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Module 7: Management control systems

Module 7 looks at the impact of control systems on decision-making and costs. As you work through the module, you learn
how management control systems help organizations achieve overall goals. Finally, the module focuses on management
control systems from the perspective of corporate and business-unit levels, and describes the different types of controls.
Test your knowledge
Begin your work on this module with a set of test-your-knowledge questions designed to help you gauge the depth of study
Assignment reminder
Assignment 2 is due this week (see Course Schedule). Be sure to allocate time to complete and submit the assignment by the
Assignment 3 (see Module 9) is due at the end of week 9. You are encouraged to review it now so that you are familiar with
the requirements as you work through Modules 8 and 9.
Topic outline and learning objectives
7.1 Management control systems: Introduction Explain how management control systems can help
in achieving organizational goals. (Level 2)

7.2 Agency theory and control Describe the fundamental concepts of agency
theory, and explain how they are used to control
operations. (Level 2)

7.3 Corporate-level strategies Describe corporate-level strategies. (Level 2)

7.4 Business-unit strategies Describe business-unit strategies. (Level 2)

7.5 Management control and strategy Explain the connection between management
control and strategy. (Level 1)

7.6 Management control and goal congruence Explain the connection between management
control and goal congruence. (Level 1)

7.7 Types of controls Compare and contrast results, action, personnel,
and cultural controls. (Level 1)

7.8 Summary: Evaluating design and use of MCS Evaluate the use of management control systems in
given situations. (Level 1)

Module summary
Print this module
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7.1 Management control systems: Introduction
Learning objective
Explain how management control systems can help in achieving organizational goals. (Level 2)
Required reading
Chapter 23, pages 1092-1094

Note: The textbook uses the term management accounting control system synonymously with the term
management control system. While some research considers management accounting control systems to be a
subset of management control systems, the two are considered to have the same meaning for purposes of this
Management control systems (MCS) guide management decision-making and behaviour by coordinating the processes of
planning and control. MCS should be aligned with the organizations strategies and goals and fit the organizations structure
and decision-making format. Control systems are often used in conjunction with performance measurement systems, and a
good control system uses information from both inside and outside the organization. MCS gather information both formally
and informally from the companys
accounting system, for information relating to revenues and expenses
human resources system, for information on payroll, absenteeism, and benefits, and
quality-control systems, for information on defects, rework, and so on.
Finally, the management control system should motivate managers and provide relevant information for evaluating employee
Resulting from the control issues at major corporations such as Enron and WorldCom, the Sarbanes-Oxley Act was passed in
the U.S. Similar legislation was passed in Canada with the National Instrument 52-109. The NI holds that the CEO and CFO
are responsible for ensuring the effectiveness of a companys internal control system, which is part of the MCS.
Exhibit 23-1 on page 1093 shows the Criteria and Control Board (CoCo) Control Framework, which defines control as
comprising those elements of an organization (including its resources, systems, processes, culture, structure and tasks) that,
taken together, support people in the achievement of the organizations objectives. CoCo was established by the CICA to
provide tools that can be used to assess the organizations ability to achieve goals.
There are four types of management control systems: diagnostic, interactive, boundary, and belief (described in Topic 7.6 as
levers of control). The textbook on page 1094 ties these systems into the Balanced Scorecard (presented in Module 9).
Evaluation of a management control system determines whether it results in appropriate motivation, goal-congruence,
and effort toward the organizations goals.
In accounting theory, management effort is often tied to and evaluated on the basis of net income, return on investment, or
share price. The management control system should be set up to evaluate the managers ability to attain revenues, achieve
cost reduction through net income, generate a return on investment, or improve the companys share price in accordance
with the compensation package design and as desired by the owners or investors.
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7.2 Agency theory and control
Learning objectives
Describe the fundamental concepts of agency theory, and explain how they are used to control operations. (Level 2)
Agency theory presents a model of the relationship between an agent and principal, and can usually be expressed in the form
of a contract. Examples of agency contracts are those that exist between managers and owners or between a company and
its creditors. Like all models of complex phenomena, the agency model makes simplifying assumptions. In some areas, the
simplifying assumptions can be challenged or clarified. The following exhibit summarizes the main points.
Exhibit 7.2-1: Agency theory Summary of assumptions
Agency theory Comments
Assumes people are rational. People act rationally in
the sense of having ordered transitive sets of
preferences. If you prefer Coke to Pepsi and you also
prefer Snapple to Coke, in order to be rational, you must
prefer Snapple to Pepsi.
Clearly some people do not behave this way.
They want Coke but at the same time they also
want and drink Snapple and Pepsi.
Assumes people are self-interested. They care only
about their own well-being.
This is a dismal view of human behaviour and
does not apply to every person all of the time. If
people were always strictly self-interested, there
would be "no place for industry because the fruit
thereof is uncertain."
Tends to equate utility maximization to wealth
Utility-maximization and wealth-maximization
are not synonymous. People derive positive
utility from more than just wealth; people may
have negative utilities toward work or effort.
Thus, people maximize their utility by obtaining
the greatest difference in value between
outcomes to which they attach positive and
negative utility.
Promotes goal congruence. Goals may be fixed core values that are stable
components of one's personality and not easily
changed, so it is not helpful to speak of
promoting goal congruence. Rather, the
objective is to align the interests of self-
interested parties.
The existence and advantages of ethical behaviour, not addressed in the basic agency model, are still important in the
context of controlling the behaviours of decision makers.
Agency costs
Exhibit 7.2-2: Categories of agency costs
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The terms in italics monitoring, incentive compensation, bonding, and residual loss are categories of agency costs that
are paid or lost. For example, the cost of monitoring can be described as follows:
Principals must pay for supervisors.
Agents buy bonds that will compensate principals if they are caught stealing.
Accounting information systems are not free.
Accounting information is used in monitoring and as a basis for incentive compensation schemes. Because agents are
assumed to be risk averse, the first example in Exhibit 7.2-2 under incentive compensation states that agents are
compensated for risk. The following example explains the concept of risk aversion.
Example 7.2-1: Risk aversion
You are the manager of a clothing store, currently earning a salary of $45,000 per year. Head office is planning a change in
your compensation: a bonus will be added if sales are at least 20% greater than last years level, and a penalty will be
imposed if sales are more than 20% less than last year. Your compensation would be as follows:
If you consider that each of these outcomes is equally probable, your expected compensation is $45,000, the same as this
years salary. However, the prospect of a $10,000 penalty if sales are below last years worries you, and you negotiate to
have the penalty reduced to $5,000, so that the low sales compensation would be $40,000 (if sales are less than 80% of last
years). The certain equivalent of this alternative bonus and/or penalty scheme would be $46,667 (the sum of one-third
multiplied by each of the three payments). You, like most managers, are risk averse because you prefer the certain
equivalent of an uncertain event to the event itself. The difference of $1,667 between the head office plan and your response
represents a risk premium or payment to you (the agent) required to make you accept a higher level of risk in your
Risk aversion describes the attitude of most people toward their employment compensation, although the degree of risk
aversion varies between individuals. People who are indifferent between certain equivalents and uncertain events are risk
neutral. Principals (head office) are assumed to be risk neutral, as if they had investments in other businesses (that is,
having more diversified portfolios). Remember, diversifying a portfolio reduces the risk of an investor to the risk of the
market as a whole, and reduces firm-specific risk. Any risk imposed on agents as part of incentive compensation is inefficient
in that principals would accept the risk for no additional charge. Compensation for risk is an agency cost.
The right side of Exhibit 7.2-2 lists costs that cannot be reasonably reduced to zero the residual loss of the agency. An
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efficient way to prevent all opportunism by agents taking advantage of circumstances for their own benefit would be to run
workplaces as prisons. But even this extreme approach would fail to eliminate a residual loss if potential investors and
customers did not believe that the control was airtight, and therefore did less business than they would if they completely
trusted the companys employees and management.
Decision rights and rights systems
Agency theory views a firm as a nexus of contracts that determines where decision rights lie in the organization. The
parties to these contracts are all individual decision makers, with their own interests to promote.
Principals may not have the knowledge necessary to make certain decisions, and may therefore want their agents to use their
knowledge and expertise. Principals may at the same time fear that their agents will take advantage of the information
asymmetry inherent in this situation. For example, information asymmetry exists if you purchase 1,000 shares of Microsoft.
You are an owner but will not be able to sit in on board meetings, make recommendations of product offerings, or look at
corporate books; you are therefore at an information disadvantage. Further, managers receive monies from investors and
creditors, and use those monies to purchase assets and to generate repayments to creditors and profits for owners (the basic
cycle of business). Managers then self-report on their own effectiveness by producing the financial statement and releasing
the information in the annual report to investors, which is what the investors use to evaluate managers. A comparable
situation would be for CGA-Canada to indicate to you that you are enrolled in MA2, send the course materials to you, and
then ask you to self-report your grade back to CGA. This may appeal to you, but CGA-Canada will want to make sure that
you have mastered the concepts, and must therefore engage in agency costs of assignments, examinations, and codes of
conduct to demonstrate that you have acquired the necessary knowledge and skills.
Organizational architecture refers to the following three administrative systems:
Performance measurement
Performance reward and punishment
Decision rights partitioning
Exhibit 7.2-2 illustrates the first two systems. They are related to two control costs: monitoring and incentive compensation.
Both systems use accounting information because of the objective nature of financial measures. The third system,
partitioning of decision rights, is addressed in the nexus-of-contracts model of the company. Exhibit 7.2-3 highlights where
decision rights lie by illustrating the difference between the nexus-of-contracts view and the conventional view (to which you
are probably accustomed).
Exhibit 7.2-3: Models of the firm
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In the conventional model, the entity known as the firm is well defined by boundaries (shown here as boxes). Classes of
participants exist within the firm owners, managers, and employees and are set apart from one another as a group and
from external parties such as the suppliers and customers. By contrast, in the nexus-of-contracts model, a firm is made up of
a series of contracts. Everyone is an individual, and contracts individually with other participants. Each contract involves
monetary compensation, and may or may not include a delegation of decision rights (ability to make decisions on behalf of
the principal) from a principal to an agent.
a. Between principals and agents

The owner is designated as a principal who contracts with three experts, each having unique, specialized knowledge
of some value to the firm. Experts 1 and 2 are given decision rights over some area of their expertise (for example,
marketing or engineering design, or accounting) because it may be difficult for them to communicate their knowledge
to the owner. Expert 3 does not receive decision rights from the owner (sales manager). It may be that the owner
wants more control over decisions in this agent's area, or that it is easy for Expert 3 to communicate knowledge,
analysis, and findings to the owner.
b. Between experts

The experts also contract with each other, distributing decision rights in a variety of ways. In each of these contracts,
one expert will act as a principal and the other will assume the role of an agent. Each expert performs many tasks, so
there is no limit to the number of contracts you might observe. Two contracts are shown between Experts 1 and 3,
one involving a delegation of decision rights while the other does not.
Outsourcing and agency theory
Outsourcing reduces, but does not eliminate, transaction costs. Exchanges occur in todays open market that you may be
more accustomed to seeing within companies. Beyond manufactured components or other manufactured products,
companies also outsource functions and services including information technology, transportation and logistics, human
resources, real estate and building management, finance, customer service, marketing, and sales. Even senior executive
management can be outsourced. Outsourcing is so extensive that our traditional notion of a company or organization as a
bounded entity is inadequate, and the amorphous nexus-of-contract model describes these relationships more accurately.
Companies sometimes have more incentive to outsource than not to do so, including the following points:
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Outsourcing reduces and controls operating costs because markets measure and reward performance independently
from the companys administrative structure. For example, with outsourcing the company does not need to incur
costs of motivating employees to perform as desired by principals.

The contract implies that the company shares the risks through outsourcing. When companies insulate employees
from risk somewhat by paying salaries and promising long-term employment, there is less motivation for employees
to perform as principals wish. Pay-for-performance through outsourcing restores that motivation by sharing risk with
external service providers.
An argument against outsourcing says that, "If a company requires a great deal of flexibility, an outsourcing contract may be
too limiting."
It is difficult to write an explicit contract that assigns rights and payments to every possible outcome. When
many outcomes are likely over a long time period, the necessary flexibility in operations would be better accommodated by
employment-style, long-term contracts within the company. Anything considered a core competency should never be
outsourced, and outsourcing of R&D can lead to losing the companys competitive edge and ability to be innovative.
Decision management and decision control
Because of moral hazard problems, decision management (or decision making) is normally separated from decision control
(monitoring). It does not make sense to have agents monitor themselves, given their inclination to advance their self-
interests. Refer to the nexus-of-contracts model in Exhibit 7.2-3. Decision (management) rights are delegated from the owner
to experts and among the experts, but decision control is missing from the diagram. To illustrate decision control, a revised
version of the nexus-of-contracts model is presented in Exhibit 7.2-4.
Exhibit 7.2-4 Decision management and decision control
Exhibit 7.2-4 displays a traditional hierarchy, with each expert manager reporting to a higher-level expert, and ultimately to
the owner. Lets say that in this example Expert 1 is the CFO, Experts 2 and 3 are the accounting and finance managers, and
Expert 4 is the legal counsel. The owner delegates decision rights to the CFO (Expert 1), who in turn delegates a portion of
those rights to the accounting and finance managers (Experts 2 and 3). Arrows indicate that decision control has been
retained by the person at the higher level in the hierarchy. No arrow is drawn from the legal counsel (Expert 4) to the owner.
No decision rights were delegated to Expert 4 in the first place, so there is no need to exercise decision control over that
person. Expert 4 merely advises the owner in his or her area of expertise.
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Thomas Hobbes, The Leviathan (cited in ERH, page A3:1)
Deborah Stokes, "Outsourcing: A special report." The Financial Post, April 25, 1998.
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7.3 Corporate-level strategies
Learning objective
Describe corporate-level strategies. (Level 2)
Required reading
Reading 7.3-1: Understanding Strategies
All organizations, including not-for-profits, must have overall long-term goals and objectives. This requires that management
determine methods (strategies) to achieve those goals. Management control systems help managers implement and evaluate
those strategies.
Profit-oriented companies have goals of profitability, and use measures such as return-on-investment (ROI), residual income
(RI), and economic value added (EVA) to evaluate those goals. Many of todays organizations also focus on goals other
than profit, such as being a good corporate citizen, protecting the environment, and maximizing shareholder value. Each goal
developed in either profit or not-for-profit organizations requires specific measures to evaluate, and should also consider the
needs and wants of the stakeholders (shareholders, bankers, government, employees, and the public).
Strategy development
Companies develop strategies at two levels: corporate and business. Corporate-level strategy development asks the question:
What business do we want to be in? This seemingly simple question is actually complex. To decide on what type of business
will provide a suitable return for shareholders, management must look at both the external and internal environments of the
organization. A PEST analysis a political, economic, social, and technological environmental scan similar to a submarine
periscope that goes above the water and examines the external landscape provides an external analysis. The SWOT
analysis (introduced in Module 1) focuses on the corporate strengths and weaknesses, (internal analysis) and opportunities,
and threats (environmental analysis).
PEST analysis looks at
the federal, provincial, and municipal political situations
legal and other regulations for business operations
the current economic situation (interest rates, inflation, employment rates)
social issues (aging population creating opportunities in health care), and
technological changes in the industry.
The external component of the SWOT analysis looks at the PEST analysis and categorizes each as an opportunity or threat.
For example, when Dupont the largest producer of CFCs (chlorofluorocarbons) used to cool cars and refrigerators
became aware of the danger that CFCs pose to the environment by damaging the Earth's ozone layer, the company also
recognized that this was a social threat to the business and embarked on research for less harmful cooling methods.
The internal scan of the organization analyzes strengths such as employee knowledge, distribution chains, and access to
capital, and weaknesses such as using outdated technology and weak current ratio. Internal analysis also scans the
company's resources, which are analyzed to determine its capabilities defined as the ability to use the company's
resources in a coordinated manner. Capabilities are the impetus for the firm's core competencies those things that it does
better than its competitors and that form the basis for competitive advantage. These are the focus of business-unit
strategies, presented in the next topic.
Developing corporate level strategies also includes making decisions about the company's mix of businesses and allocation of
resources between and among businesses. When a company has multiple businesses, should resources be shared and, if so,
how? The management control system should help managers make decisions about diversification and outsourcing parts of
the business or even entire processes. A company should never outsource a core competency, which must be guarded
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because they form the basis of competitive advantage. The extent and type of diversification are also key issues to the
design of the control system because diversification affects the company structure and resource allocation.
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7.4 Business-unit strategies
Learning objective
Describe business-unit strategies. (Level 2)
Required reading
Reading 7.4-1: Business Unit Strategies
A company's business-level strategy is one step down from the corporate-level strategy. Once the company decides on which
business or industry to operate within, principals must decide how the company will provide shareholder value within the
business. Generally, the business-level decision is a choice between two competitive advantages also called competitive
strategies cost leadership and differentiation.
Cost leadership Based on operational efficiency. This is the strategy used by Walmart. To achieve this strategy,
Walmart focuses on managing the value chain as efficiently as possible and gathering customer knowledge through
advanced technological and communication systems. A cost-leadership strategy involves simplifying the product
(minimal acceptable standards for customers), standardizing processes (minimal options), and monitoring (tight
controls to standard).

Differentiation Based on the ability to distinguish your product or service from competitors. This is often done
through marketing. Tommy Hilfiger is an example of a company that has been able to achieve high profits through a
differentiated strategy. Input costs are often higher with this strategy, as quality of the products tends to be higher
compared to discounted cost-leadership products. The cost is passed on to target consumers, who are willing to pay
the higher prices.
A third competitive strategy, (see page 7 in reading 7.4-1), often referred to as a focused or niche strategy, may also be
used. This is either a cost-leadership or differentiated strategy that focuses on a small subsection of the overall market or
niche. An example of this is the Giant Tiger Discount chain, which uses a cost-leadership strategy but focuses only on a single
region; or Porter Airlines differentiated strategy, which focuses on the market between Toronto, Ottawa, and Montreal.
An analysis of Porters 5 Forces is required to determine the best business-level strategy. This analysis looks at the potential
competition within an industry by evaluating the potential threats and opportunities of the following forces:
New entrants Looks at how easy or difficult it is for new companies to enter the industry; low entry barriers (such
as capital, regulations), result in higher competition.

Substitutes Looks for substitutes for a product or service (for example, butter for margarine).

Bargaining power of suppliers When the product is generic or easily manufactured, switching between suppliers
will give a company more power.

Bargaining power of buyers For example, General Motors has greater power with suppliers of auto parts because
there is a limited number of buyers for the products.

Rivalry amongst competition Greater the rivalry amongst competitors leads to lower profitability within the industry.
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7.5 Management control and strategy
Learning objective
Explain the connection between management control and strategy. (Level 1)
Required reading
Reading 7.5-1: The Nature of Management Control Systems (to Impact of the Internet on Management Control)
Management control systems focus on both long-term (strategic) and short-term (task) control. Management control includes
planning, coordinating, communicating, evaluating, deciding whether or not actions should be taken, and influencing the
behaviours of employees. The previous topics introduced corporate and business-unit strategies. A management control
system should help an organization develop, implement, and evaluate both corporate and business-level strategies, and
provide information for both financial and nonfinancial performance measures. The management control system accomplishes
this through
helping with strategic planning, budgeting, resource allocation, and performance measurement
providing evaluation and reward structures
measuring responsibility, and
aiding in transfer pricing decisions.
In decentralized organizations, where management decision making is allocated to lower levels of the organization (as in
globalized operations), a properly implemented management control system is especially important to control operations and
focus management attention on attaining overall organizational goals. Decentralized operations can allow for greater self-
interested manipulation by management. Enron, WorldCom, and Tyco are examples of operations that failed to implement
effective management control systems, and consequently allowed manipulation of their accounting systems.
Reading 7.5-1 defines the components of a management control system as follows:
Management a group of people working together to achieve certain common goals
Control systems used to manage operations
System a prescribed and usually repetitious way of carrying out an activity or set of activities
Control systems
Control systems which are an inherent part of management control systems are similar to the task of a pilot, who uses
multiple instruments to help ensure that the plane will arrive at the final destination safely and as efficiently as possible. For
example, if you want to go from Toronto to Beijing, a pilot must have knowledge about fuel, altitude, wind speed, locations
of other planes, and so on. Further, there is a difference between effectiveness and efficiency. To be effective, arriving in
Beijing would be the indicator did you arrive (yes or no)? You could go directly from Toronto to Beijing, or from Toronto to
London to Paris to Hong Kong to Beijing. In both cases you were effective (that is, you arrived in Beijing) but the direct route
was more efficient. In short, a good management control system should have all of the following types of control devices
(also described in Reading 7.5-1):
A detector or sensor to measure what actually happened, such as a balance sheet or income statement.
An assessor to determine the significance of what has happened by comparing to a standard or expectation, such
as variance analysis and budgeting.
An effector a device or feedback system that alters behaviour, such as the root-cause analysis used in Balanced
Scorecards, to compare budget to actual results and look for changes to continue or to change actions.
A communication network to transmit information, includes the computer system and meetings.
Strategy formulation and management controls
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Strategy formulation is the process of deciding which corporate and business-level strategies to pursue. It starts by asking
the following questions:
What type of business should you be in? (corporate level)
What competitive strategy should you pursue within this business, cost leadership or differentiation? (business level)
Management control, on the other hand, is the process of implementing and evaluating the strategy. A well-defined
management control system should evaluate both the business-level and corporate-level strategies.
Task control is the process of ensuring the implementation is carried out effectively and efficiently. Task controls are more
process and transaction oriented. For example, at McDonald's the amount of tomato, lettuce, and pickle per hamburger is
compared to industry standards and decisions are made about the optimal amount of each vegetable within acceptable or
predictable limits of control. Management controls, however, are designed to manage the behaviour of managers, including
ensuring that managers cannot manipulate financial statements (which relates to earlier discussions of agency theory to
ensure goal congruence with shareholders). Auditors are an example of this type of control. In addition to regulatory
requirements, auditors are necessary because investors cannot otherwise ensure that managers are doing the right thing.
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7.6 Management control and goal congruence
Learning objective
Explain the connection between management control and goal congruence. (Level 1)
Required reading
Reading 7.6-1: Behavior in Organizations
Chapter 24, pages 1159-1162
There are four types of control systems that exist to support the overall management control system. The textbook also calls
them levers of control.
Diagnostic systems Sets of measures to help determine (diagnose) whether a company is performing to expectations.
Examples are ratio analyses such as ROI, RI, and EVA, which are used to evaluate conformance to standards or expectations.
Boundary systems Standards of ethical behaviour or codes of conduct that direct the behaviour of employees. The
Sarbanes-Oxley Act is an example of legislation aimed at increasing corporate governance and internal control procedures
that set boundaries on the behaviour of senior managers. The Sullivan Principles are another set of standards used to
measure social responsibility in organizations. (You will find more information on the Sullivan Principles here ). Because
professional accountants are expected to meet the ethical standards of their profession, a companys decision to hire a
professional accountant is one way to import a boundary system into the company.
Belief systems Articulated by the company's mission, purpose, and vision statements. Belief systems represent the core
values of the company; they describe the norms and expected behaviour of all employees.
Interactive systems Formal information systems designed to focus managers' attention on key strategic issues.
Interactive systems track strategic uncertainties to create ongoing discussion and debate on emerging political, technological,
economic, and social issues.
Management makes decisions about each of these systems, as each system is appropriate under different circumstances and
within different organizational units. Diagnostic and boundary systems tend to work well with task- or process-oriented
strategies, while belief and interactive control systems work well at the strategic levels where there is more uncertainty.
Formal and informal systems
There are both formal and informal control systems. Formal control systems include strategic plans, budgeting, and
management reporting structures. Informal control systems include ethics, values, management styles, and corporate
culture. Norms of behaviour within an organization, as shown by top management, can have a strong influence on workers
and attitudes. Arriving early, following dress codes, corporate citizenship programs, volunteering, and participating in training
are examples of informal control systems.
Formal control systems are rule-based, and provide guidelines for work based on specific standards. Physical controls, such
as locking doors, providing manuals, and requiring passwords are examples of formal controls. Exhibit 3.1 on page 105
of Reading 7.6-1 provides a diagram of the formal control process, which includes strategic planning, budgeting, and
responsibility centre performance (such as variance analysis).
Management control systems and goal congruence
A well-developed management control system should not only provide guidance and feedback on systems and processes, but
also guide behavioural aspects of management. This involves aligning strategies in accordance with overall corporate goals
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and objectives or goal congruence.
Management compensation packages that include bonuses of stock options are a control system that aligns the goals of
management with the goals of owners. If managers are paid set salaries regardless of profitability, they might shirk their
responsibilities or do things only in their best interest, as they have no incentive to protect the assets of the organization or
make profits. Providing the incentive of stock options tied to profits changes their behaviour to achieve profitability, to attain
stock options, and then to continue to achieve profitability. This results in increased stock prices, which gives managers
higher overall compensation. This is, of course, the intention of owners who want to see their own wealth increase through
stock valuation increases. However, it also creates a situation where management could be tempted to manipulate the
financial records to artificially drive up stock prices with no long-term sustainability, and this must be controlled. Other goals
of cost leadership can be emphasized through compensation packages that provide incentives for lowering product cost or by
increasing efficiency measures.
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7.7 Types of controls
Learning objective
Compare and contrast results, action, personnel, and cultural controls. (Level 1)
Control systems rely on a number of different types of controls to be effective. There are four main types of controls used in
a management control system.
Results control
Results control, also called output control or results accountability, is based on the concept of rewarding good results and
punishing poor results. This approach focuses employees on the consequences of actions they take or dont take, without
constraining their actions. In fact, employees can be empowered through results control to take whatever actions they
consider will best produce the desired results. The four components, or elements, of results control are:
Defining the performance dimension(s)
Measuring performance on the dimension(s)
Setting performance targets
Providing rewards or punishments based on results
Results controls work best when all three of the following conditions are present:

Managers know what specific results are required in the area being controlled.

2. Individuals whose behaviour is being controlled have significant influence on the results specified.

3. Managers can measure the results effectively.
Note the importance of controllability (point 2). Individuals controlled by the measures must be able to affect the results,
and must also be able to affect their subordinates behaviour. In other words, the accountability must be 360.
Results controls are useful only to the extent that they provide information about the importance, desirability, and/or
effectiveness of actions taken. If results are uncontrollable, measurement of results controls will not help managers evaluate
the actions taken. Poorly designed controls can result in supposedly good actions that do not necessarily produce good
results, and they can also obscure ineffective or undesirable actions. When poor indicators are used to measure the results,
they will not indicate whether good actions have been taken and will therefore not result in desired actions.
A positive aspect of results controls, such as achieving cost reduction or quality goals, is that they influence employee
behaviour while at the same time allowing them significant autonomy. These types of controls yield greater employee
commitment and motivation and they are usually inexpensive to implement because performance measures are often
collected for reasons not directly related to management control.
A number of negative issues are associated with results controls. They can shift the risk due to uncontrollable factors to
employees. Employees are usually risk averse, so the employer would be required to pay a risk premium. Finally, conflicting
objectives may cause problems between divisions and between employees. This situation can result in managers lowering
targets as they attempt to balance the requirements of conflicting objectives.
Action controls
Action controls, also called behavioural controls, are used to prevent undesirable behaviour and also to detect that behaviour.
These types of controls are effective only when managers know what actions are desirable and can make sure that those
actions occur, which can be difficult in situations where tasks are highly complex and uncertain. Action controls are also not
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suitable when there is doubt about the effectiveness of an organizations processes and procedures, as when an organization
plans to benchmark its processes to identify problems. Because they hold employees accountable for their actions, effective
action controls require the following four factors:
Precise definitions of which actions are acceptable and unacceptable
Clear communication to employees about those defined actions
Observing or otherwise tracking what actions actually occur
Effective rewarding of acceptable actions and/or punishing unacceptable actions
Here are some examples of action controls:
Physical controls locks or passwords
Administrative controls separation of duties or limits to decision-making authority
Pre-action reviews requiring approvals of capital budget items
Redundancy backups, cross-trained employees
Action controls are the most direct form of control. A lock, for example, is a direct form of controlling who has access to an
area. Action controls increase the predictability of the outcomes of actions. When trying to achieve a coordinated effort,
employees knowing the outcome of a given action will have a better understanding of inter-departmental or inter-
organizational information flows.
However, action controls lose their effectiveness when the job is more complex and tend to be most effective for highly
routine or repetitive jobs. Action controls discourage creativity and innovation and are less effective in a constantly changing
environment. They can lead to sloppy work because managers engage employees less when there is a high level of control.
Because of the lack of creativity and opportunities for self-actualization, action controls can also lead to negative attitudes.
Finally, action controls can be costly to deploy.
Personnel controls
Personnel controls work with the employees natural tendencies to behave well. Most people are ethical; that is, they have a
well-developed sense of right and wrong and therefore want to do what is right. Personnel controls operate under the
assumption that most people find self-satisfaction from doing a good job, and that most people want to see their
organization succeed. Good personnel controls find the right people for the job, give them a good work environment, and
provide the resources required for success. This requires the following factors:
Effective selection and placement of employees
Adequate training for the job
Effective job design
Personnel controls alone are never sufficient to provide effective management control. However, they are essential and
should be relied on to some extent in all situations. They need to be supplemented with action and/or results controls but
they have few negative aspects and are relatively low-cost to implement.
Cultural controls
Cultural controls take advantage of the social pressures and group norms and values of a work group. Work groups often
create emotional ties between members of the group, and these ties make cultural controls more effective. Organizational
cultures are built on shared traditions and norms. To create good cultural controls, management must effectively shape the
culture under which a work group operates. There are five ways to shape a culture:
Codes of conduct Often these are formal written documents containing the broad statements of corporate values;
they can include codes of ethics and mission statements.

Group-based rewards Necessary when the actions of a team of workers rather than any individual are key to
organizational success.

Physical and social arrangements How the office is planned, including floor layout and interior decoration; dress
codes and common vocabularies are also important.

Intra-organizational transfers Promote identification with the organization as a whole rather than with a specific
subunit; ensures that socialization of transferred individuals results in compatible goals and perspectives.

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Tone at the top Statements from top management must be consistent with the culture they are trying to create
but, more importantly, top managements behaviour must be consistent with the culture; top management must
walk the walk, not just talk the talk.
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7.8 Summary: Evaluating design and use of management control
Learning objective
Evaluate the use of management control systems in given situations. (Level 1)
Required reading
Reading 7.8-1: Controls for Differentiated Strategies
The appropriate management control system to use in any given situation depends on the situation and the specific
characteristics of the organization and its environment. Researchers call this contingency theory because Management
control system design is contingent upon the factors influencing the organization. Because of the changing nature of the
environment that organizations operate within such as new regulations, new competition, changing economic, social and
technological parameters the management control system must be evaluated continually to ensure controls are influencing
management to achieve organizational goals and objectives.
Diversification leads to more decentralization and thus to a weaker direct control of management behaviour. More
decentralization leads to greater chances for management to act in ways that are not congruent with the companys overall
strategy, which means that and both formal and informal controls become increasingly important. Related diversification is
easier to control than unrelated diversification. Related diversification is an expansion strategy that derives from the
organizations major products or services. Expansion of routes for an airline and a new line of automobiles for a car
manufacturer are examples of this. In this sense, the management control system for new expansions are similar in nature to
those already implemented within the organization. Unrelated diversification, such as an airline opening hotel chains or an
auto manufacturer opening retail clothing stores, requires more controls because the level of interdependence is reduced
across the company. When managers have little knowledge of the unrelated industries, it becomes harder to control the new
Budgeting is another control area where diversification creates more complexity. Organizations must make resource allocation
tradeoffs between business units, including decisions on financial and human resources allocations. For example, managers
must decide whether profits from a division should stay in that division for expansion or be reallocated to other growing
Incentive compensation and structure
Incentive compensation also differs at different levels of the organization, and compensation depends on the companys
structure. Since they have responsibility for overall profit and resource allocation decisions, senior level managers are usually
compensated on financial measures such as ROI or EVA. At lower levels, managers are responsible for implementation of
specific strategies, and are evaluated on non-financial measures and specific task-oriented goals. The more organizational
units are independent, the more independent compensation packages will be. Unrelated diversified companies usually
evaluate each manager based on the EVA, ROI, or market share of the individual business unit.
Executive compensation packages focus on share price rather than on net income measures. Basing compensation packages
on net income focuses managers attention on short-term or task-oriented items (such as cost cutting or reduction in R&D
spending) that inflate net income in the short-term, which is counter to long-term shareholder value. Using share price in this
situation encourages spending on R&D, which would be seen by shareholders as beneficial. These actions would be reflected
in share price increases, even though the benefits often do not show up in the net income figures for five to ten years.
Management control systems design and business strategies
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The structure of the company and the chosen business strategy should affect the compensation packages and the design of
management control system. A company using a cost-leadership strategy will promote cost reduction and efficiency
measures, while a company using differentiation strategies will focus more on quality measures.
Management control systems design should also consider the lifecycle stages of individual business units. A business unit in
the early stages of development will require different measures for achieving success than one in the mature phase. The ROI
of early-stage business is typically negative because they need the infrastructure, R&D, and marketing expenses to generate
sales while not yet making a profit. As the organization grows to maturity, sales increase, R&D declines, and marketing
efforts reduce because the company is better known and likely has more stable distribution. However, uncertainty in the
internal and external environments will always require continual re-evaluation of the enterprises management control system
to ensure goal congruence is maintained.
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Module 7 self-test
Question 1
List the main points in agency theory.
Question 2
What are the key ingredients in a well-designed management control system?

Question 3
What is PEST and when would you use it?

Question 4
What are the three business-unit strategies?
Question 5
What are Porter's Five Forces?
Question 6
Name the four levers of control.

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Self-test 7

Solution 1
The main points in agency theory are:
Agency theory assumes people are rational

It assumes people are self-interested

It equates utility maximization to wealth maximization

It promotes goal congruence.
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Self-test 7

Solution 2
The key ingredients in a management control system are:
A detector or sensor to measure what actually happens

2. An assessor a device to determine the significance of what has happened

3. An effector something that alters behaviour

4. A communication network information transmission
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Self-test 7

Solution 3
PEST is a type of analysis done to work on corporate level strategies. It stands for Political, Economic, Social and
Technological. It is an environmental scan used to analyze he external environment in which the organization operates when
assessing the situation for corporate level strategies. The PEST analysis is combined with a SWOT analysis to match the
internal and external environments.
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Self-test 7

Solution 4
The three business level strategies are:
Cost leadership


Focus or niche

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Self-test 7

Solution 5
Porters Five Forces are:
Threat of new entrants

2. Threat of substitutes

3. Bargaining power of suppliers

4. Bargaining power of buyers

5. Rivalry among competitors

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Self-test 7

Solution 6
The four levers of control are
Diagnostic control systems

Boundary systems

Belief systems

Interactive control systems
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Module 7 summary
Explain how management control systems can help in achieving organizational goals
Effective management control systems should be
both formal and informal
tied to and aligned with organizational strategy and goals
designed to fit the organizational structure and decision-making format, and
designed to motivate managers and promote goal congruence.
Describe the fundamental concepts of agency theory, and explain how they are used to
control operations
Agency theory assumes people are rational, self-interested, and utility-maximizers.

Agents are compensated for risk because agents are risk averse.

Accounting information is used in monitoring and as a basis of compensation.

A nexus of contracts determines where decision rights lie in the organization.

Organizational architecture involves performance measurement, performance reward and punishment, and decision
rights partitioning.

Decision management is normally separated from decision control.
Describe corporate-level strategies
A firms corporate level strategy is determined by choices of the internal and external environment using environmental
scanning, PEST, and SWOT analysis. The decision is based upon which industry or business the company wishes to operate
Describe business-unit strategies
Business-level strategies are designed to implement the corporate-level strategies in particular industries, and generally
follow one of three strategies:
Cost-leadership focuses on offering the most value at the lowest price. The focus here is on operational

Differentiation focuses on achieving a unique offering as perceived by customers. This is often done by offering
more features, styles or design differences as well as marketing efforts.

Niche or focus a subset of the previous two, focuses either strategy at a unique subsection of the overall market.
Explain the connection between management control and strategy
Management control systems are used to help implement the strategy of the firm. Managers must first decide on which
strategy to implement based on the internal and external environment the firm operates within.
Explain the connection between management control and goal congruence
Goal congruence is a main focus of the management control system. The management control system should be designed to
alter management behaviour toward the overall goals of the stakeholders. This is usually accomplished through
compensation packages, but can also be attained through other measures of the management control system. Four types of
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systems are:
Diagnostic Measure whether the company is achieving expectations

Boundary Standards of ethical behaviour and codes of conduct that direct employee behaviour

Belief Articulated through the mission and vision statements representing the core values of the firm

Interactive control Formal systems that create debate on emerging issues (political, economic, social or
Compare and contrast results, action, personnel, and cultural controls
Through the four control systems, the management control system should be able to control the results of the company's
actions, affect behaviour of personnel, and impact ethics, values, culture, and beliefs of the firm. These help to aid in
developing the proper compensation packages to guide behaviour in conjunction with diagnostic controls to evaluate whether
implementation is efficient and effective.
Results controls reward individuals for generating good results and/or punish them for poor results.

Action controls ensure that employees take beneficial actions.

Personnel controls build on employees' natural tendencies to control themselves using their conscience.

Cultural controls take advantage of the social pressures and group norms and so require management to create an
effective culture.
Evaluate the use of management control systems in given situations
Management control systems should be continually evaluated as the uncertainty that exists in business constantly changes
the dynamics of the industry and company. New personnel, new competition, changes in social, technological, political and
economic environments all require different and unique management control system set-ups. As an organization diversifies,
either in related or unrelated industries, they face new challenges, greater decentralization pressures, and changes to the
management control system. Constant re-evaluation of the management control system is necessary to ensure continued
goal congruence is being achieved.
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Advanced Management Accounting Reading 7.3-1 1
READING 7.4-1_________________________________________ READING 7.3-1
2 Reading 7.3-1 Advanced Management Accounting
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4 Reading 7.3-1 Advanced Management Accounting
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6 Reading 7.3-1
Advanced Management Accounting
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8 Reading 7.3-1
Advanced Management Accounting
Advanced Management Accounting Reading 7.3-1 9
ew Text
New READING 7.5-1_____________________________________________ READING 7.4-1
Advanced Management Accounting Reading 7.4-1 1
2 Reading 7.4-1 Advanced Management Accounting
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4 Reading 7.4-1 Advanced Management Accounting
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6 Reading 7.4-1 Advanced Management Accounting
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Advanced Management Accounting Reading 7.5-1 1
READING 7.5-1______________________________________________
2 Reading 7.5-1 Advanced Management Accounting
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4 Reading 7.5-1 Advanced Management Accounting
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6 Reading 7.5-1 Advanced Management Accounting
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8 Reading 7.5-1 Advanced Management Accounting
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10 Reading 7.5-1 Advanced Management Accounting
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12 Reading 7.5-1 Advanced Management Accounting
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14 Reading 7.5-1 Advanced Management Accounting
READING 7.6-1 ___________________________________________
Advanced Management Accounting Reading 7.6-1 1
2 Reading 7.6-1 Advanced Management Accounting
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4 Reading 7.6-1 Advanced Management Accounting
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6 Reading 7.6-1 Advanced Management Accounting
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8 Reading 7.6-1 Advanced Management Accounting
READI NG 7 __________________________________________
Advanced Management Accounting Reading 7.8-1 1
2 Reading 7.8-1
Advanced Management Accounting
Advanced Management Accounting Reading 7.8-1 3
4 Reading 7.8-1 Advanced Management Accounting
Advanced Management Accounting Reading 7.8-1 5
6 Reading 7.8-1 Advanced Management Accounting
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8 Reading 7.8-1 Advanced Management Accounting
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10 Reading 7.8-1 Advanced Management Accounting
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12 Reading 7.8-1 Advanced Management Accounting
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14 Reading 7.8-1 Advanced Management Accounting
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16 Reading 7.8-1 Advanced Management Accounting