquarters may also be consulted with regard to drawing up
these plans. During the preparatory stage, employees from the headquarters
visit the concerned business unit to find out whether the guidelines,
assumptions and instructions are being followed.
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The completed strategic plan consists of income statements (inventory,

accounts receivable) and other balance sheet items (sales and production, of
expenditures of the plant and other capital acquisitions). These income
statements are elaborately explained and justified. The numbers are presented
in detail. They are also presented for the next two years, individually, with
summary information for the later years. Then these are submitted to the
headquarters.
Analysis
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After the plan prepared by a business unit is received at the headquarters, it is

integrated into the overall corporate strategic plan, which is analyzed in detail.
Employees from all functional areas like marketing and production, and the
planning staff take care of the analysis. If there is any problem related to a
particular business unit regarding additional funds for research and
development, or if any slack is detected, then it is resolved through
discussions between headquarters staff and their counterparts in the business
units. These discussions form an important part of the strategic planning
process, because they help identifying planning gaps. Planning gaps occur
when the individual business unit plans do not work towards achieving
corporate objectives. The best way to close these gaps is by:
Identifying the areas where the business unit plan can be improved on par
with the corporate plan
Making acquisitions
Reviewing the corporate objectives
Of the three, utmost importance is given to the first method to close the gap.
The headquarters should also ensure that there is coordination between the
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different departments. For example, if one business unit manufactures for

another unit, then it should be analyzed whether the unit is manufacturing as
per the requirements of the other unit. At the planning stage planned cash
requirements for the organization as a whole are developed, which include
additional financing or possibly increasing dividends.
Second Iteration of the Strategic Plan
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The analysis of the first plan leads to revision of the plans of certain business
units. Sometimes, the guidelines may be changed, and this leads to a change
in the overall plans of all the business units. Technically the revision is simple
enough, but implementing such changes within the organization it difficult
and time-consuming, because difficult decisions have to be made. In some
companies, changes in the business unit plans are negotiated informally, and
the results are incorporated into the plan by the headquarters.
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Final Review and Approval
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The revised plan is discussed with the senior corporate officials. It can also be
presented in the meeting of the board of directors, and the final approval
comes from the chief executive officer. The approval process should be
completed before beginning the budget preparation process, as strategic
planning is an important input for budget preparation.
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Ideas for new programs may originate anywhere in the organization- from the
chief executive to the employees in the organization. Giving employees the
freedom to put forward their proposals and paying them management attention
plays an important role in implementing new programs. Every organization
should have a management system that is flexible enough to encourage new
ideas and pay the required attention to the employees. Adoption of new
programs should be viewed as a series of decisions, and not a single decision.
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Capital investment analysis is important for taking up new proposals. The

importance of capital investment analysis is to find the net present value of the
project and the internal rate of return. The present value techniques are not
used in analyzing the proposals for the project because:
If the proposal is not attractive enough then it is not necessary to calculate

the net present value.
The estimates involved in the project are so uncertain that making present
value calculations is not worth the effort.
The present value approach concentrates on the increasing profit of the

firm. But some projects can be implemented to boost employee morale
and to improve the companys image, or for safety reasons.
The management control system should look for a systematic way of arriving
at a decision on proposals that cannot be analyzed using quantitative
techniques. Organizations must look into the following issues before
implementing capital expenditure evaluation systems:
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Rules
Companies publish rules and procedures for the submission of capital
expenditure proposals. These rules specify the requirements for a proposal to
be approved (of various magnitudes). The proposals are approved by the
business unit manager, the chief executive officer or the board of directors
depending on the degree of proposed expenditure. These rules also provide
guidelines for the preparation of proposals and the general criteria for
approving these.
Avoiding Manipulation
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Sometimes projects that have a negative net present value may get approval
because they are made attractive by adjusting the original estimates. This can
be done by making more optimistic estimates of the sales revenue and
reducing the amount of contingencies in some of the cost elements. Detecting
such manipulations is one of the important tasks of the project manager.
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Acquaintance with Planning Models
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The staff involved in planning should be acquainted with various aspects of

budgeting, such as risk analysis, sensitivity analysis, game theory, option
pricing models, contingent claim analysis and decision tree analysis. These
aspects will prove useful in situations in which the required data are available.
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Organizing for Analysis
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A team should be formed to evaluate important proposals. The analysis of a

project is usually done by a dozen functional and line executives before it is
submitted to the chief executive officer. The project then goes through pilot
testing and, at times, may not be approved for further analysis by the CEO.
New technological systems like the expert systems2 are very handy for
analyzing the proposed programs. Several software systems have been
developed, that enable each member of the team to vote and rank each of the
criteria used to evaluate the program.
There is no fixed time for the commencement of such an analysis. It begins as
soon as the proposal for the project is received. The projects that are approved
are included in that years capital budget. If a proposal is not approved that
year, then the formal approval may wait until the next year. The capital budget
contains the authorized capital expenditures for the budget year and in case
additional amounts are sanctioned, the cash plans are revised.
ANALYZING ONGOING PROGRAMS

It is not only important for a company to develop new programs, but also to
analyze the ongoing programs. The tools used for analyzing ongoing programs
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An expert system is a computer program that simulates the judgment and behavior of a
human or an organization that has expert knowledge and experience in a particular field.
Typically, such a system contains a knowledge base containing accumulated experience and
a set of rules for applying the knowledge base to each particular situation that is ascribed to
the program.
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are value chain analysis, activity-based costing and discretionary expense

center analysis.
Value Chain Analysis
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The value chain is a series of activities- from identifying the raw material to
delivering the product to the consumer. As a part of the strategic planning
process, a value chain helps an organization to understand the entire value
delivery system. It highlights three areas for increasing profits-link with
suppliers, link with customers and process linking within the value chain of
the firm. The link with suppliers should be managed in such a way that both
the firm and the suppliers benefit from it. Its relationship with customers is
equally important. These two should be mutually beneficial. Apart from
maintaining such relationships with suppliers and customers, it is also
important for the firm to realize that the value activities in a firm are not
independent, but interdependent. As part of the strategic planning process, a
company may sometimes require information about the linkages within the
value chain to improve efficiency. For this purpose efficiency in value chain
should be analyzed. The efficiency of pre-production activities can be
improved by reducing the number of vendors, adopting just-in-time delivery
systems and establishing quality standards. The efficiency of the production
unit can be increased through automation and better production control
systems. The efficiency of delivery to the customers can be increased by
automating the orders that they place, and by improving the channels of
distribution, the efficiency of warehouse operations, and so on. It is important
that improvements should be evaluated simultaneously, as all the activities are
inter-linked.
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Activity Based Costing
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Increased automation and computerization have resulted in the

implementation of certain systems for collecting and using cost information.
The traditional cost system allocated overhead costs to the products based on
the direct labor hours or machine hours. The new cost system uses multiple
allocation bases. Here, direct labor costs are combined with other costs to
obtain the total conversion costs i.e. labor and factory overhead costs of
converting raw materials into finished products. In the new system, the word
activity means cost center and hence, the cost system is called the activitybased cost system. Activity-based costing is discussed in detail in Chapter 12.
Expense Center
Service and support units, R&D centers, administrative centers are examples
of discretionary expense centers. The expenses of such units cannot be clearly
stated and hence, in the strategic planning process, the trend is to take the
current level of expenses in a discretionary expense center as the starting
point, and adjusting it upward for inflation and adjusting it further for
anticipated changes in the workload. Requests for more funds are granted if a
manager finds them really important. Usually, during the strategic planning
and budget preparation process, there isnt sufficient time to analyze the
discretionary expenses. The alternative is to make a thorough analysis of the
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discretionary expense center, following a schedule that will cover all expenses
over a period of five years. This analysis will provide a new base for
estimating the expenses in the future years. Such an analysis is called zero
based review. However, in the next five years, new expenses may creep up,
and require a new base. Usually budgets take into consideration the current
level of spending as the base, but zero based review takes into consideration
the resources that are actually needed. The importance of the activity is
considered after analyzing the importance of the function, the quality level,
the methods through which it has to be performed and the costs that have to be
incurred. This approach compares project costs and output measures for
similar operations. A zero based review follows a strict schedule, and
managers are always under tremendous pressure, because their operations are
reviewed and they have to justify their current level of expenditure.
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THE PROGRAMMING PROCESS
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The process of programming includes allocating long-term resources.

Programming involves all the responsibility centers of the organization that
draw plans for achieving the strategic goals of an organization.
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An important aspect of the programming process is that organizations make

decisions about resource allocations, that require expenditure in the present, in
anticipation of returns in the future. The programming process includes
defining, evaluating and implementing new programs in order to achieve longterm goals.
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As part of the planning process, long-term goals are identified and assigned to
responsibility centers. These goals are compared with the expected future
performance and the gaps in planning are identified. This helps in designing
and implementing programs to close these gaps.
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The decisions involving expenditure in the programming process is crucial to

the organization's success. Some difficult decisions that are made during the
programming process are:
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1. Replacement of worn-out equipment to remain competitive.

2. Expansion of the firms capacity to produce improved goods and offer
better services in order to grow.
3. Effective adaptation to the changing environmental conditions.
4. Adoption of a policy of mergers and acquisitions in order to close the gaps
in planning. Planning and programming go hand-in-hand, as programs are
developed as a part of the long-term planning process.
The programming process depends on the size and diversity of the
organization. The decisions that are made during this process have a
significant influence on the ability of the firm's ability to survive and achieve
its goals and objectives.
In short, the programming process returns a set of feasible programs directed
toward achieving long-term goals. Programming is carried out simultaneously
with the long-term planning process.
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As stated earlier, some difficult decisions are made during the programming
process. Bower's model is a widely cited model for making investment
decisions.
Bower's Model of the Investment Decision-Making Process

A discrepancy in a performance variable arises when the actual results differ
from the desired results. This discrepancy forms the basis of Bowers model.
One important discrepancy is the planning gap that arises during the long-term
planning process.
The discrepancies that arise in the various systems of the organization, such as
the production and planning system, accounting systems and information
system, generate the capital expenditure project. The capital expenditure
project requires both technical and economic analyses, which are carried out
during the first phase of the resource allocation process.
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During this phase, the discrepancy between the actual and desired values of a
key variable is focussed. The key variables include the size of the market, the
profit margin, prices, operating costs, quality, and technological
competitiveness. The discrepancy is first detected at the lower level of
management. Then a project is defined at lower levels of the organization,
where technical expertise is likely to be found, to overcome the discrepancy.
The project is then subjected to economic analysis.
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The next step is selling the project. It is at this stage where the greatest
discrepancy arises, when it is realized that projects selected are not the right
ones. Usually, the major investment decisions are approved by the top
management while the projects that are developed at the lower level are
approved by the upper-level divisional managers. The duty of the division
manager is to evaluate the goals and objectives of his division, and decide
whether to approve the project. During the process of evaluation, the division
manager keeps in mind the corporate objectives and the reward structure of
the organization.
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If the reward structure is based on the managers batting average (quantifiable

performance), then he selects the projects with a high probability of short-term
returns (low risk) instead of those with a medium probability of extremely
large returns. In other words, division managers choose projects which have a
short pay-back period than those which have high, but risky, net present value.
The projects are ranked according to the speed at which the capital outlays can
be recovered.
Division managers use the payback period, rather than the net present value
method as an economic resource tool. The NPV method is considered only
when the reward structure is based on the criteria for maximizing profits.
Thus, Bowers model suggests that project ideas come from the lower levels
of management. The middle level of management approves the projects and
allocates resources to them. In fact, the middle level of management is
responsible for matching management desires of the lower levels with the
criteria of the upper levels. The final decision regarding investment is made by
the top management, which approves the project and determines the reward.
Top management approves the project and establishes rewards. The authority
for designing the programming process lies with the top management. This
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includes planning strategy, determining the criteria for acceptance, the

approval levels, the process of programming and the reward systems.
Parameters of the Programming Process

Bowers model has been extended by Kovar3, who has proposed and tested a
model of the capital investment approval process, which incorporates factors
that influence employees behavior during the early stages of the process of
making investment decisions. There are three phases of the investment process
that involve different levels of the organization.
The initiating phase
The integrating phase
The corporate phase
Linkage to the strategic plan: The investment projects that are

undertaken by an organization should be linked to its strategic plan of an
organization. At times, profitable investments help to generate new
strategies.
Limits of approval: There should be a limit to the number of projects to

be approved, and it should apply to the entire organization.
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In the early stages of the investment process, initiating and integrating phases,
the plans proposed by managers help in identifying new possibilities. The
corporate phase helps in identifying and evaluating opportunities for growth
within the organization, and the steps to be taken to effect such growth are
determined. Organizational behavior in the programming process consists of
the employees rational, practical and emotional behavior. These are
influenced by the design of the project approval process. The approval process
is designed with the rate of return, linkage to strategy and legal constraints in
view. The control system designers should be aware that emotional and
practical problems of employees influence investment proposals, and the
programming process designed should cover all these aspects. None of these
elements should be paid excessive attention. There are a number of aspects
that are associated with programming process. Kovar has identified nine of
them. They are:
iii. Number of steps in approval: If the number of steps in the approval

process is high and if the process requires the approval of several people,
then the process of approval will move slower. This will delay the
investment process and demotivate the employees.
iv.
Involvement of the line manager and accountability: The responsibility

of the programming process should be entrusted to the line management
with the staff acting as catalysts. However, there is a possibility that the
process may be taken over by the members of the staff and the line
managers may not be accountable for the results. This will affect the
decision-making process.
Kovar, Donald G., The decision making environment of the capital investment approval
process, Phd dissertation, Claremont Graduate School, Claremont Calif., 1986.
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v.
Financial analysis and supporting detail: The programming process is

designed in such a way that it will be able to accommodate all kinds of
strategic changes any time in the future. If there is too much emphasis
on financial analysis, then some significant strategic elements may be
ignored. There has to be a balance between all these elements.
vi.
Discount rate: An organization should have knowledge of its opportunity

cost of funds. However, the firm should not be obsessed with it. Many
projects that are successful are quite insensitive to opportunity costs and
big changes in the discount rates of these costs.
vii. External environment analysis: The right investment choice can be made
with an accurate assessment of the environment in which the firm
operates. Formal processes should be introduced to support informal
mechanisms, for an accurate understanding of the external environment.
Education and training: Extensive education and training on the

objective of the programming process and the methodology of carrying it
out is quintessential.
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viii. Identification and analysis of alternatives: In order to solve problems

related to a particular project, similar projects to be identified and
analyzed. Since these projects are likely to have come across problems
those facing the project in question now. The solutions to the former may
apply to the latter, too.
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Mutually Supportive Management Systems for the Implementation of Strategy

through Programming Decisions
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To examine and redesign the management systems associated with resource

allocation, the control systems designer needs to develop a model or
framework. This framework would help in deciding making decisions
regarding the long-term resource allocation. The framework helps in designing
the elements of the programming process. It helps in answering the following
questions:
Is there consistency between the organization's structure and its strategy?
Is the control system helpful in implementing the strategy?
Have assignments been given to all the managers in the organization to

accomplish strategic objectives?
What role do performance measurement and reward systems play in

encouraging managers to focus on short-term and long-term objectives in
the resource allocation process?
How do the management style and organizational culture influence the

resource allocation process?
What role do planning and reporting systems play in the implementation

of the organization's strategy?
What role does communication mechanisms play in the resource

allocation process?
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Organization structure and strategy

The point that should be discussed first is whether the structure of the
organization supports its strategy. The second point is, whether the
responsibility of achieving the organizational goals has been appropriately
distributed within the organization.
Performance measurements and rewards
The performance measurement and reward systems should be so designed as
to achieve both short-term and long-term objectives. Bonuses should be given
both to employees for short-term and long-term success. The rewards system
should be structured according to the short -term and long-term tasks.
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Management style and organizational culture

The management style and organizational culture influence the way
organizational decisions are made. By giving autonomy to the employees and
encouraging competition between them, the management facilitates innovation
and entrepreneurship within the organization.
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Planning and reporting

The planning process should support the decisions regarding the resource
allocation with formal information available within the organization and
discussion forums within the organization. The process should also include the
financial implications of various programs and link them to short term
operating budgets.
Communication mechanisms
Effective communication is essential for managing conflicts associated with
the decision making process for short-term and long-term resource allocation.
Committees should be set up and schedules for meeting should be established
for making such decisions and to resolve conflicts regarding program
alternatives.
In evaluating management systems and their impact on the process of making
decisions about resource allocation, it is important to recognize the importance
of the interdependence of the systems.
Formal Programming Procedures

These are procedures developed by organizations for defining, evaluating and
implementing investment projects. These processes may often take a
secondary role to the previously identified organizational processes. The
different steps in evaluating and implementing investment projects are as
follows:
Project definition
If a project is found to have deviated from the organizational goals, as
reported by the information systems of various responsibility centers, than the
need for defining the project arises. This helps in identifying the reasons for
the above said variances. These variances may be caused by equipment
inefficiencies, sales forecast that exceed the plant capacity and so on. To
identify these variances, a manager uses information systems to compare the
actual performance of the firm with its goals.
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In organizations that have complex structures, the operational level of the

enterprise decides on most capital proposals. The controller plays an important
role in managing the process of proposing a project and prescribing how the
proposal should be defined. Detailing of a proposed project includes a
description of the objectives and purposes of the project and the technology to
be used. Defining a project also requires the understanding the purpose of
each project to be looked closely at, and whether these are congruent to the
organizational goals. The project should be analyzed with its influence on the
key variables in mind. It should be reviewed, considering the impact it has on
costs, quality or market shares of the competitors.
Project evaluation
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Project implementation and control
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In an organization, any employee of any hierarchical level may come up with

a project proposal. He should be given detailed, concrete instructions about
the whole process of proposing a project. The procedures and paperwork
involved in the process of project proposal are usually laid down in capital
appropriation manuals. There are different procedures based on the category
of the project and hence, there is a need for different evaluation criteria and
techniques for each category.
Each project category has its own
characteristics and has to be distinguished from others.
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Control over capital expenditures begins in the definition and evaluation

phase. Next comes the implementation phase. Projects with major capital
investment affect the organization as well as suppliers and subcontractors.
Such projects need to be monitored constantly and controlled appropriately so
as to ensure that the firm accords performance to the proposal, and that the
costs do not exceed the budget.
The capital projects manual
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This consists of details about policies related to project definition, evaluation

and implementation. This is taken as a standard procedure for the entire
organization. It contains instructions about the following:
The investment authorization schedule about the various projects and the
levels at which these projects can be implemented.
The various forms used in financial evaluation that can be used in project
evaluation as well.
Forms related to the duration of the project and the capital expenditure
incurred.
Financial and schedule status report for each project, that includes all
activities from giving authorizations to estimating costs at completion.
A periodic project audit that analyzes whether the actual results conform
to predicted results.
The formal programming process thus helps to collect, analyze and

communicate information about strategic and program alternatives being
considered by the organization.
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SUMMARY
Strategic planning is the process of deciding on the goals of the organization
and the resources necessary to attain these goals. It enables managers to
prepare for, and deal with, the rapidly changing environment in which their
organizations operate. It provides a direction to the organizations mission,
objectives and strategy, thereby facilitating the development of plans for each
of the organization's functional areas. The elements of a firms strategy are
domain sought, differential advantage, necessary strategic thrusts, and
expected target results. The strategic planning process involves reviewing and
updating the strategic plan form the last year, deciding on assumptions and
guidelines, first iteration of the new strategic plan, analysis, second iteration of
the new strategic plan, review and approval.
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The proposal for new programs in the strategic planning process should
consider the importance of existing rules and procedures; it should be free of
and should be based on existing planning models. Analyzing ongoing
programs in the strategic planning process can be done through value chain
analysis, activity-based costing and discretionary expense center analysis.
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The programming process is an organizational process for making long-term

resource allocation decisions. Bowers model of investment decision-making
examines the discrepancy between actual results and desired results. The
model suggests that ideas, proposals and approval of projects come from the
lower levels of the management.
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The investment process has three phases: initiating, integrating and corporate.
The mutually supportive management systems model helps in designing the
elements of the programming process. Formal programming procedures are
adopted by organizations for defining, evaluating and implementing
investment projects.
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09
Chapter 9
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Budget as an Instrument of
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Need for Budgeting
Forecasting, Budgeting and Strategic Planning
Budgeting Process and Control
Master Budget
Zero Based Budgeting
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Performance Budgeting
Participative Budgeting
Variance Analysis for Control Actions
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Organizations prepare plans for the successful execution of strategies. A

budget is a financial and quantitative statement, prepared and approved prior
to a defined period of time, of the policy to be pursued during that period for
the purpose of attaining a given objective. Budgeting refers to the process of
designing, implementing and operating budgets. The budgeting process starts
with the dissemination of guidelines approved by senior management.
Budgetary control refers to the establishment of budgets that relate the
responsibilities of executives to the requirements of a policy, and the
continuous comparison of actual with budgeted results, either to secure by
individual action the objective of the policy or to provide a basis for its
revision. Managers should participate in the budgeting process to ensure
consistency in the overall adherence to the corporate goals. In this chapter we
will discuss the concept of budget, budgetary control, and the variances that
arise in the budgetary process.
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NEED FOR BUDGETING
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Budgets are essential aids in planning because they force management to think
ahead and look before they leap. The main reasons for the need for a budget
are:
Budgets reduce uncertainty by allowing executives to map out the future
course of action. This helps the organization face challenges with
confidence.
Budgets increase coordination among the different departments because

budgetary control forces executives to think as a group. All the
departments in an organization tend to function in a well-coordinated
manner in an attempt to implement the planned courses of action
systematically. Budgeting also helps management coordinate the activities
of business to the economic trends.
Budgets identify weaknesses by finding out the reasons for inefficient

performance. They help management trace discrepancies in any activity of
the business and take suitable remedial measures.
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Budgets help managers analyze the expenditure and keep it under check,
thereby preventing wastage of all kinds.
Budgets help in the establishment of performance standards for

operational activities and the adoption of the standard costing technique.
Budgets help identify deviations from pre-planned courses of action.

Management can later analyze the causes for the deviations and
implement remedial measures.
Budgets help establish standards of performance. Evaluating performance

against standards enables employees to analyze their strengths and
weaknesses.
To summarize, budgeting is an action plan that is necessary for controlling all

aspects of the operations of an enterprise for a definite period of time.
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FORECASTING, BUDGETING, AND STRATEGIC PLANNING
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Budgeting is different from strategic planning and forecasting. A Forecast is

an estimate of what is likely to happen under anticipated conditions during a
specified period of time, whereas a budget shows the policy and programme to
be followed under planned conditions during a specified period. Forecasts are
statements of future events. A budget, however is a tool of control.
Forecasting is a preliminary step in the process of budgeting. Where
forecasting ends, budgeting begins. Forecasts have a wider scope than
budgets. Forecasts can be prepared for any period of time and updated
whenever new information is made available. Finally, variances from
forecasts are not analyzed formally or periodically. From the point of view of
management, a financial forecast, which includes estimates of revenue,
expenses and other items that affect the cash-flow is exclusively a planning
tool, whereas budget is both a planning and control tool.
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BUDGETING PROCESS AND CONTROL
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Strategic planning is different from budgeting in the sense that strategic

planning focuses on activities that extend over many years, whereas budgeting
usually focuses on activities that take place within a year. Strategic planning
provides the framework for the preparation of annual budgets. Strategic
planning is formed on the basis of product lines or other strategic programs
while budget is structured on the basis of allocation to responsibility centers.
Three important aspects of budget process and control must be discussed.

They are:
Budget preparation process
Budgetary Control
Behavioral dimensions of budgeting
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Budget Preparation Process

Information is essential for preparing a sound budget. Budgets are prepared by
managers; the information or the input data needed for budget preparation is
developed by people lower in the hierarchy according to their responsibilities
and functions. Managerial forecasts and accounting reports are a major source
of data for budget preparation. Managerial forecasts provide data on the
anticipated level of activity, while accounting reports provide data on the
financial magnitude of past and current operations.
The formulation of the budget involves the following steps:
Organization
The budget department
The budget department disseminates the information during budget
preparation. The members of the budget department report to the corporate
controller. The functions of the department include:
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Publishing procedures and forms for the preparation of the budget.
Ensuring that the information is communicated in the right way between

the different organizational units.
Analyzing the proposed budgets and

recommendations whenever necessary.
Carrying out budget revision at regular time periods
Coordinating the work of the business units connected to the budget

department.
making
corrections
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The budget committee
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The budget committee consists of the heads of various departments within the
organization and members of senior management such as the CEO, financial
vice president, etc. The function of the budget committee is to review budgets,
approve them, and make adjustments wherever necessary. In some companies,
the CEO decides on the budget without the help of any committee. And in
some companies, the budget committee meets only the senior operating
executives, while in some other companies, the budget committee discusses
the budget with the business unit managers.
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The first step in the budget preparation process is the issuance of guidelines.
The main source of these guidelines is the strategic plan of the organization,
which is modified from time to time according to the companys performance.
Budget guidelines are developed by the staff of the budget department, and
these guidelines are approved by senior management. Sometimes, lower-level
managers are also consulted for the finalization of guidelines. After senior
management has approved these guidelines, the timetable for budget
preparation is disseminated throughout the organization.
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The guidelines issued by the budget department have to be followed by the

responsibility centers. Some guidelines for responsibility centers are based on
important issues like inflation, wages, promotions and transfers, compensation
etc. These guidelines submitted by the responsibility centers would be a
source of input data at the time of budget preparation. However, in many
companies the budget preparation process begins as soon as the strategic plan
is approved.
Initial budget proposal
The managers of different responsibility centers within the organization
develop a budget request for facilities, personnel, and other resources.
However, these budget requests are modified according to the guidelines
issued to the responsibility centers. The changes responsible for the frequent
modifications of budget requests are:
Changes in external forces: These include changes in the level of economic
activity, changes in the labor rates, changes in the purchased materials and
services, changes in the selling price, and changes in the cost of discretionary
activities like R&D.
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Changes in internal policies and practices: These include changes in market

share and product mix, and changes in production cost and other discretionary
costs (which are based on changes in workload).
Negotiation
The budget planner discusses the budget proposal with his superior. The
superior judges the validity of each of the adjustments made in the budget
proposal. The major consideration in this step of budget formulation is that the
performance in the budget year be an improvement over the performance in
the previous year.
Slack
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In most organizations budgetees (the people, who prepare budget proposals)

tend to budget revenues lower and expenses higher than their best estimates of
these amounts. The difference between the budget amount and best estimate is
known as slack. It is the duty of the superior to discover and eliminate slack.
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Review and approval
Budget revisions
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The budget proposal developed by the budgetee goes up through successive

levels in the organization. If at one level the budget is not found satisfactory, it
is sent back for reworking. The budget committee presents the fully developed
and reworked budget to the CEO. The final approval is made by the CEO. The
CEO then submits the approved budget to the board of directors. This process
of approval of budgets takes place in the month of December, just before the
beginning of the budget year.
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Budgets are revised from time to time in order to check discrepancies, if any.
Generally, two procedures are followed for revising budgets:
Procedures that provide for a systematic updating of budgets.
Procedures that allow revisions under special circumstances.
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Systematic updating of budgets requires extra work by the budgetee. Large

Japanese companies generally update budgets. In these companies, the budget
is prepared for the whole year. Senior management formally approves the
budget during the first six months of the budget period and for the next six
months, the budget is revised and approved shortly before the budget period
begins. Budgets may provide for activities that are planned months ahead of
the time they take place. Thus, management activities should be based on the
latest information available.
Budgets are revised only when they are no longer useful as control devices.
However, it is difficult to get permission from top management to do so.
Frequent revision of the budget indicates that the budget is not well prepared.
Administration and review of budgets
The authority of administration of budgets vests with the top management. A
budget can be successful only if it is properly administered. A budget manual
is necessary to facilitate the process of administration of budgets. The budget
manual contains objectives of budgeting, the process of budgeting, and the
tasks and responsibilities of the departmental heads and individual managers
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in the preparation of the budget. Many organizations set up budget committees

at divisional offices as well as at corporate headquarters. The budget
committee at corporate headquarters consists of managers of different
divisions. When some large autonomous institutions come together to form a
federation, a programming committee' is formed. This committee consists of
managing directors of the different institutions. The programming committee
also coordinates the activities of the individual members of the union.
A major aspect of the administration of budgets is the revision of budgets.
Budgets can be revised only in extraordinary situations, when not revising will
significantly affect the budget results. Budgets are also revised when they
become unrealistic, when budget assumptions are proved incorrect, when they
are no longer useful as control devices.
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After the budget has been finalized by the budget committee or senior
management, it must be reviewed and approved. Budgets are reviewed and
approved to ensure that the departmental and divisional budgets are consistent
with overall organizational goals. For example, is the production budget
consistent with the planned sales volume? Are service and support centers
planning for the services that are being requested of them? The purpose of the
review is to ensure that the budget produces a satisfactory profit.
Budgets are prepared and finalized in accordance with the standards set by the
top management. Since budgets are used to evaluate the performance of
various responsibility centers, management must set standards that are
attainable. If standards are too difficult to attain the responsibility centers may
manipulate figures to please the top management.
Budgetary Control
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The purpose of budgetary control is to find out how the activities of an

organization are progressing. To achieve budgetary control, actual results are
compared and measured with anticipated results as provided in the budget. If
any differences are noticed, the budget estimates can be re-examined and
necessary corrective actions can be taken. While a budget is a means,'
budgetary control is the end result.' According to The Institute of Cost and
Management Accountants, London, "budgetary control is the establishment of
budgets, relating the responsibilities of executives to the requirements of a
policy, and the continuous comparison of actual with budgeted results, either
to secure by individual action the objective of that policy or to provide a basis
for its revision."
Budgetary control focuses attention on deviation from budget standards and
points out where corrective action is necessary. The budgetary controller, who
consults with various heads of departments of the organization is responsible
for the budgetary control.
Importance of budgetary control
Budgetary control has a number of advantages. The following are some of the
advantages:
Presentation of overall managerial view: Budgetary control offers an overall

picture of the various functions in an organization. In other words, it presents
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a managerial view of all the activities within an organization structure. Such

an overall perspective is essential for management success.
Narrows down the gap between planning and performance: In many
organizations there is usually a big gap between planning and performance.
Budgetary control bridges the gap between planning and performance by
anticipating the results of courses of action, by comparing the actual results
with anticipated results, and setting up proper standards for performance.
Promotes division of work and specialization: Budgetary control helps in the
allocation of responsibility and accountability for performance to each
member of the organization. It thus promotes division of labor. Division of
labor in turn promotes the process of specialization, which helps improve the
overall efficiency of the organization.
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Fosters coordination and integration: Budgetary control helps managers

coordinate the activities of the organization. The interaction between the
employees during the budget development process helps integrate the
activities of the organization's members. The budget controller conducts
meetings with the heads of various departments within the organization and
thus fosters coordination and integration between various departments.
Budgetary control thus brings about the integration of policy, plans, and
actions of the different departments.
Budgetary control is done systematically as follows:

Determining the objectives
Establishing the budget centers
Introducing adequate accounting records and assigning verifiable codes to

them.
Preparing a budget organization chart that defines the functions and

responsibilities of each member of management.
Establishing budget committees which consists of key members of the

organization, chief executive officers and budget controllers. The main
function of a budget committee is to coordinate the budget activities,
review the budgets, suggest revisions and approve the budgets.
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Preparing the budget manual to develop a schedule to identify who is

responsible for what in the organization. The budget manual consists of
accounting codes, a budget timetable, budget periods, a budget proforma,
etc.
Selecting the budget period. This is done keeping in view the nature of the
strategic plan, nature of the business, production period, financial aspects
of the business, etc. Usually, a time period of one year is considered the
budget period.
Locating the principal factors that influence the budget. The key factors
should be correctly identified and examined. For example, the principal
budget factors for a sales budget would be consumer demand, marketing,
advertising, etc.
Determining the budget cost allowance a budget center is expected to

incur during a given period of time in relation to the level of activity
attained by the budget center.
Organizing budgetary control

Systematic administration and successful implementation of budgetary control
results in sound budgets for the enterprise. The following steps should be
considered to achieve effective budgetary control:
Organizing for budgeting
Assigning responsibility for budgeting
Determining the budget period
Determining the key success factors
Preparing the budget report
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Organizing for budgeting
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Budget center: A budget center is a section of an organization developed for

the purpose of budgetary control and is intended to facilitate the formulation
of various budgets with the help of the heads of the concerned departments.
Budgetary control focuses attention on the attainment of the objectives of
various departments within the organization or the enterprise. Therefore, the
enterprise must have a clear perspective of the objectives that are sought to be
achieved through budgetary control. A budget center is established after
developing a clear perspective of the objectives that are to be achieved
through budgetary control.
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Budget manual: This is a written document that contains standing instructions

regarding the procedures to be followed at the time of budget preparation. A
budget manual is maintained to inform the concerned executives about the
procedures to be followed during budget preparation and to avoid frequent
instructions from the controllers office. A budget manual contains guidelines
for the following:
Functions of various officials connected with the formulation of budgets
Steps in the preparation of various budgets
Scheduled date of submission of budgets
Review and approval of various budgets
Final adoption of budgets
Timetable for budget operations
Records, reports, and forms to be maintained for the purpose of budget

operations.
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Assigning responsibility for budgeting

In an organization, the budget controller and the budget committees are
responsible for budgeting.
Budget controller: The entire process of budgetary control is handled by the
budgetary controller. A budgetary controller should be experienced in
handling various budgets and should be able to identify and analyze the
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deviations from the set standards and initiate corrective measures for the same.
An important function of the budget controller is to advice management on
important issues such as budget preparation, revision of budgets, approval of
budgets etc. The budget controller reports directly to the chairman.
Budget committees: A budget committee consists of the heads of various
departments within the organization, viz. production, marketing, finance,
administration, and accounts. The members of the committee discuss the
budget figures (and probable estimates) before arriving at a final decision
before finalizing the budget.
Determining the budget period
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The budget period refers to the time period for which the budget is prepared.
A budget can be a long-term or short-term budget depending on the time
period. A budget prepared for one year or less is called a short-term budget. A
budget can also be prepared on a quarterly, monthly or weekly bases
depending on the requirements of certain operations. Examples of short-term
budgets are annual sales, income and expenditure budgets. A long-term budget
covers a period of five years or more. These budgets are prepared when an
organization plans for expansion, modernization, diversification etc., Long
term budgets are used for the purpose of planning while short term budgets
which are designed to implement these plans are used for control purposes.
Examples of long-term budget are capital expenditure budgets and research
and expenditure budgets. The time period of a budget can vary depending on
the nature of the business, the production period. Electronics and consumer
goods industries prefer to prepare annual budgets as they experience a high
rate of change. For industries such as shipbuilding, the time period of budget
may vary between 5 to 10 years.
Determining the key factors
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The key success factors are those factors that influence the performance of an
organization. These factors influence the limit of output and thus have a direct
impact on the profitability of an organization. The key success factors include
the availability raw material, skilled labor, cash etc. If any of these is in short
supply work can be delayed. Due to changes in the internal and external
conditions, the key success factors can change from time to time. In some
organizations, the critical success factors are consumer demand or expected
level of revenue. In such organizations, the sales budget should be prepared
first. This budget will determine the content of other budgets. In some other
organizations, the most critical success factor can be productive capacity.
Preparing the budget report
It is essential to compare actual performance with the anticipated budgeting
performance; and the results of the comparison should be brought to the notice
of management through reports. The reports should furnish details of the
responsibility of each department or executive in budget preparation and the
reasons for variances in actual and budgeted performance so that corrective
actions can be initiated.
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Behavioral Dimensions of Budgeting

The process of budget preparation requires the involvement of managers and
other people. Since individuals are involved in the process of budgeting, the
behavioral dimensions of budgeting cannot be ignored.
Participation in budgetary process
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A budget can either be set by senior management for the lower levels of the
organization or lower-level managers may participate in setting the budgets
targets. When the senior management initiates the budgeting process, the
process is said to be a top down one; and when the lower level managers are
involved, the budgeting process is said to be bottom-up. The bottom-up
approach to budgeting is more commonly followed than the top down
approach. The top down approach rarely works because lower level managers
do not show keen interest in working towards already fixed budget targets.
Bottom-up budgeting generates commitment among the budgetees to meet the
budgeted goals set by themselves.
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However, the actual process of budgeting is a blend of two approaches. The

lower-level managers prepare the budget proposal and submit the first draft to
senior management (a bottom-up approach). The senior managers review the
budget and suggest certain guidelines for improving the budget (a top down
approach).
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Bottom-up budgeting or participative budgeting is considered an effective

budgeting approach because it results in greater acceptance of budget goals
(due to personal control) and leads to higher personal commitment towards
achieving these goals. Participative budgeting also leads to exchange of
information between the budgetee and the superiors. Moreover, once the
budget has been approved, the budgetee can boast of expertise and personal
knowledge in budgeting.
Degree of budget goal difficulty
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A budget's goals should be challenging but attainable. Budgeted goals that are
difficult to achieve force managers to take certain short-term actions that are
not in the long-term interests of the company. But if the budgeted targets are
achievable, managers do not engage in data manipulation (for example,
inadequate provision for warranty claims, bad debts etc.) to meet the budget.
A winning atmosphere and positive attitude spreads throughout the
organization when managers are able to meet and exceed targets. A budget is
prepared with the intention of increasing profits in the long-term interests of
the company. However, when an overly optimistic sales target has been set, a
profit budget is difficult to attain. Thus a budget, whether it is sales budget,
profit budget or production budget, should be easily attainable in order to
ensure the allocation of resources for the budget activities.
Sometimes when achievable targets have been set, managers will not put forth
satisfactory effort once the budget has been met. However, this limitation can
be overcome by providing bonus payments for actual performance that
exceeds the budgeted performance.
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Involvement of senior management

A budget is said to be effective only if it is supported by senior management.
Senior management should review and approve the budgets. In some cases,
the budgetee may resort to certain unhealthy practices during the
implementation of the budget, just to meet the budgeted target, if there is no
participation and supervision by senior management. Feedback from senior
management is necessary in order to motivate and guide the budgetee.
The budget department
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It is the budget departments duty to collect the input data for the preparation
of the budgets, prepare the budgets, and analyze them in detail. The budget
department ensures that no excessive allowances are present in the budget. If a
manager hides a potential situation during budgeting and the budget
department discloses the fact, then the manager will be placed in an
uncomfortable position. The managers sense of guilt will make him feel
inferior to his colleagues. The manager should be warned against repeating the
mistake. The budget department should ensure the integrity of the budget
preparation system.
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The members of the budget department should work in a fair and impartial
manner. In addition, they should learn how to deal effectively with different
types of people.
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MASTER BUDGET
The following budgets together constitute the master budget:
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1. Sales or revenue budget
2. Production budget
3. Materials budget
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4. Administrative expense budget
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5. Direct labor budget

6. Promotion & advertising expense budget
7. Research & development budget
8. Manufacturing overhead budget
9. Capital expenditure budget
10. Selling and distribution expense budget
11. Financial budget
The master budget may take the form of a profit and loss account and a
balance sheet at the end of the budget period. It is the duty of the budget
committee to approve the master budget. Sometimes more than one master
budget has to be prepared before the final one is approved by the committee.
The master budget shows the gross and net profits and the important
accounting ratios. Thus, the master budget represents the overall plan of the
enterprise.
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Steps in the Preparation of the Master Budget

The principal steps in the preparation of the master budget are:
1. Preparation of the operating budget
2. Preparation of the budgeted income statement
3. Preparation of the financial budget
Preparation of the operating budget
The operating budget consists of the following activities:
(a) Sales budget
(b) Cash collections from customers
(c) Purchases budget
(d) Disbursements for purchases
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(e) Operating expense budgets
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(f) Disbursements for operating expenses
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Sales budget: It is the responsibility of the marketing managers to prepare the

sales budget. The preparation of the sales budget starts with a sales planning
exercise. This sales planning exercise develops projections of the expected
sales volume in physical and monetary terms. The key factors that are
considered during sales planning are the size of the sales force, selling
expenses, promotion and advertising expenses, and so on.
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Cash collections from customers: These cash collections include the current
months cash sales plus the previous months credit sales.
Purchases budget: The budgeted purchases are computed as follows:
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Budgeted purchases = desired ending inventory + cost of goods sold

beginning inventory.
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Disbursements for purchases: Disbursements for purchases are based on the

purchases budget. Disbursements include 50% of the current months
purchases and 50% of the previous months purchases.
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Operating expense budget: Operating expenses are influenced by fluctuations

in sales volume and cost-driven activities. Examples of expenses driven by
sales volume include sales commissions and delivery expenses. Examples of
cost-driven expenses include rent, insurance, depreciation and salaries. These
expenses are fixed.
Disbursements for operating expenses: Disbursements for operating expenses

are based on the operating expense budget. Disbursements include 50% of the
last months and current months wages and commissions and miscellaneous
expenses.
Preparation of the budgeted income statement
The budgeted income statement is developed on the basis of information
provided in preparing an operating budget. The interest expense (calculated
after the cash budget has been prepared) is added to the budgeted income
statement. The budgeted income statement is often used as a benchmark to
judge management performance.
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Preparation of the financial budget

The financial budget comprises the capital budget, the cash flow budget and
ending balance sheet.
Capital budget: The capital budget relates to the question of capacity and
strategic direction of the firm. It deals with the evaluation of the alternate
disposition of capital funds as well as the choice of the best capital structure.
Cash flow budget: The cash flow budget is a detailed budget of income and
cash expenditure and incorporates both revenue and capital items. It is
concerned with liquidity and shows changes in opening and closing debtor
balances and between opening and closing creditor balances. It also focuses on
inflows and outflows of cash. A cash budget can be prepared by the receipts
and payment method, the adjusted balance sheet method.
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Receipts and payment method: In this method, all the expected receipts and
payments for budgeted period are considered. First the cash inflow and
outflow of all the functional budgets, including the capital expenditure
budgets, are taken. These cash flows are not affected by accruals and
adjustments in account. Second, the anticipated cash inflow is added to the
anticipated cash inflow to the opening balance of cash and all cash payments
are deducted from this to arrive at the closing balance of the cash. This
method is commonly used in business organizations.
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Adjusted income method: In this method, annual cash flows are calculated by
adjusting the sales revenue and costing figures for delays in receipts and
payments. This method eliminates non-cash items like depreciation.
Budgeted Balance Sheet
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Adjusted balance sheet method: In this method, budgeted balance sheet is

predicted by expressing each type of asset and short term liability as a
percentage of expected sales. Profits are also a percentage of sales, so that the
increase in owners' equity can be forecasted.
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The budgeted balance sheet projects each balance sheet item in accordance
with the business plan. It thus indicates the financial status as envisaged at the
end of the budget year. The balance sheet also projects the sources and uses of
financial resources.
The master budget should undergo a follow up process to ensure performance
of budget in terms of planned goals and objectives. While the formulation of
the budget is a planning process, the follow-up of the budget is a control
process. A follow-up is conducted by preparing performance analysis
statements on a periodic basis, indicating the budgeted versus actual
performance.
ZERO BASE BUDGETING

In zero-base budgeting (ZBB) all the activities are reevaluated each time the
budget is prepared. In ZBB, each functional budget assumes that the function
does not exist and that the costs are zero. Budget preparation for each function
starts with the basic premise that each activity is being performed for the first
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time and that the cost of each activity is zero. The assumption is that the
budget for the coming year is zero and every process or expenditure has to be
justified in order to be included in the budget. The manager is held responsible
for identifying the resources required for each activity, and he or she has to
justify the reason for spending the money on an activity by explaining what
would happen if the proposed activity was not carried out and no money was
spent on that activity. In ZBB a number of alternatives for each activity, and
the associated costs, have to be identified so that the one that offers the most
benefits can be selected. The basic requirements for the application of ZBB in
an organization are: the presence of a budgeting system in the organization
and the ability of the managers to develop qualitative measures for
performance evaluation.
The important features of ZBB are:
The budget requires the manager to explain the need for spending a
particular amount on an activity.
The selection of each activity is made on the basis of what each unit can
offer for a specific cost.
The targets of individual units are linked to the overall corporate targets.
The budget requires participation of all the employees at the different

decision making levels.
The budget has the advantage of maintaining the expenditure level

according to the operating costs.
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The ZBB Process
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There are three basic steps in ZBB. These steps are discussed below:
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Identifying decision units and developing decision packages: Decision

units are synonymous with responsibility centers. These units should be given
a prominent place in the organizational chart. Examples of decision units are
research and development and capital expenditure units. A decision package
describes the activities that take place in a decision unit. A decision package
describes the goals and objectives of each activity, identifies specific measures
of performance, and states the projected costs of the package etc.
Evaluating and ranking the decision packages: In this step, the decision
packages are reviewed and ranked in the order of decreasing benefit to the
firm. Ranking is done on the basis of a cost-benefit analysis.
Allocating resources accordingly: Top management allocates resources on
the basis of the ranking of the decision packages. The total available resources
will determine the acceptable expenditures. Before allocating resources, the
available resources are forecasted and matched with the ranked decision
packages on a cumulative amount basis.
ZBB Vs Traditional Budgeting

ZBB is not based on the previous years budget, whereas traditional budgeting
uses the previous year's expenditure level as the base. The main differences
between traditional and zero-base budgeting are:
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Traditional budgeting is accounting oriented and is based on the previous

years level of expenditure. The focus of this type of budgeting is
determining the additions and subtractions that need to be made in the
present budget on the basis of the previous year's budget. ZBB is decision
oriented. It relies on the managers decision regarding the costs required
for carrying out a particular activity.
In traditional budgeting the budget is sometimes inflated by managers; but

in ZBB, a rational analysis of the budget is made.
In traditional budgeting top management is usually involved in the

preparation of the budget, whereas in ZBB the responsibility center
manager takes the necessary decisions.
In ZBB it is easy to identify the important projects that require

management attention, whereas in a traditional budgeting it becomes
difficult to identify the priority items.
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Implementing Issues
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The successful implementation of ZBB requires the clear statement of the

corporate objectives and the identification of decision units on the basis of
functions or departments. The function of each division and the targets it plans
to achieve must be clearly defined and analyzed. In addition, the performance
of each activity must be analyzed. The analysis should include a clear
description of each activity, the alternate methods and costs involved in each
activity and the ability to evaluate each activity, the alternate methods and the
costs involved in each activity. Each activity or decision package must be
evaluated through a cost benefit analysis.
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Advantages and Disadvantages of ZBB
It helps the organization identify the activities that lead to unnecessary

expenditure. Since the manager of the responsibility center is involved in
the preparation of the budget, he can frame the budget keeping in mind the
requirements of a particular center. Thus wasteful expenditure is reduced.
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The benefits of implementing ZBB system for an organization are:
Since the budget is evaluated on the basis of a cost benefit analysis,

unnecessary costs are reduced. An activity is taken up only after detailed
analysis of various alternatives in terms of cost allotment.
ZBB leads to organizational development because it improves

communication and leads to wider participation within the organization.
ZBB also leads to a clear identification of the aims of the organization.
ZBB encourages cost effectiveness and efficiency and allows for quick
budget adjustments if revenue falls short during the year.
The involvement of all the managers in the preparation of budget ensures

their commitment to the successful execution of the budget.
ZBB has been criticized for the following reasons:
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It leads to an increase in paperwork and emphasizes short-term benefits

instead of long-term benefits.
In ZBB decisions are based on the ranking of the decision packages.

However, when formulating the budget, management must also consider
the opportunities and threats presented by each activity.
The managers of the responsibility centers require adequate training to

take the necessary decisions and require adequate management skills to
take constructive decisions.
ZBB does not offer significant advantage when determining the costs of
research and developmental activities. Even though ZBB, has been
criticized for many reasons it is considered to be highly relevant in a
continuous improvement environment as it involves continuous evaluation
of activities and results in effective cost-benefit decisions.
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PERFORMANCE BUDGETING
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The term performance budgeting was first introduced by the Hoover

Commission in 1949. It can be defined as a budgetary system in which input
costs are related to end results. The cost and production goals are first
established and they are later compared to actual performance. This method of
budgeting leads to an improvement in management efficiency. It involves
analyzing, identifying, simplifying and crystallizing the specific performance
objectives of a job to be achieved over a period within the framework of
organizational objectives. The budgeting system is aimed at fulfilling the
objectives of the business. The main features of a performance budget are:
It presents the purposes for which funds are required and brings out the
programs and accomplishments in financial and physical terms.
It presents the costs for achieving the various activities along with the
quantitative data for measuring the accomplishments.
It presents the expected level of performance for each activity.
It acts as an effective performance audit
It provides additional tools for management control of the organization's

finances.
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Steps in the Implementation of Performance Budgeting

The main steps in the implementation of the performance budget are:
Classification of the activities
Specification of objectives
Analysis of activities
Establishment of control norms
Establishment of authority and responsibility
Evaluation of the budget.
Classification of the activities

This is the first step in the implementation of the performance budget. The
activities in an organization are classified as. These are again divided into
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programs depending on their time frame and resources are divided based on
their importance. For example in an organization marketing programme can
be classified into public relation activities, advertising activities etc., An
activity is thus a subdivision of the programme to which resources are applied.
Specification of the objectives
In this stage the objective of the individual activity is clearly defined. Then the
resources that have to be spent for each activity are clearly outlined. The
annual, monthly targets are determined for each activity center.
Analysis of activities
The long-term strategy and short-term tactics for achieving the desired
objectives are considered.
Also, the possible alternative activities are
identified and their costs and benefits are worked out. Then the activities that
come closest to achieving the organizational goals are selected.
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Establishing control norms
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Control norms are established in the form of productivity ratios and

performance ratios. These are compared to actual performances. Norms are
also set for non-financial measures of performance.
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Clear lines of authority and responsibility
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The authority and responsibility for different activities are clearly identified
and the functions of the activities are clearly demarcated. Financial rules and
accounting systems help in the effective implementation of the activities.
Evaluation of the Budget
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To find out if the projects have been implemented according to the plan,
information and reporting systems (related to financial, economic and physical
data) are installed to monitor the execution of the activities.
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Performance Budgeting Vs Traditional Budgeting
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Performance budgeting puts more emphasis on expenditure incurred on

functions than on things to be acquired or spent. In performance budgeting
each program is further sub classified as an activity. In traditional budgeting
system, budget appropriations are made object-wise and clubbed according to
the nature of expenditure such as pay and allowances, traveling allowances,
transport, traveling allowances etc.
PARTICIPATIVE BUDGETING
Participative budgeting is based on the premise that having better
communication and motivation in an organization will lead to better
budgeting. Consequently, a participative budget draws on ideas suggested by
all the members of the organization. The organization should ensure the
following when developing a participative budget:
Targets should be achievable: Targets must be realistic and achievable. If
targets are high, they will be difficult to achieve; if they are set too low, there
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will be slack in the performance. Unnecessarily high targets results in nonachievement and, therefore, lower performance.
Participation of lower levels: If the lower levels of management do not
participate actively in decision making, then the whole purpose of a
participatory budget is lost.
VARIANCE ANALYSIS FOR CONTROL ACTIONS
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Since a budget is an instrument of control, it is necessary to compare the

actual results with the budgeted results. A variance occurs whenever actual
costs differ from standard costs. The term variance analysis refers to the
systematic evaluation of variances in an attempt to provide managers with
useful information for measuring efficiency and improving performance.
Variance analysis attempts to isolate the impact of each important variable
that contributes to the total variation. Variance analysis is done to investigate
the underlying causes for deviations in budgets so that management can take
corrective measures. Thus, variance analysis examines the amount of
difference between standard costs and actual costs and the reason for the
difference.
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If the actual cost is less than the standard cost, the variance is favorable. If the
actual cost is more than the standard cost, the variance is unfavorable. A
favorable variance indicates efficiency and an unfavorable variance indicates
inefficiency.
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Variances occur due to three reasons. A managerial decision to respond to

some new developments which were not initially anticipated, uncontrollable
exogenous factors, controllable factors that need to be investigated.
The following framework can be used to conduct variance analysis:
Identify the key causal factors that are likely to affect the profits.
Breakdown of the overall profit variances according to the key causal

factors.
Focus on the profit impact of the variation for each key causal factor.
Determine the specific, separable impact of each causal factor by varying

a particular factor while holding all others constant.
Add complexity sequentially to determine the impact of several variables

on a particular factor.
When the added complexity at the newly created level is not justified, the
process has to be stopped.
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Revenue Variances
Selling price, volume and mix variances come under revenue variances. The
variance for each product line is calculated separately and the results are
aggregated to calculate the total variance. If the actual profit exceeds the
budgeted profit, the variance is positive and favorable, but if the actual profit
is less than the budgeted profit, the variance is negative and unfavorable.
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Selling price variance: The selling price variance is calculated by multiplying

the difference between the actual price and the standard price by the actual
sales volume.
Mix and volume variance: Mix and volume variances are not separated in
general. The mix and volume variance is the product of the budgeted unit
contribution and the difference of the actual and budgeted sales volume.
The volume variance results from selling more units than the budgeted. The
mix variance results from selling a different proportion of products, as the
contribution per unit is different for different products. If the business unit has
a richer mix (i.e., a higher proportion of products with a high contribution
margin), the actual profit will be higher than the budgeted. Mix variances and
volume variances can also be calculated separately.
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Mix variance: The following equation is used to calculate the mix variance
for each product.
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Mix variance = [(Total actual volume of sales x Budgeted proportion) (Actual volume of sales)] x Budgeted unit contribution.
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Volume variance: Volume variance is calculated using the following formula:
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Volume variance = [(Total actual volume of sales) x Budgeted percentage)] [(Budgeted sales) x (Budgeted unit contribution)]
Market penetration and industry volume
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One extension of revenue analysis is to separate the mix and volume variance
into the amount caused by the differences in market share and the amount
caused by differences in industry volume. This is because while the business
unit managers are responsible for market share, they are not responsible for
industry volume as state of the economy decides the industry volume. For this
purpose, the industry sales data is also needed to exactly represent the
performance of a business unit.
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Market share variance and industry volume variance are calculated using the
following equations.
Market share variance = [(Actual sales) - (Industry volume) x Budgeted
market penetration] x Budgeted unit contribution.
Industry volume variance = [(Actual industry volume-Budgeted industry
volume) x Budgeted market penetration] x Budgeted contribution per unit.
The variance for each product is calculated separately, and the sum of
variances of all the products gives the total variance.
Sales budget variances
Sales budgets are prone to variances because actual sales usually differ from
budgeted sales. It is the duty of the concerned managers to analyze and
understand the factors that have caused the deviation. In most organizations
three principal reasons are responsible for deviations in sales budgets:
(i)
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The actual price realized is different from the price envisaged at the
time of budget formulation.

(ii)
The actual volume of product sold is different from the planned volume
of sales.
(iii)
The actual sales mix is different from the budgeted sales mix.
Variance in the sales budget is categorized as a price variance and volume

variance. Volume variance is analyzed in terms of a sales-mix variance and a
quantity variance. The same approach is used to analyze a territory-wise sales
performance report. If a sales district projects a high variance, then it is
necessary to analyze and understand the reasons for the high variance.
Corrective measures must be initiated accordingly.
Expense Variances
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Expenses are divided into fixed costs and variable costs. The variance between
the actual and budgeted fixed costs is obtained simply by subtraction, as these
costs are not influenced by market sales or volume of production. But variable
costs vary directly and proportionately with the volume.
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Material budget variances
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The material budget variance is categorized as material yield variance and

material usage variance. Material yield variance occurs due to differences
between the actual yield and the standard yield. These differences are caused
by abnormal loss sustained in different processes of production. Thus, yield
variance represents the portion of usage variance that is due to the difference
between the standard yield specified and the actual yield obtained.
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Material usage variance occurs due to the difference between the standard
quantity specified and the actual quantity used. Material usage variance occurs
due to the following reasons.
Careless handling of materials
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Wastage, spoilage, scrap, theft, pilferage, etc.
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Changes in product design, labor, performance, etc.
Use of inferior materials
Defective tools and materials
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Setting of improper standards
Labor budget variance

Labor budget variance occurs due to the following two factors:
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Differences between actual wage rate and budgeted wage rate
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Differences between actual labor hours and budgeted labor hours for a
particular activity.
The labor budget variance includes wage rates variance and labor efficiency
variance. Wage rates are determined through negotiations between union and
management. This wage rate variance is controllable at the supervisor level.
The labor efficiency variance is the difference between the standard labor
hours specified and the actual hours spent on work. Labor efficiency depends
on the skill levels of the workers, the volume of work hours put in by each
worker, and the wage rate. Labor efficiency variance occurs due to the
following factors.
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Lack of supervision
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Poor working conditions in the factory
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Use of sub-standard materials
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Inefficiency of workers due to inadequate training.
Lack of proper tools, equipment, and machinery
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Higher labor turnover
Manufacturing overhead variance
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Manufacturing overhead variances are the most complicated to compute in the

variance analysis. Fixed overhead variance refers to all items of expenditure
that are more or less constant, irrespective of fluctuations in the level of the
output. This variance represents the difference between the actual cost and the
fixed overhead cost. Variable overhead variance represents the difference
between the budgeted and the actual variable overheads.
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Summary of Variances
Time period of comparison
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There are several ways in which variances can be summarized in a report. The
different methods of calculating variances are: time period of comparison,
focus on gross margin, evaluation standards, full-cost systems, and amount of
detail information. These approaches are described below.
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Some companies use performance for the year to date as the basis for
comparison. They use the budgeted and actual amounts for the six months
ending June 30, rather than the amounts for the month June. Other companies
compare the budget for the whole year. The actual amounts are taken for the
first six months and the estimates of revenues and expenses are taken for the
next six months.
A comparison of the annual budget with current expectation of actual
performance for the whole year shows how closely the business unit manager
expects to meet the annual profit target. If the performance for the year to date
is worse than the budget for the year to date, the deficit is likely to be
overcome in the remaining months. However, the forces that caused the actual
performance to be below budget for the year to date are expected to continue
for the remaining part of the year, and this is likely to make the final figure
significantly different from the budgeted amount.
Focus on gross margin
Though selling prices are assumed to be constant throughout the year, in
practice, changes in costs and other factors make it difficult to maintain the
same selling price. So, the marketing manager must try to achieve a budgeted
gross margin, that is, a constant spread between costs and selling prices. To do
so, the gross margin variance must be considered. The gross margin is the
difference between the actual selling prices and manufacturing costs.
Evaluation standards
Three types of standards are used for evaluating reports of actual activities: (1)
Predetermined standards (2) Historical standards (3) External standards.
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Predetermined standards
Predetermined standards (also called budgets) if carefully planned, and
coordinated can be excellent standards. Most companies compare actual
performance against predetermined standards. But if the budgeted numbers are
collected in a haphazard manner then this will not provide a reliable basis for
comparison.
Historical standards
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These are records of past actual performance. Results for the current month
are compared with results for the last month, or with results for the same
month a year ago. There are two disadvantages of using these type of
standards: conditions may be different in the two periods (this invalidates the
comparison), and the prior periods' performance may not have been
considered acceptable performance. Despite these inherent weaknesses, these
standards are used by companies where valid predetermined standards are not
available.
External standards
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These standards are derived from the performance of other responsibility

centers or of other companies. The performance of one branch sales office
may be compared with the performance of other branch sales offices. Such a
comparison may provide an acceptable basis for evaluation if the conditions in
the responsibility centers are similar.
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In a full-cost system, the manufacturing cost of a product includes both

variable costs and fixed costs. Companies under the full-cost system may not
be able to make such a separation, or even if they do it, they have to identify
the variance in manufacturing costs that result from the difference between
actual and standard production volume. A Production volume variance is
developed when actual volume is different from standard volume.
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Amount of detail information

Revenue variances can be analyzed at various levels: in total; then by volume,
mix, price; analysis of volume and mix variance is done by industry volume
and market share. At each level, the variances of individual products are
analyzed. The process of analyzing the variance from one level to another is
called "peeling the onion." Similarly, additional sales and marketing
variances can be calculated, by sales territories,' by individual sales
persons,' by sales originating from direct mail,' by customer calls from other
resources, by sales to individual countries.' Additional information for
manufacturing costs can be developed by calculating variances with specific
input factors, such as wage rents and material prices. These layers of variances
correspond to the hierarchy of the responsibility center managers.
Limitations of Variance Analysis

Variance analysis identifies the occurrence of variance, but it does not tell
why the variance occurred. When using variance analysis, it is difficult to
decide whether a variance is significant or not. Another limitation of variance
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analysis is that, as the performance reports become more highly aggregated,

offsetting variances might mislead the reader. For example, a manager might
notice that the business unit manufacturing cost performance was as budgeted.
However, this may be because good performance at one plant is offsetting
poor performance at another plant.
If a variance is significant, but uncontrollable (such as unexpected inflation),
there may be no point in investigating it. Performance reports show only what
has happened, they do not show the future effects of actions that the manager
has taken. For example, reducing the budget for employee training increases
the current profitability, but may result in adverse consequences later. Since
variance analysis is limited to those events that are recorded in the accounts,
many important effects of those events are not reflected in current accounting
transactions.
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SUMMARY
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Budgets are formal, quantitative statements of resources for carrying out

planned activities over a given period of time. Budgeting plays an important
role in coordinating the activities of responsibility centers. The master budget
is the overall budget for an organization. It represents the overall plan of the
organization. The principal steps in the preparation of the master budget are:
preparation of the operating budget, preparation of the budgeted income
statement and preparation of the financial statement.
The budget process and control encompasses the budget preparation process,
budgetary control and behavioral dimensions of budgeting. The budget
preparation process involves the organization of a budget department, the
establishment of a budget committee and the issuance of the guidelines for
developing budgets. Budgets may undergo frequent modifications because of
changes in external factors, and changes in internal policies. Top management
is responsible for administering and reviewing the budget. Zero base
budgeting, performance budgeting and participative budgeting can be used to
appraise actual performance. Zero based budgeting starts with the premise that
each activity is being performed for the first time and that the costs are zero.
The manager is held responsible for identifying the resources and has to
justify the reason for spending money on a particular activity.
Budgetary control focuses attention on deviation from budget standards and
points out where corrective action is necessary. The important steps for
achieving effective budgetary control are setting up a budget center,
documenting a manual, appointing a budget controller and the budget
committee. The budget period and the key variables must also be decided on.
The budget is responsible for budgetary control. A budget committee is
established to assist the budget controller.
A budget is an important control mechanism. When actual results do not tally
with the budget; a variance is said to have occurred. Variance analysis thus
provides managers with useful information for measuring efficiency and
improving performance. The overall performance of a business unit is divided
into revenue variance and expense variance. The different types of variances
that occur in budgets are sales budget variance, material budget variance,
labor budget variance and manufacturing overhead variance.
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09
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PART IV:
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MANAGEMENT CONTROL TOOLS
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Reward Systems
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Chapter 10
Purpose of Reward Systems
Components of Incentive Compensation Plans
CEO Compensation
Incentives for Business Unit Managers
Balanced Scorecard
Design Considerations
Agency Theory
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Between 1981 and 1991, Bausch & Lomb was a highly successful company.
Its sales and earnings had tripled to $1.5 billion and $150 million, respectively
and its shares value witnessed a five fold increase. The compensation of Dan
Gill, the CEO of Bausch & Lomb had soared from $362,000 in 1981 to $6.5
million by 1991. An aggressive culture and an emphasis on performance and
rewards drove the organization too far, too fast. The sole aim of the company
was to achieve double-digit annual growth irrespective of the means used. In
19941, the SEC and the shareholders, who filed a class suit accused the
company of misleading investors by falsely inflating sales and earnings.
Rewards and incentives are clearly important, but organizations also need to
set boundaries when deciding the rewards. The more the culture and rewards
drive ambition and goal-seeking behavior, the more the need for a system of
boundaries and constraints. At Bausch & Lomb, the boundaries were set rather
late. Only after the SEC investigation began in December 1994, did Gill and
his top executives adopt more conservative practices, reduce distributor
inventories, and change bonus guidelines to incorporate broader, long term
goals.
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PURPOSE OF REWARD SYSTEMS
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Reward systems are a major motivational tool to secure the participation of

individuals to achieve organizational goals. It is a common notion that only
the employees of an organization are entitled to rewards. Organizations
however, also reward their stakeholders -customers, stockholders, creditors,
and the public for their contribution.
Reward systems are an important source of communication and feedback.
They communicate what the firm values of an individual. Rewards create a
sense of belonging which makes an individual feel more committed towards
his work. Reward systems harmonize the interests of stakeholders and
managers.
COMPONENTS OF INCENTIVE COMPENSATION PLANS
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A managers total compensation package is made up of three components:
Salary
Benefits
Incentives
Salaries are usually paid every month. Employees progress through a clearly
defined career hierarchy based on factors such as age, qualifications,
experience and performance. Factors which affect the administration of
salaries in various organizations are as follows:
Remuneration in comparable industries
Firms ability to pay
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Picken, Joseph C.; Dess, Gregory G. Out of (strategic) control, Organizational Dynamics,
Summer 97, Vol. 26 Issue 1, p35.
Reward Systems
Cost of living
Productivity
Union pressure and strategies

Government legislation
Salary administration must follow a systematic approach to ensure that
employees are paid in a logical, equitable and fair manner. The objectives of
salary administration are:
To acquire qualified and competent personnel
To retain present employees
To reinforce desired behavior-good performance, loyalty, willingness to

take additional responsibilities etc.
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To pay the employees in accordance with their efforts and merit

Benefits help employees to deal with certain contingencies and meet certain
social obligations. They satisfy an employees economic, social and
psychological needs. Benefits include safety measures, health benefits,
pension, perquisites etc. In short, benefits lessen the economic problems of the
employee. The objectives of providing benefits are:
To boost employee morale
To improve the quality of the work environment and work life
To motivate employees by identifying and satisfying their needs
To create a sense of belonging among employees and retain them
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To protect the health of employees and to ensure their safety

It is the duty of the senior management to devise the best incentive plan
possible for its employees. Incentive plans should be approved by the board
of directors before they are implemented. Corporate by-laws and security
regulators also make it mandatory for all organizations to get their incentive
plans approved by their shareholders.
Incentive compensation plans can be classified as:
(a) Short-term incentive plans
(b) Long-term incentive plans
Short-term incentive plans are usually based on the performance of employees
in the current year, while long-term incentive plans relate compensation to
long-term accomplishments. A manager can earn a bonus under both the
plans. In short- term incentive plans, bonus is paid in cash while in long term
incentive plans, the employees are provided with an option of buying the
company's common stock.
Short-term incentive plans
The total bonus pool
Bonus pool refers to a system wherein shareholders vote on the formula to be
used for deciding the total amount of bonus to be paid in a given year.
One simple method is to calculate it as a set percentage of the profits.
However, this method is not always acceptable because a company will have
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to pay bonus even if the profits are low. Further, this method does not give a
true picture of additional investments. Additional investments can result in
increased profits and thus increased bonuses even when the performance of
the company has been static or has been deteriorating. Many companies
therefore use formulas according to which bonuses are paid only after a
specified return has been earned on the capital. One method of accomplishing
this is to base the bonus on a percentage of earnings per share after a
predetermined level of earnings per share has been attained. This method,
however, fails to take into account increases in investment from reinvested
earnings. This drawback can be overcome by increasing the minimum
earnings per share each year by a percentage of the annual increase in retained
earnings.
Another method is to calculate it as a percentage of the profit before deducting
taxes and interest on long-term debt minus a capital charge on the total of
shareholder equity and long-term debt.
The fourth method is to define capital as equal to shareholder equity.
However, the problem with the third and the fourth methods is that a loss in a
year reduces the shareholders equity and thereby increases the amount of
bonus to be paid in profitable years.
There are some companies which calculate the bonus on basis of increase in
profitability in the current year as compared to the previous year. One major
drawback of this method is that a good performance in a year is not rewarded
if it follows an excellent one. Bonuses can also be calculated by comparing the
company profitability with industry profitability. However, it is sometimes
difficult to collect the industrial data as only a few companies adopt the same
product mix or employ identical accounting systems. As a result, a company
may end up paying a higher bonus in a year in which performance was
mediocre simply because one or more of its industry competitors performed
badly.
It should be noted that while calculating bonuses using any of the above
mentioned methods, adjustments need to be made in the net income and
shareholder equity. While determining the bonus, it is also important to
exclude certain gains and losses from discontinued operations.
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Carryovers
This refers to an annual carryover of a part of the amount determined by the

bonus formula to the bonus pool instead of paying the total amount in the
bonus pool. The board of directors decides the percentage to be carried every
year. The board of directors also decides the amount of accumulated carryover
is to be used if the bonuses paid in a particular year are low. This method is
flexible as the payment of bonus is not determined by any formula. In a good
year, the committee might pay only a portion of the bonus to its employees
while in a poor year, it may pay more than the amount warranted by the years
performance by drawing from the carryover bonus. However, the
disadvantage of this method is that the bonus calculated is less related to the
current performance of employees.
Deferred payments
Under this system, the amount of bonus is calculated annually, but the
employees receive the payments over a period of years, usually five.
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Reward Systems
Employees receive only one fifth of their bonus in the year in which it was
earned. The remaining part (four fifths) is paid equally over the next four
years. Thus, after five years, employees receive one-fifth of the bonus for the
current year plus one-fifth of each bonus for the preceding four years. One
advantage of the deferred payment method is that employees can estimate
their cash income for the coming year. Another advantage is that it guarantees
bonus to those employees who retire, as the payment of bonus is spread out
for a fixed year. But this method also has its drawbacks. One major
disadvantage is that the deferred amount is not available to the employees the
year it is earned. Moreover, an employee loses the deferred amount, if he
leaves the company.
Long-term incentive plans
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Long-term incentive plans are designed to reward the performance of an

employee over a longer period. The types and characteristics of long-term
incentive plans have become increasingly complex over the past several years.
Organizations today design and implement plans that are responsive to the
needs of both the enterprise as well as their employees. The different types of
long-term incentive plans are discussed below.
Stock options
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A stock option gives the employee the right to buy a certain number of shares
in the company at a fixed price for a certain number of years. Stock options
give the employees the right to buy a number of shares of stock at or after a
given date in the future. The manager who obtains stock gains if he sells the
stock at a price that exceeds the price paid for it. Managers can retain equity
even if they leave the company. They can sell the stock whenever they decide
to do so. However, managers are not permitted to sell the stock for a specified
period after it has been acquired. A major advantage of this plan is that
managers are motivated to direct their energies toward the long-term
performance of the company as it is designed to create an employee ownership
culture.
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Stock appreciation rights
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This incentive plan gives employees the right to receive cash payments based
on the increase in the value of stock from the time of the award until a
specified future date. The amount of bonus received due to the increase in the
value of stock is a function of the market price of the companys stock.
Phantom stock plans
This plan awards managers a number of shares of stock-either in the form of
cash or shares. At a specified event in future, such as retirement or termination
of employment, the employee is entitled to receive an amount measured by the
fair market value of phantom shares credited to the employees account. There
are two types of phantom stock plans, namely growth and basic. Under
the growth plan, at redemption, employees receive an amount equal only to
the appreciation in the market value of share. Under a basic plan, employees
receive the original value of the shares as well as the amount appreciated.
Performance shares
Under this incentive plan, employees are awarded a specified number of
shares when they meet specific long-term goals. This plan aims at achieving
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certain percentage growth in earnings per share over a period of three to five
years. The advantage of performance shares over stock options and phantom
shares is that they are given on the basis of performance. Moreover, they are
not affected by increase or decrease in stock price. However, one major
drawback of this incentive plan is that it is based on accounting measures of
performance. In certain circumstances, actions that corporate executives take
to improve earnings per share may not contribute directly to the economic
worth of the firm.
CEO COMPENSATION
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The compensation of the Chief Executive Officer (CEO) is decided after a

discussion by the board of directors. This takes place after the CEO has
recommended the incentives to be paid to his subordinates. The percentage of
incentive compensation decided by the CEO for his subordinates, can be taken
as the basis for determining his/her compensation. Most people believe that
CEO compensation is much higher as compared to other employees in the
organization. In most cases, CEOs are paid extraordinary bonuses, lavish
perquisites that are not related to the profits of the organization. However,
directors of most firms feel that the compensation the CEOs receive is very
little as compared to the profits they bring to the organization. However, of
late, the exorbitant salaries being paid to the CEOs have come under scrutiny.
The recent scandals in Global Crossing, Computer Associates, Xerox have
highlighted this issue further.
According to some analysts, high CEO compensation is the root cause for
collusive practices. In 2000, CEOs in the US, were paid 458 times the salary
of an average worker. The problem lies not only with the pay the CEOs
receive, but also with the methods they adopt to raise the stock price up in
time to cash in their options. Emphasizing on the need to restrict such
practices; writes Warren Buffet2: To clean up their act on these fronts, CEOs
dont need independent directors, oversight committees or auditors
absolutely free of conflicts of interest. They simply need to do whats right.
Also, the policy making process should ensure that better representation is
given to the investors.
The family run businesses in India also pay exceptionally high salaries to their
CEOs especially in the manufacturing sector where profits and stock prices
have increased continuously. The CEOs award themselves with high salaries
by manipulating shareholder meetings and share prices. The CEO
compensation which has to be decided by the board of directors now seems to
be just a farce with industrialists and professional managers rewarding one
another through cross directorships on company boards.
INCENTIVES FOR BUSINESS UNIT MANAGERS

Incentives for business unit managers include financial incentives,
psychological incentives and social incentives. Financial incentives are
offered in the form of salary increases, bonuses, benefits and perquisites.
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Reward Systems
Psychological and social incentives are provided in the form of promotions,

increased responsibilities, increased autonomy, better location, participation in
executive development programs etc.
Size of Bonus Relative to Salary
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There are two schools of thought on designing the mix between the fixed
(salary and benefits) and variable (incentive bonus) portions of a managers
total compensation. One school states that it is important to recruit good
people, pay them well and expect good performance from them. This school
emphasizes on salary and not on incentive bonus. The emphasis of this school
of thought is on the fixed pay system. In this type of compensation
performance is not related to pay. However, this type of compensation raises
an important question- what happens if a person does not perform as
expected? The other school of thought believes that compensation should be
based on performance. Thus, the emphasis is on incentive bonus and not
salary. These two philosophies have different implications for business unit
managers. While the first philosophy assures employees monthly salary it
rarely encourages employees to perform efficiently. Whereas the second
philosophy encourages managers to put greater effort and perform to the best
of their ability. Most organizations emphasize on incentive bonuses for
business unit managers.
Cutoff Levels
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Another aspect that has to be considered when deciding compensation plans is

the cutoff level for bonuses. The upper cutoff indicates the level of
performance at which maximum bonus can be earned whereas the level below
which there will be no bonus is referred to as the lower cutoff level. When
employees realize that the maximum performance level has been attained and
they will not be paid any bonus, they may not be motivated to perform well
and achieve organizational goals.
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The bonus for a business unit manager can be based on the total profits of the
company or solely on the performance of the individual business unit or a
combination of both. It is important to base bonus on the performance of the
individual business unit as the decisions and actions of the manager have a
direct impact on the performance of that unit. But such an approach can have a
negative impact on the inter unit cooperation. To encourage cooperation
among the various units, the managers ability to foster cooperation should also
be given due consideration.
Performance Criteria
The bonus of a business unit manager can be decided on the basis of the
factors mentioned below.
Controllable factors
Managers should be rewarded on the basis of variables which values are under
their control and influence. Such a reward system can be considered fair. On
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the other hand, when rewards are based on variables that are outside the
control of managers, the reward system becomes more arbitrary.
Uncontrollable factors
Sometimes corporate managers hold the subordinates responsible for variables
that are out of their control. These include effects of losses due to earthquakes
and floods and accidents not caused by the negligence of the manager.
Another uncontrollable factor is the result of decisions made by the executives
above the business unit level. These uncontrollable factors have to be taken
into account while deciding on the reward systems.
Financial criteria
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In case of a profit center, the choice of financial criteria for the business unit
manager are decided on the basis of the units contribution margin, direct
business unit profit, income before taxes and net income. However, before
considering these factors, it is important to have a clear understanding of the
definition of profit, and investment and also the choice between return on
investment and residual income.
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Linking business managers bonus to short term financial targets results in

managers looking for ways to perform existing operations more creatively and
innovatively. However, this can sometimes cause several dysfunctional
problems. Managers can encourage short term actions that are not in the long
term interests of the company. They could also discourage investments, that
promise benefit in the long term but do not contribute to short term financial
results. Managers could manipulate data to meet current period targets.
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Overcoming short-term bias
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These can be overcome by determining the manager's bonus on multiyear

performance. But having such a reward system has its own disadvantages. If
the bonus is based on multiyear performance, managers would have difficulty
in perceiving the relationship between their rewards and effort. This would
reduce the motivational effect of such rewards. Secondly it would be difficult
to implement such a reward system in case of transfers. Senior management
can thus use non financial criteria like sales growth, market share, customer
satisfaction, personal development etc. However, the best alternative would be
to have a judicious mix of financial and non financial criteria.
Non financial
For an effective and efficient control system key variables should be
qualitative. These kinds of key success factors include cycle time, measures of
quality, on-time delivery, complaints from customers, new product
introductions, supplier defects and so on.
Benchmarks for Comparison

The performance of a business unit manager can also be evaluated by
comparing the actual budgets with profit budgets, its past performance or even
with its competitor's performance. However, when using the profit budget as a
motivational tool, it is important for the business unit to set attainable targets.
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Reward Systems
BALANCED SCORECARD
In this rapidly changing world of business, the traditional measures of
performance appraisal are insufficient for making decisions. The emphasis is
not only on measuring financial performance, but also on measuring non
financial performance. The growing international competition, the TQM
movement have all widened the growing importance of non-financial
measures of performance. Thus, it has become important to take into
consideration both financial and non-financial measures of performance. A
number of studies have been conducted to include both financial and nonfinancial measure of performance. The balanced scorecard (BSC) developed
by Robert Kaplan and David Norton takes into account financial and nonfinancial measures, short-term and long-term goals, external goals, internal
improvements, past outputs and ongoing requirements, as indicators of future
performance. BSC3 acts a strategic planning and communicating device by:
Directing managers attention towards the strategic goals of the
organization.
Identifying the links between the lagging and leading indicators of

performance.
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Customer strategy that concentrates on creating value and differentiation

from that of the competitors.
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According to Kaplan and Norton, by using a BSC, managers can effectively

utilize the potential and specific knowledge of the organizations personnel to
achieve long-term goals. BSC measures performance from four important
perspectives:
Financial perspective that involves the strategy for growth, profitability,
and risk viewed from the shareholder's perspective.
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Internal business processes perspective that focuses on various strategic

priorities for various business processes that result in customers and
shareholders satisfaction.
Learning and growth perspective determines priorities to create a climate
that supports organizational change, innovation and growth.
BSC plays an important role in strategy implementation and performance
measurement. The measures of performance should be accurate, objective and
verifiable. Performance measurement should motivate employees to improve
in the key areas of competition like customer satisfaction, productivity, etc. If
performance is not measured accurately, managers may manipulate
performances, and thus the credibility of the system may be lost. The target
performance level should be challenging and, at the same time, attainable.
However, having
too many performance measures may reflect the
complexity of the organizations task. Employees commitment to achieving
goals can be enhanced by linking BSC to well understood rewards and
penalties. An organizations BSC will be effective if it is linked with best
rewards and appropriate penalties. An effective management control device
3
Mary A Malina and Frank H Selto Communicating and Controlling Strategy: An

Empirical Study of the Effectiveness of the Balanced Scorecard Journal of Management
Accounting Research, 2001.
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that promotes desired organizational output should have the following

attributes:
Performance variables should linked to the strategic goals of the

organization.
Goals should be accurate, objective and attainable, and should effectively

guide managers towards achieving the strategic objectives of the
organization.
To promote positive motivation, an effective management control system

should have:
Performance measures that are helpful in measuring the manager's actions

by relative performance appraisal measures.
Targets that are challenging, but should be attainable.
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Achieving targets should be followed by rewards.

Feedback is a powerful tool and helps the management to measure and reward
performances. Feedback can be both formal and informal. Rewards and
penalties help an employee to understand the expectations of the management
and work towards the achievement of the goals.
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The design considerations for developing reward systems follow certain

criteria. These criteria whether formal or informal are powerful motivators of
people.
Integrating rewards with MSSM
Attainability
Identifying the formal rewards
Identifying the informal rewards
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Rewards Integrated with MSSM (Mutually Supportive Systems Model)
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The MSSM (Mutually Supporting Systems Model) which consists of

infrastructure, management sytle and culture, formal control process, rewards
and coordination and integration has the ability to produce incentives or
disincentives depending upon its design and performance variables. For
example, autonomy may be considered an incentive for a manager. A sense of
authority over the organizational resources will motivate him to perform
better.
The incentives and disincentives are strongly influenced by the values and
culture of an organization. Communication and integration structures are
strong motivators. Employee participation in decision-making and problemsolving, which is usually highly valued by the employees is considered to be a
powerful incentive.
Attainability
It is important to set targets which are challenging but attainable. Targets that
can be easily achieved are poor motivators as they do not give individuals the
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Reward Systems
scope to grow. At the same time, targets which are impossible to achieve can
be demotivating.
Formal Rewards
Formal rewards are specified by the definition of goals, responsibilities,
performance measures and a number of criteria should be followed by setting
formal rewards.
Performance measures which are designed to measure reward systems
should be congruent with the goals and objectives of the organization.
Performance of the managers has to be evaluated based on the variables

over which they have significant amount of control.
Performance should be objectively measured and these standards should

be challenging but attainable.
Rewards should encourage competition and should be simple to
understand and administer.
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AGENCY THEORY
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Informal relationships among employees give rise to informal rewards.

Informal rewards are usually meant to satisfy the psychological needs of the
employees. These rewards promote self-respect, reinforce the values of the
organization and encourage self-learning. The reward and recognition
dynamics of formal and informal reward systems is shown in Exhibit 10.1.
The left side of the exhibit indicates the formal rewards like merit increases
and bonus programs. Before motivating an individual, these rewards pass
through cultural values, past training etc., The right side represents the
informal activities which also passes through cultural activities. When these
two loops positively reinforce the employee then he is motivated to perform.
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The agency theory describes the factors that should be considered while
designing incentives and shows how these incentives can be used to motivate
individuals. This theory usually uses mathematical models to describe the
incentives. Here, we only discuss the main concepts of agency theory and not
the mathematical models. The term incentive contract has been used here
instead of incentive compensation. The theory reestablishes the importance of
incentives and self interest in organizational thinking.
Concepts of Agency Theory

According to the theory, a relationship is formed when party the principal
hires another party the agent, to undertake some service. In an organization,
many such relationships exist. For example, shareholders are considered to be
the principals with the chief executive officer as their agent. Similarly, the
CEO is the principal while the managers of specific business units are agents.
The agency theory assumes that the principals and agents possess divergent
preferences and objectives. This divergence in preferences can be reduced
through incentive contracts.
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Exhibit 10.1
CEO Compensation in India
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In India, CEO compensation is becoming a highly debatable issue. Family run

businesses are awarding the CEOs hefty salaries. The late Dhirubhai Ambani, former
chairman and founder of Reliance Industries was paid $1.83 million in 2002. Hero
Honda, promoted by the Munjal family in partnership with Honda, paid Rs 29.75 crore
(Rs 297 million) to its top four executives. Hero Honda's promoters, Brijmohan Lal
Munjal, Pawan Kant Munjal, and Honda executives Matsuo Yamasaki and Kazumi
Yanagida, took home around Rs 7.50 crore (Rs 75 million) each during 2002. The
aggregate salaries of the top five executives of RIL were Rs 27.23 crore (Rs 272
million), Mukesh Ambani and Anil Ambani being paid Rs 7.21 crore (Rs 72 million)
each. Nikhil R Meswani and Hital R Meswani was paid Rs 1.93 crore (Rs 19 million)
each. Apart from these, Hindustan Lever, the Aditya Birla Group, ITC, Wipro and
ICICI have high pay packets that have attracted attention. The compensation is not
performance based and industrialists and professional managers reward one another
through cross-directorships on company boards.
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Source: BS Research Bureau, October 17th, 2002 and Sucheta Dalal, Operation Clean-up In
The US, The Financial Express May 27, 2002.
Divergent objectives of principals and agents
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The agency theory assumes that financial compensation alone cannot satisfy
the agents. Perquisites like greater amount of leisure time, attractive working
conditions, flexibility in working hours etc. are also needed. Some agents
prefer leisure to hard work (effort) and the preference for leisure over effort is
termed as work aversion. Sometimes, agents deliberately try to evade
responsibility which is termed as shirking.
Another assumption of the agency theory is that although managers prefer
more compensation to less, but satisfaction decreases with the accumulation of
more and more wealth. The compensation made to managers is usually based
on the performance of the firm. Agents try to avert risk when much of their
wealth is dependent on the company. On the other hand, owners reduce their
risk by diversifying their wealth and becoming owners in many companies.
Nonobservability of agents actions
The principal should monitor the actions of the agents in order to avoid
divergence in preferences (between the principals and agents) and to satisfy
the agents by offering the best compensation and perquisites. However, due to
the lack of adequate information about the activities of agents, the principal
cannot ascertain the agents contribution to the performance of a firm. This
situation is referred to as information asymmetry. Sometimes, the agent may
have more information about the task assigned to him than the principal. The
additional information that the agent may have about performing a particular
task is termed private information.
The agent may sometimes misinterpret information to the principal, either due
to divergence of preferences or due to the private information available with
him. Such a situation is termed as moral hazard.
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Reward Systems
Control mechanisms
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SUMMARY
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There are two ways of dealing with the problems of information asymmetry
and divergence in preferences, namely monitoring and incentive contracting.
Monitoring: The principal can design control systems that monitor the actions
of its agents. One example of a monitoring system is the auditing of the
financial statements. These statements help generate reports about the
companys performance. These financial reports are audited by a third party
and then sent back to the owners. Monitoring becomes easy when the task
assigned to the agent is well defined and the information used is accurate.
Incentive contracting: Incentive contracts are established to limit divergence
in preference. Performance measures should be set to measure the rewards
granted to the agents. The more the reward depends on performance measures,
the more incentive there is for the agent to improve the measures. The
principal should define the performance measure in such a way that it furthers
his or her interest. The ability to accomplish this is known as goal
congruence. If the agent, to whom the contract is given, is motivated to work
in the best interest of the principal, then the contract is said to be goal
congruent.
A compensation scheme that does not have an incentive contract is
demotivating. The CEO who is paid a straight salary, is likely to be less
motivated to work diligently than the CEO who gets a bonus along with the
salary. This would motivate the CEO to work hard and the organization earns
higher profits. Thus, the incentive contract is beneficial for both agents and
principals. Contracts help in aligning the interests of the two parties.
The asymmetry of information, differences in risk preference between the two
parties, costs of monitoring, etc. sometimes make incentive contracts
ineffective. These can lead to additional costs. Even an efficient system of
incentives can lead to divergence of preferences. This divergence is referred to
as residual loss. The additional costs of incentive compensation, the costs of
monitoring and the residual loss is termed as agency costs.
This chapter examined the usefulness of reward systems as a control

mechanism that encourages and motivates managers to achieve organizational
objectives. The reward system is a major tool for communication and
feedback. Reward systems help align the interests of stakeholders with that of
managers. The important components of incentive compensation plans are:
salary, benefits and incentive compensation. CEO salaries have soared very
high and is causing serious concern.
Short-term incentive plans are based on performance of employees in the
current year while long-term incentive plans are based on performance over a
longer period. The balanced scorecard can be used for comparing
performances of individuals within an organization. It provides the
management with the information that may help to prevent control failures or
at least identify them early. The control system is designed to ensure:
safeguarding of assets, reliability of information. Feedback is an important
motivational tool that helps in assessing the performance of individuals in
organizations. The chapter concludes with a description of the agency theory.
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Chapter 11
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Management Control of
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Operations
Information Used in Control of Operations
Just-in-Time Techniques
Total Quality Management
Computer Integrated Manufacturing
Decision Support Systems
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Operations management is one of the most important managerial functions. In

order to bring about efficiency in operations, there is a need to develop
techniques that help a manager to establish control. As management control of
operations involves working through others, managers should have the right
kind of information to understand the different activities that directly or
indirectly influence control. This control can be discussed in two sections. The
first section is concerned with the information that managers require to carry
out the different activities that directly or indirectly influence control and the
second section deals with techniques that are useful in management control of
operations.
INFORMATION USED IN CONTROL OF OPERATIONS
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A manager is responsible for selecting the work force, ensuring that they are
adequately trained, deciding where they fit best in the organization, providing
advice and suggestions, solving problems and ensuring that the environment
in the work place is satisfactory. Managers also need to interact with other
managers to obtain their cooperation and resolve problems when their
activities impede the work of the responsibility center. Thus, a primary motive
of a manager is to create a climate that induces employees to work efficiently
and effectively.
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In order to carry out these activities, managers require information. Hence, it

is necessary to discuss the different types of information required in
management control of operations.
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Informal Information
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Information that managers receive in organizations is mostly informal in

nature. It is obtained through observation, face-to-face conversations,
telephonic conversations, and meetings. Management by walking around
(MBWA) has gained a lot of importance in the present day business world
indicating the importance of informal information. By walking around, the
manager tries to understand the problems of the workers. The information
received through this process is informal and cannot be categorized.
Formal Information
In formal information, the manager relies principally on the formal reports.
This includes task control information, budget reports, budget signals and
internal audit.
Task control information
Task control information constitutes most of the formal information that flows
through an organization in its daily operations (production or other activities).
A production control system is one that schedules the flow of material, labor
and other resources to ensure that both quality and productivity are
maintained. An organization also has systems that control procurement,
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payroll, storage and other activities. Management control information is

nothing but a summary of task control information. The emergence of
technology has made it easier for managers to acquire day-to-day information.
However, the main issue is not of acquiring the information but deciding what
information is really useful for them.
Budget reports
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Approved budget is a financial tool which helps in controlling the activities of

the managers and comparing actual expenses with budgeted amounts. The
budget report serves as an important guide for the manager. The manager is
expected to operate in accordance with the budget to get a clear idea of the
financial position of the responsibility centers. However, the manager is free
to depart from the budget if he feels there is a better way of achieving the
objectives of the organization.
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Budget signals
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Budget signals help the operating manager to determine the amount of money
that has to be spent on various activities. These activities can be grouped
under Ceilings and Floors. Ceiling includes activities such as advertising,
entertainment expenses on which no more than the budgeted amount should
be spent. Floors include activities like training and the manager is expected to
spend the amount assigned for a particular activity. Though the expenses are
stated in the budget, the manager should be in a position to decide the amount
that has to be spent on each activity based on the requirement of the
department.
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The main emphasis for managers is to achieve the bottomline, and hence,
adjustments can be made in the individual revenue and expense items on the
income statement. With the exception of floor amounts, spending exceeding
the budget amount for one item is not criticized if the spending is
compensated for other items.
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Internal audit
If too much emphasis is placed on the budget, there is always a danger of
managers manipulating numbers to report the attainment of the budgeted
profitability in the current period. One way of doing this is to record goods
that have, not been shipped to customers during that period. On the other
hand, if performance greatly exceeds the budget, the apprehension that
reporting a high profit may lead to an increase in the budget amount or a
decrease in the following year, may prevent a manager from reporting certain
revenue transactions.
The internal audit reports help detect such behavior while the audit committee
activities ensures that appropriate action is taken on internal audit reports and
that there are adequate controls to minimize theft and defalcation. As these
activities generally involve high level managers it becomes difficult as well as
sensitive task.
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Non Financial Information

For management control systems to be effective in controlling operations,
there is a need for non-financial information. It is reported as a supplement to
the financial information. Non financial information includes the identification
of key variables and the steps that have to be taken to achieve competency in
these key variables. While financial performance shows the end result of an
organization's performance, non financial information shows the means to
achieve the ends. The relationship between financial and non-financial
information in an organization is illustrated in Figure 11.1. The exhibit
illustrates that at the lower levels of organizational hierarchy, non financial
measures are given greater importance. The emphasis on financial measures is
likely to increase with hierarchical levels.
Higher
Lower
Higher
Corporate
executive
Level of
aggregation
of measures
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Importance of
nonfinancial
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Importance of
financial
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Figure 11.1: Hierarchical Levels and Types of Performance Measures
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department
manager
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Subunits
within
functional
departments
Work centers
Lower
Higher
Lower
Source: Joseph A Maciariello and Calvin J. Kirby, Management Control Systems, (USA: Prentice
Hall of Inc, Second Edition) 431.
JUST-IN-TIME TECHNIQUES
Just-in-time is a Japanese philosophy that is used for managing all types of
inventory, purchase and production functions in an organization. The main
purpose of this philosophy is to reduce inefficiency and unproductive time in
the production process.
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Advantages of Just-in-Time Techniques

There are a number of strategic advantages for an organization using just-intime systems. They form an integral part of the corporate strategy by
focussing on cutting cycle time, improving inventory turnover and increasing
labor productivity. Some of the advantages have been discussed below:
Reduces buffer inventory
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The main aim of just-in-time is to ensure the delivery of raw materials at the
right time and in the right quantity and reduce buffer inventory. The need for
buffer inventory arises when machines break down or they produce defective
parts. The amount of buffer inventory can be reduced if steps are taken to
minimize machine breakdown and improvise quality of the inventory. The
need for buffer inventory also arises because of bottlenecks in the workplace.
These problems can be minimized by taking immediate action whenever a
problem arises.
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Decreases set-up costs
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The amount spent on set-up costs is reduced with the introduction of

numerically controlled machine tools. Traditionally when a machine was
discontinued a sizable production of each part became obsolete and these
awaited replacements. With numerically controlled machine tools, the need
for this inventory is greatly reduced and orders for obsolete parts can be filled
by simply inserting a proper computer program.
Decreasing procurement costs
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Traditionally, procurement involved a long process of first inviting bids, then

analyzing these bids, and placing an order with the best vendor, followed by
an inspection of the incoming goods. This process was time consuming as
well as expensive. To avoid this, companies are now establishing relationship
with one or two vendors who are expected to inspect the quality of the
incoming goods before delivering them. Moreover, with the advent of
information technology, orders are being transmitted electronically in many
companies. This can help companies to curtail procurement.
Relationship with customers
Manufacturers use systems through which sales persons can automatically
place orders from retailers or other customers. These systems help in
providing fast and accurate information to managers and also build strong
relationship between the customer and manufacturer. .
Implications for Management Control

Before implementing just-in-time systems a manager has to understand the
following aspects. Work-in-process inventory becomes insignificant because
of just-in-time systems and can be disregarded. In such cases inventories exist
only for raw materials and finished goods, therefore reducing record keeping
considerably.
In addition to the traditional focus on cost, a just-in-time system focuses
management attention on time. A reduction in cycle time may result in
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reduction of costs. The progress of just-in-time systems can be effectively

monitored through the following ratio:
Processing time
Cycle time
This ratio should ideally be equal to 1. The just-in-time system is an
evolutionary system, that seeks to improve the manufacturing process
continually. Keeping this ratio in mind, the management can establish targets
and monitor progress against the targets.
TOTAL QUALITY MANAGEMENT
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Total quality management (TQM) is a management concept that directs the

collective efforts of all managers and employees towards satisfying customer
expectations by continually improving operations management processes and
products. TQM emphasizes three important aspects: customer satisfaction,
employee involvement and quality improvement. The Japanese have set an
example for other countries paying considerable attention to quality. Quality
efforts initiated by the Japanese have now been adopted by several American
companies.
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Consequences of Poor Quality
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The quality of a product can be decided either on the basis of design or its
conformance to customer requirements. Design quality can be described as the
value that the consumer places on the product. A product is said to achieve
conformance quality, if it adheres to the specification of manufacturing the
product. If a product does not meet the specifications, than it implies
nonconformance to quality. This nonconformance is measured by the number
of defective products. Total quality management emphasizes manufacturing
products with zero defects. Emphasis is also laid on detecting the problem at
the initial stage because if the defect is detected at a later stage, then it results
in cost penalty for the organization, which at times can damage the reputation
of the firm. Therefore, the earlier a defect is detected; the lower will be the
cost penalty.
Total Quality Management Approach

The total quality management approach can be looked at from three aspects:
responsibility for quality, product design and relationship with suppliers.
Responsibility for quality
The traditional view held that most defects occurred at the factory floor and
that workers were primarily responsible for them. Hence, the quality control in
the traditional method involved inspecting the quality of the products. This
was a tedious process and entailed setting up a quality control department.
This led to a frequent conflict between the manufacturing department and the
quality control department. The main objective of the manufacturing
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department was to maximize output; the quality control department was

responsible for detecting problems. Thus, coordination among the various
departments became a major problem for the management. This problem was
eliminated to a large extent by using the total quality approach. According to
the total quality control approach, the responsibility for quality should be
shared by all departments as quality is the responsibility of every single
department. According to this view, most quality problems occur even before
the product reaches the factory floor.
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According to Edward E. Deming, Quality is the responsibility of the

management and not the workers and management must foster an environment
for detecting and solving quality problems. The production process in an
organization can be divided into two parts: the system that is under the control
of the management and workers who are under their control. Of the quality
problems that arise in an organization, 85 percent can be attributed to the
former while 15 percent to the latter. The system that is under the control of
management can be faulty due to several reasons like ineffective
manufacturing processes, inferior raw materials, poor working conditions etc.
Product design
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The total quality management approach thus, emphasizes ensuring quality

while the product is being manufactured rather than inspecting it for quality
after it has been manufactured. Most of the quality problems can be avoided
by identifying the errors at an early stage. Exhibit 11.1 illustrates the quality
control process implemented at Toyota. Employees in every department
should ensure that they do not pass on a defective product to the next stage of
production. Also, the function of the quality control department should not
just be related to inspecting the product after it has been manufactured but
inspecting and monitoring the production process. This will eliminate most of
the defects.
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Most of the quality problems arise in the early stages mainly during the
designing of the product. These problems occur when the designers do not
work closely with the production people, who are familiar with manufacturing
problems. Under total quality control, there is an effort to coordinate the
activities of designers and the production engineers. While designing a
product, the preference of the customers should be given due consideration.
For this it is important that the marketing department and design department
work in close coordination.
Relationship with suppliers
In the traditional method, contracts were awarded to those suppliers who
placed the lowest bid. But in total quality management, the supplier is selected
not just on the basis price but also the quality, and its timely delivery of the
product. Thus, instead of having many suppliers, one or two suppliers are
selected and a long term relationship is established with them.

The management can ensure the quality of its products by focusing on two
aspects-the financial and non financial.
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Exhibit 11.1
Quality Control at Toyota
The cornerstone of Toyotas quality control system is the role of the team members
in the production process. The team members in the Toyota plant are encouraged to
play an active role in quality control. Employees ideas and opinions are utilized in
the production processes, and they are encouraged to practice kaizen striving for
constant improvement. Every team member in the Toyota plant treats the other
member as a customer. This way they ensure that no defective product is passed on
to the other team members. If a team member finds a problem with a part or the
automobile, the team member stops the line and corrects the problem before the
vehicle goes any farther down the line.
The planning stage is an important stage where the employees emphasize on
manufacturing defect free products. Quality is designed in the automobile with
the help of advanced design techniques like computer-aided design that helps in
improving the quality. This stage also emphasizes developing a product that is
defect free. Quality control involves close cooperation of many production
departments.
Toyotas quality control during production ensures that the correct materials and
parts are used and fitted with precision and accuracy. This effort is combined
with thousands of rigorous inspections performed by team members during the
production process. The team members are responsible for any defects in the
products they use as they are the inspectors of the products they use. To ensure
that the product is defect free a quality audit is done that ensures that the product
is manufactured as per quality standards.
Encouraging and rewarding people form an important system in quality control.

Members in Toyota are rewarded for providing suggestions. Through Quality
Circles and a suggestion system that rewards employees for ideas, team members
strive to achieve the Toyota principle of kaizen, or continuous improvement. At
any time during the production process, any team member who spots a problem
can stop production by pulling the and on cord located next to the assembly
line. And on cord lets supervisors know the location of the problem with a
blinking light and a distinct musical tone.
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Source: www.toyotageorgetown.com
Financial measures
In the financial measures, the costs of doing things wrong are estimated and
aggregated. There are certain costs associated with quality management:
prevention, appraisal, internal failure costs and external failure costs. The
total cost of quality for a firm is the sum of the four costs described below:
Preventive costs
These are costs incurred to make products defect free the first time they are
manufactured. It includes quality engineering, receiving inspection, preventive
maintenance, the estimated fraction of manufacturing engineering and design
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engineering. All these ensure prevention of defects and encourage quality

training.
Appraisal costs
These are costs incurred in assessing the level of quality in the manufacturing
system. It includes technical services laboratory, design analysis and actual
inspection costs.
Internal failure costs
They fall into two major categories: yield losses (if a defective item has to be
scrapped) and rework costs (if an item is routed to previous operations).
External failure costs
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These arise when a defect is discovered after a customer has received a

product or service. The costs include cost of returns, marketing expenses
dealing with returns, repair costs etc.,
Total cost of quality and reporting can provide several benefits for an
organization.
It helps the management to analyze the costs that are incurred as a result
of poor quality. If these costs form a high percentage of total profits, the
management would need to take corrective actions and adopt total quality
control at the earliest.
These reports can help the management to understand the relationship

between preventive and failure costs. Specific programs to improve
quality can thus be designed.
These reports guide the workers and also the management to work
towards quality goals.
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Nonfinancial measures
These relate to collecting nonfinancial information about the number of
defective units delivered by each supplier, number and frequency of late
deliveries, number of customer complaints, warranty claims, machine
breakdowns, number and frequency of product returns. The major advantages
of non financial measures are:
They can be reported on a daily basis
Corrective actions can be taken everyday.

Thus non financial measures are important to provide continuous feedback to
managers and workers improve quality.
COMPUTER INTEGRATED MANUFACTURING

It is a term used for the total integration of product design and engineering,
process planning and manufacturing by means of complex computer systems.
Expensive computer systems are used to link various stages of production.
These systems automatically schedule manufacturing tasks, and keep track of
the availability labor. Then they send instructions to computer screens at
various workstations along the assembly line. The implications of such
systems for management control are:
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They increase the task control for managers as these systems convert
certain production activities that once required management control to
task control. Hence, managers no longer have to supervise the work of
their employees. They are required to handle only unusual situations.
The information provided by these systems is accurate and detailed.

However, the designers are sometimes overloaded with information and
have difficulty in deciding the amount of information they should report to
managers. The solution to such a situation is to provide a small quantity of
information routinely and permit the manager to access a large database
for other information.
Some systems are built around work teams that are responsible for all
operations. Employees are rewarded on the basis of their contribution to
the work team in terms of achieving the quality and quantity.
In team approaches, the business unit controller is primarily responsible

for assisting the business unit manager in planning and controlling the
unit's operations.
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The term decision support system is broadly used for systems that aid
decision-making by providing the answers to a series of what-if questions.
Decision support systems include expert systems, natural language systems,
artificial intelligence systems, and knowledge-based systems.
Nature of Decision Support Systems
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If-then rules or decision rules that show how an expert in the area would
solve a problem, given a certain set of facts, make up a decision support
system. The relevant information is provided by a series of questions
answered by the decision maker. These questions are asked in plain English
and does not require any knowledge of computer programming. That is why
they are called natural language programs. A course of action is then
suggested by the computer. Decision support systems are so called because
they help the decision maker to arrive at a decision. The decision maker,
however, is free to reject the computers recommendation, or to modify it.

With the use of decision support systems, the need for managers may be
reduced as they can convert management control activities into task control
activities. Managers may also be able to spend a larger fraction of their time
on other problems.
On the one hand, decision support systems can increase the quality of
decisions and reduce (or even eliminate, in some cases) the time that is
required to take them. On the other hand, they permit many types of decisions
to be made by the computer or by lower-level personnel. Decision support
systems thus, reduce the level of expertise required and, in some cases,
eliminate jobs entirely.
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SUMMARY
Operations management is being increasingly recognized, at the strategic
level, as a potentially rich source from which competitive advantage may be
leveraged. To control such a process and make it work effectively, managers
use various types of information. The simplest is management by walking
around.
Formal methods through which a manager controls performance include task
control information, budget reports and signals. Internal audit is an important
method to assess whether the manager is performing as expected by the
organization. Apart from financial information, a manager should also have an
idea about the non-financial information that is necessary to achieve the
organizational goals.
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Recent developments in operations management have helped companies to

increase quality at lower costs. Just-in-time is one philosophy that is used to
reduce inefficiency and unproductive time in the production process.
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Total quality management is a management concept that has gained

tremendous importance in continually improving operations management
processes and products. The other developments include computer integrated
manufacturing and decision support systems.
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Chapter 12
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Continuous Process
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Improvement Methods
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Target Costing
Benchtrending and Benchmarking
Quality Improvement: Process Quality Teaming
Activity Based Costing
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With more and more companies focussing on quality management and

customer satisfaction, Continuous Process Improvement (CPI) methods have
assumed great importance. Continuous Process Improvement (CPI) is the
philosophy of running business in such a way that every member of the
organization is encouraged to continuously strive to serve the customer more
efficiently.
The objective of CPI is to sustain continuous improvement within an
organization and align improvement activities to support strategic objectives.
This is done through modification in all processes, procedures and task
content. Efforts are also made to enhance product quality while maintaining
time schedules.
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However, as a methodology for achieving long-term objectives CPI has some

limitations. As it does not lead to major technical breakthroughs or
innovations, companies which excessively depend on CPI are likely to lose to
other companies which are more innovative. Conversely, companies that rely
only on technical innovations may soon lose to other companies that may take
to innovation and then continue to refine products and reduce costs through
CPI.
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Innovation and CPI require different approaches and therefore, have

different requirements. While, innovation relies heavily on technical staff,
business and investment plans, CPI requires a supportive culture, extensive
training and continuous managerial support.
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To ensure success, the management should introduce various tools and

techniques to facilitate CPI. It should focus upon improvement in the quality
of processes, the cost of operations, and the strategic planning process.
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The management must concentrate on three improvement methods: target

costing, benchmarking and benchtrending, and process quality teaming. The
successful implementation of these methods requires a reasonable
understanding of the philosophy, focus and techniques of total quality
management and an analysis of the entire business environment. Activity
based costing and the balanced scorecard can also be useful for CPI.
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TARGET COSTING
Target cost is the maximum manufacturing cost of a product. Target costing is

done to encourage various design and production departments to find less
expensive ways of achieving similar or better product features and quality. It
is decided after analyzing market niches, assessing customer requirements,
understanding cost drivers, determining elasticity of demand, and analyzing
volume-cost relationships. It is calculated by subtracting the expected market
price from the required margin on sales.
Target costing goes through three stages. They are:
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Planning stage
Development stage
Production stage
Continuous Process Implementation Methods
Planning Stage
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Traditionally, after determining the type of product to be manufactured, the

management assigned its development to the Product Design Department
(PDD). After finalizing the design, it was sent to the costing department for
assessing its costs. The costing department often found it expensive to
produce. The design then came back to the design department with
instructions to reduce costs, usually by compromising on the quality of the
product. The product design was sent back and forth between the costing and
design department till both the departments arrived at a consensus. The
product was then sent to the manufacturing department and the manufacturing
department also often declared that it was impossible to manufacture the
product as proposed. It was then sent back to the design department. Because
of these long procedures, lot of time, money and effort were wasted. All this
had a negative impact on the productivity and profitability of the organization.
Target costing helps eliminate such problems.
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Before establishing a reasonable target cost, a market research is conducted to

determine what the competitors are doing. Their products are analyzed with
regard to price, quality, service and support, promotion, work culture and
technology. Once this is done, the important features of the product are
finalized by conducting surveys and identifying consumer preferences.
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The researcher should then determine the significance of various features of

the product manufactured by the company so as to, locate a niche market
where it may have some competitive advantage. Once, this is done, a target
cost is set that is close to that of competitors' products.
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Development Stage
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After an in-depth study of the competitors products and the market has been
done, the design department takes care of the design aspects of the product by
analyzing the best possible designs. Thus, the company identifies the cost
associated with the best possible design as per the internal cost structure of the
company. The company also tries to reduce the internal costs by analyzing the
internal cost structure of its own products and comparing it with the cost
structure of its competitors. The activity based costing (ABC) approach is
generally used to estimate the cost structure. Under this approach, the
activities related to the product are identified and costs are estimated using
multiple cost drivers. Once the cost information is available, the product
development team can generate cost estimates under different situations. The
designers, manufacturers, marketers, and engineers should conduct a
brainstorming session to generate ideas on how to substantially reduce costs or
add different features to the product without increasing target costs. Finally,
they come up with a complete model of the product, to be manufactured.
Production Stage
Planned production schedules, Just-In-Time (JIT) techniques are helpful in the
production phase of target costing. Target costing becomes a tool for reducing
costs of existing products if production is carried out with perfect planning
and optimal cost-effective processes that are planned are followed carefully.
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This makes it easier for the organization to produce the product at a relatively
low and desired price. Target costing ensures less expensive means of
production with an even flow of goods.
Benefits of Target Costing

The benefits of target costing are:
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a) Target costing provides detailed information on the costs involved in

producing a new product. It is a better way of estimating different cost
scenarios by using activity based costing.
b) Target costing reduces the development cycle of a product by reducing the
wastage of time and resources and identifying the additional costs at an
early stage of product development.
c) Target costing provides an excellent understanding of the dynamics of
production costs by using activity based costing and it suggests different
ways of reducing non-value added activities, and simplifying the
production process and costing procedures.
d) Target costing increases the profitability of new products, by reducing
manufacturing costs and improving quality. Through the use of surveys
the preferences of consumers are identified and products are manufactured
according to consumers requirement.
e) Target costing forecasts the future costs and motivates the management
and the employees to meet the future cost goals.
f) Target costing helps in controlling the costs even before the company has
incurred any production cost. Thus, a great deal of time and money is
saved during the design phase.
However, estimating target the target cost for complex products (that may
require subassemblies) becomes difficult.
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BENCHMARKING AND BENCHTRENDING
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Benchmarking is a continuous process of comparing products and operations

against the best practices in the industry. The general benchmarking process is
shown in the Exhibit 12.1
The process of benchmarking consists of four sub-processes:
(a) Planning the variables to be benchmarked.
(b) Analyzing the current and projected gap in performance.
(c) Communicating the benchmark standards to operating personnel and
establishing internal goals.
(d) Developing implementation plans.
All these processes are carried out in two phases, namely: the planning phase
and the analysis phase.
Planning Phase
The first step in planning is to identify the products or services that the unit
provides. The next step is to identify companies whose performance
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Exhibit 12.1
Generic Benchmarking Process
Benchmarking Process
Benchmark
Practices
Benchmark
Practices
How to Close the Gap
Improved Knowledge
Improved Practices
Improved Processes
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Benchmark Gap
How Much
Where
When
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Employee Participation
Superior Performance
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Source: Joseph A Maciariello and Calvin J Kirby, Management Control Systems, (USA: Prentice Hall
Inc, Second edition) 498.
constitutes the best practices for a product or service. The best practices can be
identified through internal and external sources, professional associations,
libraries, journals, universities, and consultants from related industries.
Analysis Phase
The purpose of conducting an analysis is to determine the current gap in
performance between the internal operations currently being followed and the
best practices. This helps the management to project the gap in the future.
Benchmarking studies provide useful information about the gaps in
competitiveness for an operation or process at the time the study was
conducted.
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Benchtrending
The techniques involved in benchtrending are similar to the ones used in
benchmarking. The only difference is that benchmarking has a new structural
dimension. The study of benchtrending includes a projection of the critical
market conditions and the consumer preference variables. These studies
identify consumer preferences, new entrants, innovation threats, and other
market critical variables for the long-run success of the firm.
By the time the performance gaps have been bridged by a company,
competition will move forward, creating new gaps in other areas.
Overshooting the gaps in anticipation of improved competitor performance
can bring in new problems that can affect competitiveness in different ways.
This can be avoided by identifying important trends in the process and
evaluating their impact through the process of benchtrending.
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Strategic benchtrending
These methods are used to give a direction for a business unit and set longterm goals and objectives. A study team is formed with representatives from
marketing, business development, and engineering department.
The process of strategic bench trending comprises of the following steps:
1) Firstly, the market is defined by determining its size, customer
preferences, competitors and relative business position of the company
within the market.
2) The industry direction, technology shifts, geopolitical changes, consumer
changes, and potential threats from outside sources are assessed.
3) The strongest current and potential competitors are then determined by
evaluating the trends in the industry.
4) Data on the performance of competitors is gathered and the current and
future performance of the business unit is compared with that of its
competitor.
5) A performance baseline for the business units is then established, and
estimate relative performance for the current and projected competition.
6) A set of initiatives which form the basis of an improvement plan are
identified to maintain strengths while reducing projected gaps.
Process Benchtrending
If a company wants to improve a specific function or process, process
benchtrending methods are used. For example, a unit that produces electronic
circuit boards might want to improve its quality testing process. This involves
a process benchtrending study.
A typical process oriented unit would use the following steps:
1) Understanding the requirements of the process that is to be bench trended.
2) Understanding the process flow. For a clearer understanding, flow charts,
procedures and quality control parameters can be used.
3) Identifying and evaluating the specific objectives of the benchtrending

project.
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4) Identifying the benchtrending methods being adopted by different

companies and studying companies that could pose a threat in future.
5) Choosing practices that would be best suited for the organization.
6) Determining specific process gaps.
Communication and integration
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Benchmarking and benchtrending programs can be sustained only through a

formal and informal communication. Formal methods are used to acquaint the
employees of the organization with the logic of the goals and its competitive
necessity. Benchmark findings must be communicated to the people so that
they consider themselves a part of the organization and are motivated to
perform better. Informal networks should also be established to share the
examples of successes, to discuss problems, and to provide assistance in
attaining goals. Rewards and informal recognition programs should be
instituted to encourage employee communication and integration.
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Implementation
In the implementation stage, action plans are designed to attain the desired
goals. Teams are formed and responsibilities are assigned; tasks are specified
& sequenced, resources are allocated, and results are monitored.
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The organization can follow either line organization or project organization to

implement benchmarked goals.
QUALITY IMPROVEMENTS: PROCESS QUALITY TEAMING
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Traditionally, superior quality has been associated with higher costs.

Managements spend heavily to achieve high quality, but they virtually do
nothing to cut down their costs. Now, the paradigm for improving quality has
changed. Process Quality Teaming has become a popular concept, as it
combines several successful total quality techniques into a cybernetic control
system with features like feedback loops, action plans, and environmental
scanning.
Given the general structure of process quality teaming, it can be applied, with
minor modifications, to various situations. This method is effective in
improving organizational yields as long as customer and suppliers are satisfied
with the management. In the generalized structure of a quality process, as
shown in Exhibit 12.2, the control loop involves:
i)
Sensing the environment-either the customer or the current yields.
ii) Detecting the gap between expectations and results.

iii) Performing an analysis to determine appropriate action.
iv) Assigning actions.
v) Returning to step (i) by sensing the customer's needs or observing the
yields.
This cycle is repeated several times and each time an improvement results.
This structure is applicable to almost any service, production, or support
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Exhibit 12.2
Quality Process Team Cybernetic Decision Structure
Goals
Process Limits
Improvement
Objectives
Expectations
Environment
Customer
Needs
Comparator
Cause/Effect
Analysis
Perception
Team Reviews
Feedback
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Sensor
Process Control
Charts
Yields
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Action List
Due Dates
Actions to
Maintain Control
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process. The key is to focus on improving processes that are used to produce
the output.
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We shall take a manufacturing unit as an example to discuss the

implementation of a process quality teaming. Process quality teaming in a
manufacturing unit involves coordination of the efforts of the management,
support personnel, and workers.
The steps involved in this process are:
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a) The management selects a unit, say, a manufacturing department, within

which quality improvement teams are formed, the output to be improved
is determined and based on this inputs to the process are added.
b) A team of people from all key departments of the firm is formed.
c) The responsibility of each department is clarified. The responsibility of
ensuring quality should lie with the production supervisors and workers
who are directly involved in manufacturing the product.
The next four steps together constitute a closed-loop corrective action system.
The team tries to identify specific customer requirements. In some cases,
maintaining high quality may be critical, while in other cases, reliability is
extremely important.
The further steps in this process are the following:
a) Making a flow chart the process. At each step, critical control parameters
and associated measurements are noted.
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b) Establishing appropriate process control limits for each step in the

process.
c) Running the process normally, and calculating the output after the
completion of the major steps
d) Performing a cause and effect analysis of the major problems, and
determining a specific corrective action. Comparing the current yields to
the Process Control Limits (PCL).
The implementation of effective CPI methods may be difficult. It requires
many other quality tools. Each of these tools may have its own limitations.
Therefore, the management should have a good understanding of the various
tools.
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ACTIVITY-BASED COSTING
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In the last few decades, there has been a number of changes in the collection
and utilization of cost information because of increased computerization and
automation in factories. Traditionally, costs were allocated to products, based
on the direct labor hours. But today, companies presently are emphasizing on
separating material-related costs from other manufacturing costs. The
manufacturing costs are collected separately for individual departments and
individual machines which perform a series of operations that are finally
integrated to get the final product. Here, the direct labor cost is added to the
other costs which results in conversion costs. Conversion costs is constituted
of the factory and labor overhead costs of converting raw materials into
finished goods. The newer cost systems also include the administrative
expenses, R&D expenses and marketing costs. These systems use multiple
allocation bases. Here the word activity is used to represent cost center
and cost driver, and not the basis of resource allocation. Hence, this cost
system is termed as activity-based cost system. (ABC).
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As a strategic planning tool, ABC helps in understanding the effectiveness and

efficiency of products. It has a number of strategic and tactical uses in an
organization. It helps to:
Identify the values of the organizations activities, business segments, etc.,

through a comprehensive understanding of costs and related dynamics to
help organization's focus attention on target outcomes;
Identify opportunities to effectively use delivery channels to enhance

outputs;
Differentiate between activities provided to different customer segments
Identify incremental operating expenses in order to support growth
Identify cost management opportunities
Provide information to improve process efficiency.
Traditional Costing vs. Activity Based Costing (ABC)

The differences between traditional costing and activity-based costing are the
following:
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Exhibit 12.3
Contrast in Product Costing
A. Traditional Costing
Product Cost
Direct
material
Direct material
Direct Labor
Direct labor
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Production cost
centers (few in
number)
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Factory overhead
Allocated on basis of
direct labor or
machine hours
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Factory overhead
cost centers
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Source: Robert N Anthony and Vijay Govindarajan, Management Control Systems (Irwin
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The traditional cost management systems allocate service overhead costs to

services or departments, primarily to distribute the overhead cost for financial
reporting purposes. Costs are allocated by a single step process, with the costs
per service or customers as the basis. Such methods often produce inaccurate
and misleading information. Traditional costing systems take a general view
of the costs incurred by all the departments. They fail to understand that costs
for each department are marked by unique characteristics. Exhibits 12.3 and
12.4 represent the differences between traditional and activity- based costing.
ABC systems focus on the activities performed by each department and
allocate costs on the basis of this. An ABC system can gauge the amount of
resources that are consumed by individual cost centers and customers, and by
the activities and processes that deliver the products and provide services to
customers. ABC identifies activities undertaken in an organization, and
determines their cost and performance. Let us take an example to clearly
understand the difference between traditional costing and ABC.
Consider a college, where the major activities of the student administration
department involve looking after the administrative activities of the students.
The costs of students passing out is at Rs. 50,000 pa, paying salaries
(Rs.35,000), spending on occupancy (Rs.10,000) and others (Rs. 5,000).
During the year in which 500 international students graduated, the number of
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Exhibit 12.4
Activity-Based Costing
Production cost
Material
Material
Direct Labor
Conversion (labor and

overhead)
Production
cost centers
(many)
Non-manufacturing
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activities
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Many bases
of allocation
(cost drivers)
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(Design R&D, G&A Marketing,

Distribution
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Source: Source: Robert N Anthony and Vijay Govindarajan, Management Control Systems
(Irwin Publications, Eighth edition) 333.
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undergraduate was 300, that of industry funded graduates was 100,

postgraduate students who paid the regular fees were 100 in number. A
traditional costing approach would have failed to capture the cost of the
activity (Rs 50,000) understand the activity cost driver (the number of
graduates), highlight the unit true cost of the activity (Rs 100 per graduate),
accurately assign this cost to the various types of student and understand
which type of students being served by this activity.
Traditional cost accounting vs Activity-based Costing
Traditional cost accounting
Salaries
On costs
Consumables
Travel
Depreciation
Rs 2,00,000
20,000
80,000
20,000
80,000
Total
Rs.4,00,000
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Activity based costing

Enrolling students
Rs. 1,00,000
Designing a new course
50,000
Teaching Subjects (specific)
1,50,000
Tutoring students
20,000
Assessing students
30,000
Graduating students
50,000
Total
Rs.4,00,000
SUMMARY
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Continuous improvements in performance is increasingly being emphasized in

most organizations. Continuous process improvement (CPI) is the philosophy
of running business, and striving for perfection. The objective of CPI is to
align the improvement activities to support the strategic objectives, to serve
the customer more efficiently. There are three CPI methods- target costing,
benchmarking and benchtrending, and process quality teaming.
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Target costing aims at reducing the costs of a product over its life cycle,
especially design-related costs. It is a market-driven design methodology. It is
carried out in three phases-planning, development and production.
Benchmarking is a continuous process of comparing a company's products
and operations against the best practices in the industry. This can only be done
with proper planning and analysis. In benchtrending, a projection of the
critical market and consumer structural variables are made, if a company
wants to improve a specific function or process. To bring about overall
improvement, process quality teaming is undertaken. The implementation of
effective CPI methods may be complex. The management should have a good
understanding of the total improvement process, a support culture, and
providing abundant personnel support.
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There have been a number of changes in the methods for collection and for
use of cost information because of increased computerization and automation
in factories. Activity-based costing is one such method that helps to prioritize
and quantify improvement methods. It is suitable for todays companies.
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PART V:
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MANAGERIAL COSTING
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Chapter 13
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Evolution of Strategic Cost Management
Three Key Themes of Strategic Cost Management
Strategic Management and Strategic Cost Analysis
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Amazon.com, US-based internet retailing major, is known for its low costs
and excellent customer service. It not only created a new business model but
also made sure that the model worked. While many firms that had adopted a
similar internet-based retailing model perished, Amazon.com made sure it
survived. There were two main reasons for its survival: comparatively low
cost and excellent customer service.
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To survive in the market, a company has to provide excellent service at a

comparatively low cost. The internal accounting department of a company
plays a vital role in cost management. It provides all cost information on a
timely basis. This information forms the basis for the companys future
strategies. Companies have started using cost management as a strategic tool.
The focus of cost management has shifted from product costing and financial
reporting to the development of cost information to help management achieve
strategic goals. Hence, cost information is vital not just for achieving
operational efficiencies but also for the long term growth of the company.
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The application of costing information to the development and

implementation of a firms strategy is called strategic cost management
(SCM). In a broader sense, SCM can be defined as the, managerial use of
cost information explicitly directed at one or more stages of the strategic
management cycle. The four stages of the strategic management cycle are:
formulation of strategies, the communication of those strategies throughout
the organization, the implementation of those strategies, and the evaluation
and control of the strategies that have been implemented.
EVOLUTION OF STRATEGIC COST MANAGEMENT
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The change in business processes has made it imperative for companies to

change the focus of their costing systems. Initially, costing was done mainly to
account for product costs and other overheads. Costing was thus like a control
measure that enabled line managers to keep costs under control at the
departmental level. Rapid changes in the business environment and
corresponding changes in product and manufacturing processes forced
companies to adopt a more proactive and strategic approach towards costing.
They realized that costing systems should be flexible enough to support
changes in the business environment and help management take better
strategic decisions.
Strategic Measures of Success

Strategic cost management systems produce financial as well as non-financial
information. Financial information includes figures pertaining to sales, cash
flow and stock price. Non-financial information consists of details such as
market share, product quality, customer satisfaction and growth opportunities.
Financial information indicates a firms current financial position, whereas
non-financial information indicates a firms competitive position. The
competitive position is assessed on the basis of customer satisfaction, internal
business processes and innovation and learning. Financial and non-financial
measures together constitute Critical Success Factors. These factors are
essential for a firm's growth and success.
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Exhibit 13.1
Harnessing the Value Chain
Manufacturers such as Boeing and General Electric also use the value-chain concept to
find profits downstream. For example, Boeing offers a number of products and
services in addition to the aircraft it manufactures: financing, local parts supply,
ground maintenance, logistics management, and pilot training. In the cyclical industry
in which it operates, Boeing can earn profits from them during the slack
manufacturing times.
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General Electric has connected its locomotive manufacturing business to its financing
unit, GE Capital, to provide customer financing for not only locomotives but also
boxcars and other rail assets. Other GE units profit by refurbishing and reselling
boxcars and by developing advanced rail tracking systems. In effect, GE finds
providing a broad range of services to the locomotive customer more profitable than
only manufacturing.
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Source: Orit Gadiesh and James L. Gilbert, Profit Pools: A Fresh Look at Strategy,
Harvard Business Review, MayJune 1998, pp. 13947;
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Strategic cost management combines three strategic management themes. The

three themes are:
Value chain analysis
Cost driver analysis
Strategic positioning analysis
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Value Chain Analysis
In the following sections we will discuss all the three themes in detail.
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Value chain analysis is a strategic analysis tool that can be used to identify
areas in which value can be enhanced for customers or costs can be reduced.
Value chain analysis thus helps a firm gain competitive advantage (Refer
Table 13.1 for the value chain of the computer manufacturing industry).
According to Michael Porter, the value chain of a company is the linked set of
value-creating activities, all the way from basic raw material sources for
component suppliers through to the ultimate end product delivered into the
final consumers hands. The Value chain of a manufacturing firm differs from
the value chain of a services firm. The value chain of a manufacturing firm
includes activities like design and acquisition of raw materials, manufacturing,
assembling, testing, packaging, warehousing, distribution, retail sales and
customer service. Every firm can split its operations into a number of
activities to analyze its value chain and to identify areas that require
improvement.
Value chain analysis is centered around a product or service and encompasses
all the activities taken up for delivering it. An individual firm positions itself
at some point in the value chain, depending upon the competitive advantage it
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Table 13.1: Value Chain for Computer Manufacturing Industry

Step in the Value Chain
Activities
Expected Output of
Activities
Step 1: Design
Performing research and

development
Completed product design
Step 2: Raw materials

acquisition
Mining, development and

refining
Silicon, plastic, various

metals
Desired components and
parts
Stage 1:
Converting, assembling
Chips processors other

basic components
Stage 2:
Finishing testing and

grading
Motherboards and higher

level components
Step 4: Computer
manufacturing
Final assembling,
packaging and shipping
the final product
Completed computers
Step 5: Wholesaling
warehousing and
distribution
Moving products to retail

locations and warehouses
as needed
Rail truck and air

shipments
Step 6: Retail Sales
Making retail sale
Cash receipts
Step 7: Customer service
Processing returns,
inquiries and repairs
Serviced and restocked

computers
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Step 3: Materials assembled Converting raw materials

into components and parts
into components
used to manufacture the
computer
Source: higheredmcgrawhill.com
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can have over other firms. For example, in the computer hardware industry,
there are a number of players who occupy different positions in the value
chain depending on their core competency. Texas Instruments manufactures
chips, Intel manufactures processors, Seagate manufactures hard drives, IBM
purchases manufactured components, assembles them and sells them.
Value chain analysis consists of three steps:
Step1: Identifying value chain activities
Step2: Identifying the cost driver(s) at each value activity
Step3: Developing a competitive advantage by reducing cost or adding value
Identifying value chain activities
In the first step of value chain analysis, a firm identifies all the activities in its
value chain1. The value activities differ from industry to industry. For
example, in the service industry the focus is on operations, advertising and
promotion rather than purchasing raw materials and manufacturing. All the
1
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The activities that are necessary to convert raw materials into final products are called value
activities.
value activities should be identified and differentiated from other activities to

such an extent that they can be regarded as separate business activities.
Identifying cost drivers at each value activity
Any factor that changes the level of total cost of a product or service is called
a cost driver2. In this step, those activities that have potential for cost
reduction are identified. For example, in an insurance company the costs of
data entry and recording can be reduced. Insurance companies can find ways
to reduce costs in this area. They can also outsource this activity to someone
who can provide the service at a lower cost.
Developing a competitive advantage by reducing cost or adding value
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In the final step, firms conduct a detailed study of the value activities and cost
drivers that have been identified earlier to determine the nature of current and
potential competitive advantage. This helps the firm improve its strategic
positioning. In addition, analysis of value activities also enables the firm to
identify areas in which the company can provide greater value. For example,
Wal-Mart uses high-end computer technology to coordinate with its suppliers
to quickly restock its stores. This enables it to maintain optimum stocks of all
products and thereby reduce inventory costs. Companies like Sony, Compaq
and Cisco have tied up with Flextronics International Ltd, Solectron Corp. and
SCI Inc. respectively for supply of various computer parts and subassemblies.
These companies realized that outsourcing some of the manufacturing would
reduce costs and improve speed and competitiveness.
Cost Driver Analysis
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Every activity in the value chain is associated with a cost. During value chain
analysis, companies try to identify various activities for reducing costs. Cost
driver analysis is used to quantify the cost of poor quality and determining the
root causes of poor quality or high costs. It is a useful technique that integrates
the problem-solving and analytical tools for quality and process improvement.
Cost driver analysis combines these tools and techniques to generate
information needed to reduce costs and improve the overall financial
performance.
Daniel Riley3 has categorized cost drivers into two types: structural cost
drivers and executional cost drivers.
Structural cost drivers
There are five structural cost drivers: scale, scope, experience, complexity,
and technology. Refer Table 13.2 for the various structural cost drivers, their
implications, and the ways in which a company can control these cost drivers.
A cost driver is a factor that causally affects costs. For variable costs, a change in the level
of activity or volume would result in a proportional change in cost. Fixed costs have no
short run cost driver but may have a long run cost driver.
Competitive Cost Based Investment Strategies for Industrial Companies, manufacturing

Issues (Booz, Allen, Hamilton, New York, 1987).
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Table 13.2: Structural Cost Drivers
Scope
Experience
Complexity
Technology
Controlling structural cost

drivers
Take
decisions
concerning Develop scale economies to
investments in manufacturing, control costs
R&D and marketing
Decide on the degree of vertical Enhance vertical integration;
integration needed
otherwise outsource
Identify the repetitive tasks
Enhance employee learning
and experience
Decide about product line and Find sharing opportunities
number of products
with other business units in
the enterprise
the
use
of
Take decisions pertaining to Optimize
technologies to be used at every technology between value
chain activities
stage of value chain
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Scale
Implications
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Cost Driver
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Executional cost drivers
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Executional cost drivers determine a firms cost position, which in turn

depends on the firms ability to execute value activities successfully. Some of
the basic executional drivers are:
Commitment of workforce to continuous improvement
Managements attitudes towards quality
Cycle time for getting new products to market
Firms utilization of existing capacity
Proper design of internal business processes
Managements ability to work efficiently with suppliers and/or customers

to reduce costs
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Strategic Positioning Analysis

The third important theme of strategic cost management is strategic
positioning or strategic competitive analysis. Michael Porter, in his book
Competitive Strategy, states that a firm can choose to compete in the market
either on the basis of cost or differentiation. This means that in order to remain
competitive, a firm has to offer its products either at a lower cost or with a
greater number of features.
Cost leadership
If a firm produces its products or services at a cost lower than its competitors,
then the firm is said to be following a cost leadership strategy for gaining
competitive advantage. To make sustainable profits, such a firm depends on
high sales. A company that follows cost leadership strategy has a large market
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share and uses its price advantage to attract customers. Such a firm limits the
growth of profit margins within the industry. A company can afford to adopt a
cost leadership strategy only when its productivity is high and its
manufacturing processes run smoothly. In addition, its selling and distribution
costs must be low and its administration expenses should be minimum.
Examples of companies that practice cost leadership are: Texas Instruments,
Wal-Mart and Compaq (before its merger with HP). Companies that adopt this
strategy often do not spend much of R&D. As a result, their products may
become obsolete.
Differentiation
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Firms that adopt a differentiation strategy try to make their customers feel that
their products are different, qualitatively superior and have a greater number
of features than the competitors products. This strategy allows a firm to
charge a higher price for its products and thereby make profits without major
cost cutting. Most firms in the automobile, telecom, and consumer electronics
industry use a differentiation strategy. Some of the companies that have
adopted this strategy are Rolex, Bentley, Tiffany and Mercedes-Benz. Firms
that follow this strategy tend to undermine the importance of cost reduction. If
customers do not perceive a great difference between a lower cost product and
the firm's product, the firm may lose market share. Table 13.3 shows the
differences between cost leadership and product differentiation in terms of
strategic emphasis and control.
Table 13.3: Conventional Management Accounting Versus Strategic Cost
Management
Paradigm
In terms of products,
customers
and
functions. It has a
strong internal focus
and believes in value
added concept.
In terms of various stages in

the value chain. It has an
external focus and value
added concept is supposed to
be a narrow concept.
What is the objective of

cost analysis?
The objectives are

scorekeeping, attention
directing and problem
solving
Apart from these objectives,

the SCM system changes
depending on the basis of
strategic positioning
How
should
understand
behavior?
Cost is a function of
output volume. It is
cumulative figure of
variable cost, fixed
cost, step cost and
mixed cost.
Cost is a function of strategic

choices. Its mainly to do
with managerial skills needed
in executing choices i.e.
Structural costs drivers and
executional cost drivers.
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Conventional
Management
Accounting Paradigm
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Which is the best way

of analyzing costs?
one
cost
Source: John K.Shank, Strategic cost Management: New Wine, or Just New Bottles, Journal
of Management Accounting and Research, Fall 1989.
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STRATEGIC MANAGEMENT AND STRATEGIC COST ANALYSIS

As already discussed, strategic cost management combines three strategic
management themes: value chain analysis, cost driver analysis and strategic
positioning analysis. These themes can be used by managers as tools for
gaining competitive advantage. For each of these themes, conventional
management accounting does not provide the needed financial analysis
support for successful implementation of strategies.
Strategic cost management evolved because conventional management
accounting was not able to cater to the information needs of top managers.
When costing techniques were used along with strategic management tools, a
paradigm shift took place in the field of strategic management.
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Management accounting and Strategic Cost Management differ in three ways.

First, in the way costs are analyzed; second, in the objective behind
conducting cost analysis; and third, in the way cost behavior is understood
(Refer table 13.3 for differences between management accounting and SCM).
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SUMMARY
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The application of costing information for developing and implementing

strategies in firms is called strategic cost management. Strategic cost
management combines three strategic management themes: value chain
analysis, cost driver analysis, and strategic positioning analysis. Value chain
analysis is a strategic analysis tool that can be used to identify areas in which
value can be enhanced for customers or costs can be reduced. All the activities
of a value chain have costs associated with them. The process of driving up or
down the cost of value chain activities is called cost driver analysis. Cost
drivers can be of two types: structural cost drivers and executional cost
drivers. There are five structural cost drivers: scale, scope, experience,
complexity, and technology. Executional cost drivers are those drivers that
determine a company's ability to execute value activities. Strategic positioning
refers to the way in which a firm positions itself against its competitors in the
market. A firm can choose to compete in the market either on the basis of cost
or differentiation. Management accounting and Strategic Cost Management
differ in three ways. First, in the way costs are analyzed; second, in the
objective behind conducting cost analysis; and third, in the way cost behavior
is understood.
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Chapter 14

Benefits of Audit
Limitations of Audit
Timing of an Audit
Audit Process
Audit Tools and Techniques
Management Audit
Internal Audit
Financial and Cost Audit
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Social Audit
Audit Evidence
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Auditing
Auditing for Continuous Improvement
Audit is the examination and verification of records and other evidences by an

individual or a body of persons so as to confirm whether the records and other
evidences present a true and fair picture of whatever they are supposed to
reflect.
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Audits can be categorized basically into two types- Financial audit and nonfinancial audit. Financial audit is a statutory audit that helps in monitoring the
financial performance of the company. Non-financial audit is non-statutory
and serves two purposes. Firstly, it checks a companys compliance to
standards and secondly, determines whether a product or service satisfies
customers' demands in terms of features and quality. Table 14.1 shows the
differences between financial and non-financial audits. Though financial and
non-financial audits differ greatly, there are some similarities, too. Both the
audits are conducted to measure compliance to a set of standards. Both
generate performance data that can be used for benchmarking and
performance analysis and both identify opportunities for performance
improvement.
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BENEFITS OF AUDIT
Identify Opportunities for Improvement
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Audit yields multiple benefits. Some of these benefits are the following:
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Audits can help managers identify job priorities by showing which changes
would have the highest impact on overall performance. Audit can be used as a
tool for identifying the gap between the desired and actual performance and
help the management take steps for the improvement of performance.
Reality Check
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Companies prepare formal plans before executing them, but in many cases
these plans do not get executed as supposed because the assumptions made by
the executives may not have been correct. Systematic collection of data and
comparing reality with manager's assumption help companies to be more
resilient when faced with change.
Identify Outdated Strategies

When there is a change in the organization's strategy, processes that support
the strategy do not evolve automatically. Regular audits of management
processes help managers understand when the strategy becomes outdated and
needs to be changed.
Increase Managements Ability to Address Concerns

The compilation of audit information increases the managements ability to
address issues arising from increasing regulation and litigation, and to clarify
queries by outside stakeholders in the business. Auditing is a systematic way
of clarifying and prioritizing the information.
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Auditing
Table 14.1: Financial versus Non-financial Audit

Non Financial Audits
Relies primarily on standards set internally
on the basis of customer and competitor
information.
Procedures are fluid and should be adapted
by each company. Measures should be
created that suit the companys needs.
Standards should change as performance
improves.
Focus is on exceeding standards set
internally or by industry competitors.
Audience is generally internal, with data
being
used
primarily
to
improve
performance.
Conducted, on average, every 18 to 24
months.
Focuses on measures that affect only Focuses on a broad range of functions that
contribute to the success or failure of a
financial performance.
particular process.
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Financial Audits
Relies primarily on standards set externally
(by government or by professional standards
groups).
Procedures are formalized and consistent
from company to company. Compliance
with procedures adds credibility to the audit.
Standards are essentially the same from audit
to audit
Focus is on complying with standards set by
external groups
Audience is often primarily external, with
audit standards used as a way of building
credibility
Generally conducted yearly
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Source: The Company audit guide, Strategic Direction publishers Ltd., Switzerland.
Enhances Teamwork
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Systematic collection and sharing of audit information enhances the ability of

the various segments of an organization to work in coordination. The breaking
of barriers between the different parts of an organization enables a company to
respond more quickly and effectively to the demands of customers and other
stakeholders.
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Increase Commitment to Change

The audit process increases the commitment of the employees of an
organization to change. Audit results may succeed in convincing the
management about the need to re-order its priorities.
LIMITATIONS OF AUDIT
Audit has its limitations, too. It is not a cure for all kinds of management
problems. Given here are some of the issues that cannot be solved through
audit.
An audit can neither help in prioritizing changes nor in allocating

resources. At the most, it can provide certain clues regarding changes that
are most important.
Audit cannot mobilize people to take action. Though audit identifies

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various problems that exist in the organizational systems and processes, it

cannot help the management bring about changes to solve these problems.
In order to bring about such changes, there is need for commitment and
support from all the people within the organization.
Audit cannot generate better data than the measures used to gather those.
For example, if a questionnaire used during audit for collecting data has a
flaw, then the results of the audit will also be faulty. Hence, it is important
to plan on proper audit tools to be used in the audit.
An audit, by itself, cannot improve performance. Since an audit brings out

the weaknesses in the system and identifies opportunities for
improvement, it should not be conducted unless there is a strong
commitment to improve or strengthen the process being studied.
Audit should not be used for wrongful purposes. It should not be used for
personal indictment and to justify improper actions.
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TIMING OF AN AUDIT
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The timing of an audit depends on the type of audit. Financial audits are
conducted once in every year whereas non-financial audits may be conducted
once in every two years. Before deciding on the timing of the audit, the
management has to answer the following questions:
How important is the audit process to the achievement of the companys
strategy?
How does the company fare when compared to its competitors in terms of
the efficiency of its systems and processes?
What are the types of resources needed for conducting an audit? Does the
company have enough human resources to form a separate team for
conducting audits?
Has the company diligently implemented the previous audit report

recommendations?
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AUDIT PROCESS
An audit process consists of following stages:
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Staffing the audit team
Creating an audit project plan
Laying the groundwork for the audit
Analyzing audit results
Sharing audit results
Writing audit reports
Dealing with resistance to audit recommendations
Building an ongoing audit program
Auditing
Staffing the Audit Team

The audit team usually consists of three to four people. The number of people
may be higher, depending on the volume of data required and the number of
customers or employees to be interviewed. The audit team reports either to the
CEO or some other senior executive. Quality of an audit report is directly
related to the competence of the audit team members. Hence an audit team
should consist of people who have substantial knowledge of systems and
processes within the company. An audit team should consist of people who
have knowledge in diverse areas. Some other aspects that should be
considered are:
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The team should consist of newcomers as well as experienced people.

Importance is given to people with prior experience in auditing. In case a
particular function is being audited, then functional experts should be included
in the audit team. If it is a process that is being audited, then people who are
closely associated with that process should be included in the audit team.
Team members should possess strong analytical and interpersonal skills. They
should be able to communicate well with their peers and establish strong
working relationships. They should also possess facilitation and interviewing
skills. Finally, they should have an understanding of a company's overall
strategy and its goals and objectives.
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The audit team leader is selected from among the audit team members. He
plays an important role in data gathering and is responsible for the overall
success of the audit. As the team leader plays a very important role in the
audit, the selection should be done after careful consideration. The following
are the qualities required in an audit team leader: Excellent interpersonal
skills, good relationship with the CEO and other senior executives, strong
analytical skills, ability to assimilate and process large amounts of complex
data quickly, some knowledge of the function being audited and extensive
knowledge of the type of process being audited.
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Creating an Audit Project Plan
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Before starting an audit, it is necessary to prepare plan that explains how an

audit is to be conducted in a step-by-step manner. An audit plan helps in better
allocation of resources, especially if the resources are scarce. It makes sure
that audit tasks are completed on time. It also ensures accountability and
responsibility of the management by clearly stating what is to be done, who is
responsible for which task and when the audit should be completed.
Laying the Ground Work for the Audit

After preparing the audit plan, the next step is to gather support from the
employees for the audit. The following steps will help an audit run smoothly:
Garnering executive support
There are two benefits of gathering the executives support for the audit.
Firstly, those involved in the area being audited will cooperate with those who
are gathering data and secondly, it ensures executive support for the area
being audited and shows a commitment to improve performance in this area.
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The executive sponsor of the audit introduces the audit by means of a memo
which explains the purpose of the audit and asks for support from everyone in
the area being audited.
Make arrangements with the area being audited
The audit team leader should check with the manager in charge of the process
or site being audited if arrangements have been made for on-site visits,
interviewing, surveys etc. The manager, and the team leader together should
ensure that audit does not affect the normal workflow in the company. Before
commencing the audit, the team leader should hold discussions with
employees regarding the timing of the audit, the methods of data collection,
the availability of required data, etc.
Exhibit 14.1
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Develop a checklist
A checklist is used to outline all the issues that are central to the audit. It can
help in organizing the audit work. It helps in performing tasks systematically
and maintaining a record of those tasks. Exhibit 14.1 shows a sample financial
audit checklist.
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Sample Financial Audit Checklist

Collect all accounting materials.
Receipts
Deposit slips
Invoices
Cancelled Checks
Bank Statements
Check Registers
Note lost or Illegible material
Last Annual Financial Report
Monthly Financial Reports
Review Accounts Used.
Income Accounts (Should have separate account for each income type)
Are all deposits recorded as to income type?
Are all deposits reconciled to bank statements?
Expense Accounts (Should have separate account for each expense type)
Are all expenditures recorded as to expense type?
Are all checks reconciled to bank statements?
Verify the following:
Starting Balance
Receipt for every expenditure
The officers of the chapter approved all expenditures
An approved budget exists for each expense type
All expenditures are within approved budget
All individual account's starting and ending balances match the chapter's ledger
The annual ending balance matches the chapter's ledger
Source:/www.ssq.org
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Auditing
Analyzing Audit Results

When the audit is completed, the gaps between a company's targets and its
actual performance can be identified. These gaps usually pertain to specific
areas in the various functions of the management. The audit results identify
the opportunities for improvement, but arranging the areas in terms of
importance is a difficult task. Apart from this, due to limited resources,
choices must be made about which options are more important.
Sharing Audit Results
Introduce the meeting and preview its agenda
Present the audit findings
Present audit recommendations
Ask others to react to the data
Develop preliminary action plans
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The audit results are presented before the members of the executive team, the
managers who work in the area covered by the audit, the audit team members
and anyone else who is affected by the audit or is interested in the results, in a
feedback meeting. The audit team's objective during the meeting is to present
a clear and simple picture of the current situation, as revealed by the audit.
The following structure can be followed for conducting a feedback meeting:
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Writing Audit Reports
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After the audit work is completed, the whole process of auditing, the resultant
findings and recommendations are written in a formal report called an audit
report. An audit report may be a plain summary of the audit. But such a report
is not recommended because the probability of taking action in this case is
less. An audit report may supplement a feedback meeting and provide useful
guidelines to those who attended the meeting, for future action. An audit
report serves as a baseline document for measuring improvement in
performance possible in future audits.
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Dealing with Resistance to Audit Recommendations

The audit team gives its recommendations when the audit is completed. These
recommendations may not be always accepted, especially when they require
people to change their way of working. Change is usually resisted because it
requires a great deal of energy and effort. Employees resistance to change
usually inhibits auditors from making recommendations that require
transformational changes.
Direct resistance to audit recommendations
Resistance to audit recommendations can take two forms-direct and indirect.
Direct resistance to audit recommendations is easy to identify and address.
Direct resistance usually comes from the management in the form of doubts
about the implementation of the audit team's recommendations. During the
meeting between the audit team members and the management, some people
may wish to voice their concerns over these recommendations. It is necessary
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Table 14.2: Differences Between Surveys, Questionnaires and Interviews

Surveys
Questionnaires
Interviews
Completed by respondents, May be computed with or Involve the presence of a

independent of researcher without researcher
researcher, either face-toface or on the telephone
Highly structured
Usually highly unstructured
May be structured or
unstructured
Require
absence
of May or may not capitalize on Capitalizes on the interaction
interaction
between the
interaction
between between researcher
and
researcher and respondent researcher and respondent respondent
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May be difficult to ensure Rate of response depends on Ensuring a high response rate
a high response rate
whether the questionnaire is is usually quite easy
used like a survey or like an
interview
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Results can be generalized Results can usually not be Results can generally not be
to a larger population
generalized to a larger generalized to a larger
population
population
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Allow
researchers
to Allow
more
researcher Researchers
have
little
exercise high control over control than an unstructured control over content of the
content of the response
interview, but less control response
than a survey
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Results are quite easy to Ease of tabulating results Results are not easy to
tabulate
depends
on
type
of tabulate
questionnaire used
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Source: The Company audit guide, Strategic Direction Publishers Ltd., Switzerland.
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for the audit team members to allow people to do. There should be no attempt
to suppress their views. At the same time, audit team members should not
become too defensive when someone is vociferous in his/her objections.
Some of the ways in which one can deal with direct resistance to audit
recommendations are the following:
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Prioritize the concerns raised by the management. Deal with the serious
ones immediately.
These concerns should be summarized and the management should be

convinced that their concerns would be taken care of.
Deal with differences in opinion through free and fair dialogue with an
aim of arriving at a resolution.
Auditing
Indirect resistance to audit recommendations

Indirect resistance to audit recommendations is subtle and difficult to identify.
Peter Block has named some specific forms of indirect resistance that come up
during meetings between audit team members and managers.
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Managers during an audit meeting show indirect resistance by frequently

asking for more details or by providing unnecessary details to questions. They
may also say that there is not sufficient time to implement the audit teams
recommendations. They may question the authenticity of the methods used by
the audit team. They may, at times act times pretend to be confused or remain
silent, indicating that they are uninterested in audit recommendations. In such
a situation, audit team members should encourage those people to write down
what they feel about the recommendations and why they are resisting them.
Making people talk often solves a lot of problems. Hence, the audit team
should encourage people to frankly air their opinions. They should identify
people who have reservations against the audit teams recommendations and
work with them to address their concerns.
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Building an Ongoing Audit Program
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With the increasing pace of changes, organizations need to continuously

increase their efficiency and effectiveness. In order to accomplish this,
organizations must adopt ongoing audit programs. Ongoing audit programs
help in monitoring improvement in performance over a specific period of
time. They help in systematically monitoring the changes taking place in the
company's work environment and also help managers deal with resistance to
change.
AUDIT TOOLS AND TECHNIQUES
Budget
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Collection of accurate and comprehensive data is one of the keys to effective

audit. Data for an audit can be collected through surveys, questionnaires,
interviews, focus groups, and direct observation. The selection of a research
method for data collection depends on several factors:
In many cases, the funds available for conducting the research is the most
important factor in the selection of the research type. When the budget is tight,
qualitative research (any method the results of which cannot be communicated
or presented to a larger population) is advisable rather than quantitative
research (surveys), because it usually involves lower costs.
Timing
Timing, too, has an important role to play in the selection of a research
method. Compared to other methods, preparation time and analysis time for
surveys is longer. Questionnaires, focus groups and interviews require lesser
time for preparation or analysis. While a survey may take several weeks to be
completed, there are some methods that can be completed almost immediately.
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Projectability
If the goal of a project is to determine the attitudes or behavior of a large
group then the only effective method is to conduct a survey. While a fairly
comprehensive picture can be obtained from focus groups, interviews and
questionnaires, the results cannot be accurately generalized and presented to
the larger population in statistical terms.
Geography
All the sources of data for a project may be found at one location, or may be
widely dispersed. This factor tells upon the cost of a research project, both in
terms of time and money. Consider the problems related to traveling to
various locations, surveys done through mail or telephone seem to be rather
cost effective and convenient.
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Surveys help in collecting information regarding five variables-background

data (age, education and income), behavioral data (buying habits, etc.) data
about attitudes and beliefs, data about opinions, and data about the knowledge
of the products offered by a company.
Types of surveys
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Surveys are of two types-written survey questionnaires and telephone surveys

using a written questionnaire. The difference between a written survey
questionnaire and a telephone survey using a written questionnaire is that in
the former case, the questionnaire is answered by the individual respondent,
whereas in case of the latter, the questionnaire is filled in by the interviewer
himself. Written survey questionnaires, which are sent to respondents by
direct mail, have the lowest response rate and are likely to provide unreliable
data because the researchers have no control over who responds to the survey.
Telephone surveys serve are a fast means for collecting data. A telephone
survey includes forced choice, scaled questions and open-ended questions.
The risks of survey research
Because surveys are somewhat superficial, there is no way of probing people's
responses to determine why they answered in the way they did. Also,
respondents answers may be based on what is socially or politically
acceptable, rather than on the basis of their own attitude, opinions, or
behavior.
Surveys can be used most effectively when auditors are aware of the following
limitations of survey:
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A survey assumes that the researcher knows in advance what the

important organizational issues are, and thus, what questions should be
asked.
Surveys assume that people use the same language when they discuss
similar issues and interpret survey questions in the same way.
Auditing
Although surveys can provide precise statistical information, they usually

reveal only superficial information that is incomplete at best.
A survey distorts the political reality of the organization by aggregating

responses and implying that all opinions carry equal weight.
The use of random samples in a survey assumes that the required

information is distributed evenly across the organization or customer
group. This can lead to the researcher developing a distorted picture of the
company or its customer base.
The very process of the survey affects the responses which depend on
when and by whom the question is asked.
Surveys assume that people have independent opinions, but in reality,

these often end up controlling people to give an opinion which they do not
hold, because the close-ended questions in a survey impose a response
framework on the respondents.
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Questionnaires
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In terms of the applications for which they are best suited, questionnaires fall
midway between surveys and interviews.
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Structure of a questionnaire
The most common problem with questionnaire research is the design of the
questionnaire. Since the use of vague and ambiguous terms is the major
problem in questionnaire design, Michael Patton, in his book Practical
Interviewing (1982), suggests the following questions as a guide for framing
clear-cut questions.
1. What do we want to find out?
2. Why do we want to find that out?
3. When do we need the information?
4. Who has that information?
The purpose of the questionnaire and the topic it covers governs the structure
to be used in designing the questionnaire. In most cases, the relatively general
questions should be placed in the beginning of the questionnaire and the most
specific ones follow them. This enables the respondents to warm up to the
issues and prepares them to provide specific data.
The use of open-ended or close-ended questions is another important choice to
be made in questionnaire design.
Effective questionnaires should use easily understandable language, avoid
ambiguity, avoid expressing point of view that are likely to make the
respondents biased and use short sentences, and avoid using jargons.
Focus Groups
Focus groups serve as yet another approach to data collection. It allows for the
collection of more information and the involvement of more people than is
possible in one-on-one interviews. The participants in focus groups, at the
same time, can be asked to provide more depth than can be obtained from
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survey respondents. The dynamics of a focus group may also allow the
expression of ideas which might otherwise go unstated. A focus group may
have four to ten participants, and the session may last for about two hours.
A successful focus group usually has a skilled facilitator, who is responsible
for guiding the research and managing group dynamics. The role of a
facilitator of a focus group is different role from that of an interviewer. The
primary responsibility of a facilitator is to manage the information flow
between group members rather than asking questions and documenting
responses.
Interviews
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Interviewing is a technique to gather data from a conversation with a

respondent. It is a highly flexible research tool. Also, it is an effective way of
collecting data about sensitive subjects, as skilled interviewers can establish a
relationship of trust with the respondent. Moreover, the interviewer probes
these responses and elicits information that might otherwise be overlooked. As
the rate of responses to interviews is considerably high they are often used in
audits.
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Types of interviews
There are three basic types of interviews:
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Structured interviews are an interactive approach to surveys or questionnaires.

Interviewees have a set of formalized questions that do not allow for great
flexibility in terms of responses.
Semi-structured interviews
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These provide a somewhat formalized approach to the question and answer

procedure and make use of a protocol format.
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Unstructured interviews
In unstructured interviews, the researcher initiates the interview with a set of
basic questions, and then allows the rest of its course to be guided by the
responses of the interviewees.
Direct Observation
For decades, direct observation has been a favorite research tool of
anthropologists. However, it has evolved into a sophisticated research method
now. Direct observation finds many applications in corporate environments,
particularly in the audit process.
Direct observation techniques
There are several direct observation research techniques. These include the
following:
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Auditing
Participant observation
This technique involves the full participation of the researcher in an activity,
and requires him to make mental notes of the dynamics of and feelings
involved in participating.
Field observation
Here, an observer closely watches the interaction of a group without being
directly involved in it. The detachment of the observer from the group activity
makes it difficult for him to understand any particular situation during the
interaction from a participants point of view.
MANAGEMENT AUDIT
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With the continuous growth of firms, the importance of control has increased.
Decentralization in organizations is responsible for the fact that control has
assumed more importance. The growth of organizations should not lead to
laxity in controls. An efficient manager understands the need for an impartial
analysis of the firms operations and conducts a management audit. A
management audit is defined as an examination of the conditions and a
diagnosis of deficiencies with recommendations for correcting them.
According to John C Burton, In a management audit, the auditor will see
whether management is getting information relevant to the decisions and
actions which it must take. This will require a much more intensive analysis of
information needs and the efficiency of the existing system in meeting them.
The auditor will not have to decide whether management is making the right
strategic and operative decisions but rather whether management has available
to it and is using the relevant information and techniques necessary to evaluate
rationally the various alternatives that exist.
Objective of a Management Audit
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The main aim of conducting a management audit is to critically analyze and

evaluate management performance. Apart from this, it is conducted to detect
and overcome existing managerial deficiencies and resulting operational
problems. Management audit helps to evaluate the methods and processes
used by the management to accomplish its organizational objectives; it helps
to determine the effectiveness of management in planning, organizing,
directing, and controlling the organizations activities. It also helps to
ascertain the appropriateness of the management's decisions for achieving the
organization objectives.
Development of Management Audit

The very concept of management audit came into being due to the limitations
of financial audit. Theo Haimann in his book Professional management,
writes about the need for independent appraisal of management performance.
He discusses the importance of management audit and how it can help in
overcoming the limitations of financial audit. He was of the opinion that
management audit can help in assessing the operations of an enterprise from
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multiple angles. According to Haimann, management audit would become

compulsory like the financial audit due to three major reasons.
Increasing number of professional managers
Increasing separation between management and owners
Wider distribution of stockholders
Benefits of Management Audits

As the approach to management auditing is proactive, it provides an earlywarning signal of managerial problems and related operational difficulties.
It can be used as a source of information in assisting the organization to

accomplish the desired objectives.
It helps to objectively and impartially evaluate organizational plans,

structure, and the directions that management gives in the form of
strategies and management processes in planning, organizing, directing
and controlling the organizational resources.
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Management audit can be categorized into six types:

Complete management audit
Compliance management audit
Program management audit
Functional management audit
Efficiency audit
Propriety Audit
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Complete management audit
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Complete management audit evaluates the firms current activities, and

measures the gaps between its existing policies and objectives, and its actual
activities. In case its actual practice does not conform to the firms policies
corrective action is proposed. If the auditor comes across some weaknesses in
the policies and objectives, he may suggest changes in them, regardless of the
degree of conformation. Complete management audit is however, not
designed to punish the inefficient or reprimand people who make honest
mistakes. Complete management audit is conducted from a positive, and not a
negative viewpoint, that is when weaknesses in operations or people are
uncovered, non-vindictive suggestions are given with the hope of improving
operational performance and the productivity of the personnel concerned.
Compliance management audit
According to compliance audit, auditors are asked to identify the gaps
between the companys existing policies and objectives, and its actual
practice. However, in this case, the auditors do not make any
recommendations for improvements. They simply present their observations
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Auditing
to the top management. The top management consults its personnel to decide
whether, what, or how corrective action should be taken. This type of audit
eliminates the fear of directives being imposed on the firm by an outside party.
However, the disadvantage of this type of audit is that it fails to utilize the
knowledge and experience of the auditors. It also does not avail of the possible
benefits of observations made by the trained specialists from outside the
organization.
Program management audit
Program management audit is similar to complete management audit and
compliance audit; the only difference being the fact that it focusses on a
specific program. Program management audit is designed to appraise
performance within a specified program and it does not disturb other
operations of the firm.
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Functional management audit
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Functional audit measures the difference between the actual performance of an

organization and its objectives, with emphasis on a particular function. For
example, manufacturing firms may regularly hold an audit of their quality
control function. Such an audit will help the firm to regularly check the
efficiency of internal controls over the quality of its products.
Efficiency audit
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Efficiency audit is conducted to ensure that money is so utilized as to generate

handsome returns. The objectives of efficiency audit are:
To invest the capital in areas that generate optimum returns
To plan and invest judiciously in various functions
Propriety audit
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Propriety audit is conducted to examine the effect of the management's

decisions and actions on the society and public. While conducting this audit,
the auditor examines all transactions of the company to find out whether any
of the transactions has negatively affected public interests. The audit of public
sector companies conducted by the Comptroller and Auditor General of India
is a type of propriety audit. The objective of this kind of audit is to identify the
loopholes in administrative rules and regulations, and to suggest methods for
improving the execution of future plans and projects.
Organizing the Management Audit

The management's approval is essential for establishment of a general
program for management audit. If the proposal does not receive the total
support of the management, it may face enormous difficulties at later stages.
Devising the statement of policy
The managements support should be reflected clearly and categorically in the
company's highest policy statement. The statement should be specific in
nature. It should clearly describe the scope and status of the
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Allocation of personnel
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management/operational auditing within the enterprise, its authority to hold

audits, issue reports, make recommendations, and evaluate corrective action.
The statement of policy should lay down very clearly the scope of activities to
be undertaken by the management auditor. The statement must give the
auditor the extent of authority he needs, but it should not assign to him any
task that he cannot conceivably take care of. The statement must categorically
state that the management auditor is authorized to review administrative and
management controls on any activity within the company.
Depending upon the size and nature of their business, organizations set up a
separate audit department, the head of which reports directly to the top
executive. In certain cases, the audit group may be a part of the management
the administrative control department or some other unit of the organizations.
However, some analysts feel that the audit function should be free from
pressures of various groups in the enterprise. The greater its independence, the
greater is its capability to function to work effectively. Therefore, it is
necessary to place the audit department in a considerably high position in the
organization. The auditing unit should report only to an officer whose status is
such that he can command prompt and proper consideration of the auditor's
opinion and recommendations. The management auditor's goal therefore, is to
attain such a level of operational independence, which will prevent him from
having to compromise with his audit objectives.
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Everyone placed in the audit unit should have good understanding of the
theory of auditing, thorough knowledge of the fundamentals of both the
organization and the management, the principles and effective methods of
control, and requirements for scientific appraisal. The management auditor is
expected to evaluate operational performance and non-monetary operational
controls. He should possess basic knowledge of the technology and
commercial practices of the enterprise, an inquisitive, analytical, pragmatic
and imaginative approach and thorough understanding of the control system.
The management auditor should also have basic knowledge of commerce, law,
taxation, cost accounting, economics, quantitative methods and EDP systems.
Those who have a sound background in accounting along with knowledge of
other relevant disciplines are best suited for this job.
The individuals to whom this job is assigned should have an inclination
towards analysis, a high degree of imagination and an ability to write and
express themselves clearly and logically.
Staff training program
A continuous training program is necessary to achieve quality in performing
audit assignments. An effective training program enables the staff to assume
additional responsibilities in the organization. Training programs act as an
incentive for drawing capable people into the department and retaining them.
Time and other aspects
The time required to complete a management audit varies, depending upon the
extent and nature of the assignment. The time and cost will vary for each
assignment, depending upon the nature of the assignment, the number of
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Auditing
auditors assigned to perform the work, and whether more specialists in a

particular field are required.
Frequency
The frequency of conducting audits depends on the organization. When the
organization is subject to rapid change or the total resources utilized are
expensive, the frequency of management auditing should be greater than when
it does not undergo rapid changes or the resources employed are not high in
value. In essence, management audits should be conducted often enough to
provide protection against growing problems. On the other hand, they should
not be so frequent as to lead to repetitious results.
Conditions for Successful Management Audit
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A major aspect of a management audit, is related to the selection of the audit

personnel. The auditors must be competent, have clear idea about the subject,
experience, and professional ability. In addition, they must possess an ability
to deal successfully with human relations issues. They must be able to
objectively appraise other's actions without generating undue suspicion.
Almost every employee's attitude towards an audit is defensive. This attitude
must be avoided. For this to happen, auditors should establish a pre-audit
condition, expressing their willingness to discuss their observation with the
affected personnel before it is reported to the top management. In many cases,
this will evolve into a negotiation-discussion process, whereby those
concerned begin to view audit as a way in which weaknesses of the system
may be pinpointed and their performance be improved. Finally, the
willingness of the firms employees to accept change is essential for the
success of an audit. Several people in managerial positions, particularly those
who have risen through many ranks, feel that the current way of running
business is good enough. They may be allowed to retain this belief only if the
audit supplements it with facts. However, this is rarely the case. The good
enough syndrome would eventually destroy all desires for continual
improvement. Audits are meant to highlight the strengths and weaknesses of
the firms operations. It is up to the management at all levels to reward
employees or to take corrective action. If no action is taken in response to the
auditor's findings, then his effort is wasted.
INTERNAL AUDIT
Internal audit can be viewed from two different perspectives-the traditional

perspective and the modern perspective.
Viewed from a traditional
perspective, internal audit is found to play the following roles:
Check whether the existing controls are effective and adequate
Check whether the financial reports and other records show the actual
results of the company
Check whether the sub-units of the organization are following the policies
and procedures laid down by the management.
The traditional concept of internal auditing has a narrow scope whereas the
modern concept has wider scope. The fact that the modern internal auditing is
wider is reflected in the new definition of internal auditing given by the
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Institute of Internal Auditors, "An independent appraisal function established

within an organization to examine and evaluate its activities as a service to the
organization. The objective of internal auditing is to assist members of the
organization in the effective discharge of their responsibilities. To this end,
internal audit furnishes them with analyses, appraisals, recommendations,
counsel and information concerning the activities reviewed." This definition
implies that an internal auditor has to go beyond checking the books of
account and related records. He has to appraise the various operational
functions of an organization and provide recommendations about these. Thus,
according to the modern concept of internal auditing, the internal auditor is
involved in conducting a review of operations, and internal audit and
operational audit are almost synonymous.
Need for Internal Auditing
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FINANCIAL AND COST AUDIT
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The need for an internal audit is determined by the increasing size and
complexity of organizational operations. Many organizations operate in a
number of countries and therefore have a large number of employees. In order
to avoid discrepancies from creeping into their systems, processes, and
operations, such organizations appoint a team of specialists called internal
auditors to monitor, track and report such discrepancies, inefficiencies of
personnel in the concerned departments.
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Financial audit is defined as an exploratory critical review by an independent

public accountant of the underlying controls and accounting records of a
business enterprise that leads to an opinion of the propriety of the financial
statements of the enterprise. It is conducted to examine the correctness of
financial statements, and to establish whether they present a true and fair
picture of the company's financial position on a particular date. Financial audit
is a statutory audit and should be definitely conducted by an independent
statutory auditor at the end of every financial year. The statutory auditor has to
certify that financial statements have been prepared without violating the
accounting rules and principles of accounting.
Cost audit is also a statutory audit conducted to report the cost of production
of a particular product to the government. A cost and works accountant
performs a cost audit of routine operations. A cost audit report follows a
prescribed format, and does not offer the much needed flexibility to the
professionals to use it as control mechanism.
SOCIAL AUDIT
Companies should not focus only on increasing profitability and improving
financial stability, but also on social welfare and uplift of the society. The
inadequate reflection of the social performance of the organization has given
rise to the concept of social accounting and social auditing. Social accounting
and social auditing help in evaluating the contributions made by the company
to the society. Social accounting is defined as systematic accounting and
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Auditing
reporting of those parts of a company's activities that have a social impact.

Social accounting, unlike financial accounting lacks an accounting structure.
Social accounting is rather an approach that can be used for reporting social
performance of organizations. Some of the companies that publish social
performance reports are Body Shop (See Exhibit 14.2), BP Amoco, Novo
Nordisk and British Telecom. A social accounting report contains the
following information:
Details of financial performance against the stated objectives of the
company
An assessment of the impact of the company's operations on the local

community
A report on the company's environmental performance
A report on the company's compliance with statutory and voluntary
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Exhibit 14.2
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Social Audit Statement of Body Shop
Main characteristics
Foundations
Environmental
Statement (1992).
Environment protection is the main

theme of the statement;
Products-focus approach, rather
than stakeholder-focus approach
The report comprised of three
statements on the companys
performance on environmental,
animal protection and social
issues;
Each statement has an element
of independent verification in
line with established best
practice;
Included in the publication a
paper
The
Body
Shop
Approach to Ethical Auditing
describing
the
methods
underpinning the three reports;
A
verification
statement
indicating
an
external
verification process.
Single statement covering these
three aspects: environmental
performance; animal protection;
and social issues.
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The European Union Eco

management
and
Audit
Regulation (EMAS)
Mission Statement
Trading Chart
Managers and
Employees Handbooks
Community Trade
Programme
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The Values Report

1995, published in
January
1996.
It
contains three separate
statements
concerning:
Performance on
environmental
issues
Animal protection
Social issues
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Statements
The Values Report

1997, published in
January 1998
Mission Statement
Trading Chart
Managers and
Employees Handbooks
Community Trade
Programme
Source: http://intranet.bexhillcollege.ac.uk
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quality and procedural standards
Views of stakeholders about the objectives and values of the company.
Social Accounting versus Social Audit

Often the phrases, social accounting and social auditing are used
interchangeably, which is not correct. The main reason for this confusion is
that both social accounting and social audit lead to the compilation of social
reports. Audit starts where accounting ends. The social accounting report is
prepared by accountants working in a company. Social audit is conducted by
an independent auditor who reviews the information given in the social
accounting report. Hence, social audit can be conducted only after the social
accounting report has been prepared.
Definition of Social Audit
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Blake, Fredrick and Myers in their book 'Social Auditing' define social audit
as systematic attempt to identify, analyze, measure, evaluate and monitor the
effect of an organization's operations on society. Turnbull (1995) defines
social audit as the process whereby an enterprise measures and reports on its
performance in meeting its declared social, community or environmental
objectives. The word 'social audit' has been often used wrongly to mean
activities pertaining to a company's social programs, social surveys, etc. For
example, in India, the MAOCARO1 report given by the company's auditor
was wrongly taken as a social audit report.
Features of Social Audit
Social audits adhere to the specified norms. These norms may pertain to
the government's standards of social performance, standards established
by the organization and norms set by outside agencies.
The aim of conducting a social audit is to influence the policies, objectives

and actions of the concerned organization to improve its social
performance.
Social audit is conducted by professionals who have knowledge about the

social area being audited.
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Approaches to Social Audit

Any one of the following approaches can be adopted to conduct a social audit.
Inventory approach
It is a simple listing and short description of programs which the firm has
developed to deal with social problems.
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MAOCARO stands for Manufacturing and Other Companies Auditors Report Order.
Auditing
Program management approach

It is a more systematic effort to measure costs, benefits and achievements of
an organization. It is an extension of a traditional management audit to social
programs.
Cost-benefit approach
This is an attempt to list all social costs and benefits incurred by an
organization in terms of money.
Social indicator approach
This pertains to utilizing social criteria (e.g., suitable housing, good health, job
opportunities) to clarify community needs and then evaluating corporate
activities in the light of these community indicators.
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Fredrick, Myers and Blake have identified six types of social audit. These
audits mainly differ in terms of their scope and coverage.
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Social balance sheet and income statement

This kind of audit requires quantification of social costs and income. It is
conducted to reduce social costs in terms of money.
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Social performance audit

This audit is conducted to assess the performance of companies with respect to
some area of social or public concern. For example, this audit can assume the
form of research-based appraisal, that is conducted to find out the extent of
pollution caused by cement and steel industries.
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Macro-micro social indicator audit

This type of audit is conducted to evaluate a company's social performance in
terms of social indicators that signify public interest. It evaluates the
contribution of the company to the well being of the local community.
Constituency group attitudes audit
This kind of audit is conducted to ascertain how corporate actions affect
employees or the general public in different ways. Depending on the findings
of the audit, the policies or actions of companies are modified.
Government mandated audits
This type of audit is conducted by authorized government agencies to study a
firm's performance in areas of social concern. The focus of agencies that
conduct this audit is environment protection and equal employment
opportunity.
Social process or program audit
This audit is limited to specific processes and programs of an organization that
may have social implications. It aims to appraise a program which has already
been initiated by the company.
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AUDIT EVIDENCE
Audit evidence is any kind of information used by the auditor to determine
whether the financial statements being audited are in accordance with the
established rules and regulations. For audit evidence to be useful for the
auditor, it must possess the following four characteristics:
Persuasive
Relevant
Unbiased
Objective
Persuasive
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Evidence is persuasive if it is sufficient in quantity and quality so that the

auditor is able to arrive at a conclusion.
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Evidence must pertain to the objective or assertion that is under observation

(e.g. being tested).
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To be unbiased, evidence should not unduly influence one alternative over

another. Bias can result either from the characteristics of the evidence or from
the auditors sample selection of items that are to be examined.
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Objective
The ability to reach a similar conclusion that another auditor would find in the
same circumstances.
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AUDITING FOR CONTINUOUS IMPROVEMENT

Managers can use audit as a continuous improvement tool. Initiatives for
continuous improvement should be undertaken to achieve long-term goals
rather than making short term improvements. In order to maximize the
benefits of an audit, companies should:
Make the most of audit results
Achieve competitive advantage through frequent auditing
Identify improvement trigger points
Lay down action plans
SUMMARY
Audit involves examination and verification of records and evidences by an
independent person or body of persons so as to express an opinion about
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Auditing
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whether the company's records and other evidences present a true and fair
view of what they are supposed to reflect. Audits are of two types: financial
audits and non-financial audits. An audit is conducted for various purposes,
some of which are to identify opportunities for improvement, as a reality
check, to identify outdated strategies, to measure performance improvements,
to increase managements ability to address concerns, enhance teamwork, to
change mind-set and increase acceptance to change. An audit process consists
of these stages-staffing the audit team, creating the audit plan, laying the
ground plan, analyzing audit results, sharing audit results, writing audit
reports, dealing with resistance to audit recommendations and building an
ongoing audit program. For collecting data during an audit, auditors use
various audit tools- surveys, questionnaires, interviews, focus group methods,
the direct observation techniques and the field observation technique. The tool
is selected on the basis of budget, timing, projectability and geography of the
audit. With the continuous growth of firms, the importance and complexity of
control has increased. At this point, an efficient manager acknowledges the
need for an impartial analysis of the firms operations and conducts a
management audit. Management audit is defined as an examination of
conditions and a diagnosis of deficiencies of an organization with
recommendations for correcting them. It is basically constructive and
objective in its approach. It has one purpose-that of helping the management
to enhance the position of the company. In short, the main aim of conducting a
management audit is to critically analyze and evaluate management
performance. Management audits can be categorized into six types-complete
management audit, compliance management audit, program management
audit, functional management audit, efficiency audit and propriety audit.
Setting up a general program for management audit requires the
managements approval and support. The management's support must be
reflected clearly and categorically in the company's highest policy statement.
Apart from this, management should allocate personnel, train them and decide
on the timing and frequency of audits. Internal audit is conducted for
systematically examining the records, systems, procedures and operations of
an organization. Financial audit is another type of audit conducted to examine
and verify the correctness of a company's financial statements. Cost audit is a
statutory audit, conducted to report the cost of production of a particular
product. Social audit is a systematic attempt to identify, analyze, measure,
evaluate and monitor the effect of an organization's operations on the society.
There are four approaches of social audit- the inventory approach, the program
management approach, the cost-benefit approach and the social indicator
approach. There are six types of social audit audit-social balance sheet and
income statement, social performance audit, macro-micro social indicator
audit, constituency group attitudes audit, government mandated audits and
social process or program audit. Audit evidence is any kind of information
that is used by the auditor to determine whether the financial statements being
audited are in accordance with the rules and regulations of the company. Audit
evidence should necessarily possess four characteristics- persuasive, relevant,
unbiased and objective.
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Chapter 15
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Audit of Management
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Functions
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Audit of Purchasing Function
Human Resource Audit
Research & Development Activities Audit
Production Audit
Marketing Audit
Sales Audit
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In order to conduct business properly, activities pertaining to a particular

domain are clubbed under specific functions of management. For example, all
activities related to people come under the personnel function. Similarly, all
activities that are performed as a part of manufacturing fall under the
production function. Over a period of time, an organization may not be able to
perform these activities efficiently due to systemic problems and human
inefficiencies and this may affect the performance of the organization. Hence,
it is necessary to regularly conduct audits of these functions.
AUDIT OF THE PURCHASING FUNCTION
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Purchasing is an important function of the management especially in the case

of manufacturing firms. In manufacturing firms, material costs form 50 to
60% of the total cost. If a firm can reduce its purchasing costs, it would lower
the material cost as well as the cost of production, thereby earning higher
profits. In most of the big companies there is a centralized purchase
department that takes care of purchasing needs of other departments. The user
departments forward the list of items they need along with the quantity desired
and specifications, if any. The purchase department is responsible for
negotiating a price and buying items at the lowest possible rate without
compromising on quality. If there is some technical help needed, the purchase
department can hire technical experts from outside or get them from other
departments within the company.
Purchasing Procedure
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In most companies, the purchasing department performs the following

functions:
Verifying purchase requisition
Inviting Quotations, tenders, etc.
Negotiating price
Selecting the source of supply
Settling delivery date, mode of dispatch, payment terms etc.
Following-up delivery
Securing evidence of receipt of materials/services
Negotiating adjustments with suppliers
Checking invoices
Serving as a source of information for user departments.
Maintaining the register of suppliers, vendor files etc.,
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Characteristics of an Effective Purchase Department

The characteristics of purchasing department determine whether it is
innovative or not. The following are the important characteristics of
purchasing department:
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Maintaining the continuity of supply of raw materials in support of the

production schedule.
Purchasing material at the least available price
Adhering to the standards of quality while buying goods
Formulating and implementing plans for reducing costs through value

analysis programs
Keeping all the relevant people informed about its activities, market
developments, availability of substitutes etc.
Purchase Audit Areas

While conducting an audit of purchase functions, an auditor should look into
the following aspects before giving his approval.
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As a first step, the auditor should determine whether the organization has a
system for collecting information pertaining to purchases. If a system exists,
he should analyze all the documents that trigger the purchase activity. During
investigation, the auditor should look at the adequacy, format and correctness
of those documents. He should conduct a critical review of the purchase
procedure of the company. After the review, the auditor has the freedom to
comment whether the purchase department is playing an innovative role in the
organization or not. The auditor should look for failures, if any, on the part of
the purchase department to get valid competitive quotations. It should check
that there are no loopholes in the quality control measures adopted by the
purchase department. An effective purchase department should compare the
prices of the market quotations with the prices obtained from new sources of
supplies. If there is any discrepancy, it should look for alternative sources of
supply.
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HUMAN RESOURCE AUDIT
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The Human Resource (HR) Audit is the process of examining policies,

procedures, documentation, systems, and practices with respect to an
organizations HR functions. The purpose of an HR audit is to reveal the
strengths and weaknesses of the human resources system, and identify any
issues which need to be resolved. The main purpose of an audit should be to
analyze and improve the HR function in the organization.
Some other objectives of an HR audit would include:
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Examining a companys compliance with established employment laws

and regulations.
Determining how to serve the relevant needs of stakeholders,

management, employees and customers better.
Streamlining company practices and procedures used in carrying out

recruitment, wage & salary administration, managing leaves of absence,
benefits, training, discipline & termination, etc.
Establishing an early warning system to spot problems or identify issues

before they become crises
Conducting an HR Audit
An HR audit is conducted by an audit team comprising a cross-section of the
organizations staff, including the line staff, middle and upper management,
and the department responsible for HR functions. Using a questionnaire, the
team collects information for a number of categories. For example, a
questionnaire to collect information pertaining to recruitment would have the
following questions.
How did the work force increase to its current size?
What are the future needs of personnel in your organization?
What are the procedures, for hiring in your organization?
What are the recruitment sources used? (e.g., advertisements, referrals

from other agencies, personal contacts)
Are the current employees given appropriate consideration for promotion

or lateral position changes?
By whom is the preliminary screening of candidates done?
Who selects candidates for interviews?
Is training provided to those who conduct interviews?
How is the recruitment, screening, and selection process documented?
What is the interview process that is used (e.g., individual, sequential,

panel)?
Who holds the final authority to hire?
Who checks references?
How are the reference checks documented?
Who makes the offer of employment?
Where is the hiring paperwork generated?
Who negotiates compensation packages?
What is the turnover rate (percent of employees leaving each year) in your
organization? Has this changed over time?
Who gives references for former employees?
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By seeking an answer to these questions one can gain considerable insight into
the recruitment activities of the organization.
Caution for the HR auditor
Conducting an HR audit is not an easy task. An auditor1 should bear the
following points in mind while conducting an HR audit.
It is difficult to quantify the human contributions to the success or failure

of an organization.
If the HR audit is conducted by an outside consultancy, then the auditor is a senior agency
who has experience in conducting the audit. If the audit is conducted internally, then a
senior manager would play the role of auditor.
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It is difficult to develop a yardstick to measure the performance of

workers.
It is difficult to assess the contribution of workers to the work as they are

influenced by fellow workers and their industrial background.
It is necessary to have a proper understanding of human behavior in order

to keep the workforce motivated to achieve organizational goals.
Therefore, the auditor should assess whether the supervisors and managers
have leadership qualities to motivate the employees or not.
It is not easy to assess the impact of training programs on workers ability.
It is necessary for the auditor to understand the importance of the

personnel function and its role in optimum utilization of resources
available in a firm.
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RESEARCH AND DEVELOPMENT ACTIVITIES AUDIT
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Due to the tremendous technological progress most of the existing

technologies become obsolete within no time. Thus it becomes imperative for
companies to come out with innovative concepts, products and procedures so
that they can survive. If a company has to constantly innovate, it has to invest
heavily in research and development. The following guidelines will help a
company monitor its research and development in a better way:
Set a definite R&D goal
Set aside an R&D budget every year
Decide the extent of R&D required for a young company.
Select broad research concepts which an organization is capable of

developing.
Form a consensus on the research project being undertaken.
Conduct a pilot project before starting the research project on full scale.
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Evaluation of R&D Activities

While conducting an R&D audit, the auditor should look into the following
aspects.
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The auditor should make sure that the company has allocated a specified
amount as R&D budget based on detailed report of each project.
The auditor should make sure that the details of expenses of each project
are maintained separately and systematically.
The auditor should make sure that there is control in material requisition
and consumption.
The auditor should make sure that R&D personnel are recruited on the
basis of merit and competency.
Every R&D project may not prove to be commercially viable. The auditor
should see to it that the company does not incur unnecessary expenses on
projects which are not commercially viable.
R&D projects can be successful only if the R&D activities are well
coordinated and within the overall objectives of the company.
The R&D development center should have a well stocked library and
necessary equipments for conducting the research. A team of experts
should make sure that books and equipments are available and properly
maintained.
PRODUCTION AUDIT
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The production audit also referred as manufacturing audit is conducted to

measure the effectiveness and efficiency of all production facilities and
processes. It is conducted for the primary production activities as well as
support activities like maintenance, stock keeping etc. Production audit may
include an extensive plant tour utilizing a number of checklists developed
specifically for that plant. The plant tour helps the auditor get a general
understanding of the manufacturing processes and their inherent problems.
Some of the major reasons for conducting a production audit are:

To make sure that actual production procedures are in conformance with
standard production procedures
To study consistency of a process on a day to day basis
To demonstrate a proactive approach to process improvement; and

encourage ongoing corrective action
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Characteristics of a Good Manufacturing Audit

A good manufacturing audit has the following characteristics:
A manufacturing audit is not supposed to be a fault finding exercise. It is
rather meant to help people do things more efficiently through evaluation
and feedback.
It should use rating schemes to classify problems discovered. A rating

scheme helps in ranking problems in order of priority so that corrective
actions can be undertaken accordingly.
It not only helps in discovering problems but also aid in taking corrective
actions.
It is necessary for the auditor to be familiar with the area he is auditing as

well as auditing techniques.
It is more than just walking into a work area and looking for trouble.
Rather it should be a proactive process wherein problems are identified
and eliminated.
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MARKETING AUDIT
Marketing audit is a comprehensive, systematic, independent and periodic
examination of a company's or business unit's marketing environment,
objectives, strategies and activities. A marketing audit is conducted to
determine problem areas and opportunities and recommend an action plan to
improve the company's marketing performance.
Characteristics of Marketing Audit

There are four main characteristics of marketing audit. They are:
Comprehensiveness
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A marketing audit is conducted to cover all the marketing activities of a

business. If the audit covers only some activities that form a part of the
marketing function such as sales force, pricing etc, then it is called a
functional audit. Functional audits do not give a fair picture, and can
sometimes mislead the management. For example, excess sales force turnover
may not always be due to poor training or compensation but due to weak
products and poor promotion by company. Thus a comprehensive marketing
audit is more effective in locating the real problem.
Systematic
Independent
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A marketing audit is an orderly examination of both the macro and micro

marketing environments, the marketing objectives and strategies, of an
organization. The audit shows the areas where improvement is required. The
improvements are made with the help of both short run and long run plans.
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A marketing audit can be conducted in various ways. It can be a self-audit,

audit from across, audit from above, company task force audit, outsider audit
etc. Self-audits are conducted by marketing managers themselves by using a
checklist to rate their own operations. Self-audit has a number of
disadvantages. A self audit lacks objectivity and independence. Hence, it may
not reflect the actual performance of the marketing function. To avoid this, it
is always better to go for an external agency for conducting a marketing audit.
Periodic
Marketing audits are usually initiated when there is a deterioration in sales.
Conducting a marketing audit after encountering a problem is not of much
help. Hence, it is better to conduct a periodic audit both during good times as
well as bad times.
Marketing audit checklist
A marketing audit checklist is a tool used by auditors to conduct internal
marketing audits. The checklist gives a list of situations each having three to
four options. This checklist is given to all the people within the marketing
department to know their views regarding the company's products, price,
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promotion activities etc. The data collected gives the management an insight
into the marketing efforts and strategies and ways and means of improving
them. In exhibit 15.1, a list of situations pertaining mainly to a companys
products and pricing strategy are given in the form of a checklist.
SALES AUDIT
Competitive environment, increasing consumerism and advent of the internet
has made it imperative for companies to monitor their sales closely. Sales
audit is the process of examining and assessing the current state of sales, the
sales environment and the sales objectives, strategies and activities.
Approaches to Sales Audit
Collective approach
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Separate approach
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For conducting a sales audit, an auditor can use two approaches.
Marketing Audit Checklist

Uncertain
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Agree
Disagree
Company has sometimes failed to meet production targets
Suppliers are very reliable
The majority of our sales are in one product
We do not introduce new products as often as our competitors
Our product range matches customer wants
We monitor new product development in the industry
We are aware and comply with current legislation
We are aware of how our customers perceive our products
We do have a system of quality control
We monitor the quality of incoming supplies
Level of sales returns is negligible
Level of purchase returns is negligible
Company collects feedback from after sales complaints
Company uses feedback from sales to influence new products
Markets are sensitive to price changes
Prices are in line with the competition
Profit margins are wide enough to meet price competition
Credit terms and discounts are in line with competitors
An increase in credit sales will lead to cash-flow problems
Company follows competitors in pricing the product/services
Adapted from Marketing Audit Questionnaire, Strathclyde European Partnership Project, Glasgow.
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Separate approach
In a separate approach, individual sales executives are interviewed to find out
their personal sales experiences and views regarding the existing sales process
and ways of improving them.
Collective approach
On the other hand, when views of a group of sales executives are sought then
it is known as the collective approach. For example, if the regional sales
manager wants to know the views of all the sales executives in a regional
meeting he can use this approach. Questionnaires are generally used for
collecting data.
Conducting a Sales Audit
Characteristics of a Sales Auditor
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A sales audit can be conducted in-house by the sales manager or by an outside

consultant. It is always better to appoint an outside consultant for the sake of
objectivity. Before conducting a sales audit, the company should make sure
that it has a strong sales foundation and excellent sales relationship (Refer
Exhibit 15.2). In the absence of these, the sales audit may not prove to be
successful and hence, the purpose of conducting it may be lost.
He must be detail oriented. He should pay specific attention to the

different product aspects when counting inventory and recording
information. He should always cross-check to make sure that all sales
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The main characteristics of a good sales auditor are:
Exhibit 15.2
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Pre-requisite for Conducting Sales Audit
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The Five Foundations of Sales

Attention Possibly through advertising, the potential customer needs to be attracted.
Interest Generate their interest in the product.
Desire Show off your product; make the customer want it.
Conviction Prove that your product is the best. Tell them about your competition
and give them stories from satisfied customers.
Action Persuade customers to decide. If they have any doubts, address those
concerns.
Establishing Selling Relationships
Sales people who are honest and show an actual interest in the client develop the best
type of customer-salesperson relationship.
To keep these relationships strong, a company has to maintain contacts with the
clients and keep several channels of communication open.
Source:www.consultomc.com
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invoices have been retrieved for the audit period. If an invoice appears to
be missing, the auditor should make every effort to retrieve the missing
invoice from the stores manager.
An effective sales auditor will always give importance to collecting

invoices from a stores manager, and never assume that all the invoices
were handed over to him or her.
Sales auditors must have exposure to store management while they are
doing their job. Auditors not only act as data collectors but also as
representatives of the service providing firm. For this reason, they must
interact with stores manager and plan store visits in such a manner that
they do not disturb the stores manager's schedule.
Process of Collecting Data During Sales Audit
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During a sales audit, data is usually collected from sales representatives

through questionnaires. The questionnaire may have questions pertaining to
different aspects of sales like sales strategy, sales planning, territory
allocation, motivating salespersons, performance modeling of salespersons,
sales analysis and control etc. For example, some of the questions pertaining
to sales control that can be incorporated in the questionnaire are:
What is the Sales Control (SC) system is used?
Which sales activities are controlled?
Who sets the sales standards? How?
Who uses or gets to see the sales figures?
When variances occur, who takes care of these variances?
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SUMMARY
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The data collected provides great insight into the sales management function
and can help to improve sales processes.
Organizations club activities pertaining to a particular domain under a specific

management functions. In order to prevent functional activities form
becoming inefficient, organizations conduct functional audit. An audit of the
purchase activities is referred as purchase audit. It is conducted to control
purchase costs and to identify loopholes, if any, in the purchase function. The
Human Resources (HR) audit is a process of examining policies, procedures,
documentation, systems, and practices with respect to an organizations HR
functions. The purpose of an HR audit is to reveal the strengths and
weaknesses of the human resources system. In order to remain competitive, it
has become imperative for companies to develop innovative concepts,
products and procedures. For achieving this, companies need to invest heavily
in R&D. R&D investment may prove to be a waste if the R&D activities are
not monitored and controlled. Therefore, organizations conduct R&D audits to
ensure that their R&D efforts are fruitful and not simply a waste of money and
resources. The production audit is conducted to measure the effectiveness and
efficiency of all production facilities and processes.
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A marketing audit is a comprehensive, systematic, independent and periodic

examination of a company's or business unit's marketing environment,
objectives, strategies, and activities. This is done to identify the problem areas
as well as opportunities. An action plan is then recommended to improve the
company's marketing performance. Sales audit is the process of examining
and assessing current state of sales, the sales environment, and sales
objectives, strategies and activities.
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PART VII:
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MANAGEMENT CONTROL AND

EMERGING AREAS
Chapter 16
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Control in Multinational
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Corporations
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Types of Controls Used by MNCs
Concept of Strategic Control
Factors Affecting Control Systems in MNCs
Analysis of Foreign Investment Projects by MNCs
Transfer Pricing in MNCs
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Control of Foreign Affiliates
Budgeting for Foreign Affiliates
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In the last few decades, companies have grown across borders at a tremendous
pace. This growth in business has made it imperative for managers to increase
their awareness in relation to the important issues involved in cross-border
investments, subsidiary control, global benchmarking practices and cultural
diversities of countries. Multinational Corporations (MNCs) have to adapt
various control practices used in their home countries (headquarters) to suit
the requirements of the host countries (subsidiaries). Improper adaptation of
control systems used in the home country for subsidiaries, works against the
interests of the organization. As control is one of the most important issues for
an MNC, we will discuss the ways and means by which the headquarters
exercises control over its subsidiaries.
TYPES OF CONTROLS USED BY MNCs
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MNCs use different types of controls to monitor and improve the performance
of their subsidiaries. Some of the controls are:
Personal controls
Output controls
Cultural controls
Result controls
Bureaucratic controls
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Personal Controls
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Output Controls
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Personal control is exercised through informal meetings that take place at all
levels between the officials of the headquarters and the subsidiary. These
meetings help them to establish greater coordination and communication
between the headquarters and the subsidiary.
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Output control relates to the performance of a subsidiary in quantitative and

qualitative terms. Performance measures can be established to determine
profitability, productivity, quality of the product and market share of a
subsidiary. The headquarters often set stiff targets for the subsidiaries
especially in terms of profitability and productivity. These targets act as
controls for the subsidiary.
Cultural Controls
Cultural controls are exercised by an MNC directly or indirectly in order to
uphold, manage and improve the work culture in its subsidiaries. These
controls help in regulating the behavior of employees at the subsidiary.
Result Controls
Controls that are used for rewarding individuals or groups for generating good
results are called result controls. One of the best examples of result control is
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the pay for performance system used in the US. In this system, employees
are paid on the basis of their performance rather than the number of hours they
have worked. A similar system is often used in MNC subsidiaries in order to
control performance.
Bureaucratic Controls
Bureaucratic controls take the form of rules, norms and regulations imposed
by the headquarters on the subsidiaries so that the business is conducted
properly. For example, a company may have rule that restricts subsidiaries
from spending more than 10% of their allocated budget on business-related
travel.
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CONCEPT OF STRATEGIC CONTROL
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Strategic control is defined by Prahlad and Doz as the extent of influence that
a head office has over a subsidiary concerning decisions that affect subsidiary
strategy. In many multi-business, multinational companies, more than 50% of
the assets, sales and profits come from overseas operations. As MNCs grow
and as their operations become more complex, the headquarters has to devise
and implement strategies to control subsidiaries effectively. However, the
controls should not hamper the growth of the subsidiaries. Some of the factors
that determine the kind of influence the headquarters has over the subsidiary
are:
Headquarters-Subsidiary Environment
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Earlier, MNCs used to invest and consolidate their position only in their home
countries. But with better growth prospects in foreign markets compared to the
domestic markets, MNCs have started to invest and create a stronger asset
base for their foreign subsidiaries too. For this reason, the headquarters of a
company has to exercise greater strategic control over its subsidiaries.
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Impact of Global Competition

Over the last few decades, competition between players in a wide range of
industries has intensified. Industries like automobiles, chemicals, and
consumer electronics have experienced intense competition. In order to
compete in the global market, an MNC should surpass the boundaries of
national markets and prepare a global strategy. In order to do so, it has to
constantly review and change its sourcing patterns, pricing strategies, product
designs, etc. This has led the headquarters of MNCs to exercise greater control
over their subsidiaries.
Impact of Host Government Demands

Often, the host government (i.e. the government of the country in which the
subsidiary of the MNC operates) intervenes in the operations of an MNC.
Host governments are averse to centralization and may penalize the MNC for
excessive controls. Hence, MNCs find themselves in a tricky situation where,
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on the one hand, the government demands greater autonomy for the
subsidiaries, and on the other hand, the government itself intervenes in their
functioning. Strategic control by the headquarters has gained importance for
this reason.
Impact of Joint Ventures
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In order to gain entry into certain foreign markets, an MNC may form a joint
venture with a local company because the host government restricts the direct
entry of MNCs. In recent years, many joint ventures have not proved
successful in the long term because of lack of coordination and conflicting
interests between the MNC and the local company. Due to lack of
coordination and communication between the MNC and the local company,
the subsidiary cannot operate properly. The MNC cannot exercise excessive
control because it fears that the joint venture may be called off and it may be
deprived of a prospective market. Here, established control systems for the
subsidiary are useful.
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FACTORS AFFECTING CONTROL SYSTEMS IN MNCs
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MNCs need to adapt the control systems practices prevalent in their home
country to the conditions prevalent in the foreign country. These control
systems should be evaluated on a continuous basis and should be modified
when required. Control systems need modification or changes because they
are affected by a number of factors such as:
Cultural Differences Across Countries
Differences in Business Environment
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Cultural Differences Across Countries
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Culture and traditions vary from country to country. MNCs need to be

sensitive to these differences when designing control systems for their
subsidiaries. Culture has a great effect on management control systems
(MCSs) because a number of control problems are in fact behavioral
problems. A number of studies have been conducted to study the implications
of various aspects of culture for MCSs. Geert Hofstede, in his landmark study,
identified four types of cultural dimensions, which have distinct implications
for control systems. According to Hofstede, the four cultural dimensions are:
Individualism
Power distance
Uncertainty avoidance
Masculinity
Individualism
Individualism is a cultural dimension, which determines how an individual
sees himself, i.e. as an individual entity or as a part of a larger group. Cultures
that are highly individualistic consist of people who give priority to their selfinterest rather than that of the group. When the culture is collectivist, people
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give more importance to the group interest rather than the individuals interest.
This dimension of culture is important for designing the reward system in an
organization- an integral part of MCSs. For example if the culture is highly
individualistic, organizations use individual incentives for motivating their
employees. If the culture is collectivist, it gives incentives based on group
performance.
Power distance
In an organization different people are vested with different degrees of power
and authority. This often creates a feeling of inequality. Power distance means
the extent to which employees understand and accept this unequal distribution
of power. In the context of MCSs, employees who score high on power
distance always prefer centralization and do not like to delegate authority.
Employees who score low on power distance prefer greater decentralization
and participation.
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Uncertainty avoidance
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Uncertainty avoidance is a cultural dimension seen in employees who avoid

taking risks. Employees who favor uncertainty avoidance, do not take quick
decisions and feel uncomfortable when confronted with difficult situations. If
an organization has a large number of employees who are averse to risk
taking, then it must have clear rules and guidelines for every action. It has to
do things in a planned and systematic manner so that employees know
beforehand what they have to do in unfamiliar situations.
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Masculinity is defined here as a strong drive for achievement. Employees

with this attribute are highly assertive and are often entrusted with responsible
roles. They take decisions quickly and are not worried about the results. The
implication for MCSs is that such employees demand more autonomy and
freedom at the workplace. They do not like excessive controls and cannot
perform well in a highly centralized organization. They also prefer
performance-based rewards.
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Differences in Business Environment

Business environment is dynamic and differs across countries. Organizations
need to learn to adapt to these changes in environment in order to survive and
prosper. Some of the elements of business environment that have an effect on
control systems are:
Inflation
Business risk and uncertainty
Labor availability and quality
Inflation
Inflation refers to a sustained increase in the general price level in an
economy. As the rate of inflation increases, the value and purchasing power of
money decreases. Rates of inflation vary widely across countries. MNCs need
to evaluate the impending financial risk due to fluctuations in inflation rates.
An MNC operating in a country which has a high rate of inflation, may
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experience an erosion in the value of its assets. High inflation can also
adversely affect the compensation of employees. As the prices of goods
increase, there should be a corresponding increase in salaries. This would in
turn mean that the management has to make changes in its rewards system -an integral part of the control system.
Business risk and uncertainty
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MNCs operating in different countries are exposed to different types of risks

and uncertainty. Business risk and uncertainty is lower in countries which are
economically and politically stable than in countries which are politically and
economically unstable. Risk also differs across countries depending on the
extent of economic development. Companies in economically underdeveloped
countries may not have strong and well-developed control systems. A poor
and undeveloped MCS is characterized by a poor accounting system, an
ineffective information system, limited computerization and excessively
subjective performance reviews. A companys growth strategy also affects the
way an organization manages risk. Companies may grow organically (i.e.
gradual growth due to increase in profit or returns) or by acquiring other firms.
When companies grow by acquiring other firms, they encounter variations in
control systems. A company that can adopt the best control system for all its
acquisitions will be more adept at managing risks.
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MNCs operating in underdeveloped countries find it difficult to hire skilled

labor due to the lack of quality education and vocational training. This forces
the management to have a highly centralized structure and to exercise a high
degree of control. Even at the managerial level, there is a marked difference in
the quality of managers across the countries. An MNC needs to consider all
these factors before designing the control systems for its subsidiaries.
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ANALYSIS OF FOREIGN INVESTMENT PROJECTS BY MNCs
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MNCs often invest in different countries by taking up a number of projects.

They use various methods like Net Present Value (NPV), Pay back period, or
Accounting rate of return, for assessing the profitability and viability of a
project. They also conduct risk-benefit analysis before initiating a project.
There are a number of other issues that should be considered by an MNC
before embarking on projects in foreign countries. Some of them are:
Taxes on income from foreign investment projects
Political risks
Economic risks
Exchange rate risks
Different types of exchange rate exposure
Taxes on Income from Foreign Investment Projects

All over the world, host countries levy taxes on MNCs on the income they
earn in the host countries. Taxes are levied not only on the income earned but
also on the income repatriated to the home country of the MNC in the form of
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dividends. The rate of taxation differs from country to country. At times, an

MNC may get tax concessions due to the nature of the project or its location.
It may also get concessions because of the employment opportunities the
project generates for the local people. MNCs should have a transparent and
efficient accounting system in order to avoid complications that may arise due
to the incorrect assessment of tax to be paid.
Political Risks
The most extreme form of risk an MNC faces in its overseas operations is the
risk of expropriation of the business by the host country due to policy changes.
Expropriation can take the form of seizure of property or assets of an MNC.
For example, in 1970 in Chile, the government took control of companies like
Anaconda, Ford and AT&T as part of its nationalization policy.
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Economic Risks
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Economic risk can be divided into exchange rate risk and inflation. As we
have already discussed inflation in the previous section, here we will discuss
exchange rate risk in detail. Political risk has a strong bearing on economic
risk. Frequent political changes in a country can adversely affect the economy
of the country and the operations of MNCs.
Exchange Rate Risk
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Exchange rate is the value of one currency in terms of another. The value of
one US dollar can be quoted in terms of another currency like the Euro. The
exchange rate of a currency is governed by the laws of demand and supply.
The demand and supply of a currency is influenced by many factors including
interest rate differentials, relative inflation, export competitiveness and
economic growth. Exchange rate fluctuations influence the cash flows of an
MNC because they may be denominated in several currencies and the value of
each currency relative to the dollar is different at different times. This
complicates the problem of measuring the performance of subsidiaries. Apart
from this, exchange rate changes also affect costs. If a countrys currency has
depreciated, there will be an increase in the prices of raw materials imported
from other countries. Moreover, since domestic inflation often accompanies
depreciation/devaluation of the currency, prices of raw materials purchased
locally will also rise. As costs and prices rise, so will wages. Therefore, if
there are risks of exchange rate changes, these risks should get reflected in
estimates of project costs and revenues.
Different types of exchange rate exposure
The sensitivity of a firms cash flows to changes in exchange rates is called
exposure. MNCs face different types of exchange rate exposures.
Some of them are:
Translation exposure
Transaction exposure, and
Economic exposure
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Translation exposure
Fluctuations in exchange rate affect the income statement and balance sheet of
companies either positively or negatively. The erosion or appreciation in the
value of earnings, assets and liabilities is referred to as translation exposure.
This exposure arises because MNCs maintain their accounts in a single
currency (usually the currency of parent country) whereas the cash inflows are
in different currencies. For example, the accounts of a US-based MNC would
be maintained in US dollars, but its cash inflows would be in different
currencies. As the value of dollar fluctuates against the value of other
currencies, the figures in the income statement and balance sheet are affected.
Transaction exposure
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Transaction exposure indicates the exchange rate exposure that the firm has in
its cross-border transactions, when such transactions are entered into at the
present time, but payments to settle the transactions are made at some future
date. If nominal exchange rates change during the interim period, and the
payment or receipt commitments are outstanding, the value of transactions is
put at risk. Examples of such transactions are receivables and payables, and
debt or interest payments outstanding, in foreign currencies.
Economic exposure
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Economic exposure, also referred to as operating exposure, or competitive

exposure, is the exchange rate exposure of the firms cash flows to changes
in the real exchange rate.
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TRANSFER PRICING IN MNCs
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One of the most controversial and often least understood issues in a

multinational's operations is transfer pricing1. In chapter 7, we explained the
basic concept of transfer pricing and the way it is used by domestic firms to
achieve goal congruence. In the following sections we will study transfer
pricing from an MNC perspective and the ways in which MNCs manipulate
this system for tax gains.
When one subsidiary of an MNC in one country transfers (read sells) goods,
services or know-how to another subsidiary in another country, the price
charged for these goods or services is called the 'transfer price'.
MNCs can manipulate their income by the use of transfer pricing in following
ways:
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MNCs set high transfer prices for subsidiaries in countries with a

relatively high rate of taxation.
MNCs set low transfer prices when goods are subjected to high import
duties in a particular country.
In order to prevent companies from manipulating their incomes using he transfer pricing
mechanism, tax authorities may insist on companies adopting the principle of arms length
pricing which means that whenever goods are sold by a foreign affiliate to its parent
company or vice versa, the transaction should take place as if the two companies were
separate entities.
MNCs set relatively high transfer prices for their subsidiaries in countries
experiencing hyperinflation and currency devaluation.
MNCs set high transfer prices for goods and services that are purchased
by their subsidiaries situated in countries that restrict repatriation of
income.
We will see in the following paragraphs that the transfer price can be set at a
level which can reduce or even cancel out the total tax which has to be paid by
an MNC.
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Let us assume that ABC Automobile Company, based in the UK,

manufactures and assembles automobile components and exports them all
over the world. It has its main assembling division in the UK but manufactures
a number of other parts in its plants in the US. The US subsidiary transfers
certain automobile parts at a transfer price that is fixed by the parent company
in the UK. This effectively means that the subsidiary belongs to the parent
company and ultimately it is the parent company that takes all the decisions
for the subsidiary.
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The finance director of the parent company explains how income can be
manipulated for tax gains in four different situations. The first situation is one
in which the MNC pays some tax to the authorities.
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Assume that the US subsidiary manufactures one of the automobile

components for $100. It transfers the component to the assembly division in
UK at $200 each and hence makes a profit of $100. The parent company in
UK sells the same component for $300 in turn making a profit of $100 ($300$200). The overall profit is thus $100 in the host country and another $100 in
the home country, a total of $200.
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However, one has to consider the tax these companies have to pay on their
profits. Tax rates (company or corporation tax) are different in the USA and
the UK. Assuming the US subsidiary has to pay corporation tax at the rate of
20% on profits, the tax amounts to $20 (20% of $100). The parent company in
UK has to pay tax at the rate of 60% on profits which amounts to $60 (60% of
$100). Overall, tax paid is $80 ($20+$60). This reduces the overall profit
before tax of $200 to profit after tax of $120 ($200-$80). The US subsidiary
contributed $80 to this profit, while the parent company in UK contributed
$40. The after-tax profit generated by the parent company in the home
country, was smaller because of the corporation tax of 60% which is higher
than the subsidiarys tax rate of 20%.
However, the parent company can tell the subsidiary what to charge and can
fix the transfer price for the subsidiary. The transfer price is arbitrary, and is
decided by mutual agreement between the parent company and the subsidiary.
Situation 2-Inflating Profits

Suppose, the US subsidiary manufactures the part for $100 but sets the
transfer price at $280 on the advice of the parent company. In this situation the
profit made by the subsidiary is $180. Assuming that the parent company sells
it for $300, it will make a profit of $20 in the home country. The total profit
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before tax is again $200 but as the profits of the parent and the subsidiary have
changed so will the taxes. Now the tax paid by the subsidiary will amount to
$36 (20% of $180) whereas the tax paid by the parent company will be $12
(60% of $20). In total the tax paid is $36+$12= $48. The overall profit after
tax now stands at $152 ($200-$48=$152) which is much more than the earlier
profit of $120. Hence by merely manipulating the transfer price, the company
has been able to inflate its profits by $32.
Situation 3 - Paying No Tax
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Now, assume that the US subsidiary has increased the transfer price to $300
on the advice of the parent company. Assume that the parent company buys
the product at $300 and sells it at the same price. One may think that this does
not make sense at all but in fact the parent company stands to gain a lot from
this transfer. When the transfer price is $300, subsidiary makes a profit of
$200 ($300-$100) whereas the parent company neither makes profit nor incurs
any loss. The tax paid by the subsidiary would be $40 (20% of $200) and $0
by the parent company. The total tax paid is only $40. In this scenario, the
profit after tax becomes $160. The subsidiary contributes $160 to this while
parent company's contribution is $0. The parent company has successfully
shifted all the profits to the subsidiary and hence does not pay any tax in the
home country. The parent company can shift even more of its profits to the
subsidiary. It can make a loss and get a tax rebate. This is illustrated by
situation 4.
Situation 4 - Getting Tax Rebates
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Assume that the subsidiary has now set the transfer price at $400. This means
that it will make a profit of $300, assuming manufacturing cost remains the
same at $100. If the parent company cannot sell the component at $400, then
effectively it will incur a loss of $100. In this situation the total tax paid by the
subsidiary would be $60. As the parent company has incurred losses, it
reduces its tax bill by $60, in effect getting a rebate of $60. It can use this loss
to reduce the tax liability on other profitable operations in the home country.
Hence the overall result is that the MNC pays no tax at all on this transaction,
and its after-tax profit becomes $200.
Tax Avoidance Inflates Profits

So, by arbitrarily increasing the transfer price, the company almost doubled its
after-tax profit. This was done by merely changing book entries and not by
any change in operations.
In other words, it is possible for a multinational company to minimize its tax
liability by manipulating transfer price. This is legal until governments
enforce laws to prevent this practice. However, in the case discussed above,
the tax paid to the host country increased while the tax paid to the home
country decreased gradually. In other words, one government's loss was
another government's gain. So one government may want to enforce
legislation against unfair transfer pricing practices, while the other
government may object to such legislation.
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Methods of Transfer Pricing

Basically, there are three methods of transfer pricing used by MNCs. The
method adopted depends on the market price of goods that are being
transferred, the tax structure of the country in which the subsidiary operates
and the position of the affiliate in the industry. The three methods commonly
used are:
Market price method
Resale price method
Cost method
Market price method

Here, MNCs set transfer prices for their affiliates according to the prevailing
market price of the particular good or service.
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Resale price method
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Here, MNCs estimate an appropriate transfer price for a product if it becomes

an input for another product within a reasonable period of time. In this case,
the transfer price is the difference between further processing cost plus profit
markup, and the selling price of the product.
Cost method
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Here, MNCs determine the transfer price on the basis of the costs incurred by
the affiliate in producing the goods. For this method to be successful, MNCs
need to have sound cost accounting practices and access to the cost structure
of the affiliate.
CONTROL OF FOREIGN AFFILIATES
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In 1979, Persen and Lessig conducted a survey of the differences between the
financial evaluation of domestic firms and foreign affiliates. There were 106
respondents to the survey. The differences as conveyed by the respondents
can be broadly can be categorized into the following five types, based on their
cause:
Currency and exchange rate fluctuation
Translation of currencies
Variation in inflation
Variation in financial and economic conditions
Multiplicity of government regulations and controls
Currency translation was found to be the most important issue that an MNC
should consider before designing control systems for its foreign affiliates.
Currency Translation
We shall understand the effect of currency translation on the performance of
an affiliate with the help of an example. ABC Inc. is a US-based company
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Table 16.1 Budgeted and Actuals for Balanced Subsidiary

Budgeted
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which has a subsidiary in India. The Indian subsidiary produces electric bulbs
which are sold only in the Indian market. Suppose the initial exchange rate of
the Indian rupee was Rs.50/$
Assuming the subsidiary was given the target of selling goods worth Rs.500,
with a corresponding profit of Rs.50 (10% of net revenue as profit). Suppose
the Indian rupee depreciates by 10% against the dollar over a period of a year
(i.e. it now stands at Rs.55/$). Due to the depreciation, the performance of the
subsidiary appears poor in dollar terms, although it has achieved its target in
rupee terms. From Table 16.1, we can see that although the budgeted and
actual revenues were same in terms of rupees, they were different in terms of
dollars. This happened on account of the depreciation of the rupee against the
dollar. The loss suffered by the parent company is called Translation Loss.
There is little that parent companies can do to control such exchange rate
fluctuations.
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In preparing a report for stockholders, a company has to consolidate the

accounts of all its foreign subsidiaries with the accounts of the parent. During
this process of consolidation currencies of subsidiary countries are translated
into the currency of the parent company. The performance of the subsidiary
should not be affected by such translation gains or losses.
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Budgeting for Foreign Affiliates
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One of the best methods of control an MNC can use over its affiliates is
budgeting. Budgeting data helps in comparing the actual performance against
the budgeted, and helps the management to identify the areas in which greater
control is needed. Budgeting can also be used to improve coordination
between the affiliates and the parent company. The major problem in
budgeting for foreign affiliates pertains to exchange rate fluctuations. Some of
the issues involved are:
1. Which exchange rates should be used for budgetary planning?
2. Which exchange rates should be used for reporting performance?

3. Should the managers of foreign affiliates be held responsible for the
effects of exchange rate fluctuation?
These issues can be resolved by establishing goal congruence and better
controllability.
Goal congruence
The main concern for an MNC while designing a control system is the returns
it gets in terms of the parent company's currency. If the parent company is
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UK-based then it would like to calculate revenues, profits and dividends in the
local currency i.e. Pound Sterling. In order to avoid complications due to
fluctuations in exchange rates, the parent company can budget using exchange
rates projected for the end of the period.
Controllability
Exchange rate fluctuations cannot be controlled by the management of local
subsidiaries. In a survey conducted by Persen and Lessig, it was found that
most of the firms used projected exchange rates for budgeting whereas they
used actual rates for reporting the performance. This leads to discrepancy and
may reflect a poor performance on the part of the subsidiary even though that
may not be the case. Hence in order to establish better controllability, it is
recommended that the same exchange rates be used for budgeting as well as
reporting performance.
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SUMMARY
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MNCs need to control their subsidiaries so that the subsidiaries perform better
and achieve higher profits. MNCs make use of different types of control
systems. These include personal controls, output controls, cultural controls,
action controls, result controls and bureaucratic controls. The headquarters of
the company tries to exercise control over the subsidiaries. This is referred to
as strategic control. Some of the factors that determine the influence of the
headquarters over the subsidiary are: the headquarters-subsidiary environment,
host government demands, joint ventures and global competition. Cultural
differences across countries, differences in the business environment and local
institutions also influence control systems used by MNCs. Geert Hofstedes
cultural dimension reveals the cultural dimensions affecting control in an
organization. Hofstede's cultural dimensions are individualism, power
distance, uncertainty avoidance and masculinity. The environmental elements
that can greatly affect control systems in an organization are inflation,
business risk and uncertainty, labor availability and quality. An MNC
planning to invest in projects in other countries needs to consider a number of
factors before starting operations. Some of the factors are taxes on income
from foreign investment projects, political risks and economic risks. MNCs
use transfer pricing to manipulate their incomes. Some of the methods of
transfer pricing are cost method, resale price method and market price method.
Currency translation is an important issue that an MNC should consider before
designing a control system for its foreign affiliates. Budgeting is an important
tool that an MNC to exercise control over its affiliates. One of the major
problems encountered when budgeting for foreign affiliates pertains to
exchange rate fluctuations. Exchange rate fluctuations can adversely affect the
performance of foreign affiliates. In order to solve the problems arising out of
exchange rate fluctuations, MNCs have to achieve goal congruence and ensure
better controllability.
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Chapter 17
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Control in Nonprofit
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Mission of Nonprofit Organizations
Key Characteristics of Nonprofit Organizations
Designing Control Systems for Nonprofit Organizations
Employee Characteristics and Organizational Culture
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Control in Non Profit Organizations
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A nonprofit organization1 is defined as an organization that does not have

owners who profit when revenues exceed expenses. A nonprofit organization
operates in the interests of society. It does not participate in the equity markets
since it has no shareholders. The sources of funds for nonprofit organizations
are contributions, grants, and operating surplus. The activities of a nonprofit
organization uphold the organizations stated mission, which describes the
nature of its contribution to society; profits do not form a part of its mission.
Most nonprofit organizations provide services. They are run professionally, by
managers who develop objectives, strategies and budgets. Performance
reviews are conducted for the employees and they are suitably rewarded.
Controlling employees, systems and processes in a nonprofit organization is
different from controlling them in profit seeking organizations. In this chapter
we will discuss the differences between nonprofit and profit-seeking
organizations and their implications for control systems.
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MISSION OF NONPROFIT ORGANIZATIONS
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The major difference between profit seeking and nonprofit organizations is

their mission. The mission of an organization is explained in its mission
statement. A mission statement is a written statement of purpose that can be
used to initiate, evaluate and refine all organizational activities. According to
Peter Drucker, a mission statement should state the following:
Opportunities that an organization can exploit or needs that it can meet
Strengths of an organization
Beliefs of members of the organization
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A mission statement serves as a road map that guides an organization to

success. Many organizations recognize the need to have a mission statement
and to put this powerful tool into action -- especially nonprofit organizations
that sincerely attempt to provide quality services. The basic problem that most
nonprofit organizations face is that they find it difficult to measure the success
of their mission. But, contemporary research indicates that this can be done.
For this purpose, they need first to define their mission clearly. Nonprofit
organizations have three options to help determine the organizations success
in terms of its mission. First, the organization can define its mission narrowly
so that progress can be measured easily. Second, it can invest in research to
show how its activities help in achieving the objectives stated in its mission.
Third, it can develop micro-level goals that if achieved, imply success on a
bigger scale.
Though there is no perceived difference between nonprofit and not-for-profit organizations,

the legal definition differentiates between the two. Not-for-profit refers to an activity, for
example, a hobby (like fishing). "Nonprofit" refers to an organization established for
purposes other than profit-making. For example, a "nonprofit" organization can be an
association of people who like fishing.
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Exhibit 17.1
Mission Statement of Ford foundation
Founded in 1936, the Foundation operated as a local philanthropy in the state of Michigan
until 1950, when it expanded to become a national and inter-national foundation. Since its
inception it has been an independent, nonprofit, nongovernmental organization. It has
provided slightly more than $10 billion in grants and loans. These funds derive from an
investment portfolio that began with gifts and bequests of Ford Motor Company stock by
Henry and Edsel Ford. The Foundation no longer owns Ford Motor Company stock, and its
diversified portfolio is managed to provide a perpetual source of support for the
Foundation's programs and operations.
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The Trustees of the Foundation set policy and delegate authority to the president and senior
staff for the Foundation's grant making and operations. Program officers in the United
States, Africa, the Middle East, Asia, Latin America and Russia explore opportunities to
pursue the Foundation's goals, formulate strategies and recommend proposals for funding.
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The Ford Foundation is a resource for innovative people and institutions worldwide. Its
goals are to:
Strengthen democratic values,
Reduce poverty and injustice,
Promote international cooperation and
Advance human achievement
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A fundamental challenge facing every society is to create political, economic and social
systems that promote peace, human welfare and the sustainability of the environment on
which life depends. Ford Foundation believes that the best way to meet this challenge is to
encourage initiatives by those living and working closest to where problems are located; to
promote collaboration among the nonprofit, government and business sectors, and to ensure
participation by men and women from diverse communities and at all levels of society. Such
activities help build common understanding, enhance excellence, enable people to improve
their lives and reinforce their commitment to society.
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The Ford Foundation is one source of support for these activities. It works mainly by
making grants or loans that build knowledge and strengthen organizations and networks.
Since its financial resources are modest in comparison to societal needs, it focuses on a
limited number of problem areas and program strategies within their broad goals.
www.fordfound.org
KEY CHARACTERISTICS OF NONPROFIT ORGANIZATIONS

After studying a number of nonprofit organizations, seven key characteristics
of these organizations have been identified:
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Atmosphere of scarcity
Bias towards informality, participation and consensus
Dual bottom lines: mission and financial
Difficulty in assessing program outcomes
Governing board with both overview and supporting roles
Mixed skill levels of staff
Participation of volunteers
Atmosphere of Scarcity
There are factual and perceptual components to scarcity in nonprofit
organizations. Most nonprofit leaders are severely constrained by lack of
resources. In addition, many nonprofit organizations rely on altruism. As a
result, they often have underdeveloped infrastructures.
Bias towards Informality, Participation and Consensus
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Nonprofit organizations are characterized by informality, participation and

consensus. They give less importance to hierarchy. Taken too far, informality
can limit the appropriate exercise of authority, over-participation can inhibit
appropriate division of labor, and the tendency toward consensus can bog
down decision making.
Dual Bottom Lines: Mission and Financial
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Tension between mission and financial results is fundamental for nonprofit

organizations. (One can debate to what extent this is unique. For-profit
organizations have increasingly focused on the importance of mission, relative
to the priority of return on investment. Governmental organizations have
increasingly focused on the importance of mission relative to the priority of
political impact).
Internally, the tension between bottom lines influences many strategic
decisions as well as the sense of how well the organization is doing at all
operational levels. Externally, some stakeholders of a nonprofit organization
care about both bottom lines (funders, competitors and regulators) while some
stakeholders care primarily about mission (clients and community). The
complexity of dual bottom lines figures in many consulting engagements.
Difficulty in Assessing Program Outcomes

Most nonprofit organizations have limited capacity for program evaluation.
This is caused partly by the absence of standardized program outcomes in
most fields. In childcare for example, standards for adult-child ratios exist, but
little is standardized in terms of the quality of care delivered. Similarly, arts
groups, advocacy organizations, mental health agencies and community
development corporations face substantial challenges in measuring their
effectiveness. Furthermore, most nonprofit organizations do not have the
benefit of unambiguous market feedback to let them know how well they are
serving their clients. Nonprofit organizations exist because neither the market
nor government is providing the service; most are funded in part or completely
by sources other than the direct beneficiaries of their work. Thus, assessing
cost-effectiveness and comparing alternative actions is difficult. Also,
different individuals may make different assumptions about the relationship
between cost and effectiveness. Some groups essentially ignore the issue
assuming their efforts are as effective as they can be.
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Governing Board with both Overview and Supporting Roles
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The governing board of a nonprofit organization has dual roles: it is

responsible for ensuring that the public interest is served by the organization,
and, -- unlike private sector boards of directors or government boards and
commissions -- is expected to help the organization to be successful. The first
role is analogous to protecting the interest of stockholders or voters. The
second role complicates the distinction between governance and management
because, in this role, board members do staff-like work. As helpers, board
members may raise funds, send mailings, paint buildings, or do the
bookkeeping. This can lead to confusion about when, and how, it is
appropriate for board members to be involved in initiatives at work.
Furthermore, board members are often not experts in either nonprofit
management or in the organization's field of service. They may either be
unprepared to make decisions, or may give up their authority inappropriately
to staff.
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Mixed Skill Levels of Staff
Participation of Volunteers
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The individuals passion for the mission, the limited financial resources of the
organization, and a shallow pool of candidates often result in nonprofit
organizations hiring managers with limited management training and program
staff with little program experience. Though the staff is often composed of
professionals (e.g. social workers, artists and scientists), since most
organizations are small, there is seldom much internal capacity to provide
training for staff for the particular roles they are playing.
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Many nonprofit organizations rely on the active participation of volunteers.

Members of the Board of Directors are normally not paid for their work, and
individuals contribute considerable time and effort in delivering services and
providing administrative support. The contribution that volunteers make to the
nonprofit sector is significant; indeed without volunteerism, many needed
social services would not be available to the public. However, volunteers
usually have to juggle multiple commitments, and the relative priority they
assign to their volunteer job may have to be balanced with their paid job,
family responsibilities, and other volunteer commitments. Board meetings are
therefore often held in the evenings or on weekends. Finally, there may be
resentment on the part of certain volunteers that some people are being paid
for work that they are doing for free, and the feeling that everyone should be
volunteering.
DESIGNING CONTROL SYSTEMS FOR NONPROFIT ORGANIZATIONS

Designing a control system for a profit seeking organization is different from
designing a control system for nonprofit organizations. Some of the reasons
are:
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Absence of profit measure. This makes performance evaluation difficult.
Separate tax and legal status. Nonprofit organizations are exempted from
taxation and there are no shareholders.
Most nonprofit organizations provide services rather than products. It is

difficult to measure the quality and quantity of service.
Fragmented governance due to numerous sources of influence.
Excessive constraints in terms of usage of funds.
Differences in senior management.
Traditionally nonprofit organizations have had poor management controls

because the management consisted of professionals like teachers, priests,
doctors, etc. These professionals tended to give greater importance to
professional goals and did not give requisite value to managerial skills.
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Employees of a nonprofit organization are different from employees of a

profit seeking organization. This can have positive or negative implications
for organizational control. Control problems are usually aggravated when
employees of nonprofit organizations compare themselves with the employees
of profit seeking organizations. For example, compensation of employees in
nonprofit organizations is usually not competitive when compared to
compensation in profit seeking organizations. A positive aspect for control,
seen in nonprofit organizations, is employee commitment. Because of the
nature of work, which is quite often philanthropic in nature, employees find it
easier to identify themselves with the organization and its goals. High
commitment minimizes control problems that may arise due to lack of
motivation and direction.
Cultural characteristics of profit seeking and nonprofit organizations also
differ. Nonprofit organizations which are dominated by professionals, have
little regard for management control systems. These people prefer to
concentrate on their profession and undermine the value of MCS. Because of
poor compensation, nonprofit organizations do not attract the best of
managerial talent too. Absence of performance measurement methods
compounds this problem. This leads to a culture in which there may be poor
coordination and lack of trust among employees.
Rewards
Generally, employees working in profit seeking organizations get better
compensation and rewards when compared to employees in nonprofit
organizations. In nonprofit organizations, employees feel rewarded when they
achieve the goals which form a part of the mission statement of the
organization. For example, employees of a nonprofit organization that is
working towards preventing the spread of AIDS will feel rewarded when the
rate at which the disease is spreading decreases. As financial rewards are
negligible in nonprofit organizations, achieving the goals in the mission
statement keeps employees motivated. However, there are exceptions to this
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generalization. In certain nonprofit organizations like universities and research

organizations, employee compensation is better than in private sector
companies.
Performance Measurement
Measuring performance of nonprofit organizations is difficult and arduous
because most nonprofit organizations provide services which are measured in
qualitative terms rather than quantitative terms. Without a quantifiable
performance indicator, it is difficult: to measure organizational performance in light of the overall goals and to
use results control at the broad organizational level;
to analyze the benefits of alternative courses of action
to decentralize the organization and hold sub-unit managers responsible

for specific areas of performance; and
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to compare the performance of sub-units which are performing dissimilar

activities.
It has been observed that many nonprofit organizations, irrespective of their
mission, scope and needs, design three types of performance metrics. They
are:
Success in mobilizing resources
Effectiveness of staff on the job
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Progress in fulfilling the mission

The way these metrics can be applied differs from organization to
organization. For example, for a museum, the performance of its staff will be
rated on basis of the number of people who visited the museum. Of these three
metrics, the first two are easy to develop but measuring the success of a
nonprofit organization in terms of the achievement of its mission, is difficult.
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Fund accounting is an accounting system used by many nonprofit

organizations. In this system, accounts are kept separately for several funds,
each of which is self-balancing, with the sum of debit balances equaling the
sum of credit balances.
Most nonprofit organizations have: (1) a general fund or operating fund,
which corresponds to the set of operating accounts; (2) a plant fund and an
endowment fund, which account for contributed capital assets and equities and
(3) a variety of other funds for special purposes.
Programming and Budget Preparation

Compared to a typical business, programming is a more important and timeconsuming process in a nonprofit organization, where a decision has to be
made on how best to allocate limited resources to worthwhile activities.
Nonprofit organizations have to work within their budgets and cannot exceed
the set monetary limits because they do not market their services to increase
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their revenues. They limit their expenditure and aim to break even at the
estimated amount of revenue. Hence, the budget is a very important
management control tool for a nonprofit organization.
SUMMARY
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A nonprofit organization is defined as an organization that does not have

owners who profit when revenues exceed expenses. Nonprofit organizations
such as hospitals, government organizations, fraternal organizations and
religious institutions play a vital role in society. The major difference between
profit seeking and nonprofit organizations is their mission. Nonprofit
organizations are passionate about their mission. Their main aim is to achieve
the goals listed in their mission statement. Controlling employees, systems
and processes in a nonprofit organization is different from controlling them in
profit seeking organizations. Nonprofit organizations provide services, not in
order to create wealth for their shareholders but to meet a felt need. The
reasons why control systems of a nonprofit organization have to be different
are: absence of profit measure, difficulty in performance measurement,
separate legal status, non-imposition of income tax, provision of services
rather than products, and fragmented governance. The seven key
characteristics of nonprofit organizations are: the atmosphere of scarcity;
bias towards informality; participation and consensus; dual bottom lines:
financial and mission; difficulty in assessing program outcomes; dual role of
the governing board - oversight and supporting; mixed skill levels of staff;
and, participation of volunteers. The employee characteristics and
organizational culture of a nonprofit organization are different from those of a
profit seeking organization. Attributes like rewards, performance
measurement, programming and budgeting are also correspondingly different.
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Chapter 18
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Control in Service
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Organizations
Control in Professional Organizations
Control in Government Organizations
Control in Financial Service Organizations
Control in Securities Firms
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Over the years, the industrial landscape has changed drastically. Initially, the
focus was mainly on the manufacturing sector but during the later half of the
20th century the focus shifted to the service sector. In the US only, growth of
employment in the service sector during the 1980s, was twice as much as the
growth of employment in the manufacturing sector.
Control in service organizations is different from control in manufacturing
organizations due to the following reasons:
Absence of inventory buffer
Difficulty in controlling quality
Multi Unit organization
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Manufacturing organizations maintain an inventory of goods in order to tackle

sales fluctuations in future. This does not hold true for service organizations.
They cannot store their services. For example, the airplane seat, hotel room, or
the service of professionals like lawyers, physicians cannot be stored.
Moreover, many service organizations have a fixed cost in the short run which
cannot be reduced. For example, a hotel cannot reduce its fixed costs by
closing down some of its rooms. Thus, service organizations have to match
their current capacity with demand. Organizations match their current capacity
with demand in two ways. The first way is to stimulate demand in the off peak
seasons by increasing marketing activities and decreasing prices. For example
the airlines and hotels offer heavy discounts during the off-season to increase
demand. Secondly, companies can also try to right-size their workforce
according to the anticipated demand.
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The products of a manufacturing company should be inspected for quality

before they are released in the market, but this cannot be done in case of a
service organization's products. The quality of the products offered by service
organizations cannot be judged until it is rendered to the customer. Also, the
judgments regarding the quality of the product are often subjective. The
management of a restaurant may judge the quality of the food and approve of
it, but customer satisfaction also depends on how the food is served.
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Service organizations operate through many small units set-up in different

locations. These units act as individual profit centers for the service
organizations. Fast-food companies, gasoline stations and auto rental
companies are some of the examples of such service organizations. The units
of a service organization are either wholly owned or franchised. Most of these
units are similar in size and operations and hence provide a basis for analyzing
budgets and evaluating performance. The information generated from such an
analysis can be used to distinguish the high performing units from the low
performing units.
CONTROL IN PROFESSIONAL ORGANIZATIONS

Service organizations can be categorized into professional organizations,
healthcare organizations, financial services organizations, etc. The
characteristics of these service organizations differ from each other and hence
the control systems also differ. We will first discuss the characteristics of
professional organizations and their implications for control systems.
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Characteristics of Professional Organizations

Organizations that provide specialized professional services are called
professional organizations. They include law firms, consulting firms,
engineering firms, sports organizations and so on. These organizations possess
special characteristics like the following:
Small size
Labor intensiveness
Different objectives and goals
Difficulty in measuring output
Different marketing strategies
Small size
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Most professional organizations are relatively small in size and operate in a

single location, with the exception of some law and accounting firms. Senior
management personally monitors and motivates their subordinates. This
brings down the need for sophisticated control systems. Even though
professional organizations are small, they still need to prepare budgets,
compare the budgeted and actual performance, and compensate employees on
the basis of their performance.
Labor intensiveness
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Professional organizations are labor intensive, and they employ individuals

who are specialists in respective fields. Professionals who are also managers
prefer working independently rather than in teams. Professionals are the most
valuable asset of an organization. Due to this, some management thinkers
advocate the idea that these professionals should be valued highly and their
value highly included in the company's balance sheet. A system called human
resource accounting was developed by Likert for valuing the professionals but
very few companies used it.
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Different objectives and goals

The goal of a manufacturing organization is to earn a satisfactory return on the
assets it employed. As most assets are tangible, they appear in the balance
sheet. In professional organizations, as most assets assume the form of the
employees' skills it is difficult for the company to set for itself a goal in terms
of returns on assets employed. The financial goal of professional organizations
is to provide satisfactory compensation to its employees. Another goal of
professional service organizations is to increase their sizes and networks.
Difficulty in measuring output
The output of manufacturing organizations can be measured in terms of units,
tons, gallons, etc. but this method cannot be applied to professional
organizations. For example, the output of a physician, can be measured in
terms of number of patients treated, but one cannot measure whether the
service provided by the physician satisfied the patient. In some cases, the
revenues earned indicate the measure of output, but only in terms of quantity.
In a professional service organization, the non-repetitive nature of work
compounds the problem of measuring output. Since no two professionals
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work in the same way, it is difficult to set standards in terms of the time spent
for a task and the way in which the task is performed.
Different marketing strategy
In manufacturing companies, production and marketing activities are clearly
demarcated. But no such demarcation is done in professional organizations.
These organizations do not market themselves openly. It is done through the
use of articles, personal and professional contacts, speeches etc. An auditing
firm may market itself through the articles written by its auditors (on
contemporary issues) or through the marketing activities done by
professionals who spend much of their time working for clients. Thus, it
becomes difficult to identify a single employee who is responsible for
promoting the organization.
Control Systems in Professional Organizations
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The most important aspects of management control systems in professional

organizations are:
Pricing
Strategic planning and budgeting
Control of operations
Performance measurement and appraisal
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Pricing
Most professional firms determine the price of their services in a traditional
manner. If the professional service offered is dependent on time, then the fee
is fixed on the basis of time spent on the service. Investment banking is an
exception to this. In case of investment banking, the service charge is
determined on the basis of monetary size of the securities issue. Prices of
services offered differ from profession to profession. The prices are high for
accountants and physicians compared to research scientists, for instance.
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Strategic planning and budgeting

Manufacturing organizations have better strategic planning systems when
compared to professional organizations of similar size. One of the main
reasons for this could be that professional organizations do not need such a
system. Strategic planning is important for manufacturing organizations
because any commitment relating to the procurement of plant and equipment
does effect its capacity and expenditures for years, and such effects are
irreversible. In professional organizations, the main assets are people and
changes in the size and composition of the staff are irreversible and easier to
make. The strategic plan of a professional organization is not as
comprehensive as that of a manufacturing organization. It is mainly a longrange staffing plan and does not cover other functions.
Control of operations
Scheduling the working hours of employees is one of the most important
aspects of controlling the operations in professional organizations. The billed
time ratio, that is the ratio of hours billed to total professional hours available,
should be analyzed thoroughly. Idle time should be minimized and appropriate
rates should be used for billing engagements.
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CONTROL IN GOVERNMENT ORGANIZATIONS
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Performance measurement and appraisal

In professional organizations, it is easy to analyze the performance of
employees at the top most and the lowest hierarchical level, but it is difficult
to analyze the performance of employees who are placed somewhere between
the two extremes. The main reason for this is the absence of objective criteria
for performance appraisal. But there are exceptions to this too. For example,
the performance of an investment analyst can be appraised by comparing his
recommendations and the market behavior of securities.
In many cases, performance appraisal depends on human judgment. An
employees performance may be judged by his superiors, peers, subordinates
and clients. Professional organizations use a formal performance appraisal
system numerical ratings of specified performance attributes. These ratings
are used as deciding factors for wage hikes and promotions.
Public information
Attitude towards clients
Management compensation
Political influences
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Government bodies too, are service organizations and except for those
performing business- like activities, they are nonprofit organizations. In
addition to the characteristics of service organizations discussed above,
government organizations also have some special characteristics. These are:
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Political Influences
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Government organizations work under high political pressure. Politically

elected officials often exert pressure on managers which, in turn, inhibits
managers from taking sound decisions. For example, managers may have to
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favor certain suppliers.

Public Information
Government organizations are under the constant vigil of the press and the
public. In a democratic society, the public assumes that it has the right to
know everything about government organizations. Due to exaggeration by the
media, at times, even minor issues appear to be major ones. Therefore, to
discourage unfavorable media coverage, managers in government
organizations exercise greater control on their tasks and try to limit the
outflow of sensitive information about the company that flows through the
formal management control systems.
Attitude towards Clients

The main source of revenues for many profit-oriented and non-profit
companies is their clients. The principal source of revenues for government
organizations is the general public. In case of profit-seeking organizations,
more clients mean more revenues. Every client that is added to the portfolio of
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the company brings in additional profits. But for government organizations, an

increase in the client base is a burden. For example, one may draw a
comparison between government hospitals and private hospitals. An increase
in the number of patients visiting private hospitals result in additional
revenues, whereas in case of government hospitals, it may result in
deterioration of the quality of service.
Management Compensation
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Managers working in profit-seeking organizations are better paid when

compared to their counterparts in government organizations. This is because
legislators are influenced by the populist perception that one person is as
good as another. Due to this the best managers do not prefer to work in
government organizations. There is, however, an exception to this. University
faculty and scientists in certain government organizations are paid as highly as
managers in profit- seeking organizations.
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CONTROL SYSTEMS IN GOVERNMENT ORGANIZATIONS
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organizations are:
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Strategic planning is of great importance in government organizations. The

objective of strategic planning is to allocate resources judiciously.
Governments employ the benefit/cost analysis method to make strategic
decisions. Political pressure often influences managers decisions.
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Performance Measurement
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Income is the difference between revenues and expenses. Expenses can be

measured accurately in government organizations as well as private
organizations. However, the revenue of government organizations is not just a
measure of its monetary output. Therefore, governments have developed nonmonetary indicators for performance measurement. These measures can be
classified in various ways. On the basis of the purpose of measurement, they
are classified as (1) results measures, (2) process measures, and (3) social
indicators.
A results measure, also known as outcome measure, measures the output
that is supposedly related to the organizations objectives. Some examples are,
the number of students graduating from high school, the number of miles of
road completed, the number of timely arrivals of planes at airports, etc.
However, these do not represent an exact measure of output. For example, the
number of graduates does not provide any information about the quality of
education the students have received.
A process measure relates to an activity carried on by the organization, for
example, the number of livestock that are inspected in a week, the number of
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purchase orders issued in a day, the amount of data fed into a computer in an
hour, etc. Process measures are used to measure current, short-run
performance. As there is a close causal relationship between inputs (i.e., costs)
and the process measure, the latter are easier to interpret than results measures.
Process measures what was done, and not whether what was done helped the
organization achieve its objectives. Thus, process measures relate to
efficiency, not to effectiveness. In contrast to results measures, which are
ends-oriented, process measures are means-oriented.
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A social indicator is a broad measure of output, which reflects the overall

achievement of the organization. As social indicators are affected by external
forces, they are at best only a rough indication of the organization's
accomplishments of the organization. For example, although life expectancy
indicates the effectiveness of a countrys healthcare system, it is also affected
by the standard of living and the dietary and smoking habits of people, and
other external causes. Social indicators are useful in long-range analyses of
strategic problems. The use of social indicators is limited in day-to-day
management, since they are very nebulous, difficult to obtain on a current
basis, little affected by current efforts, and greatly affected by external factors.
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Financial service companies are involved in the business of managing money.

They may act as intermediaries-they may take money from depositors and
lend it to individuals or companies, risk shifters (commercial banks)-they may
earn money in the form of premiums and invest it accept the risk such as
damages to property or death (insurance companies) and traders i.e. buying
and selling securities (securities firms).
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insurance companies and securities firms and the role they play in
management control.
General Characteristics of Commercial Banks
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Commercial banks receive cash deposits from people and pay them interest on
the deposited amount. They also lend money in the form of loans and charge a
rate of interest on these loans. The difference between the interest paid on
deposits and the interest obtained on loans constitutes the banks revenue.
Regulatory Capital
In most countries there is a central bank that regulates the money lending
operations of commercial banks. For example, in India, the Reserve Bank of
India (RBI) is the regulatory body. It controls the money-lending operations
through cash reserve ratio. Similarly in the US, the Federal Bank is the
regulatory body for the commercial banks.
New Products
Apart from accepting money in the form of deposit and giving for loans, banks
generate income through other financial products and services. Some of the
services which earn them substantial revenue are banks get substantial
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revenues are credit card fees, accounting services for companies, payroll
services, foreign exchange services and so on. The service fees charged by
banks help them in increasing their revenues.
Banks are exposed to three types of risks:
Credit risk, i.e., the risk of loaned money not being repaid
Interest rate risk, i.e., the fluctuations in interest rate that is spread
between rates paid on deposits and rates earned on loans.
Transaction risk, i.e., the risk of theft, embezzlement and numerical errors
in the processing of transactions. This risk can be greatly minimized by an
effective internal audit and control system.
Management Control Implications
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Commercial banks establish a number of branches that function as individual

profit centers. These branches need to be controlled. Some of the important
control issues are:
Interest rates
Loan losses
Transfer pricing
Expenses
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Interest rates
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One of the most important aspects of banking which needs to be controlled is

the interest rate exposure. Interest rate exposure is the difference between
interest-sensitive assets and interest-sensitive liabilities of the bank. Interestsensitive assets of a bank are the loans on which the bank earns interest, and
interest-sensitive liabilities are the deposits on which the bank pays interests.
Traditionally, interest rate exposure was managed by buying or selling
securities, or by increasing or decreasing the amount of loans. But with the
increase in new and complex financial transaction like futures, options, floors,
swaps etc., it has become difficult to exercise greater control over interest
rates. The control system is responsible for communicating the prevalent rate
of interest to the employees responsible for investment decisions. Control
system should also see to it that managers adhere to the prevalent interest
rates.
Loan losses
In several cases, banks suffer huge losses because customers do not pay back
the loans. The reasons for their not paying back the loans could be numerous
and varied. Also this shows the banks incompetence or ethical management.
The internal auditors, bank examiners and external auditors should constantly
maintain a vigil on the banks loan portfolio.
Transfer pricing
Banks set up a number of branches for the convenience of their customers.
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The activities of these branches are coordinated and controlled by the

headquarters. The headquarters play a vital role in solving problems related to
transfer pricing of money. Over a period of time, the branches of the bank may
become loan-heavy that is their loans may exceed their deposits while some
may become deposit-heavy. The headquarters try to maintain a balance
between deposits and loans through intra-branch transfer of money. Branches
that are deposit-heavy extend financial help to branches that are loan-heavy
and, in the process, charge a transfer price for the amount of money being
transferred. The profitability of a bank cannot be assessed unless transfer price
is determined fairly. If the transfer price is low then the profitability of loan
heavy branches will be overstated, and if the transfer price is too high, then the
profitability of deposit-heavy branches will be overstated.
Expenses
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Banks face several problems in controlling their expenses. Unlike

manufacturing organizations, most of the expenses of a bank pertain to the
personnel. Back-office expenses of a bank can be budgeted and controlled but
allocating common costs to all activities is difficult.
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A banks customers carry out transactions in different branches of the bank,

depending on their convenience. Employees in one branch are often reluctant
to provide service to the customers of another branch and feel unrewarded
when they have to do so. They feel that they do not gain anything by
providing service to customers of another branch. In this situation it is the
responsibility of the top management of the bank to convey to the employees
of all the branches that it is necessary for them to strengthen customer
relationships through excellent customer service in order to achieve long-term
success.
Basle Committee Principles on Banking
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In 1975, the Basle Committee on Banking Supervision, a committee of

banking supervisory authorities, was set up by the Central-Bank governors
from Belgium, Canada, France, Germany, Italy, Japan, Luxembourg,
Netherlands, Sweden, Switzerland, United Kingdom and the United States.
The Basle Committee laid down certain principles for better control and
governance in banks. These principles pertain to supervision, policies and
procedures, measuring and monitoring systems, internal controls and
information for supervisory authorities.
The role of the board and senior management
Principle 1
In order to carry out their responsibilities, the board of directors of a bank
should approve strategies and policies with respect to interest rate risk
management and ensure that the senior management takes the necessary steps
to minimize these risks. The board of directors should be kept informed about
interest rate risk exposure of the bank, for the above said purpose.
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Principle 2
The senior management must ensure that the structure of the bank's business
and the level of interest rate risk it assumes are effectively managed, that
appropriate policies and procedures are established to control and limit these
risks, and that resources are available for evaluating and controlling interest
rate risk.
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Principle 3
Banks should clearly define the individuals and/or committees responsible for
managing interest rate risk and ensure adequate distinction of duties in key
elements of the risk management process to avoid potential conflicts of
interest. Functions such as risk measurement, monitoring and control with
clearly defined duties that are sufficiently independent from position-taking
functions of the bank and which report risk exposures directly to the senior
management and the board of directors are quiet essential. Larger or more
complex banks should have a designated independent unit responsible for the
design and administration of functions like interest rate risk measurement,
monitoring and control.
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Principle 4
It is essential that banks interest rate risk policies and procedures be clearly
defined and that their nature and complexity of their activities remains
consistent. These policies should be applied on a consolidated basis and, as
appropriate, at the level of individual affiliates, especially when recognizing
legal distinctions and possible obstacles to cash movements among affiliates.
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Principle 5
It is important that banks identify risks accompanying new products and
activities and ensure these are subject to adequate procedures and controls
before being introduced or undertaken. Major hedging or risk management
initiatives should be approved in advance by the Board or by the committee
set up for this purpose.
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Measurement and monitoring system

Principle 6
It is essential that banks have interest rate risk measurement systems that
capture all material sources of interest rate risk and that assess the effect of
interest rate changes in ways that are consistent with the scope of their
activities. The assumptions that the system is based on should be clearly
understood by risk managers and the bank's management.
Principle 7
Banks must determine and enforce operating limits and other practices that
restrict their exposures within limits, so that these confirm to their internal
policies.
Principle 8
Banks should analyze their vulnerability to loss under stressful market
conditions, including the breakdown of key assumptions, and ponder the
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results when establishing and reviewing their policies and determining limits
for interest rate risks.
Principle 9
Banks must have adequate information systems for measuring, monitoring,
controlling and reporting interest rate exposures. Reports must be provided on
a timely basis to the board of directors, the senior management and, when
required to individual business line managers.
Internal controls
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Banks must have an adequate system of internal controls over their interest
rate risk management process. A fundamental component of the internal
control system involves regular independent reviews and evaluations of the
effectiveness of the system and, when required ensuring that the internal
control system has been appropriately revised. The results of such reviews
should be passed on to the concerned supervisory authorities.
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The supervisory authorities should obtain from banks sufficient and timely
information for evaluating the levels of interest rate risk. This information
should include the range of maturities and currencies in each bank's portfolio,
including off-balance sheet items, and other relevant factors such as the
distinction between trading and non-trading activities.
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General Characteristics of Insurance Companies
Insurance companies are of two types: life and casualty.
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A life insurance company collects premiums from policyholders, invests these

premiums, and pays a specified amount to the beneficiary on the death of the
policyholder. While term insurance offers a person insurance coverage for a
limited number of years in the policy holders life; whole life insurance
provides coverage for the insured person until his death. Usually, whole life
insurance policies include an investment feature, that is, a part of the premium
is devoted to building up the policys cash value. Cash is paid regularly over a
specified period in the annuity version of such a policy.
A casualty company collects premiums, invests them, and makes payments to
policyholders for specified losses -- losses to property caused by fire, theft,
accidents, or other causes, or losses to individuals caused by malpractice,
negligence, illness, accidents, and so on. Casualty policies usually provide
short- term coverage not exceeding three years. While some policies pay for
claims made during this period, others pay for losses incurred during the
period, even though the claims are made later.
Usually, insurance policies are sold by agents, some of whom are independent,
and work for several companies while some others are employed only by a
single company. The income of both the types of agents is a specified
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percentage of premium earned from the policies they sell. Through branch
offices, insurance companies exercise some control over the agents' activities.
Management control implications
A major problem in the management control system of insurance companies is
that profits from current policy sales cannot be determined until the next few
years. This is especially true in case of life insurance companies. Though
premiums are determined on the basis of the best estimate of the inflows and
outflows associated with the policy, they may turn out to have been wide off
the mark. While profitability cannot be ascertained until the final payment has
been made, it may not be possible for the management to wait that long in
order to make control decisions, as it would require information immediately.
Insurance managers pay considerable attention to the controlling of
expenditure unlike investment bankers.
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Product pricing
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A typical insurance company offers dozens of products and the price (i.e., the
policy premium) of a given product varies in many respects for different
customers. For example, the age of the insured person and, hence, his or her
life expectancy, health, smoking habits, and, in some cases, gender, are taken
into account to determine the premium. A tentative premium is determined by
actuaries, and the final premium is a reflection of feedback from the marketing
people about the attractiveness of the policy and their respective premiums
offered by the competitors.
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Because of the importance of determining the premium, the performance of

each actuary and the accuracy of and promptness in collecting huge data to
furnish current information to the actuaries, is closely observed by the senior
management. Is the calculated premium out of line with those of competitors,
and if so, why? Is the actuary making use of the updated information? Is the
calculation overly conservative or overly liberal? By answering these
questions the senior management can analyze whether the actuary is
furnishing current information into its data.
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Sales performance
There is a wide variation in the actual profitability of various types of
insurance policies, partly because of adjustments made in the actuarial
calculation for fixing the premium, and partly because subsequent
developments made the assumptions included in the actuarial calculation
unrealistic. Although management would like the sales organization to
concentrate on products that are actually the most profitable, it is difficult to
calculate the current profitability of various policies, and to communicate this
information to the sales organization. Therefore, there is a tendency to focus
on the sales volume, rather than on profitability. Therefore the agents
commissions are hence based on the first-year or early year premiums, or on
the face amount of policies written. Such appraisal methods are used in
appraising the performance of branches. Computer programs are being
increasingly used to help agents compute the actual profitability of various
types of policies.
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Expense control
As is done in industrial companies, expenses are controlled through programs
and budgets in insurance industries. Productivity measures are used to control
clerical and other repetitive operations. The activities of claims adjustors are
carefully monitored, although judgments about their performance are
somewhat subjective.
Control of investing
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As in other financial services organizations, managing the investment function

is important in insurance companies. Traditionally, insurance companies
offered conservative investment policies, partly due to the influence of
regulatory agencies. In the recent years, insurance companies have also made
inroads into direct placement of loans, and investments in real estate and other
commercial ventures. This shift involves an increase in risk, and requires a
different approach to investment activities the control system of insurance
companies is similar to that of other financial services organizations.
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CONTROL IN SECURITIES FIRMS
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Firms that deal with shares or securities are called securities firms and include
investment bankers, securities traders, securities brokers and dealers, fund
managers (investment, mutual, and pension funds), and investment advisors.
Best known examples of investment bankers are J.P.Morgan, Drexel and
Company, and Kuhn Loeb and Company. The management of the investment
portfolio of individuals and companies was done by bank trust departments of
the banks. The attitude of bank trust departments towards fiduciary
responsibility resulted in an overemphasis on safe investments. This reduced
the role of bank trust departments thus reducing their returns. Between 1975
and 1985, commercial banks lost one third of their business.
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Many traditional investment bankers expanded their services which now

included all forms of securities underwriting, trading, and investment
counseling. Many of them set up branches to offer services to individual
investors, including relatively small investors. Firms that specialized in
providing expert advice about investment were also set up. The 1970s saw a
proliferation of all types of mutual funds and an increasing fraction of
securities issues were absorbed by pension funds. The result of all these
developments was increased competition among securities firms and reduction
in their profit margins.
In course of time, financing became more complicated. A variety of issues
with different risk / reward characteristics were invented. These were an
addition to the already existing issues of long-term debt, preferred stock, and
common stock. Foreign investors became an important source of funds. The
execution of complicated decision rules for buying and selling huge quantities
of securities in a matter of minutes (in some cases, seconds) was made
possible through computer programs.
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Management Control Implications

The characteristics of securities firms are different from those of other
financial service organizations. These include:
1) The importance of customer relationships
2) Stars and team-work
3) The need of rapid information flow
4) Focus on short-term performance
Customer relationships
Stars and teamwork
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The products of securities firms are intangible, and it is difficult to measure

their quality. The skills of the firms professionals contribute to the quality of
its products in a big way. The quality of these products is difficult to measure
as compared to the tangible goods. Earlier, firms could count upon, at least, a
group of customers who stayed with the firm for a considerable period of time,
but current trends show that customers are now much more aware and switch
to another firm when they feel that the latter offers the products of the same
quality at a better price.
Customers opinions about the employees with whom they interact directly
primarily determine their attitude towards the firm.
Therefore, the management tries to find out what customers opinions are, and
how well (and also how often) an employee interacts with a customer,
especially with a potential customer. Most firms, therefore, require their
employees to fill out call reports for every customer contact. These, at least,
serve the purpose of measuring the quantity of an employees efforts.
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Decisions about buying or selling securities, or recommendations for

corporate financing involving huge amounts of money, are made by a few
senior employees in securities firms. These senior professional are called
'stars' and constitute a firms most valuable assets.
Because of the dominance of stars, there are relatively fewer levels in the
organizational structure of securities firms. The relationship between superiors
and subordinates are typically unstructured and informal. Loose control is,
therefore, appropriate in such an environment. Firms acquiring such
organizations experience difficulties in adapting their management control
systems.
Securities traders rely upon the advice of research people and others who have
knowledge about securities or industries. These informal, though important
relationships are in contrast to the relationships that exist between production
departments and support departments in a manufacturing company. In a
manufacturing company, production supervisors who need to get some work
done by the maintenance departments, fill out a work request form, and wait
for the work to be done. In a securities firm, paperwork is minimal, and
responses to requests are often immediate.
Need for rapid flow of information
Many securities are listed in all the three stock exchanges-London, Tokyo and
New York, which are located in three different time zones. Therefore, in a
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large securities firm, business takes place 24 hours a day, with responsibility
passing from London to New York to Tokyo stock exchanges, as each market
closes. Each trader maintains a book displaying the firms position in each
security for which the trader is responsible, and in the buying and selling
orders that are to be executed. Computers providing information about
worldwide developments that might affect prices are also set up. Securities
and commodity market prices are affected due to developments within
minutes of their occurrence. Investment bankers also require current and
complete information about everything that has a bearing on the deals in
which they are involved at present or may be involved in the future.
The information systems of these firms must, therefore, fulfill the following
requirements:
(a) Signal flash news separately, differentiating it from the routine news.
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(b) Transform mountains of data into meaningful information. Develop

comparable data from raw data most importantly, provide accurate data.
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Development and maintenance of information systems in securities firms is,

therefore, an important function.
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Focus on short run performance
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The purchase of a growth stock today may produce satisfactory results three
years later, or may never pay off at all. In other words, it may not be possible
to observe the actual soundness of investment decisions made today, but only
after the elapse of a considerable amount of time.
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In spite of this, securities firms, with some important exceptions, have a

tendency to focus on short-run performance, and by 'short-run' they mean the
current quarter. The reason for emphasis on short-term performance is that no
one knows what the distant future if like, but also because it has become more
of a tradition to have a short-run emphasis.
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Investors tend to rely on information about current performance, and

performance in the recent past, of the securities firms they have hired to
manage their funds. Data about the firms performance over 5-10 years may
not be a valid basis for judging its overall performance or the performance of a
specific fund that the firm manages, because the decisions of the firms stars,
who probably were not with the firm over the past few years, heavily
influence the performance of a securities firm. Japanese firms, on the other
hand, tend to pay more attention to the long term performance. Although
many people are convinced that the American emphasis on short-run
performance has serious adverse economic consequences, no one seems to be
able to change this emphasis.
Measuring financial performance
Measurement of the financial performance of securities firms and of
managers, accounts executives, and others within the firm who trade or deal
with customers tends to be primarily in terms of revenue and secondarily in
terms of gross profit (the difference between revenue and direct expenses).
Account executives commissions are based on the revenue or gross profit
from the transactions with their customers. Bonuses are based on the firms
fee for the service, and partly on the judgment of the senior management.
These comprise the compensation given to investment banking professionals.
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Securities firms do not make much use of the profit center idea, nor do they do
detailed cost accounting.
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This is partly because, unlike law or accounting firms, which charge fees
according to the actual hours spent on the assignment, securities firms
generally charge a fee that is a certain percentage of the total amount involved
in the deal. Therefore, the need to collect costs by assignments in case of
securities firms is much less when compared to other firms. The informal
exchange of advice and other assistance that occurs in securities firms is
another reason for the lack of detailed cost accounting in such firms. It is
much more difficult to measure the cost of this assistance to the recipient then
to measure the cost of a maintenance work order in a factory. A third reason
for the absence of detailed cost accounting in securities firms is that expenses
are relatively unimportant. The direct expense (i.e., the transaction cost) of a
securities trade is small, and a deal that generates many millions of rupees in
fees may cost only a few hundred thousand rupees in terms of direct cost.
Nevertheless, although the relative amount may not be huge, every rupee of
legitimately saved expenses increases the net income by that amount.
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SUMMARY
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Control systems in service organizations are different from control systems in

manufacturing organizations due to absence of inventory, and difficulty in
controlling quality, and because service organizations are usually multi-unit
organizations. Organizations that provide specialized professional services are
called professional organizations. These organizations have some special
characteristics like: small size, labor intensiveness, different goals and
objectives, difficulty in measuring output and different marketing strategies.
There are four factors that control MCS in professional organizations. They
are: pricing, strategic planning and budgeting, control of operations,
performance measurement and appraisal. Government organizations are also a
type of service organizations. Some special characteristics of government
organizations are: political influences, public information, and management
compensation. There are two attributes that have strong implications for
control system in government organizations. They are strategic planning and
performance measurement. Financial service organizations are different from
other service organizations. Some of the control issues that are important for
banks are: Interest rates, Loan losses, Transfer pricing, Expenses, Joint
revenues. The Basle committee's principles can be used as guidelines for
better governance and control in banks. Control systems needed for managing
insurance companies differ from those needed for managing commercial
banks. Some of the control systems implications for an insurance company
pertain to product pricing, sales performance, expense control and control of
investments. Firms that deal in shares or securities are called securities firms
and include investment bankers, securities traders, securities brokers and
dealers, managers of funds and investment advisors. The characteristics of
securities firms are different from those of other financial service
organizations. The importance of customer relationships, stars and team-work,
the need for rapid information flow, and focus on short-term performance, are
some of the important characteristics of securities firms that are relevant to
management control systems.
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Chapter 19
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Management Control of
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Projects
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Differences between the Control of Projects and the Control

of Ongoing Activities
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Project Planning
Project Control
Reporting for Control
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Project Team and Matrix Structure
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Project Audit
Project Evaluation
A project is defined as a set of activities intended to accomplish a specified

end result of sufficient importance to be of interest to management. There are
many different types of projects: constructing physical structures, developing
and marketing new products, conducting audits, carrying out financial
restructuring, developing and installing information systems. A project is said
to have started when management develops a project plan that specifies the
work to be done and allocates resources for the completion of the work.
Management also determines the timeframe within which the project must be
completed. The project ends when its objective has been accomplished or
when the project has been canceled.
The resources needed for the successful completion of projects vary from
project to project. Some projects can be executed with only a few people,
while others need thousands of people. Managing people, money, time and
quality are of utmost importance for the successful completion of a project.
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Project control systems are designed by management to achieve targets within

cost, time and quality constraints. When a project starts, management sets the
desired level of performance for each activity, but the actual performance may
not meet the desired levels of performance. Project control systems help
management identify performance gaps, understand the reasons for variances
between the desired and the actual performance, and take corrective action.
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In this chapter, we will examine the various concepts of project planning, and
the control mechanisms that help improve the execution of projects.
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DIFFERENCES BETWEEN THE CONTROL OF PROJECTS AND THE

CONTROL OF ONGOING ACTIVITIES
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Single Objective
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The control of projects is different from the control of ongoing activities.

Some of the characteristics of projects that make the control of projects
different from the control of ongoing activities are discussed below.
Projects usually have a single objective, whereas ongoing activities have

multiple objectives. A manager of a responsibility center has to supervise
work everyday and also plan for future activities. He has to take decisions that
affect the current as well as future operations of the center. A project manager
also takes decisions that affect future operations but in his case, all operations
conclude at the end of the project.
Projects, aim at leveraging the operational efficiencies of a traditional
functional structure while remaining flexible enough to take on any
eventuality that requires a change in structure. Hence, most projects have a
matrix structure. This structure offers flexibility along with efficiency.
Focus on Projects
The objective of project control is to produce a satisfactory product within the
timeframe at a minimum cost. The focus is mainly on the accomplishment of
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the project objective. The control of ongoing activities however, focuses on

activities performed during a specific time period and on all the products on
which work was done during that period.
Need for Trade-offs

In projects, there is usually a trade-off between scope, cost, and schedule. The
schedule of the project can be shortened if extra costs are incurred. Though a
trade-off may occur in the control of ongoing activities, but they are not
typical of day-to-day activities in an organization.
Less Reliable Performance Standards
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Performance standards for projects are less reliable than performance

standards for ongoing activities. This is because the project design of each
project is unique. Except for repetitive project activities, it is difficult to have
common cost and time standards for all activities. For example, while
constructing a house, data regarding the unit costs of building similar houses
can provide some basis information, but changes in construction technology,
materials, building codes may make this information unreliable.
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Project plans undergo frequent changes due to unforeseen environmental

problems or unexpected happenings during the course of the project. Plans for
ongoing activities are much more predictable and less likely to require change.
Difference in Rhythm
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There is a difference between the rhythm of projects and the rhythm of

ongoing activities. Usually, projects start slowly and build momentum as they
reach their peak. Ongoing activities, on the other hand do not demonstrate any
change in rhythm over a period of time.
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Environmental Influence
The environment has a greater influence on projects than on ongoing

activities. For example, work in a factory can go on uninterruptedly even
when the weather changes because the work is done within the premises
specially built for it. Construction projects, however are adversely affected by
climatic conditions since most of the activities take place outdoors.
PROJECT PLANNING
Project planning is defined as the process of developing the basis for
managing the project, including the planning objectives, procedures,
organization, routines, finance and other chain of activities. A project plan
describes how all the major activities of each project management function are
to be accomplished, including overall project control. The project plan evolves
through successive stages of the project life cycle.
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Project planning takes place at two levels: tactical and operational. At the
tactical level, decisions are taken regarding the implementation of these
activities. The development of the project plan is not a single stage exercise. It
goes through a number of stages before the final draft is prepared. The project
plan also describes the various control mechanisms that will be used during
the execution of the project. The plan takes into consideration time, cost,
quality and the different ways in which these can be overcome.
Planning Process
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As the complexity of a project increases, so does the need for planning. Low
complexity projects tend to be more action oriented rather than planning
oriented. Complex projects require a systematic analysis of the issues involved
before the execution of the project. A good project plan can rescue the project
manager in the event of failure of the project. A good project plan can help the
project manager save face in the event of failure of the project. Such a plan
shows that the project failed because of some unexpected event, not because
of poor planning. A project plan should be developed systematically which
should include the following steps:
Determine the logical sequence of activities
Estimate the time and resources required for the project
Facilitate communication
Clearly state reporting relationships
Take logically sound decisions
Avoid trivial activities and remain focussed on the core activity
Create a broad framework for assessment project programs. Emphasize

the post project review process.
Compare actual results with desired results after the project is completed.
Learn from previous mistakes and constantly revise and refine project
management processes and methods
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Nature of Project Plan

The final plan of a project consists of three related parts: scope, schedule, and
cost.
Project Scope
The project scope describes the activities that will be performed and the
resources needed for performing those activities. It clearly defines the role of
all the people involved in the project. The project scope is prepared after
extensive discussion between the client and the project manager. During the
course of the discussion, the project manager explains the way in which he
will execute the project and the client conveys what he expects from the
project manager. The project scope is a part of the project overview statement,
which is also sometimes referred to as the statement of work.
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Project Schedule
A project consists of a sequence of activities which have to be completed in a
specific time period. The project schedule is an estimation of the time required
to complete each activity (that forms a part of the entire project). It also shows
the relationship among different activities and indicates which activity must be
completed before starting another activity. The sequence of the activities
identified in the project schedule should be properly planned so that the entire
project is not affected, when a particular activity is delayed. A project
schedule can be in any of the following forms:
Milestone
Deliverables
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Activity
A milestone is defined as a clearly identifiable point in a project or set of
activities that commonly denotes completion of a key component of a
project. For example, laying the foundation is a milestone in the construction
of a building,
A deliverable is a synonym for products, services, processes or plans that are
created during the project. Deliverables can be of two types: interim
deliverables and final deliverables. Interim deliverables refer to the products
or services that are produced during the project, whereas final deliverables
refer to the end product that is produced as a result of the completion of the
project.
An activity is a specific project task that requires resources and time to
complete. For example, when constructing a house, laying the floor is a
distinct activity that requires material resources and time.
Project Cost
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Total project cost (TPC) is defined as all costs that are specific to a project and
are incurred through the startup of a facility, prior to the operation of the
facility. Thus, TPC includes Total Estimated Cost (TEC) and Other Project
Costs (OPC).
TEC + OPC = TPC.
Before a project starts, an estimate of the costs that will be incurred during the
project is prepared. When estimating the cost of a project, the estimator should
not only be aware of the quantity and price of the material and labor required,
but also the technical scope and schedule of the project. A good cost estimate
should include the following:
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Description of what is included in the total project cost (TPC).
Description of the method used for developing the estimate. This should
include information regarding cost databases used, actual quotes, any cost
estimating relationships (CERs) used, etc.
Description of direct and indirect costs. Field distributable overheads

should be given in enough detail to describe what is included and what is
not (e.g., site security, on-site trailers, health and safety, etc.).
Details of other overhead expenditure that may be incurred at the project

site should be provided.
Details of operating costs if the estimate is a program estimate that

includes operations as well as construction activities.
Details of approximate time and cost escalations that may take place
during the project should be provided.
Details of estimate history if the estimate is a revision of existing estimate

or a change order estimate.
The name, signature, and/or initials of the preparer and reviewer of the
estimate.
Project Scheduling
One of the major activities described in project plan is project scheduling.
Scheduling is done well in advance of the beginning of the project. It involves
The identification of the tasks/activities that need to be carried out during
the project
The estimation of the time each task/activity will take
The allocation of resources (mainly personnel)
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Critical Path Method (CPM)
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The time needed for performing each activity is calculated to arrive at the total
time needed for completing the project. Two techniques are commonly used in
scheduling a project:
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Program Evaluation and Review Technique (PERT)

Both these techniques use network diagrams for sequencing and scheduling
project activities. A network diagram is a schematic representation of all the
activities that are performed during the course of the project. It helps project
managers schedule and sequence the activities of a project. Let us examine the
concept and elements of a network diagram through a study of CPM and
PERT.
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Critical path method

The Critical Path Method (CPM) is a technique of network analysis that uses
network diagrams to identify the sequence of activities that are critical for the
project. A critical activity is defined as an activity which can, if delayed lead
to a delay in the entire project. Let us study to understand the concept of CPM.
Suppose a company is planning to acquire a new machine. This process of
acquisition would begin with the approval of the budget for purchasing the
machine. Once the machine has been purchased, the company needs to hire an
operator to operate the machine. After hiring an operator, the machine must be
installed and the operator must be trained to use the machine. Once the
operator has been trained, the machine becomes operational. Each of these
activities, from getting the budget approved to making the machine
operational, takes some time. Table 19.1 shows the time needed for each
activity. The immediate predecessors (shown in table) are those activities that
must be completed just before the commencement of the next activity. For
example activity B can start only when activity A has been completed. Hence
activity A is the immediate predecessor to activity B. Using table 19.1 we can
draw a network diagram to show how the activities should be scheduled.
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Table 19.1: List of Activities and Precedence Relationships

Activity
Description
A
B
C
D
E
F
Duration
(weeks)
Immediate
Predecessor
2
5
1
1
6
1
A
A
B
C
D, E
Getting budget approval

Buying machine
Recruiting operator
Installation of machine
Training operator
Produce goods
Source: ICFAI Center for Management Research
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Figure 19.1 shows a network diagram that has been drawn on the basis of data
given in table19.1. In the diagram, arrows represent the activities of the
project (in this case, the process of purchasing, installing and making the
machine operational). Alongside each arrow, the name and duration of each
activity is written. For example, the first activity is getting budget approval,
which is represented by A, and the duration of the activity is two weeks.
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Figure 19.1 Network Diagram

3
D1
B5
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A2
2
C1
F1
E6
4
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The circles in the diagram are called nodes. A node indicates completion of an
activity. It is important to understand the difference between nodes and
activities. An activity is a recognizable part of a project that requires time and
resources for accomplishing one or many project tasks. A node is a point in
the project that indicates completion of an activity. It requires neither time nor
resources.
Determining critical path
A Path is defined as a set of continuous series of activities through the
network from the initial node to the final node. In figure 19.1, the first activity
is A and the last activity is F. The start of the project is indicated by node 1
and the end by node 6. Hence the critical path would be the longest path
through the network from node 1 to node 6. There are two possible paths for
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traversing the network to reach node 6. The first path is A-C-E-F and the
second is A-B-D-F. The total duration of traversing path A-C-E-F is 10 weeks,
whereas the total duration of traversing path A-B-D-F is 9 weeks. Path A-C-EF is the critical path because the total duration of traversing this path is more
than that of traversing path A-B-D-F. The sum of the duration of this path (10
weeks) also indicates the minimum time needed for completing the project.
Program evaluation and review technique (PERT)
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One of the disadvantages of CPM analysis is that it cannot be used when the
duration of activities cannot be predicted correctly. It is often difficult to
predict exactly the time required to complete a particular activity of a project.
The activities often take more time than originally anticipated. As CPM
analysis requires that exact time needed to complete an activity, CPM analysis
cannot be used when one is not sure of the exact time needed to complete an
activity. To overcome this problem, PERT was developed. PERT uses three
time estimates for the likely completion of an activity rather than one estimate
(as used in CPM). The three time estimates are:
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Optimistic time
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This refers to the shortest possible time in which an activity can be completed.
It is often referred to as the ideal time within which an activity should be
completed. It is designated as 'a'.
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Most likely time

This refers to the time that the activity would take if it were frequently
repeated under exactly the same conditions. It is designated as 'm'.
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Pessimistic time
This is the longest possible time that an activity can take for completion. It is
the worst possible time estimate. It is designated as b.
Once the three time estimates have been obtained, one can combine them to
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a + 4m + b
=
ei
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arrive at the expected completion time using the following formula:
t
where
tei = expected time of the ith activity,
a = optimistic time
m= most likely, or modal time
b = pessimistic time
The standard deviation I, of the completion time of an activity is calculated
ba
=
i
6
as follows:
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Variance I,2 is calculated as follows
2
ba
2
i =
6
In order to understand PERT better, we will draw a network diagram for a
project and calculate the expected time for every activity.
Example 19.2
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Suppose the owner of a fast food company is planning to install a

computerized accounting and inventory control system. He identified four
companies that could install the system for the fast food company. One of the
companies sent the following data regarding the project (refer table 19.2) On
the basis of the data provided by the company, let us construct a network
diagram, determine the critical path, and calculate the expected project time
and variance.
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With the help of the data provided in Table 19.2 and the values given in 19.3
(calculated on the basis of the PERT formula discussed earlier), we can draw
the network diagram (figure 19.2)
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Time (days)
Immediate
Predecessor
Optimistic
Most
likely
Pessimistic
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12
Description of activity
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Activity
Table 19.2
Select the computer
Design the system
Design
system
Assemble hardware
15
20
25
Develop main program
10
18
26
Develop
routines
16
Create database
12
Instal system
D,F
Test and Implement
G,H
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monitoring
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input/output
Determining the critical path

The critical path for the network diagram is A-B-E-G-I because the time taken
to traverse the path is the longest. The expected time taken by this path is:
Te=6+8+18+8+7 = 47 days. Hence, the shortest duration within which this
project can be completed is 47 days. The variance of the project length is Vt=
4/9+25/9+64/9+16/9+1/9= 110/9=12.22
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Table 19.3
Activity
variance
Time
Expected time
b
t ei =
a + 4m + b
6
i =
Variance
ba
6
ba
i2 =
1-2
4/6
4/9
2-3
15
10/6
25/9
2-4
12
8/6
16/9
3-6 15 20 25
20
10/6
25/9
3-5 10 18 26
18
16/6
64/9
4-6
16
10
8/6
16/9
5-7
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a m
SD
16/9
6-7
7-8
20
8/6
1/9
2/6
1/9
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C
4,8,12 8,9,16
(8)
(10)
(6)
I
6,7,8
(7)
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A
4,6,8
E
10,18,26
5
3
G
(18)
4,8,12
D
(8)
(20) 15,20,25
H
1,2,3
7
6
(2)
F
U (8)
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5,7,15
Figure 19.2 Network Diagram Related to the Computer Project
PROJECT CONTROL
After the project has been planned, it must be executed. The project plan is
implemented during the execution stage. During this stage, the project
manager's main concern is the control of performance in terms of time and
cost. The project manager uses a number of project control tools to identify
deviations from the actual plan and bring them in line with the actual plan.
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Objectives of Project Control

There are three main objectives of project control:
To regulate a project by altering the way activities or tasks are performed
To protect and guard the assets of the company
To facilitate decision making.

In most projects, the emphasis is mainly on regulating and conserving
resources, financial or otherwise. The project managers are often seen as
conservationists who have to guard the physical assets of an organization, its
human and financial resources. For conserving these resources, project
managers devise special controls. Controls used by project managers to
conserve assets are discussed below:
Physical assets control
Human resource control
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This refers to the process of controlling the physical assets of a project. The
process also involves maintenance of assets. Project managers who control the
physical assets of projects have to prepare a maintenance plan to ensure that
there is no work stoppage due to breakdown of machinery used in the project.
Inventory control also falls within the purview of physical asset control.
Inventory control refers to the process of receiving, storing, inspecting and
recording the materials used or generated during the execution of the project.
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Human resource control is concerned with making the right kind of human
capital available for project execution. It also involves the training and
development of people involved in the project. Human resource control is far
more difficult than physical asset control. Physical asset control can be
established through an audit, but it is difficult to perform a human resource
audit.
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Financial control
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Financial control is a combination of regulatory and conservatory control.

The regulatory control of financial resources involves the regulation of capital
flows for obtaining better return on investment. Conservatory control mainly
deals with capital investment decisions. Current asset control and project
budgeting are also part of financial control. The financial controls used for an
ongoing activity differ slightly from those used for a project because, unlike
ongoing activities, projects are accountable to an outsider-usually an external
client.
Control as a Function of Management

Projects are always controlled through people. Project managers exert control
over the project team and other people who are associated with different
functions of the project. The purpose of control is to ensure that the project is
executed within the planned schedule, budget and specifications. So, control is
a necessary function of any project.
Project managers have to often motivate employees who have been
discouraged by managerial control. They have to set controls that encourage
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behavior/results that are desirable. The purpose of control is to motivate

individuals to behave in the required manner. Though control systems do not
always elicit the desired behavior from employees, individual reactions to the
various types of control affect the levels of motivation. The possible responses
of employees towards different control systems are:
(i)
Active and positive participation and goal seeking.
(ii)
Passive participation in order to avoid loss.
(iii) Active but negative participation and resistance.
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An individuals reaction to different controls depends on several factors such

as the control mechanism used, the nature of the goal being sought, the
individuals self image, the value of the goal, the individual's ability to
achieve the goal, and tolerance for being controlled. Generalizing the human
response to various controls is difficult. However, some controls and the
resultant behavior from the use of those controls can be described. These are
discussed below.
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Controlling a project is a complex job. Even before the project starts, certain
decisions must be taken: Who will control the project? What will be
controlled? How will performance be measured? What is the extent of
acceptable deviation? Three types of control processes are used to control a
project:
Cybernetic controls
Go/No-go controls
Post controls
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Cybernetic controls
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The concept of cybernetic controls has been discussed in chapter 2. Here we

will discuss how cybernetic controls are used in projects.
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Cybernetic controls, also known as steering controls, are used to monitor and
control tasks on a continuous basis. The main controlling work is done by a
sensor that measures one or more aspects of the output and transmits the
measurements to a comparator, which compares the measurements with the
set standards. After comparing and measuring the variations with the
standards, the output is sent to a decision maker to decide on the action to be
taken. If the variation is large, the decision maker sends the output to an
effecter who makes the necessary changes in the process or the input to
control the variation. Cybernetic control systems can be divided into three
types, depending on the standards that have been set:
A first order control system is a goal seeking device. It is a highly rigid system
that does not allow for any alteration in the set standards.
In a second order control system, the set standards can be altered according to
some predetermined set of rules.
In a third order control system, standards can be changed from time to time.
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This system does not have any pre-programmed instructions and can act
independently.
Go/No-go controls
Cost and time overruns are common in projects. Go/No-go controls are used
to ensure that the project is completed within time and budget. These control
systems are flexible and are used in most projects. Go/No-go controls are used
at periodic and regular intervals, but they can also be exercised at the
discretion of the controller. When these controls are used periodically at preset
intervals, the intervals are determined on the basis of a clock, calendar, or the
operating cycle of machines.
Post controls
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Post controls or post-performance controls (or reviews) are exercised after the
project has been completed to see whether the project objectives have been
met in terms of cost, quality and time. While cybernetic and Go/No-go
controls help a firm accomplish the goals of a current project, post controls
help a firm to enhance the possibility of meeting future project goals, on the
basis of lessons learned from past projects.
REPORTING FOR CONTROL
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During the project execution phase, the project manager has to keep the
management of the organization informed about the progress of the project.
This is done by preparing project progress reports. Project reports are essential
for controlling projects. Project reports are prepared on a continuous basis till
the end of the project. An effective reporting system ensures that management
is kept informed about the status of the project.
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Effective Reporting System
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Information provided by a reporting system should be complete, timely and

accurate. It should clearly differentiate between the planned figures and the
actual figures in terms of cost and time. Reports should be easy to understand
and should enable senior management to take critical decisions. Cost and time
variances should be reported clearly along with the reasons for those
variances. The reports should be such that they help the reporter foresee
problems that could arise in future. As every project is unique, the reporting
system for different projects will vary.
Types of Project Reports

Project status reports are of five types:
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Current period reports
Exception reports
Cumulative reports
Variance reports
Stoplight reports
Current period reports

Current period reports give details of activities that are in progress or have
been recently completed. They focus on the planned and actual completion
dates of tasks. They also provide explanations for variances between the
planned and actual dates of completion of a project.
Exception reports
Exception reports contain details of time and cost variances. They are mainly
prepared for executive and senior managers. These reports are prepared in
such a way that a cursory glance through them provides a lot of information to
the senior executives. Most of the details are summarized and presented in
the form of tables.
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Cumulative reports
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Cumulative reports provide details of all the activities of a project, from its
inception to its current status. They indicate the trends in the projects progress.
These reports are lengthy and highly informative in nature.
Variance reports
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Variance reports provide details of differences between the planned output and
the actual output. It is present in a tabular form and consists of three columns.
The column headings are planned output, delivered output and variance.
Variance reports can also be presented in a graphical format. In the graphical
format, the variance is not reported; only the planned and actual output are
reported in the form of two curves or bar diagrams. A consistent format is
followed in the report to make it easy to use across all the levels of
management.
Stoplight reports
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Stoplight reports are different from all other reports. Colors are used in the
report to indicate the progress of the project. A green colored sticker is pasted
on the top right hand corner of the project report, to indicate that the project is
progressing well. A yellow sticker is placed on the top right hand corner of the
project, to indicate that though there have been minor problems, plans are in
place to tackle them. An additional sheet attached to the report, describes the
problems in a detailed manner along with the measures that have to be taken
to correct these problems and gives an estimate of the time needed to complete
this rectification. A red sticker is placed on the top right hand corner of the
report to indicate that the project is not going smoothly and that it has run into
problems. It also indicates that no corrective action has been taken to correct
the problem.
PROJECT TEAM AND MATRIX STRUCTURE

A project team is assembled for a specific project under the direction of a
project manager. The team is temporary and is dissolved once the project is
completed.
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The project manager exercises direct and autonomous control over the project
team and is responsible for the coordination and monitoring of the activities.
Matrix Structure
In the matrix structure, the personnel and other resources that a project
manager requires are obtained from a pool controlled and monitored by a
functional manager. Personnel required to perform specific functions in a
particular project are engaged for the necessary period, and are then returned
to the control of the functional manager for reassignment. Refer Figure 19.3.
For example an engineer assigned to a project is responsible to the functional
manager for completing the task as scheduled, and to the project manager for
providing an acceptable design. The two managers report to a matrix
executive.
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The project manager in the matrix works with the functional manager to
establish the resource requirements and to develop a timetable for their
utilization in the project. The functional manager is responsible for the
optimum utilization of resources. The formal role of the matrix executive (in
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Figure 19.3 Matrix Structure
Matrix
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PRESIDENT
Marketing
Manager
Finance
Manager
Finance
Manager
Finance
Manager
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Manager
Project A
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HR
Manager
Manager
Project B
Manager
Project E
Adapted from Kathryn Bartol and David Martin, Management, (McGraw Hill Publication,
second edition)
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this case, the general manager) is to coordinate the activities of the project
manager and the functional managers. The general manager is literally on top
of or outside the basic matrix structure, and therefore has a clear perspective
of all activities and personnel within the matrix. The general manager leads a
dual command structure- the functional and the project hierarchies- which
must be balanced through a careful blend of autocratic and cooperative
managerial styles. A cooperative style is required to resolve disputes regarding
resource allocations. An autocratic style is essential for the establishment,
enforcement, and revision of priorities between the functional and project
entities within the matrix. This role involves three major managerial concerns:
Balancing power
The balance of power involves allocating both project and functional budgets,
orchestrating personnel assignments, applying schedule pressures on others
etc.
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Managing the decision context
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This is accomplished by establishing strategy, policy, and control systems to

ensure that decisions are made to benefit the overall organization rather than
the individual functional department or project.
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Setting standards
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Performance standards are set by top management. They must be established

and enforced by the general manager, since his position in the matrix enables
him to control the performance of both project managers and functional
managers.
Advantages of the matrix organization
Retains the benefits of both functional organization and project team
structure.
Leads to efficient distribution of resources among different projects.
Employees can create rapport with project team members and their
functional department colleagues.
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Disadvantages of the matrix organization
Potential for conflict between functional and project personnel.
Greater administrative overheads
PROJECT AUDITS
Project auditing is defined as a planned and documented activity performed
by qualified personnel to determine by investigation, examination or
evaluation of objective evidence, the adequacy and compliance with
established procedures or applicable documents, and effectiveness of
implementation. When a project is under progress, a quality audit should be
conducted to prevent defects from creeping into the system. The project
auditor investigates the underlying records, the working of project
management, the project methodology and techniques, and the organization of
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controls. It is advisable to conduct an audit while the project is in progress.

This way minor discrepancies in the project can be identified before they
become major problems. After conducting the audit, an audit report is
submitted to the senior managers. This report contains information pertaining
to:
Current status of the project
Current status of crucial activities of the project
Significant changes in the cost or schedule of the project
Project risk and uncertainties
Limitations of the project report
Levels of Audit
Detailed audit
Technical audit
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Time and cost are two major constraints when conducting an audit. Hence, the
level or depth of an audit differs from project to project. An audit can be
conducted at one of the following levels:
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A general audit is a comprehensive audit conducted within a short period of

time. It covers all the dimensions of auditing like current status of the project,
project risk etc.
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A detailed audit is conducted if the general audit reveals serious problems or

unacceptable levels of risk in the project. Such an audit examines a project in
minute detail.
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A technical audit is usually conducted when the project manager is unable to

identify the technical problems in a project either due to lack of knowledge or
complexity of the problem. In technology intensive projects, outside
consultants are usually preferred over internal auditors.
PROJECT EVALUATION
The process of evaluating the performance and progress of a project in
comparison to what was planned is called project evaluation. The primary
objective of project evaluation is to measure the success of the project. Such
evaluations also help project managers conduct a SWOT analysis of the
project. Lessons learnt from the current project help the organization manage
its future projects better. The evaluation of project involves
1) An evaluation of performance in executing the project.
2) An evaluation of the results obtained from the project.
The former is carried out shortly after the project is completed, and the latter
once the results start coming.
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Evaluation of Performance
The evaluation of performance when executing the project comprises the
evaluation of project management, and the evaluation of the process of
managing the project. The purpose of project evaluation is to help project
managers take decisions pertaining to rewards, promotion, reassignment etc.
The purpose of the latter is to discover better ways of managing future
projects. While evaluating the performance of a project, two more aspects
need to be considered: budget overruns and hindsight.
Budget overrun
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When actual costs exceed budgeted costs, a 'budget overrun' is said to have
occurred. If higher costs are incurred because of changes in the scope of the
project or uncontrollable factors, the costs are said to be underestimated. A
common error in analyzing costs is assuming that the budget represents what
the costs should have been. Actually, the budget simply estimates what the
cost would be on the bases of information that was available at the time it was
prepared.
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Hindsight refers to the process of looking back to assess at how well the
project was managed. Hindsight, helps the organization discover instances
when the right decision was not made while carrying out the project.
However, the decisions made at that time may have been entirely reasonable
and the manager may not have had all the information required to take the
"right" decision at that time. The manager may have taken the decision on the
basis of personality considerations, tradeoffs or other factors not recorded in
written reports.
Hindsight also helps the organization identify other instances of poor
management: diversion of funds or other assets for the personal use of the
project manager and embezzlement of funds due to project manager's inability
to exercise control. The evaluation of the process may indicate that reviews
conducted during the project were inadequate, or that timely action was not
taken on the basis of the reviews. The review may express that the project
should have been redirected. This suggests that thorough analysis of the
progress of the project should have been done more frequently. Consequently,
requirements for such reviews of future projects should be modified.
The evaluation may lead to changes in rules and procedures. It may identify
some rules that impeded efficient management of the project. Conversely, it
may uncover inadequate controls.
Evaluation of Results
Until one gets the results and benefits of a project, one cannot clearly evaluate
its success. The evaluation of results depends on the type of projects being
evaluated. This evaluation may take many years to complete. For example, the
benefits of the introduction of a new product line can be measured easily,
because the revenues and expenses associated with that product line are
known. But the benefits of installing a labor-saving machine cannot be easily
identified if the resulting costs are associated with a variety of product costs
and cannot be separately traced to the new machine. In this case, separate
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counts must be maintained to evaluate the benefits of the labor saving

machines.
In many cases, the evaluation becomes complicated by the fact that the
expected benefits were not stated in the objectives. So a cost-benefit analysis
cannot be carried out and the evaluation is based on the judgment of person's
conducting the evaluation.
R&D projects and projects whose objective is to improve safety or eliminate
environmental deficiencies cannot be measured in quantitative terms.
Normally, results are anticipated on the basis of certain assumptions. They are
documented during the process of approving the project. The evaluation is a
comparison of actual results with these anticipated results.
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SUMMARY
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Management control of projects is different from control of ongoing activities.

This is because the nature of projects is different from the nature of ongoing
activities. The plan of a project consists of three important parts: scope,
schedule, and cost. For scheduling a project, two techniques that are
commonly used: Critical Path Method (CPM), and Program Evaluation and
Review Technique (PERT). Once the project is planned, it has to be executed.
During the execution stage, the project manager is concerned about
controlling performance in terms of time and cost. The controls exercised by a
project manager in a conservationist role are physical assets control, human
resource control and financial control. Controlling a project is a complex job.
Three types of control processes that are used to control a project: Cybernetic
controls, Go/No-go controls and Post controls. Project reports are essential
for controlling projects. They prepared on a continuous basis until the project
ends. There are five types of project reports: current period reports, exception
reports, cumulative reports, variance reports and stoplight reports. A project
team structure consists of an autonomous project team, independent of the rest
of the organization. A project audit is conducted to identify problems in the
project and to prevent minor discrepancies from becoming major problems.
There are three levels of audit: general audit, detailed audit and technical
audit. The process of evaluating the performance and progress of a project in
comparison to what was planned is called project evaluation. The evaluation
of a project involves the evaluation of performance and the evaluation of
results.
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PART VI:
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MANAGEMENT CONTROL IN
SPECIFIC SITUATIONS
Chapter 21
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Management Control and
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Ethical Issues
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Identifying Control Related Ethical Issues

Designing Control Systems to Regulate Ethical Conduct
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Control System Supporting the Ethics Program
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The Ethical Principle of Fairness in the Design of Control

Systems
The word ethics is derived from the Greek word ethicus, which means
character or manners. Hence, ethics is the science of morality and recognized
rules of conduct. Business ethics is the application of ethical rules and
principles to a business environment.
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Over the years, various economists and management thinkers have given
several explanations of the relationship between business and ethics. Milton
Friedman has proposed the separatist view. According to this view, there is
no room for morality and ethics in business. The main aim of business should
be to make profits and maximize its shareholders wealth. According to
Milton, social and moral issues should be tackled by government not by the
business organizations. Unitarian view opposes the separatist view. It states
that, if a business wants to sustain itself for a long term, then morality and
ethics cannot be separated from it. Talcott Parsons proposed a view that
integrates business and ethics. He was of the opinion that ethics and business
should be combined into a new area, which he referred as Business Ethics.
Talcotts idea of business and ethics has been largely accepted by the business
community. Nevertheless, it is necessary that managers understand the ethical
aspects of business. The focus of this chapter, is to understand ethical issues in
business organizations and their implications for control systems.
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While designing a control system, the manager should have a basic

understanding of various relevant ethical issues. Ethics is an important tool for
defining how employers should behave and an important component of
personnel control. If the ethical and moral standards of employees are high,
then they can augment action controls. For example, if employees in an
organization are not fraudulent, then the company can do with mild financial
controls.
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IDENTIFYING CONTROL RELATED ETHICAL ISSUES
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There are a number of ethical issues that have strong implications for control
systems within an organization. In this section, we will discuss four important
issues:
Creating budgetary slack
Responding to flawed control indicators
Managing earnings
Using excessively tight control measures
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Creating Budgetary Slack

Budgetary slack can be described as the difference between managers
proposed budgetary expectations and their previously established
expectations. This difference appears sufficient to them to achieve their
budgetary objectives. Let us take an example. An HR manager feels that the
training budget should be Rs.10 million, but he is not sure whether this
amount will be sufficient. Hence, while fixing the budget he will quote the
training budget at Rs.12 million, thus having a cushion of 2 million. This
excess amount is referred as budgetary slack.
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The question that may arise here is this: Is creating a budgetary slack an
ethical practice? Budgetary slack provides protection against economic
downturn and spiraling costs. According to Cyert and March (1963),
budgetary slack provides with the desired freedom to operate and allows
smoothing of income. Due to this, managers evaluate budgetary slack as being
positive or ethical. Some managers hold a different view on this issue. They
feel that creating budgetary slack is unethical, especially in organizations that
give performance-linked bonuses. Here the creation of a budgetary slack may
lead to show dysfunctional behavior and practice dishonesty, (managers who
try to favor their own interests over those of the organization). Budgetary
slack may lead to loss of profitable opportunities and an increase in the overall
expenses of the organization. Therefore some managers evaluate the creation
of budgetary slack as negative or non-ethical.
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Responding to Flawed Control Indicators
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Employee performance is measured on the basis of the targets they achieve.

Organizations need to provide employees with clear guidelines regarding the
processes and methods that can be used for achieving the targets. These
guidelines act as control measures for monitoring and controlling the behavior
and activities of employees. In many organizations, these guidelines are
ambiguous, defective or even missing. Defective guidelines encourage
employees to act or behave in a way which may prove to be disastrous for the
organization. For example, organizational myopia is a flawed control
indicator. It occurs when an organization sacrifices long-term stability and
growth for short term profits. In this situation, employees may be forced to
resort to unethical practices which would help the organization present a better
financial picture of itself. Professionals like management accountants face a
similar problem. They are bound by an ethical code of conduct that prevents
them from adopting unethical accounting practices. But in an organizational
setting, they may be forced to adopt certain unethical practices which
conforms to the interests of the organization.
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Managing Earnings
Another important ethical issue that affects control systems is management of

earnings. The phrase earnings management is often associated with
manipulation of financial accounts. Examples of earnings management
include increasing reported profits to avoid violating debt contracts,
underreporting a companys earnings in order to negotiate a favorable price in
a management buyout offer. Company executives can also manage reported
earnings in order to increase their bonus compensation, obtain loans on more
favorable terms, increase the companys stock price, or report the smooth flow
of annual revenues and earnings growth.
Earnings management is one of the most important ethical issues accountants
come across in their everyday practices. Investors and creditors depend on
accountants for fair and reliable financial information. Companies that engage
in earnings management may mislead the public regarding the actual
profitability and/or stability of their operations. If a company inflates its
profits then this may make investors pay an unduly high premium to purchase
shares of the company. Most of the times, it is difficult to find out whether
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earning management actions are ethical or not, because manipulations in

accounting are not easy to detect. Only after thorough analysis and auditing
can one say for sure that a company has been unethical in managing its
earnings. Some of the situational factors that help in understanding the
unethical aspects of earning management are:
The direction of manipulation, that is whether the company has increased

or decreased its profits.
The extent to which the accounts have been manipulated.
The timing of manipulation, that is, before the annual statement was
published or before the quarterly publication of statements.
The method used for manipulation (decreasing reserves, increasing

accruals, etc.)
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Using Excessively Tight Control Measures
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Another important ethical issue relates to the use of excessively tight control
measures. Advances in technology have enabled companies to use software
programs for surveillance and supervision. Apart from these telecom devices
and cameras are used for monitoring employees' movements and listening to
their conversations. Excessive supervision reduces employees freedom and
autonomy. Organizations should outline the purpose and need for using such
tight control measures before implementing them.
DESIGNING CONTROL SYSTEMS TO REGULATE ETHICAL CONDUCT
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Employees are often under tremendous pressure to achieve organizational

goals. This makes them adopt unethical practices to expedite the work. A
supervisor may ask his subordinate to complete a particular task within a short
period of time. Though this may not be possible, he still has to complete a
particular task within short period of time. In such a situation, he may be
forced to make compromises on the quality of the product. In order to prevent
employees from adopting such unethical practices, the organization should
conduct ethics programs. The focus of such programs rest on developing a
corporate code of conduct, which should be followed by all employees.
Cybernetic Control Process for Developing an Ethics Program

Organizations usually adopt a cybernetic approach to develop an ethics
program. Such an approach consists of six steps:
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The first step is to comply with all laws, ethical codes and policies of the
organization.
The second step is to sensitize all managers and employees as to what

kind of behavior is improper.
The third step is to audit the behavior of employees regarding their

interaction with all stakeholders.
The fourth step is to report significant deviations from the desired ethical
conduct.
The fifth step is to investigate violations of the prescribed ethical conduct
The sixth and final step is to implement regulations to correct improper

behavior.
CONTROL SYSTEM SUPPORTING THE ETHICS PROGRAM
Management style and culture
Infrastructure
Rewards
Coordination and integration
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In the earlier sections, we discussed the cybernetic control process for

supporting an ethics program. Here, we will discuss the control structures
needed for supporting an ethics program. Figure 21.1 represents the various
elements of a control system needed for an ethics program. The control system
is made up of:
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Management Style and Culture
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Management style and culture have a strong influence on the attitude of

employees. A good work culture nourishes the ethical conduct of employees.
In Chapter 3, we saw that there are two types of management styles: internal
style and external style. Ethical conduct varies depending on the style adopted.
If the management adopts an external style that emphasizes formal
performance measurement and links rewards to such performance, then
employees develop a tendency to adopt unethical practices. Internal
management style1 relies more on informal controls. If a firm adopts an
internal management style then there is a risk of employees showing
indisciplined behavior. External and internal management styles are two
extremes. External style is indicative of excessive control whereas internal
style indicates lack of control. The management should try and avoid both
these extremes in order to instill a sense of discipline in its employees.
Infrastructure
Ethics programs should be ideally looked after by the board of directors. The
board should appoint an ethics administrator who should work along with the
HR, legal and operations departments to implement the ethics program. The
legal department consults employees from time to time to know whether any
rules or regulations have been transgressed or whether any ethical policies
have been overlooked. The HR department conducts various training
programs and helps in implementing the ethical guidelines.
Refer control styles in Chapter 3 for more details on internal and external control
styles.
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Rewards
Rewards and punishments play a vital role in enforcing ethical behavior in
employees. If an employee sticks to the ethical policies of the company he
needs to be rewarded for it; but if he adopts unethical practices then he should
be reprimanded. Organizations can use penalties, threat suspension or
dismissal to inhibit employees from adopting unethical practices.
Coordination and Integration
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Formal communication channels should be established for reporting violation

of ethical norms. There should also be channels to protect employees who
report such violations. Organizations can set-up ethics hotlines for employees
to report violations directly to the top management.
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THE ETHICAL PRINCIPLE OF FAIRNESS IN THE DESIGN OF CONTROL

SYSTEMS
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The objective of control systems is to assist managers to achieve the goals and
objectives of the organization. A control system in which all subsystems are
designed to achieve these goals and objectives, is a goal-congruent subsystem.
For a control system to be ethical, it requires an environment conducive to
ethical conduct. This requires aligning with each stakeholder an environment
that is congruent with ethical behavior, business objectives and stakeholder
objectives. Thus, the concept of fairness is stressed to achieve the environment
which is conducive to ethical behavior.
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Managerial controls that do go by the concept of fairness tend to create stress

for and resentment among, the employees. Unfair controls result in loss of
employees goodwill for the organization. One dangerous effect of unfair
managerial controls is the distortion of control information. This leads to
faulty decisions and misallocation of resources.
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The ethics administrator should maintain disciplinary records to ensure that

the ethics program is perceived as fair by the organizational participants.
Unfair control systems undermine trust in organizations. Without trust, it
becomes difficult to achieve the expected levels of performance. Loss of trust
also results in defensive, bureaucratic and dysfunctional behavior.
The concept of fairness should not be confined to the employees of the
organization; it should be extended to the companys stakeholders too. For
example, a customer is a stakeholder of the company and fairness to the
customer can be maintained by truthful advertising, to help the customer to
make wise decisions. Employees should be informed about the financial
condition of the organization and its plans for future. Fair wages and salaries
should be paid to the employees to motivate them. Compensation and reward
systems (discussed in Chapter-10) should be based on the principle of fairness.
Employees should be given appropriate recognition and rewards for their
performance.
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Exhibit 21.1
Control Systems for Ethics Program
INFRASTRUCTURE
MANAGEMENT STYLE
AND CULTURE
Corporate responsibility
committee of the board
Ethics administrator
Human resource
department
Legal department
Operating management
Dimensions of morality,
responsibility and
integrity in culture and
style
CONTROL PROCESS
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Establish standards of
conduct using both formal
and informal means
Conduct training sessions
to impact standards
Periodic reports on
compliance
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REWARDS
Various ethical policies

and procedures
Lines of communications
for reporting violations
Ethics committees
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Penalties and sanctions for

violations
Positive reinforcements for
outstanding ethical conduct
COORDINATION AND
INTEGRATION
Source: Joseph A. Maciariello and Calvin J. Kirby, Management Control Systems

(New Jersey: Prentice HallInc, 1994) p 651.
Suppliers are, often, the key stakeholders in an organization. They should be

kept informed about the company's future business plans.
Organizations should obey local laws and regulations. They should contribute
to civic and charitable causes.
SUMMARY
Ethics is the science of morality and recognized rules of conduct. While
designing the control systems, a manager should have a basic understanding of
various ethical issues. There are a number of ethical issues that have strong
implication for control systems within an organization. Some of them are293
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creating budgetary slack, responding to flawed control indicators, managing

earnings, using excessively tight control measures. In order to inculcate ethical
values in their employees, organizations should conduct ethics programs. For
developing an ethics program, organizations can adopt a cybernetic approach.
Control structures are made up of management style and culture, infrastructure
rewards, coordination and integration. For a control system to be ethical, it
requires an environment conducive to the ethical conduct. Thus, the concept
of fairness is stressed to achieve the environment which is conducive to ethical
behavior.
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Chapter 20
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Control in the Age of
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Empowerment
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Balancing Empowerment and Control

Control Systems and Conflict Resolution
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To encourage entrepreneurship and enhance employee initiative, managers

need to give greater responsibility and authority to employees. Managers also
have to counsel, and coach employees and provide them with the resources
needed to accomplish their goals. Facilitating and providing greater autonomy
to employees in achieving their goals is called employee empowerment.
Several successful organizations have entrusted their employees with decision
making authority. However, empowering employees and giving them greater
autonomy may have a negative implication for control. In many companies,
including well-known names such as Sears Roebuck and Company and
Standard Chartered Bank1, management control failures, following greater
employee empowerment, were responsible for losses and damaged reputation.
Another important aspect for consideration is the conflict that arises out of
control systems. Conflict is defined as a state of disagreement or
disharmony.
Empowerment, conflict and control systems are intricately related. Often
empowering employees creates a power imbalance that leads to conflicts. In
order to overcome these conflicts, an organization needs to have a good
control system. In this chapter, we will discuss the implications of employee
empowerment and organizational conflict for control systems.
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BALANCING EMPOWERMENT AND CONTROL
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A major problem managers face today is maintaining control, efficiency, and

productivity while still giving employees the freedom to be creative,
innovative and flexible. In other words, managers have to balance
empowerment and control. An example of a company that maintains a good
balance between control and empowerment is Nordstrom2. In Nordstrom,
salespeople are given freedom to tailor their services according to the
requirements of the individual customer. In the process, they take decisions
that are usually taken by managers. On the other hand, an example of
management control failure was that of Kidder Peabody3 and Company, which
lost $350 million because of the failure of its control systems. How can
managers protect their companies from control failures in an environment
where employees are highly empowered? One method is to revert to the
bureaucratic system of management. In this system, employees are told how to
do their jobs and are monitored constantly by superiors to ensure the
instructions are carried out. However, in organizations which operate in a
highly complex and dynamic environment, this method of managing
employees is not possible except in industries where standardization is critical
for efficiency and yield.
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Sears, Roebuck and Company took a $60 million charge against earnings after admitting
that it recommended unnecessary repairs to customers in its automobile service business.
Standard Chartered Bank was banned from trading on the Hong Kong stock market after
being implicated in an improper share support scheme.
Nordstrom is one of US leading fashion retailers, offering a wide variety of high quality
apparel, shoes and accessories for men, women and children at stores across the country.
Kidder Peabody and Company is a readymade garments manufacturer and makes the
famous Arrow shirts.
Managers must find ways to encourage employees to be creative and to

initiate process improvements, but must still retain enough control to ensure
that employee creativity benefits the company. To avoid a trade-off between
creativity and control, managers can use the following four types of control
levers or systems (Refer table 20.1):
Diagnostic control systems
Belief systems
Boundary systems
Interactive control systems
Table 20.1: Levers of Control
Potential
Managerial
Solution
Control Lever
Lack of focus or Build and support Diagnostic control

resources.
clear targets.
systems.
To contribute
Uncertainty
about purpose.
To do right
Pressure
temptation.
or Specify and enforce Boundary systems.

rules of the game.
To create
Lack
opportunity
fear of risk.
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To achieve
Organizational
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Communicate core Beliefs systems.

values and mission.
Diagnostic Control Systems
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of Open organizational Interactive control

or dialogue
to systems.
encourage learning.
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Diagnostic control systems use quantitative data, statistical analyses and

variance analyses to scan for anything unusual that might indicate a potential
problem. Diagnostic systems can be very useful for detecting problems, but
they can also result in employees and managers behaving unethically to meet
the pre-set goals.
Employee rewards are often based on how well performance goals have been
met. Diagnostic systems work well if the goals are reasonable and attainable.
Diagnostic control systems relieve managers of the task of constant
monitoring employees as the employees usually work diligently to meet the
agreed-upon goals.
However, when goals are unrealistic, empowered employees may sometimes
use their creativity to manipulate the factors under their control to live up to
their managers expectations. Such manipulations have only very short-term
positive effects, and can lead to long-run disaster for the company.
Belief Systems
Belief systems are used to communicate the tenets of corporate culture to
every employee of the company. Belief systems are generally broad and
designed to appeal to different groups working in different departments, and to
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inspire and promote commitment to the organization's core values. For belief
systems to be an effective lever of control, employees must be able to see key
values and ethics being upheld by those in supervisory and other high
positions. Senior management must be careful not to adopt a particular belief
or mission simply because it is in vogue, but rather because it reflects the true
nature and value system of the company as a whole.
In the past, a companys mission was easily understood by employees without
any reference to the core values or formal beliefs. With businesses becoming
more complex, it has become necessary to establish formal, belief systems.
Formal belief systems help in understanding the core values of the
organization and what constitutes acceptable behavior in the workplace.
Boundary Systems
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Boundary systems are based on the principle that in an age of empowered

employees, it is easier and more effective to set the rules regarding what is
inappropriate rather than what is appropriate. The effect of this kind of
thinking is to allow employees to create and define new solutions and methods
within defined constraints. Boundary systems work on the premise that
empowered employees should not be given the freedom to do whatever they
want. Employees should focus their efforts on areas that are in the interest of
the company, in terms of profitability, productivity and efficiency.
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Boundary systems are thus minimum standards that the employees have to
maintain. Examples of these kinds of standards include forbidding employees
to discuss client matters outside the office or with anyone not employed by the
company, and encouraging them not to accept work on projects or with clients
deemed to be undesirable. Often companies implement boundary systems only
after they have suffered a major crisis due to the lack of such a system. It is
important that companies be proactive in establishing boundaries.
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Boundary systems have an approach to control that is in direct contrast to that

of diagnostic control systems or belief systems, in the sense that boundaries
are stated in negative terms whereas diagnostic and belief systems are positive
and inspirational.
Interactive Control Systems

Small organizations facilitate informal discussion across the table between the
managers and the employees. As organizations grow, such personal contact
becomes difficult. For this reason, the organization needs a control system
which is interactive. For this kind of control system to work, it is critical that
subordinates and supervisors maintain regular communication with each other.
Companies use different tools to facilitate regular communication. One
popular method of doing this is to analyze data from reports that are
frequently released (for example, internally generated productions reports).
Though this may seem somewhat similar to the diagnostic control system
discussed earlier, there are four important characteristics which set the
interactive control systems apart: 1) interactive systems focus on constantly
changing data that are of a strategic nature, 2) the strategic nature of the data
warrants frequent and regular attention from all levels of management, 3) the
data generated is best analyzed in face-to-face meetings which include
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employees at all levels, and 4) the system itself stimulates regular discussions
relating to the underlying data, assumptions and action plans.
CONTROL SYSTEMS AND CONFLICT RESOLUTION
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As organizations grow, they need to decentralize their operations. Along with

decentralization, they should delegate authority to the lower levels of the
hierarchy. Often this does not happen. Decentralization is not always followed
by delegation of authority. Instead stringent control measures are put in place
to prevent irregularities. This creates an atmosphere of distrust in which
employees feel alienated. They feel that it is because the top management does
not have faith in them that they have imposed such control measures. A rift
develops between individual objectives and corporate objectives. This rift
soon expands into a conflict between individual objectives and corporate goals
and objectives. This kind of conflict is highly dysfunctional for the
organization and can hamper organizational growth. There are a number of
control systems which open up the possibility of conflict. One of these is the
planning and control system. Planning and control systems have a number of
sub-systems. The sub-systems of planning and control are:
Planning
Measuring
Recording
Appraising
Reporting
Remedial action
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In the following paragraphs, we will discuss how and why conflicts arise in
the various subsystems of a planning and control systems.
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Conflicts in the Planning Subsystem
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A large number of conflicts arise during the planning stage particularly during
budgeting. Budgets are prepared to evaluate performance of organizational
units and employees against the preset standards. Conflicts that arise during
the planning stage occur at two levels:
At the level of the senior managers who form a small minority and who
actually participate in the planning process.
In interaction between the senior managers and the junior managers who
form the majority and who are not involved in the planning process.
In the first type, conflicts arise when the suggestions or views of a senior
manager regarding corporate goals, objectives and strategies, are not accepted
by other managers at that level.
It is at the second level that conflicts are more common within organizations.
Often, strategies and objectives are framed by the top management without
taking junior managers into confidence. Junior managers may reject these
plans and proposals because they were not involved during the planning
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process. They may reject the standards used during the planning process and
question the feasibility of projects.
Conflicts in the Measuring Subsystem
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Many conflicts arise due to improper and ambiguous rules in the measurement
systems. They also arise due to poor allocation of overhead expenses within
an organization. This problem is compounded by accounting conventions used
in the measurement process. Most of these conventions, particularly those
relating to depreciation and amortization of expenses, cannot be understood by
all employees, and hence lead to confusion and conflict within organizations.
The fairness of the measurement process is another area which can result in
conflicts over a period of time. For example, whether sales should be
measured on despatch or on the basis of amounts billed, is a major area of
conflict.
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Conflicts in the Recording Subsystem
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Conflicts that arise due to problems in the recording system are rare. After the
rules for measurement are set up, the recording system functions flawlessly.
One major problem arises due to the recording of performance in monetary
terms. Not all people within the organization feel comfortable when their
performance is recorded in monetary terms. For example, production
managers prefer to record their performance in terms of volume rather than in
terms of money.
Conflicts in the Appraisal Subsystem
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Conflicts arising out of the appraisal subsystem are often violent and bitter.
The appraisal subsystem is responsible for the evaluation of the performance
of employees. Most of the conflicts begin in the planning subsystem in which
targets and goals are set, cost standards are determined and resources are
allocated. Conflicts arise again when performance is appraised against the
backdrop of the targets and goals set. Employees react negatively and at times
violently when their performance is rated against set standards, because they
feel that the targets, goals and standards are unrealistic and unfeasible.
Another problem arises when the targets, goals and standards are laid down
for a decentralized unit. It is possible that when the overall performance of the
organization is measured, the performance of the sub-units is not highlighted.
This is seen as discriminatory. Conflicts also arise when employees doubt the
objectivity and time span of appraisals. The inability of the control experts or
the people who conduct appraisals to understand the circumstances or
environment in which other employees work, also creates conflicts.
Conflicts in the Reporting Subsystem

Conflicts that arise in this area are of two types:
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Conflicts that arise due to reporting delays. Delayed reports are of little
value to managers as no remedial action can be taken.
Conflicts that arise when reports do not provide the kind of information
required, in terms of decision made, costs incurred and revenues earned by

the subunits.
Conflict may also arise due to improperly demarcated reporting levels.

This leads to the control department crossing operational boundaries for
the purpose of reporting.
Conflicts in the Subsystem for Remedial Action

Conflicts arising in this area pertain to the inability of the supervisory manager
to understand the problems of feasibility and possible levels of achievement.
This means that conflicts arise when recorded performance is at variance with
expected goals.
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FRAMEWORK FOR CONFLICT RESOLUTION
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According to Robert Anthony4, organizations should try to achieve goal

congruency while designing control systems. Achieving goal congruency will
help in reducing conflicts that arise from various control subsystems. A
control system can be termed as effective if it encourages managers to take
actions that eventually have a positive impact on the company. One of the first
steps an organization can take to minimize conflicts and to make managers
proactive, is to establish accounting and control departments which are viewed
as service departments. Accounting and control department executives should
assist and advise the line and staff members in achieving corporate objectives.
They should also collate, measure, record and report performance against
assigned goals. Secondly, organizations should minimize role ambiguity by
having proper delineation of levels of authority and responsibility.
Organizations should encourage participative management, encourage
teamwork, and break up organizational goals into specific tasks so that
performance can be measured objectively. Organizations should try to involve
as many people as possible in the planning process. Tasks should not be
assigned arbitrarily but on the basis of interest and intellectual capability of
the individual. A number of conflicts can be resolved if control departments
adopt an information systems approach rather than an overseeing approach
while reporting performance. This means that control systems should
continuously report progress and variances from the preset standards. When
reporting variances, the control department should not demand explanation for
the variances; rather it should provide information and insights on the reasons
for variances and should show to other departments the extent to which they
have varied from predetermined goals or standards. In order to enhance the
effectiveness of control systems and reduce conflicts arising in them,
employees should be provided cross-functional training. Employees working
in functional departments should be provided training in the operation of
control systems, whereas accounting and control executives should be trained
in the operational aspects of different functions. Finally, it is necessary for
large companies to review the mechanisms of their control systems from time
to time. They should constantly try to determine the effect of control systems
4
Robert N. Anthony was the Ross Graham Walker Professor of Management Control at the
Harvard Business School until his retirement in 1983.
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on employee creativity and motivation. For this purpose, companies can

conduct attitude surveys that measure some of the following indices:
Span of control
Levels in hierarchy and their appropriateness
Ratio of administrative to production personnel
Time span for appraisals
The objective of conducting control mechanism reviews would be to report to

the top management the effect of control mechanisms on issues such as
employee morale, tension, stress, grievances and employee participation.
SUMMARY
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A major problem managers face today is maintaining control, efficiency, and

productivity while still giving employees the freedom to be creative,
innovative and flexible. When managers try to exercise excessive control, the
trade-off between creativity and control comes into play. In order to avoid this
trade-off, managers can use the following four types of control levers or
systems: diagnostic control systems, belief systems, boundary systems, and
interactive control systems. Another major issue that managers need to tackle
is that of conflict arising in the sub-systems of the planning and control
systems. The sub-systems of the planning and control systems that may give
rise to conflict are those related to: planning, measuring, recording, appraising,
reporting, and remedial action. Organizations should develop a framework for
conflict resolution that tries to achieve goal congruency for reducing conflicts
that arise in the various control subsystems.
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Glossary
Action controls: These are controls that work on the standard sets of
procedures.
Administered development program: These programs are initiated and
implemented for the benefit of a target group. For example, Government
initiates a program of free education in all the Universities.
Administrative audit: It is a thorough examination of a project covering all
the administration related aspects (other than the detailed examination of
technical quality).
Agency theory: It explores how contracts and incentives can be written to
motivate individuals to achieve goals. It describes the major factors that
should be considered in designing incentive controls.
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Audit evidence: Audit evidence is any kind of information used by the

auditor to determine whether the financial statements being audited are in
accordance with the established rules and regulations.
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Audit: A tool used to monitor a companys financial performance in

comparison to a set of standards, which are typically imposed by government
regulators or by professional standards groups.
Belief systems: Belief systems are used to communicate the tenets of

corporate culture to every employee of the company.
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Benchmarking: It is the process of comparing products and operations

against the best practices in the industry.
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Billed- time ratio: The ratio of hours billed to the total professional hours
available in a professional organization.
Bonus pool: In a short-term incentive plan, the shareholders vote on the

formula to be used in arriving at the total amount of bonus that can be paid in
given year, which is called bonus pool.
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Boundary systems: Boundary systems are based on the principle that in an

age of empowered employees, it is easier and more effective to set the rules
regarding what is inappropriate rather than what is appropriate.
Bowers model of investment decisions: Bowers model suggests that ideas,
proposals, and approval of projects come from the lower levels of
management. The lower levels also help in the identification of gaps in the
control process.
Budget manual: It is a written document that contains standing instructions
regarding the procedures to be followed at the time of budget preparation.
Budget committee: The budget committee consists of head of various

departments within the organization and the members of senior management
such as CEO, financial vice president etc. The function of the committee is to
review budgets, approve them, and make adjustments wherever necessary.
Budget key factor: A budget key factor is a factor whose influence on the
various budgets should be assessed in order to ensure that those budgets are
capable of fulfillment.
Management Control Systems
Budget signals: These are the budgetary items which signal to the managers
the amount required to be spent on the particular item. Budget signals may
include expected amounts, ceilings and floors.
Budgeting control: It is a device to find out how the activities in an
organization are progressing.
Business-unit strategy: The business unit strategy of a firm deals with the
specific product market strategy for each business.
Ceilings: Budget items that signal that the manger is expected to spend no
more than the budget amount without obtaining specific approval. Examples
are entertainment expense, dues and subscriptions, advertising.
Closed loop control mechanism: Corrective actions are initiated
automatically when a comparison of the performance measured and the
performance standard shows a distinct deviation.
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Close-ended questionnaire: Questionnaire consisting of questions in which

a list of acceptable responses is provided to the respondent.
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Continuing information systems (CIS): These are used to collect the

information scientifically and systematically on continuing basis over a long
period of time
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Cooperative society: All the producers of the basic commodity form a society
called cooperative society. The marketing and distribution activities are
carried out by the society for the benefit of all the producers.
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Cost-based transfer prices: The transfer prices are estimated on the basis of
the costs incurred by the other business center. This is used when market
prices are not available.
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Critical Path Method (CPM): It is a technique in project management

which helps the top management to concentrate their attention on the critical
activities and their completion in time. This method considers the time-cost
estimates of each activity and suggests an optimum schedule for the project.
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Critical path method: The Critical Path Method (CPM) is a technique of

network analysis that uses network diagrams to identify the sequence of
activities that are critical for the project.
Cybernetic controls: These are also known as steering controls, are used to
monitor and control tasks on a continuous basis.
Data envelopment analysis: Technique applied for adjusting the differences
that arise out of comparison of the information for each unit in multi unit
organizations with system wide or regional averages.
Diagnostic control systems: Diagnostic control systems use quantitative data,
statistical analyses and variance analyses to scan for anything unusual that
might indicate a potential problem.
DSS: The acronym stands for Decision Support Systems. The term applies
broadly to systems that aid decision making by providing the answers to a
series of what-if questions.
Entrapment: A special form of escalation of conflict in which the parties
involved expend more of their time, energy, money or other resources than
seems appropriate or justifiable according to some external standards.
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Glossary
Expense center: Responsibility centers in which inputs or expenses and not

outputs are measured in monetary terms. Management attention is focused on
the control of expenses incurred by the center.
External information system: It is designed to provide the latest market
trends and this information is used to reduce the uncertainty.
Floors: Budget items that signal that the manager should spend at least the
budget amount. For example, training.
Focus group: A focus group is a group of people who jointly participate in an
interview that does not use a structured question-and-answer method to obtain
information from these people. The interview is conducted by a trained
moderator with a group of, ideally, 8-12 willingly recruited participants. The
composition of the group varies according to the needs of the client, especially
the problem under study.
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Formal control system: Formal control systems are written, managementinitiated mechanisms that influence the behavior of employees in achieving
the organizations goals.
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Fund accounting: An accounting system used in many nonprofit

organizations, wherein accounts are kept separately for several funds, each of
which is self-balancing (i.e., the sum of the debit balances equals the sum of
credit balances).
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Go/ No-go controls: These are the most frequent type of control exercised in
projects. The project team performance is the primary focus of these controls
rather than specific items performed by the individuals.
Historical standards: These are prepared on the basis of the actual
performance. Results are compared with the results of the past period.
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Human resource accounting: Refers to the method of reflecting the rupee

value of the human asset in the companys balance sheet. It works on the idea
that human assets in an organization are no less important than its material
assets.
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Human resource audit: The Human Resource (HR) Audit is the process of
examining policies, procedures, documentation, systems, and practices with
respect to an organizations HR functions.
Indoctrination: It is a process used by the organization to socialize members
to its values, procedures, and policies.
Informal control system: These are unwritten, typically worker-initiated
mechanisms that influence the behavior of individuals or groups in business
units.
Information asymmetry: A station when the principal has inadequate
information about the performance of the agent. Therefore the principal can
never be certain how the agent contributed to the actual firms results.
Input controls: These are the actions taken by the company before a planned
activity is implemented.
Investment center: A responsibility center whose performance is evaluated in
terms of profit and assets employed in earning the profit. It is a special type of
profit center in which managements attention is also focused on the assets
employed.
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JIT: The acronym stands for Just-In-Time. The purpose of the just-in-time
approach is to eliminate the need for a buffer inventory by ensuring that every
work station produces and delivers to the next work station the right items in
the right quantity at the right time.
Key success variables: These are the variables in the external environment to
which goals, objectives, and strategies of managers are most sensitive.
Loose control: It is based on the philosophy that the people work their best
as they know what they are supposed to do and also know how to do. The
management never considers that the poor performance of the company is
because of the poor performance of the people.
Management control system: A management control system is a set of
interrelated communication structures that facilities the processing of
information for the purpose of assisting managers in coordinating the parts
and attaining the purpose of an organization on a continuous basis.
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Open-ended questionnaire: Questionnaire consisting of questions in which

the respondent is free to choose any response deemed appropriate, within the
limits implied by the question.
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Marketing audit: Marketing audit is a comprehensive, systematic,

independent and periodic examination of a company's or business unit's
marketing environment, objectives, strategies and activities.
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Master budget: A master budget is defined as the summary budget

incorporating functional budgets, which is finally approved, adopted, and
employed.
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Matrix organization: In a matrix organization, there is one basic structure in

which responsibility centers are arranged by functions, and alongside this
structure - or superimposed on it- there is another structure in which the focus
of responsibility is by projects.
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Moral hazard: A situation when an agent being controlled is motivated to

misinterpret private information by the nature of the control system.
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Open loop control mechanism: In this mechanism, initiation of corrective

action lies outside the scope of the system. An external entity is needed to
initiate corrective action.
Organizational slack: It is defined as the difference between the total
payments to organizational participants and total necessary payments.
Output control: Output control relates to the performance of a subsidiary in
quantitative and qualitative terms.
Overview audit: This suggests whether a project is in trouble or not. The
project is continued only if the report of the overview audit is positive.
Performance shares: A performance share plan awards a specified number of
shares to a manager when specific long-term goals have been met.
Post controls: These are seen as report cards. These are exercised after
completion of project. These serve as a basis for reward or punishment.
Process Controls: Process controls involve tracking certain variables and
taking corrective action whenever there is any deviation from specified
parameters in the variables.
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Glossary
Production audit: The production audit also referred as manufacturing audit

is conducted to measure the effectiveness and efficiency of all production
facilities and processes.
Profit center: Organizational unit that not only measures the monetary value
of inputs and outputs but also compares outputs with assets used in producing
them.
Program Evaluation and Review Technique (PERT): This method
considers the uncertain activity times of all the activities of the project and
suggests an optimum schedule of the project.
Programming: Programming is an organizational process for making longterm resource allocation choices.
Project audit: It is a formal and systematic verification of the performance of
an ongoing project. Normally, it is carried out along the work.
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Project planning: Project planning is defined as the process of developing the

basis for managing the project, including the planning objectives, procedures,
organization, routines, finance and other chain of activities.
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Purchase price: The price at which the organization purchases the basic
commodities from the producers.
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Responsibility center: Any organizational or functional unit headed by a

manager who is responsible for the activities for that unit.
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Responsibility structure: It consists of responsibility centers and related

performance measurement systems.
Result controls: These are used to control the behavior of employees. These
are effective in addressing motivational problems.
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Revenue center: Responsibility centers in which outputs are measured in

monetary terms. The focus of managements efforts is on the revenue
generated by the center.
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Sales audit: Sales audit is the process of examining and assessing the current
state of sales, the sales environment and the sales objectives, strategies and
activities.
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Self regulated development program: A group of people who start a

development program for the benefit of the group.
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.
Social accounting: Social accounting is defined as systematic accounting and
reporting of those parts of a company's activities that have a social impact.
Social auditing: Social auditing help in evaluating the contributions made by
the company to the society.
Social controls: Social control refers to the prevailing social perspectives and
patterns of interpersonal interactions within subgroups in the firm.
Social indicators: Non-monetary indicators to measure the output in
government organizations. It is a broad measure of output that reflects the
result of the work of the organization.
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Social information systems: These are used to indicate the social conditions
with an aggregation of organization.
Stock appreciation right: It is a right to receive cash payments based on the
increase in the value of stock from the time of award until a specified future
date. It is also a long term incentive plan.
Stock-option: A stock option is a right to buy a number of shares of stock at
the given date or in the future. It is a long-term incentive plan.
Superordinate (shared) goals: The set of values or aspirations that
underscore what an organization stands for and believes in. Superordinate
goals are values that genuinely seek congruence between the individual and
the organizations purposes, and encompass the concepts of service to society.
Systematic information systems: These are used to appraise the views in
making a decision through dialectical approach.
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Target cost: Target cost is the maximum manufacturing cost of a product.

Target costing is done to encourage various design and production
departments to find less expensive ways of achieving similar or better product
features and quality.
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Technical audit: This is concerned with the specific technical issues and
problems of a project. The auditor examines all the technical aspects of the
project.
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Tight control: It is based on the management philosophy that people work

more effectively only when they are forced to meet the specific goals. So, the
management monitors each and every work part of the employees.
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Total quality management: Total quality management (TQM) is a

management concept that directs the collective efforts of all managers and
employees towards satisfying customer expectations by continually improving
operations management processes and products.
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Transfer price: It is the value placed on the transfer of goods or services

among two or more profit centers of the same organization.
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Value chain: Value chain analysis is a strategic analysis tool that can be used
to identify areas in which value can be enhanced for customers or costs can be
reduced.
Variance: The differences that arise between the actual and the budgeted
revenues and expenses of a business unit, is called variance.
Zero base budgeting: The Zero base budgeting refers to a net budget as the
starting point: it starts with the premise that the budget for next period is
zero. This assumption of ZBB is beneficial to the managers as this technique
helps them to carry out the cost benefit analysis of each of their responsibility
centers.
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BIBLIOGRAPHY
Books:
1. Anthony, Robert N. and Govindrajan Vijay. Management Control
Systems. Washington DC: Irwin Publications, Eighth Edition, 1995.
2. Bartol, Kathryn M and Martin C. David. Management. New York: Irwin,
McGraw-Hill, Third edition, 1998.
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303
INDEX
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Budgetary control, 115, 119, 120, 121,

137
Organizing, 121
Budgeted proportion, 132
Budgeting, 25, 26, 115, 116, 123, 127,
128, 129, 130, 131, 137, 233, 234
Behavioral dimensions, 123
Involvement, 124
Participation, 123
Budgeting process, 116
Guidelines, 117
Budget proposal, 117
Budget revisions, 118
Negotiation, 118
Review, 118
Business ethics, 288
Business unit strategy, 24, 27
Competitive advantage, 26, 27
Differentiation, 26
Focus, 27
Low cost, 26
Mission, 24
Build, 25, 27
Divest, 25
Harvest, 25
Hold, 25
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Accumulated carryover, 142

Action controls, 29, 30, 31
Activity based costing, 171, 174
Actual costs, 92
Adaptive organization, 66, 68
Need for adaptive controls, 66
Environmental complexity, 67
Environmental diversity, 67
Environmental factors, 67
Environmental hostility, 67
Environmental uncertainty, 67
Administrative expense budget, 124
Agency Theory, 149
Concepts, 149
Objectives, 150
Control mechanisms, 151
Monitoring, 151
Incentive contracting, 151
Amazon.com, 178
Anthony, and Govindarajan, 6
Apple computers, 23
Appraisal costs, 160
Asset management variables, 46
Audit evidence, 206
Audit, 186, 187, 188, 189, 190, 191, 192,
194, 198, 199, 200, 202, 203, 204, 205,
206, 207
Benefits, 186
Limitations, 187
Process, 188
Timing, 188
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Balanced scorecard, 147

Customer, 147
Financial, 147, 150, 151
Innovation and learning, 147
Internal process, 147
Bausch & Lomb, 140
Belief systems, 281
Benchmarking, 166, 174
Benchtrending, 168
Boston consulting group (BCG), 25
Boundary systems, 281, 282
Bowers Model, 108
British Telecom, 203
Budget center, 121
Budget manual, 121
Budget report, 154
Budget signals, 154
C
Capital expenditure budget, 124
Capital projects manual, 113
Carryovers, 142
Ceiling, 154
Centralization, 59
Class I products, 94
Class II products, 94
Compensation scheme, 151
Competitive strategy, 47
Complete management audit, 198
Compliance management audit, 198
Computer integrated manufacturing, 160
Conglomerate businesses, 24
Contingency approach, 20, 21
Continuous process improvement, 164
Control process hierarchy, 19
Control process, 4
Strategic level, 4
Management level, 4
Operational level, 5
Control systems, 12, 15, 24, 30, 60, 283
Elements, 5
Assessor, 5, 15
Communications network, 6
INDEX
Diversification strategy, 73
Management policies and
procedures, 73
Management style and processes,
72
Divisional structure, 51
Donaldson Brown, 75
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Economic risks, 227

Emotional tension, 50
Enron corp, 4
Ethics program, 290, 291, 293
Ethics, 288, 290, 291, 293
Evaluation standards, 134
Exchange rate risk, 227
Economic, 228
Transaction, 228
Translation, 228
Executional cost drivers, 182, 184
Expense centers, 78,107
Discretionary, 78, 79
Engineered, 78
Control characteristics, 78
External failure costs, 160
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Detector, 5
Effector,5 6, 15
Controller organization, 65
Controls in MNCs, 222
Bureaucratic, 223
Cultural, 222
Output, 222
Personal, 222
Result, 222,
Factors influencing controls, 224
Individualism, 224, 225
Masculinity, 224, 225
Power distance, 224, 225
Uncertainty avoidance, 224, 225
Corporate strategy, 22
Related diversification, 23
Single business firm, 23
Unrelated diversification, 23
Cost audit, 202
Cost center, 83, 86
Cost driver analysis, 181
Cost leadership, 27, 182
Creative tension, 50
Critical Path Method (CPM), 263, 276
Critical success factors, 178
Cybernetic control system, 269
Cybernetic controls, 269, 276
Cybernetic paradigm, 18, 19, 27
Cybernetics approach, 16
Characteristics, 16
Cycle time, 157
Cyert and March, 37, 289
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Data architectures, 39
Decentralization, 37, 41, 58, 197, 283
Decentralized operations, 84
Performance measurement, 84
Decision support systems, 161
Implications for control, 161
Design quality, 157
Designing management controls, 18
Impact of IT, 39
Managerial styles, 32
External control, 32, 41
Internal control, 33
Mixed control, 34
Diagnostic control systems, 281
Differentiation, 183
Direct labor budget, 124
Direct observation, 196
Divisional autonomy, 72
Variables, 72, 86
F
Feed-forward system, 11
Financial audit, 188, 202
Fixed costs, 133
Floors, 154
Focus groups, 195
Formal control process, 13
Formal planning, 13
Formal reporting, 13
Formal control system, 11
Input controls, 11
Output controls, 12
Process controls, 11
Formal information, 153
Formal programming procedures, 111
Formal rewards, 149
Full-cost systems, 135
Functional management audit, 199
Fund accounting, 240
G
General Electric, 25, 52
General Motors, 75
Go/No-go controls, 270, 276
Government organizations, 246, 257
Griesinger, 17
305
INDEX
Historical standards, 135

Human resource audit, 210
Conducting, 211
Long-term incentive plans, 141, 143

Stock Options, 143
Stock appreciation rights, 143
Phantom stock plan, 143
Performance shares, 143
Loose control, 7, 35
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Job design, 8
Just-in-time techniques, 155
Advantages, 156
Implications for control, 156
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Kaplan and Norton, 147

Kenneth R Andrews, 22
Key actions, 29
Key results, 29
Key variables, 44, 50
Concept, 43
Identification, 44
Input, 44, 45, 54
Marketing, 46
Output, 44, 54
Production, 45
Sources, 47
Types, 47
Environmental, 47, 54
Process, 47, 48, 49, 51, 52, 54
Strategy, 47
Structural, 47, 54
Kidder Peabody, 280
Kimberly-Clark, 5
306
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Management audit, 198, 199, 209

Management by objectives, 78
Management control systems, 5, 7, 9, 15
17, 22, 28, 30, 32, 37, 38, 79
Features, 5
Management control, 5 , 8, 11, 12, 15, 37
Manufacturing overhead budget, 124
Market penetration, 132
Market share variance, 132
Marketing audit, 214, 215
Materials budget, 124
Matrix structure, 59, 62, 272
Matrix and multinational firm, 61
Control factors, 63
Problems, 64
Milton Friedman, 288
Mix and volume variance, 132
Mix variance, 132
MSSM, 148
Attainability, 148
Formal rewards, 149
Informal rewards, 149
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IBM, 36, 180

Incentive compensation system, 26
Industry volume variance, 132
Inflation, 225, 226
Informal control system, 12
Cultural controls, 12
Self-control, 12
Social controls, 12
Informal information, 153
Information asymmetry, 150
Innovation, 164
Insurance companies, 252, 253, 254
Interactive control systems, 282
Internal audit, 154, 162, 202
Internal failure costs, 160
Interviews, 196
Semi structured, 196
Structured, 196
Unstructured, 196
Investment bankers, 254
N
Non-financial audit, 186, 188, 208
Nonfinancial measures, 160
Nonprofit organizations, 235, 237, 238,
Mission, 235
Norbert Weiner, 16
Nordstrom, 280
NPV, 108
O
Ongoing programs, 105, 113
Operational control, 201
Operations management, 153, 162
Organizational structure, 58, 59, 66, 67,
Organizing, 121
P
Participative budgeting, 123, 130
Performance budgeting, 129
INDEX
R
Research & development budget, 124
Residual loss, 151
Responsibility center, 75, 76, 85
Nature, 76
Types, 77
Responsibility structure, 72, 74, 86
Efficiency measure, 75
Process measure, 75
Effectiveness measure, 75
Result controls, 30, 31, 222
Return on Investment (ROI), 75
Revenue centers, 77
Revenue variances, 131
Roger Hall, 50
Quality control, 45
Questionnaires, 195
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Sales audit, 215, 217, 218

Sales budget, 125, 132
Samuel Paul, 47
Scheduling, 263
Scope, 89, 261
Securities firms, 257
Selling and distribution expense budget,
Selling price variance, 132
Sensitivity analysis, 79
Service organizations, 243, 248
Short-term incentive plans, 141, 151
Total bonus pool, 141
Carryovers, 142
Deferred payments, 142
Slack, 37, 118, 288
Social accounting report, 203
Social audit, 202
Definition, 204
Features, 204
Types, 205
Social balance sheet, 205
Social performance audit, 205
Macro-micro social indicator audit,
205
Constituency group, 205
Government mandated, 205
Program audit, 205
Approaches, 204
Inventory approach, 204
Program management approach, 206
Cost benefit approach, 205
Social indicator approach, 205
Social controls, 13
Social indicator, 248
Standard costs, 92
Stars, 255
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Implementation, 130
Performance evaluation, 91
Performance reports, 83, 136, 204
Performance criteria, 146
Controllable factors, 146
Uncontrollable factors, 147
Personal controls, 222
Peter Drucker, 235
Phantom stock plans, 143
Planning phase, 166
Political risks, 226
Post controls, 270, 277
Predetermined standards, 135
Predictable variables, 44
Preventive costs, 159
Process controls, 11
Process measures, 248
Process quality teaming, 169
Processing time, 157
Product design, 158
Product organization, 60
Product pricing, 253
Production audit, 213
Production budget, 124
Professional organizations, 244, 245
Profit centers, 81, 128, 156
Types, 81
Program evaluation and review
Technique , 263, 264, 265, 276
Program management audit, 199, 200
Programming, 107, 108, 110, 113
Initiating, 109
Integrating, 109
Corporate, 109
Project auditing, 273
Detailed, 274
General, 274
Technical, 274
Project control, 259, 268
Project definition, 111
Project evaluation, 112
Project implementation, 112
Project managers, 268
Project plan, 260, 261
Promotion & advertising expense
budget, 124
Propriety audit, 199
Purchase audit areas, 210
307
INDEX
Cost method, 231

Market price method, 231
Resale price method, 231
Transfer pricing, 88, 89, 91
Calculation, 90
Cost based, 91
Market-based, 91
Negotiation, 92
Administration, 93
Negotiation, 94
Arbitration, 94
Product classification, 94
Two-by-two growth share matrix, 25
Tyco International, 4
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Unfair controls, 292

United Airlines, 33
Upstream fixed costs and profits, 92
Profit sharing, 93
Two sets of prices, 93
Two step pricing, 93
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Stock appreciation rights, 143

Stock options, 143
Straight salary, 151
Strategic control, 5,223, 224, 233
Strategic cost analysis, 184
Strategic cost management, 178, 179,
183, 184
Evolution, 178
Three key themes, 179
Value chain analysis, 179
Cost driver analysis, 181
Strategic positioning analysis,
182
Strategic planning, 100, 101, 102, 103,
104, 113
Characteristics, 100
Benefits, 101
Planning process, 102
Reviewing, 102
Guidelines, 102
First iteration, 103
Analysis, 103
Second Iteration, 104
Review, 104
Strategy elements, 100
Strategy formulation, 10
Structural cost drivers, 182
Surveys, 194, 195
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Target costing, 164, 165, 166, 175

Stages, 164
Planning, 165
Production, 165
Development, 165
Benefits, 166
Task Control, 10
Texas Instruments, 180, 183
Three-by-three matrix, 25
Tightness of controls, 31
Total project cost, 262
Total quality culture, 38
Total quality management, 39, 40,
Toyota Corporation, 159
Transfer pricing in MNCs, 231
Methods, 231
308
Value chain analysis, 179, 180, 184

Variable costs, 133, 136
Variable overhead variance, 134
Variance analysis, 131, 136
Vijay Sathe, 65
Volume variance, 132, 133, 135
W
William G Ouchi, 12
Work aversion, 150
Working capital management, 66
Work-in-process inventory, 156
Z
Zero base budgeting, 126
Process, 127
Implementing issues, 128
Advantages and disadvantages, 128

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ICFAI Center for Management Research

The Institute of Chartered Financial Analysts of India, January 2006.

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Introduction to Management Control Systems

Approaches to Management Control Systems

Designing Management Control Systems

Key Success Variables as Control Indicators

PART II: MANAGEMENT CONTROL ENVIRONMENT

Autonomy and Responsibility

PART III: MANAGEMENT CONTROL PROCESSES

Budget as an Instrument of Control

PART IV: MANAGEMENT CONTROL TOOLS

Management Control of Operations

Continuous Process Improvement Methods

PART V: MANAGERIAL COSTING

Strategic Cost Management

Audit of Management Functions

PART VI: MANAGEMENT CONTROL IN SPECIFIC SITUATIONS

Control in Multinational Corporations

Control in Nonprofit Organizations

Control in Service Organizations

Management Control of Projects

PART VII: MANAGEMENT CONTROL AND EMERGING AREAS

Control in the Age of Empowerment

Management Control and Ethical Issues

Chapter 2: Approaches to Management Control Systems: Cybernetic

Chapter 3: Designing Management Control Systems: Steps in Designing

Comprehensive Performance Indicators: Limitations of Indicators Key

PART II: MANAGEMENT CONTROL ENVIRONMENT

Chapter 6: Autonomy and Responsibility: Divisional Autonomy:

PART III MANAGEMENT CONTROL PROCESSES

Chapter 8: Strategic Planning and Programming: Elements of Strategy

PART IV: MANAGEMENT CONTROL TOOLS

PART V: MANAGERIAL COSTING

Chapter 11: Management Control of Operations: Information used in

Chapter 13: Strategic Cost Management: Evolution of Strategic Cost

Chapter 14: Auditing: Benefits of Audit: Identify Opportunities for

PART VI: MANAGEMENT

Chapter 16: Control in Multinational Corporations: Types of Controls

Chapter 17: Control in Nonprofit Organizations: Mission of Nonprofit

Chapter 18: Control in Service Organizations: Control in Professional

PART VII: MANAGEMENT CONTROL AND EMERGING

Chapter 20: Control in the Age of Empowerment: Balancing

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

Principles of Management Control Systems

IMPORTANCE OF CONTROL SYSTEMS

This chapter focuses on the importance of control systems, the nature of

A control system is a set of formal and informal systems to assist the

The control process in any organization can be undertaken at three levels.

Management control deals with effective resource utilization, the state of

Operational control is primarily concerned with efficiency issues.

Introduction to Management Control Systems

Adapted from Veliyath, Raj; Hermanson, Heather M. Organizational control systems:

Elements of a Control System

Principles of Management Control Systems

Figure 1.1 Elements of the Control Process

standard result. The communication network transmits information between

Implementing the programs or policies,