MANAGEMEN丁

CON丁ROL SYS丁EMS
Performance Measurement, Evaluation, and lncentives

Kenneth A. Merchant
University ofSouthem Ca=fo「nia

Wim A. Van derStede

London SchooI of Economics

Fou「thedition  ‘        一 章

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Names: Merchant, Kemeth A., author. l Van der Stede, Wim A-, author・
Tltie: Management controi systems. performance measu「ement, eValuation and incentIVeS / Kemeth A・ Merchant,

UnlVerSrty Of Southem Caiifomia, Wim A. Van der Stede, London SchooI of Economics・
Description: Fourth EditiOn. l New York: Pearson, [2017] i Revised edition of the authors’Management controI

SyStemS,2012.
identifiers: LCCN 2016053625i lSBN 97812921 10554 (Print) i iSBN 97812921 10585 (Pd用
iSBN 9781292181875 (epub)
Cost contro口Manageriai accounting. l Performance-Measurement. i
Cost control-Case studieS. i Manage「ial accounting-Case studies・
 BR看EF CON丁EN丁S

Preface xiii = Remediestothe Myopia Problem

Acknowledgements xvi 12 Using Financial BesuItsControIs in

the Presence of Uncontro=able Factors

SECTION I
The Controi Function of Management SECTION V
Corporate Govemance, impo巾ant

「 Management and ControI 3 ControI-ReIated RoIes, and Ethics

13 Corporate Govemance and Boards

SEC丁ION II Of Directors
Management ControI Altematives 14 Controilers and Auditors
and Their E什ects
15 Management Cont「oi-Related
Ethical issues
33 86 28 73

2 BesuIts ControIs

3 Action, Persomel, and CuituraI Controis

SEC丁ION VI
1     1

4 Controi System Tightness

Management Contro! When
5 Cont「oI System Costs
FinanciaI Results Are Not the Primary
6 Designing and EvaIuating Management
Consideration
ControI Systems 221

16 Management Controi in Not葛for-PrOfit

SECTiON I= Organizations
Financial Results ControI Systems
Index

7 Financiai Responsib冊y Centers     261

8 Pianning and Budgeting

9 1ncentive Systems

SECT音ON看V
Performance Measurement lssues
and Their Effects

lO FinanciaI Performance Measures and

Their E什ects 397
 CON丁EN丁S.

Preface Xiii Prevention vs, Detectjon

Ackno wIedgemenきs Xvi Cond砧ons detem面白g
the effectiveness of action

器97⋮⋮器器嵩 1 28聖霊義1 4。1 42 1 68 1 7。聖霊詣高棚∴⋮嵩2。6∵Ⅸ

SEC丁ION i COntrOis
PersonneI controIs
The ControI Function of Management
Cultural controIs
Personnel/cuIturai controis and
1 Management and ControI      3
the controi probIems
Management and controi 8 E什ectiveness of persomei/cuitura1
Causes of management controi probiems 1 2   controIs
Characteristics of good management controI 15 Conciusion
ControI problem avoidance 15 Notes
Controi aitematives 19 MtskyandAssocfates, hc.
Outiine of this text 19 777e Pfathum Pohte LandDeaI
Notes 20 句reOn PhamaceuticaIS, hc.
Leo Js Four-P/ex 77?eater 22 AxeonNV
Wbng :s Phamaq′
Phvate Hれess, hc. 23 4 Contro- System Tightness
AtfanねHome Loan 25
Tight results controI
Tight action controIs
SEC丁ION =
Tight personnei/cultural controIs
Management Cont「oI AItematives
Conciusion
and their Effects
N otes
Controts at the Be伯gio
2 ResuIts Controis 33 Casho Reso万
343 73 8 42464 6485 87 17 8

Prevaience of results controis PCL: A Breakdown h"的e Ehforcement

ResuIts controIs and the controI probIems Of Management Contro1

Eiements of results controIs
Conditions determining the effectiveness 5 Controi System Costs
Of resuIts controis
Direct costs
Conciusion
lndirect costs
N otes
Adaptation costs
OHlce Soんf/ons, hc.
Conciusion
Puente HWs 7dyofa
N otes
Koois tra AutogI℃ep
Ph〃ゆAncterson
Houston Fear/ess 76, hc.
Suns励)e Fashion: Ffaud, 777e匂

and Misbehavior among

3 Action, PersonneI, and Cuiturai
E/7岬Ioyees
Controis 86
Better Beau功hc。
Action controis 86 HtFbo匂Inc.
Action controIs and the controi problems 91 A脆nfis Chemica/ /ndus紡es
 3 3 3 3 3 3 3 3
6 6 7 7 7 7 7 8
4 5 0 0 1 4 5 4
6 Designing and Evaiuating lncentive system design
Management ContrQI Systems 221 Criteria for evaiuating incentive systems
Group rewards

2 2 2 2 2 2 2 2 2
2 2 2 3 3 3 3 3 4
1 2 9 0 1 1 2 3 2
M了at /s des〃ed and what /s Me咋‘‘
Conciusion
Choice of controIs
N otes
Choice of controi tightness
Harwood Medical /nstIひments PLC
Adapting to change
Supe/℃Onductorねchno/ogies, /nc.
Keeping a behavioraI focus
Raven Cap伯方LLC
Maintaining good controi
Notes
Dfagnosfro Products Co/pOrafron
Game Shop, hc. SECTION IV
Fam均y Care?peci主催ts Medica/ Performance Measurement
Group, /nc. 252 Issues and Their E什ects

SEC丁ION音i看 10 Financial Performance Measu「es

9  9 9 0 0   0
3  3 3 4 4   4
7  8 9 1 4   6
Financial Resuits ControI Systems and Their E竹ects

VaIue creation
7 Financiai Responsibility Centers 261
Market measu「es of performance

Advantages of financial resuits Accounting measures of performance

COntrOi systems
Types of financiai responsib冊y
CenterS
Choice of financial responsibiIity centers
The transfer pricing probiem
261 lnvestment and operating myopia
Return-On-investment measures
262  Of performance
267 Besidua=ncome measures as a possibie
269  SOIution to the ROi measurement

4 14 14 1 4 14 14242424344
Conciusion 274  Probiems
Notes 275 Conclusion
Kranworfh Chair Co/POration 275 Notes
Zumwald AG 283 BehaviolaI lmp〃caf/ons ofAi研he Deprecfation

Gbbal /nvestoIS, /nc. 285  Accoun加g Po〃ey Choices

Las Fe〃ete/fas de M5x/co, S.A. de C. V:

8 Pianning and Budgeting 297 /n〔面stIfal EtectIOnics, /nc.

9799飢 1 01 21 31 523323342

Haengbok BancoIp
2 2 3   3 3 3 3 3 3 3 3

Purposes of pIanning and budgeting

Co/めhdye /ndustries, /nc,
Pianning cycIes
King Ehgh了eeI面g Group, /nc.
Target se同ng
Be庇shiIe /ndustrfes PLC
PIaming and budgeting practices,
and criticisms
Conclusion ○○ Remediesto the Myopia
4  4 4 4   4 4 4 4 4
4  4 5 5   5 5 5 5 6
8  8 0 1   3 5 5 6 0

N otes ProbIem
RQyaI Messanen NV
Pressures to act myopjca=y
777e Stimson CompaIry
Reduce pressures for short-term PrOfit
MuItゆ/e Vさrsions of肌e Pfan
Controi investments with preactjon reviews
Wtesse Semicond[/Ctor Co/pOra的n
Extend the measurement horizon
VtsuSon, hc": Bushess Shess Testing
(use iong-term incentives)
Measure changes in vaIue directiy
9 lncentive Systems 353
lmprove the accounting measures
Purposes of incentives 355 Measure a set of value d「ivers
Monetary incentives 357 Conciusion

X
 Contents

Notes 461 14 Contro=e「s and Audito「s 629

Caねlytic SoIuf/ons,爪c・   _ 462

Contro=ers 629
Do万munderLKopp e/ GmbH 470
Auditors 633
Johansen七: 771e New Scoreca/d 639

788801
ConcIusion

4 4 5
Sys tem 640
Notes
Mainrfeigh t
Don Pusse〃: E〆pehences ofa Con書roM9〃CFO 641
SねtoiI
Desktop Solu書ions, /nc・ W: Audit

of書he St. Louis BIanCh

12 Using FinanciaI ResuIts Desktop SoIutions, /nc. (B): Audit

ControIs in the Presence Of C)peI省f/ons GI℃up Systems

of Uncontro11able Factors 517 And伯W G, Scave朽ChiefRisk O研cer

The controliab冊y principie

丁ypes of uncontroiiable factors 520 15 Management Control-ReIated

Contro=ing for the distorting e什ects Ethica=ssues 677

Of uncontroIiabies 522 Good ethical anaiyses and

Other uncontroIIabie factor issues 529 678

their importance
Conclusion 529 why do peop-e behave unethicai-y? 682
Notes 530
Some common management
Olympic Car Wash 531 controi-reIated ethica=ssues 684
Be伯ng Chuang ¥七VさhicIe G′Oup 532 spreading good ethics within

Ho筋7]an Discount Drugs, /nc・ 534 689

an o「ganization
Howard BuiIding CoIpOIation, /nc・ 541 691
ConcIusion
Bank of me Deserf 44) 554 692
N otes
Bank of the Dese万(B) 556 694
Two Budget T却gets
F栃e Han伯st Resねurant GIりup 44) 561 conser胞five Account/ng in肋e GeneI省/

Hne HaWest Pestaurant Group @)
SECT看ON V
694 695697698699700701708
565
Products Division
Educaf/on Fbod SeWices at CentraI
Mahle Sfate Universi書y
777e “Sa/es Acce/eIation ProgIam ’’

Corporate Gove「nance, 771e E*pimg So#ware License

lmpo巾ant Control-Related W伯匂PLC
Mean Screens USA, Inc,
Roles, and Ethics
Lemout & Hauspie?peech Products
Ethics@ Cisco
1 3 Corporate Govemance
and Boards of Directors

Laws and regulations 574 SEC丁看ON VI

The Sarbanes-Oxley Act 575 Management ControI When Financial
Boards of directors 580 ResuIts Are Not the Primary
Audit committees 583 consideration
Compensation committees
Conc山sion
Notes 言器16 Management Cont「oI in 721
A仰w MotoI℃ar Co仰Oration 588 Not-for-PrOfit Organizations

Go/den Parachutes? 594 Corporations, B corporations’and

722
FねCi#c Sunwear of Ca〃fomfa, /nc. 598  n Ot-fo r- P rOfits

E/うtrOpic Communications, /nc・ 61 0 Key d冊erences between for-PrOfit

723
Bio/Precise Medica/ Devices, /nc, 625  and noトfor-PrOfit organizations

Xi
Contents

Goai ambiguity and confIict 724 Notes

D輔cuIty in measuring andつ東 SCI Onねho: Achievhg, Measuhngタand

rewarding performance 725  Communic∈涌ng S脆tegic Success

Accounting d冊erences 727 University of Southem Ca〃fomia:

ExtemaI scrutiny 728  Respons酬iリCenter Management dystem 746

Empioyee characteristics 731

ConcIusion 731 1ndex

CHAP丁ER I
Management and Control

Management control is a critical function in organizations. Management control failures can

lead to large financia=osses, rePutation damage, and possibly even organizational failure. Tb
illustrate this, let us start with some examples in the financial services sector that, Since the
financial crisis have been beset by a raft of control failures related to rusty information sys-
tems;1 misconduct related to misselling丘nancial services such as pay-PrOteCtion insurance

stemming from aggressive sales-based tactics;2 allegations that financial services companies
helped their clients evade taxes;3 manipulation of interest rates, SuCh as the venerable LIBOR
fthe benchmark inter-bank rate that is used to calculate interest rates on m箪Or financial trans-

actions throughout the world);4 faults in intemal controIs surrounding the reporting of com-
modity prices by banks, trading desks; mOre isolated but crippling unauthorized urogue
trades,,;5 and anti-mOney-laundering violations,6just to name the most striking ones.
Tb provide some more detail about one particular case to demonstrate its relevance to man-
agement controI systems (MCSs) and the signi丘cant risks when they fail, the Financial Services

Authority (FSA) fined UBS, a Swiss-based global bank, f29.7 million (discounted from
f42.4 million for early settlement) for systems and controIs failings that allowed an employee
(Kweku Adoboli) to cause substantial losses totaling US$2.3 bi11ion as a result of unauthorized
trading. In particular, UBS, failings included the following:7

苺The computerized system operated by UBS to assist in risk management was not effective in

COntrOlling the risk of unauthorized trading.

ミ The trade capture and processing system had significant deficiencies’Which Adoboli

expIoited in order to conceal his unauthorized trading. The system allowed trades to be
booked to an intemal counterparty without su飴cient details, there were no effective meth-

ods in place to detect trades at material ofr皿arket prices’and there was a lack of integration

between systems.

ミThere was an understanding amongst personnel supporting the trading desk that the opera-

tions division,s main role was that of facilitation. They focused mainly on e飴ciency as

opposed to risk control, and they did not adequately challenge the front o綿ce.

ミThere was inadequate front o綿ce supervision. The supervision arrangements were poorly

executed and ineffective.

一三 The trading desk breached the risk limits set for their desk without being disciplined for

doing so. These limits represented a key control and de宜ned the maximum level of risk that

the desk could enter into at a given time. This created a situation in which risk taking was not
actively discouraged or penalized by those with supervisory responsibility.
Chapter l. Management and ControI

e Failing to investigate the underlying reasons for the substantial increase in profitability of
the desk despite the fact that this could not be explained by reference to the end-Of.day risk

POSitions.  一‥

㊥ Profit and loss suspensions to the value of $1,6 billion were requested byAdoboli, and these

were accepted without challenge or escalation. The combined factors of unexplained profit-
ability and loss suspensions should have indicated the need for greater scrutiny.

The FSA report concluded that these failings were particularly serious because:8

㊤ Market confidence was put at risk, given the sudden announcement to the market and size of

the losses amounced. Negative announcements, SuCh as this, Put at risk the con丘dence

which investors have in financial markets.

㊥ The systems and controIs failings revealed serious weaknesses in the firm,s procedures’

management systems and intemal controIs.

㊤ The failings enabled Adoboli to commit financial crime.

Global regulators have similarly exposed flaws in banks, intemal controI systems that
allowed traders to manipulate interest rates, SuCh as LIBOR, arOund the world・9 Tb add, Stuart

Gulliver, the chief executive of HSBC, the largest financial institution in Europe, admitted that
負our anti-mOney-laundering controIs should have been stronger and more effe証ive’and we

falled to spot and deal with unacceptable behavior.,,1O

The press headlines to which these examples are selectively referenced speak for themselves"
Of course, nOt all banks have been entangled in each and every issue. However, that the list of
those being caught in these nets has been so Iong, SParing few, is surprising for organizations
whose reputations are among their most valuable assets. Failures of this type and magnitude
also damage the integrity of the wider market and financial system on a global scale. But these
failures have also been costly money-Wise, Where the wave of fines and lawsuits that has swept
through the financial sector since the丘nancial crisis has cost big banks a whopping $260 bil-

1ion, aCCOrding to research from Morgan Stanley. The report also suggests that寝actions taken

by banks to prevent future litigation issues include everything from changing remuneration
[compensatio巾policies twhich we discuss under the rubric of res融s co庇roZs in Chapter 2 and
ince融ve eys亡e肌s in Chapter 9] to a greater focus on `non孟nancial metrics’[Chapter ll], adding

compliance staff [Chapters 3 and 14], tO elevating chief risk o鯖cers to boards [Chapter 13] and

using `robo-SurVeillance’in trading rooms [a form of ac亡iorl CO庇rOZs which we discuss in Chap-

ter 3],, (brackets added).11 clearly, the issues illustrated here touch on, and cut across, many Of
the issues we discuss in this text.
Tb add, though, here is a quote from a F証αnC王c[汀fmes columnist that builds nicely on the

above but extends it to other sectors:

It turns out that bankers may not be aIone・ The traders who rigged Libo「 and foreign

exchange rates cheated ciients out of money・ Vo漢kswagen’We nOW know’deIjbe「ateiy

po11uted our air" The carmaker had a choice‥ insta= additionai emissions cIeaning equip-
ment; admit that its diesei cars were not very fueI e怖cient; Or SPeW Out iilegai amounts of

nitrogen oxide" lt chose the iast of these options, and covered it up by designing soft-
ware to deceive the US regulators, […] This round-the-WOrId tour of fraud aIso takes in

Toshiba. The nucIear-tO-Semiconductor congIomerate was hit by a record fine from

Japan,s stock exchange and ordered to improve its governance and intemal controIs, in
the wake of a $2bn accounting scandaI〇 〇〇。,] Not even the tech industry has proved

immune. European 「esearchers reveaied this week that Googie has been charging adver-

tisers for haying their ads seen on YouTube, eVen When fraud-detectjon systems discover
that the `viewer, is a robot. That practice is cleariy not in the same Ieague as rate-rigging,

4
 yearS of accounting fraud or emjssion test decejt" But the disc-osure reinforces a grow-
ing sense that companies around the wor-d are pushing ethjcaI boundaries twhich we

Another article commen亡ed that the issues at vw were predictable because ofvw,s lax board-

rOOm COntrOIs (which we discuss in Chapter 13) and its peculiar corporate culture (Chapter 3):
“The scandal clearly also has to do with structural jssues at vw... There have been warnings

about vw,s corporate governance for years’but they didn,t take it to heart and now you see the

reSult,,, says Alexander Juschus’director at IVOX’the Geman proxy adviser.13

Effedive cultures’StruCtures’and controIs are quintessential as the above examples suggest,

but not only in the foaprofit sectorras the next example i宣lustrates twe discuss non-PrOfit organ-

izations in Chapter 16). Consider the case ofan award-Winning teacher who at the time headed
Atlanta,s public schooIs, and who had been praised by the American Association of SchooI
Administrators for the significant gains in student achievement she had overseen, Where AtIan-
ta’s schooIchildren made sizable gains on the standardized tests used to determine yearly pro-

greSS. At one school, forinstance’the share of 13irear-Olds who passed the test・s maths section
rOSe from 24% to 86%, and the share of those who “exceeded expectations,・ rose from l% to

46% - both in a single year・ However,

…he state of Georgia aI-eges that those remarkab-e -eaps rested on neither pedagogy
nOr determjned study, but something far more invidious‥ Cheating・ A report by a speciai

investigative team [・○○] found wjdespread evidence of cheating [・・"」・ Sometimes teachers

gaVe PuPiis the correct answers. sometimes they erased pupi-s’answers after the test and
filied in the correct ones themse-ves. The jnvestigative team fer「eted out cheating by ana-

1yzing erasure marks on test sheets" They f-agged c-assrooms wjth an average number of
WrOng-tO-right erasures more than three standard deviations above the state average. The
Chance of that occurring randomly is one in 370・ More than ha-f of Atlanta’s elementary and

middie schoo-s had such cIassrooms’and many had erasures more than 20 to 50 standard

deviations above the norm. of the 178 teachers accused of having taken part in the cheat-
ing, 82 confessed. [The head], Said the report’either knew or should have known what was

gOing on"暮・・"I Prosecutors did not charge me headJ with taking part in the cheating, but
With put的`面でaSOnabIe pressure” on pwhc匝and feachers fo do we帰nd for crea+
ing `fan envfronment where achie面g the des胸end resuIt was more inportant鵬刷fe

This is an example ofresults controIs (Chapter 2) and’。eady no亡Only the fmtional but also the

behavioral displacements that they can create触pters 5 and ll)’in part due to target pressure

伽pter 8)’but a]so empIoyees, and organizations, moral failures伽pters 3 and 15).
Excessive target pressure was also identified as a cuIprit jn the accounting scandal at Tbshiba
that was mentioned in passing earlier:

In Aprii 2015, an improper accountjng scanda- came to light that infIated profits by weII
OVer $1bn at Tbshjba’the Japanese industrja- conglomerate’Which makes -aptops, mem-

Ory Chjps and nuclear reactors- A paneI of externa。awyers and accountants that was

aPPOinted to investigate was said to have uncovered emails showjng that Hjsao fanaka,
Chief executive・ and Norio Sasakj, former chief executive and then vice-Chairman,
``instructed emp-oyees to de-ay the booking of costs to make the financial figures Iook bet-

ter” [.・・書and that “the prob-ems were worsened by reporting procedures for projects that

Were time-COnSuming and old-fashioned" Some of the paperwork was being done by junior
emP10yees in their first few years at the company",, Experts further commented that =the
acCOunting issues at Tbshiba a-so exposed concerns around Japanese corporate govern-
anCe PraCtices [which we discuss in Chapter 13], inc-uding the weak roie of externai

5
Chapter l. Management and Controi

directors and the extensive power that many former chief executives continue to exe卜

cise.”1三㌔he scathing paneI report aiso detaiIed what it said `’were `institutionai’accounting

maIpractices・[Chapter 5] and a corporate culture [Chapter 3] in which empIoyees were

afraid to speak out against bosses’push for increasingIy unachievabIe profits [Chapter 8〇・

[○○.] Pressures to meet aggressive, Short-term PrOfit targets [Chapter l「]一known as `the
cha=enge,一eXisted from the presidency of Atsutoshi Nishida’Who headed the company

from 2005 to 2009 and remained an adviser. Those pressures escaiated as the company’s

eamings deteriorated in the wake of the globai financial crisis and […] the Fukushima

nuclear accident. The panei declared that Mr" Tanaka and Mr" Sasaki were aware that prof-
its were bejng inflated and djd not take any action to end the improper accounting・ In some

instances, the report added, tOP eXeCutives pressured empIoyees to achieve their ta「gets

with suggestions that the company may withdraw from underperfo「ming businesses if they

were not met, But the paneI found no evidence any of the three current and former chief
executjves had given specific instructions to divjsion chiefs to infIate profit figures",,16 They
described a corporate cuIture - One Of exerting pressure on empIoyees to meet aggres-
sive, Short-term PrOfit targets spanning three generations of chief executives - in which
emp10yeeS Were afraid to speak out against bosses when they pushed for unreaiistic eam-
ings targets・17

The consequences of failures of organizational control (which we define more precisely in

the later sections of this chapter) can reach far and wide beyond the organizations in which
they take place. As mentioned above’the banking failures have undermined the integrity ofthe

wider market and financial system on a global scale, But there are other m亘ior impacts:

Sharehoiders and customers are obvious victims of the current flood of bad news. They
are seeing their investments shrink’having their cars reca=ed and paying too much fo「

goods and services. But there is another set of Iosers: the empIoyees and shareholders of
the companies that try to piay fair" Back in the ea「iy 2000s’a COmPany Ca=ed WorIdCom

upended the telecommunications industry by repeatediy posting profit margins that its
rivais simply could not match. Five big groups’inciuding AT&T, reSPOnded by siashing

about 5 per cent oftheircombined workfo「ces- mOre than 20,000jobs" In 2002, WorIdCom

was exposed as the US’s iargest accounting fraud and its chief executive sentenced to jaii・

However, the empIoyees who were laid off at rivaI companies did not get theirjobs back.18

And in the case ofAtlanta’s schooIs:

[…l the scandal,s real casualties are Atlanta’s schoo漢chiidren・ SchooIs that cheated their
way to fa-se improvements Iost federal funds which couId have been used to make actuai
improvements. Because of their apparently high test scores’Strugg=ng pupiis were denied

the heip they needed and deserved・ A generation of Atlanta,s students have, in fact・ been

Ieftbehind.19

We discuss these impacts in the light of organizations, co岬ora亡e soc証reやons油揖ty and their

concems about sus亡c血αb拒ty and the wider stakeholder communities in Chapter 16.

Not all control failures are as consequential, Or Of similar magnitude’aS the examples listed

above; yet they can, and do, inflict costs and/Or embarrassment. For example’

[〇〇〇] this happened when Deutsche Bank paid $6 bi=ion to a hedge fund client by mistake in
a `fat finger’trade, Where a junior member of the bank’s forex saies team, WhiIe his boss

was on hoiiday, PrOCeSSed a gross vaiue instead of a net vaIue, meaning that the trade had
・too many zeroes’" Whereas the bank recovered the money from the U・S. hedge fund the

next day, the incident wasバan embarrassing bIow to the bank,, and it aIsoバraised fresh

questions about Deutsche,s operationaI controis and risk management.’’The $6bn error

6
 aisQJaised questions about why it was not spotted under the bank’s ・four eyes principie,

[an acf/o凡OOntroI djscussed in Chapter 3一, requirjng every trade to be reviewed by another

Other examples of this type also occur in the public sector and do not always invoIve money
being inadvertentlywired. This happened at the Bank ofEngland (BoE)whre its head ofpress
mistakenly sent an email to the media revealing that officials were quietly researching the
impact of Britain,s ex沌om the European union, a m担blunder given the secrecy of this

Study. wha亡had caused this mistake? The “auto-COmPlete,, tool in BoE・s internal email service.

The BoE confirmed that fo11owing this incident’it had switched off auto-COmPIete fron its emaiI

SyStem - that is’Staffnew have to write the皿name of the recipient of their email messages

rather than being automa〔ically proposed through the outlook auto-COmPlete functiona]ity -
``to preserve the securi亡y ofits data.,,21

叫oyees do not always have to steal or engage in fraudulent activities to cause harm.
Sometimes it su描ces tojust “faH asleep.,, This happened when a bank teller was making a pay-

ment OfC64.201eut as he制asleep亜ft his finger on the number 2 key accidentally put亡ing
through a payment ofC22,222’222.22. The payment almost went through when the supervisor

Who was supposed亡O be looking out for such mistakes allegedly faifed to notice and approved

the transaction. The mis亡ake was spotted only by another col]eague who managed to correct it

before it was too late.22 As we will see, this Is an example of a rather simple fnter血o融

PrOCedure. wediscuss internal controls as one type ofwhat we call czctto柵roZs in Chapter 3,
and we discuss how tightly they should be applied in Chapter 4. The example further illustrates
that not every controI problem invoIves fraud’yet adequate controI systems must also be able to

PreVent mistakes. Furthermore’When there are irregularities or control breaches’mOney or

ince姐ves like bonuses are not always亡he motive for the wrongdoing. For example,

[〇〇・] two cIerical workers at the Laguna NigueI’Ca冊ornia-based service center of the U,S.
immigration and Natura-ization Service (一NS) were accused of destroying thousands of

immigration documents, inc-uding visa appIications, PaSSPOrtS, and other papers. Accord-
jng to the probe, the clerks started shredding unprocessed paperwork after an inventory
reVeaied a processing backlog of about 90’000 documents" A month Iate川e backIog was

rePOrted to be zero・ The shreddi=g aI-eged-y went on for about another month to keep the

bacl(iog at zero, u剛NS officials discovered the shredding spree during an evenjng

Although it is not entirely clear what the clerks, motives were’there were no bonuses

involved here’and maybe they were concerned about keeping theirjob and庇lso not doing

theirjob well or being lazy and cutting corners. Nonetheless’their actions were completely

inappropriate’and thus proper controI systems are needed to mitigate such undesirable

Howeve叩Ore COntroIs should not always be equated with better controIs. when copious

MCSs are stifling’they can exacerbate rather than mitigate controI problems怖discuss this

further in Chapters 4 and 5vyhere we consider not only direct’eXPlicit・ mOre easily quantifia-

ble, Out-Ofpocke亡COStS’but also various types of繭rect,垂yCtt COStS Of tightening the con-

trOIs. For example, When froancial irregular工ties were discovered at Eurostat, the European

Commission,s statistical service’it was not immediately clear whether these had occurred for

the personal enrichment ofthose invoIved; instead・ SOme argued that the “secret accounts,, may

at least initia11y have been set up to give Euros亡a〔 a way to pay for research quickly without

gOing through the commission,s cumbersome procedures. Ironically then’While the commis-
Sion had elaborate procedures to prevent financial fraud’these procedures may not on]y have

PrOVed insufficient (because they 。early could be circumvented), they may actually have made

7
Chapter l. Management and ControI

the problem worse. Because tortuous form-filling was required to request funds, requeSterS had
to jump throug血number of bureaucratic hoops to get anything approved, and funds delivery

WaS nOtOriously sIow,てOmmission o飴cials and sta任may have taken to cutting comers and find-

ing “creative’’ways to expedite the process. Of course, these ``work-arOunds’’should be a red

flag for possible expIoitation and potential improprieties, tOO.24

By this point, it should be no surprise that we are claiming, but also that it is widely accepted,
that good MCSs are important. Comparing the books and articles written on management con-
trol is di飴cult, however, because much of the MCS language is imprecise. The term ``control’’as

it applies to a management function does not have a universally accepted definition. An old, nar-
row view of a MCS is that of a simple eyberrle亡fc or regu血亡証g system invoIving a single feedback

loop analogous to a thermostat that measures the temperature, COmPareS the measurement with
the desired standard, and, if necessary, takes a corrective action ftum on, Or O埠a fumace or air

conditioner). In a MCS feedback loop, managerS meaSure Performance, COmPare that measure-
ment with a pre-Set Performance standard, and, if necessary, take corrective actions.25
In this text, however, We take a broader view. Many management controIs in common use,
such as direct supervision, emPIoyee selection and retention, and codes of conduct, do not
focus on measured performance. They focus instead on encouraging, enabling, Or SOmetimes
forcing empIoyees to act in the organization’s best interest. This is consistent with the observa-

tion that all the above examples have one key question in common: how can organizations of
all types ensure that their empIoyees up and down the hierarchy carry out their jobs and
responsibilities properly? Moreover, SOme management COntrOIs are proαC互ve rather than

reacfive. Proactive means that the controIs are designed to preve庇problems before the organi-

zation su任ers any adverse effects on performance. Examples of proactive controIs include

Planning processes, required expenditure approvals, Segregation of duties, and restricted

access. Management control, then, includes all the devices or systems that managers use to
ensure the behaviors and decisions of their empIoyees are consistent with the organization’s

Objectives and strategies. The systems themselves are commonly referred to as manage耽e虹

CO庇ro工γS亡e肌S (MCSs).

Designed properly, MCSs influence empIoyees’behaviors in desirable ways and, COnSe-

quently, increase the probability that the organization will achieve its goals. Thus, the primary
旬批正orz of management control is to influence behaviors in desirable ways. The berle庫ofman-
agement control is the increased probability that the organization’s o聯ectives will be achieved.

Management and controI

Management control is the back end of the management process. This can be seen from the
various ways in which the broad topic of management is disaggregated.

Management
The literature includes many definitions of management, All relate to the processes of organiz-
ing resources and directing activities for the purpose of achieving organizational objectives.
Inevitably, those who study and teach management have broken the broad sutlject into smaller,
more discemable elements. Table l.1 shows the most prominent classification schemes. The
first column identifies the primary management functions ofthe value chain: PrOduct or service
development, OPerations (manufacturing products or performing月elivering services), market-

ing/Sales (丘nding buyers and making sure the products and services ful乱I customer needs),

and finance (raising money). Virtually every management school o縦ifS COurSeS focused on only

One, Or Only part ofone, Of these primary management functions.

8
 Management and control

ltlble l,1 D肺erent ways of categorizing the b「oad area of management

__.基 Functio購S. Resources P「ocesses

Product(OrSerVice)deveiopment PeopIe Objectivesetting

Operations Money Strategyformuiation

Marketing/Saies Machines ManagementcontroI

Finance Information

souI℃e. K A Merchant, Modem Mar)agemenf Con章ro/ $ystems而xt and Cases (Upper Saddle BIVe「, NJ PrentlCe Hal=998)' P 3

The second column of Table l.1 identifies the major types of resources with which managers
must work: PeOPle, mOney, maChines’and information. Management schooIs also offer courses

organized using this 。assification- These courses are often called human resource manage-

ment, aCCOunting and finance, PrOduction and operations management・ and infomation sys-

tems, reSPeCtively. These are sometimes also referred to as the support management functions.26
The term m伽ageme庇co庇roZ appears in the third column ofTable l.1’Which separates the man-

agemen血nctions along a process invoIving objective setting’Strategy formulation’and manage-

ment control. Control, then, is the back end of the management process. The way we use the term
management control in this text has the same meaning as the terms execu亡iorrand s軸的′ irxpZe-

me庇伽iorl. In most organizations’focusing on improving MCSs will provide higher payoffs than

wi皿一CuSing on improving strategy. Afor加e study showed that 7 out of lO CEOs who fail do so not

because of bad strategy, but because ofbad execution.27 The above examples reinforce this・ tOO.

Many management COurSeS’including business policy’Strategic management’and manage-

ment controI systems, focus on elements of the management process. Tb fdeus on the control
function of management, We muSt distinguish it from objective setting and strategy formulation.

Objective setting
Knowledge ofo切cc。ves is a prerequisite for the design of any MCS and, indeed’for any pur-

poseful activities. Ol)jectives do not have to be quantified and do not have to be financial’
although that is how they are commonly thought of in for-PrOfit organizations. A not-for-
profit organization・s primary objective might be to provide shelter for homeless people, for
example; but even in these organizations’there have been calls to express the achievement

of these obje⊂tives in financial or叫c[S誼nancial terms, SuCh as social return on invest-

m。nt,28 H。WeVer, many for-PrOfit organizations also have nonfinancial objectives’SuCh as

related to sustainability or personnel development and we11-being (see Chapter 16). In any
organization, however’emPIoyees must have a basic understanding of what the organiza-

tion is trying to accomplish. Otherwise’nO One COuld claim that any ofthe empIoyees’actions

are purposive, and no one could ever support a 。aim that the organization was successful.

In most organizations, the ohectives are known. That is not to say that all empIoyees always
agree unanimously as to how to balance their organizations, responsibilities to a11 of their
stakeholders, in。uding owners (equity holders), debtholders’emPIoyees・ SuPPliers, CuStOmerS,

and the society at large. They rarely do.29 That said’Organizations develop explicit or implicit

compromise mechanisms to resolve conflicts among stakeholders and reach some level of
agreement about the objectives they will pursue. As Jason Luckhurst’managing director of

Practicus, a UK-based prQject-management reCruitment firm, argueS:

Hb achieve organizational success], it takes a cIear vision around which the entire busi-
ness [can] be designed, [and一案think it is something you shouId be abie to communicate

9
Chapter l. Management and Cont「oi

simply to everyone, Whether a client or [an empIoyee]. Having a simpIe and easiIy undeト

stood statemettt of intent is vitai for setting cIear objectives and targets.30

Strategy formuIatiorm

Having set the fim’s strategic intentions or objectives, Stra亡egies then define how organizations

should use their resources to meet these objectives. Awell-COnCeived strategy guides empIoyees
in successfully pursuing their organization’s o旦iectives; it conveys to empIoyees what they are

SuPPOSed to be doing" OI., aS Mr. Luckhurst at Practicus states:

AI=he planning in areas as diverse as marketing, branding, financing and training言S

designed around書oun objective - aS are [ou印ncentive [systems]" We have a detailed road

map, but it starts with a simpIe vision that everyone can understand and buy into. Eve「y-

thing e-se we do comes on the back of those goals" In effect, We Can reVe「Se-engineer the

business to those objectives,31

Many organizations develop formal strategies through systematic’Often elaborate, Planning

processes (which we discuss further in Chapter 8). Put differently, they have what can be called
an証e融ed stra亡egy・ However, Strategies can sometimes be left largely unspecified. As such’

some organizations do not have formal’Written strategies; instead they try to respond to oppor-

tunities that present themselves. M亘ior elements of these organizations’strategies e桝eIge from

a series of interactions between management, emPloyees’and the environment; from decisions

made spontaneously; and from local experimentation designed to learn what works well. None-
theless, if some decision-making consistency exists, a Strategy Can be said to have been formed,
regardless of whether managers planned or even intended that particular consistency. In that
sense, StrateglC VISIOnS SOmetimes come about through dynamic organizational processes
rather than through formalized strategic planning.32
Not even the most elaborate strategic visions and statements are complete to the point where
they detail every desired action and contemplate every possible contingency. However, for pur
poses ofdesigning MCSs, it is useful to have strategies that are as specific and detailed as pos-
sible, if those strategies can be kept current. The formal strategic statements make it easier for
management both to identify the feasible management control altematives and to implement
them effectively. The management controIs can be targeted to the organization,s critical success
factors, SuCh as developing new products, keeping costs down, Or grOWing market share’rather

than aiming more generally at improving profitability in otherwise largely皿specified ways.

Formal strategic statements are not a sufficient condition for success’however. As Adrian

Grace, managing director ofBank of Scotland - Corporate, StateS:

i have seen businesses with 400-Page documents outlining their strategy and it’s ciear

they should have spent Iess time outlining the vision and more time thinking about how
they wi一一de-iver on it. You can have the best vision in the worid but if you can’t put it into

effect, yOu are WaSting your time・33

It is on the execution side of the management process that MCSs play a critical role. Jason
Luckhurst explained:

The d冊erence between merely having a strategic vision and achieving strategic success is

having a detaiIed understanding of what that vision means for every leveI of the business -
how much funding you need, the branding and marketing strategy’Which channeis you wⅢ

deveIop, how many peopIe you need in which areas and when and what the organizationaI
structure wi= be, it is also important to revisit the vision often and be aware of how ciose

you are to achieving it at any given stage. This helps everyone in the company to stay
focused.34

10
 Management and controi

Management contrOl
Mc胴ge肌e庇co証rO=ecuses on execution, and it invoIves addressing the general question: Are

our empIoyees likely to behave appropriately? This question can be decomposed into several

PartS:

㊧ First, do our empIoyees understand what we expect of them?

e¥ Second, Will they work consistently hard and try to do what is expected ofthem - that is’Will

they pursue the organization’s objectives in line with the strategy?

㊧ Third, are they capable ofdoing a goodjob?

Finally, ifthe answer to any ofthese questions is negative, What can be done to solve the man-
agement controI problems? All organizations who must rely on their employees to accomplish
organizational objectives must deal with these basic management control issues. Addressing
management control issues’therefore’invoIves reflecting on how to influence’direct, Or align

empIoyees, behaviors toward the achievement of organizational objectives consistent with the
espoused strategy・

From a management COntrOI perspective’Strategies should be viewed as useful but not

absolutely necessary to the proper design of MCSs. When strategies are formulated more
。early, mOre COntrOl altematives become feasible’and it becomes easier to implement each

form of management control effectively. Managers can’however’design and operate some

types of MCSs without having a 。ear strategy in mind. As Adrian Grace, managing director

ofBank of Scotland - Corporate, PrOffers‥ “Ifyou don,t have [a strategy] but you know how to

deliver, yOu might still make it. Success in business is 25% strategy but 75% execution.,,35
or, the other way around’tO devise a strategy and write it down is one thing; it is another

thing entirely to make the plan work in practice" That said, there is some evidence that
organizations with formal systems for managing the execution of strategy outperform those
that do not.36

Behavioral emphasis
Management contrOl invoIves managers taking steps to help ensure that the empIoyees do what
is best for the organization. This is an important purpose because it is people in the organiza-
tion who make things happen. Management cOntrOIs are necessary to guard against the possi-
bilities that people will do something the organization does not want them to do’Or fall to do

something they should do. For example’aiming to achieve greater cost contrOl is open to ques-

tion without reference to people because costs do not control themselves; PeOPle control them.
As many examples throughout the text will illustrate’emPIoyees can work against or around

systems, thereby leaving many ot)jectives unmet or producing unintended consequences.

This behavioral orientation has Iong been recognized by practitioners. For example, Roman
stanek, Chief executive of GoodData in San Francisco’a business analytics company’aCknowト

edgedthat:

Having a vision and having confidence doesn’t mean anything unIess you’re able to com-

municate it to your team [...]" The ability to communicate weli didn’t come easily for me・ l

always assumed that everybody wou-d see things the same way I see them’and now I

understand it takes a Iot of time to get peopIe a佃ned"37

If a11 empIoyees could always be relied on to do what is best for the organization・ there would be

no need for a MCS. But empIoyees are sometimes unable or unwi11ing to act in the organization’s

best interest, SO managerS muSt take steps to guard against the occurrence of undesirable
behaviors and encourage desirable behaviors.

11
Chapter l. Management and Controi

Causes of manag婁ment COntrOi probiems

Given the behavioral focus of controIs, the next logical question to ask is: What is it about the
empIoyees on whom the organization must rely that creates the need to implement MCSs? The
causes of the needs for controI can be class綿ed into three main categories: lack of direction,

motivational problems, and personal limitations.

Lack of direction

Some empIoyees perform inadequately simply because they do not know what the organiza-
tion wants from them. When thisねck qfdirec亡Iorl OCCurS, the likelihood of the desired behav-

iors occurring will be haphazard or random. Thus’One function of management control

invoIves informing empIoyees as to how they can direct their contributions to the fu皿Iment

of organizational objectives. Indeed, this is also the key point that came through in the quote
from Stanek above.
Lack of direction is not a trivial issue in many organizations, although it is often taken for

granted (as the quote from Stanek also suggests). For example, SurVey eVidence collected by
KPMG, a big-four professional services company providing audit’taX, and advisory services’

from approximately 4,000 US empIoyees spanning a11 levels ofjob responsibility across a wide
range of industries and organizational sizes revealed that 55% ofthe sample respondents had a
lack of understanding of the standards that apply to their jobs.38 Moreover, a Study of 414
World-at-Work members in mostly managerial positions at large North-American companies
suggested that 81% of the respondents believe that senior managers in their organizations
understand the value drivers of their business strategy; 46% say that middle management
understands these drivers; but just 13% believe non-management emPIoyees understand them"
This indicates that organizational goals are not cascading down to al1 1evels in the organization"
And while 79% ofthe respondents in this study believed that their employees, goals are aligned
with organizational goals, 44% also stated that empIoyees set goals based on their own views
rather than direction from leadership.39
Another survey from KPMG asked what factors might cause managers and empIoyees to
engage in misconduct, Which, aS We Will see across several chapters in this text’is an impor-

tant management controI problem. The answer, in fifth place and mentioned by 59% of the
respondents, WaS “a lack of understanding of the standards that apply to theirjobs.,40 Another

survey of 5,00O respondents, induding ``techies’’(e.g. software developers or engineers), indi-

cated that only 28% ofthe techies said they understood their companies, vision compared with
(also only) 43% of non-teChies.41 And, in a university one of the authors of this text is familiar
with, a Staff survey revealed that only half of the empIoyees responded a節rmatively to the

question whether “they had a dear understanding ofthe purpose and objectives of [the univer-
sity],・, whereas (also only) 68% said this to be the case for the ohectives oftheir department.42

All told, then, it should not be taken for granted that empIoyees have a clear understanding of
direction. Tb the contrary, the survey evidence suggests that a lack of direction may be quite a
COmmOn OCCurrenCe.

Motivational probIems
Even if empIoyees understand what is expected of them’SOme do not perform as the organi-

zation expects because of mo亡iva亡ionc[Z probZe肌s. Motivational problems are common

because individual and organizational objectives do not natura11y coincide - individuals are
selfinterested.

12
 Causes of management contrOi probIems

EmpIoyees sometimes act in their own personal interest at the expense of their organiza-
tion’s interest. Frederick Taylor, One Of the m亘ior丘gures in the scie庇折c m肌age肌e庇movement

that took place in the early twentieth century, WrOte: “Hardly a competent worker can be found

who does not devote a considerable amount oftime to studyingjust how sIowly he can work and
still convince his empIoyer that he is going at a good pace.珂3 such q的r亡aversion and other se折

証eres亡ed behaviors are still a problem today. Gary Gill, the author of KPMG,s Fraud Barometer

for Australia, believes that broad economic conditions have a significant effect on fraud levels:
・・It goes up following a boom period. People want to maintain their standard of living’eVen if it

means criminal activity享4 Another survey suggests that fraud is on the increase in the United

Kingdom・s public sector as austerity programs imply personnel reductions and fewer resources

being spent on intemal controIs, aCCOrding to a report from PwC’a big-four competitor of

KPMG.4与

overall, SurVey eVidence suggests that wasting’mismanaging’and misappropriating organi-

zational resources, amOng Other types of empIoyee misconduct’are PreValent in most organiza-

tions.46 Even ostensibly inconsequential forms of wasting time on the job can have high costs.
su血g the Intemet while on the job’for example, has been estimated to have cost US empIoy-

ers in the bi11ions of dollars per year"47 All told, SurVey Participants in the most recent report by
the Association of Certified Fraud Examiners estimated that the typical organization loses 5%
of its amual revenue to fraud. Applied to the estimated 2014 Gross World Product’this figure

translates to a potential global fraud loss ofmore than $3・7 tri11ion.48 staggering as these statis-

tics may be, they suggest that it should not be taken for granted that empIoyees will always reli-
ably act with the best interest of their organizations in mind. Because of this’the costs to

organizations are nontrivial・ tO Say the least.

Indeed, the most serious forms of empIoyees, misdirected behaviors, SuCh as fraud, Can have
severe impacts, including deteriorated empIoyee morale, impaired business relations’lost rev-

enues from damaged reputations’investments in improving controI procedures’legal fees and

settlements of litigation, fines and penalties to regulatory agencies’and losses from plummet-

ing stock prices. Many of the examples that we included at the start of this chapter illustrate
this,49 and various fraud or integrity surveys’SOme Of which have been conducted over many

years by mgivr organizations, reinforce this with statistics.50

These huge fraud costs can be traced back to human weaknesses but also’and importantly,

as we will see later in this text, tO the lack of effective MCSs. Anecdotal assertions abound. For
example, One manager Claimed’rather brashly’that ・・every single person in your [business] is

trying to steal from you.,,51 Another manager’s estimate’While more measured’Sti11 suggests

that:

Between lO and 20% of a company’s emp-oyees wi= steai anything that isn’t nailed down・

Another 20% wilI never steai; they would say it is mora11y wrong. The vast majority of peo-
p-e are situationa一一y honest; they won’t stea冊here are prope「 COntrO-s"52

Regardless ofthese oplnlOnS’One might argue that “stealing,, is a rather literal’PeCuliar・ and

perhaps too extreme or negative type of behavior to illustrate se距nterest.嶋king偉stealing’’

less literally, many Other foms of misaligned behaviors occur when employees’for example’

manipulate their performance reports’either by falsifying the data or by taking decisions that

artificially boost performance’With the intention of eaming higher’but undeserved’incentive

pay (see also Chapter 15). The most common cause of this is reported to be pressure to do
“whatever it takes・, to meet business targets.53 This goes to the heart of res融s co庇roZs (which

we discuss in Chapter 2) and related perfomance targets (Chapter 8) and incentives (Chapter 9).
Well-designed MCSs are needed to protect organizations against these behaviors.
However, in addition to focusing on how MCSs can be used to prevent or mitigate these
negαfive or dy垂ncfroれaThehaviors, this text,s emphasis is also’eVen Primarily’On how MCSs

13
Chapter l. Management and ControI

Can be empIoyed to motivate pos注ive or prod」C亡ive behaviors; that is, how they encourage

empIoyees to wQI-k consistently hard to accomplish organizational objectives. As we will dis-

CuSS further below, whenever feasible, mO高vc証ort should be the primary focus of effective

MCSs, mOSt COmmOnly brought about through res【克s coutroZs (Chapter 2) while also providing

any necessary behavioral constraints and/Or mitigating any behavioral displacements through
a well-designed combination or “configuration’’of ac亡Zorl and perso柵eZ産油uraZ co庇rOIs

(Chapter 3).54

Persona=imitations
The final behavioral problem that MCSs must address occurs when employees who know
What is expected of them, and may be highly motivated to perform well, are Simply unable to

Perform we11 because of any number ofother limitations. Some ofthese limitations are per-
SOn-SPeCific. They may be caused by a lack of aptitude, training, eXPerience, Stamina, Or
knowledge for the tasks at hand. An example is the too-COmmOn Situation where empIoyees
are promoted above their level of competence; that is, When empIoyees are `くover their

heads.’’Sometimes jobs are just not designed properly, CauSing even the most physically fit

and apt empIoyees to become tired or stressed, leading to on-the」ob accidents and decision

Regarding lack of training, for example, I11inois-based Ace Hardware was forced to restate
its eamings for four fiscal years because of a $152 mi11ion accounting error made by a poorly
trained empIoyee, Who incorrectly entered accounts in ledgers in the Finance department at
the company’s headquarters. Ace CEO Ray Gri飴th stated: “We are embarrassed by it. We did

not provide the training, OVerSight or checks and balances to help that person do (the) job.”55

Errors such as these are not uncommon. For example, When Bank of America, a global US-
based bank, disdosed that it had made a signi丘cant error in the way it calculates a crucial

measure of its financial health, Which led the bank to report that it had $4 billion more capital
than it actually had, the error raised serious questions about the “quality of its accounting

empIoyees.,,56 similarly, at Ttsco, the largest UK supermarket chain, When it announced to

have overstated its expected profits by f250 million, One COmmentatOr Observed that “even if

there was no fraudulent intent and the problems stem from a misunderstanding of the rules
[…], the apparent scale of the error suggests that, at the very least, Tesco’s intemal controIs

need a thorough overhauL,,57

MoreoveI., reSearCh in psychoIogy and behavioral economics suggests that all individuals,
even intelligent, We11-trained, and experienced ones, face limitations in their abilities to per-
Ceive new problems, tO remember important facts, and to process information properly (or
rationally). In looking at the future, it has been shown, for example, that people tend to overes-
timate the likelihood of common events and events that have occurred relatively recently (both
Of which are easier to remembeD as compared with relatively rare events and those that have
not occurred recently. Such biases may, for example, affect employees’propensities to assess

risks by biasing their estimates ofeither the likelihood or impact, Or both, Ofcertain risk events.
Sometimes training can be used to reduce the severity of these limitations. Nonetheless, these
limitations are a problem because they reduce the probability that empIoyees will make
the correct decisions or that they wi11 correctly assess the problems about which decisions
should be made.58
These three management controI problems - lack of direction, mOtivational problems, and

PerSOnal limitations - Can Obviously occur simultaneously and in any combination. However,
a11 that is required to ca11 for the necessity of effective MCSs is that at least one ofthese prob-
lems occurs, Which will almost inevitably be the case in complex organizations as the above
arguments and examples have suggested.

14
Characteristics oLgood management contrO一

耽have a high probability of success’Organizations must therefore maintain good management

.ontr。l. G。。d.。ntr。I means that management can be reasonably confident that no major

unpleasant surprises will occur・ The label ou亡Qfcor軒oZ is used to describe a situation where

there is a high probability ofpoor performance’either overall or in a speci丘c performance area’

despite having a sound strategy in place.

However, eVen gOOd management controI still allows for some probability of fallure because
pe7佃t control does not exist except perhaps in very unusual circumstances. Perfect controI
would require complete assurance that all controI systems are fooIproof and all individuals on
whom the organization must rely always act in the best way possible. Perfect control is obvi-
ously not a realistic expectation because it is virtually impossible to install MCSs so we11
designed that they guarantee good behaviors. Furthermore’because MCSs are costly, it is

rarely, if ever, COSt effective to try and implement erro“gh controIs even to approach the ideal-

ized perfect control・

The cost of not having a perfect controI system can be called a co庇ro川oss. It is the diiference

between the performance that is theoretically possible given the strategy selected and the per-
fdrmance that can be reasonably expected with the MCSs in place. More or better MCSs should
be implemented only if the benefits by which they would reduce the control loss exceed the
costs, Except in cases where the consequences of failure are incalculable’OP亡imc[! co佃O! can be

said to have been achieved ifthe control losses are expected to be smaller than the cost ofimple-
menting more controIs. Because of controI costs, Perfect control is rarely the optimal outcome
(or even conceivable). The benchmark, therefore’is adequate control rather than perfect con-

trol, eXCePt again in cases where failure is not an option and where control must be uncompro-
misingly focused on avoiding fallure at any cost (such as in nuclear plants).
Assessing whether good control has been achieved must be future-Oriented and objectives-
driven. It must be庫ure-Orie庇ed because the goal is to have no unpleasant surprises in the

future; the past is not relevant except as a guide to the future’SuCh as in terms of experiences or

lessons leamed from control failures. It must be o坊ec亡豊ves-drtven because the ot)jectives repre-

sent what the organization seeks to attain. Nonetheless’aSSeSSing whether good control has

b。。n a.hieved is di飴cult and subjective. It is di飴cult because the adequacy of management

control must be measured against a future that is inevitably di鯖cult to predict’aS are Predic-

tions of possible unintended consequences of the controIs. Good control also is not established
over an activity or entity with multiple ot)jectives unless performance on 。f significant dimen-

sions has been considered. As di飴cult as this assessment of management control is’however’it

should be done because organizational success depends on good MCSs.

As the examples at the beginning of this chapter illustrate’Organizations that fail to imple-

ment adequate MCSs can suffer loss or impairment of assets, deficient revenues’eXCeSSive costs’

inaccurate records, Or rePOrtS that can lead to poor decisions’legal sanctions, Or business dis-

ruptions. At the extreme’Organizations that do not controI performance on one or more critical

dimensions can fail,

ControI problem avoidance

Implementing some combination of the behavior-influencing devices commonly known as

MCSs is not always the best way to achieve good control; SOmetimes the problems can be
avoided. AγOfdc[rlCe meanS eliminating the possibility that the controI problems will occur・

15
Chapter l. Manageme=t and Controi

organizations can never avoid all their controI problems’but they can often avoid some ofthem

by limiting expt)sure to certain types of problems and problem sources’Or by reducing the max-

imum potential-loss if the problems occur. Four prominent avoidance strategies are activity
elimination, autOmation, Centralization, and risk sharing.

Activity eiimination
Managers can SOmetimes avoid the controI problems associated with a particular entity or
activity by turning over the potential risks’and the associated profits’tO a third party through

such mechanisms as subcontracting, licensing agreements’Or divestment. This form of avoid-

ance is ca11ed act[v互y轟肌inc[tiorh

Managers who are not able to controI certain activities’Perhaps because they do not have the

required resources, because they do not have a good understanding of the required processes’

or because they face legal or structural limitations’are those most likely to eliminate activities.

Here is an example:

when the German financiaI regulator ordered Deutsche Bank ‖to do more to enSure that

commodity prices cannot be manipu-ated by its traders,,・ the bank responded that it償has

since shut trading desks dedicated to energy・ agricu-ture’dry bulk and freight and base

metais. Other commodity businesses have been transferred to Deutsche,s non-COre bank
where they wiI- be wound down or so-d’While some partS remain active・,, adding that “we

significant-y sca-ed back our commodities business and exited entireIy non-PreCious meト

als trading・ As we have previous-y said, We COntinue to cooperate With authorities in their

industrywide review of certain benchma「ks and are investing to further improve our cOntrOl

environment.,・59

when managers do not wish to avoid completely an area that they camot controI we11’they are

wise at least to limit their irrvestments, and hence (some of) their risks, in that area. An example is
。oud computing, Which means that companies obtain computing resources (processing, StOrage’

messaging, databases, and so on) from outside’and pay only for what they use, rather than

develop their own computing infrastructure and run their own systems. With the increase in
demand for servers to store and process data, many COmPanies would need to multiply their
server capacity manyfold’fdr which they sometimes have neither the money nor the skills’nOr the

interest, because doing so細1s outside of most companies, core competencies. By using 。oud

computing services’丘rms can leave a11 that to be managed by those who have the competencies

and, hence, Can PrOVide essential controI over the process. Whereas this does not eliminate all
risks, it partially avoids some controI problems related to data management and a11 that it entails.
Indeed, many COmPanies have been expanding their use of 。oud services’With growing

numbers running systems such as email services’human resources, and administrative pro-

cesses via the 。oud, aS We11 as data storage and backup. James Petter’UK managing director of

EMC, the data storage and software group’Said: “Organizations move to the 。oud for a number

of reasons, but they most often relate to agility, CO庇rOhand efficiency,, (italics added). “More

than just hosting services, the 。oud is ensuring availability and perfomance’PrOteCting data

and helping businesses with change management by depIoying functions and lessening disrup-
tion,,・ Joe King, Senior vicei)reSident at JDA, the supply chain software group’added.6O

The economics-based literature that focuses on whether specific activities ftransactions) can
be controlled more effectively through mrke亡s (extemal) or through organizational hferarchIes

(intemal) is known as trcmsac亡{on cost econo扉cs. A detailed examination of the theories and

evidence in this field of study is outside the scope ofthis text.61 wejust note that the cost/benefit
tradeoffs of dealing with management control issues intemally do not always favor arms-1ength’

market-based transactions or inter-Organizational arrangements’and thus a care餌balance has

16
 Controi probiem avoidance

to be struck.62 Referring back to the doud services, for example, One issue that sometimes holds
companies back is a concem about security. As such’Organizations wi11 always have to rely on

MCSs intemally, Which have been found to be e鉦ctive in a broad range of settings. The preva-

1ence oflarge diversified organizations has depended to a large extent on good MCSs.

Automation
Automa亡ioれis a second avoidance possibility" Managers can sometimes use computers, rObots’

expert systems, and other means of automation to reduce their organization’s exposure to some

controI problems. These automated devices can be set to behave as required’and when they are

operating properly, they perfom more consistently than do humans. Computers eliminate the
human problems of inaccuracy, inconsistency, and lack of motivation" Once programmed’COm-

puters are consistent in their treatments of transactions’and they never have dishonest or dis-
loyal motivations. Here is a representative quote from the mining industry:

Rio Tinto has roiIed out fuliy automated driverless t「uck fIeets at two of its iron ore mines in

the Piibara in Weste「n Australia。 [.○ ○寒“Our autonomous fIeet outpe「forms the named fieet by

an ave「age of 12 per cent, PrimariIy by eiiminating required breaks, absenteeism and shift

changes,,, said Andrew Harding’Rio,s iron ore chief executive・償In=OVation and technoIogy

is critica=n our e什OrtS tO improve safety.” […] The worId’s biggest miners are turning to

technoIogy to cut costs〇 〇〇〇〇] This fo=ows a similar trend across a wide range of industries,

from car manufacturing to computing, Whereby robots o「 artifjcia=nteIIigence are increas-

ingIy taking roles traditionaIly performed by humans. […寒“Removing people from the mine

environment is safer” said Dr. CarIa Boehi, a Iecturer at Curtin University - “tt has cost

advantages too, It can be very costiy for companies if empioyees are hurt onsite"’’音…] ``We

have also seen a 13 per cent reduction in Ioad a=d hauI costs due to the greater e冊Ciency’”

Mr. Harding said. Dr. Boehl said embracing techno10gy COuid create more interesting jobs
whiie making Iower skilled positions obsoIete・ ‖You wiii tend to Iose the boring, rePetitive

jobs performed in the 50 degrees centigrade heat in the Piibara but you can aIso create new
imovative rotes in ana-yzi=g data and deve-oping techno-ogy’,, she said"63

As technology has advanced, Organizations have substituted machines and expert systems for
people who have been performing quite complex actions and making sophisticated judgments
and decisions. In hospitals, for example, artificial intelligence systems are able to perform many
of the tasks doctors and nurses used to perform. These systems monitor the patients’conditions

and trends and alert the medical staffofpossible problems; they assist in making diagnoses; they
order the needed drugs; and they check for potential drug interactions and allergic reactions.
Computer-aided insertions of central venous catheters are more accurate and reduce complica-
tions (such as punctured arteries that can lead to infections).64 And so on. Importantly, these
systems allow hospitals to avoid one of the behavioral problems - the personal limitations ofthe
medical staff. In the vast majority of situations, these systems are more likely than are medical

personnel to recall all the details of every condition’medication’and possible complications to

initiate the proper response, Needle iIjection robots use tracking algorithms to keep the blood
vessel aligned, and thus, are mOre aCCurate. Hence’these systems make it more likely that no

major, unPleasant surprises wi11 occur; in this case, aVOidable medical errors and complications.
Similarly, many legal tasks, although sometimes quite complex’are Variations on a theme,

where the production of certain types of legal documents does not di任er vastly from one

instance to another. Legal firms are therefore increasingly using what is called docume庇

asse肌bfy s〔昨wclre, allowing them to reduce the time needed to put together a certain type of

legal document (such as a trademark registration or a real estate lease) to a fraction ofthe time
it takes an empIoyee to do the same and, POSSibly, mOre COnSistently and accurately with fewer

17
Chapter l. Management and ControI

errors. Moreover, autOmating these onerous processes reduces costs and allows lawyers to
spend mor釦ime dealing with their clients.65

Another example is where banks (when they have not exited parts of the trading business as
Deutsche Bank did in the example above) have sped up digital trading to settle trades via auto-
mated processes to minimize human intervention because traditional trading over the phone
has come under intense regulatory scrutiny due to a11eged manipulation ofbenchmarks such as
CurrenCy fixes and interbank lending rates. Automation leads to a better dient experience at
lower cost with stronger control, thereby reshaping a once opaque but lucrative business to
become less risky・66

In most managerial situations, however, autOmation can provide only a partial controI solu-
tion at best. One limitation isjねsめ据ty. Humans have many talents - Particularly those invoIv-

ing complex, intuitive judgments - that no machines or decision models have been able to
duplicate. There are often also regulatory constraints, Where the regulators maybe understand-
ably wary of fu11y autonomous systems in some settings, SuCh as in health care, In other set-
tings, SuCh as automated trading in banks, they may welcome them. Regulators may find fully
autonomous or ``self-driving’’cars not yet feasible, but they are likely to welcome semi-autOnO-

mous systems that help ・・take the human error out of driving・,・67

A further limitation is cos亡. Automation often requires mayor lnVeStmentS that may be justifi-

able only if improvements in productivity, aS Well as in control, are forthcoming. Finally, autO-
mation may just replace some controI problems with others, Or introduce different control
issues. The elimination of source documents can obscure the audit trail; the concentration of
information in one location can increase security risks; and placing greater reliance on com-

Puter PrOgramS Can eXPOSe the company to the risks ofprogrammer errors or fraud.

CentraIization
Ce庇rc揖za亡iorl Of decision-making is a third avoidance possibility, Which is a key element of

almost all organizations’MCSs. High degrees of centralization, Where a11 the key decisions are

made at top management levels, are COmmOn in small businesses, Particularly when they are
run by the founder or owner. High degrees of centralization also exist in some large businesses
Whose top managers sometimes have reputations for being “detail oriented’’or ``control freaks.’’

When that is the case, tOP management reSerVeS the important, and sometimes the not-SO-
important, decisions for themselves, and in so doing, they avoid having the lowe「level employ-

ees make poorjudgments.

Centralization inevitably exists to some extent in a11 organizations, aS Well as at all levels of
management within organizations, aS managerS tend to reserve for themselves many of the
most crucial decisions that fall within their authority. Common candidates for centralization
are decisions regarding major acquisitions and divestments, mqjor capital expenditures, negO-
tiation of pivotal sales contracts, Organization changes, and hiring and firing of key personnel・

However, in most organizations of even minimal size, it is not possible to centralize all critical
decisions, and other controI solutions are necessary. As we wi11 see in Chapters 2 and 7, reSults
COntrOIs play a critical role when decisions are decentralized. When decisions are decentral-
ized, reSults controIs need to be in place to hold the managers who erjoy the decision authority
accountable for the results of their decisions. Accountability for results is what makes delegated
authority legitimate.

Risk sharing
A丘nal, Partial avoidance possibility is risk sharing. Sharing risks with outside entities can bound

the losses that could be incurred by inappropriate empIoyee behaviors. Risk sharing can involve
buying iJISurarlCe tO PrOteCt against certain types of potentia11y large losses the organization

18
 might not be able to afford. Many comPanies purchase fidelity bonds on empIoyees in sensitive
positionsifuch as bank te11er9 to reduce the fim,s exposure. These insurance COntraCtS PaSS at
least a portiorl-of the risk of large losses and errors to the insurance PrOViders. Another way to
share risks with an outside party is to enter into ajo而ve融re agreement. This shares the risk

These avoidance alternatives are often an e任ective partial solution to’Or bounding of’many

of the controI problems managerS face. It is rarely possible to avoid all risks because fims are
rewarded for bearing risk’but most fims use some forms of elimination’autOmation, Centrali-

zation, and risk sharing in order to limit their exposure tO the management COntrOI problems.

Control altematives

For the controI problems that cannot be avoided, and those for which decisions have been made
not to avoid, managerS muSt implement one Or mOre COntrOl mechanisms that are generally
called mc[Jlαgeme姉OntrO s. The collection of control mechanisms that are used is generally

referred to as a maⅢge肌e柾COrl面eystem (MCS).

MCSs vary COnSiderably among organizations and among entities or decision areas Of any
single organization. That said, they commonly in。ude a co肌b血ion of action’reSults, and

personnel/Cultural controIs’Which we discuss in depth in the next twO Chapters. The MCSs of
some organizations consist primarily of trying to hire people who can be relied upon to serVe
the organization well. Other organizations provide modest pe血mance-based incentives’and

still others offer incentives that are highly leveraged. Some organizations base incentives on the
accomplishment of targets defined in terms of accounting numbers, Others use no血ancial

measures of performance, and still others evaluate pe血mance supeCtively. Some organiza-

tions have elaborate sets Of policies and procedures that they expect emPloyees to follow’

whereas others have no such procedures’Or they allow the procedures that were onCe in place

to get out of date" Some organizations make extensive use of a large profdssional internal audit
staff甲hile others only ensure to be in minimal compliance with regulatory requirements in

this regard. These are just examPles. The distinctions that can be made among the MCSs in use

Management COntrOI choices are nOt random, however. They are based on many factors.
some controIs are not effective’Or are nOt COSt-effective’in certain situations. Some typeS Of

controIs are better at addressing particular types of problems’and different organizations and

different areas within each organization often face quite di任erent mixes of controI problems.

some types of controIs have some undesirable side effects that can be particularly damaging in
some settings. And some contrOIs merely suit particular management Styles better than others.
A mgiv purpoSe Ofthis text is to describe the factors affecting management COntrOI choice deci-
sions and the effects on the empIoyees and the organization when different choices are made.

Outline of this text

The text discusses MCSs from several different angles, eaCh the focus of one m担section・

section II distinguishes controIs based on the o輝Qf co融’Which can focus on the results

produced (resuZ亡s cond)’the actions taken ouon cort亡rO[)’Or the types of people empIoyed
and their shared norms and values (persormeZ ond c血r。 cond). Chapters 2-6 in Section II

discuss each of these forms of control, the outcomeS they produce (Which can be both positive
and negative恒nd the factors that lead managers to Choose one object of controI over another.
19
Chapter l. Management and ControI

Section IⅡ focuses on the major elements of月rlCmC壬。iresl庇s-CO融rOZ $rste肌S, an important

type of re糾lts control in which results are defined in financial terms. This section includes dis-

CuSSions of financial responsibility structures (Chapter 7), Planning and budgeting systems
cehapter 8), and incentive systems (Chapter 9).
Section IV discusses some m砧Or PrOblems managers face when they use financial results-

COntrOI systems and, Particularly, the performance measurements that drive them. These prob-
lems include the tendency of accounting measures to cause managers to be excessively
Short-term Oriented (myopiO, the tendency for retum-On-investment measures of performance
to cause poor investment and performance evaluation decisions, and the likelihood of negative
behavioral reactions from managers who are held accountable for factors over which they have
less than complete control. Throughout Chapters lO-12, We also discuss several approaches
Organizations can rely on to mitigate these problems.
Section V discusses some key organizational control roles, including those of controllers,
auditors, and audit committees of the board of directors. It also discusses recent developments
in corporate govemance (Chapters 13 and 14) as well as common control-related ethical issues
and how to analyze them (Chapter 15).
Given the focus on缶nancial results controIs in primarily Sections III and IV, in the final sec-

tion (Chapter 16), We COme back to broaden this focus by discussing the pertinence of MCSs
even when financial results are not the primary rc[isorl d枕re ofthe organization, SuCh as in non-

PrO丘t organizations, Or Where there are broader missions or concems beyond the financial
realm, SuCh as regarding sustainability and corporate social responsibility.

N otes

I See, for example, and selectively only, “Royal Bank of  8 Ibid.
``Libor Probe Said to Expose Collusion, Lack of Intemal
Scotland Fined f56m for IT Meltdown,’’FirlarlCZc[Z TimeS ∴∴ 9

(November 20, 2014), Online at on.ft.com/14PBtV9. ControIs,’’Bfoomberg (February 15, 2012), Online at
2 See, for example, and selectively only, ``Banks Braced for WWW.bloomb e rg.com.
“HSBC Reveals Problems with Intemal ControIs,” The
Additional f22bn in PPI Claim Payout,’’F壬rlanC融Ti肌es lO

(Apri1 4, 2016), Online at on.ft.com/1VoDSwj. New Ybr友Hmes Uuly 12, 2012), Online at nyti.ms/NO7PkC.
“Bank Litigation Costs Hit $260bn - With $65bn More to
3 See, forexample, andselectivelyonly, “BNPParibasMade ll

Ethical and Legal Mistakes, Says Chairman,’’瑞ncmc融
Tt肌es (February 15, 2015), Online at on.ft.com/1ITIq14.
4丁bomanyarticles on the LIBORscandalhave appeared in 12
the press to make a sensible selection. For a taste, and
indicatively on獲y, tyPe “Libor Investigation’’in the search
box on next.ft.com.                       13
Come;’軸narlC拙Times (August 23, 2015), Online at on.
ft.com/1JHtTIP.
“Bankers Not Only Ones Pushing Ethical Boundaries;’
Ffrl肌C融n肌es (September 25, 2015), Online at on.ft.
COm/lFmAXiS.
“Boardroom Politics at Heart of VW Scandal,’’F[rICⅢCZaZ

5 See, for example, and selectively only, ``Hong Kong Mar- Tf肌es (October 4, 2015), Online at on.ft.com/1hiUICQ.
`Atlanta’s SchooIs - the Reckoning,’’The Economis亡(Apri1
ket Regulator Fines RBS for Trading ControI Failure;’ 14

B上oombe7官(Apri1 22, 2014), Online at bloom.bg/1VKR912; 6, 2013), Online at www.economist.com.

“London Whale Complains of Unfair Blame for $6.2bn 15 `Accounting Scandal Set to Shake Up Tbshiba,’’瑞narlC出

JPMorgan Losses,” FfJtCmC融TZmes (February 23, 2016), T壬mes Uuly 16, 2015), Online at on.ft.com/1fMNz7h.
“Scathing Report Says Tbshiba CEOs Had Role in Accounト
online at on.ft.com/1SR98Ek.              16

6 See, for example, and selectively, ``BNP Paribas Made Eth-
ical and Legal Mistakes, Says Chairman;’op. cit.; ``HSBC
Monitor Says Bank’s Compliance Progress Too SIow - 17
Bank Needs to Do More to Fix Corporate Culture, Update
ing Scandal,’’Ft朋71Cねは涌es (July 20, 2015), Online at
On.ft.com/1KgFnZB.
“Tbshiba Chief Hisao Tanaka Resigns over $1.2bn Account-
ing Scandal,’’F主rmれC融n肌es Ouly 21, 2015), Online at on.

耽chnoIogy, Compliance Monitor Says,’’T五e W〔亜Sfree亡 ft.com/ 1ed zVbE.

“Bankers Not Only Ones Pushing Ethical Boundaries,’’op. cit.
Jo肌mZ (Apri1 1, 2015), Online at on.w?j.com/1ajxzqz. 18
`Atlanta’s SchooIs - the Reckoning,’’op. cit.
7 “FSAFines UBS f29.7 Million for Significant Failings in 19
``Deutsche Bank in $6bn `Fat Finger’Slip-Up,’’F証ancrdZ
Not Preventing Large Scale Unauthorized Trading,’’ 2O

F証arlC[d Serv[ces A【丑JIOrめ′ (November 26, 2O12), Online 耽mes (October 19, 2015), Online at on.ft.com/1QMFz2q.
``Bank of England Moves to Stamp Out `Fat Finger’Errors,”
atwww.fsa.gov.uk/librar)γtOmmunication/Pr/2012/105. 21

Shtml or at www.fsa.gov.uk. F証oncic[据meS Uune 14, 2015), Online at on丘.com/1 JNEF5M.

20

22 “Bank Clerk Nods Offwith Finger on Keyboard and Gives
Away f189m,’’Ever血g Sfαnd。rdjJune ll, 2013), P. 3.
23 “丁Wo Accused of INS Shredding Spree,’’The Los Angeles
Ti肌es (January 31, 20O3), P. B5.
24 “The Road to Perdition: Are the EU,s Financial ControIs so
Exasperating that They Force Its Own Staff to Evade
Them?,’’The EcoJtOmist Uuly 24, 20O3), P. 39.
25 For an academic article on the various concepts of man-
agement control, See T. Malmi and D. A. Brown, “Manage-
ment ControI Systems as a Package ○ ○pportunities,
Challenges and Research Directions,” Ma朋geme庇
Acco肌血gReseclrCh, 19, nO. 4 (December 2008), PP. 287-
300. For a lighter reading, See also ``How Not to Lose Con-
trol,’’FinarlCe & Marlageme叫, 242 (Apri1 2016), PP. 14-15,
online at www.icaew.com.
26 Fora dassic text, See, for example, M. E. Porter, Compe缶
t章γe Adv肌でage: Creat誼g arld SzJS亡a諒ing Superior Pe所〕r-
m仰ce (NewYork: The Free Press, 1985), Chapter 2.
27 ``Why CEOs Fail,’’For亡lme (June 21, 1999), Online at
WWW.businessbuilders.bz/why-CeOS-fail.pdf. See also
“How to Execute a New Business Strategy Successfu11y,’’
F narlC融Post (August 8, 2013), Online at natpo.st/21KIsrs.
28 M. Hall, Y Miユユo, and E. Barman, “Who and What Really
Counts? Stakeholder Prioritization and Accounting for
Social Value;’JourrlaZ QfM肌agemenてStudies, 52, nO. 7
(November 2015), PP. 907-34.
29 See R. E. Freeman, S亡rcl亡egic M肌。geme7砧A StakehoZder
ApprocICh (Cambridge: Cambridge University Press,
2010). See also “Shareholders vs. Stakeholders: A New
Idolatry,’’TJle Economis亡(Apri1 24, 2OlO), Online at econ.
St/KAIp7h; `Analyse This,’’The EcorlO扇st (Apri1 2, 2016),
Onlme at eCOn.St/1V9hSFB,
30 “Keep Sight ofYourVision,’’The S肌dqy T血es (March 23,
2008), Online at www.business.timesonline.co.uk.
31 Ibid.
32 A seminal framework for “strategy analysis’’is that by M. E.
Porter, Co机petitive SけC叱gy; 7tc手刷Iq 【JeSゆr Amlyz血g Jn血s-
tries肌d Co7xpedtors (New York: The Free Press, 1980). A
Seminal contributor to the “emergent strategy’’view is H.
MmtZberg, “Crafting Strategy,’’Harvc[rd B重上Sfrzess Reγiew,
65, nO. 4 (July-August 1987), PP. 66葛75. For a recent edi-
tion ofa textbook on strategic management, See R. M. Grant,
Co庇emporαJγ Strcl亡egy Arlalysis, 9th ed. (Ch主chester, UK:
Wiley, 2016). For a recent empirical study on the ``ongoing
riddle’’of formal and/or emergent plaming practices, See
R. B. Bouncken, V Fredrich, and R. Pesch, “Configurational
Answer to the Ongoing Riddle of Formal and/Or Emergent
Planning Practices,’’Jour7rd QfBI」S証eSS Research, 69, nO. 9
(September 2016), PP. 3609-3615.
33 “Keep Sight ofYourVision,’’op. cit.
34 Ibid.
35 Ibid.
36 R, S, Kaplan and D. P. Norton, Exec山dorl Pre耽誼m (Bos-
ton, MA: Harvard Business SchooI Press, 2008); See also
D. C. Hambrick and J. W. Frederickson, `Are Ybu Sure You
Have a Strategy?,’’Acclde ny QfManc[geme柾ExecL証ve, 15,
no. 4 (November 2001), PP. 48-59.
Notes
37 `A Good Manager Must Be More Than a Messenger,’’Ifte
New Ibrk Tines (May30, 2013), Online at nyti,mS/12Skw5l.
38 KZMG2005/2006加fegrfty Sl[rVey (KPMG LLP, 2005).
39 World-at-Work, Sibson, and Synygy,現e Sfate QfPe7Jbr-
marlCe M融geme庇(Survey Report, August 2004); and J.
Kochanski and A. Sorensen, ``Managing Performance
Management,” W)rksp肌(September 2005), PP. 21-6.
40 KPMG 20I3 Jrl亡egr[ty SI上rγの′ (KPMG LLP, 2013), P. 16,
Online at www.kpmg.com/CN/en/IssuesAndInsights/
ArticlesPublications/Documents/Integrity-Survey-
2013-○○201307.pd王
41 ``The Other Side of Paradise,’’The Ecor10肌is[ (January 16,
2016), Online at econ.st/1URPB3P.
42 A [university] staff survey (2016); SOurCe Withheld for
COnfidentiality reasons,
43 F.嶋ylor, The Princ珂es qfScfe批准c Mcmageme71亡(New
York: Harper, 1929).
44 “EmpIoyee Fraud Is a Growing Problem, Survey Shows;’
The AIJS亡r〔龍an (June 25, 2010), Online at www.adelaide-
45 “PWC Survey Shows Rise in Fraud by Public-Sector Sta埠’’
The Jndependerit Uuly 4, 2010), Online at www.indePend-
ent.co.uk.
46 KPMG20]3 hl亡eg申y S肌vqy, OP. Cit.
47 `Are EmpIoyees Wasting Time Online?’’pCWorld.com
(August 2, 20Ol); See also ``These Charts ShowWhatWe’re
Not Doing because We’re Online A11 the Time,’’BIJS証ess
血srder (October 21, 2013), Online at read.bi/16qZVGz.
48 Assodαtio放ずCert昨ed Frαl」d E糊m五ers - 20ユ6 Repo「亡亡o
t九e NαtiorlS (ACFE, 2016), Online at www.acfe.com/
rttn2016.aspx (hereafter AC押20J6 ReporO.
49 See, for example, ``Bank Litigation Costs Hit $260bn -
With $65bn More to Come,’’op. cit.
5O KPMG 20J3玩亡egrdy Surγqy, OP. Cit.; ACFE 20ヱ6 Repoγt,
Op.Cit.
51 “Thou BetterNot Steal,”Fbrbes (November 7 1994), P. 170.
52 “Crime Is Headed Up - and So Is Business,’’Boston Gfobe
(February 15, 1983), P. 47.
53 KPMG 20ヱ3血fegrftySl上rV切OP. Cit.
54 For a recent study of``configurations’’ofthe various types
Of MCSs that organizations empIoy, See, for example, D. S.
Bedford and T. Malmi言`Configurations of Control: An
Exploratory Analysis,’’Marlageme庇Acco肌亡irlg Research,
27, nO. 2 (June 2015), PP. 2-26. For another recent study
in a non-PrOfit setting that pertinently illustrates the
“inter-relatedness’’of pay-for-Performance, autOnOmy
(related to inceれ亡ives or resI克s corl[「OZs), and mission con-
gruence (related to persoれnel在uturaZ co庇roj), See M. A.
Barrenechea-M6ndez and A. Ben-Ner, “Mission Congru-
ence, Incentives and Autonomy: An Empirical Analysis of
Child-Care Facilities in Minnesota, the U.S.;’Wo手短ng
Paper (2016), Online at papers.sioe.org/PaPer/848.html.
55 “Poorly Trained Finance Worker Makes $152m Flub,’’
CFO.com Uanuary 14, 2008), On獲ine at ww2.cfo.com,
56 “Bank of America Finds a Mistake: $4 Billion Less
Capital,” The New Iかk Times (January 14, 2008), Online
at nyti.ms/1mR3FLb.
21
Chapter l. Management and Contro1
57 “Not So Funny: Booking Revenues, Like Comedy, Is All
about Timing,’’The EcorlO肌畦(September 27, 2014),
onlineatecon.st/1qxwvPw. ∴ ..
58 For a flavor ofresearch in this area ofbehavioral econom-
ics, See, for example, R. Thaler, Misbe庇v証g: The M疎[rlg
QfBe庇viorαZ Econom[cs (London: Allen Lane, 2O15).
59 “German Regulator Warns Deutsche Bank on Commodity
Trading,” Firlam貢aZ Ti肌es (June 19, 2014), Online at
on.ft.com/T9Xacd.
60 “Companies Take to The CIoud for Flexible Solutions,’’
FinarlC融Ti肌es (January 28, 2014), Online at on.ft.
COm/1evKHmS.
61 Oliver Williamson is genera11y recognized as the most
PrOminent theoretical contributor in the area of transac-
tion cost economics, and went on to win the Nobel Prize in
Economics for it in 2009. For a layman’s overview ofsome
Of the key ideas behind his semina量contributions, See
“Reality Bites,’’The Econo肌is亡(October 15, 20O9), P. 92.
CASE STUDY
Leo’s Four-P看ex Theater
Leo’s Four-Plex Theater was a single-location, four-
screen theater located in a small town in west Texas,
Leo Antonelli bought the theater a year ago and hired
Bi11 Reilly, his nephew, tO manage it. Leo was concemed,
however, because the theater was not as profitable as he
had thought it would be. He suspected the theater had
some controI problems and asked Park Cockerill, an
accounting professor at a college in the adjacent town,
to study the situation and provide suggestions.
Park found the following:
1. Customers purchased their tickets at one of two
ticket booths located at the front of the theater. The
theater used general admission (not assigned) seat-
ing. The tickets were coIor coded to indicate which
movie the customer wanted to see. The tickets were
also dated and stamped “good on day of sale only.’’
The tickets at each price (adult, Child, matinee,
evening) were prenumbered serially, SO that the
number of tickets sold each day at each price for
each movie could be determined by subtracting the
22
62 For a more detailed discussion and overview of the issues
related to inter-Organizational controIs, See S. W. Ander-
son and H. C. Dekker, “The Role ofManagement ControIs
in Transforming Firm Boundaries and Sustaining Hybrid
Organizational Forms’,, Fo即lda亡ioJIS and TTe71ds in
Accou批±れg, 8, nO. 2 (November 2014), PP. 75-14l・
63 “Rio Tinto Shifts to Driverless Trucks in Australia;’瑞ncm-
c融n肌es (October 19, 2015), Online at on.ft.com/
1WIIJGh.
64 See, for example, ``Medical Robotics: To the Point,’’The
Economfs亡(Apri1 11, 2015), Online at econ.st/1JpkkjU.
65 “Curbing Those Long, Lucrative Hours,’’The EcorlOmisf
(July 22, 2010), p. 66.
66 ``Banks Speed Up Shift to Forex Automation,’’Financ融
Times (June 22, 2014), Online at on.ft.com/11hky2N.
67 “Google’s Self-Driving Cars Get Boost from U.S. Agency,’’
BZoombeng (May 30, 2013), Online at www.bloomberg.
COm.
number of the first ticket sold from the ending
number.
2. The amounts of cash collected were counted daily
and compared with the total value of tickets sold- The
cash counts revealed, almost invariably, 1ess cash
than the amounts that should have been co11ected.
The discrepancies were usually small, less than $1O
Per CaShier" However, On One day two weeks before
Park’s study, One CaShier was short by almost $1OO.
3. Just inside the theater,s front doors was a lobby with a
refreshment stand. Park observed the refreshment
Stand,s operations for a while. He noted that most of the
stand’s attendants were young, PrObably of high schooI
or college age. They seemed to know many of血e cus-
tomers, a m亘iority ofwhom were of similar ages, Which
was not surprising given the t:heater,s small-tOWn loca-
tion. But the familiarity concemed Park because he had
also observed several occasions where the stand’s
attendants either failed to collect cash from the custom-
ers or failed to ring up the sale on the cash register.
 Private Fitness, inc,

4. Customers entered the screening rooms by passing
through a tumstile manned畦an attendant who
separated the ticket and placed partJ)f it in a locked
`stub box., 1七st counts of customers entering and
leaving the theater did not reconcile either with the
number of ticket sales or the stub counts.
Park found evidence of two speci丘c problems. First,
he found a few tickets of the wrong coIor or with the
wrong dates in the ticket stub boxes" And second’he
found a sometimes sign脆⊂ant number of free theater
passes with Bill Reilly,s signature on them. These
PrOblems did not account for all of the customer test
count discrepancies, however. Park suspected that the
ticket co11ectors might also be admitting friends who
had not purchased tickets, although his observations
provided no direct evidence of this"
When his study was complete, Park sat down and
wondered whether he could give Leo suggestions that
would address all the actual and potential problems,
yet not be too costly.

CASE STUDY
Wong’s Pharmacy

Thomas Wong was the owner/manager of Wong’s phar- Although the store thrived in its early years’Perfor-

macy, a Small, Single-location drugstore. The store was mance in the last few years had not been good. Sales
founded by Thomas’s father, and it had operated in the and profits were declining’and the problem was get-

same location for 30 years. All of the empIoyees who ting worse. The performance problems seemed to have
worked in the store were family members. All were hard begun approximately at the time when a large drug-
workers, and Thomas had the utmost trust in all of them. store chain opened a branch two blocks away"

CASE S丁UDY
Private Fitness, lnc,

“Idon・tknowhowmuch moneyI might have lostbecause 丘gure out a way to make my business work effectively

ofKate. She is a long-time friend whom I thought I could without my having to step in and do everything myself.,,
trust, but I guess that trust was misplaced. Now I,ve got Rosemary Worth was talking about the conse-
to decide whether or not to fire her. And then I,ve got to quences of a theft that had recently occurred at the

23
Chapter l. Management and Controi
business she owned, Private Fitness, Inc. Private Fitness
WaS a Small health club locateq互Rancho Palos Verdes,
Califomia, an uPSCale community !QCated in the Los
Angeles area. The club offered personal fitness training
and fitness classes of various types, including aerobics,
SPinning, body sculpting, air boxing, kickboxing, hip
hop, SteP and pump, dynamic stretch, Pilates, and yoga.
Personal training clients paid $50 per hour for their
instructor and use ofthe dub during prime time. Dur-
ing sIower times (between 9:OO a.m. and 4:00 p.m.) the
Price was $35 per hour. The price per student for each
hour-long fitness class was $12. Some quantity dis-
COuntS Were Offered to clients who prepaid. Unlike the
large health clubs, Private Fitness did not oifer member-
Ships for open access to fitness equipment and classes.
Prior to starting Private Fitness, Rosemary had been
WOrking as an aerobics instructor and fitness model.
She had won many local fitness competitions and was a
former finalist in the Ms. Fitness USA competition. She
Wanted to go into business for herself to increase her
Standard ofliving by capitalizing on her reputation and
knowledge in the growing fitness field and to have
more time to spend with her two young children. Pri-
Vate Fitness had been operating for six months.
Tb open the dub, Rosemary had to use almost all of
her personal savings, Plus she had to take out a bank
loan. The building Rosemary rented, located in a con-
Venient strip mall with ample parking, had formerly
been operated as a fresh food market. Rosemary spent
about $15O,000 to renovate the facility and to buy the
necessary fitness equipment. The club was comprised
Of丘ve areas: an eXerCise room, a rOOm COntaining aero-
bic equipment (e.g. treadmills, Stair climbers, Station-
ary bicycles, CrOSS-COuntry Ski machines), a rOOm
COntammg Weight machines and free weights, men’s
and ladies’locker rooms, and an o飴ce.
Rosemary contracted with five instructors she knew
to run the classes and training sessions. The instructors
Were a11 capable of running personal training sessions,
but they each tended to specialize in teaching one or
two types of fitness classes. Rosemary herself ran most
Ofthe spinning classes and some ofthe aerobics dasses.
The instructors were paid on commission. The commis-
Sion, Which ranged between 20% and 50% of revenue,
Varied depending on the instructor’s experience and on
Whether the instructor brought the particular client to
Private Fitness.
As manager of the business, Rosemary hired Kate
Hoffman, One Of the instructors and a long-time friend.
Kate’s primary tasks included marketing, fac・ility
24
upkeep, SCheduling of appointments, and record keep-
ing. Kate was paid a salary plus a commission based on
gross revenues. During normal business hours when
Kate was teaching a class, One Of the other instructors,
Or SOmetimes a part-time clerical empIoyee, WaS aSked
to staff the front desk in retum for an hourly wage, Pri-
Vate Fitness was open from 5:30 a.m. to 9:00 p.m., Mon-
day through Friday. It was also open from 6:00 a.m. to
noon on Saturday and noon to 3:OO p.m. on Sunday.
Rosemarywas still in the process ofbuilding the vol-
ume necessary to operate at a profit. Typically, One Or
two private fitness clients were in the facility during
the prime early morning and early evening hours. A
few clients came in at other times. Classes were sched_
uled throughout the times the club was open. Some of
these classes were quite popular, but many ofthem had
Only one or two students, and some classes were can-
Celled for lack of any clients. However, Kate’s market-
ing efforts were proving effective. The number of
Clients was growing, and Rosemary hoped that by the
end ofthe year the business would be earning a profit.
As the quote cited above indicates, however, Rose-
mary gradua11y realized that Kate Hoffman was stealing
from the club. On one occasion when Rosemary came to
the club she noticed $60 in the cash drawer, but she
noticed when she was leaving that the drawer contained
Only $2O. She asked Kate about it, and Kate denied that
there had been $60 in the drawer. Rosemary wondered
if other cash amounts had disappeared before they had
been deposited at the bank. While some clients paid by
Credit card or check, Others, Particularly those attend-
ing丘tness classes, Often paid cash.
Rosemary became very alarmed when, during a cas-
ual conversation with one of the other instructors, the
instructor happened to mention to Rosemary some sur-
Prising “good news.’’The good news was that Kate had
brought in a new private fitness client who was working
Out in the l:00-2:00 p.m. time period on Monday,
Wednesday, and Friday. Kate was doing the training
herself. However, Rosemary checked the records and
found no new revenues recorded because of this new
Client. She decided to come to the club during the
Period to see if this dient was indeed working out.
Since the client was there and no revenue entry had
been made, She confronted Kate. After丘rst explaining
that she had not yet gotten around to making the book-
keeping entry, Kate finally admitted that this client had
been writing her checks out to Kate directly, in
exchange for a discount. Kate said that she was very
sorry and that she would never be dishonest again.

Rosemary realized she had two major problems.
First, She had to decide whaLto do with Kate, Kate
WaS a Valuable instructor and a longtime friend, but
her honesty was now in question. Should she forgive
Kate or fire her? Second, Rosemary also realized that
She had an operating problem. She did not want to
SteP in and assume the managerial role herself
because she had significant family responsibilities to
Which she wanted to be able to continue to attend.
CASE STUDY
AtIanta Home Loan
In late 2002, Albert (Al) Fiorini was becoming more and
more frustrated and depressed. In September 2002, he
had taken a leave of absence t:O retum tO SChool to eam
his MBA’and he had trusted some empIoyees to run the
mortgage lending business he had founded. Now it was
dear to Al that those empIoyees had schemed to wrest
COntrOl of the business away from him. And amazingly,
they seemed to have been successful. A=amented,
``They didn’t just steal some of my assets. They stole my
Whole business!,, Being 2’500 miles away and busy with
his studies’Al fdt nearly powerless to stop them. He had
SPent many Sleepless nights wondering what he could
and should do to get his business back. He also thought
about where he went wrong - What he should have done
to prevent this problem from happening in the first place.
丁he company
Atlanta Home Loan (hereafter AHL) was a mortgage
lending and financing company based in Atlanta, Geor-
gia. AI Fiorini founded the company in Apri1 2OO2, With
an initial investment of about $4O,000. He started
OPerating the company from his home.
Al had many years of experience in the mortgage
banking industry. He had worked for several different
COmPanies and had also served a yea‡a6-PreSide虹of
ま
¥
Atlanta Home 」oan
But how could she ensure that her business received
all the revenues to which it was entitled without
being on site at a11 times herself? Should she leave
Kate’Who promised not to steal again, in the man-
ager position? Or should she hire one of the other
instructors’Or Perhaps a non-instructor, tO become
the manager? And in either case, Were there some
PrOCedures or controIs that she could use to protect
her business,s assets?
the Orange County Chapter of the Califomia Associa-
tion of Mortgage Brokers. under his direction, AHIJs
business grew rapidly in its first quarter of operation.
By the summer of20O2, the company consisted offour
telemarketers and eight loan officers, all of whom
WOrked from their homes.偽Ielecommuting,, was con-
Venient for the empIoyees because Atlanta was a large
City with heavy tra鯖c,
Al established banking relationships that allowed
AHL clients to borrow money at wholesale rates. The
actua1 1oan terms varied depending on the clients, FICO
scores.1 In summer 2OO3, banks might offer an AHL 。i-
ent with a very high FICO score (over 620) a rate of
6.25-6.75% on a fixed 30-year mOrtgage. This rate pro-
Vided the bank with an opera亡ing margin of l.5% to
2.0%. AHL eamed a fee of l.50% ofthe loan amount
for every loan funded. This provided AHL with an aver-
age revenue per loan of $3,2OO.
-
25
-
-
-
手
す
-
I
手
ノ
Chapter l. Management and Controi
AHL bought leads from list brokers for $0.2O per
name. These lists provided垂formation as to whether
the individuals owned their honges; if so, When they
bought their homes; and when, if ever, they had refi-
nanced their mortgages.
The telemarketers called people on the lead lists to
assess their interest in refinancing. Al knew from
industry experience that telemarketers should gener-
ate a minimum of one lead per hour. They were paid a
COmbination of an hourly wage plus a performance
bonus ($1O.OO) for each lead produced. Since most of
them worked part-time, AHIJs telemarketers gener-
ated, On aVerage, about four new leads per person per
day.2 They gave the leads, the potential clients’names,
to AI Fiorini. Al distributed the names to AHIJs Ioan
o鯖cers.3
The loan o鯖cers helped the prospective clients to fi11
Out their loan applications and to assemble the needed
backup documents, SuCh as W-2s, Pay Stubs, and bank
StatementS. After the clients, information had been col-
lected, O鯖ce support personnel, Called “loan proces-
SOrS,’’would order an appraisal and a credit report,
OPen eSCrOW, and independently verify the financial
information. After all the information was collected
and verified, the completed創e would then be submit-
ted to the prospective lenders either electronically or in
PaPer form.
AHL did not yet have electronic links to the proces-
SOrS’触es that would allow monitoring of the progress
Of the applications before they were submitted. Capa-
bilities for those links were being put into place. How-
ever, eaCh application required a credit inquiry, SO Al
monitored the activities of his Ioan o鯖cers by tracking
the number of credit inquiries each requested. This
PrOVided him with an early indication of how many
applications were being submitted. The loan applica-
tion/lead ratios varied from 5% to 20% depending on
the ski11 of the loan o鯖cer. Al also dosely monitored
these ratios and their trends.
In the mortgage lending industry, a 30% “fallout
ratio’’fthe proportion of loans submitted to processing
that were not funded) was typical. AHrs fallout ratio
WaS Slightly less than 30%.
Once approved, the lega=oan documents were pre-
Pared. At that time, Al knew the revenue due to his
2 AHL also developed leads from the Intemet, aS it operated the
website www.lowerrate.com.
3 In Georgia, unlike in some otherstates, loan officers are notlicensed.
26
COmPany and the fees due to the loan o鯖cer involved.
AHL paid the loan o飴cers 4O% of this total loan reve-
nue on loans that AHL originated, and 60% on loans
they originated (by generating their own leads), At
dosing, AHL received its funds directly from the pro-
Ceeds. A broker’s check would be ovemight mailed to
AHIJs o飴ce, Or the money would be wired directly into
AHIJs general account.
Back to schooI
For years Al had been thinking about earning an MBA
degree. In June 2002, he was admitted to the executive
MBA (EMBA) program at the University of Southem
California in Los Angeles, and he decided to enroll.
While in Califomia, he planned to start another mort-
gage lending company.
Al had several options for AHL. He could find some-
One tO run it; he could try to sell it; Or he could shut it
down. Ifhe chose to shut it down, he would turn the
unfunded applications over to a contract processing
firm. The contract processing firm would be responsi-
ble for ordering credit reports and appraisals and for
interfacing with the escrow companies and attomeys
until the loans were funded. For its services, this firm
WOuld charge AHL $3OO-$400 per contract.
But Al decided that he did not want to close AHL, It
WaS a PrOfitable business with considerable growth
POtential. In September 2OO2 alone, AHL Ioan o鯖cers
Were PreParing to submit 30-40 new applications to
banks for funding, and the volume ofbusiness was con-
tlnulng tO grOW. Al enlisted the services of a business
broker who placed a value of $600,OOO on the company.
However, Al doubted that he had enough time to find a
buyer before he left for Califomia. He decided to find
SOmeOne tO OPerate the company in his absence.
A partner
Joe Anastasia4 was one ofAHIJs Ioan officers. He had
20 years’experience in the mortgage lending business.
AlthoughAl had known him for only about two months,
his initial judgments about Joe were quite favorable.
Joe seemed to have excellent sales ability; he was peo-
Ple-Oriented; and he was knowledgeable about all areas
Of mortgage lending and financing. On his resume, he
described himself as “dependable and honest.’’Before
joining AHL, Joe had worked for lO years as vice presi-
dent of operations for a sizable financial corporation

and had previously operated his own mortgage service
COmPany for three years. Since Joejoined AHL, he had
dosed a higher loan volume than any ofthe other loan
o航cers.
Impressed by Joe’s background and performance, Al
decided to make Joe a deal to be his partner. In July
2002, Al and Joe reached a verbal partnership agree-
ment. Joe would invest $8,40O, Which was used to rent
an o鯖ce and to purchase some o飴ce equipment, and
Joe and AI would share AHIJs profits equally.
Curiously, however, On the day when the two parト
ners were to meet their new landlord, Joe did not show
up for the meeting. AI could not find him for two days.5
In the first lO working days after becoming Al’s part-
ner, Joe showed up in the o鯖ce only three times,
Al did not feel comfortable letting Joe continue to
run the company. Two weeks after their partnership
agreement had been struck, he made Joe a deal. In
exchange for teminating their agreement, Al agreed to
PayJoe lOO% of the fees eamed on loans that Joe
dosed. Al then brought in an acquaintance, One With
banking experience, tO run AHL in his absence, but this
manager lasted only three days before quitting. Faced
With limited options and desperate to find someone to
run the company before he left for Los Angeles the next
day, Al tumed again to his first option - Joe. Joe apoIo-
gized for his absences with the admittedly weak excuse
that “he had been partying, but it wouldn’t happen
again.’’So Al and Joe reinstated the previous agree-
ment. When Al left for Los Angeles in August 2002,
AHL had 90 loan applications in the pipeline, COnStituト
ing nearly $300,000 in potential revenue.
AI started monitoring AHL from afar. He leamed
that in the following two weeks, Joe went to the o鯖ce
Only four times. One day he took a large batch of loan
飢es home and did not retum to the office for three days.
A new partner and licensing
agreement
In September 2OO2, Al made a丘nal decision that he
COuld not trust Joe. He tumed to Wilbur Washington,
to whom Al had been introduced by Joe several months
earlier. Like Al and Joe’Wilbur had considerable expe-
rience in mortgage banking, Al judged quickly that
圧∵- 崎鮎OI
Atlanta Home Loan
Wilbur would be quite good at sales. He had the requi-
Site knowledge, and “he was smooth.’’On the basis of
these quick judgments, On September l, 2002, AI
Signed a written partnership and licensing agreement
With Wilbur. This agreement stated that AI would offer
Wilbur the use and privileges of AHL as an ongoing
business until he retumed, and Wilbur would provide
AHL with his management services. AHL would make
COmmission payments to Wilbur at lOO% on all loans
dosed less a monthly licensing fee of $5,OOO or lO% of
all revenue, Whichever was greater. Wilbur would also
be responsible for interviewing and hiring all new Ioan
O鯖cers, Paying the expenses of running the o鯖ce, and
managing the entire sta鯖i
Wilbur asked for authority to sign checks written
against AHIJs main bank account, but Al refused.
Instead, aS a geSture Of good faith, Al left with Letitia
Johnson (the o飴ce manageD four signed, blank checks
Written against the main account. Al’s instructions to
Letitia were that the checks were not to be used with-
Out Al’s permission.
Letitia had been with AI since May 2002. She had
effectively managed the telemarketers and had dem-
OnStrated her loyalty to Al. In August 2OO2, because
Of sIow funding loans, AI was unable to pay Letitia
her full salary. He asked her whether she would like
to find empIoyment elsewhere or go through the
hardship with AHL. Letitia responded that she would
like to staywith AHL. AI promised to pay Letitia the
deferred part of her salary as soon as some loans got
funded, Which they did in September. Al trusted
Letitia,
Later that month, When Joe found out what was hap-
Pening, he became quite upset. Not only was he no
Ionger the managing partner of AHL, he thought Al
OWed him a lot ofmoney. He wanted his $8,400 invest-
ment back. But Al refused to pay him until he retumed
all of AHrs leads and loan files in his possession. Not
Only had his dereliction ofduty caused AHL great harm,
but none of Joe’s Ioans had cIosed since August, Which
Al found suspicious.6 In response, Joe創ed a civi=aw-
suit demanding payment.7
27
Chapter l. Management and ControI

Monitoring from Califomia Al had been monitoring the activity in the BofA
account on the Intemet from Los Angeles. He noticed
While he was no Ionger managi塾the day-tO-day oper-
that the four checks had been written without his
ations of the company, AI continued tb monitor AH己s
knowledge and that they had all bounced. He immedi-
OPerations closely. Daily, Or aS SOOn aS the information
ately called Wilbur for an explanation. Wilbur told Al
WaS aVailable, he tracked the empIoyee head count, the
that he had withdrawn money from the account to pay
number of leads produced, Credit inquiries requested,
the empIoyees" Al did not believe this explanation, in
1oan applications funded, O鯖ce expenses, and bank
Part because the checks were made out to Wilbur and
activity. AI was also on the phone three to four hours
not run through the payroll account where payroll
Per day亡alking with empIoyees and, Particularly, loan
taxes would be withheld if the checks were meant for
O鯖cers. He thought that this would allow him to moni-
empIoyees. On October 7, 2OO2, AI sent a fax and certi-
tor the employees’emotional states, an important lead-
fied letter to Wilbur and Letitia and also spoke directly
ing indicator of forthcoming company performance. Al
to them, Ordering them not to write any more checks
also had all of AHLs corporate mail forwarded to his
Without his permission and to make sure that there
California address. AI was particularly concerned
Were Su鯖cient funds in the account to cover the checks
about Wilbur keeping overhead expenses in line with
they wrote. with the retumed check charges, the main
PrOduction levels so that he would be able to pay the AHL account was already $1,533.09 overdrawn.
empIoyees’tO Whom AI continued to feel a responsibil-
Al also called BofA to stop payments on the four
ity, aS Well as Al himself.
Checks and asked the bank to transfer the funds from
In late September’Wilbur hired a new loan proces-
the general checking account to a side payroll account
SOr. Al knew from experience that every loan o鯖cer
to which Wilbur would not have access. However,
believes that there is never enough processor time
Wilbur managed to release the stop payments on the
available to get “his’’particular loan documents com-
Checks. He transferred the money from the payroll
Pleted on a timely basis. But Al,s experience also told account back into the general account and cashed the
him that each processor should be able to fund 20 loans
Checks. Bank personnel apparently assumed that
Per mOnth, SO the company needed only one processor Wilbur had authority over [he account since he had
for every four loan o鯖cers. Al thought that Wilbur was
deposited the funds in the first place.
now empIoying one’Or maybe even two, tOO many PrO-
Angry and frustrated, Al decided that he could no
CeSSOrS and/Or Salaried, OVerhead personnel. He sent
Ionger trust Wilbur and could not do business with him.
Wilbur a note telling him that his processor-tO-loan-
On October 9, 2002, Al asked a friend ofhis who used to
O綿cer ratio was too high. But Wilbur reacted angrily.
be a sales manager in the mortgage company that Al
He told Al ``not to tell him what to do:, that he was man-
had worked for previously to act as his agent. The friend
aging the company in the best way he saw fit.
WaS tO gO tO AHrs o鯖ce and fire all the empIoyees.

Among other things, AI was particularly concemed that

Subsequent events
At the time Wilbur took over the operation ofAHL, four
loans, Which would generate total revenues of $11,700,
Were about to be funded. This amount was supposed亡O
be wired into AHIJs main corporate checking account
at Bank ofAmerica (BofA). When the loans funded,
however’On October l, 2002, Without Al,s pemission,
Wilbur personally collected the four checks himself
from the dosing attorneys, POOled them together, and
deposited them into BofA. After depositing the checks,
AHL had over lOO client創es with sensitive personal
information that might be misused. However, When Al,s
agent went to the AHL premises to fire the empIoyees,
they all refused to go" AI called in the police to support
the firing action, but when they arrived, Wilbur told the
POlice that he was the owner, nOt Al- Not knowing who
WaS te11ing the truth, the policejust left.
On October 14, 2002, AI sent a letter to all lOO+
AHL dients whose loans were in process that the com-
Pany had to drop their applications. The key phrase in
the letter was, αwe are no Ionger going to be able to ser-

Wilbur immediately wrote checks to himself and Leti- Vice your application.’’

tia for the entire amount of $11,700 using the four pre-
Signed checks Al had left.8 However, Since Wilbur
WrOte the checks against uncleared funds, the checks
bounced.

28

On October 15, Wilbur opened a new account at Citi-
ZenS Bank & Trust (CBT) in Atlanta,且bank where he
did his personal business and where he knew the man-
ager personally. Wilbur wired the funds being held in
AHIJs corporate name at the offices of the dosing attor-
neys into this new bank account. He now had signing
authority over the checks.
Al discovered the second bank account when a ``wlel-
come,, 1etter from CBT arrived tO his California address.
AI was outraged that personnel at CBT did not ask
Wilbur for any corporate documents:
Wiibur showed no documentation whatsoever. ‥ Ybu
WOuid expect highly reguIated institutions like banks
to provide better protection for the pubiic, but , ‥
Al immediately called bank personnel and informed
the manager that Wilbur had opened a fraudulent
account with CBT. But CBT refused to freeze the
account or return the money. As a last resort, Al
infomed the Atlanta police and the FBI, thinking that
they might be interested in this identity theft case.
However, POSSibly due to the relatively sma11 amount of
money invoIved, neither the police nor the FBI gave the
CaSe any attention.
Tb make things worse, the day Wilbur opened the
fraudulent bank account at CBT, he also乱ed two appli-
cations for warrants for Al’s arrest. Wilbur claimed that
AI was the one who had taken the proceeds received
from the dosing attorneys out of the company’s
accounts. Al had to return twice to Atlanta to defend
himself. Both cases were dismissed, but Al incurred
This case was prepared by Professors Kenneth A. Merchant and Wim A. Van der Stede, and research assistant Clara (Xiaoling) Chen.
Copyrlght @ byKenneth A. Merchant and Wim A. Van der Stede.
Atlanta Home Loan
OVer $7,50O in legal fees and travel costs, and he wasted
Substantial time and energy dealing with these frivo-
lous lawsuits.
During all this time, the AHL persomel were main-
taining their daily routines. Wilbur renegotiated a lease
with the landlord and established AHL as his own com-
Pany. AI suspected that Wilbur had used all of his
means of persuasion to mislead the empIoyees in order
to break their bonds with Al. Al received his $5,OOO
licensing fee in September, but that was the last money
he received. By December, Al realized that he had
already lost at least $15,000 in licensing fees, and pos-
Sibly more that might have been realized from the
funding of the loans in the pipeline. Moreover, he had
lost his company. AI said, Sadly, “I have no idea how
much revenue ended up being taken in my name.’’
Sensing defeat, Al亀nally asked the Georgia Depart-
ment of Banking and Finance to withdraw AHIJs mort-
gage banking license. Not only had he lost his business
and his income, he had also lost his credit rating since
he had incurred bills that he was unable to pay. And in
February 2003, AI was forced to sell his home.
In the summer of 2003, Al had sti11 not decided what
he should do. Should he fight to regain controI over
AHL? But what was left of it? Perhaps only about
$25,OOO worth of equipment. Or should he give up, let
these crooks get away with it, and try to rebuild some-
where else?
Al also pondered how he had gotten into this mess.
What might he have done to prevent this disaster from
happening?
29
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CHAP丁ER -2
Results ControIs

If asked to think about powerful ways to influence behavior in organizations, mOSt PeOPle
WOuld probably think first about pay-for-Performance, Which is no doubt an e任ective motivator.

For example, at Thor Industries, a large recreational vehide manufactureI., CEO Wade Thomp-
SOn attributes much of the company’s success to its incentive compensation system. Among

Other things, the company shares 15% of each division’s pretax profits with the division manag-

ers, because, Mr. Thompson explained, “I want every one of our company heads to feel like it is

their business, in their control. If they don’t perform, they don’t get paid very much. If they do,

there is no cap to what they can make.・,1 Indeed, Vicky Wright, managing director at Hay Group,

a compensation consultancy firm, argueS:

[Many] companies on the Most Admjred Iist [a list of companies produced annuaIiy by
Fortune] have chief executives who understand what performance measurement is aIi
about・ It’s about Iearning how to motivate peopIe - how to Iink those performance meas-

ures to rewards.2

Pay-for-Performance is a prominent example of a type of control that can be ca11ed resl庇s

CO庇rOZ because it involves rewarding empIoyees for generating good results. Identifying what

aregood results, aS We Will see, is crucial. Indeed, following the financial crisis through to today,

Pay-for-Performance systems, eSPeCially in banks, have received a hard look, in part because,
rather than producing “good’’results, they have been bashed for having bred “bonus cultures’’

Ofgreed and short+ermis机. Even the chief executives of such mgivr banks as Barclays admitted

that their bonus systems were overly “geared,’’created temptations for empIoyees to “cut cor-

ners;’and may have backfired through “ethica=apses,” while the chief executive of Deutsche

Bank touched on the basic underlying motivational effect of bonuses by contemplating that
``[he] ha[d] no idea why [he] was offered a contra⊂t With a bonus in it because [he couldn’t

imagine he would] work any harder or any less hard in any year, in any day because someone is

going to pay [him] more or less.,,3

Nonetheless, eVen in the aftermath of the宜nancial crisis, investors, regulators, and politi-

Cians did not indiscriminately call to do away with pay-for-Performance; rather, their calls for
reform were typically directed at making compensation more cわsely tied to souJld performance,

particularly long-term Value creation.4

Setting aside possible idiosyncrasies ofthe丘nancial sector, Where one could argue that good

empIoyees work hard every day in other organizations without monster bonuses, reSults con-
troIs of the pay-for-Performance variety are widely used, eVen increasingly so in the non-PrOfit
SeCtOr. For example, the National Health and Hospitals Reform Commission in Australia argued
that the fee-for-SerVice system of healthcare rebates often fails to promote the most e任ective
Chapter 2. Pesuits ControIs

treatments because doctors get paid for each consultation or clinical activity regardless of
whether the呼tient recovers well or not. In considering how to refom this system’the Commis-

sion recommeridedto link the pay ofdoct:OrS and nurses to measures ofhow well they treat their
patients or how quickly they are seen.5 similar initiatives to create負accountable care organiza-
tions,, by providing extra rewards for e鯖ciency and quality performance have also been consid-

ered elsewhere, Particularly in the United States.6 ・くThe idea is to see whether shifting financial

incentives for hospitals can make people healthier and save the U.S. money before Medicare’s

hospital trust fund becomes depleted’Which could happen by 2024.・,7

clearly, designers of results controIs of the pay-for-Performance variety have寝good,, result§

te.g. 1ong-term Value creation) - eVen Perhaps lofty results (e.g. making people healthier and
saving a country,s healthcare system from ruin) - in mind when implementing themブbrought

about through the motivational, reSults-driven effects such systems purportedly can have.
Anecdotal as well as research evidence, however, have repeatedly thrown the potency of these
systems into sharp relief by suggesting that either they have weak or no effects or, Where they
do, they can produce the wrong results or have severe unintended consequences.
Even so, and despite, Perhaps’a PreValent emphasis on pq)′-for-Performance in many con-

texts, the rewards that can be linked to results go far beyond monetary compensation. Other
rewards that can be usefully tied to measured performance include job security’PrOmOtions’

autonony plum assignments, and recognition. (We discuss the vast array of rewards that can
be given more fully in Chapter 9.)
Furthermore, reSults controIs create mer[亡ocrcIC{es. In meritocracies’the rewards are given to the

most talented and hardest-WOrking employees, rather than to those with the longest tenure or the
right social comections・ At Koch Industries’a COnglomerate’reSults controIs are seen as the “secret

sauce,, with two main ingredients - meritocracy and operational efficiency. Charles Koch, its boss,
is proud to proclaim that “workers can eam more than their bosses [and] high-SChool-educated

farm boys from Kansas can rise faster than Ivy League MBAs,, based on their performance.8
The combinat:ions of rewards linked to results inform or remind empIoyees as to what result
areas are important and motivate them to produce the results the organization rewards. Result§

controIs influence actions or decisions because they cause empIoyees to be concemed about the
consequences of their actions or decisions. The organization does not dictate to employees what
actions or decisions they should take; instead’emPIoyees are empowered to take those actions or

decisions they believe will best produce the desired results. Results controIs also encourage
empIoyees to discover and develop their talents and to get placed into jobs in which they can

Perform well.
For all these reasons, We虹designed results controI systems can help produce the result§

desired. A review of studies on the use of incentives to motivate performance found an average
gain in perfomance of about 22% stemming from the use ofincentive programs.9 Like all other
forms ofcontroIs, however, reSults controIs do not operate in isolationlO and’equally・ CannOt be

used in every situation. They are effective only where the desired results can be clearly defined
and adequately measured by the organization’and where the measured results can be su飾-

ciently controlled by the empIoyee.11 we discuss the conditions for the eifective use of results
controIs in greater depth in this chapter.

Prevalence of resu看ts contro看s

Results controIs are commonly used for controlling the behaviors of empIoyees at many organi-
zational levels. They are a necessary element in the empIoyee empower肌e庇aPPrOaCh to man-

agement, Which became a m車vr management trend starting in the 199Os.12 Results controIs

34
 Prevaience of resuits cont「ois

are particularly dominant as a means of controlling the behaviors ofprqfessioれα! empZayees;

those with decision宙r誼orZty, like managers. Reengineering guru Michael Hammer even

defines a professional as “sdineone who is responsible for achieving a result rather than ifer]

perfoming a task.,,13
Results controIs are consistent with, and even necessary for, the implementation of decen-
tralized forms of organization with largely autonomous entities or responsibility centers (which
we discuss in more detail in Chapter 7). For example, business pioneer Alfred SIoan observed
that he sought a way to exercise effective controI over the whole corporation yet maintain a

philosophy of decentralization,14 At General Motors (and numerous other companies that fol-
1owed), the results controIs under SIoan’s leadership were built on a return-On-investment

(ROI) performance measure (which we discuss in more detail in Chapter lO)・ By using this type
of controI system, COrPOrate management COuld review and judge the effectiveness of the vari-
OuS Organizational entities while leaving the actual execution of operations to those responsible
for the performance of the decentralized entities - the entity managers.
Many large corporations have gone through the process ofinstituting decentralized forms of
Organization with a concurrent increased emphasis on results control. For example, DuPont
replaced a complex management hierarchy by splitting the company into 21 strategIc bus証ess

硯克s (SBUs), eaCh of which operates as a free-Standing unit. The SBU managers were given

greater responsibility and asked to be more entrepreneurial and more customer-focused. They
Were also asked to bear more risk, because a large portion of SBU managers’compensation was

based on SBU performance (sales and profitability). The managers noticed the change. One
SBU manager said, “When I joined DuPont [21 years ago], ifyou kept your nose clean and

WOrked hard, yOu COuld work as Iong as you wanted. [But today] job security depends on
results.・,15 The change was perceived as being successful: A Bus証ess Wcek article noted that’
“The image of DuPont has morphed from giant sIoth to gazelle.”16

In 2010, Sano丘-Aventis, a large pharmaceutical company, divided its vast resources into

decentralized disease-based units, eaCh with its own departments for research and develop-
ment, regulatory affairs, marketing, and sales - a Plan designed to identify promising drugs
more quickly and weed out failures before spending large amounts of money on unsuccessful
drugs. One industry expert noted that “the [model of] fully independent units, OPerating under

the parent company’s umbrella, [constitutes] a break丘om the traditional big pharma business

model, and represents companies’interest in duplicating the flexibility and cost-e鯖ciencies of

small biotech and biotech-1ike companies.,・17 By establishing accountability for a fu11y inte-

grated entity’s results, Where the entity manager dosest to the business makes the tradeoffs and
takes responsibility over the entity’s budget, the company aims to instill a ``performance cul-

ture’’that encourages both operating discipline (e綿ciency) and greater responsiveness to Iocal

business needs (flexibility).

In other words, decentralization attempts to replicate an “entrepreneurial model’’within

typically large corporations, Where entity managers are given decision authority but then held
responsible for the results that their decisions prOduce. Accountability for results was exactly
the driving motive behind a recent reorganization into “reporting segments’’at Air Products

Chemicals Inc., a large industrial gases producer, Which Sei丘Ghasemi, Air Products’chiefexec-

utive, Claimed would retain Air Products’leadership position through “a decentralized, Simpler,

and more e鯖cient structure which creates true profit and loss (P&L) accountability at many

levels of the organization.,,18

Similarly, When Nick Reilly became CEO in late 2009 0f troubled Opel, the German car man-
ufacturer owned by General Motors, he announced that he wanted to encourage an entrepre-
neurial spirit at Opel by delegating most decisions to country heads and dismantling GM’s

bureaucratic style of centralized management that fostered a “debilitating culture of passing

the buck.,, =It might seem obvious, but it isn,t the way GM was managed and there was definitely

35
Chapter 2 ・ Resuits Controis

some confusion about who was accountable," he said.件From the top line of revenue to the bot-

tom line ofprt脆t, this is now the responsibility ofthe managing directors ofthe m亘ior entities’”

Rei11yadded-19’一‥

However, managerS Will act in an entrepreneurial manner necessary to thrive in competitive

environments not only if they are subjected to the same market forces and pressures that drive
independent entrepreneurs’but also if they are promised commensurate rewards for the risks

they bear from doing so. As such, Richard Chandler’founder of Sunrise Medical’a medical

products company, defended his company,s decentralized organization and lucrative incentives
by stating that “people want to be rewarded based on their own efforts. [Without divisional

accountability] you end up with a system like the U・S. Post O飴ce. There,s no incentive [for

workers to excel] :,20

Results controIs need not be limited to management levels only; they can also be driven
down to Iower levels in the organization, aS many COmPanies have done with good effects. Lin-
coln Electric, a WOrldwide leader in the production of welding products’SerVeS aS the poster

child of companies that use results controIs down to the lowest organizational level. Lincoln
Electric provides wages based solely on piecework for most factory jobs and lucrative perfor-
mance-based bonuses that can more than double an empIoyee,s pay・21 This incentive system

has created such high productivity that some of the industry giants (General Electric’Westing-

house) found it difficult to compete in Lincoln Electric’s line ofbusiness (arc welding) and exited

the market. A Bひsiness Week article observed that存in its reclusive, iconoclastic way, Lincoln

Electric remains one of the besトmanaged companies in the United States and is probably as

good as anything across the Pacific.,,22 And even though Lincoln’s legendary庇e証l,e Pe直r-
maJICe fystem has essentia11y remained the same since it was installed in 1934, the company is
still ac。aimed for its systems and perfomance today, SuCh as in the book The Modeγn F{rm.23

Whereas decentralization is an effective way to empower empIoyees in a results-COntrOI con-

text, there can, and even should, be limits to empowerment in certain circumstances. One prob-
1em is infighting, aS eXemP皿ed at Sears’a Struggling US retailer・ Edward Lampert’the investor

who had tried for eight years to tum around the company’=divided Sears into more than 30

units, eaCh with their own presidents, Chief marketing officers’boards of direc亡ors and profit-

and-loss statements, Which former executives say has caused infighting.,・24

Other issues stem from loss of economies of scale or increased costs and ine鯖ciencies, Or

even inconsistencies, and complexity・ This is reflected in the situation that Alex Gorsky’a

21-year Johnson & Johnson veteran who was named CEO in Apri1 2012’inherited:

The J&J that Gorsky inherited was superficia=y easy to understand: 40% of sales came
from drugs, anOther 40% from medical devices’and the rest from consumer products" Dig

deeper and it was unimaginab看y compiex: 275 operating companies, 450 distribution cent-

ers, mOre than 120 manufacturing sites’500 outside manufacturers, and 60 enterprise

resource-Planni=g SyStemS〇一t was more a flo制a of speedboats than a singie ship" in the

past, that famous decentralization inspired entrepreneurial thinking・ Lately’it caused quaI-
ity-COntrO- probIems that bedevi-ed the company"25

Gorsky said: “We have to be more decisive and disciplined’and more e鯖cient- Otherwise’it

is too complex, and it costs too much.,, part of that was addressing decentralization‥ Gorsky

introduced a program to centralize procurement, Which would enhance J&J’s buying power. He

also ordered up new quality and compliance controIs to ensure consistent standards.26
Decentralization may also increase overlap’and curiously’it ``may also create more oppor-

tunities for corruption by increasing the number of decision makers with the power to exploit
the decision-making process for personal gain.・,27 For example’When pursuing rapid growth

in China, French hypermarket Carrefour faced systemic corruption among its management
ranks at the loca=evels. Unlike the centralized approach to management that Wal-Mart

36
 Resuits controis and the controi probiems

employed in China, Carrefour empowered local managers to take charge of virtually all
aspects of runIr料g their stores, including product pricing and promotions, SuPPlier selection,

and store desig丘Whereas this high degree of flexibility gave ample leeway for managers to

expand fast in the early stages of building the chain, it also encouraged widespread bribe-
taking at the loca=evel and, OVer time, led to higher operating costs and reputation risk than
would a centralized system.28
But decentralization puts decision making cIosest to where the detailed knowledge and
understanding of the business resides, allowing greater responsiveness. `A decentralized struc-
ture provides better information over time, Which helps decision-making and accountability,’’

said Lambert of Sears,29 and echoed by Airbus chiefFabrice Bregier‥

Now is the time to give a littie bit more power to iocai teams in our countries, in our pro-

grams, in our pIants [as] we need to take decisions faster. This is a weakness of Airbus. it
takes much too -ong to make decisions,一want to speed it up and simp-ify it.30

The chief executive at China’s Huawei, Ren Zhengfei, Put it as follows:

The future mode=s to give the biggest say to our Iocai teams who are cIosest to our cus-
tomers and empowerthem so they have flexibiIity in interaction with customers, The head-

quarters or corporate functions w冊change into a more supporting and service function"31

And at Samsonite, the luggage maker, Chief executive Tim Parker said:

i think we were trying to run a very centraIized business in a marketpIace where our con-
SumerS d田ered enormousiy. We had to decentraIize our decision-making, So we created

an Asian business, a Europe business and an American business, and that a=owed each
management team to concent「ate on -oca- customers"32

The multitude of examples above also illustrate that firms can decentralize by geographical
regions, business groups or segments, PrOduct lines, Or a Variety of other lines of delegation in
their organization structure. One critical point, however, is that dece庇rC亜za亡王orl Or “delegation

Ofdecision rights’’to managers, and the design of証cendve eys亡ems to motivate these managers

to generate the desired results, are tWO Critical organizational design choices in a results-COn-
troI context; they are part ofwhat organizational theorists call the o7ga証zc証o融Z arc柾亡ec亡ure.

This literature maintains that organizational choices about decentralization and incentive sys-
tems should be madejoir亘ty, and that concentrating on one element to the exclusion ofthe other

will lead to poorly designed organizations.33

Resu看ts controIs and the controi problems

Results controIs provide several preventive-tyPe benefits, Well-de宜ned results inform empIoy-

ees as to what is expected ofthem and encourage them to do what they can to produce the
desired results. In this way, the results controIs alleviate a potentia=ack of direction. Results
COntrOIs also can be particularly e任ective in addressing motivational problems. Even without

direct supervision or interference from higher up, the results controIs induce empIoyees to
behave so as to maximize their chances of producing the results the organization desires. This
motivational effect arises particularly when incentives for producing the desired results also
further the empIoyees’own personal rewards. Finally, reSults controIs also can mitigate per-

SOnal limitations. Because results controIs typically promise rewards for good performers, they
Can help organizations to attract and retain employees who are con丘dent about their abilities.

37
Chapter 2. Pesuits ControIs

Results controIs also encourage empIoyees to develop their talents to position themselves to
eam the r鼠Ilts-dependent rewards.34

The perforIrihce measures that are a part of the results controIs also provide some non-
motivational, detection-tyPe COntrOl benefits of a cybemetic (feedback) nature, aS WaS men-
tioned in Chapter l. The results measures help managers answer questions about how various
strategies, Organizational entities, and/Or emPIoyees are performing. If performance fails to
meet expectations, managerS Can COnSider changing the strategies’the processes’Or the man-

agers・35 Investigating and intervening when performance deviates from expectations is the

essence of a mrlage肌e庇-dy-eXCePttOrl aPPrOaCh to management, Which large organizations

COmmOnly use・

Elements of resu看ts controIs

The implementation of results controIs invoIves four steps: (1) defining the dimension(s) on
which results are desired; (2) measuring performance in the chosen dimensions; (3) setting

performance targets for employees to attain for each ofthe measures; and co providing rewards
for target attainment to encourage the behaviors that will lead to the desired results. While
these steps are easy to list, eXeCuting them effectively can be challenging.

Defining performance dimensions

Defining the right performance dimensions invoIves balancing an organizations’responsi-

bilities to all of their stakeholders, including owners (equity holders), debtholders, emPIoy-
ees, SuPPliers, CuStOmerS’and the society at large. Should a firm,s sole aim be to maximize

shareholder retums, Or Should it also, Or eVen Primarily, be customer- Or emPIoyeefocused?

Are these performance foci mutually exclusive, Or are they rather mutually reinforcing?36
Where do performance dimensions such as imovation and sustainability belong? And so on.
As challenging as defining the desired performance dimensions may be, it is equally critical
to choose performance measures that are coJtgruerlt Or品grled with the chosen perfomance

dimensions because the goals that are set and the measurements that are made wi11 shape
employees, views of what is important. Phrased differently, W庇tyou measL‘re is w姐you get・

For example, firms may define one of their desired perfomance dimensions to be shareholder
value creation, and yet measure performance in terms of accounting profits. This implies that
empIoyees are likely to try to improve the measured pe所かmcmce (in this example, aCCOunting

profits) regardless of whether or not it contributes to the desired pe7舟rmc耽e (in this example,
shareholder value). We discuss this problem, and the di鯖culties related to this particular exam-

ple, further in Chapters 5’10・ and ll・

Similarly, fims may aim to pursue innovation’yet they end up measuring patents創ed.

Anxious to promote innovation, many COmPanies offer incentives to their empIoyees to

develop patentable ideas, and such incentives are likely to produce results in the fom of an
increase in the number of patents乱ed. But as Tbny Chen’a Patent attOmey With Jones Day

in Shanghai, nOteS, “PatentS are eaSy tO創e, but gems [can be] hard to find in a mountain

ofj皿k.,,37

citibank・s chief executive, Michael Corbat, Slightly rephrased this adage by proclaiming

that ・you are w砧you meaSL‘re・,,38 He felt he needed to measure perfomance in five catego-

ries to try to a11eviate the singular focus of managers on one measure’eXaCtly becauseyou get

whcltyOur meaSure・ His plan was welcomed by an analyst who commented that =the most

important job of a CEO is to make sure that the right incentives are in place [because]
improper measures lead to improper behavior・,,39 we discuss the use of multiple measures of

38
 EIements of resuits controIs

Performance, SuCh as by way of so-Called scorecards, Which Mr. Corbat advocated at Citibank,
inChapterll. _
The problem of misalignment has also been at the heart of some of the work by Jean Tirole,
the 2014 Nobel Prize winner in economics. Tirole examines the undesirable consequences that
performance-dependent incentives in the measured areas can have, either by skewing how
empIoyees approach theirjobs, Shifting e任brt away from less-eaSily measured (and hence unre-

warded) tasks such as Iong-term investments, emPIoyee development, and within-firm cooper-
ation; Or by undermining work ethic by encouraging excessive risk-taking, inducingバmanaged’’

pe正brmance or producing “fudged・・ performance metrics.4O The first part of this problem - the
Skewing part - is known in the literature as the m血t亡as短ng problem, and we discuss it in more

detail in Chapter 5.
Even though Bfoo肌be7官COnCluded that ``there’s a role for Tirole to advise on how to struc-

ture compensation without inciting the kind of disastrous risk-Chasing that sparked the finan-
cial crisis,,41 this important congruence problem also surfaces in many other sectors’

including the non-PrOfit sector・ For example, a Study by the Home O鯖ce in the United King-

dom found that organized tra鯖cking was a “thriving industry’’that “makes a killing,’’amass-

ing healthy profits with little risk of detection. The study suggested that one ofthe reasons for
this was the ill-defined performance targets that the police had to meet. Solving high volumes
Of simple crimes such as petty thefts and home burglaries is easier and cheaper than the long-
drawn-Out and expensive police work that is needed to crack down on tra綿cking rings. Even

though the goal was to reduce crime, the result may have been that hardened criminals were
leto請42

Hence, nOt Only do firms need to decide what is desired, but they also must ensure that their
measurements of the desired performance dimensions are aligned with what is desired・ If they

are not, the results controIs are likely to encourage employees to produce l‘JldesIred results. The

results controIs can then be said to have肌王rlterlded coJtSeql上enCeS.

Measuring performance
As per the above, then, meaSurement is a critical element ofa results-COntrOI system. The oセject

of the measurement is typically the performance of an organizational entity or an employee

during a speci丘c time period. Many o車iec互ve financial measures, SuCh as net income, eamings

per share, and retum on assets, are in common use. So, tOO, are many Objective nonfinancial
measures, SuCh as market share, CuStOmer Satisfaction, and the timely accomplishment of cer-
tain tasks. Some other measurements invoIve s担yec亡ive judgments invoIving assessments of

qualities; for example, “being a team player’’or “developing employees e任ectively.’’

Performance measures typically vary across organizational levels. At higher organizational
levels, mOSt Of the key results are defined in either stock market terms (such as share price)
and/Or丘nancial or accounting terms (such as a retum on equity). Lower-1evel managers, On

the other hand, are tyPically evaluated in terms ofoperational measures that are more control-
lable at the loca1 1evel. The key result areas for a manager in charge ofa manufacturing site’for

example, might be a combination of measures focused on production e鯖ciency’inventory con-

trol, PrOduct quality, and delivery time" The variation in the use of丘nancial and operational

performance measures between higher- and lower-level management creates a届nge in the
management hierarchy. That is, at SOme Critical middle organizationa1 1evel’Often a profit

center level (see Chapter 7), managerS muSt tranSlate financial goals into operational goals.
These managers’goals are defined primarily by financial measures, SO their communications

with their superiors are primarily in financial terms. But because their subordinates’measures

are primarily operational, their downward communications are primarily in operational

termS.

39
Chapte「 2. BesuIts Controis

If managers identify more than one result measure for a given empIoyee’they mu§t attaCh

weigh亡噛to each measure so that the judgments about performance in each result area can be

aggregated info in overall evaluation. The weightings can be additive. For example, 60% ofthe
overall evaluation is based on retum on assets and 40% is based on sales growth. The weight-
ings can also be multiplicative. For example’aChievement of profit and revenue goals might be

multiplied by a score assessed on the basis of environmental responsibility. If the environmen-

tal responsibilityscore is less than 70%’Say’the multiplier is zero, yielding no bonus. Sometimes’

organizations make the weightings of performance measures cxpZicit to the empIoyees・ aS in the

example just presented. Often’however’the weightings are partially or totally impZic互such as

when the performance evaluations are done supectively. Leaving the weighting implicit blurs
the communication to empIoyees about what results are important. Employees are left to infer
what results will most affdet their overall evaluations. That said’eVidence suggests that implicit

weights can generate improvements in performance and’thus, Can be effective as an alterna-

tive, Or at least complement, tO the explicit weighting of performance measures in incentive

contracts.43

Setting performance targetS

performance targets are anOther important results-COntrOl element because they affect behav-
ior in two ways. First’they improve motivation by providing 。ear goals for empIoyees to strive

foL Most people prefer to be given a specific target to shoot for’rather than merely being given

vague statements like “do your best,, or “work at a reasonable pace享4 second’Perfomance

targets allow empIoyees to assess their performance・ People do not respond to fdedback unles§

they are able to interpret it’and a key part of interpretation invoIves comparing actual pe血-

mance relative to target. The targets distinguish strong from poor performance. Failure to
achieve the target signals a need for improvement. (We discuss performance targets and target
setting processes in more detail in Chapter 8.)
The following example illustrates both points. Maria Giraldo, a nurSe in the intensive care
unit at Long Island Jewish Medical Center’uSed to be evaluated on such criteria as leadership・

respectfulness’and how well she worked with others. A few years ago’her hospital imple-

mented a new computer-based performance system that broke down her job description into

quantifiable goals’SuCh as to keep infection rates for her unit low and patient satisfaction
scores high, a11 relative to specific target levels. Ever since this new system waS implemented,
at review time, the discussion does not linger on about how Ms. Giraldo had performed. Either
she hit the targets, Or She did not. The clarity about measures and goals, and the reviews ``by
the numbers” that they a11ow’Changed Ms. Giraldo,s views about success and what she needs

to do to get ahead in her career- a11 for the better’She believed.45 (In Chapter 9, We discuss the

drawbacks of relying exclusively on ot)jective, formulaic performance evaluations in more

detail.)

Providing rewards

Rewards or ince証ves are the final element of a results-COntrOI system. The rewards included in

incentive contracts can cOme in the form of anything empIoyees value’SuCh as salary increases’

bonuses, PrOmOtions,46 job security, job assignments, training opportunities’freedom, reCOgni-

tion, and power・ Punishments are the opposite of rewards. They are things empIoyees dislike,

such as demotions, SuPerVisor disapproval’failure to eam rewards that colleagues eam’Or, at

worst, dismissal.

40
 Eiements of resuIts cont「oIs

Organizations can elicit motivational effects from linking the prospect of rewards (or
Punishment) tQ近eSults that empIoyees can influence. For example, Organizations can use
any of a numberof融rinstc rewards・ They can grant additional monetary rewards, SuCh as

in the form of cash or stock. They can use non-mOnetary reWards, SuCh as by granting high-
Performing empIoyees public recognition and more decision authority. Altematively, in
entities where performance is mediocre or poor, they can threaten to reduce the decision
authority and power that managers derive from managing their entities or decline to fund
PrOPOSed prQjects.
Results measures can provide a positive motivational impact even if no rewards are explic-
itly linked to results measures. people often derive their own intemally generated誼でrtrlStC

re胸rds through a sense of accomplishment for achieving the desired results. For example,

When William J. Bratton became the New York City police commissioner, he gave his police
force one dear’Simple goal: Cut Crime.47 (Previously the thinking had been that crime was due

to societal factors beyond the department,s control, SO the police were measured largely by how

quickly they responded to emergency calls.) He also implemented a results-COntrOI system. He

decentralized the department by giving the 76 precinct commanders the authority to make
most of the key decisions in their police units’induding the right to set personnel schedules,

and he started collecting and reporting crime data daily. Even though Commissioner Bratton
lega11y could not award good performers with pay raises or merit bonuses, the system was
deemed eifective. In the subsequent two years, m匂or felonies in New York fell first by 12% and

then a further 18%’reSPeCtively. This clearly could not have been attributable to pay-for-Perfor-

mance in the strictest sense; it was instead due’at least in part, tO PrOViding o鯖cers with clear

goals and empowering them to go about fighting crime. Seeing the results of their initiatives
may have given police o鯖cers a sense of accomplishment and a greater intrinsic motivation to

Perform well.
The motivational strength of any of the extrinsic or intrinsic rewards can be understood in
terms of several motivation theories that have been developed and studied for over 50 years,
SuCh as e埠,eCrCmey鳳eo7γ Expectancy theory postulates that individuals, motivational force, Or

effort, is a function of (1) their expec亡anctes, Or their beliefthat certain outcomes will result from

their behavior (e.g. a bonus for increased effort); and (2) their血erlCeS, Or the strength of their

Preference for those outcomes. The valence of a bonus’however, is not always restricted to its
monetary value; it al§O may have valence in securing other valued items, SuCh as status and

prestige.48
Organizations should promise their empIoyees the rewards that provide the most powerful
motivational effects in the most cosトeffective way possible. But the motivational e飾ects of the

Various forms of reward can vary widely depending on an individual,s personal tastes and cir-
CumStanCeS. Some people are greatly interested in immediate cash awards, Whereas others are
more interested in increasing their retirement benefits, increasing their autonomy, Or improv-
ing their promotion prospects. Reward tastes also vary across countries for a number of rea-
SOnS’induding differences in cultures and income tax laws.49 However, if organizations can

tailor their reward packages to their empIoyees, individual preferences, they can provide mean-
ingful rewards in a cost-e鯖cient manner. But tailoring rewards to individuals or small groups

Within a large organization is not easy to accomplish and is sometimes even seen as possibly, Or
even legally, inequitable. A tailored system will likely be complex and costly to administer.
When poorly implemented’it can easily lead to empIoyee perceptions of unfalmess and poten-

tia11y have the opposite effects of those intended: demotivation and poor empIoyee morale. We
discuss the choice ofdiiferent forms of incentives and incentive system design in more detail in
Chapter 9.
三雲霧

41
Conditions determi巾ng the e情ectiveness of resuits contro!s

Although they are an important form of control in many organizations, reSults controIs cannot
atways be used effectively. They work best only when dZ ofthe following conditions are present:

1. Organizations can determine what results are desired in the areas being controlled;

2. The empIoyees whose behaviors are being controlled have significant influence on the
results for which they are being held accountable; and’

3" Organizations can measure the results effectively.

Knowledge of desired results

For results controIs to work, Organizations must know what results are desired in the areas they
wish to control, and they must communicate the desired results effectively to the employees
working in those areas. Res庇s des{rc[拙ty means that more of the quality represented by the

results measure is preferred to less, eVerything else being equal・

As we allud。d to earlier, eVen if one might agree that (one of) the primary dbjective(S) of for-

profit firms or corporates is to maximize shareholder value, this does not imply that the desired
results, eVen if the overall o旦iective is understood, Will be unequivocally known or have unam-

biguous meaning at all intermediate and lower levels in the organization. The disaggregation of
overall organizational objectives into specific expectations for all empIoyees Iower in the hier-
archy is often di飴cult. Different parts of the organization face different tradeoffs.

For example, PurChasing managers create value by procuring good-quality’low-COSt materi-

als on time. These three result areas (quality, COSt, and schedule) can often be traded offagainst
each other, and the overall organizational objective to maximize profit provides little guidance
in making these tradeoffs. The importance ofeach ofthese results areas mayvary over time and
among parts of the organization depending on differing needs and strategies・ For example’a

company (or entity) short of cash may want to minimize the amount of inventory on hand’

which may make scheduling the dominant consideration. A company (or entity) with a cost
leadership strategy may want to emphasize the cost considerations. A company (or entity) purL
suing a unique product quality image or differentiation strategy may emphasize meeting or
exceeding the specifications of the materials being purchased. Thus’tO enSure PrOPer PurChas-

ing manager behaviors’the importance orderings or weightings of these three results areas

must be made dear and aligned with the strategy.

If the wrong results areas are chosen’Or if the right areas are chosen but given the wrong

weightings, the combination of results measures will not be congr脚亡with the organization’s

intended objectives. Using an incongruent set ofresults measures may then result in motivating
empIoyees to take the wrong actions. In the above setting’for example, ill-guided cost consid-

erations may damage the company’s pursued product-quality reputation.

Ab皿y to infiuence desired results (COntrOllab皿y)

A second condition that is necessary for results controIs to be effective is that the empIoyees
whose behaviors are being contro11ed must be able to aifect the results in a material way in a

given time period. This confro批品据typrinciple is one of the central tenets of responsibility
accounting twhich we discuss in more detail in Chapters 7 and 12)・ Here are some repreSenta-

tive expressions that have stood the test of time of this perennial principle:

It is almost a self-eVident p「oposition that, in appraising the performance of divisionaI

management, nO aCCOunt Shou-d be taken of matters outside the division’s contro一・50

42
 Conditions determining the effectiveness of resuits controis

A manager is not norma=y heid accountabIe for unfavorabIe outcomes or credited with
favorab-e o凸2S if they are c-ear-y due to causes not under his contro一〇51

The main ration乱e behind the controllability principle is that results measures are useful

only to the extent that they provide information about the desirability of the actions or deci-
sions that were taken. If a results area is totally uncontrollable, the results measures reveal
nothing about what actions or decisions were taken・ Partial controllability makes it difficult to

infer from the results measures whether or not good actions or decisions were taken.
In most organizational situations, Of course’numerOuS unCOntrO11able or partially uncontrol-

lable factors inevitably affect the measures used to evaluate performance. These uncontro11able
in且uences hinder efforts to use results measures for controI purposes, As a consequence, it

becomes di飴cult to determine whether the results achieved are due to the actions or decisions

taken or, rather, tO unCOntrOllable factors or JIO王se・ Good actions and decisions wi11 not necessar-

ily produce good results. Bad actions or decisions may similarly be obscured.
In situations where many significant, unCOntrO11able influences a任ect the available results

measures, reSults control is not eifective. Managers cannot be relieved of their responsibility
to respond to some uncontrollable factors or be exempted from dealing with reasonable or
normal uncertainty in their environment; but if these factors’Or the uncertainty’are difficult

to separate from the results measures’reSults controIs do not provide good information for

either evaluating performance or motivating good behaviors. We discuss the methods that
organizations use to cope with uncontrollable factors in results-COntrOI systems in more detail
in Chapter 12.

Ab皿y to measu「e controIlabie resuits e惰ectiveIy

Ability to measure the controllable results effectively is the final constraint limiting the feasi-
bility of results contro工s. Often the controllable results that the organization desires’and that

the employees involved can affect’CannOt be measured eifectively. In virtually all situations,

some掘ng can be measured; but often, however, the key results areas camot be measured

錐c亡王γeか
The key criterion that should be used tojudge the effectiveness of results measures is the
ability to evoke the desired behaviors. If a measure evokes the right behaviors in a given situ-
ation葛that is, ifthe measure can be said to be coれgruerl亡With the desired results area - then

it is a good control measure. If it does not’it is a bad one’eVen if the measure accurately

reflects the quantity it purports to represent; that is’eVen if the measurement has little meas-

Tb evoke the right behaviors, in addition to being congrue加and co庇roZZc謝e, reSults meas-

ures should be precise, O切ec亡ive, [王metw and肌der如nda弛. Even when a measure has a1l ofthe

above qualities, it should also be cos亡c研cie証; that is, the costs of developing and using the

measure should be considered.

Precision
Measurements inevitably contain error, SOme random’SOme SyStematic. Error makes the meas-

urement inaccurate. Measurement accuraey refers to the degree of doseness of measurements

of a quantity to its actual (true) value. Precisiowis the degree to which repeated measurements
under similar conditions show the same result; if they do, the measurements can be said to be
re融bZe. Using a bull,s-eye analogy, aCCuraq′ describes the doseness of arrows (measurement)

to the target (true value). When all arrows are grouped tightly together, the cluster of arrows
(measurement) is consideredpγeCこse since they all struck dose to the same spot, eVen ifnot nec-

essarily near the bu11’s-eye.

43
Chapter 2. ResuIts Controis

Reducing systematic error (or弛s) improves accuracy but does not change precision" How-

ever, it is n鏡possible to achieve accuracy in measurement without precision; that is’When the

measures ccntain’mostly random error or, thus’When they are unreliable. In other words’and

in the bull・s-eye analogy, ifthe arrows are not grouped 。ose to one another’they cannot all be

dose to the bull,s-eye. Therefore’1ack of precision is an undesirable quality for a results meas-

ure to have. But even precise measures that are biased (i.e. that contain systematic error) may
not be of great use for controI purposes. If the degree of the systematic error is not known; then
the measurement wi11 be systematically biased by either showing greater or lesser values than
the actual value (see the next section on o巧ec亡i高ゆ・

It is obvious that some aspects of performance (such as social responsibility’leadership acu-

men, and personnel development) are difficult’Or eVen impossible’tO meaSure PreCisely’either

because the measurements contain random error or are systematically biased (such as may be
the case when su11iective performance evaluations are used). Precision’therefore, is important

because without it, the measure loses much of its information value. Imprecise measures
increase the risk of misevaluating performance. Employees will react negatively to the inequi-
ties that inevitably arise when equally good perfbmances are rated differently.

Objectivity
An o卸ec亡工ve measure here means that it is not influenced by personal feelings’mental states’

emotions, taSteS, Or interpretations - hence, that it is肌btαSed. Measurement objectivity will be

inevitably suspect where either the choice of measurement rules or the actual measurmg lS
done by the persons whose performances are being evaluated. Low objectivity is likely’for

example, Where performance is se11reported or where evaluatees are allowed considerable dis-
cretion in the choice of measurement methods. Indeed, and referring to the earlier definition
related to measurement precision, low objectivity is likely to introduce systematic error due to,
for example, Selectivity, 1eniency, Or lack of self-Criticalness. If that is the case’the measure-

ment may be precise’but it wi11 not be accurate. Good measures for controI purposes therefore

should be both precise (reliable) and objective (unbiased).

There are two main ways to increase measurement objectivity. The first is to have the meas-
uring done by people independent of the processes that generate the results’SuCh as by person-

nel in the controller,s department. The second is to have the measurements verified by
independent parties, SuCh as auditors.

TimeIiness
T王肌e軸ess refers to the lag between the empIoyee,s performance and the measurement of

results (and the provision of rewards based on these results). Timeliness is an important meas-
urement quality for two reasons. The first is motivational. EmpIoyees need repeated perfor-
mance pressure to perform at their best. The pressure helps ensure that the emI)loyees do not
become complacent, inattentive’SIoppy, Or WaSteful. Measures’and thus rewards’that are

delayed for significant periods of time lose most of their motivational impact. The sustained

pressure can also encourage creativity by increasing the likelihood that employees will be stim-
ulated to repeatedly search for new and better ways to improve results.
As The F証a近aZ Times noted about deferred bonuses in banks,偉beloved by the regulators

because they allow the payout to be adjusted if conditions change’[they do’howeve巾reduce

the motivational value of bonuses - by the time the empIoyees receive the money they may not
remember what was being rewarded’,・52 making it also unlikely that the rewards will affect or

adjust the behaviors that led to those results.

A second advantage is that timeliness increases the value of interventions that might be nec-
essary. If significant problems exist but the performance measures are not timely, it might not
be possible to intervene to fix the problems before they cause (more) harm.

44
 Conditions determining the e値ectiveness of resuIts controIs

Understandability
Two aspects互肌ders亡anda掘dy are important. First, the empIoyees whose behaviors are being

controlled mdst urrderstand what they are being held accountable for. This requires communi-
cation. Training, Which is a form of communication, may also be necessary if, for example,
employees are to be held accountable for achieving goals expressed in new and different terms,
such as when an organization shifts its measurement focus from accounting income to, Say,
economic value added (more on this in Chapter ll)・

Second, emPIoyees must understand what they must do to influence the measure’at least in

broad tems. For example, PurChasing managers who are held accountable for lowering the
costs of purchased materials will not be successful until they develop strategies for accomplish-
ing this goal, SuCh as improving negotiations with vendors’increasing competition among ven-

dors, Or WOrking with engineering personnel to redesign certain parts" Similarly, emPloyees
who are held accountable for customer satisfaction must understand what their customers
value and what they can do to affect it. The same holds for teachers in universities who often do
not understand what specific teaching skills or approaches result in better (or worse) teaching
evaluations by their students at the end ofthe term.
When empIoyees understand what a measure represents’they are empowered to work out

what they can do to influence it. In fact’this is one ofthe advantages of results controIs‥ gOOd

controI can be achieved without knowing exactly how empIoyees will produce the results.

Cost e情ciency

Fina11y, meaSureS Should be cosf e伊cZe証A measure might have all of the above qualities and

yet be too expensive to develop or use (e.g. when it invoIves third-Party SurVeyS Of customers’
say, tO COllect the data), meaning that the costs exceed the benefits. When that is the case’the

fim may need to settle for an altemative’mOre COSt-e鯖cient measure. Advances in technoIogy

and data analysis, SuCh as related to αbig data,,, have made data that had hitherto been hard to

obtain or analyze more readily available. But data are not information’and these data do not

uniformly have good properties, Where much of it is unstructured. For example’understanda-

bility in terms of the claimed relationships with specific actions and decisions often is particu-
larly problematic. And even o助ectivity can be an issue, Perhaps surprisingly, because, aS it has

been said, “tOrture the data long enough and they wi11 confess to anything.,,53

For example, Califomia,s MemorialCare Health System is part of a movement by hospitals

around the United States to change how doctors practice by monitoring their progress toward
goals. What is different this time’SOme hospital executives argue’is that ``new technoIogy ena-
bles closer, faster tracking ofindividual doctors’,, where MemorialCare is keeping detailed data

on how the doctors perform on many measures’including adolescent immunizationsブmammO-

grams, and keeping down the blood-Sugar levels of diabetes patients. The results are compiled,
number-CrunChed, and eventually used to help detemine how much money doctors wi11 eam,
where the new insurance payments also factor in quality goals. An assessment of this ``doctor-
data,, system indicates that it has helped reduce the average stay for adult patients’trimmed the

average cost per admitted adult patient’and led to improvements in indicators of quality’

including patient re-admissions, mOrtality’and complications. This has not been unconten-

tious, however. Cardiologist Venkat Warren said that he worried that負some bean-COunter Will

decide what performance is,・ and wondered whether doctors would be pushed to avoid older

and sicker patients who might drag down their numbers.54

Overall, many meaSureS CamOt be dassi亀ed as either dearly good (effectivO or poor (inef

fective). Different tradeoffs among the measurement qualities create some advantages and dis-
advantages. For example, meaSureS Can Often be made more congruent’COntrOllable’PreCise

and objective if timeliness is compromised. Thus, in assessing the effectiveness of results

45
Chapter 2. Results Controis

measures, many di鯖cult judgments are often necessary. These judgments are discussed in

more detail throughout several chapters of this text.

ConcIusion

This chapter described an important form of control, reSults control, Which is used at many lev-
els in most organizations. Results controIs are an indirect form of control because they do not
focus explicitly on the empIoyees, actions or decisions" However, this indirectness provides
some important advantages. Results controIs can often be e節ective when it is not clear what

behaviors are most desirable. In addition, reSults controIs can yield good controI while allowing
the employees whose behaviors are being controlled high autonomy. Many people, Particularly
those higher in the organizational hierarchy but also so-Called knowZedge workers, Value high
autonomy and respond well to it, although they may not always respond well to the measures
used, Particularly when these suifer from significant weaknesses in terms of the various meas-
urement properties we discussed.
Results controIs are therefore clearly not effective in every situation. Failure to satisfy all
three effectiveness conditions - knowledge of the desired results, ability to affect the desired
results, and ability to measure controllable results effectively - Will impair the results controIs’

effectiveness, if not render them impotent. Worse, it could produce dysfunctional side effects’

various forms ofwhich we discuss in later chapters.

That said, reSults controIs usually are the major element of the management controI system
(MCS) used in all but the smallest organizations. However, reSults contro量s often are supple-

mented by action and personnel/Cultural controIs’Which we discuss in the next chapter.

Notes

l “Lord ofthe Rigs,’’励rbes (March 29, 2OO4), P. 68. a Manufacturing Firm,’’嵐上rOPearl Accol抑血g Reγ[e丁年24,

2 “Measuring People Power,’’Forさ肌e (October 2, 2000), P. no. 2 (2015), pp. 241-76.

186. 11 As an example of several results-COntrOl issues that can

3 “Bank Bonuses: Bashing Ignores the Benefits for Inves- arise when these condi亡ions are not met, See S. Kerr, “The

tors,,, FirlarlCiαけtmes (November 27, 2015), Online at on. Best-Laid Incentive Plans;’HαrVard BllSfrleSS Re高ew, 81,

ft. com/ 1 kXpBJ9" no. 1 Uanuary2003), PP. 27-40.

4 Ibid. See also “Geithner: Link Executive Pay to Perfor- 12 See, for example, K. H. Blanchard, J. P. Carlos, and W. A.
mance:’The Was砧ng亡orl Hmes (June lO, 2009), Online at RandoIph, The T加ee Keys fO Empowerment (San Fran-

WaShingtontimes.com. cisco, CA: BerretトKoehler Publishers, 1999). AIso see ``C.

5 “Performance Pay Likely for Doctors,’’The Austrd誼n Oswick,伍Engaging with EmpIoyee Engagement in HRD

(May 6, 2009), Online at www.theaustralian.com.au. Theory and Practice,,, Humarl Resource Deve!opmerl亡

6 ``Hospitals Prescribe Big Data to Track Doctors at Work’’’ Re高ew (2015), PP. 1-9, Parti⊂ularly Figure l, P. 2.

The W硯SfreetJoIJr棚Z (July ll, 2O13), Online atwww" 13 M. Hammer, Bのりrld Reengineering: How血e Process-Cen-
W♀き・COm・ tered Orga庇如亡io証s Charlging Our Work肌d Our Lives

7 “Medicare,s $963 M皿on Experiment,’’軌s[rleSS Week (New Ibrk: Harper Business, 1996).
(September 6, 2O12), Online at www.bloomberg.com. 14 A. P. Sloan,砂地rs証h Gerlera耽oto「s (NewYork: Dou-
8 “From AIpha to Omega:’T庇Ecor10mist (August 15,  bleday, 1964).
2015), Online at econ.st/1J5S3AE.        15 “For DuPont, Christmas in April’,, Busi71eSS Week (Apri1

9 S. J. Condly, R. E. Clark, and H, D. StoIovitch, “The Effects  24, 1995), P. 130.

ofIncentives onWorkplace Performance: A Meta-Analytic 16 Ibid., P. 129.

Review of Research Studies,,, pe垂rmarlCe Improveme庇17 ``Sanofi Seeks E描ciencies with New Model:’The Bosfon

Qmr亡erly, 16, nO. 3 (2003), PP. 46-63・ Gfobe (August 16, 2010), Online at www.boston.com.
10 I, Friis, A. Hansen, and TVamosi, ``On the Effectiveness of 18 `Air Products Unveils Widespread Reorganization,’’The

Incentive Pay: ExpIoring Complementarities and Substi- W拙S亡reet JourrlαZ (September 18, 2014), Online at on.

tution between Management ControI System Elements in W垂com/ 1w5yrGy.

46
 Notes

19 “In Break with Past, No More Passing the Buck at Opel,’’ 35 See, forexamp獲e, D. Campbell, S. Datar, S. L. Kulp’andV.

Reu亡ers (December 6, 2009), Online_at WWW.reuterS"COm. G. Narayanan, ``Testing Strategy with Multiple Perfor-
20 R. H. Chandler, quOted in “Sunrise Scam Throws Light on mance Measures: Evidence from a Ba獲anced Scorecard at

Incentive Pay Programs,’’The Los AngeZes TZmes (January Store 24,,, J。urrlaZ Qf財arlagemerl亡Acco肌血g Research,

1与, 1996), p. D3・ 27, nO. 2 (Fal1 2O15), PP. 39-65.

21 The details of Lincoln Electric’s legendary JrlCe融ve Pe)佃r- 36 ``Shareholders vs. Stakeholders: A New Idolatry;’T心e

martce?yste肌are described in the case bearing the compa- Econo証s亡(Apri1 24, 2010), PP. 65-6.

ny,s name at the end of Chapter 4. See also “Ohio Firm 37 ``patents, Yes; Ideas, Maybe,7’丑e EcorlOmis亡(October 14,

Relies on Incentive-Pay System to Motivate Workers and 2010), pp" 78-9・

Maintain Products,’’T九e W拙S亡reet JoI上γmZ (August 12, 38 “Citi’s CEO Is Keeping Score;, The Wa甘sfree亡JourmZ

1983), P. 23; and “Lincoln Electric‥ Where People Are Never (March 4, 2O13), Online at www.w吏i・COm.

Let Go,” Hme (June 18, 2001), P. 40. Tbday, the company’s 39 Ibid.
website states that最Every year since 1934, eligible empIoy- 40 See, for example, R. Benabou and J. Tirole’αBonus Cul-

ees have received a profit sharing bonus in December. ture: Competitive Pay’Screening and Multitasking,’’

Lincoln,s payfo叩erformance culture’reWards empIoyees Working Paper ]8963 (Cambridge, MA: National Bureau
for their contributions to the success and profitability of the of Economic Research, 2O13).
Company. The average bonus award over the last lO years 41 ``Banker Bonuses Get a Nobel Dis,’’Btoomberg VIew (Octo-

is 4O% of an employee,s year to date’base eamings’’ ber 13, 2014), Online at bv.ms/1toxQQN.
(www.1incolnelectric.com/en-u S/COmPany{areers/Pages/ 42 “Making a Killing,’’The Ecor10mfs亡(July 16, 2OO9), P. 36.

1incoln-tradition.aspx; aCCeSSed December 2015). 43 D. Campbell, ‖Nonfinancial Performance Measures and

22 ``This Is the Answer,’’BIJS証ess Week Uuly 5, 1982), PP・ 50-2. Promotion-Based Incentives,’’Jo置上rmZ qf Accou庇ing

23 J. Roberts, The Modern Fim: Orgarliza亡io7mZ Designjbr Researc九, 46, nO. 2 (2008), 297-332・

Peげor肌c[JICe arld Growth (New York‥ Oxford University 44 G. P. Latham, “The Motivational Benefits ofGoal-Setting,”

Press, 2004). Acαdeny qf晩rtc[gemerlt Execudve, 18, nO. 4 (November

24 “Lampert Cuts Sears Below 50% to Meet Redemptions,’’ 2004), pp. 126-9・

Bfoomberg (December 4, 2013), Online at bloom. 45 “Performance Reviews bythe Numbers’’’The VI硯Street
bg/1RodSO2. Jou刑αZ (June 29, 201O), Online at online.w争j.com.

25 “Embracing the J&J Credo,’’Bc[rrO証; (December 14, 2013), 46 See, for example, D. Campbell, ``Nonfinancial Perfor-
online at www.barrons.com. mance Measures and Promotion-Based Incentives,’’Jour-

26 Ibid. 朋Z QfAccourl亡王rlgResearch, 46, nO. 2 (2008), 297-332.

27 “OECD Casts Doubt on Indonesia Growth View,’’The W班 47 `A Safer New York City:’Business Week (December ll,

Stree亡JoL[rrlaZ (September 27, 2012), Online at on.w車 1995), p. 8l.

COm/10ao9zG. 48 V. H. Vroom, Worたarld Mot高ation (New York‥ Wiley,

28 “Carrefour Contends with Bribes in China,” Forbes 1964).

(August 27, 20O7), Online at www.forbes.com. 49 E, P. Jansen, K. A. Merchant, and W, A. Van der Stede,
``National Differences in Incentive Compensation Prac-
29 ``Lampert Cuts Sears Below 50% to Meet Redemptions,”

Op.Cit・ tices: The Diffc正ng Roles of Financial Performance Meas-

30 `Airbus ChiefBregier to Empower Local Sites in Company urement in the United States and the Netherlands,
Overhaul,,, BZoo肌beI官(September lO, 2O12), Online at Acco肌血g, Org肌浸;αfiorlS and Socie助34, nO. 1 (January

www.bloomberg,COm. 2009), pP" 58-84・

31 “Huawei,s Chief Breaks His Silence;’B重JSiness Week (May 50 D. Solomons, D高siomZ Pe函)rmanCe: Measuremeri弛融

9, 2013), Online at www.bloomberg.com. Corl亡rOき(Homewood, IL: Richard D, Irwin, 1965), P. 83・

32 αSamsonite Sees Rapid Growth in Asia,,, The W軸Streef 51 K. J. Arrow,寝Control in Large Organizations,,7 in M" Schiff

Jo工」rrmさ(December 29, 2013), Online at on.wsj. and A. Y. Lewin (eds.), Be庇VtoraZ Aspects qfAcco肌血g

COm/ 1 zDPRcr. (Englewood Cliffs, NJ: Prentice Hall, 1974), P. 284.

33 See, for example, J. Brickley, C. Smith, and J. Zimmer- 52 ``Bank Bonuses: Bashing Ignores the Benefits for Inves-
man, Marlageria! Ecor10m[cs肌d O7gC血zatio庇l Arc柾tec- tors,” op. cit.

ure (Boston, MA: McGraw-Hill Irwin, 2001). 53 `A Different Game: Information Is Transforming Tradi-

34 For the so-Called “selection e任ect’’benefits of (results) tional Businesses,,, The Economist (February 25, 2010),
controIs, See, for example, D. Campbell’``EmpIoyee Selec- online at http:〃econ.st/KAlqb8.

tion as a ControI System,’’JourrlC[Z QfAccou証fug Research, 54 “Hospitals Prescribe Big Data to Track Doctors at Work’’’

50, nO. 4 (September 2012), PP. 931-66. Op・Cit"

47
 CASE STUB)V
O冊ce Solutions, lnc,
In December 2014, Bob Mairena, PreSident of O鯖ce
Solutions, Inc., an O鯖ce supply distributor based in
Southem Califomia, WaS COnSidering making a signifi-
cant change in the compensation plan for his sales per-
sonnel. The company,s current compensation plan for
a11 sales personnel was based on sales commissions’
plus the potential for an incentive of 2-4% for achieve-
ment of some specific sales goals.
However, Bob had come to believe that a commis-
sion-based compensation system was appropriate
only for the few individuals bringing in significant
amounts of new business, those whom he called
“hunters.・, Most of the company,s salespeople were
not hunters; they were not generating significant
amo皿ts ofrrew business. Theywere more like account
managers who, Bob thought, Should be compensated
with a lower-risk plan based on a relatively high pro-
portion of guaranteed salary’SuPPlemented with a
perfomance-dependent bonus. Because of lower job
pressure and more stable compensation’the account
managers should be paid less than sales reps. O鯖ce
Solutions could use the cost savings to funnel more
money to the relatively few salespeople who were
generating growth opportunities for the company・
But Bob was not yet totally sure how the new system
should be designed and what kind of transition would
be required to get the salespeople comfortable with
the change.
The company
O鯖ce Solutions, Inc., headquartered in Yorba Linda’
Califomia, SOld and distributed a full range of o鯖ce
supplies to customers in Southem Califomia’from San
Diego in the south to Santa Barbara in the north. The
company was founded in 1984 by a husband-and-Wife
team, Bob and Cindy Mairena.
Prior to starting Office Solutions, Bob worked for
UPS and Cindy worked for an o鯖ce supply company・
48
Both Bob and Cindy had an entrepreneurial spirit and
were looking for an opportunity to start their own busi-
ness. They saw an opportunity in the early 1980s. Per-
sonal computers were just coming into prominence,
creating a new need for computer supplies. Traditional
office supply companies did not have the technical
expertise to sell computer supplies effectively. Bob and
Cindy prepared themselves by taking computer classes
at night・ By 1984, they had gained enough expertise to
start a company called Data Extras’the predecessor to
O鯖ce Solutions.
For several years, Data Extras successfully pro-
vided supplies to companies with computers. Eventu-
ally, however’COmPuter SuPPlies became a commodity,
and the expertise and consulting services that Data
Extras offered were no Ionger as valuable and the
business was not scalable. Bob and Cindy made a stra-
tegic decision to expand the business to carry a full
line of o範ce supplies. In 1989, the Data Extras name
was changed to O飴ce Solutions to reflect the change
in service scope.
Over the years, O範ce Solutions grew both organi-
cally and by acquisition. In 2014’it was generating
approximately $36 m皿on in annual revenue. The
company had llO empIoyees’induding 40 salespeople
who sold four product lines‥ O鯖ce supplies’Office fumi-
ture, facility supplies, and print services. (Exhibit l
shows an organization chart.) O飴ce Solutions used
23 company-OWned trucks to deliver its products to
O鯖ce Solutions used sophisticated management
techniques. Its distribution system was very e範cient.
The company carried only the most basic supplies in
its own warehouse. Most of the products sold were
delivered to them on the following morning and
delivered to the customer with a 98.5%飢I ratio. The
company was also metrics-driven. A vital-factor
spreadsheet’Which tracked sales, Sales leads・ and
multiple other measures’WaS PrOduced regularly・ An
 Office SoIutions, lnc.

electronic ticker on the wall tracked call-SerVice sta- Adding to the management challenges in the indus-
tistics in real time.        _ try, Sales of o鯖ce supplies were shrinking. As customers

0鯖ce Solutions had many long-tenured empIoyees moved toward digital information sharing, they needed
and a fun working atmosphere. For example, Bob was a fewer supplies such as paper, tOner, files, and binders.

PrOPOnent Of fitness. He encouraged empIoyees to wear Some privately owned distributors posted small posi-
exercise gear at work, and most of them participated in tive, Single-digit sales growth in 2013,1 but the big-box
a company exercise break twice a day. COmPanies in the industry were reporting continuing
O鯖ce Solutions offered every empIoyee, eXCluding sales declines. Sales at O航ce Depot fel1 4% in 2013,

those induded in any other incentive plan, a quarterly exduding effects of the merger with O綿ce Max. Staples’

incentive of l% of salary if the company made its sales declined 5% in 2013, and the company announced
quarterly profit numbers. This incentive was designed plans to 。ose more than 225 of 2’OOO stores.2
both to enhance unity of purpose and to share profits
and risks with the empIoyees. The O冊ce Solutions strategy

O鯖ce Solutions managers’understanding of the com-

lndustry environment petitive landscape allowed it to carve out a successful
COmPetitive niche. They categorized industry custom-
Until the mid-1980s, the office supply industry was
ers using a pyramid paradigm (see Figure l). At the
dominated by sma11, independently owned dealers,
bottom of the pyramid were small customers, defined
some owned by the same families for generations. Then
as businesses with l-15 empIoyees. These customers
three large big-box retailers - Staples, O鯖ce Max, and
typically bought o飴ce supplies directly from retail out-
O飴ce Depot葛aS Well as consolidators - SuCh as Corpo-
lets or online.
rate Express, USOP, and BT, Who were more focused in
the commercial contract space - entered the market. Figure l Customer pyramid
These o鯖ce supply giants built nationwide distribution

networks and retail presence. They enjoyed economies

ofscale, and they shaved margins. Among other things,
they offered “loss leaders;’selling some popular prod-

ucts at or below cost to attract new customers. In 2013,

Staples, the largest o鯖ce supply retailer, had annual

revenues of $23 billion. O鯖ce Depot and O飴ce Max

merged in November 2013 and had combined 2013 rev-

enue of $17 billion. The success of the big葛box stores
At the top of the pyramid were enterprise custom-
drove thousands of independent dealers out of busi-
ers, defined as businesses with 25O+ empIoyees. These
ness. But in 2014, the office supply industry still
businesses typically had multiple empIoyees purchas-
included the two remaining big-box companies, thou-
ing o飴ce supplies, but prices and product choices were
sands of independent retailers, and, increasingly,
controlled with a contract between the company and
online retailers such as Amazon that had moved into
the dealer that was negotiated at the corporate level・
the o鯖ce supply space. By early 2015, an additional
Staples and O鯖ce Depot served most of the enterprise
merger between Staples and Office Depot had been
customers. pricing strategy was the key to winning
negotiated and was awaiting FTC approval.
enterprise business. Dealers in this market segment
The independent dealers that survived consolida-
Offered popular products at low prices to win contracts;
tion and the onslaught ofthe retailers were strong deal-
margins for some products could be as Iow as 5%.
ers that were competitive, Independents still owned
These dealers had to bid carefully and have an excel-
about 35-45% of the market, and they were especially
lent understanding of product mix so that they could
strong in the small and medium business space. Two
win contracts and still eam a reasonable profit.
m亘ior wholesalers served this market. They both pro-

vided depth and breadth of product o任erings and pub-

1ished the two major marketing catalogs that were 1 M. E. Biery (2014). 0綿ce Supply Stores Seelng Profit Margins Erased,

customized by the individual dealers to provide brand- Forbes.com, April 13.

2 sEC創ings・
ing consistency in their speci丘c markets.

49
Chapter 2. PesuIts Controis
。。塁謹書蒜詰詰寄聖霊
customers with 15-250 empIoyees. These businesses
typica11yworked with dealers and had a single decision
maker responsible for all ofthe o飴ce supply purchases.
commercial customers were the most likely to value
strong relationships and excellent customer service・
office Solutions had recently started moving up the
customer pyramid’COmPeting for enterprise-level con-
tracts. Bob recognized the mergers of the big-box sup-
pliers as an opportunity. Enterprise customers usually
considered three bids. With only two, Or maybe only
one, big box distributors remaining’Bob reasoned that
o鯖ce Solutions could be a viable second or third option.
The role of the sales representatives was different at
the enterprise level. They were responsible for initially
requesting participation in the RFP and for building
enough of a relationship to understand the expectations
and priorities of the customer. The formal bid response
and margin management waS Wholly provided by cor-
porate. once the contract was established, the role of
the representative became less important as customer
service provided more direct and immediate contact
and problem resolution.
Bob also recognized the move towards e-COmmerCe.
He committed a growing share of company resources
towards the company website and online marketing.
A major growth engine for O飴ce Solutions was the
acquisition of other office supply dealers. Over the
years, O鯖ce Solutions had acquired quite a few smaller
companies. The purchase of an office supply company
was, in essence, the purchase of the target’s salespeo-
ple and their customer relationships. Every effort was
made to retain the target・s salespeople for at least a
year, at Which point their customer relationships were
transferred to O飴ce Solutions.
The sa!es roie
The role of the sales personnel at O鯖ce Solutions was
thre efold :
1. Retention: Sales reps were responsible for keeping
their current customerS happy・ Customer service
responsibilities included consultative services’
ensuring that customer orders were handled cor-
rectly and on time, handling rush orders and other
special requests’and general relationship building.
2, Penetration: Sales reps were responsible for increas-
ing sales to their existing customers" They could
50
increase product penetration by introducing, mar-
keting, and selling additional products and services
to existing customers.
3" Acquisition: Sales reps were expected to open
doors for the acquisition ofnew customer accountS.
After the door was opened, O飴ce Solutions sup-
ported the reps as needed with specialists in the
areas of fumiture, Printing, and janitorial sup-
plies. At the enterprise level’Sales reps were
expected to identify when current contraCtS
expired and to register O鯖ce Solutions for the con-
tract bid process. Once in the bid process’O鯖ce
solutions management became involved with the
contract negotiations (e.g. pricing) and responded
directly to customer queries without the input of
the sales rep.
Sales personnel were also charged with maintaining
the accuracy of the information in Office Solutions’
sales-related systems.
The reps were not reSPOnSible for pricing because
they did not understand the business well enough to
consider all the relevant factors and all of the dynamics
affecting pricing.
The o飴ce supply market in Southern Califomia was
huge, eStimated at $1.2 billion per year, SO Plenty of
opportunities existed for Office Solutions sales person-
nel. The sales people were free to develop new busi-
ness wherever they thought their potentials were
highest; they were not assigned to sales territories.
They could use Office Solutions, customer-relation-
ship-management (CRM) system and identify poten-
tial customers that were not already buying from
o飴ce Solutions. The salespeople lived all over South-
em califomia, and they tended to call on customers
near where they lived.
The existing sales compenSation
PrOg ram
sales personnel were included in a commission-Plus-
bonus program"3 They eamed a commission of 25% of
the gross profit generated by sales to their customers. A
commission-based compensation structure had the
obvious benefit of making the sales compensation costs
3 In 2O14, a few sales persomel were in different compensation
programs・ They had joined O飴ce Solutions as part of an acquisition,
and they remained on the comI)enSation structure proVided by their
former empIoyer.

.fabIe l Caicuiation of base bonus
Achievement 二一.義 Bo「tusea喜ned
Ofgrossprofitgoal (%grossprofit)
100.00-104,99% 0.4%
105.00-109.99% 0.5
110.00-114.99% 0.6
115.00-119.99% 0.7
>120% 0.8
variable. If sales declined, COStS declined with them,
thus reducing profit risk.
Bonuses were paid only if the sales personnel met or
exceeded their gross profit goal. The goal was set by top
management based on a targeted growth rate. Sales
managers met with their sales reps to explain the goal
and to secure commitment to the goal. They spent time
breaking down the goal by month’CategOry, and cus-
tomer and discussing how it could realistically be
achieved.
The base bonuses ranged in value from O.4% to O.8%
Of the gross profit eamed by the sales rep’s accounts
according to the step function shown in Table l. The
sales reps could eam an additional bonus of O.15% of
gross profit for each of three smaller product categories
(fumiture, facility supplies, Printing) if they exceeded
a category revenue goal・ These sales categories were
smaller and more volatile than the o鯖ce supply cate-
gory, but they were also more profitable・
Under this system, bonuses amounted to a rela-
tively small part ofthe overall compensation package’
maxing out at less than 4.8%4 0f a sales rep,s total
COmPenSation.
Additional accountabiIity
O鯖ce Solutions tracked several measures in addition
to the o鯖cial gross profit goal in a report ca11ed the
vital factor spreadsheet (VFSS). (Exhibit 2 shows an
excerpt from a VFSS.) This report tracked sales leads
all the way from initial contact to a yes置Or-nO decision’
as reported by the sales reps" The sales reps did not like
reporting their leads in such detail, but the information
Office Solutions, Inc.
was vital for management to correct slumps before they
materialized into Iow sales numbers.
Managers and sales reps met together as a group
every month to discuss their performance against
their official goals and the other measures on the
VFSS. The meetings could be unpleasant for those
who did not meet their goals. Performance against
goals was also discussed during annual perfomance
Fina11y, O億ce Solutions held annual sales meetings
where the top sales reps were recognized. Bob found
that the recognitions were surprisingly motivating. He
explained:
l can think of some saIes reps who were perfectIy
content with their compensation, but became very
unhappy when they were no Ionger recognized as
one of the top saIes reps at the saIes meeting"
Concems
Bob recognized some shortcomings in the current com-
pensation structure. First’it did not seem to provide
adequate motivation to generate new business. Bob
noted that while there were some exceptions,
Most peopIe don’t enjoy hunting・ Hunting onIy hap-
pens when you have to and that happens when you
are buiIding your book of business・
Bob wanted the sales reps to generate more new busi-
ness. He had ambitious growth goals for the company.
But many, Perhaps even most, Of the sales personnel
could seemingly eam enough money to satisfy their
lifestyle needs just by retaining the customers that they
Were already serving.
Second, the compensation structure was perhaps
too lucrative. O鯖ce Solutions was competing with the
big-box stores that had lower costs of sales. Bob wanted
to reduce his company,s overall cost of sales so that
they were more in line with the competition.
Finally, the commission structure attempted to moti-
vate the reps with αcarrots.,, The reps acted too much
like independent contractors. Bob thought that he
needed a better way to express dissatisfaction with job
performance, and he needed o切ective criteria for ter-
minating underperforming employees. He explained:
In addition to setting the pay structure, yOu need to
manage the activity・ You have to monitor what they
are doing and motivate them to se= more" PeopIe
sIack off when they have met their own needs" For
51
Chapter 2. Pesults ControIs

w冊am is a goOd example of someone Who

exampIe, One Of our reps-1,II cail him lbm-SeemS
shouId be an accOunt manager・ He has been with us
p。,fectly happy earning也0,000 a year. 1 suspeCt
for many yearS and is our ♯2 salesperson, reSPOnSi-
that he spends as muCh time as a tennis instructor
ble for $2.5 m輔On in sales, He works 24/7. He is up
as he does as a SaIes rep・ We reprimand Tom
all the time checking backorder repo「tS. The cus-
private-y afte「 every mOnthly sales meeti=g’but
tomers iove him, He micro-manageS their accountS
that seemS tO be of no consequenCe tO him"
to make sure that nothing goes WrOng" He does a
By age 50’mOSt Of the reps are Cruising" They

are not out generating new aCCOuntS. i need to
grow the business" Shou-d =ire ali of my estab-
Iished reps who are nOt W冊ng to hunt?
A p「oposal for change
In determining what changes to make’Bob decided
that he should divide the sales personnel into two
groups - Sales reps and account managerS - and differ-
entiate their compensation programS. Those desig-
nated as sales reps would be just those personnel who
were bringing in significant amounts of new business.
The sales reps, compensation structure WOuld continue
to be based almost exclusively on commission.
rfo i11ustrate the characteristics of a near-ideal sales
great job of customer retention and seIiing more Cat-
egories of products to his acco…tS. But he hasn’t
generated even twO neW aCCOuntS eaCh year" I have
had asaies managergO With him to heip him deve10P
new Ieads, but that is just not What he is good at.
Bob,s instinct was to leave the compensation plan for
those in the sales rep categoryjust as it was. The com-
pensation mix for the account managerS WOuld change
dramatica11y to a targeted 70% base salary and 30%
variable compensation, Which in。uded both commis-
sion and bonus. The expected total compensation of
the account managerS WOuld be set to be slightly lower
than the current comPenSation levels’reflecting the
reduced compensation risk.

rep, Bob thought immediately of Marsha:

Transition
Marsha is in her Iate 40s. She wili do about $3 miト
Through some early’CaSual discussions’Bob had got-
Iion in saies this year・ She is a pure hunte「, and she
ten some indications that the transition to a new cOm-
Ioves comPeting" She 10St a $600,000 account Iast
pensation structure for the account managerS WOuld
year because her cIient was aCquired, but she has
not be easy. Bob raised the subject first with William’
rep-aced it a-ready" Her weakness is that she deals
someone who was important to the company but also
with too much minutiae" When she is ready’1 wiil
the perfect candidate for the switch to account man-
give her an asSistant to do computer Set-uPS and
ager. Bob offered William what he thought was a gener-
the like, 1 want her focused on new business"
ous package: a base salary that was 90% ofWilliam’s
The non-hunter sales reps would be placed into the current commission level, With the potential to eam an
account manager category・ Many of these personnel additiona1 10-15% as a bonus. (Exhibit 3 shows Wil-
were exce11ent at customer relations and retention of 1iam,s compensation calculations.) But William
accounts, but, for whatever reason, they did not bring resisted. He insisted that he wanted to continue as a
in significant amounts of new clients. Bob explained: sales rep despite Bob,s wamings that there would be a
lot more pressure tO Win new accountS Should he
If a sales rep is on-y retaining existing customerS,
choose to remain in that role"
his or her job description should be changed to an
Bob suspected that the conversations would be
account manage「 with a pay StruCture that makes
even more difficult if the change in structure WaS
sense for those job responSib嗣es. Theoreticaily I
combined with the reduction in expected compensa-
would 10Ve tO have a cOmPany fu= of saies reps who
tion, aS Bob thought it should. For the reps who wished
are aggressive-y pursuing =eW business, but l don’t
to stay on the commission structure’Should he add a
want to use a saIes rep comPenSation model to pay
negative consequenCe if they failed to acquire new
someone who is actual-y functioning as an aCcOunt
accou nts?
manager or rea一一y working as an OutSide custome「
Bob knew that he still had some details to work out.
service representative"

52
53
J> Exhibit2 Excerptfrom theVFSS

NewAccounts Jan-14 Feb輸14 Mar-14 Ap「-14 May-14 Jun-14 Juト14 Aug-14 Sep-14 Ocト14 Nov-14 Dec-14 丁ota!

Manager「 8 9 14 13 7 6 8 16 6 10 4 8

Manager2 10 4 12 9 4 5 3 9 9 6 2

Manager3 9 7 10 12 20 10 9 8 6 17 6 5

Manager4 1 1 7 1 3 2 2 4 0 4 1 4

Manager5 3 1 0 2 1 3 0 0 1 2 2 0

Totai 31 22 43 37 35 26 22 37 22 39 15 24

Manager「 13,448 21,730 23,271 18,861 52,671 26,750 28,146 59,864 67,255 67,957 45,639 47,417 473,0

Manager2 9,559 9,278 13,053 18,043 20,620 22,450 21,629 27,317 32,833 41,019 31,279 32,591 279,6

Manager3 3,949 3,542 13,771 17,779 29,084 40,260 43,052 42,337 82,297 84,185 54,250 70,911 485,4

Manager4 19,583 37,788 18,107 1,125 16,267 5,159 5,779 8,290 1,747 64,215 106,122 284,

Manager5 847 8,479 301 1,266 5,874 7,974 17,879 4

TotaI 26,956 54,133 87,882 72タ790 103,500 106,574 106,465 135,598 191,941 200,782 203,358 274,921 1,564,89

TotaIGoai 37,750 69,000 100,750 132,400 169,750 206,500 238タ750 264,500 296,250 333,250 353,000 364,500 2,566,40

Variance (10,794) (14,867) (12,868) (59,610) (66,250) (99,926) (132,285) (128,902) (104,309) (132,468) (149,642) (89,579) (1,001,501)

Var% -28,6% -21.5% -12,8% -45.0% -39.0% -48.4% -55,4% -48,7% -35.2% -39.8% -42.4% -24.6% -39.

Bids: 」an-14 Feb-14 Ma「-14 Ap「-14 May-14 Jun-14 Jui葛14 Aug-14 Sep輸14 Oct-14 Nov-14 Dec-14 丁otai

Managerl 5 27 35 21 17 18 19 14 11 10 11 4

Manager2 16 13 17 12 11 9 17 6 11 6 3 10

Manager3 5 12 13 13 10 9 14 7 12 8 4 4

Other 2 4 5 4 5 4 4 6 5 2 2

TotaI 28 56 70 50 43 40 54 33 39 26 20 20
Exhibit 2 Conthued

Opportunities Jan-14 戸eb-14 Ma「-14 Ap「-14 May-14 Jun-14 Juト14 Aug-14 Sep-14 Ocト14 Nov-14 Dec-14 Tbtai

Stagel- Qualifying 430 484 507 544 545 541 520 577 552 566 576 394

Stage2-lnitial Meeting 351 379 426 425 440 416 340 366 368 357 367 289 .」

Stage3 一Deveiopjng Proposal 163 167 193 216 219 200 174 166 164 155 157 134 l

Stage4 ーPresentation 118 114 113 114 121 108 146 149 157 169 162 127

Stage5 ーCommjtment toBuy 51 70 98 58 57 51 45 47 51 53 56 50

TotaICurrent Opportunities 1,113 1,214 1,337 1,357 1,382 1,316 1,225 1,305 1,292 1,300 1,318 994

Stage6-Won 255 272 284 293 304 318 319 348 387 418 436 321

Stage7-Lost 180 192 226 244 270 268 299 318 413 440 468 333

TbtalA= Opportunities 1,548 1,678 1,847 1,894 1,956 1,902 1,843 1,971 2,092 2,158 2タ222 1,648

(Con tinued)
 言上

Exhibit 2 Continued

2013Web It● 」an-14 Feb-14 Ma「-14 Ap「-14 May-14 Jun-14 Juト14 Aug-14 Sep-14 Oct-14 Nov-14 Dec-14
AnaylCS S 20812 17,825 7,813 18,806 8,297 18,780 18,182 34,969 37,566 35,964 37,869 39,959 31,827 28,523

eSSIOnS Users 8,851 8,045 7,974 14,681 15,957 15,895 16,603 16,805 345,600 14,381 275,187 13,634

PageVIeWS
35903 30,877
P/V.’t1.73 2:48
17333,137 1.76 2:41
1.84 33,426
1.88 34,216
8,69 304,010
8,67 325,674
8,6 309,291
8.41 318,452
8,65 8,65238,281
8.

ageSISI VisitTime 2:46 2:42 2:44 7:33 7:25 7:05 6:56 7:14 7:06 6:

R t %NewVisits
Bounceae 6602% 66,55% 30,63%
 0 67.09%
31,16%31.61% 66.57%
30.11%
67.10%
31,44%
42.62%
35.92%
43.87% 44,11%
30,98%
44.29%
31,52%
43.22%
31.13%
43.76%
29.45%
45,86%
30.77% 31.69
 Exhibit 3 W冊am’s Compensation Caiculator

Wiiiiam’s 2014 performance

2014Goai 2014Actual Variance Va「iance%

丁otalRevenue $2,104,350 $2,254,393 $150,043 7.1%

OfficeSuppiyBev. $1,411,512 $1,403,717 $(7,795) -0.6%

FumitureRev. $313,899 $505,495 $191,596 61,0%

FaciiitySupplyBev. $228,071 $239,152 $11,081 4.9%

PrintingRev. $150,868 $106,029 $(44,839) -29,7%

GrossProfit $502,939 $538,799 $35,860 7,1%

RevenuefromNewAccounts $39,000 $1,200 $(37,800) -96.9%

Percentage GrossProfitBase Compensation

Commission 25.00% $538,799 $134,700

BaseBonus ,50% $538,799 $2,694

FurnitureBonus .15% $538,799 $808

Fac冊yBonus .15% $538,799 $808

PrintingBonus 0 0

lbtalCompensation $139,010

ASOFFEREDTOWILLIAM

90%baseIlO%bonus 1f70%base130%bonus

BaseSaIary $121,230 $94,290

BonusPotentiaI $13,470 $40,410

TbtaiCompensation $134,700 $134,700

This case was prepared by Professor Kenneth A. Merchant and Research Assistants Michelle Spaulding and Seung Hwan
(Pe亡亘) Oh.

Copyright ◎ by Kenneth A. Merchant.

57
 CASE STUDY
Puente H冊s Tdyota
1豊±血書
In December 2003, Howard Hakes, Vice president of
Hitchcock Automotive Services’reflected on some of the
challenges his team faced in managing his company’s
stable of automobile dealerships. He illustrated his points
by discussing the challenges faced at Puente Hi11s Tbyota’
Hitchcock・s largest dealership’although all of the Hitch-
cock dealerships faced essentially the same problems.
This is very muCh a peoPle business. It,s peopie
who give us our biggest SuCCeSSeS aS Well as our
biggest Chat-engeS. At ou「 Toyota StOre’in sales, I
wouid say that about 20% of our peOPle are loyai
to the comPany and 「ea一!y want tO do a good job.
丁heother80% arejustinthisforthe money " ‥ and
they can make more mOney he「e than anyWhere
eIse. Our comPenSation attraCtS SOme Very tai-
ented people" But some O=hese peOPle are
sharks who try tO get aWay With whatever they
can. others have perSOnal probiems" They live
from payCheck to payCheck; that is their mentaiity・
s刷Others are CanCerS Whose bad habits can
spread" We coaCh and counSe一; We give written
notices; and for moSt Of the emp-oyees’OnCe they
get the mesSage that is the end of the prObiems・
Butfor some Others ‥ ・
I think the key to manageme=t in this business is
ali about managing attitude・ How can We keep the
team moving in the same direction’tO get eVery-
body to be part Of the team’and prevent the can-
cers from spreading?
The comPany and industry
Hitchcock Automotive Services was a Privately held cor-
poration comprised of seven automObile dealerships -
three Tbyota dealerships and one each for Volkswagen,
Ford, Hyundai, and BMW - and a large body shop. All of
the entities were located in southem Califomia. Four of
the dealerships, inc鵬ing Puente Hi11s Tbyota, Were Sit-
uated adiacent to eaCh other in City of Industry’Califor
nia, about 25 miles east of Los Angeles. The others were
located in Anaheim’HermoSa Beach’and Northridge.
58
It was important for the dealerships to keep two
important COnStituencies - manufacturers and custom-
ers - happy・ The manufacturers allocated larger
numbers of their best-Se11ing models to their better
perfoming dealers・ The manufacturers evaluated
their dealers in terms of their abilities to fu皿I their
market potential‥ tO meet Sales targets the manufactur-
ers set for each geographical trading area, known a§
the pr血ary mc[rたe亡αrea. The dealerships also had to
satisfy the manufacturers’licensing and certification
standards. The manufacturers regularly performed
compliance audits to evaluate dealership practices in
comparison with the established standards. However,
Howard Hakes believed that short of flagrant violations
of standards (e.g. se11ing competing brands under the
same roof), fu胤1ing market potentials was the pri-
mary factor affecting the dealers・ relationships with
the manufacturers.
customer satisfaction was obviously important in
obtaining repeat Sales and, hence, future profits. Cus-
tomer satisfaction surveyS Were given to every CuS-
tomer who bought or leased a vehicle or had one
serviced at a dealership. A copy of the survey given to
all Tbyota cuStOmerS Who purchased or leased a vehi。e
is shown in Exhibit l.1 The responseS tO these survey
questions were mailed directly to the manufacturer
and aggregated into a cus亡omer SC[。ザvc亡ion irldex (CSI)’
to which considerable attention was paid by both the
manufacturer and dealership managerS. Manufactur-
ers sometimes changed dealership vehicle a11ocation§
when CSI ratings fell below acceptable levels in three
consecutive years.
Puente Hi!ls toyota
puente Hills Tbyota (PHT) was a large Tbyota dealer-
ship. Annual sales were about $85 million’in。uding
l Tdyota also required the use of a serv{ce survey’Which asked service
customers a comparable set of questions focused on satisfaction with
(1) making the service appointment, (2) writing up the service orderJ
(3) work quality証) work timeliness’(5) price’and (6) the facilities.
 Puente H冊S lbyota

approximately $10 mi11ion from the body shop’Which only marginally profitable. Used vehicles provided a
better profit source, aS Howard Hakes explained‥
provided services to all of the Hitchcock dealerships in
City oflndustry. PHT had a total of 145 empfoyees, and
This is one of the last barter businesses Ieft, For
annual profits totaled about $1.8 million"
some new vehicies, there is only an $800 d田erence
PHT had won many awards for excellent perfor-
between the window sticker price and deale「 COSt,
mance. For example, the dealership had been awarded
sothere is not much margin and not much room for
Toyota’s President,s Award for overall excellence in
bargaining. In used vehicles, We have a Iittle more
each ofthe prior 13 years.
profit opportunity" We can sometimes take a trade-
In 2003, PHT moved into a new, State-Ofthe-art, $13
in for$2,000, Put$1,500worth ofwork in it, and se=
million facility with l19,000 square feet of space. The
it for $6,000.
new building provided the latest in customer ameni-
ties, including a children,s play area, a mOVie theatre’ The service department was consistently PHT’s

efficient work layout areas, and room for growth. most profitable department’With margins typically

PHT・s organization structure was fairly typical in in the range of 15-2O%. (See comparison statistics
the industry. Reporting to the dealership general man- from an industry consulting report shown in
ager were a general sales manager whose organization Appendix A")
induded both new and used vehicle sales, a SerVice As required by Tbyota, PHT managers kept separate

manager, a body shop manager’a PartS manager’and records for new and used vehicle sales, aS ifthey were sep-

a director of finance and insurance (F&I) (see arate departments’eVen though all PHT salespeople could

Exhibit 2). The one unique feature of the organization sell both new and used vehicles. The separation of new

was the combined new and used vehicle sales depart- and used vehicle profits required some a11ocations of

ment. only about one in five auto dealerships’tyPi- expenses. with rare exceptions, all items of expense were
cally the smaller ones’had such a combined vehicle split 70% to new vehides and 3O% to used vehicles, an
sales department. More typically, the managers of the allocation formula that was typical in the industry. How-

new and used vehicle sales departments reported ard Hakes knew that this formula was somewhat arbitrary.

directly to the dealership general manager. But PHT For example, he knew that some forms ofadvertising’SuCh

managers liked the flexibility of having their sales per- as halfhour television shows or “infomercials’’on Spanish

sonnel se11 whatever vehicle customers wanted, neW Or language television stations’Were SOlely aimed at selling

used, and some customers wanted to Iook at both new used vehides. But, he explained, ``I,ll bet we aren,t off by
and used vehicles. more than 5%wi血the 70 -30 split. Maybe it’s 65 -35, One

Each of PHT,s departments was managed as a profit way or the other, but we won,t be fu血er offthan that.,,2

center. Many indirect or overhead expenses, SuCh as All interdepartmental transfers were done at market

dealership administrative salaries and dealership prices. Thus’for example’When PHT,s used vehicles were

advertising expenditures, Were aSSigned or allocated to serviced in the PHT shop, the sales department paid full
the departments. Only some infrastructure-related retail price for parts and labor. This policy gave the used

expenditures (e.g. rent and equivalent) and some other vehicle manager some negotiating power in the service

expenditures over which the department managers area. paying fu11 retail price ensured that intemal used
had little or no control (e.g. insurance, taXeS, legal, and vehicle service jobs would not be given lower prlOrlty.

auditing) were not allocated to them. Valuations of used vehicle trade-ins sometimes cre-
Exhibit 3 shows one page of the financial statement ated disagreements. These valuations were important

report that PHT was required to submit monthly to primarily because the sales personnel eamed commis-
Tbyota Sales Corporation. The other pages in this report sions based on the profits of the負deals,, they dosed.

called for an extensive array of information, including Such disagreements were commOn in dealerships
the profitability of the other departments’balance sheet

data, unit sales by model, PerSOnnel counts by depart- 2 The industry consulting report showed that for FY 2OO2, the average
ment and category, and a variety of performance ratios ove血ead expenses (equivalent to line 57 in Exhibit 3) in the industry

(e.g. total bonuses as a percentage of sales’grOSS PrOfit

were $2.6 mi11ion for new vehicle departments, Or 7.22% of sales
(equivalent to line l in Exhiblt 3) or 94・48% of new vehi。e deparト
average per unit of each model sold).
ment profit (equivalent to llne 33 in Exhibit 3)・ For used vehicle depart-
The profitability of PHT,s departments varied widely. ments, aVerage OVerhead expenses in the industry amounted to $1.4
As in most dealerships, neW Vehicle sales at PHT were million, Or 8.12% of sales or 85-78% ofused vehicle department profit.

59
Chapter 2. Resuits Co=trOis

because new car salesmen were often motivated to over

pay the customer for trade-ins to secure the new car
sale. And at PHT, and indeed allもealerships, needed
repairs on trade-ins were sometimes not spotted at the
time of the sales deal. This could happen anytime, but
at pHT it was most likely to happen on Sundays when
the service department was dosed and no service
advisor could be called in for a second opinion on esti-
mated trade-in repair costs. As Howard explained:
On Mondays, We Often have animated discussions
between saies and service about the repairs that the
service department c-aims are required on trade-ins.
But we stick to the market price ruie! If the costs of
repair are higher than what the salesmen had antici-
The bonuses, Which were typica11y 250 -300% ofthe
sales empIoyees, base salaries’PrOVided a sign誼cant
proportion of total compensation. The salaries were
paid semi-mOnthly, and commissions and bonuses
were paid monthly・
Howard Hakes explained that one side benefit of
having a combined new and used vehicle sales depart-
ment was that, COmbined, the department was
generally profitable’Whereas new vehicle sales depart-
ments alone often were not.3 Howard wondered how
managers provided “profit-based,, incentives in sales
departments that were losing money.
All of the sales managers・ bonus plan contracts also
induded the fo11owing wording:
Adyustmen書s. “Any cancelIed saIes or subsequent

pated on Sunday’it eats into their deaI profit" lf they
don't agree with the service repair cost estimate’
they are free to sell the trade-in ``as-is,, on the whoie-
saIe market. Sometimes they even get lucky when
the repair prob-em isn・t spotted there either. That’s
why some used vehicles come to be caIled ``iemons.”
Performance measureS and incentives
changes to the account aS a reSuit of a retumed
product wil- be ca-cu-ated into the commissionabIe
gross profit and w冊be used to caiculate you「 com-
missions earned for each month, AdjustmentS may
aIso be made to correct errO「S, Or fo「 rewrites to
the deai; unWinds, nuiI and voided deals; CuStOmer
receivabIes not co=ected (including, but not Iimited
to down paymentS’drive-Off fees, insu「ance

coverage, Or Penaities on trade-in)’Or POiicy

Compensation of line personnel at PHT was high’Pa手
ticularly given the empIoyees, generally relatively
modest education levels. Even young salespeople’those
still in their early 2Os, COuld eam $6,OOO-$7,OOO per
month if they hustled and followed up effectively with
customers. Tbp sales personnel could eam $20’OOO per
adjustmentS"’’
O書her Factors〇 ・・Other factors such as the Custome「
Satisfaction lndex (CSI)4 and EmpIoyee Satisfac-
tion Index (ESi〉5 score may be taken into account in
determining bonuses"’’

month, Or eVen mOre. Some service technicians eamed

How these non血ancial performance indices were
over $10,OOO per month. Performance-based incen-
taken into account for bonus determination was left
tives were a significant part of the compen§ation of a11
vague. They could be used in a positive sense’tO PrO-
1ine personnel.
vide “discretionary,・ bonus awards’Or they could be

A. lncentives in the saIes department used to limit the formula bonuses. However, nO One at
pHT could remember any situations where they had
A11 personnel in the sales department were paid a rela-
made a substantive difference in the bonuses awarded’
tively modest base salary plus incentive pay・ The saZes-
perhaps because at PHT・ the indices had never fallen
men and c[SSisfcm亡SC[Zes marlαgerS eamed commissions
below acceptable levels.
on the deals they closed. The average commission rate
For comparison purposes’Appendix B provides
was 2O% and 7% of deal gross profit for salesmen and
assistant sales managers, reSPeCtively. The generaZ sa!es
mc[rlClger; uSed ve柾cZe sc[Zes mcⅢC[ger; and saZes desk man-

c[gerS, bonuses were based on a proportion of depart-

mental profit after overhead expenses but before taxes

(line 59 in Exhibit 3). The general sales manager and

desk sales managers were paid 2.25% and l.2-1.5% of
this amount for the total sales department’reSPeCtively・

The L[Sed ve疑cZe soZes mc[Jmger WaS Paid 5% of this

amount for the used vehicle department only.

60

excerpts from a consulting report showing vehicle
dealership department manager compensation data. In
廊appendix, Schedule l shows data aboutthe amounts
and forms of monetary compensation given to depart-
mentmanagers. Schedule 2 shows the measures used in
allocating formula bonuses. Schedule 3 shows the inci-
dence and size of discretionary (nonformula) bonuses.
B. Incentives in the service department
The service tec加lZcicmS Were Paid from $1O to $23 per
``flag hour,, of work completed. The actual hourly rate
depended on each individual,s technical specialty and
their certifications (e.g. master technician). Flag hours
Were Standards set by the manufacturer for the
accomplishment of specific tasks. The standards were
Set SO that an average qualified technician could
achieve them. However, it took technicians at PHT,
Who were generally very experienced, about 45 min-
u亡es on average to do one fIag hour ofwork. For some
technicians the disparity between flag and actual
hours was much higher. Jesus Barragan, PHT,s service
manager, Said ``Our top guy, Who is a `natural,’beats
the flag time by 600%.,, The disparity also varied by
The ser庇e adl,isors eamed a base salary of approxi-
mately $2,000 per month. They also eamed bonuses as
ん1lows:
8% eom肩ssとoれOn C直S亡O肌eγゼa書dねbor a融pαr吟
6% comm[ssforl On maれ早舟c亡urer-Pafd Zabor皿der
WOrra n坊
6% co耽肌iss章oれOn妃bor aれdpαr亡S paidjbr証でerna砂
atP廿T
The PHT servfce manager was paid a base salary of
$3,000 per month plus a bonus based on a percentage
Of the service department gross profit (before overhead
expenses). The percentage was 3.75% ifthe gross profit
figure was $195,OOO or less in any given month; the
PerCentage rOSe tO 4% if gross profit exceeded
$195,000. The $195,00O was the total annual budgeted
amount divided by 12.
C・ GamepIaying temptations in the service
area
Because they were paid by the job, SerVice technicians
had temptations to cut corners. For instance, for a
typical Electronic Engine Control (聞C) repair, the
technician might be required to diagnose the problem,
Puente Hilis Toyota
replace the defective electronic module, hook up a test
recorder, and tesトdrive the vehicle. The flag rate for
thisjob might be 48 minutes. A technician who wanted
to cut comers might skip the test drive. Knowing that a
SuPerVisor would check the vehicle’s mileage-in and
mileage-Out, he would have to put the vehicle up on a
hoist and run it for, Perhaps, three minutes to increase
the odometer mileage. But by cutting comers, he might
be able to complete the entire job in less than
15 minutes.
PHT managers had two types of controIs over these
gaming behaviors. First, if the time spent on ajob was
Very loW service managers asked the technician for an
explanation of the anomaly. Second, management mOn-
itored the number of “re-Checks,” instances where the
PrOblem was “not fixed right the first time:’In the indus-
try, a l% re-Check rate was considered good. The re-
Check rate usua11y could not go to zero because some of
血e蹄-Cheぐks were nor血e艇ぐ血皿でda皿を慮り九丁心e cause
might be simply that a needed part was unavailable.
Technicians who cut comers were寝written up,,, that
lS, glⅤen nOtice, and their ticket was deducted. “Bad
habits can be corrected; bad mechanics can,t,,, Jesus
Barragan observed.
Howard Hakes had some confidence that this gam-
ing problem was under control because the service area
at PHT was averaging only about four re-Checks per
month for approximately 70O completed servicejobs. If
SerVice technicians were cutting comers in a signifi-
Cant Way, he estimated that the re-Check rate would be
Significantly higher.
The service technicians at PHT were very loyal to
the company, because αwe treat them as people, nOt
mechanics,’’Jesus said. “We also train and pay them
well・,,珊mover was virtually zero.6 But the mechanics
had to buy their own tooIs. Jesus Barragan noted that
“one of our guys has bought well over $535,000 worth
OftooIs during his 36-year Career With us, but then, he
makes $130,000 per year too.’’
Managemen=ssues
Howard Hakes knew that his PHT management team
had not solved all their problems. He lamented about the
fact that, in general, Sales personnel were not effective
at following up with customers. Follow-uP meanS that
6 This is in stark con亡rast with turnover in the sales department, Which
Howard described as ``horrid’’(about 6O% per year, aS OPPOSed亡O
Only about 5% in service).
61
Chapter 2. Results ControIs

inputs for the influential ratings of automobile reliabiト

the sales staff keeps in touch with potential customers
ity published by the丘m J.D. Power & Associates and’aS
with whom there has been an竜Litial contact. Fo11ow-uP
mentioned above, the manufacturers used those ratings
in。Iud。S 。utreaChes (e.g. phone calk∵ thank you cardD
to allocate their vehi。es. As a consequenCe’in the quest
to customers who visited the sales department but have
for “perfect,・ ratings・ CuStOmerS Were regularly
not yet decided to purchase a vehicle’aS Well as sales “coached,, on how to complete the questionnaire at the
approaches to customerS Who are driving an older vehi-
time they purchased a new vehicle. And, SOmetimes,
cle that has recently been serviced at PHT. PHT had
dealerships asked customers tO drive to the dealership
established regular processes for both types of fo11ow-
when they received the questionnaire from the manu-
up. For examPle, SerVice advisors were enCOuraged to
facturer. When they arrived’the customer WOuld give
explain to customerS Which service costs were likely to
the questionnaire to a dealership empIoyee and receive
occur on their older vehicle in the coming years and to
a present’SuCh as a皿tank ofgas. The empIoyee would
invite the dient to visit the sales department. However・
complete the questionnaire and send it to the manufac-
these activities consumed time, and the service advisors
turer. Howard was not sure Whether some of his ``shark’’
regularly ignored them. Could incentives be provided to
salesmen also engaged in such practices’and if they did,
encourage fo11ow-uP and refdrral behaviors?
what he should do about it"
Howard also worried that the CSI measure, Which
Despite these issues’Howard was confident that
could provide useful infomation’SOmetimes had ques-
pHT was one Of the best-managed dealerships in the
tionable validity・ Howard had heard that some dealer-
COu ntry.
ships regularly “gamed,・ the measures because they had

become so important. The CSI ratings were important

Chapter 2. Pesults ControIs

Exhibit l Continued

5 When you picked up you川eW ToyoぬWEHICしE DEしIVERY), did the foilowing occur…

Int「oduced to service area/pe「SOnnei (if department was open)

6 Did you have any concems with your vehicle WHEN YOU PiCKED IT UP from the deaIership?
□ No /SkゆめOues#on 7)

ifyes,Pleasechecktheappropriateboxanddesc「ibetheconce「ninthebiank:phecka〃紡a書ap肋
□Noise/rattle:                  □WheelaIignment/Stee「ing:
口Malfunction:                   口Missingitem:
□NotcIean:                        ロOther:
□Chip/SCratCh/dent:

HasthedeaiershipresoIvedtheconce「n?  □Yes  口No

PurChaselIease experience?
口No (Sk佃to Oues〃on 8)

口No /Sk佃to Oues歌on 9)

1 4 Although we do not identify you with your indiViduaI check box resuIts to the deaIership, may We aSSOCiate you「 name with

your w皿en comments?

口Yes, yOu Can ldentify me when sharing my COmmentS With the deaier
口No, i do notwish to share any information on this survey with the dealership

"  臆萱
◇

64
 ibit 2 Puente H用s toyota: Organization structure

ーReco[ditjoning

manager (1 )

(hourly)
-口0U「iy

empioyees (2)

65
Chapter 2. Resuits ControIs

Exhibit 3 Puente Hiiis Toyota: SampIe page of financiaI reporting package

NAMEOFACCOUNT DEAしERSHIP NEWCARDEPT USEDCARDEPT

MONTH Y丁D MONTH Y丁D MONTH Y丁D

1 TOTA」SA」ES

2 TOTALGROSSPROF音T

3 DEPARTMENTALSELしINGEXPENSES

4 SaiesCompensation

5 SaIesCompensation-Sciononly
6 SupervisionCompensation
7 SupervisionCompensation-Sciononiy
8 DeliveryExpenses

9 Financing,insurance&ServiceCenterCommissions
10 Financing,insurance&ServiceCenterCommissions-SciononIy
11 AdvertlSing-Departmental

12 interest-FIoorPlan

13 TOTAしSEしLINGEXPENSES(Lines4to12incl.)

14 DEPARTMENTAしOPERATINGEXPENSES

15 PolicyAdjustments

16 ClaimsAdjustments

17 Demos&CompanyVehicles-DepartmentaI
18 Invento「yMaintenance

19 Pe「someIT「aining

20 OutsideServices-DepartmentaI
21 F「eight

22 Suppiies&Sma=TooIs

23 Laundry&U両forms

24 Equipment&Vehicies-Departmentai

25 EquipmentMaintenance,Repair&Rental-DepartmentaI
26 MiscellaneousExpenses
27 SaIaries&Wages
28 Cie「icaiSalaries

29 Vacation&TimeOffPay
30 TOTALOPERATINGEXPENSES(Lines15to29inci,)
31 TOTALSEL」音NG&OPER,EXPS.(Lines13&30)

32 TOTAしSEしし.&OPER,EXPS,%OFGROSSPROFIT

33 DEPT.PROFIT(しOSS)(Line2しessLine31)
 ■●’’ NAMEOFACCOUNT DEA」ERSHIP NEWCARDEPT USEDCARDEPT

MONTH Y丁D MONTH Y丁D MON丁H Y丁D

34 OVERHEADEXPENSES PRORATiONOPTIONA」

35 Rent&Equivaient

36 Saia「ies&Wages-Administrative&Gene「al

37 Owne「sSalaries

38 Pay「oi廿axes

39 EmpioyeeBenefits

40 PensionFund/ProfitSha「ing

41 Adve巾sing-GeneraI&institutionaI

42 Stationery&O冊CeSupplies

43 DataProcessingServices

44 OutsideServices-Generai&lnstitutionai
45 CompanyVehicies-Administration
46 Contributions

47 Dues&Subscriptions

48 Teiephone

49 Legai&Auditing

50 Postage

51 T「aveI&Entertainment

52 Heat,Light,Power&Wate「

53 Fu「nitu「e,Signs&Equip.-Depreciation,Maint",Repair&Bentai

54 insurance-OtherthanBu脚ngs&lmp「OVementS

55 Taxes-OtherthanReaIEstatePayments&incomeTaxes
56 Inte「est-OtherthanFioorPian&ReaIEstateMortgage

57 TOTA」OVERHEADEXPENSES(Lines35to56incI・)

58 TOTAしEXPENSES(Lines31&57)

59 ADJUSTEDDEPT,PROFiT(LOSS)(Line2Less58)
60 61 OPERATINGPROFiT(」OSS)(Line2Less58) NETADDITIONSORDEDUCTIONS(Pg,2Line77)

62 NETPRO円T(LOSS)BEFOREBONUS(Line60Less61)

63 Bonuses-Empioyees

64 Bonuses-Owners
65 NETPRO円T(しOSS)BEFORETAXES(Line62Less63,64)

66 EstimatedlncomeTaxes

67 NETPROFiT(LOSS)AFTERTAXES(Line65Less66)

67
Appendix A Puente …s toyota‥ Excerpts from Consulting Repo巾Showing automobife dealership and
department data (FY 2002)1

SaIes ($000)
Net profit ($000)2
Retum on saies

Sales ($000)
Net profit ($000)2
Retum on sales
 Puente H冊s Toyota

Appendix B Puente Hi=s ’foyota‥ Excerpts from Consuiting Report showing depa直ment manager compensation
data (FY 2002)       _

Scheduie l: Department Manager Compensation: lbtaI and Breakdown into Components - Base Salary, FormuIa
Bonuses, and Discretionary Bonuses (OVeraiI averages)

(Averagetotaicompensation=$78,428)1 $31,901 $44,829 $5,104

Average($)
Percentreceiving 79.23% 64.48% 23.50%
Average%oftotaicompensation 44.89% 36.77% 4.26%

(AveragetotaIcompensation=$72,195)1 $31,672 $40,376 $4,046

Average($)
Percentrecejving 85,04% 66.14% 27.56%
Average%oftotalcompensation 47.12% 38,32% 5,03%

SERVICEDEPAR丁MENTMANAGERS

(Ave「agetotaIcompensation=$61,422)1 $33,278 $30,575 $2,302

Average($)
Percentreceiving 90.00% 68,00% 20.00%
Average%oftotaicompensatjon 56.00% 34,26% 3.53%

仁roTAL CoMPENS仰ON COnSIStS Of any or a= of the fo=0Wlng COmPOnentS. BASE SALARY, FoRMULA BoNUSES (maxlmum Of three), D】SCRETlONARY BoNUS, and

SpIFFS
Def面trons.
’FoRMULA BoNUSES are based on quantltatlVe Performance measures (e g department proflt). Some contracts have up to three formula bonuses, although

lhe ma」Orlty Of the managers (6O%) recelVe One formuIa bonus only. Across departments, the frst fo「muia bonus IS On aVerage 85% of the total formula
bonus AIso, the fl「St formula bonus IS On aVerage mOre than seven tlmeS larger than the second formula bo…S
’DISCRE丁IONARY BoNUSES are based on the supe「vISOr’s subJeCtlVe 」udgments of the managers’performances
「SpIFFS a「e mlSCe=aneous rewards (not reported above), WhlCh a「e difficult to characteriZe 「n a Standard way Common examples a「e the use of

PrOmOtlOnal vehlCles and certaln lnCentlVeS PrOV「ded by the vehlCle manufacturers (e g vacatlOn trlPS) Although recelPt Of sp苗s IS COmmOn (about 63%
Ofthe managers recelVe them), the-r eCOnOmlC Slgnif'CanCe 'S relatlVeIy 10W (about $4,593 fo「 those who recelVe SPIffs, COmPared at $15,000 to $20,000
forthose who recelVe a dlSCretlOna「y bonus)

(Conthued〉

69
Chapter 2. PesuIts Controis

Appendix B (Continued)
ScheduIe 2: Deaiership Perfor「珊nCe Measure Used in Department Manager Formula Bonuses (as a percentage of aii
formula contracts)        _..

Formulabonus 擁1、 ♯2 ♯3

Dealership Grossprofjt 1.8 1.7 0,0

Netprofit 27,0 10,9 20.0
Grossprofit 6,4 6,9 0,0

Newvehiciesaies Netprofit 5,8 1.7 2.9

Inventory 0.0 1.1 0.0
Unitsales 0,0 6.3 2.9
Grossprofit 5,9 4,6 14.3

Usedvehiciesaies Netprofit 2,2 5,2 8,6

lnventory 0.2 2.9 14.3
Unitsales 0.5 7,5 2.9
Grossprofit 14.5 4,6 2.9

New=uSed Netprofit 8.6 6.9 11.4

lnventory 0,0 0,0 5.7
Unitsales 0.3 8,6 2.9
Grosspro冊 2.7 1.1 0.0

Parts Netprofit 1.9 2.3 0.0

Revenue 0.2 0.0 0.0
Grossprofit 9.4 4.0 0.0

Service Netprofit 8.6 6.9 5.7

Revenue 0.8 0.0 0.0

Body,PartS,&service Grossprofit 2.6 5.7 2.9

Netprofit 0.6 10.9 2.9
%Grossprofit 43,3 28.7 20.0
%Netprofit 54.8 44.8 51,4

Pct,reCeiving Doilars %tot.comp.

Averagediscretionarybonus

Newvehiciedepartmentmanagers 23,5% $21,958 18.1%

UsedvehicIedepartmentmanagers 27.6% $15,719 18,3%

Servicedepartmentmanagers 20,0% $11,801 17.7%

AIidepartmentmanagers 23.1% $16,664 18.0%

70
 ㊨ASE STUDY
Kooistra Autogroep
When he took over as CEO of the Kooistra Autogroep in
2002, Tbm Kooistra made significant changes to his com-
pany,s management controI system. Most significantly,
he decentralized decision-making authority, developed
a performance reporting system that included both
financial and nonfinancial information, and introduced
a pay-fo手performance system for the company’s dealer-
ship and department managers. Tbm explained:
My father had been ruming this company iike a
famiIy, but we’ve become too big to operate iike
this. Besjdes, We need to be more competitive to
SurVive. That’s why i am so keen on implementing
the new pay-fo「Performance pian" With decentra臣
Zation comes accountabiIity for perfo「mance" 1f our
PeOPie are w=Iing to accept that accountab掴ty,
then I am quite wi11ing to share with them a fair pro-
POrtion of the company’s success・
But while the company’s managers seemed to value
the increased authority and performance-related infor
mation, their feelings regarding the pay-for-Perfor-
mance system were mixed. In 2007, Tbm was considering
whether he should try to reinforce the system by telling
血e managers that the system was here to stay and that
theyneeded to leam how to make it work’Or Whether he
should revise, Or POSSibly even abandon, the system.
丁he company
Kooistra Autogroep was a family-OWned auto皿obile
retailing company founded in 1953. Over the years,
Kooistra grew from a small company that sold and ser-
viced cars of only one or two brands from a single location
to a top-2O player in the Dutch car dealership market.
In early 2007; it owned and operated 13 dealership Ioca-
tions se11ing lO brands of automobiles and empIoyed
approximately 325 people.
The Kooistra dealerships were located in the city of
Tilburg and in smaller surrounding towns in the
southem part of the Netherlands. Kooistra owned five
Opel dealerships, three Tbyota dealerships, One Citroen
dealership, One Suzuki dealership’One Saab dealer-
ship, One Alfa Romeo dealership’and one combined
Chevrolet, Cadillac, Corvette, and Hummer dealer-
ship. Opel (a brand of General Motors) had been the
market leader in the Netherlands since the 1970s,
with a market share of almost lO% in 2006. Toyota
was the sixth-largest brand, With a 7% market share.
Citroen had a market share of 4%, and Suzuki and
Chevrolet had market shares of about 2-3%. The
other brands sold by Kooistra - Saab, Alfa Romeo,
Cadillac, Corvette, and Hummer - all had market
shares of less than l%, For these smaller brands, the
nearest competing dealership was typically located
far away. In addition to the car dealerships, the Koois-
traAutogroep also owned abodyrepair shop and a car
lea§e COmPany・
In the context of Dutch automobile retailers, Koois-
tra was large. Even in 2OO7, the typical Dutch car deaト
ership sold and serviced cars of only one brand from a
single location. Most dealerships were family-OWned’
With about 20 empIoyees on average.
In the early 2000s, aS a COnSequenCe Of the weak
economic conditions and increased competition, the
financial performance of most Dutch car dealers dete-
riorated. This performance deterioration gave rise to
many changes in the industry. One important change
was industry consolidation. Many larger car dealer-
ships expanded through acqulrmg SeVeral formerly
family-OWned dealerships. Kooistra Autogroep was
among the first to expand the number of brands sold’
standardize operating procedures, and expIoit econo-
mies of scale.
In 2002, Tom Kooistra’s father retired, and Tom
took over as the company’s CEO. Tom chaired the
company’s top-management team (see Exhibit l).
AIso on the top-management team Were Anna Lub-
bers, CFO, and eight managers. Five of the managers
were dealership managers, eaCh responsible for sev-
eral dealership Iocations selling between one and
five brands. Each dealership Iocation empIoyed a
sales manager, a SerVice manager’a WOrkshop
71
Chapter 2. ResuIts ControIs

“Itlble l Average retum on saies in the Dutch car

manager,1 and a parts manager. The other亡hree top-

1evel managers were respo鴫ible for the body repair dealershjp sector (2001-2005)

shop,2 the car lease company声nd the group,s central

after-Sales department.3 These managers supervised

receptionists, Salesmen’teChnicians, and ware-

housemen. AIso in the company was a central corpo-

ra亡e s〔aff responsjb上e for finance and accom亡jng,
Source BOVAG Autodealers 2006 Peproduced with permlSSIOn
marketing, quality management, PerSOnnel and
organization’uSed car auctions,4 and fleet sales.5

Although some of its dealerships had been perfom- company,s management controI system needed to

ing quite well’reCent OVerall performance of the Koois- change・ Tbm,s father used to make most ofthe signi缶cant

tra Autogroep was subpar, but still in line with industry decisions across all the company’s operations. Tom,

averages. Tb ensure adequate resources necessary for however, believed that he needed to decentralize deci-

business continuity, a rule of thumb in the Dutch car sion-making. Tbm thought that the dealership managers

dealership business was that the retum on sales (net
profit over sales) should be at least 2%. However’due
primarily to generally poor economic conditions’the
average retums of Dutch car dealerships had not been
near this level since the late 1990s (see Table l).
The new management COntrOI system
should have substantial authority for the critical deci-
sions in their business, including the hiring, firing’and
supervising of their dealership personnel; advertising
investments; Sales promotions in their local market§;
Intαes面轟
and price reductions that might be needed to move
excess inventory or to meet the competition.
But Tom also believed that with decentralization
2. Bud9帥
came results accountability・ Tb make this accountabil-

As Kooistra Autogroep became a larger and more com- ity possible, Tbm implemented three new systems when

plex organization’Tbm Kooistra concluded that the he took over as the CEO in 2002: Performance report-
ing, budgeting, and payfor-Performance. These new
systems were to be implemented by fiscal year 20O3・
l some of the dealerships were lo⊂ated in dose proximity. For these

dealerships, KooIStra Autogroep maintained one central work-

shop managed by the after-Sales department (See Exhibit l)’Which
1, Performance reporting
serviced several brands. The dealerships in the other locations had
their own workshop. The workshops essentially serviced both the
The new performance reporting system included both
sales and servICe departments. For service jobs, CuStOmerS Went financial and nonfinancial information. It was used as
through the servICe department’Which determined the work that
an instrument to communicate the company’s most
needed done as well as the (estimated) cost and time for completion
of the work. In addition, the workshop performed ge直eady work for
important objectives to the dealership and department
new ⊂arS SOld by the sales department’installation of accessories managers; tO PrOVide these managers with the infor-
on new cars, and service and reconditioning work on used cars for
mation they needed to do their jobs; and to provide
resale by the dealership.
2 Like the service workshop, the body repair shop obtained busi- feedback to top management so that they could moni-
ness intemally through the servICe deparment and from used car tor the lower-1evel managers’performances. Tom
sales for re⊂OndltlOning body work. The body repair shop’however・
explained:
also had its own reception for walk-1n CuStOmerS’aS nOt all Dutch

car dealerships provided car body repair work. Another significant
source of business consisted of contracts with insurance companies
3誌霊蒜慧豊霊嵩ksh。, W。S 。ul,e large, ,h。 r。l。 。f
after-Sales manager was created to oversee several workshop super葛
visors who, ln tu叫SuPerVISed the mechamCS (See Exhibit l).
4 customers who bought a car often expected the dealership to
My father needed to inform the deaiership manag-
ers and the department managerS Only about the
most important performance indicators because
he made most of the operationai decisions. i decen-
t「aIized an important part Of his decision-making

purchase their old car. Like most dealerships’Kooistra Autogroep authority" But when I made the operating managers
classi丘ed these used cars into two categories- Cars that were in good
responsib-e for achieving the required perfor-
enough condition were offered for sale by the dealership to used car
cus〔OmerS. Cars in poor condition’however, COnSidermg the repu亡a- mance, l a獲so had to communicate much more
tion of the dealership, Were auCtioned off in batches by the auction detaiIed perfo「mance information to them.
sales department to other companleS血at specialized in selling these

One type of perfbrmance report, Which was referred to

与篭悪霊窪謹書書誌窪謹書誌上g and as the ``Balanced Scorecard” within the Kooistra organ-
maintaining relationships with, and selling cars to’COmPameS that

bought cars in large numbers. ization, WaS distributed to the managers on a weekly

72

basisJt reported year-tO-date summary perfomance
on key metrics for each individual Eanager’s opera-
tions (e,g. a dealership) with an indicatio旦Qf progress
[OWards budget target accomplishment. Exhibit 2
shows this so-Called Balanced Scorecard for the Tbyota
dealership. In addition to the weekly balanced score-
card§, [he managers also received far more detailed
monthly reports, With sometimes up to hundreds of
line items pertaining to their areas of operation.
The dealership and department managers apparently
used the performance reports actively. Tbm explained:
Every Thursday at 2 o,cIock, the deaIership and
department managers receive their Balanced
Scorecards by emaii" When I waIk through the
company on Thursday afternoon and the reports
have not yet been emaiIed, department managers
ask me what’s up. The department managers are
interested in their performance and, Particuiar看y’in
COmParing their performance vis-a-Vis target・
2, Budgeting
At the same time, Tbm introduced a formal amual budg-
eting process. Although various types of financial and
nonfinancial information were considered during the
budgeting process, the main focus was on determining
net profit targets for the forthcoming year.
Net profit was defined as revenues minus controlla-
ble expenses, Which in practice meant that most
corporate overhead allocations were ubelow the line’’
on which the operating managers focused. However’
Tbm felt that continued decentralization would eventu-
ally lead the company to improve its methods of allo-
cating shared service costs to obtain more inclusive net
profit numbers and’thus, tO allow even better account-
ability at lower organizational levels.
The budgeting process was intended to be bottom-
up. The responsible managers prepared their own
budget proposals. The budget proposals were then
reviewed by Tbm and the CFO, Anna Lubbers, followed
by what they both described as ``rather tough, SOme-
times vociferous, discussions’’with each manager. Tbm
and Anna decided the final budgets.
The budget discussions served several useful pur-
poses. Most managers were inexperienced with budg-
eting and only few ofthem had had any formal business
education. Anna noted that,
For these and other reasons we can’t aiways trust
the initial budget proposais, SO We have to have a
Kooistra Autogroep
very hard iook at them. In the end, however’I
believe that we find the proverbiaI happy medium
for targets that we feeI the manager shouId be w冊
ing to commit to"
But not only did the budgeting discussions serve a
training role, they also were a valuable communication
tool to focus discussions about the business, Which
allowed Tbm and Anna to solicit information from
those who were dosest to the day-tO-day operations
from which they themselves had become farther
remove d.
Tbm and Anna monitored performance through
weekly reviews ofthe Balanced Scorecards. When they
saw performance patterns that were ofconcem to them
because they were not consistent with the budget tar-
gets and/Or the perfomance of other company entities’
they had conversations with the managers. The entire
top-management team also held monthly meetings to
review performance issues and discuss other company-
wide business matters.
The net profit budget targets were believed to be
achievable with considerable eff。rt. As Exhibit 2 shows,
the Tbyota dealership had almost achieved its 2OO6 net
profit target even though there were still five weeks to
go in the budget year. When asked’the Tbyota dealer-
ship manager estimated that at the time his budget was
approved, his likelihood of achieving the net profit tar-
getwas around 90%. He also pointed out that `Although
I,ve made my budget in each of the past three years’it
was rather cIose. But not a11 of my department manag-
ers met their budget each year. My workshop depart-
ment had some cost control issues and did not always
achieve its net profit targets.,, The Tbyota dealership
was among the best-Performing entities in the Kooistra
Autogro ep.
Some of the other dealership managers, however,
complained that they had trouble meeting their budget
targets due to factors outside of their control. For exam-
ple, the combined Chevrolet’Cadi11ac’Corvette’and
Hummer dealership complained that recent hikes in fuel
prices had negatively impacted car sales beyond what
could have been foreseen atbudget time. He wasn’t sure,
however, that Tbm would be sympathetic if he failed to
meet his budget, Which he likely would this year"
But Tbm also could sometimes “help’’the dealerships
make their target・ Kooistra Autogroep had a sizable con-
tract with a big rental car company that specified the
number and type of cars (e.g. small cars, medium-Sized
family cars, VanS), but not the brand, that the rental car
73
Chapte「 2. ResuIts ControIs

dealership that had been acquired. These contract!

company purchased. Thus’When the Opel dealership
could not easily be renegotiated. Considering these faぐ
was cIose to making its targ疎but needed寝a little help’’’
tors, Kooistra・s top managers admitted that the sales
fom could offer the Opel Astra血6del to the rental car
bonus plan was limited in scope. It also was still su函
company" Altematively, if the Tbyota dealership needed
to change. Anna Lubbers’CFO’eXPlained that manage.
some help, he could propose the Tbyota Corolla instead.
ment was considering fine-tuning the sales bonus plan
Tbm noted that, because of this leverage’he faced con-
by incorporating other perfomance criteria - Perhapr
siderable lobbying from the dealership managers to gO
with their brand. He said, ・・I never hear any complaints
gross, Or eVen net, PrOfit per car.
rfom’s new pay-for-Performance system for managers
when good fortune comes their way. It,s only when they
added a bonus element to the managers, compensation
miss their targets that I hear them grumbling.’’
package. The bonuses were added on top of the manag.
ers, salaries. Target bonuses for dealership managers
3. Pay-for-Performance were set between lO% and 20% of amual salary・ rぬrget

bonuses for department managerS Were Set at 8% of

A third major change was the expansion of a pay-for-
annual salary・ For dealership and department manag-
performance system for salespeople and the implemen-
ers, the bonuses were based on the extent to which the
tation of a pay-for-Performance system for dealership
managers met their annual net profit targets as set dur-
and department managerS. Some salespeople already
ing the budgeting process. Only managers who met their
received a bonus. But now 「Ibm introduced a pay-for-
net profit target eamed their target bonus. No bonuses
performance bonus plan for the managers.
were paid for below- Or above-target Performance・
Traditionally, COmPenSation for nearly all personnel
Both Tbm and Ama believed that the bonus plan
in the Netherlands was not performance-dependent. It
specifically, and the idea of payfor葛Performance more
was based on ajob rating, an aSSeSSment Of the training
and experience needed for executing a job’rather than generally’WaS Putting the company on the right track.
Tbm explained:
on the individual performance of the empIoyee" Thejob
ratings were linked to pre-eStablished salary increases.
I introduced bonuses Primariiy to make manage「S
Hence, the relationship between levels of compensation
conscious of the fact that something had changed
and actual empIoyee perfomance was usually weak.
rfo bypass the limits of salary increases for a certain […] that department managerS Were =Ot Oniy given
more decision-maki=g autho「ity but that thei「
job grade, tOP-Performing individuals often were
respons輔ties to meet eXPeCted perfe「mance aIso
promoted to jobs with a higherjob rating when those
had changed〇一think the p-an had that desired effect.
positions became available. For example, SOmetimes’
excellent car salespeople were promoted to sales man- Management also had the authority to reduce any or
ager positions. These promotions sometimes happened all bonus awards. However, in the first three years since
even when the dealership would have benefited more implementation of the system’SuCh discretion had
from the individual,s continued selling efforts than it never been applied. Moreover’the criteria that might
would from their management Skills.
justify a bonus reduction were not yet Clear, aS Tom
For years at Kooistra, Salespeople had had monthly explained:
sales targets, defined in terms of the number of (new
Theoreticaily we might reduce bonuseS because’
and used) cars sold. Some ofthe salespeople were eligi-
fo「 examP-e, administrative proCedures were nOt
ble for bonus payouts. In 20O7’these bonus-eligible
fo=owed or customer Satisfaction ratings were tOO
salespeople eamed租8.50 per car sOld. In addition,
Iow, But a bonus reduction wouid be a very Subjec-
when the salesperson met his or her monthly sales tar-
tive decision. We need to articulate the criteria for
get, the bonus amount waS doubled to鵜7.OO per car
such decisions more C-early. This is a priority for
for the month. On average, bonus paymentS Were about
the coming year.
25% of salary for salespeople who met their targets.
However, nOt all salespeople were yet eligible for
bonuses. Of the 45 salespeople at Kooistra Autogroep, issues
only 25 were bonus-eligible because some of them had
payfor-Perfomance was a relatively unknown phe-
negotiated a compensation package without a bonus
nomenon in Dutch companies. For examPle’One Study
contingency when they were hired’SOmetimes at a

74

Showed that in 2001, Only lO% ofthe department man-
agers in Dutch car dealerships reGeived a formula
bonus, and only 7% received a “discretionary’’(su切ec-
tively assigned) bonus (see Exhibit 3). For sales manag-
ers, these percentages were somewhat higher: 20% and
7%, reSPeCtively (not tabulated in Exhibit 3).
However, SeVeral studies had shown that Dutch
COmPanies (not just car dealerships) were increasingly
relying on pay-for-Performance practices, Which was
COmmOnly attributed to increased intemational com-
Petition. One study concluded that although only a
minority ofDutch companies applied some form ofpay-
for-Performance, the trend towards doing so was
upward, With 33%, 36%, and 4O% of a sample of Dutch
firms using some form of pay-for-Performance in 1997
1999, and 2001, reSPeCtively.6
Because such systems were rare in Dutch dealer-
Ships, Perhaps not surprisingly, Kooistra Autogroep
faced considerable skepticism from its empIoyees
When it first introduced its pay-for-Performance sys-
tem. A survey conducted by a consultant showed that
the vast majority of Kooistra empIoyees preferred a
Salary raise over a bonus, eVen if the raise was sign誼-
Cantlylower than the expected bonus. Tb i11ustrate this
POint, Edwin Vliering, a dealership manager,
recounted the fo11owing conversation he had had with
one of his salesmen:
In terms of profit and sales volume, the last three+our
years were genera=y bad years for Dutch car deaier-
Ships, At the beginning of 2006, One Of my top saies-
men asked for a salary raise. I offered her a bonus
instead. In her situatjon the bonus wouid have resuited
in more moneythan the raise she had asked for, eVen
in the poor iast coupie of years. Nevertheiess, She
WaS unhappy, She ciearIy valued the security of a
fixed income, I’d say that she is quite representative
Of the vast majority of empioyees around here.
6 For example, See S. Bekker, D- Fouarge, M・ Kerkhofs, A. Ro皿in, M・
de Voogd-Hamelink, T. Wilthagen, and C. de Wol年7teJtd-raPPOrt:
V「aag marArbefd 2002 (Tilburg, August 2003, ISBN 906566 O623).
Kooistra Autogroep
Did the pay-for-Performance system provide a sig-
nificant motivational boost? Edwin thought the answer
to this question was no:
Due to the economic situation, the last coupIe of
years were not good years, Consequentiy, my
deaiership and some of my department managers
did not make their targets and did not receive their
bonus. In my opinion, however, this has not affected
the motivation of any of us, We are a= stiil working
hard. On the other hand, eVen in good years the
IeveI of the bonuses is, I think, tOO 10W tO mOtivate,
ParticuIar看y for the department managers. In aIl
truth, I wouIdn’t mind if we abolished the bonuses
for department managers,
On the other hand, Tbm Kooistra and Anna Lubbers
Were COnVinced that the bonuses could, and did, affect
motivation. Tbm explained:
Our managers are ce「tainiy highly motivated. This
WaS true in recent years even though, due to the
POOr eCOnOmic situation, SOme Of them were una-
bie to rea=ze their performance targets. But l am
COnVinced that they make considerable extra effort
When they have a chance to meet their targets. For
exampIe, they organize extra sales activities when
realization ofthe target is possibie. 1 also know that
they feeI good when they achieve their targets,
That is part of the motivation, But the money is
Obviously important as weil.
Anna Lubbers agreed that the bonuses could provide
StrOng mOtivational effects, although she believed that
that depended strongly on the likelihood that the man-
agers can meet their targets:
It is important to set reaIistic targets. Only bonuses
that are based on realistic targets have a motivat-
ing effect. Setting realistic targets is particuiarIy
important in years of an economic sIump, like in
recent years. When the target is apie ;n的e sky, the
bonus wi= not work.
SaiesDepartment

Newcarunjts 250 229 92 221

Usedcarsunjts 225 231 103 225
Newcarrevenues 5,900,000 5,467,522 93 5,298,521
Usedcarrevenues 3,100,000 2,978,644 96 2,906,335
Salesrevenues 9,000,000 8,446,166 94 8,204,856
Newcarnet 125,000 112,135 90 107,154
Usedcarnet 5,000 3,504 70 982
Salesnet[1] 130,000 115,639 89 98 106,172
SalesnetmargIn 1.44% 1,37% 1.29%
Newcarnet/unit 500 490 485
Usedcarnet/unit 22 15 -4
UsedcarwarrantyexpenseS 84,275 82,364 90,264
Warrantyexpense/usedcar 375 357 82 401
Manufacturerincentives 150,000 122,687 165,922

ServiceWorkshop 〇一・’￣

Servicerevenues a 860,000 815,367 95 845,648

Servicenet[2] 215,000  0 191,819 2353% 89 201,087 2378%
ServICenetmargin Numberoforders 25.00% 1,650  0 1,621 98 1,648

Numberofcarshandied 1,050 1,002 95 1,010

Capacity(numberofhours) 8,800 8,745 99 8,800
Productivehours b 8,350 8,328 100 8,319
invoicedhours C 7,400 7,149 97 7,380
Productivity b/a 95% 95% 95%
lnvoicedhourspercentage C/a 84% 82% 84%

PartsDepartment

Partsrevenues 1,325,000 1,318,879 100 1,291,820

Partsnet[3] 275,000 276,312 100 88 256,562
Partsnetmargin 20.75% 20.95% 19.86%
Partsrev,/invoicedhrsworkshop 179 184 175
Inte「estExpenses[4] 245,000 216,560 232,487
Totalrevenues 11,185,000 10,580,412 95 10,342,324
TbtaInet[1]+[2]+[3]-[4] 375,000 367,210 98 331,334
Totainetmargin 3.35% 3.47% 3,20%
Inventory Newcarsinstock 50 47 58

Newcarsaveragedaysinstock 45 40 51
Newcarsinstock>90days 10 8 14
Numberofbackorders 50 62 49
Usedcarsinstock 60 55 60
Usedcarsaveragedaysinstock 50 45 60
Newcarsinstock>90days 0 1 12
Usedcarsstock(euros) 475,000 424,954 287,469
Partsinstock(euros) 135,000 133,659 136,953

77
Chapter 2. ResuIts Cont「oIs

Exhibit 3 United States vs・ Nether-ands compa「ison of compensation plans used in ca「 deaierships
豊里コ

∴ussampie(1998) Nethe「Iandssample(2001〉

Base Formuia Discretionary Sp附s Base Formula Discretionary Sp珊S

Salary bonus bonus Salary bonus bonus

GeneralManagers [N=250】Avg.1t)t.Comp〇二$190,658(∩=240) [N=61]Avg,lbt・Comp.=C58,303(n=61)

Comp.packagebreakdown 56.8% 36.5% 3.9% 2.9% -110 96.9% n-61 2.6% nこ9 0.4% n二3 0,1% nこ1
NumberreceiVing PercentreceIVmg n=238 95.2% n二1了0 68.0% n=49 19,6% n_ 44.0% 100% 14.8% 4.9% 1.6%

Averageamount $82,262 $136,724 $36,449 $10,458 毛56,029 ∈13,079 C6,000 C3,000

Av  ctoftotaIcomp
g・p・ DartmentManagers 58,2% 51,5% 18.9%
[N=526]Avg.1bt.Comp.=$72,390(n=510) 6.3% 96.9% 17,5% 8,1%
[N=145]Avg.1bt.Comp"=C36,318(n=145)5.1%

ep Comp・PaCkagebreakdown 49.8% 36,2% 4.2% 9.9% -323 98.7% -145 0.9% n-15 0,2% n二10 0.3% n=30

NumberrecelVlng PercentreceiVing nこ433 82.3% n=338 64.3% n二118 22.4% n_ 61,4% n- 100% 10.3% 6.9% 20.7%

Averageamount $35,757 $53,751 $15,149 $4,585 ∈35,745 ∈3,992 C940 C457

Avg.pct"OftotaIcomp. 58.7% 54.6% 18.0% 15,6% 98.7% 8.6% 2,7% 1.2%

CASE STUDY
Houston Feariess 76, lnc,

In late 200O, M.S. Lee, PreSident/CEO of Houston Fear- peop-e and give them opportunities to be success-
ful, but I a-so want the company tO get tO the next
less 76, Inc. (HF76), WaS COnSidering making a major
ievel of performance. Are our structureS Set uP tO
change in the company,s sales incentive system:
motivate them to do that?
We need revenue growth and consistent profitabii-
ity, a=d right now we don’t have them" l think our
l think we have a range Of probIems" We,re cIearIy
not doing enough to deveiop new markets, tO
primary prob-em reIates to sales, Which have
expand our existing markets・ Or tO deveIop syner-
siowed. Some of this is due to market conditions・

but l also thinkthat our saies effort and sales sup- gies among Our ma「kets" We have an obvious mis-
match between our COmPany Objectives and our
port can be improved・ I want to take care of our

78

SaIes force incentives because ou「 commissions
are based on sales, nOt PrOduct profitab冊y. We use
different compensation structu「es jor different
PrOducts, and I have heard some grumbiing among
the saIes peopie about equaiity, And our saIes fore-
CaStS are inconsistent, Forecast accountab掴ty is
not st「Ong Since there is no downside for saIespeト
SOnS fo「 overstating forecasts. This sometimes
CauSeS PrOduction planning probiems.
So we need to make some changes to improve
Perfo「mance. We need better systems now more
than ever because we are entering some new ma「
kets that are more competitive than those to which
We have been accustomed,
With these concems in mind, Mr. Lee asked his son,
James (who joined HF76 in 1998 and later became
head of corporate development and operations, and
Who was attending the University of Southem Califor-
nia Executive MBA Program), tO Critically evaluate
HF76’s sales function and to revamp the sales incentive
Plan. M.S. and James Lee planned to present a proposal
for change at the amual sales meeting to be held in
mid-December 2OOO.
Company history
Houston Fearless 76, Inc. was a privately held company
headquartered in Compton, Califomia. Annual company
Sales were approximately $15 million. The company had
120 empIoyees. HF76 was a worldwide leader in the
design, manufacturing, marketing, and service of high-
quality micrographic products, Photographic創m and
PaPer PrOCeSSOrS, Photographic chemical handling
equipment, and photographic quality control accessories.
HF76’s roots dated back to 1939 when H.W. Hou-
StOn, One Of Howard Hughes’s movie-making business
PartnerS, founded a company around the development
Of the first automatic roll film processor. Most of the
H.W. Houston Co.’s early customers were dosely con-
nected to the motlOn-PICture industry, Later in the
1940s, the company went public and expanded into a
manufacturing company that produced a wide range of
PrOducts, induding創m processors, hair-Clips, turbine
blades, and radar. At one time it was one of the largest
manufacturing companies in the Los Angeles area. In
1950, the company merged with Fearless Camera Cor-
POration of Culver City and became known as the
Houston Fearless Corporation. Later, however, the
COmPany faced many problems, and it was forced to file
for bankruptcy and to liquidate its assets.
Houston Fearless 76, inc.
In 1976, M.S. Lee, a former Houston Fearless empIoyee,
and two partners bought the Houston Fearless Photo Divi-
Sion. They named their company Houston Fearless 76,
Inc., both to take advantage of the excellent reputation
the company had developed, eSPeCia11y in鮒m-PrOCeSSing
Circles, and to commemorate the year of their acquisition.
Mr. Lee later acquired a11 of his partners’shares.
HF76 prospered in the 1970s and 1980s. In the 199Os,
however, film-based product markets experienced a dra-
matic decline. Many corporate customers, including
those in the banking, healthcare, and movie industries,
Were mOVing toward digital production and record-
retention technologies. Facing the declining market
demand, SeVeral of HF76’s competitors had exited the
乱m-PrOduct market. Mr. Lee believed, however, that
“the demise of創m was greatly exaggerated:’He wanted
the company to cont:inue serving its traditional film-
based market, Particularly in good niche markets, aS it
repositioned itself in faster-grOWing markets.
In the 1990s, Mr. Lee aggressively expanded in both the
traditional film market and growing digital market
through a series of acquisitions, In 199O, HF76 acquired
Extek Microsystems, an imovator of film-duplicating tech-
nology that served a customer base similar to that ofHF76’s
in the micrographics marketplace. Extek’s operations were
integrated into HF76’s Compton facility. In 1997, HF76
acquired Houston Intemational, Inc. which manufactured
large-VOlume, SPeCialized te.g. long roll)餌m processors.
This division was renamed HF Intemational, but its opera-
tions were not moved from its Yuma, Arizona, 1ocation. In
1999, HF76 acquired 8O% ofMekel Engineering, located in
Brea, Califomia, Which produced scamers that converted
micro創m and micro宜che to digital format工ightweight
餌m and video cameras, heads-uP display units for fighter
aircraft, and tra鯖c photo-Citation analyzers.
For over 3O years, HF76 also had a govemment divi-
Sion, Ca11ed HF North, that supported the US Air Force
through a variety of special prQjects that invoIved film
PrOCeSSerS, POWer distribution systems, mObile shelters,
Climate control units, and po11ution controI systems,
This division was Iocated at Beale Air Force Base, near
Sacramento.
HF76 was also attempting to diversify its product line
by capitalizing on potentially sizable commercial appli-
Cations of the pollution controI systems developed by HF
North originally for the US Air Force. These innovative
POllution controI systems separated practically all
kinds ofwater contaminants, from heavy metals to toxic
biohazardous waste. A production facility for these sys-
tems hadjust been started in the Compton location.
79
Chapter 2. Results Cont「Ois

HF76 product gross margins averaged approximately

The company in 2000
After the 1999 Mekel acquisitiorlJ HF76 was organized
into four product divisions (see Exhibit l). Each divi-
sion operated as a profit center・ Corporate staff pro-
vided support and coordination of activities" The
pollution control business was being developed at the
corporate level under the purview ofJames Lee.
The HF76 culture was dose-knit, family-1ike, and
casual. M.S. Lee, the president/CEO’WaS a former local
“entrepreneur of the year.,, He was a strOng Central fig-
ure, but he was also perceived as being highly caring’
28%, but they varied significantly across product lines
and models. Relatively low profit margins (10-15%)
were eamed on processors and po11ution controI systems.
Duplicator sales were relatively profitable (30-35% mar.
gins). However, HF76,s managers were selling some spe-
cific models of their older product lines at minimal, Or
even negative, grOSS margins. They did so because they
wanted to retain their customer base in order to earn
profits on forthcoming replacement part sales, the mar-
gins on which were usua11y in excess of4O%.
Industry performance benchmarks were di飴cult to

honest, and nurturing. Staff were given recognition establish accurately because HF76,s smaller competi・

and periodic awards (e.g. parties, 1ogo merchandise). tors were all privately held and their larger competitors
M.S. Lee described the company,s strategy as follows: fe.g. Eastman Kodak’Be11 & Howell) were so large tha[
they could bury their HF76-relevant financial results in
We now have products at d冊erent market stageS"
aggregated financial statements. However, HF76’s
we have some emerging products, Particularly pol一
managers believed that their company,s performance
iution controI systemS and tra情c photo-Citation
was lagging behind that of its major competitors on all
ana-yzers. We have some POtentialiy high growth
dimensions. For example, in 1999’HF76,s profit margin
markets for some Of our scanner PrOducts. And we
(as a percentage Of sales) was only O.04%’While the
have a Iot of mature PrOducts, SuCh as our PrOCeS-
industry benchmark, aS given to HF76 management by
sors and dupiicators"
a management consulting fim’WaS 5.7%. HF76’s
Each market requi「es a d冊erent strategy. For
inventory tumover WaS 2.6 compared to the industry
examp-e, for products in the emerging and growing
benchmark of 4.9. The HF Intemational division, Which
markets, We need our sales fo「ce to identify new
was operating at a loss’WaS Creating concem.
customers and new markets. For products in the
mature markets, Our Sa-es force should capitaiize
on our brand name and maintain as muCh voiume Marketing and sales e情orts
as possibIe in the niche market, PrObabiy through
All of the HF76 products’With the exception of replace-
targeting Ioca- government and accounting fi「ms
ment parts’SOld for significant prices’SO they were
and through specia- trade-in programS tO Stimuiate
capital equipment for the buyers. For example’a tyPical
the repIacement Of old machines.
new photo processing machine’One Of HF76,s Iow-end

The HF76 divisions each did their own manufactur- products, SOld for approximately $60’000’and some of
the high-end products sold for several hundred thou-
ing. Most product lines had some standard products,
sand dollars. Thus, the sales process usually invoIved
or at least subassemblies. In these cases’HF76 would
more thanjust taking an order・ For many Of the prod-
build to inventory, based on demand forecasts. In the
ucts, the sales cycle was lengthy, a year Or mOre. In
micro創m and motion-Picture飢m processing markets,
many cases, Particularly for the more advanced prod-
customers typically waited about 30 days for delivery
ucts, the salespeople had to serve as consultants’help-
ofmachines that required some customization. Largely
ing their customers tO SOIve problems.
custom products were built after the orderwas booked’
until the last few years, mOSt Of HF76,s sales were
and the wait in such cases could be several months.
made through a network of dealers (sometimes referred
HF76 suffered from the sales/OPerations frictions
to as “strategic partners,・) and independent sales repre-
common to many companies. Operation managers
sentatives. The dealers and reps provided HF76 with a
often complained that salespeople were not aware Of
the required lead times and that some of their rush professional sales effort’local customer knowledge’
and, in the case of the dealers’Sales of complementary
orders imposed significant overtime labor costs. Sales’

on the other hand, COmPlained that they sometimes
Iost orders because their operations department could
not meet the required delivery schedule.
products and a service capability, With little or no fixed
costs. However, mOSt Ofthe dealers and reps did no pro-
active marketing; they merely responded to inquiries.

80

Further, having the dealers and reps do the selling was
expensive because HF76 had to Q暫er them significant
price concessions (typically 40% off list price) or high
commission rates (typically 7-10%). One active inde-
pendent rep was also paid a fixed retainer fee. She was
somewhat like an empIoyee, but with a lower salary
and no benefits, and a higher commission rate. She also
had no obligation to serve HF76’s interests (e・g. market
development) if she did not believe that those e徹)rtS
would lead to her own commissions.
To provide a more effective and more company-
focused selling effort and, SeCOndarily, tO Cut COStS,
HF76 managers were trying to build up the company’s
own intemal sales force. A11 of HF76’s competitors sold
a11 their products direct to customers. For intemal
§ales, HF76’s goal was to keep the sales costs (compen-
§ation and expenses) to less than lO% oftotal sales, but
they did not always achieve that goal.
The tasks required to se11 the various HF76 products
varied signi丘cantly depending on a number of factors’
induding the product characteristics’the market
conditions, and the company’s customer relationships.
Despite some redundancy (e.g. some of HF76’s sales-
people for different equipment lines called on the same
cu§tOmerS), HF76 managers did not think that they
could organize the company’s sales effort entirely geo-
graphically. Selling the HF76 products required consid置
erable technical knowledge, for example, about optics,
micrographics, and software. Little of that knowledge
was consistent across product lines.
The photo processing business (HF Intemational)
was mature. Most sales in this market involved replace-
ment of existing equipment and replacement parts, SO
the potential customer base was quite we11 known. The
US photo processing market had l’00O-1’500 potential
customers, mOStly those who did wholesale photo fin-
ishing (e.g. schooI portraits, Weddings)・ One HF76
salesperson, Brett Hutchins’COVered the eastem halfof
the country. Sales in the western half were made
through independent sales reps.
The micrographics and motion-Picture processing
markets (Extek) were also mature. Most of the micro餌m
customers were local govemment entities, (Most corpo-
rations had moved to digital storage of documents.) The
vast m亘iority of sales in this market were made through
a network of approximately 125 dealers, Only some of
which were active. HF76 had one salesman, Matt Petilla,
working in the micrographics and motion-Picture mar
kets. Matt was also given the task of culling the dealer
list to a smaller number. HF76 managers wanted their
Houston Fearless 76, lnc.
dealers to be more aggressive, They were planning to
require the dealers to do some significant selling in order
to remain on the dealer list. In retum, theywere going to
PrOmise some exdusive territory protection.
The scanner business (Mekel), Which had more high-
tech products with higher growth potential’uSed all the
sales channels. The company had two in-house salespeo-
ple. Jim Mancini sold throughout the United States. Ryan
Chase was responsible for Asia and Latin America. And
some sales were made through dealers and independent
reps. one rep, Stephanie Eller’described earlier as being
on retainer, generated almost one-Sixth of Mekel’s total
scanner sales in 200O. HF76 managers estimated that its
customer base for scamer products numbered about
300-4OO, but it did not know the names ofall its custom-
ers because some distributors did not share their lists.
One HF76 salesman, Mark Fogarty, WaS reSPOnSible
for selling pollution controI systems. Mark was a
technical person with little sales experience. By late
2000, HF76 had just gotten to the point that it could
build the pollution controI systems in any volume’and
Only one system had been sold.
One constant across all the divisions was that the
salespeople were not, by themselves’aCtively develop-
ing new customers. They generally relied on a list of
regular customers to contact and on company advertis-
ing to interest customers. They then responded to tele-
Phone and email inquiries.
The in-house salespeople reported to Bob Smith (VP
Marketing), although in reality they worked relatively
independently・ The salespeople were geographically
spread across the country. For example’Brett Hutchins
(Houston Intemational) lived in Maryland; Matt Petilla
(micrographics) lived in St. Louis; Bob Smith lived in
Atlanta. All of the salespeople traveled extensively to
meet with their customers. The salespeople had the
authority to discount up to 5% off list price. Larger dis-
counts had to be proposed to and approved by Mr. Lee.
Assistants at both corporate and division levels pro-
vided support to the sales force. Among other things’
they made some follow-uP telephone calls to customers’
maintained the databases, delivered the sales contracts
to production, designed the company’s advertisements’
and set up the marketing shows. They also helped allevi-
ate some of the salespeople,s weaknesses. For example,
one salesperson had no typing or computer skills. Thus,
he needed more support in preparing sales contracts・
Bob Smith managed the sales function primarily by
monitoring the weekly sales reports. He also periodi-
ca11y observed salespersons, behaviors on sales trips
81
Chapter 2. Results ControIs
and trade shows. About the evaluation process, Bob
noted: “I can distinguish go♀竺Performers from poor
OneS through the ways they de聖.vyith clients. But
more directly, their performances are re血ected auto-
matically in the reports of items shipped to their terri-
tory,’’Bob also noted that HF76 had not had formal
Performance evaluations in two years. He said言`we
Can’t aff。rd raises, SO Why bother evaluating people?”
HF76 had gradually been computerizing its sales track-
ing systems. Previously, all tracking had been manual.
SaIes forecasts
The sales personnel were asked to provide an annual
Sales forecast at the beginning of each year. Then they
Were aSked to update their forecasts on 30-, 60-, and
90-day rolling bases. The forecasts were important for
PrOduction planning purposes; for example, for deci-
Sions about which parts to buy and what subassemblies
to produce to inventory.
However, aCCOrding to Mr. Lee, the sales forecasts
Were lnCOnSIStent:
Fo「ecast accountabiIity does not rea=y exist in our
Current COmPenSation structure. There is no mech-
anism to prevent saIespersons from overstating
forecasts or sandbagging. Thus, the saIespeopIe
tend to be optimistic, and e冊cient production pIan-
ning sometimes becomes very di簡Cuit,
Bob Smith, On the other hand, thought that the sales
forecasts were reasonably accurate. He noted:
Last year our saIes goals were too tough. We worked
hard, but the market was soft, This year’s targets are
more reaIistic, SO I think we’Il do better. But we can’t
COntrOi a看I of the results. Things happen. For exam-
PIe, SOme Sales get heid up pastthe period end. This
year one of our big customers, OIin MiIis, Cut their
budget at the Iast minute, and we did not get a Iarge
Order that we expected, On the other hand, We
SOmetimes get a “bluebird’’[a large order that was
not forecast], We surely have to be out there working
With our customers to know what is going to hap-
Pen, but even so we can’t controI everything.
Ryan Chase (Scanner Product Sales - Pacific Rim)
explained the forecasts from his perspective:
I don,t have an annuai forecast because i,m reIa-
tively new on the job, I have no basis for a forecast.
i guess if they forced me, I would forecas=O scan-
ners peryear. I gOt iucky Iast year with saies of 14,
82
but my big saIe took me two years of effort, The
year before last I sold only two scamers , ‥ ln my
forecasts, i wouidn’t mention the name of a com.
Pany if the probab冊y of the saie is less than 80鮪
Or 90%. You often don’t get a soiid answer from
intemationaI customers until the last minute.
丁he old saies incentive plan
Up through 200O, all of the salespeople, eXCePt Mark
Fogarty,1 were paid a base salary plus commission.
The salespersons’base salaries Iooked relatively low,
typica11y $40,000-$60,000, but the total compensa'
tion packages and their structure were industry com
Petitive. Commissions were set at a defined percentage
Of sales, meaSured as revenue from items shipped
Within the salesperson’s assigned territory. The com・
mission rate differed across salespeople on a negoti-
ated basis with specific attention paid to product
Characteristics and market situation. Two salesmen,
Brett Hutchins and Matt Petilla, eamed a 4% commis.
Sion. Ryan Chase eamed a 2% commission because he
WaS relatively new in hisjob. Bob Smith eamed l% on
all company sales within the United States, Canada,
and Mexico, The actual commissions the salespeople
eamed were typically in the range of 50% ofbase sal-
ary, but they could be substantially more.
The sales assistants shared a small bonus pool if
HF76 met its overa11 sales goals. In 1999, eaCh assistant
WaS given approximately $1,000. One assistant, Eva
Colton (Mekel), described her reaction to the bonus.
I had forgotten about the bonus. The $1,000 came
as atotaI shock , ‥ ifwe make thisyear’s goaI, and
right now we’re behind, it’= be great. But there is
not much I can do to help us getthere.
A new incentive pIan being
COntemPlated
M.S. Lee wondered what could be done to improve the
COmPany’s marketing and sales efforts. He explained:
Some causes of our low p「Ofits and cash fiows are
Obvious, SuCh as a deciining fiim-based product
market and ou「 decision to invest strategica=y fo「
1 Mark Fogarty had been assigned to the job of marketing and sales
Of pollution controI systems only recently, and he had not yet been
induded in the current incentive plan. However, he was Iobbying for
indusion, and a decision on that had to be made soon.

future gains, However, I beiieve that we are not fu=y
expioiting market and profit op掌「tunities for either
Our traditionaI products o「 our-neツ.PrOducts" ln
Particular, Ou「 Sales force has not do=e What i want
them to do, l want them to open new markets, tO
Se旧n more profjtable markets, and to give us more
iead time for better operationaI piannjng,
After a series of discussions, M.S. and James Lee
COnCluded that they needed to make a major change in
the company’s sales incentive plan to attempt to alter
behaviors in the desired ways. James observed:
It was pretty cIear that the oid incentive plan was
not working, The commissions were exclusiveiy
based on saIes voiume, WhiIe we tried to teIl the
Saies force which products were most profitabie,
they seemed to be w冊ng to push saies at any cost
Or Price, They aiso were paying iittie attention to
Other strategic goais, SuCh as the opening of new
markets or accounts or improving the accuracy of
their forecasts. This is pe「haps naturaI because
they were not evaiuated on those factors" In addi-
tion, the Iinkage between efforts and rewards was
unciear, Sales peopie received compensation for
items shipped within their territory regardless of
Whetherthey were instrumental in making the saIes
Or nOt, So, OVera=, the old incentive pIan created
distorted incentives.
Tb overcome the problems in the old system, M.S.
and James were considering a quite different incentive
Plan that they thought would translate HF76 missions
and strategies into sales actions. They planned to leave
base salaries at current levels but were planning to
implement a new incentive plan consisting of three ele-
ments: (1) a commission based on product gross mar-
gins, but with no commissions paid until gross margins
exceeded 70% of forecast; (2) a bonus based on fore-
cast accuracy; and (3) a bonus based on achievement of
individual management-by-Objectives targets"
The o切ective of basing commissions on product
gross margins was to encourage salespeople to focus
their effort where company profit potentials were
greatest. M.S. and James hoped that the salespeople’s
knowledge of product gross margins, COmbined with
the incentive reinforcements, WOuld affect their sales
behaviors bene丘cially.
One unsolved issue: M.S. and James had not yet
decided what commissions they should pay on negative
and low-grOSS-margin products. They thought that it
Houston Feariess 76, lnc.
WaS SOmetimes in the company’s strategic interest to
make some of these sales. Should they report “phony’’
gross margins to the salespeople to motivate them to
sell these low margin products? Or should they weight
the commission payouts according to the ``strategic
importance,, ofthe sale? Ifthe latter, how should strate-
glC lmPOrtanCe be defined, and how should it be
explained to the salespeople?
The actual commission sIopes would be set for each
individual so that at lOO% of plan, eaCh salesperson
could expect to eam in commission slightly more under
the new plan than they would have eamed under the
old plan. This feature was considered essential for
securing the salespersons, easy acceptance of the
change. However, the commission structure (see
Exhibit 2) would be quite di任erent. No commissions
would be paid for sales up to a minimum performance
standard, de宜ned as 7O% of the annual gross margin
forecast. This feature was intended to allow for greater
PayOut leverage at high performance levels. Between
70% and lOO% of the planned annual gross margin,
commissions would be paid at rates that were much
higher than would be the case if commissions were
paid on all sales. That is, if commissions were paid on
all sales, the commission rate (as a percentage of gross
margin) would be in the range of lO -12% onhigh mar-
gin sales and 3O-35% on low margin sales. Because of
the leverage provided by the minimum performance
standard, the actual commission rate paid on gross
margins earned above the 7O% threshold could be
raised to 3O-100%. For sales above lOO% of the annual
gross margin plan, the sIope on the commission curve
would be 25% higher than in the 70 -10O% range, tO
encourage the higher performers to develop new mar-
kets and customers effectively. No cap was placed on
the maximum commissions that could be earned.
Salespeople were to be paid commissions on an annual
basis, but monthly cash advances would be paid at a
rate of 8O% of annual plan to allow the salespeople to
smooth out their cash凪ow.
Tb encourage the salespeople to take their sales fore-
casts seriously, a SeCOnd element of the plan promised
an extra bonus based on the accuracy ofthe sales fore-
casts. The salespeople would eam an extra 5% ofbase
salary if their total gross margins were within lO%
(plus or minus) of the annual gross margin forecasts.
M.S. and James Lee hoped that this “truth-inducing’’
feature of the plan would motivate the salespeople to
reveal their best estimates of their market prospects
rather than be optimistic, aS had been typical in the
83
Chapter 2. Results Controis

Assessment was subjective and intended to lean in

past, Or COnSerVative’aS might be expected with the
new 70%-Offorecast minimum performance standard. favor of the empIoyee" If top management deemed the

The third element ofthe contempla艇d new plan, the salesperson,s perfomance in all of the defined areas as
MBO targets, WaS designed to facilitate communica- satisfactory, the salesperson would be given an extra

tion and reinforcement of management desires and 5% ofbase salary.

expectations in any of a variety of areas. The target No changes were planned to the bonus system for
areas and specific targets would be negotiated between the sales assistants.

each individual and management. Typical MBO targets

might include items such as the fo11owing:
'ミ adding a significant number of new customers;
こ∴ COOrdinating well with production;
ニ keeping annual travel expenses below travel
expense forecasts;
ミ Strengthening ties with professional associations;
ニimproving communications through effective use of
email;
← learning and utilizing Microsoft O飴ce and other
Concems
M.S. and James were preparing to present their pro-
posal for the new sales incentive plan at the company’s
annual sales meeting, tO be held on December 13,
2OOO. However, both of them were concemed. They
knew that changes of this magnitude could be made
only rarely, SO it was important that this change be
made correctly. They were offering to pay their sales-
men significantly more money. Would they be getting
at least equivalent value in return? And even more
importantly, WaS this plan what the company needed to

software. push itselfto a higher level ofperformance?

Exhibit l Houston FearIess 76, lnc,, CO「PO「ate Organization chart, 2000

Co「porateDeveIopment S.McLa「en
J.Lee Manager VP-Finance

CustomerService R.Prescott Marketing/Sales R.Smith

Custome「&Technical ServiceManager VP-Marketing

Personnel/Govemment ContractSupport
」〇三」 Saies

i Operationsand Finance/Accounting
i        l

ExtekP「oducts MekeiTechnoIogy HFInternational HFNorth

P,Kemedy D.G「een B.Scotts P,Linder
GeneralManager Exec.VP/GeneraiManager VP/GeneralManager VP/GeneraIManager

84
Exhibit 2 Comparison of oId and new commission structure

Commission
PayOut ($)

70% of gross lOO% of gross

margin pian margin pIan
Saies doIla「s (Oid pIan) or gross margin dolia「s (new pian)

85
 CHAP丁ER 3
Action, Persome看, and Cultural
ControIs

Results controIs are not the only form of control. Organizations can supplement or replace
results c。ntrOIs with 。ther forms of control that aim to make it more likely that employees will

act in the organization・s best interest.1 one such type of control, aCt証corl亡rO】s’invoIves ensur-

ing that empIoyees perform (do not perform) certain actions known to be beneficial (harmful)
to the organization. Although action controIs are commonly used in organizations’they are not

effective in every situation. They are feasible only when managers know what actions are
fun)desirable and have the ability to ensure that the (un)desirable actions (do not) occur. Other
forms of control, PerSOmeZ co庇roZs, are designed to make it more likely that employees will

perform the desired tasks satisfactorily o証hefr own because the employees are experienced,
honest, and hard-WOrking and derive a sense of selfrealization and satisfaction from perform-
ing tasks well. Related, C庇u「。 co庇rOZs exist to shape organizational behavioral norms and to

encourage empIoyees to monitor and influence飽ch o証er,s behaviors. Action’PerSOnnel’and

cultural controIs are part ofvirtually every management controI system (MCS). In some organ-
izations, they are so important they can be said to be the dominant form of control・

Action cont「o看s

Action controIs are the most direct form of management control because they involve taking
steps to ensure that empIoyees act in the organization,s best interest by making their actions
themselves the focus of control. Action controIs take any of four basic forms: behavioral con-
straints, PreaCtion reviews’aCtion accountability, and red皿dancy・

Behavioral const「aints

Be庇vioraLeo鵬tra誼s are a “negative・, or, aS the word suggests’a uCOnStraining,章erm of action

control. They make it impossible’Or at least more difficult, for empIoyees to do things that they

should not do. The constraints can be applied physically or administratively.

Most companies use multiple foms of p互y扉caZ cous亡ra証亡s, in。uding locks on desks’COm-

puter passwords’and limits on access to areas where valuable inventories and sensitive infor-
mation are kept. Some behavioral constraint devices are technically sophisticated and often
expensive, SuCh as magnetic identification card readers and fingerprint or retina readers. In
situations where a high degree ofcontrol is desired’SuCh as in facilities where radioactive mate-

rials are processed, SeCret SerVice agencies where 。assified information is gathered’Or CaSino

count rooms where cash is handled, the benefits of such sophisticated controIs outweigh their
cos亡S. But physical constraints are important in more everyday settings’tOO’SuCh as retailing.

For example, a Study by the Center for Retail Research indicated that theft by empIoyees is the
second-largest sourcedf旬ventory shrinkage” - t:hat is’losses stemming from shoplifting, theft

by empIoyees, SuPPlier力endor fraud, Or aCCOunting errors. According to this stud扉n the year

to June 201O, retailers spent $26.8 b皿on (or O.34% of sales) on preventing theft.2 or’aS

another report suggested:

`fb put retai- shrinkage in perspective, tOta- do一一ars Iost to shrinkage is aImost the same

amount as the totaI investment made each year by the entire Ca=adian retaiI industry in
their lnf。.mation lt}Chno10gy (lT) departments and more than what retaiIers invested in

their Finance departments・ Un-ike lT and Finance spending however, Shrinkage provides

no benefits to retaiiers and requires significant time and expense to identify’manage and

prevent,,, said Paul Beaumont・ Director of PwC・s Ca=adian Retail Consuiting Se「vices

practice・3

Tb contro1 1osses in both store and warehouse environments’retailers use dosed circuit TV/

DVR recording systems, Observation mirrors, and ``tip lines,, to report incidents.
Effective physical constraints are also increasingly crucial in the context of data protection
and privacy concems faced by virtually all organizations’both private and public, that elec-

tronically store infomation about their clients’CuStOmerS, Patients’Or Citizens. In a survey

focused on the issue of data theft, the vast majority of respondents (84%) perceived data theft
as a significant risk to their business’While more than half of the respondents (52%) thought

that the risk ofdata theft would only increase and become an even more serious threat. Further-
more, eVen though most data theft coverage focuses on the risks presented by extemal attack-
ers, nearly two-thirds of the respondents (64%) suggest that empIoyees’Who inevitably have

access to company data in the normal course of business, are the most likely perpetrators of
data theft.4
For example, Venerable HSBC,s Swiss private bank arm had to apoIogize embarrassingly to
its clients, Whose data were stolen by a fomer employee who should not have had’but did

retain, aCCeSS tO 。ient information.5 similarly, a US Internal Revenue Service (IRS) empIoyee

took home a computer thumb drive containing unencrypted data on 20’000 fellow workers’

where “the Social Security numbers, nameS and addresses of empIoyees and contract workers

were potentially accessible online because the thumb drive was plugged into the empIoyee’s

unsecure home network,” IRS commissioner John Koskinen said’adding that’αthis incident is a

powerful reminder to all of us that we must do everything we can to protect SenSitive data -
whether it invoIves our fellow empIoyees or taxpayers・・・ This IRS breach’Significant as it was in

terms of poor controIs’nOnetheless was much narrower in scope than the security incident at

Target, the US retailer, Where hackers stole credit-Card information used by millions of shop-

pers; Or at Barclays’the large UK bank, Where confidential data of 27,000 of its customers

(in。uding their eamings, SaVings’mOrtgageS, health issues・ insurance policies’PaSSPOrtS, and

national insurance numbers) were allegedly stolen and offered for sale by the hackers.6
The growing importance of such data systems risks cannot be overstated’aS SuggeSted by a

correspondent at T庇Ecor10mfs亡:

untiI recentIy, for most businesses security was a question of buying decent iocks’doors

and windows, insta…ng CCTV’making sure that reception staff sign visitors in and out’and

trying =Ot tO -eave confidentia- papers in the photocopier. But attacks on their computer
systems’be they by business riva-s, POlitica- activists, CriminaIs or foreign govemmentS,

are much harderto defend against - and can have farworse conSequenCeS than a physjcal
break-in. A company can suffer a devastating b`ow to its reputation・ its inteiiect=al prop-

erty, Or its ab皿y to serve cuStOmerS - nOt tO mention its bank baiances" it may never Iearn

87
Chapter 3. Action, PersonneI, and Culturai ControIs

Who has attacked it or why, Or how much information has been taken; SO it may never be
sure if出has done enough to p-ug the -eak.7

Of course, the controIs evolve, tOO. For example, COmPanies can hireperle亡rC証o所esters to check

their data defenses. They also set traps, Called hon卯Ots, Which are bogus but convlnClng COm-

PuterS, netWOrks, Or乱es to lure hackers while revealing their presence and tactics. And organi-
Zations keep sensitive information in separate chunks with no single person in possession of
them all, Which is a variation of the physical world’s segrega亡iort Qft7千句rm融on principle.

In addition to, Or in lieu of; physical constraints, ad肌誼is亡ra轟ve corlS亡rC血ts can be used to

Place limits on an empIoyee’s ability to perform all or a portion of specific tasks or actions. One
COmmOn form of administrative control invoIves the restriction of decision-making authority.
Managers at a low organizational level may be allowed to approve expenditures of up to, Say,
$1,OOO only, those at a higher level up to $5,000, and so on. Above those limits, the purchasing
department is instructed not to place the order. The senior managers who restrict the decision-
making authority in this way are trying to minimize the risk that resources are being disbursed
by empIoyees without proper approvals. However, this process of supervisory checks critically
assumes that managers higher in the hierarchy are doing their job of checking and approving
Well and/Or Can be trusted. Survey evidence suggests that this, Perhaps, Should not be taken for

granted and, thus, that the checkers also require checking. This is in evidence from the penulti-
mate bullet point below taken from a recent occupational fraud survey‥8

二 Survey partlCIPantS eStimated that the typical organization loses 5% of revenues each year

to fraud.

余「 Occupational frauds can be dassified into three primary categories: aSSet misappropriations,

COrruPtion and financial state皿ent fraud. Of these, aSSe亡血sc[PPrOpr融10rlS are the most

COmmOn, OCCurring in 85% of the cases in our study, aS Well as the least costly, CauSing a
median loss of$13O,OOO. In contrast, Only 9% ofcases invoIvedj訪伽c融state肌e所有α1td, but

those cases had the greatest financial impact, With a median loss of $1 million. Corrxption
SChemes fell in the middle in terms of both frequency (37% of cases) and median loss
($200,000).

㊧ Tips are consistently and by far the most common detection method. Over 4O% of a11 cases

Were detected by a tip-mOre than twice the rate of any other detection method. EmpIoyees
accounted for nearly half of all tips that led to the discovery of fraud.

遼 Organizations with hotlines were much more likely to catch fraud by a tip, Which our data

Shows is the most eifective way to detect fraud. These organizations also experienced frauds
that were 41% less costly, and they detected frauds 50% more quickly.
呑 The higher the perpetrator’s level of authority, the greater fraud losses tend to be. Owners/

executives only accounted for 19% of all cases, but they caused a median loss of $500,000.
EmpIoyees, COnVerSely, COmmitted 42% ofoccupational frauds but only caused a median loss
Of $75,00O. Managers ranked in the middle, COmmitting 36% offrauds with a median loss of
$130,000.

奮 Collusion helps empIoyees evade independent checks and other anti-fraud controIs, enabling

them to stea=arger amounts. The median loss in a fraud committed by a single person was
$80,OOO, but as the number ofperpetrators increased, losses rose dramatically. In cases with
two perpetrators the median loss was $200,000, for three perpetrators it was $355,000 and
When four or more perpetrators were invoIved the median loss exceeded $5OO,000.

Another common form of administrative control is generally referred to as sepc[rC証on Qf

d証es. This involves breaking up the tasks necessary to accomplish certain sensitive duties,

thus making it impossible, Or at least di鯖cult, for one person to complete the entire task on their

88
own. There are many examples of separation of duties・ One common example invoIves making

sure that the臆enPIoyee who makes the payment entries in the accounts receivable ledger is not

the employee wh(rreCeives the checks. If an empIoyee who is diverting company checks to a
personal account has only the payment-entry duties - that is’OPening the mail and listing’
endorsing, and totaling incoming checks - CuStOmerS Will eventua11y complain about being
dunned for amounts they had already paid. But a person with both check-reCeiving and

paymenトentry duties could divert the checks and cover the action by making fictitious entries
of retums of goods or, Perhaps, Price a句ustments.

Separation of duties is one of the basic requirements of what is known as証er旭coutro!,

which is the control-Oriented term used by the auditing profession. The effectiveness of separa-
tion of duties is limited, however, aS it cannot completely eradicate possible co肌sioれ, SuCh as

between those with the check-reCeiving and payment-entry duties. Although collusion requires
empIoyees with malign intent to reveal their intentions to other empIoyees whom they seek to
engage in the scheme as their accomplice’SurVey eVidence (such as in the last bullet point ofthe

list above) suggests that it does occur, and that it can pay o鮒Regardless’inadequate intemal

controIs heighten the risks of fraud and misconduct. Two-thirds of executives surveyed by
KPMG admitted that when fraud and misconduct go unchecked in their organizations’it is

likely due to innde叫aとe証erJ調Z co庇roZs.9

Sometimes physical and administrative constraints can be combined into so-Ca11ed pokα-

yokes that are designed to make a process or systemJbo互)rOQflO A poka-yOke is a step built into
a process to prevent deviation from the correct order of steps; that is’Where a certain action

must be completed before the next step can be performed. A simple mechanical poka-yOke
example is the inclusion of a switch in the door of a microwave oven so that the oven cannot be
operated with the door open. Similar mistake-PreVenting poka-yOkes can also be built into
some production and administrative processes. For example’airlines make their pilots use

融ot-PrOQfsoftware on laptops or handheld devices in the cockpit instead of letting them make

manual preflight calculations that are error-PrOne. The software does not slip up on the math
and flashes a waming if an ouトOf-range number is entered’SuCh as a lO-tOn mistake in the

weight ofthe plane or fuel load.11 In hospitals’greater uSe Ofcomputerized provider order entry

can substantially reduce costly and potentia11y harmful drug errors; a Study of the Institute for
Healthcare Improvement in Cambridge’Massachusetts’found that processing a prescription

drug order through a computerized system led to a 48% reduction in the likelihood ofan error.12
Similarly, Signature-Verifying software can be used to authorize cash disbursements. Only after
all the required signatures have been recognized by the software will the order be released or
the transaction be approved.
It is often di鯖cult to make behavioral constraints fooIproof, eSPeCially when the organiza-

tion is dealing with disIoyal, deceitful empIoyees. For example, despite reasonable safeguards’

a fomer secretary at Bear Steams’a nOW-defunct global investment firm’uSed disappearing

ink to write checks that her boss requested. After the manager signed the checks, She would
erase the name of the payee and rewrite the checks for cash. In her eight months with the firm’

sh。 mad。 m。re than $800,000 vanish from her boss,s bank accounts.13 or at Ti触ny’s, the jew-

eler, a manager a11egedly stole, Very SIowly and systematically it seems’$1.3 million worth of

jewelry by checking out the jewelry for professional reasons - marketing purposes’Showing

potential buyers, and so on - and then not retuming them’and by being careful to keep only
items that were valued under $10,OOO because Tiffany,s has a policy of investigating only miss-
ing inventory valued over $25,000.

Chris McGoey, a SeCurity advisor’be-ieves that other empIoyees at T冊any’s may have had

suspIC-OnS `o=g before the investigation’but were afraid to speak up"雌i guarantee you that a

company like T描any’s has checks and ba-ances,,, he says・ ‖But it didn’t apply to her. PeopIe

89
Chapter 3. Actton, Personne!, and Culturai ControIs

reported to her, and they had to 「eiinquish thej「 inventory to her, based on her say-SO,’’Eve掴

tbey had concems about why the jewetry she was checking out wasn’t being retumed, they

mightdye been reiucta=t tO raise any red flags一仙nobody wants to rat out their boss,” he saidi14

P「eaction reviews

Preact壬on rel,teWS invoIve the scrutiny of action plans. Reviewers can approve or disapprove the

PrOPOSed actions, requeSt mOdifications, Or aSk for a more carefully considered plan before
granting final approval・ A common form of preaction review takes place during planning and
budgeting processes, Characterized by multiple levels of reviews of plamed actions and budgets
at consecutively higher organizational levels (see Chapter 8).

Action accountab冊y

Ac亡王o71 aCCO【上庇。b講ty involves holding empIoyees accountable for the actions they take. The

implementation of action accountability controIs requires: (1) de丘ning what actions are accepト

able or unacceptable, (2) communicating those defined actions to empIoyees, (3) observing or
Otherwise tracking what happens, and (4) rewarding good actions or punishing actions that
deviate from the acceptable.
The actions for which empIoyees are to be held accountable once properly defined are typically
COmmunicated through work rules, POlicies and procedures, COntraCt PrOVisions, and/Or COmPany
COdes of conduct. It is common in fast-food franchises to prescribe and communicate through pro.
Cedures and clarify and reinforce through training how virtua11y everything should be done,
including how to handle cash, how to hire personnel, Where to buy supplies, and what temperature
to keep the oil to fry chips. At McDonald’s, for example, a memO from the vice chairman stated:

WhiIe we don’t want to limit your creativity, f「om an operations standpoint there are three

must-dos:

1. Sta什yourfry station a= day long.

2" Check times and temperatures three times a day,

3" Remember to salt your fries properly.15

Similarly, nurSeS uSe PreOPerative checklists to help ensure that they prepare patients thor-
Oughly for surgery・ These checklists remind them to check on the patient’s allergies, drug-tak.

ing history, and time oflast meal.廿ain operators are provided with detailed sets ofprocedures

COmmunicated through safety rules and procedures handbooks that they must know and foト

Iow. The importance ofthe procedures is reinforced through training and examinations.
Sometimes the actions desired cannot be communicated in detail. In many operational
audits, POSt audits of capita鵜investment decisions, and peer reviews of auditors, lawyers, doc・

tors, and managers, individuals are held accountable for their actions that invoIve prq厄ssiond

judgmerif. The desirability of the actions ofprofessionals generally cannot be clearly prescribed
in advance. Nonetheless, these individuals are held accountable for their actions under the
Premise that they are expected to `act professionally.’
Although action accountability controIs are most e任ective if the desired actions are well

COmmunicated, COmmunication is not su鯖cient by itself to make these controIs e任ective. The

a任ected individuals must understand what is required and be confident that their actions wi11

be noticed and rewarded or punished. Actions can be tracked in several ways. EmpIoyee actions
Can be observed directly and nearly continuously, aS is done by direct supervisors on production
lines" This is called d王rect s叩ervisZon or mo面or証g. They can be tracked periodically, SuCh as

retail stores’use of undercover rrrystery shoppers to evaluate the service provided by store clerks,

They can also be tracked by examining evidence of actions taken, SuCh as activity reports or
expense documentation. Examining evidence about compliance with pre-eStablished action

90
 Action controis and the controi problems

Standards is a key function of irlterrlC[Z c[【⊥d克(which we discuss in more detail in Chapter 14).

LechnoIogical advances have allowed greater monitoring in terms of both scope and frequency:

l七ChnoIogy alIows品ne-and-mOtion studies to be carried to new Ievels. Severa=irms,

including Workday and Salesforce, PrOduce peer-reView software that turns performance
assessments from an annuaI rituaI into a never-ending triaI, AIex PentIand of MI丁has

invented a ``sociometric’’badge wom around the neck that measures such things as your

tone of voice, geStureS and propensity to talk or Iisten,巾mer Construction is using drones

to monitor progress on a sports stadium it is bu‖ding in Caiifomia, Motorola makes termi-

nais that strap to warehouse workers’arms to help them do theirjobs more e鮒ciently-but

aIso to keep tabs on them.16

Action accountability is usually implemented with negative reinforcements; that is, With
Punishments instead of with rewards. For example, emPIoyees late for their shift might lose a
day’s bonus, and those who miss their shift may lose their bonus for the week. Truck drivers

Whose every move is tracked with a GPS device can be disciplined for driving unsafely or for
taking extra time on their lunch breaks.17

Redundancy

Re血rld肌ey, Which invoIves assigning more empIoyees (or equipment) to a task than is strictly

necessary, Or at least having backup empIoyees (or equipment) available, also can be considered
an action control because it increases the probability that a task will be reliably completed.
Redundancy is common in computer facilities, SeCurity functions, and other critical operations.
However, it is rarely used in other areas because it is expensive. Further, aSSlgnlng mOre than
One emPIoyee to the same task usually results in conflict, frustration, and/Or boredom.

Action controIs and the controI probiems

Action controIs work because, like the other types of controIs, they address one or more of the
three basic controI problems. Table 3.1 shows the types of problems addressed by each of
the action controIs.
Behavioral constraints are primarily effective in eliminating motivational problems. EmpIoy-
ees who might be tempted to engage in undesirable behaviors can be prevented from doing so.
Preaction reviews can address a11 three of the controI problems. Because they often involve com-
munications to the empIoyees about what is desired, they can help alleviate a lack of direction.
They can also provide motivation because the review of an empIoyee’s actions usually prompts

鴫ble 3,1 ControI probIems addressed by each of the action controI types

Lackofdirection
Typeofactioncontroi MotivationaiprobIems
Controiproblem Personailimitatjons

Behaviora/constraints X

Preact/onreviews X X X

Actionaccounねb〃ty X X X

Pedundancy X X

91
Chapter 3. Action, Personnel, and Cultu「ai ControIs

extra care in the preparation of the expenditure proposal, budget’Or aCtion plan. Preacti

臆エeViews also mitigate the potentially costly effects of the personal limitations, Since a go

reviewer can add expertise if it is needed. The reviews can prevent mistakes or other harmf
actions from happening. Action accountability controIs can also address all of the controI pro
lems. The prescriptions of desired actions can help provide direction and alleviate the types

persona=imitations due to inadequate skills or experience. The rewards or punishments he

provide motivation. Finally, redundancy is more limited in its application" It is primarily effecti
in helping to accomplish a particular task if there is some doubt as to whether the employ
assigned to the task is either motivated to perform the task satisfactorily or capable of doingso

Prevention vs, Detection

Action controIs can also be usefully class誼ed according to whether they serve to preve融or de[c

undesirable behaviors. This distinction is important・ Prevention controIs are’When they are eff

tive, the most powerful form ofcontrol because the costs and harm stemming from the undesi
ble behaviors will be avoided. Detection controIs differ from prevention controIs in that the form
are applied申er the occurrence of the behavior. Still, they can be e館頂ive if the detection is ma

in a timely mamer and if it results in a cessation ofthe behavior and a correction ofthe effdets
the harmful actions. AIso, the promise of prompt detection of hamful actions is itself preven
tive; it discourages individuals from purposefully engaging in such behaviors.
Most action controIs are aimed at preventing undesirable behaviors. The exception is acti
accountability controIs. Although action accountability controIs are designed to motiva
empIoyees to behave properly, One CannOt Verify whether proper actions were taken until e
dence of the actions is gathered. However, if the evidence-gathering is concurrent with t
activity, aS it is with direct supervision and real-time monitoring’then action accountabili

controI can approach the desired state of prevention of undesired actions. For example’tru

drivers are monitored by way of so-Called ``critical event reports,, generated by a truck’s compu

ers, reCOrding things such as hard braking, aCtivation of the vehicle,s stability controI system’(l

other events that might indicate unsafe driving; and traders in banks are monitored by ``tran(
actions reports,,, which use aggregated data to spot insider trading and market manipulation11
Table 3.2 shows examples of common forms of action controIs dassified according to whe血

their purpose is to prevent or detect problems"

「略ble 3.2 Exampies of action controis classified by purpose

Source. K A Merchant, Modem Management ContIO/ Sys書ems.花xt and Cases (Upper Saddle RlVer, NJ’Prent(Ce Hall, 1998), P 31

92
 Conditions determining the effectiveness of action controis

Conditions determi団ng the e情ectiveness of action controis

Action controIs cannot be used effectively in every situation. They are effective only when both
Ofthe following conditions exist, at least to some extent:

1・ Organizations can determine what actions are (un)desirable; and,

2・ Organizations are able to ensure that the (un)desirable actions (do not) occur.

Knowiedge of desired actions

Lack of knowiedge as to what aLCtions are desirable is the constraim that most severeiv limits the
use of action contr。s. This knowiedge is often diffroult to bbtain. AIthough the actions required

Of employees on a production line may be straightforward to define relatively completely, the

definitions of preferred actions in highly complex and uncertain task environments, SuCh as
血ose of salespeople’reSearCh engineers, Or managerS’Often are incomplete and imprecise.

Most organizations do no亡have a good idea as to how empIoyees in these roles s九o面d best spend

Knowledge of the desired actions in feasible roles often can be established by analyzing
the action pattems in a specific situation or similar situations over time to learn what actions
PrOduce the best results. For example’loan approval decisions in banks tend to be quite
StruCtured. Over time’lenders observe which borrowers are likely to fail their loan pay-

ments. In so doing’banks can develop a loan approval protocol’delegate loan approval deci-

Sions, and monitor or audit the decisions in accordance with their adherence to the decision
PrOtOCOl.
It is important that the actions for which empIoyees are to be held accountable are, in fact,
the actions that will lead to the highest probability of accomplishment of one or more of the
Organization,s goals’Or at least the proper implementation ofthe strategy being pursued. In the

Same reSPeCt aS With results controIs’Which we discussed in Chapter 2, many Organizations

have actually found themselves encouraging empIoyees to take the wrong actions. This hap-

PenS・ for example’When policies and procedures are no亡kept up to date or are applied too
tightly (see Chapter 4)’CauSing the action controIs to produce unintended side effdets, Which we

discuss in Chapter 5.

AbiIity to ensure that desired actions are taken

Knowing what actions are desirable is not su鯖cient by itself to ensure good control; Organiza-

tions must have some ability to ensure or observe that the desired actions are taken. This ability
Varies widely among the different action controIs.
The effectiveness of the behavioral constraints and preaction reviews varies directly with the
reliability of the physical devi⊂eS Or administrative procedures the organization has in place to

ensure that the (un)desired actions are (not) taken. Clearly, these devices and procedures are not
always effdetive. For example, a rOgue CurrenCy trader at A雌rst Financial, Who had lost about

$7OO million in foreign exchange trading, WaS Said to have “targeted every controI point in the

SyStem and systematically found a way around them.・, when called aside by managers for going

OVer his trading limits’the trader complained that the computerized risk-mOnitoring system he

used to check his risk exposure during the daywas too cumbersome. He got away with it.19 Tb
COVer uP his Iosses, the trader allegedly started selling bogus option contracts. This practice was
not detected in a timely manne串ither’in part, because the responsibility for the monitoring

and reporting of the trader’s foreign-eXChange risks was given to a junior, relatively inexperi-

enced staff member.20

93
Chapter 3. Action, Personnel, and CuIturaI ControIs

Examples such as these are consistent with the findings of numerous fraud surveys that sug-

gest that misconduct occurs and goes undetected not only because of poor intemal controIs
(many of which fa即nto the category of what we call be庇VtOraZ coJZStratrZtS) but also due to
mcmage肌eれt Ol,erride of the controIs. According to the occupational fraud survey cited above’

one-third ofthe reported cases could have been prevented ifthere had been better intemal con-
troIs; but one-fifth could have been prevented ifmanagers had done a su飴cientjob ofreviewing

transactions, aCCOuntS, Or PrOCeSSeS; and yet another one-紐h could have been prevented had

there not been an override of existing intemal controIs.21 o卓O quOte anOther report’αcompa-

nies find that one of the greatest challenges in countering fraud is that unscrupulous manage-
ment may override otherwise effective intemal controIs.,,22
Action tracking also provides a significant challenge that must be faced in making αC亡ion

acco研融掘ty controIs effective. Usually some actions can be tracked even where employees’

actions cannot be observed directly" But this tracking is not always effective. The criteria that
should be used tojudge whether the action tracking is effective are precision, Ot)jectivity’time-

1iness and understandability (as we also discussed in Chapter 2 in a results-COntrOI context). If

any of these measurement qualities cannot be achieved, aCtion accountability controI will not
be e縦3Ctive in evoking the desired behaviors.

prec扇。n refers to the amount of error in the indicators used to tell what actions have taken

place. If action tracking invoIves direct supervision’Can the supervisors accurately distinguish

good actions from bad actions? If action tracking involves scrutinizing transaction records’do
those records reliably tell whether the proper actions were taken? For example’an initiative

aimed at tracking whether salespeople spend enough time on market development activities’aS

opposed to direct sales activities’is doomed to fail until precise definitions can be developed as

to which actions fall into each of these two areas. Here is an example of this:

Eiaine Murszewski worked in customer service for more than 30 years. The job she found
two yea「s after getting laid off was in customer service too’but he「 new empioyer moni-

tored her c10Seiy, faking the personaI touch out of the job, She said" The new empioyer’

kept track of the length of her phone caiIs’the amount of time she took between caIIs・ and

the tjmes she wasn’t at her desk. /fa calIer was particu/atry d肪CuIt, She saidタ書he numbers

didnタ書re〃ec刷at〇 ・・Metrics are an empIoyee,s worst enemy’・, she said葛23

A similar precision failure of an action control exists within the context of the US Foreign Cor-
rupt practices Act・ This act was intended to make `bribes, to foreign o鯖cials illegal’but it

allowed亀cilitating payments, to Iower-1evel officials. The distinction between bribes and facil-

itating payments is not precise’however, CauSing concem for company o綿cers who cannot be

sure that their interpretations of the actions by company personnel in foreign countries will
match those made by independent observers (such as a jury) at a later date in lawsuits of bribe
allegations.
O切ect王l,壇y Or absence of bias, is a concem because reports of actions prepared by those

whose actions are being controlled cannot necessarily be relied upon" PrQject- and sales-Ori-
ented personnel are frequently asked to prepare self-rePOrtS Of how they spend their time- In
most cases, these reports are precise, aS the allocations may be in units oftime as small as by the
minute. But the reports are not otyiective. If the personnel involved want to obscure the true
time pattems, Perhaps to cover a bad performance or to allow some personal time, it is rela-
tively easy for them to report that most of their time was spent on productive activities. Most
companies use direct supervisors and intemal auditors to provide objectivity checks on such
reports, aS Well as, increasingly, advanced monitoring technoIogies as mentioned above. With-
out of)jectivity, management CannOt be sure whether the action reports reflect the actual actions
taken, and the reports Iose their value for controI purposes.

94
 ⋮蒜1e t。噂皿Vlng闘町や

n肌e妬ness in tracking actions is important as well. Ifthe tracking is not timely, interventions

are n帆possible before harm is done. FurtheI., muCh ofthe motivational e任ect ofthe feedback is

Iost whenthe tracking is significantly delayed. Aga主n, teChnoIogy has a11owed timeliness to be

SOmetimes real time’Which is often decried by those being monitored as oppressing.

Finally, it is important that the actions for which individuals are to be held accountable are
皿derstandc謝e・ Although empIoyees presumably can easily understand prescriptions to arrive

at work on time or to not steal’understanding and consistently acting in full compliance with

the detailed rules and regulations contained in procedures handbooks is obviously much more
Challenging. Forensic investigations o庇en suggest that incidents and accidents are often due to
.軸螺両肘川n。亡

a lack of empIoyees, understanding of (and, hence, inevitably curtailed compliance with) all of
the necessary procedures.
Implementing action controIs where one of these action-traCking qualities cannot be
achieved wil=ead to undesirable e節ects. (These are discussed further in Chapter 5.) However,

like results controIs, aCtion controIs usually cannot be made near-Perfect, Or at least it would be

PrOhibitively expensive to make them nea手perfect. As a consequence’Organizations use per-

SOnnel and cultural controIs to help糾some gaps. These controIs motivate empIoyees to con-
庇n山車暁

trol their own behaviors (perso肌eZ co虹roZs) or to control each other,s behaviors (c血urc[Z

COntrOさs).

Personnel contro書s

Perso柵eZ co庇roZs build on empIoyees, natural tendencies to controI or motivate themselves.

Personnel controIs serve three purposes. First, SOme PerSOnnel controIs help clarify expecta-
tions. They help ensure that each empIoyee understands wha亡the organization wants. Second,

SOme PerSOnnel controIs help ensure that each empIoyee is able to do a good job; that they have
all the capabilities (e"g. eXPerience, intelligence) and resources (e"g. information and time)
needed to do thejob. Third, SOme PerSOnnel controIs increase the likelihood that each empIoyee
Will engage in selfmonitoring. Se昨肌o庇oring is an imate force that pushes most empIoyees to

Want tO do a good job, tO be naturally committed. Selfmonitoring is effective because most

PeOPle have a conscience that leads them to do what is right’and they are able to derive positive
feelings of selfrespect and satisfaction when they do a goodjob and see their organization suc-
Ceed. Self-mOnitoring has been discussed in the management literature under a variety of
labels, including融rt涌c motiγat王orl and kyr担y

Persomel controIs can be implemented through (1) selection and placement, (2) training,
and (3) job design and resourcing. In other words, finding the right people to do a particular

job, training them, and giving them both a good work environment and the necessary resources
is likely to increase the probabili亡y that the job wi11 be done properly.

Seiection and pIacement

Organizations devote considerable time and effort to empIoyee selection and placement. A
large literature studies and describes how that should best be accomplished. Much ofthis litera-
ture describes possible predictors ofsuccess’SuCh as education’eXPerience, PaSt SuCCeSSeS, Per-

SOnality, and social skills,

EmpIoyee selection often invoIves refdrence checks on new empIoyees, Which many organi-
Zations have stepped up in response to heightened worries over workplace securitywhile ensur-
ing fair’inclusive and equitable recruiting practices.24 But beyond screening new empIoyees to

mltlgate SeCurity issues, Organizations primarily focus on matching job requirements with job

applicants, skills・ For example’Home Depot’the large American retailer of home improvement

95
Chapter 3. Actjon’Personnei, and CuIturaI ControIs

and construction products and services’has an in-house computer system that contains the

names ofpre棄reened candidates who have the right skills and experience. This allows manag-

ersto fud q規範a・とandjdates qutckJy融en the need arises. B細山e au亡Oma[ed system also

provides cues about what interview questions to ask’What answers to listen for, and even what
advice to give the interviewees.25
social media also has emerged as a mgivr background-Check tool for empIoyers, Where one
survey indicates that over two-thirds of them decide against hiring afte血ding negative details

about the candidates. Meanwhile, though, many emPloyers surveyed said they are likely to hire
a person if they find on social media that the candidate,s personality is a good fit within the
company culture’has strong communication ski11s’is creative’and possesses a wide range of

interests, amOng Other presumably desirable traits.26

Employee selection can be expensive, but the benefit is to help find the best talent and to
avoid hiring someone who is a “poor fit,, with the company・ One estimate for the United States is

that the cost per hire averages about $4’500’and the average time to fill ranges anywhere from

25 days (production positions) to 88 days texecutive positions).27

巾aining

Training is another common way to increase the likelihood that empIoyees do a goodjob. Train-
ing can provide useful information about what actions or results are expected and how the
assigned tasks can be best performed・ Training can also have positive motivational effect§

because employees can be given a greater senSe Of professionalism, and they are often more
interested in performing well in jobs they understand better.
Many organizations use formal training programs’both through in-COmPany training and

by supporting in-Classroom continued education’tO improve the skills of their personnel. This

is important in all sectors because直r example’a global study of hospitals in developed co皿

tries found that competition, hospital size and independence’and professional management

and decision autonomy were amOng the most important factors that explain hospital perfor-
mance.28 Factor§ SuCh as professional management and decision autonomy, however’require

training to help develop the skills for managers to perform we11. But training is also important
at the worker level, Where some companies see ・・a mismatch in the labor market between what

businesses need and the kind of education young people are getting’,, said Nader Imani, Chief

executive of Festo Didactic, the stand-alone education division of Gemany,s robotics company
FestoAG.29
Much training takes place informally’SuCh as through empIoyee mentoring. For example’

every month, neW aJld some existing franchisees for The Pita Pit’a quick-SerVice sandwich

chain with more than 240 locations across the United States and over 580 worldwide’aSSemble

in Coeur dAlene, Idaho, for several days oftraining. However, Peter Riggs’Vice president ofThe

pita Pit, WantS tO make sure that the franchisees also share their experiences after the formal
training is completed〇 ・Anyone can leam systems’・, he said; but then he hinted at the need to

continually transfer knowiedge among empIoyees’Which he saw as perhaps the most important

aspect of the training and the way it was provided.3O At Jaburg Wilk, a law fim in Phoenix,
Arizona, junior co11eagues have two monthly mentoring meetings for 30 minutes to an hour
each with a senior colleague, Which is seen as an effective way to help the junior colleagues
improve their marketing and networking efforts to attract more SOPhisticated 。ients. Scott

Allen, a COnSultant, nOteS that through mentoring’“yOu Will get insights [from the] one-On-One

face time that no market research report could ever give you; and if the mentor is luckwithat
person] may even learn a thing or two froo].,,31 A similar approach is followed in other profer
sional services firms. At Moneta Group, an investment adviser’its training program spanS丘ve

years and includes extensive coaching on business development because ``if we weren’t
 intentional about replacing our top people who will be retiring in the next decade, Our COmPa-
ny’s ability to s也y independent would be in jeopardy,,, said Gene Diederich, the firm,s 。hi。f

executive.32 ・ _・・

Firms also make growing use of social media for their training and coaching needs. “Social

leaming platforms,, are redefining the leaming experience by providing empIoyees with a vir-
tual community to interact’engage, Share, and learn; and social media are used to establish a

dialogue with colleagues and instructors before’during’and after training sessions. These

approaches expand the tradi亡ional classroom, Creating a culture of co11aboration and leaming

across multiple o鯖ces, job familie§, and teams.33

Job design and provision of necessa「y resources

Another way to help empIoyees act aptly is simply to make sure that thejob is designed to allow
motivated and qualified empIoyees a high probability of success. some organizations do not

give all their empIoyees a chance to succeed. Some jobs are too complex・ Salespeople may be
assigned too many accounts to handle effectively. EmpIoyees also need a particular set of
resources available to them in order to do a goodjob. Resource needs are highlyjob-SPeCific, but
they can include such items as infdrmation’equipment’SuPPlies’Staffsupport, decision aids, Or

freedom from interruption. In larger organizations’Particularly, there is a strong need for

transfer of infomation among organizational entities so as to maintain亡he coordination of

Well-timed’efficient actions and decisions. This latter point was illustrated pertinently in the

example ofThe Pita Pit above’Where the purpose oftraining’and the way in which it was deliv-

ered’also included and facilitated ways to allow transfer of knowledge, eXPeriences, and best

PraCtices. But there are circumstances where the situation is less conducive:

Matt l也bi routineiy works 12-hour days as a driver for UPS, the U"S" ParCel company"丁he

COmPany WOuid rather pay him and other drive「s ove「time instead of hjring more worke「s,

Talbi has no complaints about his pay. He makes $32・35 an hour’PIus benefits, and hasjob

SeCurity as a teamster [union membe巾But he wonders how much 10nger he can keep up

the breakneck pace.傭There,s more and more push towards doing more with -ess workers,・,

Said leribi"償There are more stops’mOre PaCkages, mOre Pickups■ What,s happening is that

We’re stretched to our Iimits and beyond.”34

Cuitural controIs

Cr血raZ co柾roZs are designed to encourage mutual monitoring; a POWer皿form of group pres-

Sure On individuals who deviate from group noms and values. In some collectivist cultures,
SuCh as Japan, incentives to avoid anything that would disgrace oneself and one,s family are

ParamOunt. Similarly, in some countries’nOtably those in Southeast Asia, business deals some-
times are sealed by verbal agreement only. In those instances, the dominant social and moral
Obligations are stronger than legal contracts. But strong cultural controIs produced by mutuaし

monitoring processes also exist within single organizations.

Cultures are built on shared traditions’nOrmS’beliefs, Va量ues’ideoIogies, attitudes, and

WayS Ofbehaving. The cultural norms are embodied in written and unwritten rules that govem
empIoyees, behaviors. Organizational cultures remain relatively fixed over time, eVen While
goals and strategies necessarily adapt to changing business conditions. Tb understand an
Organization,s culture’aSk long-time empIoyees questions like‥ What are you proud of around

here? What do you stand for? What does it take to get ahead? If a strong organizational culture
exists’the seasoned empIoyees wi11 have consistent answers to these questions even when the

97
Chapter 3. Action’Personnei, and Cuitu「ai ControIs

answers are not otherwise codified. When that is the case’StrOng Organizational cultures can

prompt empIoyees to work together and be aligned・ It also implies, however’that despite the
benefits of directibn狐d cohesiveness, StrOng Cultures sometimes can become a source of iner-

tia or create blind spots, Which can get in the way of needed change and adaptation in rapidly
Changing environments.
organizational cultures can be shaped in many ways’both in words and by example’in。ud-

ing by way of codes of conduct’grOuP reWards’intra-Organizational transfers’Physical and

social arrangements’and tone at the top.

Codes of conduct
Most organizations above minimal size attempt to shape their organizational culture through
what are known, Variously, aS COdes of conduct, COdes of ethics’Organizational credos’Or State-

ments of mission, Vision, Or management Philosophy. These formal, Written documents provide
broad, general statements of organizational values, COmmitments to stakeholders’and the

ways in which management would like the organization to function. The codes are designed to
help empIoyees understand what behaviors are expected even in the absence of a specific rule;
that is, they are to some extent Principle-based rather than merely rule-based. They may include
important messageS about dedication to quality or customer satisfaction, falr treatment of
empIoyees and customers’emPIoyee safety, innovation, risk taking’adherence to ethical princi-

ples, OPen COmmunications and willingness to change丑be effective, the messages included in
these statements should be reinforced through both formal training sessions and informal dis-
cussions or mentoring meetings among empIoyees and their superiors.
A recent study from the Institute of Business Ethics (IBE) estimated that fourLfifths of FTSE
lOO companies had an explicit code of conduct or equivalent in 2OlO’increasing from only an

estimated one-third in 1993.35 But codes of conduct can vary considerably in form across firms.
There are an increasing number of defensive’COmPliance-Oriented’Or legitimizing reasons to

establish or review a code, but a more meaningful motive proactively and regularly communi-
cates the organization,s distinctive culture and shared sense of purpose. The latter may invoIve
developing the code to properly calibrate the organization,s rules-based policies with a more
values-based approach to drive ethical decision-making. As such’Other than to comply with

legal requirements’effective codes aim to shape a shared company culture and to protect or

improve the organization,s reputation. The most commonly cited values embedded in the codes
are integrity, teamWOrk’reSPeCt’innovation’and client focus. In addition to general policy

statements, Which almost all codes of conduct necessarily elaborate, SOme COdes provide guid-
ance on specific issues’SuCh as regarding confidential information, aCCuraCy Of reporting

(fraud), PrOteCtion of corporate property声nd dealing with gifts and entertainment. If such

guidance is in。uded’then the detailed behavioral prescriptions provide a form of action

accountability control because employees who violate the prescriptions can be reprimanded.
Many companies use e-learning modules to implement their code and have an ethics hotline
and whistle-blower mechanisms to report Violations and misconduct・36

Do codes of conduct work? The evidence is equivocal. One study in the financial services sec-
tor found that:37

ミOver two-thirds of the firms in the survey had raised awareness ofthe importance of ethical

conduct over the last three years’and roughly the same number had strengthened their for

mal code of conduct and the system for evaluating empIoyee behavior, but only two-fifths
said their firms had introduced career or financial incentives to encourage adherence to eth-

㊨ While respondents admitted that an improvement in empIoyees, ethical conduct would

improve their丘rm,s resilience to unexpeCted and dramatic risk, half think that career

98
 CuIturai controIs

PrOgreSSion at their firm would be difficult without being且exible on ethical standards; the
Same PrOpQrtion thinks their fim would be less competitive as a consequence of being too
rigid in this area; and less than two-fifths think their firm’s financials would improve as a

result of an improvement in the ethical conduct ofempIoyees at their firm.

A11 told’eVen though two-thirds of FTSE 350 respondents stated that ethics plays a part in

their company,s recruitment process, and over four-fifths stated that conformity to the compa-
ny,s code of ethics is included in contracts of empIoyment,38 the weakness remains that three-
珊hs also believe that’When push comes to shove, the code of conduct is not taken seriously.39

Overa11, the latter survey suggests that the most commonly cited factors that contribute to
misconduct in the workplace were not only cynicism toward the organization,s code of conduct,
but also pressure to meet targets; fear ofjob loss if targets are not met; SyStemS that rewarded
results over means; lack of understanding ofstandards that apply to thejob; lack ofresources to

get the job done without cutting comers, and a belief that policies or procedures are easy to
bypass or override. The sum of these issues underlines the importance of the types of controIs
We have discussed throughout this chapter.

Group rewards
Providing rewards or incentives based on collective achievement also encourages cultural con-
trol. Such incentive plans based on collective achievement can come in many forms. Common
examples are bonus, PrOfit-Sharing’Or gain-Sharing plans that provide compensation based on

OVerall company or entity (rather than individual) performance in terms of accounting retums,
PrOfits, Or COSt reductions. Encouraging broad employee ownership of company stock, With
effective corporate communications to keep empIoyees infomed and enthusiastic, enCOurageS
all empIoyees to think like owners" According to Sarah McCartney-Fry, member of Parliament
and the A11 Party Parliamentary Group on EmpIoyee Ownership, there is a αgrowing interest in

[…] businesses [thatl are substantia11y or majority owned by its empIoyees, [because] co-OWned

firms appear adept at managlng lnnOVation and change and are underpimed by very high lev-
els of productive empIoyee engagement享O

Indeed, eVidence suggests that group-based incentive plans create a culture of負ownership,,

and =engagement,, to the mutual benefit of organizations and their empIoyees.41 specifically, a
review of 70 studies over a 25-year Period found that both empIoyee ownership and profit-Shar-
ing programs improved empIoyee productivity, COmPany Performance, and company survivor
rates"42 According to an empIoyee engagement study by the Corporate Executive Board・s Corpo-

rate Leadership Council’emPIoyees most committed to their organizations put forth 57% more

effort and are 87% less likely to leave their company than empIoyees who consider themselves
disengaged. The study concluded that ``it should be no surprise then that empIoyee engage-
ment, Or lack thereo白s a critical factor in an organization,s overa11 financial success.,43

Group rewards are discussed here as a type of cultural control rather than as a results con亡rol

臼s we do in Chapter 9) because they are quite different in character from rewards given for indi-
Vidual perfomance. With group rewards’the link between individual efforts and the results being

rewarded is weak, Or at least weakened. Thus, mOtivation to achieve the rewards is not among the

Primary forces a航頂ed by group rewards; instead, COmmunication of expectations and mutual
monltOrmg are. That is not to suggest that group rewards cannot have positive eifects on motiva-
tion, eVen if only indirectly- Group rewards can encourage teamwock, On-thejob training of new
empIoyees (when assigned to teams that include experienced colleagues), and the creation of peer

PreSSure On individual empIoyees to exert themselves for the good ofthe group. All told,

[…] for many organizations, teamWOrk is a fundamental bu脚ng biock in their culture, and is
a feature the CIPD [Chartered lnstitute of Persomei and DeveIopment] research showed

99
Chapter 3. Action, Perso=nel・ and Culturai ControIs

they wanted to keep" A-though persona- achievement waS reWarded’it was aiso seen aS

important tOidevelop a way of acknow-edging a=d promoting teamwork since good company
results are nbt achieved by a sing-e person"書〇・・岬UKFast’a business-tO-business hosting

company, reWard is a device to reinforce team Cu-ture" Rather than giving high-Performing
peopie individua- cash rewards’the money is poo-ed to fund a team event〇日These rewards
create shared memories, he-p team bonding, increase aPPreCiation of peopIe’s d田erent per-

sonalities and reinforce the company’s va看ues of being supportive’Caring and fun・44

Other app「oaches to shape o「ganizational cuIture

As mentioned earlier, Other common approaches to shape organizational culture in。ude intra-

organizational transfers’Physical and social arrangements’and tone at the top.

克ra-07官arl融王orla朝型fGrs or e肌pkyee rotc[亡io証elp transmit culture by improving the

socialization of empIoyees throughout the organization’giving them a better appreciation of

the problems faced by different parts of the organization’and inhibiting the formation of incom-

patible goals and perspectives.

pkysic。 arr肌ge肌eれ亡S (such as o鯖ce plans’arChitecture・ and interior decoD and socid

c[rrOrlgemeJ暁(such as dress codes’institutionalized habits’behaviors, and vocabulary), Can

also help shape organizational culture" Some organizations’SuCh as technology firms in Silicon

valley, have created informal cultures’With open office arrangements and casual dress code§

that deliver messages about the importance of innovation and empIoyee equality. For example,
Alibaba - nOt a Silicon Valley company’but one that accounts for more than three-quarterS Of

china・s retail ecommerce - “Credits its awesome grOWth over the past 15 years to a uniquely

corporate culture and the visionary leadership of founder Jack Ma," replete with distinctive,
cult-1ike features:

Both admirers and detractors a-ike credit the creativity and drive that got the company this
far to AIibaba・s somewhat cuit-一ike espr,書。e co岬s - and the quirky Mr" Ma〇日Investors

[must] decide what stomaCh they have for A-ibaba’s quirks - its governanCe StruCture gives
virtually a-1 powe「 to 27 board members’and very -ittle to ordinary sharehoiders・ They wilI

also have to have a high to-e「ance for sometimes bizar「e antics by senior managerS・ and a

corporate cu-ture that is more co-o仙than its wor-d-SPanning peers like Google and Face-

book. […l The Chinese company,s 22・OOO empIoyees’known as AIiren, aPPear tO be fueiled

by adrena-in and inspired by Kung Fu nove-s〇日“Corporate cuIture is stil看Chinese・ [the]

appraisa- system is that of a Chinese comPany’,, said Jasper Chan’formerly Alibaba’s sen-

ior corporate COmmunications manager, Who worked for the company f「Om 2007-12.

Emp-oyees a「e CO=StantIy evaluated by managerS On their commitment to six core vaiues:

teamwork, ;nfegri書y, CuStOmer伽st, embrace change, COmmi書ment and passion・ “An

empIoyee could have great Sales, they cou-d bring in a to= Of revenues’but if they don’t

score we旧n core vaiues, they could s剛ose theirjob,・・ she said"45

But many other “old-eCOnOmy,・ companies also possess’and are reputed for’their unique

cultures. At Disneyland, emPIoyees are called ccIS亡members; being on the job is being onstage

toffthejob is Q輝age); a WOrk shift is ape加rmαれCe; and ajob description is a scr垂This vocab-
ulary, Which is imparted on joining the company and is reinforced through training’SeParateS

Disney employees from the rest’brings them 。oser together’and reminds them that they are

pe血mers whose job is to help ful即the company・s mission-that is’that “every product tells
a story,, and that ・・entertainment is about hope’aSPiration and positive resolutions.,,46

Finally, management Can Shape culture by setting the proper torle研he tqp. Their statements

should be consistent with the type of culture they are trying to create’and’importantly’their

actions and behaviors should be consistent with their statements. Managers serve aS rOle
 Effectiveness of personneI/cultural controIs

models and, aS the various surveys quoted earlier in this chapter suggest, are a determining fac-
tor in creating a c血ure of integrity in their organizations, Management cannot say one thing

and do another. That said, management SOmetimes sets the wrong tone by not responding
appropriately to matters brought to their attention, SuCh as ethics concems or reports of mis-
conduct.47 All too common, W柾stle-bfowers (empIoyees who draw attention to suspected mal-

PraCtice) are ignored, and so forth. Several studies, indeed, Paint a rather gloomy picture of
tone at the top. For example, a SurVey COmmissioned by PwC suggests that while tone from the
top is vital in developing and maintaining the ethical integrity ofthe business, nearly halfofthe
respondents reported that leaders do not always act as role models in setting the right tone.48

Personnel元ultural controIs and the controI problems

Taken together, PerSOmel/Cultural controIs are capable of addressing all of the controI prob-
lems although, aS Shown in Table 3.3, nOt eaCh type of control in this category is effective at
addressing each type ofproblem. The lack-Of-direction problem can be minimized, for example,
by hiring experienced personnel, by providing training programs, Or by assigning new person-
nel to work groups that will provide good direction. The motivational problems, Which may be
minimal in organizations with strong cultures, Can be minimized in other organizations by hir-
ing highly motivated people or by assigning people to work groups that wi11 tend to make them
a句ust to group norms. Persona=imitations can also be reduced through one or more types of

PerSOnnel controIs, Particularly selection, training, and provision of necessary resources.

「fabie 3,3 Controi probiems addressed by the various ways of effecting personnei
and culturaI controIs

Se/ectionandp/acement X X X
7ねining X X

Jobdes/gnandpI℃VisIOn Ofr)eCeSSaryreSOUI℃eS X

Source. K. A. Merchant, Modem Management ControI?ystems. 7axt and Cases (Upper Saddle BlVer; NJ‥ PrentlCe Ha=, 1998), P 130

離ectiveness of persomeihuItura看cont「oIs

All organizations rely to some extent on their empIoyees to guide and motivate themselves.
Some corporate controI systems are dominated by personnel controIs. Wi11iam F. Cronk’

now-retired president of Dreyer’s Grand Ice Cream (since acquired by Nestle), Said at the time

that, “We consider hiring the most important decision we can make. We hire the smartest,

101
Chapter 3. Action, Persomel, and Cultural Controis

most inspired people we can find, give them the resources they need, then get out of their
way.”49 c亜ural controIs can also, by themselves, dominate a controI system・5O The best

chance to create a strong culture, however, SeemS tO be early in an organization’s life whena

founder can imbue the organization with a distinctive culture. Examples are the “cult-1ike’’

cultures created by the late Steve Jobs at Apple, Jack Ma at Alibaba, Jeff Bezos at Amazon,
and Herb Kelleher at Southwest Airlines, just to name a few notorious ones.51 cultural con・

troIs often have the advantage ofbeing relatively unobtrusive. Employees may not even think
of the shared norms or ``the way we do things around here’’as being part of the “control’’

system・ As such, Organizational cultures can substitute for other formal types of controIs. In

otherwords:

A company’s culture is iikeiy to a什ect every aspect of how the organization operates and

how peopIe work, Research from the Chartered lnstitute of Persomei and Deve10Pment
(CiPD) has consistently found that culture w川a什ect a business’s success because,
un=ke strategy, ;t /s hard fo /mitate and can di施rentiate organjZations from肋eir com-

petifors. In the words of management guru Peter D「ucker, “CuIture eats strategy fo「
breakfast,,,52

As such, PerSOnnel/Cultural controIs can have distinctive advantages over results and action
COntrOIs. They are usable to some extent in almost every setting, their cost is often lower than
more obtrusive forms ofcontroIs, and they might produce fewer harmful side e鮒ects. Moreover,
“soft’’personnel/Cultural controIs have also been shown to make “economic sense’’as surveys

and evidence suggest that “it pqys to be nice to empIoyees.・,53 At the SAS Institute’the large’

Privately held software and business inte11igence systems company, emPIoyee loyalty is instilled
with an unusual array of perks for its roughly 3,OOO headquarter empIoyees. These include a

profit-Sharing plan; a free health clinic; daycare centers; Private o鯖ces for everyone; flexible
35-hour weeks; free sodas, fresh fruit, and pastries in the coffee-break rooms; and even a pia-
nist in the subsidized lunch and recreation room. SAS,s tumover rate has been about 4% for
years, COmPared to an industry average of about 20%. Stanford University professor Jeffrey
Pfeffer concluded, “The roughly $50 million per year that SAS saves with its Iow turnover pay§

for all the family-friendly stuff. And, While the free company dinic costs $1 million per year to
operate, that is $5OO,OOO less than what it would cost the company if empIoyees were treated
elsewhere.,,54
However, the degree to which personnel/Cultural controIs are e任ective can vary signifi-

can[]y across indjvidua]s, grOuPS’COmmunities’and societies. Some people are more hones〔

than others, and some communjties and societies have stronger 。es among their members. Cuト

tures that are ・・too strong・・ can also be a disadvantage’eSPeCially when they need changing.55

culture change requires strong “culture carriers・」 rOle models who embody the new values -

and strong reinforcements’SuCh as changes in emphasis in the reward systems:

・・Take somebody who,s produced m冊OnS Of 「evenues but is sometimes a bit disruptive:

how do you judge them against somebody who has Iower financiai pe「formance but is a

great cu-ture carrier?,・ Co-in Fan’the co-head of investment banking at Deutsche Bank’
asks〇 ・・We used to have those debates" lbday, it,s not even a debate" The first group gets

knocked out of that year’s promotion p「ocess・,・56

And sometimes it requires a change at the top’SuCh as at Tbshiba’the Japanese electronics-

to-nuClear conglomerate, Where top executives played a role in a company-Wide accounting

scandal invoIving at least Y152 billion ($1.2 billion) in inflated profits over a seven-year Period‥

in an 82-Page Summary Of its findings・ a Panel of externa- lawyers and accou=tantS detailed

what it said were ・・institutiona一・・ accounting ma-practices and a corporate cuIture in which
 Notes

empIoyees were afraid to speak out against bosses, push for increasingiy unachievabie proト

its, ``There ex瞳ed a corporate culture at “foshiba where it was impossibie to go against the

boss, wilI," the fePQJ.宣・ Said" Pressures to meet aggressive, Sho巾term profit targets - known

as ``the chalIenge" - eXisted from the presidency of Atsutoshi Nishida’Who headed the com-

pany from 20O5 to 2009・ Those pressures escalated as the company’s eamings deteriorated
in the wake of the globaI fina=Cia獲crisis and the March 2011 ea巾hquake and the Fukushima

nucIear accident. “fop executives pressured empIoyees to achieve their targets with sugges-

tions that the company may withdraw from underperforming businesses such as teIevision if
they were not met. […1 Hisao klnaka, Chief executive, StePPed down after making a 15-SeC-

ond bow of contrition at a packed news co=ference in “fokyo, Saying that傭“foshiba had suf-

fered what could be the biggest erosion of its brand image in its 140-year history.”57

Conclusion

In this chapter, We PrOVided an overview of the most direct type of controIs’aC亡壬on corttγOZs,

which take any of several di縦uent foms: behavioral constraints’PreaCtion reviews, aCtion

accountability, and redundancy. Action controIs are the most direct type of management con-
trol because they ensure the proper behaviors ofthe people on whom the organization must rely
by focusing directly on their actions.
We also described persomeZ and c庇urαZ co庇roZs, Which managers implement to encourage

either or both of two positive forces that are normally present in organizations: Self- and mutual-
monitoring. These forces can be encouraged in a number of ways’including effective persomel

selection and placement, training, job design and provision ofnecessary resources, COdes ofconduct,

group rewards, intra-Organizational transfers, Physical and social arrangements, and tone at the top.
Personnel and cultural controIs, SOmetimes referred to as s草controIs, have become more

important in recent years. Organizations have become flatter and leaner. Managers have wider
spans of control, and elaborate hierarchies and systems of action controIs (bureaucracies) have
been dismantled and replaced with empowered empIoyees. In this environment, Shared organ-
izational values have become a more important tool for ensuring that everyone is acting in the
organization,s best interest.58

See, forexample, M. A. Abemethy, H. C. Dekker, and A. K. 5 ``Mass Leak of Client Data Rattles Swiss Banking,’’軌e

Schulz, `Are Employee Selection and Incentive Contracts W七諏Street Jo事(rrlaZ (July 8, 2OlO), Online at on.w争j.

Complements or Substitutes,’’JourrlaZ Q/ Acco肌亡Zrlg COm/1mnNOUO.

Research, 53, nO. 4 (September 2015), PP. 633-68. 6 αIRS EmpIoyee Took Home Data on 2O,000 Workers at
“Five-Fingered Discounts;’T九e Ecor10証s[ (October 23,
Agency,’’BZoomberg (March 18, 2014), Online at bloom.

2010), p. 80. bg/1MjMWKM; See also ``Bardays Launches Investiga-

3 (`Stealing Retailer,s Thunder: PwC Estimates Canadian tion after Reported Customer Data Leak’,,耽e瑞narlC融

RetailersAre Losing over $1O Mi11ion a Day to Shrinkage:’ Ttmes (February 9, 2014), Online at on・ft.com/1J9wSdF.

PwC (October 31, 2O12), Online at www.pwc.com/Ca/en/ 7 “Manage Like a Spymaster,’’T庇EcoJlOmis亡(August 29,

media/release/2O12-1O-31-Canadian-retailers-losing- 2015), Online at econ.st/1Uqj8KK.

ten-mlllion-a-day-Shrinkage.html. 8 R印ort亡O亡兄e規正ons oれOcc 岬a亡ionα肝ra標d a肩Ab地se2014

4軌ropean Dam耽昨Survq′20ヱ2 (KPMG, 2012), Online at GわbaZ Frand S弛め′ IAssociation of Certified Fraud Examin-

www.kpmg.de/docs/Central-and-eaStern-eurOPean-data- ers, 2014), Online at www.acfe.com/rttn/docs/2014-

theft-SurVey-2012.pdf. See also負Business Warned of reporトto-nations.pdf (hereafter 20J4 GLobaZ F「and Survey).

Enemy Within on Fraud and Cyber Crime,’’The F証a旭aZ 9切fccdve71eSS Qf FraL[d R巌Marlagement切f。rtS (KPMG
Hmes (November 23, 2015), Online at on.ft.com/11DkSwe. LLP, 2009).

103
chapter 3. Action, Perso=nel’and Culturai ControIs

26 “So。i。I Media Emerges as Major Tool for Background

lO D. Stewart and R. Chase,掘s調ke-Proqfirlg: Des[g扇五g
check of EmpIoyees: Survey’,, DM (September 14, 2014),
E.r。rS Ouf (Portland, OR‥ Pr釦uctivity Press, 1995).
online at dnai,in/Cn4m; “Survey: Social Media Back・
pokaγOke is the Japanese term forfb妙γOQ手It was intro_

duced to the management literature by the Japanese ground Checks, Policy Enforcement・”朋Dady Adγisor
(Sep亡ember 4, 2014), Online at shar.es/1GNkle.
quality guru Sigeo Shingo.
27 “Three Approaches to Pre-Screening Job Candidates’’’ERC
11 ・At Some Airlines, Laptops Replace Pilots, `Brain Bags,’’’
(July 14, 2013), Online at www.yourerC.COm/blog/POSt/
T九e W棚StreetJouma! (March 26, 2002), P. Bl・
3-Approaches-tO-Pre-Screening-Job-Candidates"aSPX.
12 ・・Computer Systems Cut Hospital Drug Errors・,,施dpage
28 ・・How to Save Lives,,,丑e Ecor10m[st @ctober 23, 2010), P. 72'
T坤y (February 22, 2013), Online at www.medpagetoday"
29 See, for example, “German-Style Training for American
com/HospitalBasedMedicine/GeneralHospitalI)ractice/
Factory Workers,,・ The V‘硯Street JourrlaZ (September 9’
37496,
2014), Online at on.w争i "COm/11U4XsG.
13 ・・Bear Steams Ex-Staffer P獲eads Guilty to Taking Funds in
3O “Improve Your EmpIoyee廿aining Sessions’"鎚s王rlesS Week
check Scheme,,,耽e W拙Sfreef LJourr証’(February 26’
(February 2, 2010), Online at www.businessweek.com.
2002), p. C14・
31 ・・Mentors Make a Business Better;, Business Week (March
14 “How a Tiffany・s EmpIoyee Stole $1.3 Mi11ion in Jewelry’’’
20, 2008), Online at www.businessweek.com.
Busincss Week Uuly 8, 2013), Online at www.bloomberg.
32 “Fim Shares Tips for Succession Planning’,,丑e W加工Street
com/bw/articles/2013-07-08/how-a-tiffanys-emPIoyee-
J。um。Z Oanuary24, 2014), Online at on.w車com/1caDnQH.
stole-1-doト3-million-injewelry.
33 “Skillsoft Selected as Gold Winner in Exce11ence in Social
15 ・・Memorable Memo: McDonald’s Sends Operations to War
Leaming by Chief Leaming O鯖cer Magazine," Business
on Fries,” The W拙Street JourrlC直December 18’1997)・
wire (September 26’2012)’Online at www.businesswire.
online at on.w料com/1xjJzSy・
com/news/home/20120926OO5748/en/Skillsoft-
16 ・・Digital Taylorism’,, T71e EcorlOm[st (September 12・ 2O15)’
selected-Gold-Winner-Exce11ence-Social-Leaming.
online at econ.st/lQqLUAM.
34 ・As Employers Push Efficiency’The Daily Grind Wear§
17 ・・廿acking Wockers・ Every Move Can Boost Productivity- and
Down Workers;・ The Los AngeZes Times (Apri1 7’2013),
stress,” The LosArlgeZes ’Z証es (Apri1 8, 2013), Online at w .
online at fw.to/yxImzOM・
1atimes.com/1a-fi-harsh-WOrk-teCh-20130408’O,6413O37.
35 Codes QfCondrc亡: A Bc[rrier or Brec[軸rong坤r Corporo亡e
Be庇高oLlr? (PwC, 2013), Online at www.ibe.org.uk/
18 《・Driver Fatigue Cited as Cause of Crash that巾ured
u sera s s ets/SurVeyS/PWCCO de sofconductrep ort2 01 3 ・P df.
comedian;, AP (August ll, 2O15), Online at bigstory・aP. uSeraSSeしb/叫1 VCry>/ r’WししuuしoU重し〉…-〉“一-r〉一￣￣￣ ￣￣ ’

org/urn:Publicid:aP・Org:dlbab7054636428c81e75ea540 36 ・・Business Codes of the GIoba1 200‥ Their Prevalence,

1繋輩三警誓菜輩薬輩諾
Memo,・, The War SfrectJournc岬bruary25’2002), P" C16. 37 A Crisis Qf(混ture (The Economist Intelligence Unit’2013),

霧謹霊諾崇豊謹言。8蒜謀議繋箋崇詐
22 Dr涌ng軸icaZ Growh New胸rkets, New C棚enges 39庇egr王tySurvの′20ユ3, OP.Cit.
(Emst &伽ng llth GIobal Fraud Survey’2010); See also 4O “Employee Benefits: Share Ownership Schemes - Should
. 《 〈… ′,,…r ,.〈_ハ言、∴つnlQ¥_1人手hp.p E7%  YouCoCo?,,,HR施ga加e (September l・ 2008)’Online a[
匝egrity Sowey 20薦(KPMG Forensic’2013) - Where 57%
of the respondents reported that they付believe that policies
www.hrmagazine.co.uk. See also “Could the John Lewis
CAS且
Model Work in Any Industry:, T庇7弛graph (November 14・
or procedures are easy tO OVerride,, as a root cause for man-
2014), Online at www.telegraph.co.uk/finance/festival- W itsky
agers and empIoyees to engage in misconduct - Online at
of-business/11229674/Could-the-LJohn-Lewis-mOdel-
www. kpmg" COm/CN/en/ Issue sAnd Ins ights仏rticle sPubli-
work-in-any-industry.html; and ``TSB Bank to Move
cations/D ocume ntS/ Integrity- Su rvey-2 01 3 - O -2O 1 3 0 7.pdf.
Tbwards John Lewis Model,,・ The Fin肌cia腫肌es (June 5,
23 ・・廿acking Workers’Every Move Can Boost Productivity -
2O14), Online at on.ft.com/1kN8dhN.
and Stress;’op. cit.
41 C. Rosen, J. Case, and M. Staubus’坤砂WlyE肌pZayee
24 “New Background Check Survey Reveals Security Issues
owrler誼p Js GoodJ扉軌siness (Boston’MA: Harvard
in the Screening Process,,, Securtr所をWctch (July 3’
Business SchooI Press, 20O5).
2014), Online at wwW・SeCurityinfowatch.com/arti-
J. Blasi, D. Kruse, and A. Bemstein, J油e CompaγryQfOwn-
cle/11545613/new-hireright-SurVey-highlights-POten- 42
ers: The T油ot abo“t Stock Qpt{orrs佃d WlyEve7y動pZQyee
tial-SeCurity-gaPS-in-the-SCreening-PrOCeSS. See also `Are shou融耽ye TherrD (NewYork: Basic Books’2003)・
workplace Personality Tests Fair?’・, The W拙S亡reet Jour- “The Role of Employee Engagement in the Return tO

坤september 29, 2014)’Online at on.Wgivom/1KHI7CY. 43 Growth,,,軌StrleSS Wee短August 13, 2010), Online at www.

25 ``軸re a Lumber Expert, Click Here’,, For柵e (Apri1 3・ bloomberg.com/news/arti。es/201O-O8-13/the-rOle-Of-

2(剛席. 267-70・

104

empIoyee-engagement-in-the-retum-tO-grOWth. See also
“organizations in Central and Eastem Europe with High
EmpIoyee Engagement Are AchievinすBetter Business
Results, Says Aon Hewitt,,, PR Newsw謡e (Detember 3,
2012), Online at www.pmewswire.co.uk; and State Qf亡Jle
Americ肌VMorkpZace (Ga11up, 2013), Online at www.gallup.
com/SerVice s/ 1 785 14/State - ame rican-WOrkplace. aspx ・
44 “Reward Culture: Strong Foundations,’’P`ry & Ber均缶s
(August 27, 2014), Online at www.payandbenefitsmaga-
zine. co.uk/a rticle/reward- Cu ltu re -StrOng-foundations.
45 ``Method in the Madness of the Alibaba Cult,’’The FinαnCidZ
T血es (September 7, 2O14), Online at on証・COm/WAoqTa.
46 See the company,s website, Online at corporate.disney.
go.com/C areerS/Cu lture "
47 See, for example, αTbne at the Tbp: Why Investors Should
Care,’’St「a亡eg[c瑞nαrlCe (March 2013), Online at www.
皿anet.Org/docs/default-SOurCe/Sf/03_2013_king-Pdf.
Pdf?sfvrsn= O"
48 7加e力・O肌丑e T巾-廿d甲句mfrlg Words証oAcdon (PwC,
2013), Online at www.ibe.org.uk/userimages/PWC_tOne_
from葵the_tOP_2013.pdf.
49 Quoted in D. Ferguson, “Do Entrepreneurial Companies
Lo§e Their Innovative Spark as They Grow Larger?’’Cc[Z
BusirleSS (Fal1 1995), P. 12・
50 In addition to the brief description of the Alibaba culture
earlier in this chapter, Southwest Airlines is another
poster child of a firm with an acclaimed corporate cuト
ture. see, for example, G. Smith,伍An Evaluation of the
Corporate Culture of Southwest Airlinesブ’’Measu高rlg
軌slrleSS Exce【ZerlCe, 8, nO. 4 (2004), PP. 26-33; and M.
Thomas, ``Strategic Principles at Southwest Airlines,’’
Stra亡egfcDirect[orl, 31, nO. 8 (2015), PP. 10-12.
51 Many articles have been written about these and other lead-
ers, but to mention one as an illustration, See `Ueff Bezos
CASE STUDY
Witsky and Associates, inc"
Brayton McLaughlin was a young associate at Witsky
and Associates, Inc., a management COnSulting firm
亡hat helped small and family businesses with a vari-
ety of issues, including strategy, OPerations’logistics’
and corporate govemance. Brayton had joined Wit-
sky two years ago immediately after completing his
MBA degree.
Witsky and Associates, inc・
Reveals His No. 1 Leadership Secret;’forbes (Apri1 4, 2012),
online at www.forbes.com/forbes/2012/0423/CeO-COm-
pens ation-1 2-amaZOn-teChnoIogyj eff-bezos-getS-it.html.
52 ``Reward Culture: Strong Foundations;’op. cit.
53 See, for examp獲e, αPeople Work Harder When They’re
Happy, Study Finds,’’T庇財egraph (March 21, 2014),
online at www.telegraph.co.uk/news/health/10713606/
People -WOrk-harder-When-theyre -happy-Study-finds.
html;負Virgin Pulse Named One of Bos亡On軌S誼ess Jour-
rlaZ’s Healthiest EmpIoyers,’’軌s証eSS Wfre (March 27,
2014), Online at www.businesswire.⊂Om.
54 `An Idyllic Workplace under a tycoon’s Thumb:’The W硯
S亡ree上JollrnCIZ (November 23, 1998), Online at on.wsj.
COm/1sMFu7O.
55 See, for example, αSatya Nade11a: This Is How I,m Rea11y
Going to Change Microsoft,s Culture’,, Busi71eSS血sic!er
Uuly 15, 2014), Online at read.bi/lwpztta.
56 “Colin Fan, Deutsche Bank: `OMG, Colin’sVideo Has Gone
Viral,,, The F王narlCiαi珊meS (October 12, 2014), Online at
on.ft,COm/1tlRYDc; ``Deutsche Bank Wams Traders in
Video over Boasting and Vulgarity,7, The FinαrtCic{けfmes
(May 16, 2014), Online at on.ft.com/叫1oqi・
57寝Scathing Report Says Toshiba CEOs Had Ro看e in
Accounting Scandal,’’The瑞nαrlC証n柵es (July 20,
2015), Online at on.ft.com/1KgFnZB; “Tbshiba Chief
Hisao Tanaka Resigns over $1.2bn Accounting Scandal,’’
The Fincmc融Hmes (July 2l, 2O15), Online at on.ft.
com/1edzVbE.
58 For further study and a recent academic perspective and
overview of the control literature in the area of what we
call personnel/Cultural controIs’See M. Loughry・ “Peer
Control in Organizations;, in S. Sitkin’L. Cardinal, and K.
B珂sma-Frankema, O即証如tZorlal Coutro! (New York:
Cambridge University Press, 2OlO), Chap. 11.
In early June, Brayton was assigned to do time-and-
motion studies at an o鯖ce supplywarehouse and distribu-
tion center located in Riverside, Califomia. Management
needed accurate cost data to be able to negotiate profita-
ble contract terms in the forthcoming year. Theywere also
concemed that some of the warehouse personnel were
not performing a11 of their activities e億ciently.
105
Chapter 3. Action, Personnei, and CuituraI Controis
It was expected that Brayton would have to be on
Site for approximately …p hours’at Various times since
the center operated 24/7, tO Observe the proper mix of
activities wil:h enough detail. Then Brayton would have
to prepare and submit his report. As Brayton was also
WOrking on other prqjects, the due date for his report
was the end ofJune.
Brayton reported to Pete Mahlendorf, Witsky’s man-
aging partner and the lead consultant on the job, that
he visited the warehouse and distribution center on
SeVeral days in June, both during the day and night
Shifts. He submitted his report on time and on budget.
On July l, Pete got a phone call from Jeremiah
Jones, OPerations manager at the Riverside distribution
center. Jeremiah wanted to know when he could see
Brayton’s report. Pete said that he had just received it,
and he would send it right over. ButJeremiah expressed
SurPrise that the report was丘nished. He told Pete that:
As far as I know, Brayton only visited the ware-
house once, and that was for a quite brief time,
How could he have finished his report? Maybe he
WaS here when l was out, but I have not heard oth-
e「S mention his presence either,
Pete checked again with Brayton, and Brayton
assured him that he had completed all the needed work.
CASE S丁UDY
丁he Piatinum Pointe Land Deal
In early December 2006, Harry Hepbum, PreSident of
the Southern California Division of Robinson Broth-
ers Homes, WaS faced with a sign誼cant cha11enge.
The markets his division served had sIowed consider-
ably. To sell its homes, the division often had to make
Signi丘cant price concessions. But construction costs
Were COntinuing to rise, SO margins were getting
SqueeZed. It was clear that the division was not going
「O6
A few days later, rather by chance, Pete mentioned
Jeremiah’s surprise reaction to Priscilla Musso, Wit.
Sky’s chief financial officer. After some reflection,
Priscilla suggested that they perhaps should check
the location-traCking data provided by Brayton’s ce11
Phone. Witsky paid the cell phone bills for the firm七
Staff, and location tracking was one of the applica.
tions that the staff was required to keep turned on'1
The firm had never had an occasion to use these
data, but Priscilla thought that it might be useful to
Iook at it in this instance. Pete and Priscilla checked
the computer records and found, indeed, that Bray.
ton had been near Riverside only once in the month
of June.
Pete called Brayton into his o鯖ce and asked him to
explain the discrepancy. Brayton immediately broke
down in tears. He explained that because of some per-
SOnal problems he was waybehind in his work. Tb tryto
COPe, he took the shortcut of creating a report based
mostly on data he had found on the Intemet. He admit.
ted that he had not spent the requlSlte tlme at the River-
side warehouse and distribution center.
to achieve its 20O6 sales and profit plan. But what
was worse, COrPOrate eXeCutives were recommend-
ing a sign誼cant downsizing of the division in 2007
to wait until the housing market rebounded. Harry
resisted this idea. He thought he had assembled a
great empIoyee team. The division’s performance had
been outstanding during the good years in the early
2000s. He wanted to keep his team intact. But that

required finding a continuing stream of good prqiects
rthem to work on.
0ne promlSmg PrQject on the horizon was ca11ed
一’ .
latinum Pointe. It was a large prqject that promised to
rovide over $100 million in revenue and nearly $14
mi11ion in profits in the 2OO8-11 time period. It would
keep a lot of empIoyees productively busy. Harry really
anted to do the prQject. However, the financial prqiec-
tions suggested that the prqiect would not quite eam
the returns that the corporation required for prQjects
with this level of risk. He contemplated preparing pro-
jections that were a “1ittle more optimistic’’to ensure
that the prQject would be approved.
The company
Robinson Brothers Homes (RBH) was a medium-Sized
homebuilder. The company built single-family and
higher-density homes’SuCh as townhouses and condo-
miniums. By 2006, RBH built almost 2,OOO homes per
year. Because it was much smaller than the largest
homebuilders who had economies-Of-SCale advan-
tages,1 RBH focused on building higher quality/higher
price homes for first and second move-uP buyers. In
2006, the average dosing sales price for an RBH home
was slightly more than $400,00O.
RBH,s stock had been traded publicly since 1995"
The company had been highly profitable throughout
the past decade, but finances were expected to be much
tighter in 2007 because of the homebuilding sIowdown
that had started in early 2006. The stock price had
declined almost 50% from the all-time peak in 2005.
RBH,s organization was comprised of a headquar-
ters staff located in Denver, CoIorado, and 15 divisions
Iocated in most of the metropolitan areas of the Cen-
tral, Mountain, and Southwest areas of the United
States. The headquarters staff was small, COmPrised
mainly of specialists in the areas of finance’aCCOunt-
ing, legal, information systems’Sales and marketing’
and customer service, and their staffs.
Each division was largely se11contained, With its
own construction supervision, CuStOmer Care, PurChas-
ing, Sales and marketing, 1and development, land
acqulSlt10n, and accounting staffs. The only m亘ior func-
tion that was outsourced was construction. RBH’s con-
struction superintendents supervised the general
contractors who built the homes to RBH’s spec綿cations.
1 For example, D. R. Horton, Inc.’the largest homebuilder in the
Unlted States, WaS building over 50,00O homes per year.
The Piatinum Pointe Land Deal
Exhibit l shows the organization chart for the
Southem Califomia division. This division, One Of
RBH,s largest, emPloyed approximately 120 people. In
2006, it was prQjected to sel1 637 homes, generating
$235 million in revenue and $4O mi11ion in net income.
Land acquisition
Land acquisition was a key function in the homebuild-
ing business. RBH,s land acquisition personnel had to
丘nd land on which the company could build homes that
could be sold at a good profit. The lag between acqulSl-
tion of the land and sale of the final house built was
typically three to丘ve years. Sometimes the permit-
acqulSlt10n PrOCeSS itselfdragged on for years’With the
company宜ghting lengthy, emOtional battles with city
councils and other permit-granting organizations. On
the other hand, SOmetimes land was acquired at “retail
price;, with all the permits already having been
granted.
As a standard part of the land acquisition process,
RBH,s land acquisition personnel were required to
prepare a detailed land acquisition proposal. These
PrOPOSals provided detailed information on:
● the nature ofthe request;
㊨ the location;
㊨ entitlements;
㊨ infrastructure;
㊧ PrOduct design;
㊧ market overview;
⑮ enVironmental considerations;
㊨ development fees and costs;
㊥ SPeCial assessments and homeowner association
dues (if any);
㊨∴ SChool information;
㊧ P重互ect milestones;
㊥ risk evaluations; and,
㊥ 丘nancial prqiections.
Many of the detailed proposals were lOO or more pages
in length and often included detailed maps’PrOduct
sketches, and excerpts from consultants’reports.
An important part of the proposal-Writing process
was a detailed evaluation of the prQject’s risk in four
areas: POlitical, development’market’and financial.
The risk in each area was evaluated subjectively into
three categories‥ 1ow, mOderate’Or high. The risk
「O7
 Chapter 3. Action, Persomei, and Culturai ControIs
assessments in these areas were translated into a mini_
mum intemal rate ofretu聖(IRR) requirements for the
Prqiect, aCCOrding to the proce如re shown in Exhibit 2.
Many land acquisition ideas failed to progress亡O the
approval stage for any of a number of reasons, includ-
ing inadequate financial retums’eXCeSS risk in the per
mit-granting process, Or a mismatch between the needs
Ofthe market and the company,s capabilities. Ifthe pro-
POSals were approved by the division president and
RBH’s cEO and CFO, the division president then pre-
Sented them to the Executive Land Committee of the
Board of Directors for final approval・ Only then could
the monies be released.
The Piatinum Pointe site
The Platinum Pointe site was identified by Michael
Borland’the vice president of land acquisition for the
Southern Califomia Division. The Platinum Pointe site
WaS Iocated in the Emerald Estates master planned
COmmunity being developed by Jackson Development
Company.
Jackson Development was recently formed by Tbm
Jackson’Who had formerly worked as division presi-
dent of one of RBH’s competitors. Michael Borland and
Tbm Jackson were long-time friends, back to their time
together as fratemity brothers at San Diego State Uni-
VerSity. Michael called Tbm soon after he leamed ofthe
formation of Jackson Development. He looked forward
to developing some prQiects jointly with Tbm.
Michael discussed with Tbm several sites in the
Plamed Emerald Estates community・ They finally set-
tled on a 21-aCre Site on the northeast comer of the
master planned community. The proposed purchase
Price was $22,500,OOO plus a profit participation by
Jackson Development in the amount of 50% above 9%
net profit, With a soft cost allowance of 20%.2
2 soft costs are cos亡S related to items in a pr(*ct that are necessary to
COmPlete the nonconstruction needs of the prqject, Which typically
lndude such items as architecture’design, engineering, Pemits,
inspections, COnSultants’enVironmental studies, and regulatory
demands needing approval before constru⊂tion begins.
Michael,s experience suggested to him that higher.
density housing’rather than single-family detached
homes, WOuld provide the best use ofthis site. Over the
forthcoming several months, he fleshed out the idea
With the division and corporate specialists, Particularly
in亡he areas of sales and marketing and construction.
He also contracted for special studies from two outside
COnSulting丘rms. One consulting firm prepared a report
detailing pl句ections ofthe costs needed to develop the
Site. The other prepared a marketing study that pro-
Vided pricing and absorption rate estimates based on
analyses of competitive o任drings and forecasts of mar-
ket trends in the geographical area.
Michael wrote a detailed proposal for building 195
homes in two formats: a triplex townhome and a six-
Plex duster home. Other RBH divisions had produced
Similar homes’but the format had not been previously
Offered in Sou血em Califbmia, and some modifications
Were made to appeal to southern Califomia buyers.
The homes would range from l,628 to 2,673 square
feet and be priced from $445,000 to $705,000.
The executive summary of the detailed proposal,
With the required risk assessments and宜nancial pro-
jections, is shown in Exhibit 3.
Michael was disappointed when he saw the pro-
jected IRR for the prqject. It was only 21%, Which was
below the minimum required for a prQject with this
level ofrisk - 24"5%. He decided to discuss the problem
With Harry Hepbum to see what, if anything, COuld
be done.
What to do?
Harry’tOO’WaS disappointed. He had hoped that the
Platinum Pointe prqject would provide a significant
PrOPOrtion of the revenues and profits that the division
WOuld need over the next four-year Period. He still
Wanted to do the prQject. So he and Michael sat down
to take another look at the detailed proposal. What
modifications could they make to Iower the required
IRR or to raise the prQjected IRR to ensure that the pro-
ject would be approved?
Chapter 3. Action, Personnei, and Cuiturai Cont「oIs

Exhibit 2 1RR requirements

Land acquisition opportunitiesr an吐the reIated product choices continue to expand for RoblnSOn Brothers Homes. Given
that risks can vary greatiy from oppo血njty to oppo山nity’guidelines to assess rlSk and the required minImum retumS
have been estabiished, The risks to be assessed are as foIIows:

1. Poi-tical/Entitlement - abiiity to achieve expected entitIements a=d timi=g;

2・ Deveiopment - Site conditions and abi=ty to accurateiy pro」eCt deveiopment costs;

3. Market - eXPerience with proposed product type, PrOduct price points, buyer types, Current market conditions both
Current and future;

4. Financial/Financing - ab冊y to achieve projected results and obtain proposed financing.

Based on these factors, a minimum unieveraged旧R is to be estabIished" Risk ratings are to be assessed based on the

Projects’specific characteristiCS" Each area is to be rated as Low, Moderate, Or Hゆ. A numericai vaiue is to be a請ached
to assessment as fo=ows:
The minimum lRR for the prpject is assessed as the sum of the ratings assigned in each ofthe four assessment areas,

しow Moderate High

Politicai 5,0 6.5 8.0

Development 5,0 6,5 8,0

Market 5.0 6.0 7,0

Financial/Financing 4.0 5.0 6.0

110
帥ibit 3 Piatinum Pointe investment proposal - eXeCutive summary (initiai draft)

The Southem Ca冊omia DiVision is requesting approval to acquire the 21 -aCre Site known as Platinum Pointe in CarIsbad,

CA.丁he slte Wiii yieid 198 detached and attached homes・ The purchase priCe is $22,500,000" The projected lRR is cur-
rently 21%, and the required iRR is 24.5%・ CIose of escrow is projected to occur ln June 2007"

PURCHASE

The SeIier is Jackson Deveiopment Company, inc. The purchase price of the property is $22,500’000 for 21 net acres・
The purchase priCe is not tied to unit count. We are currentiy projecting construction of 123 tow=home units and 72
cluster units. The Master Deveiopment P-a= aPPrOVai is a ciosing contingency" Shou教d the Master Development Plan not

be approved, We have the option to waive the condition or terminate the Agreement・ The ciose of esc「ow is targeted for

June l , 2007, We have the option to purchase two non-refundable nonappiicable 30-day extensions shouid our tentative
tract map not yet be approved. ShouId the Seller cause a deIay that wouId prevent us from processing our entitiements
ln a timeiy manner, We W川be g「anted the right to have the extensions without payment of the extension fee・ This pro」eCt
incIudes profit participatiOn by the Sel-er for the amount of 5O% above 9% net profit’With a soft cost aIiowance of 20%"
We have run muitip-e scenarios to inc-ude interest rate increases・ financing optio=S, COnst「uCtion deIays, and a siow

down in absorption. We are comfortabie that we w冊stay beIow the 2O% threshoId"
We have expIored the option of negotiating this deal with no profit participation. Jackson was open to negotiations
where we would increase the iand price and move forward w-th no profit participation on the back end of the deai・ But
the increase in land price wouid decrease the projected lRR on the project.

RISK EVAしUATION

トPoliticai

The property is -ocated within the Emerald Estates Master Pian area. 1t is zoned PCD (Piamed Community Develop-
ment). The Selier is preparing a detaiIed Master Deve-opme=t Plan (MDP) that w-iI be submitted to the City of Carisbad
in eariy Ja=uary 2007. Our proposed project w川be part of that submissio=・ The SeiIer has been working with the City
throughout the creation of the MDP a=d has gained support of the project" if one contingency - PreServation of habitat
forthe Westem SpeckIed lもad possibiy located in the area - Can be soIved’the SeIier projects that the guideiines w剛be
approved by the City in March 2007" A neighbor claims that the site is habitat for the -road, but the E=Vironmenta。mpact
report has not yet been comp-eted〇一f the -foad issue is reaI, We W冊ave to piace a permanent habitat on the property
We think we can do this without iosing any buiidable iots"
With the approvaI of the MDP our review by the Design Review Comm請ee w川be expedited" Our proposed pro」eCt
w用be designated Fl-M (Medium ResidentiaI, 8 -10 duplexes/acre)・ Our current site pIan shows a totaI of 195 units・
which is approximate-y 9.29 dup-exes/acre. We have met with the Director of Development Services three separate
times. We beIieve that our iatest site plan incorporates the City,s requests. We wiIi need to process a tentative map a=d
to obtain approva- from the Design Beview Board for the site p-an and architecture. The tentative map is expected to be
received by May 2007, and al- appea- per-Ods are expected to expire before we cIose in June 2007"

. OveraiI poIiticai risk is moderate.

> Deveiopment

Site DeveIopmenf

The site is current-y raw land, but it wii- be de-ivered as a mass-graded pad. The Seller rece一Ved the g「ading permit on

November 7, 2006, and has sta巾ed grad-ng. Grading w冊e compieted in Ja=uary 2007. The Seiler w帥COnStruCt aii offsite
backbone sewer, Water, stOrm drain, dry u輔ty, Street improvements’and perimeter iandscaping・ The street and storm
drain P-a=S are aPPrOVed’aS We-1 as the sewer and water pIa=S" Backbone utiiity pIans are currentiy being desig=ed. The

Seller w冊provide u冊y stubs to the site if we are abIe to give them fixed entry locatiOnS Prior to their instaIiing the
improvements" Otherwise, We W冊ave to comect to the systems" The EmeraId Estates master development infrastruc-
ture w冊not be comp-eted prior to our c-ose’but the SeIler w川SOOn begin the improvements. The improvements are being
f…ded by the CFD [Community Facii-tieS Dist「ict]. Shouid the SeiIer fai=o make the improvements in the timeline Pre-
sented in the agreement a=d their faiiure to compIete the improvements affects our site specificaliy’We have the right to

(Con紡ued)

己旺
Chapter 3. Action, Personnei, and Cuitural Cont「ois

Exhibit 3 Continued

assume responsib=ity for complction of the remaining Seiier work, and Seiier sha= reimburse Buyer at = O% of the third
Party direct costs" in addition to cooperatjng with Buyer without iimitation, Seiler sha旧nsure that Buyer is abie to draw
against or obtain rejmbursement from the CFD for compieting the rema涌=g lmPrOVementS.
As mentioned above, the CFD w用be funding the entire infrast田Cture for the site" The CFD has an approved Resolution of
intent. The Resolution of Formation went to City CounciI and was continued to January 12, 2007. The CFD is confident that the
formation w川be heard at the January 13th meeting. The bonds wilI be soId in two issues. The first bond saIe, eXPeCted to be

$30-35 miiiion wiii cover backbone infras血Ct=re, incIuding sewer, Water, StreetS, and stom drain. This is expected to occur in
March 2007" The second bond saie wiIi occur approximateiy six months later and wi旧nclude dry utiijties a=d landscapIng. The

CFD has toId us that the appraisai is underway and should be completed shorty They do not see any iSSueS With the appralSai
meeting the 3‥1 coverage requirement. The bid package forthe first bond saie is compIete and w紺be subm請ed for City review
in January/February 2006. Furthermore, the City of Carlsbad is the lead agency and -S PuShing to get the backbone infrastruc-
tuI℃ COnStruCted・ The improvement pIans have been through muitjpIe pian checks and the tax rate wi= be appr(函mately 「.8%.

ln addition to the infrastructure, the CFD w川be funding certain impact fees, We are expecting to receive a $8,500

Pius credit per unit from the CFD to cover a portion ofthe fees・ The fees that w冊be covered by the CFD inciude webbed
toed =zard・ drainage fees, Sjgnalization fees, SeWer and water comectjon fees, SuPPIementai water fees, and A山n Pub-
Iic Piaces fee・ Our in-traCt deveIopment costs are derived from a cost estimate based on our current slte P-an, Which was

PrePared for us by the Evensen Group. These costs言ncIuding fees and net of the pianned CFD reimbursement, COme tO
$63’088 per unit. This total includes a 15% contingency on construction items and a lO% contingency on fees.
A sIte Visit was performed by an enviro=mental co=Sultant and previous Phase l report were aiso reviewed, Other than
the possibie Westem Speckled -road issue, there are no potentiai envlronmentai concems and no addjtional assessment
appears to be necessary" A geotechnicai investigation concIuded that the sjte was suitabie for the intended use,
The SeIler w川aiso be establishing a Master Homeowners Assocjation to maintain the perimeter and median la=dscap-
ing. We w川create our own sub-aSSOCiation to ma輔ain our on-Site iandscaping detention basin and recreation fac踊es.
The Se=er w川be mass grading the we= and park sites and designing the park. We wi= be responsible for con-
StruCting the we= site improvements, eXCIuding the we旧tseif, and construction of the park, We have included $1 ,O
m冊on for the park and weII site. The weII site improvements consist of a block perimeter wali, SOme landscaping
iron drive gates and drive approach"丁he park improvements are in the preiiminary planning stages and are
expected to inciude landscaping, a tOt lot’Picnic tabies, Shade structures, Walkways and -ighting, and posslbie
restroom fac冊es. The costs of the park and weiI site w冊be initi訓y funded from equity in the short term but wiiI be
reimbursed through the CFD. The weli site wiIi be deeded to the Carlsbad Water District (CWD), and the park w紺be
deeded to the City Of Carisbad. Both the weli site and the park w紺be maintained by each entity respectiveIy.

DiI℃C t ConstnノCtion

The townhome product consists of new pians that we have not built before and direct construction costs continue to
rjse. However’the ciuster product is a modification of product our Phoenix Division has bu航before. The direct construc-

tion estimates we have used a「e derived from our actuaI costs in building the lO-Piex product in Ei Cajon, Which is
COming in at about $80 psf・ There we added an additional $10 psf to account for the -nCreaSed specs we are inciuding
in these new townhomes.
Overa= we conclude that the riSks associated with both site development and dlreCt COnStruCtion are moderate.

● Overa= deveiopment risk is moderate.

> Competitive AnaIysis/Ma「ket Risk

We w川be bu淵ng two product types, a tripIex townhome a=d a six-Plex c-uster product・ The tripIex townhome ranges in
Square footage from l ,753 square feet to 2,442 square feet and wiIi be prjced from $445,000 to $595,000. We feel this
PrOduct wili appeal to buyers who work in north San Djego County and second home owners (Weekend or seasonal) who
are attracted to a low maintenance home with a larger yard・ The cluster w旧ange in square footage from l,628 square
feet to 2・673 square feet and be priced from $45O,000 to $705,000"丁hese pricing projections are the exact prjces recom-
mended from our marketi=g COnSultant, the Biackfieid Group. This is an upgrade version of a product that was very suc-
CeSSfui in Phoenix. 1t w紺be highIy amenitjzed. The master baths have been revised to meet the new ``wow” factor that is

PervaSive in this submarket" There is currently very littie competition for attached or mid-density product in the CarIsbad
area・ We are currentiy unaware of any other 8 -1 O units/acre deveIopment projected within the Cify of Carlsbad at this
tlme, but we continue to monitor new development projects within the City. We have a compIeted marketing study by the
BiackfieId Group that supports our product type and pricing. We are comfortable with the absorption recommendation
from Blackfieid given the two very separate product lines. The models in our estimates are current看y sIated to open in Ju-y

2008. Our absorption wouid maintain 1 5 homes per month average as recommended by the Blackf'eId Group. But there

「12
 The Piatinum Pointe Land Deai

Exhjbit 3 Conthued

馴Sk. The north San Diego County market has experienced a noticeab-e downturn in the last 12-18 months. 1f interest
rates COnt血e to increase and if prjces in markets throughout north San Diego County continue to moderate, We may nOt

be abie to maintain our absorption rate’Or We W冊ave to shave our margins,

' The rlSk associated wjth the market is moderate to high.

> Financjal/Fjnancing Risk

Al。ndieat10nS are that interest rates w川contjnue to rise・刷e eve刷a冊erest rates j=CreaSe Substa刷Iy duwhg the
tife of this pr函, OUr P「Oduc出’I sti’l be posifioned ,n a mO′℃ a施rdab’e segment of the rrla繭. Give両he s廃of
the transaction 648 mi/Iion at March 2009)タSOme form of outside capita, w冊e used・ Lot optjo= and or joint venture
W冊e considered and Ieads to the moderate financjaI rjsk.

.胴nancla碗nc鳩胸r is mo朗fe gfro,)鵬prewfousfy 。fecussed po伽a, and deveIopment riske.

iRR I]EQUIREMENTS
虎sGO On the above analysis and assessed risk, the lRR requirements are as foiIows:

lbtalSalesBevenue: Profit($): Profjt(%): EquityRequired二 HomeSizeTripIex二 $112,050,000

$13,707,000

12.2%

$8,722,000

2・151sfweightedaverage

HomeSizeCiuster: 2,126sfweightedaverage $93/sfweightedaverage

DirectCostsl十iplex:

DirectCostsCluster: $82/sfweightedaverage $531,667/unitweightedaverage $571’667/unjtweightedaverage

BaseSaIesPriceTriplexこ

BaseSalesPrjceC山ster:

BaseSalesPriceTripIex:($tsf) $247.17/sfweightedaverage $268"89/sfweightedaverage

BaseSalesPriceCluster:($庵f)

IRRLeveraged: IRRUnieveraged: 丁O-「ALPEAKEQUiTY 41.4%

21・0%(Required24,5%)

$11,809,000

113
 CASE S丁UDY ’’
EyeOn Pharmaceuticals, 1nc,
In early 2016, Frank DeMartino, Senior vice president
Of Science and耽chnology at EyeOn Pharmaceuticals,
Inc.’re皿ected on his concems about the challenges his
COmPany faced in controlling its research and develop-
ment (R&D) activities:
R&D is the most criticaI part of EyeOn’s business.
The company wiIi thrive onIy if we are effectjve at
deveIoping new breakthrough products. in manag-
ing the research function, We have to address
three d輔cuit but important issues. First, We have
to decide how much to spend on R&D. Then we
have to decide how to a=ocate the resources
among the various p「OgramS and projects. And,
finaily, We have to ensure that the resources are
used e什ectively. How we address these issues
determines how productive our research activity
Wiii be.
I am especia=y concerned about the third issue
- how to cont「oI the use of our resources. i don’t
think we do a very good job of measuring our p「o-
ductivity. At the time we are spending our
resources, both money and time, and even for
SOme time after they have been spent, it is very diト
ficuIt to te= how productive we are being and have
been" We couId be missing some important infor-
mation about probIems we might be having. I feeI
We ShouId do some thinking about this issue and
What we can do to improve the tracking of our P&D
PrOductivity.
The company and its products
EyeOn Pharmaceuticals, Inc. (EyeOn) focused on the
OPhthal皿ology segment of the pharmaceutical mar-
ket. It developed, manufactured, and sold a wide
range of products for the diagnosis and treatment of
OPhthalmic disorders; that is, those used in the treat-
ment ofdefects and diseases ofthe eye. The company
marketed both prescrlPtlOn and nonprescription
drugs, a Wide variety ofproducts for use in ophthalmic
「14
Surgery and for the care ofhard, SOft, and gas-Per
able lenses, and a few dermatoIogical produc
Despite contmumg Price pressure from the chea
generic drugs entering the market, EyeOn reven
and profits nearly tripled over the period betwe
2OO5 and 2O15. In 2016, EyeOn sold products ino¥
80 countries, and worldwide sales totaled almost
billion.
EyeOn used a traditional product-1ine organiza(i
StruCture. Reporting to EyeOn’s cEO were the man
ers of each of the product lines, and the managers
Science and耽chnoIogy (Mr, DeMartino), Finance a
Administration, Intemational, and Legal.
The R&D organization
R&D was critical to the maintenance of EyeOn’s rate
growth. Over 25% of 2O16 sales were from produ
released injust the past five years.
The company’s R&D department was headed by
Prakash Kumar, Who reported to Mr. DeMartino. T
department included 35O people - 290 scientists (80
Whom had PhD degrees) and 6O support staff. Thep
POSe Of the R&D organization was to develop new, m
ketable eye-Care PrOducts that would fuel t
COmPany’s growth. EyeOn’s board of directors esta
1ished broad research policies based on the long-ter
Strategies of the marketing divisions, but the boar
depended heavily on Mr. DeMartino and Dr. Kumar
PrOVide the guidance and direction necessary to en§u
e任ective research activities.
Mr. DeMartino and Dr. Kumar complemented eac
Other well in terms of knowledge and experience.
DeMartino had an in-depth knowledge of EyeOn’
PrOducts and markets because he had advance
through血e sales organization. Dr. Kumar was
chemist.
The R&D department was organized in matrix for
With eight key senior directors (plus staff support
reporting to Dr. Kumar. On one dimension ofthe matri
Were four medical specialty groups: OPhthalmoIogy

optical, dermatoIogy’and basic research" Personnel in
these groups specialized in particular types ofdiseases.
The basic research group was distinguished from the
other血ee medical specialty groups in that its work
took place early in the drug development cycle
鮎scribed below). On the other dimension of the
matrix were four preclinical science departments:
皿icrobioIogy, Chemistry, tOXicology, and pharmaceuti-
cal sciences. Personnel in these departments were
experts in one of these scientific fields. Each research
ram and prQject was managed by a medical spe-
ty expert. The preclinical science personnel were
gned to programs and prqiects when needed. They
en had more than one assignment at any particular
The personnel on the research staff had needs and
characteristics that were different from those of
mployees in other parts of the EyeOn organization"
anagers in the R&D department had to be sensitive to
ose differences. The senior director of the basic
esearch group explained:
We,re not an organization comprised of conform-
ists, and we don’t want to be" The other companies
can have those peopIe" Good researchers are
unique・ They are creative a=d inte冊gent’and
aithough they ca= be aloof a=d seemingIy disen-
gaged, theywiIi work theirta=s o竹When they get on
a project they like, But theirfeeiings are easily hurt"
it’s very easy to k川ideas. We have to be careful
because if we use punishment, discouragement or
penalties for faiiure, We may neVer get anOther idea"
Product deve看opment cycle
The product development cycle in pharmaceutical com-
panies such as EyeOn was Iong’tyPically totaling up to
15 years for a totally new drug and from. 3 to 5 years for
a simple product. Often the cycle started with some
basic research designed to provide a better understand-
ing of the underlying biochemistry of the disease pro-
cesses at the molecular level. In 2016, EyeOn had five
basic research programs underway’all in the area of
ophthalmoIogy‥ in皿ammation, immunology, glaucoma’
diabetic retinopathy/cataracts’and drug delivery.
When a new product concept was fomed’the prod-
uct development cycle was said to begin. Development
consisted of a number of relatively distinct steps. First
was the discovery phase of development’the purpose
of which was to identify compounds with potential
EyeOn Pharmaceuticais, lnc・
commercial applications. Scientists designed and
tested new drug compounds against the characteristics
of the diseases they were studying both in test tubes
and later in live animal subjects. For most new drug
concepts, these screening and testing activities would
last from two to five years.
When the compounds moved into the discovery
phase of development’EyeOn management assigned
the effort a development program number. This num-
ber identified the effort until the product entered the
clinical phase of testing. In 2O16, EyeOn had a total of
ll development programs underway, 4 each in oph-
thalmoIogy and optical’and 3 in dermatoIogy.
A successful culmination of the discovery phase of
development was marked by the identification of a
compound that showed promise. Such compounds
were moved into the optimization phase of develop-
ment. This phase usually involved one to two years of
studies of how the compound might act in the body.
Scientists would study how the compound was
absorbed, distributed, metabolized and excreted in
animal subiects. They would do some expIoratory test-
ing of toxicity (i.e. harmful side effects) and stability
(i.e. length of time the drug retains its effectiveness
when stored). By the end of this phase of development,
the scientists would prescribe a preliminary chemical
formulation and make a preliminary packaging deci-
sion (i.e. mode of delivery and size of dosage).
Drugs continuing to show promise were moved into
the preclinical phase of development. This phase
invoIved better contro11ed laboratory experiments to
validate the results of the expIoratory tests conducted
in the optimization phase of development- The preclin-
ical phase of development usually lasted about 6-12
months. The drugs that continued to show promise
were釦ed as IND (Investigation of a New Drug) candi-
dates with the US Food and Drug Administration
(FDA). At this point, a reaSOnably complete composi-
tion and speci宜cation existed’and a manufacturing
procedure suitable for the preparation of dinical sup-
Plies was in place.
Once the IND was filed, the prqiect moved into the
clinical phase of development. This phase invoIved tox-
icity and stability testing of a longer-term nature than
had been done previously. The testing was performed
on live su切ects: first normal human subjects and then
diseased human sut)jects. During this testing, the sci-
entists would make judgments of the safety and e筒-
cacy of the drug candidates and make final decisions
about the dosages and modes of delivery to be used.
115
Chapter 3. Action, PersonneI, and Cuiturai Controis

The clinical phase of development generally lasted available for controI purposes because the investments angl
between five and eight yea卦When a product entered in basic research were longer-term and riskier. As Mr.
the clinical phase of development, a Prqject number DeMartino explained:
WaS aSSigned. This number would stay with the effort
What’s important高conducting research is to keep
until the product received FDA approval or the e鮒ort
achieving progress on a daily basis, When it take§
WaS abandoned. In 2016, EyeOn had a total of3O active
ten years to deveIop a product, yOu Can’t wait untii
PrQJeCtS.
tomorrow to get the work done,丁he importan(
A drug that passed dinical testing was創ed as an

NDA (New Drug Application) with the FDA. The FDA
approval process took from one to three years.
Approval was needed before the drug could be mar-
questions are: Are we doing everything we can to
ensure that we are being productive eve「y day?
And how can i teiI if we十e being productive?    " ¥上
l高宮・ -

keted in the United States. However, the product could

be sold in many other countries after it had passed Drug investments and payo情s
dinical testing.
New product development invoIved high-risk invest-
Exhibit l shows an overview ofthe product develop-
ments for potentia11y lucrative payoffs, Across the
ment cyde" The times shown in the exhibit for comple-
industry, Only about l of every lO,000 compounds
tion of each of the phases in the cycle are for
investigated in the early expIoratory research stages
development of major drugs. For fairly simple drugs
eventually proved to be commercially successful. The
and optical devices, the times were considerably
Shorter where INDs were often創ed within 12 months, PrObabilities offailure of a typical compound in each of
the phases of the product development cycle were
and clinical testing took between 12 and 18 months.
approximately as follows:

A shift in emphasis Phase ProbabilityofFailure

Through most of its history, EyeOn had relied heavily

Discovery 90%
On Other pharmaceutical companies not invoIved in
OPhthalmic markets as sources of new product ideas, Optimization 50%

EyeOn scientists would screen compounds developed Prec=nical 25%

from these companies, and if they showed promise,
Clinical 70%
EyeOn would license the compounds and introduce tai-
lored forms of them into ophthalmic markets. Com- FDA&Patent NegiigibIe
POunds screened in such a manner were entered into
the product development process in the preclinical
The payoffs from the research were highly depend-
Phase of development because the properties of the
ent on the magnitude and duration of the competitive
COmPOunds were already understood.
advantage that EyeOn eI互oyed when the new products
In recent years, however, EyeOn management had
Were developed. Some drugs were breakthrough prod-
been shifting their R&D efforts to emphasize more
ucts that provided significant advantages over the com-
basic research・ As the ophthalmic markets had grown,
Petition in large market segments. Others were either
Other pharmaceutical companies had entered some of
minor modifications of already-eXisting EyeOn prod-
EyeOn’s market segments. These companies were less
ucts or were aimed at small market segments. Some-
PrOne tO Offer EyeOn their newest compounds. Thus,
times competing firms developed altematives to
the research focus had been evoIving toward larger-
COmmerCia11y successful new drugs in periods as short
SCale, longer-tem Studies of more complex and sophis-
as two to three years, While on other occasions EyeOn
ticated diseases of the eye. This is because EyeOn
PrOducts were sold for 20 years or more with little or no
already had a broad product line covering most niches
COmPetition, As Mr. DeMartino noted:
in the eye-Care market’and to meet the company,s

aggressive growth targets, neW breakthrough products From my perspective, it’s not very important

Were needed. The inevitable shift toward more basic Whether a product costs $30 mi=ion or $60 m冊On
research made management even more concerned to deveIop. When we are working on a drug that wiil
about having measures of research productivity give us severai bi=ion do=ars in saIes over 15 years

「16

and a 75 percent gross margin’OVerSPending a
little on research doesn’t matteLmuch as Iong as
the drug gets created.      重・ ・
The timing ofthe development e任orts was critical. If
e development of a particular drug was pursued too
両he company could be subject to a high probabil-
of failure and/Or Significant extra development
enses and, if problems were found after introduc-
。, POSSible lega=iability expenses・ If the develop-
t was pursued too late’the result would be a
Plaming and budgeting
EyeOn u§ed a well-developed set of management sys-
tems to help manage its R&D effort. Planning and
dgeting was done on an annual cycle’Which took
lace from mid-July to mid-September. Planning was
an iterative process. Mr. DeMartino and Dr・ Kumar
began the process by setting program and pr。ject
obectives and priorities and by outlining an overall
budget for the R&D department. In establishing these
guidelines’they met with EyeOn directors and top-
level managers to ensure that they had a good under-
納れdinq ofmarket trends and the amount of resources
e company was willing to spend on R&D. Then direc-
and managers in each medical specialties group
and each preclinical science department determined
the labor hours and resources required to satisfy pro-
ject and program objectives. This process was accom-
plished through a series of meetings between directors
and managers.
As compared to plans for the development prQjects,
plans for the basic research programs were easier to
prepare because they used few resources from the pre-
clinical science departments. Thus’Very little cross-
organizational coordination was required. Most
development prQjects required the assistance of all, Or
at least most, Ofthe preclinical science groups, SO many
meetings between the managers of the medical spe-
cialty groups and the director of Pre-Clinical Sciences
were required to ensure that resources were allocated
appropriately and, if necessary’that steps were taken
〔O PrOCure additional resources.
After the plans were prepared’Dr. Kumar reviewed
〔hem and made suggestions and a句ustments as neces-
sary. Then the plans were consolidated and compared
with the overall targets. Sometimes further adjust-
mentS Were neCeSSary・
EyeO= Pharmaceuticals’inc.
By February, all EyeOn empIoyees were required
to develop, in consultation with their immediate
supervisor, PerSOnal objectives for the year. The
company did not require the use of a standardized
form or format for documenting these objectives, but
the ol)jectives had to be written down, and this docu-
ment had to be signed by both the empIoyee and the
SuPerVisor.
During the year, budget updates were prepared on a
quarterly basis consistent with the planning schedule.
The budget analysis process, 1ike the annual planning
processes’WaS Very informal because’aS Dr・ Kumar
explained:
We do not expect the scientists to act Iike busi-
nessmen when they plan new product activity" We
want to encourage them to deveIop new ideas with-
out many constraints, and they don't like a 10t Of
PaPerWOrk.
Indeed, bne research program manager explained his
dislike for paperwork requirements:
We work onIy on programs with payo惰s so poten-
tia=y large that a monkey can run the figures show-
ing that the investment is worthwhiIe. The t「ick is to
make the new product wo「k, nOt tO try tO figure out
that a new breakthrough therapy for gIaucoma wi=
Pay Off. 1t wiii!
Mr. DeMartino had two main concems about the
planning process. First’he wondered if too much detail
was still being required. Second’he wondered ifrequir
ing numbers about the research activities made the
managers and scientists conservative in presenting
their ideas. Given the company,s need for good ideas’
he thought it was important that no administrative bar-
riers to ideas be erected,
Measurement and reporting
Accounting in the R&D department was done on a full
absorption cost basis. Direct expenses・ both labor and
materials, Were Charged to specific programs and pro-
jects. Labor was charged on the basis of time sheets
completed weekly by R&D personnel. Costs not specifi-
cally identifiable with a particular prQiect or program
were allocated monthly on the basis of direct labor
hours.
EyeOn produced an extensive set of cost reports.
Many of the reports were on a prQject, PrOgram, Or
medical specialty basis. They showed costs by line item
「17
Chapter 3. Action, PersomeI, and Cultu「al Controis
COmPared to budget. These reports were available on a
monthly basis. Another set of喋POrtS Showed expenses
aggregated by cost center. The R&D department was
divided into 75 cost centers. The cost reports were sum-
marized by type of medical specialty and by type of
P量Pjec亡or program. The program/Prqiect cost accounト
ing system provided the information necessary to mon-
itor the flow of resources to medical specialty areas,
research versus development, and long term versus
short term.
The prQject/PrOgram and cost center reports were
Sent tO the managers responsible for the costs. The
managers reviewed the reports, but they were not
required to explain variances. This was because most
Ofthe variances were caused by changes in the scope or
timing of the prqject/PrOgram, and such changes were
almost always preapproved by Mr. DeMartino and/Or
Dr. Kumar.
EyeOn management recognized that the cost
reports were useful for measuring the inp種でs to the
R&D processes, but they were not useful for measur-
ing the productivity of the R&D activity because they
did not re血ect any o叫匹ts. The outputs, Which might
be measured in terms of profits generated or value
Created, WOuld not be known for years. The signifi-
Cant lag between the investments in R&D and the
retums generated ensured that traditional account-
ing measures, SuCh as retum on investment, Were nOt
Very meaningful except in very long measurement
windows.
Tb date, Mr. DeMartino and Dr. Kumar had focused
their atten亡ion on the deparment’s consolidated丘nan-
Cial summary (actual versus plan) and on the major
R&D achievements of the year. In the last few years,
these achievements were as follows:
2013 2014
iNDsf=ed 3 4
NDAsfiied 6 5
ResearchpubIications 25 19
Patentapp=cationsfiIed 15 9 8
Patentsindicateda=owable 7 8
Patentsissued 5 6
They realized, however, that none of these indica-
tors was a totally reliable indicator of forthcoming com-
mercial success.
118
1ncentive plans
EyeOn used two formal incentive plans offchng cash
awards for good performance, One for scientists and
One for senior-level managers. The sc e:r証s白JICe融ve
pZ肌was introduced in the R&D department in 2013.
Four cash awards of $25,000 each were made annually
申しi¥間刷
for technical exce11ence. The awards were split between
五両hいい
SCientists doing basic research and those invoIved in
=当用¥血圧
development activities,
Candidates for the scientist award were nominated
by senior directors in the R&D department. The candi-
dates’accomplishments were judged by a seven-PerSOn
COmmittee which included four working-1evel scien-
tists, tWO director-level managers, and one person from
OutSide R&D (e.g. from corporate marketing). The com-
mittee assigned the awards based on ``perceptible con-
tributions or unusual problem-SOIving capabilities
Which are perceptible to fellow workers.’’
The ma珊gemen高nce砧ves were provided through
a company-Wide program which provided stock options
and bonuses to managers down to the director level of
the firm. Each year an incentive award pooI was
assigned to the R&D department based on a predeter-
mined percentage of EyeOn profits. This pooI was allo-
Cated by R&D management to R&D empIoyees included
in the plan in coIjunction with the annual performance
For purposes of assigning the awards in the R&D
department, R&D empIoyees were classified into
three categories of achievement: (1) distinguished
Performance (DP), (2) superior performance (SP),
and (3) good solid performance (GSP). (A fourth cate-
EyeOn ma
gory called “Needs Improvement’’was also used on team小紋
OCCaSion, but, aS Dr. Kumar observed, “these col-
PrOduct8
leagues don’t get to stay very long:’) Table l shows the
approximate percentage of people who were class誼ed
2015
in each category of achievement and the bonuses that
3
COuld be expected in an average year in each of the
3 CategOries.
17
“i古bIe 「
5
Categoryof PercentSo AverageAward
4 Achievement EvaIuated (%ofsaIary)
DP <1% 30-35%
SP 50-60% 15-20%
GSP 40-50% 10%

The evaluations were based on a weighted average
three factors: (1) meeting the technical milestones in
e annual plan; (2) discovering new product candi-
ate§; and (3) getting new products with commercial
otential through FDA approvals. The factors used for
leigh†ing accomDlishments in each ofthese areas were
pre-eStablished at the begiming of the year. In general,
the highest weightings were given to the accomplish-
ments that could be measured in a tangible fashion in
the next 12 months.
The weighting factors varied significantly among
thevarious areas ofthe department. For example, man-
agers in development areas (as opposed to those in
basic research) were expected to have products pro-
gress through the FDA approvals, but they were not
expected to generate many new product leads.
The standards used to assess performance also
varied significantly among the areas’re租ecting the
probability of payoffs of the various activities. For
example, tO be evaluated as SP (superior perfor-
mance), managerS Of basic research activities might
be expected to achieve 40% of their o切ectives in a
given year. For managers of ophthalmoIogy drug
development activities, however, the achievement of
50% oftheir o切ectives might qualify only as GSP; SP
might require the achievement of 70%. For product
development managers in optical, GSP might require
achievement of60% oftheir o切ectives, and SP might
require achievement of 80%.
Management concems
EyeOn managers felt they had an excellent research
team that had produced an ever-increasing set of new
PrOducts that had fueled the company’s growth. Mr.
DeMartino highlighted a critical success factor - hiring:
Eighty percent of the rea=y good ideas - those that
Iead to breakthrough products - cOme from 20 per-
Cent Of our co=eagues, lt is important for us to hire
as many of those good peopie as we can, and per-
haps even more important not to Iose any we’ve
aIready empioyed, But it is very d櫛cuit to teli who
EyeOn Pharmaceuticais, lnc"
the rea=y good peopIe are untiI their accomp=sh-
ments are apparent, and that might not be for some
years after they were hired・
Mr. DeMartino’s continuing concem was that EyeOn
did not have a good early warning system in place to
signal potential problems on a timely basis because of
the di飴culty in measuring R&D productivity, and this
might be particularly costly as the emphasis shifted
toward more basic research.
Mr. Kumar had two related concerns. One was the
challenge he faced in demonstrating the productivity of
his department to his boss and the board ofdirectors.
in defining what we mean by productivity, We have
to be carefuI in how we define our terms and the
measures that we reIy on. For exampie, We rareIy
termjnate projects, but we do adjust prio「ities and
Iet some of them sit in an inactive state untiI a solu-
tion to a particular problem surfaces・ Shouid the
inactive projects refiect negativeIy on our produc-
tivity?. ‥ It’s important that whatever measu「es we
use be simple enough to assembie and use without
devoting too much time away from the job at
hand - doing promising, leading research.
His second major concem was about the growing com-
Plexity in his department:
We now have = programs and 30 projects unde卜
Way, and the growth has made coordination of the
groups more d田icult. it is increasingIy d珊cult to
keep up with the status of each program and pro-
ject we= enough to be ab漢e to decide priority
issues. In the iast six months, We have started an
effort to t「y and identify a set of standard product
deveIopment miIestones and decision points
around which a computerized informatjon system
COuId be buiit and used for controI purposes.
Because of the great variance among projects,
however, nOt eVerybody is convinced how much
use there is to organize an information system
around a standardized process that doesn’t reaily
match any reaI project.
119
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 CASE STUDY
Axeon NV,
In October 2016, Anton van Leuven, managing
director of Axeon NV, a large Dutch chemical com-
pany, WaS faced with a difficult decision. Ian Wall-
1ngford, managing director of Axeon,s British
subsidiary, Hollandsworth, Ltd.’and Jeremy Noble’
a member of Hollandsworth’s board of directors,
were frustrated that an investment proposal that
hadbeen presented some time ago had not yet been
approved. The board member had even threatened
toresign his post. But Mr. van Leuven had received
advice from some ofhis other managers to reject the
Hollandsworth proposal.
丁he company
Axeon NV was headquartered in Heerlen’in the south-
ern part ofthe Netherlands. Axeon produced an exten-
sive product line of industrial chemicals in 24 factories.
Early in its history, Axeon had a simple functional
organization structure, With just one manufacturing
division and a sales division. Over the years, however,
Axeon acquired some foreign companies. These
included Saraceno, S.p.A., in Milan; Ho11andsworth’
Ltd,, in London; and KAG Chemicals, AB, in Gothen-
burg, Sweden. Tb take advantage of the geographical
expertise in these acquired companies’eaCh of these
sub§idiaries was asked to assume responsibility for
sales of all Axeon products in their assigned territory:
Southem Europe for Saraceno; the United Kingdom for
Hollandsworth; and Scandinavia for KAG. Southern
Europe, the United Kingdom’and Scandinavia, reSPeC-
tlVely accounted for 8%, 14%, and 6% of Axeon’s total
sales. All other sales were handled by Axeon’s organi-
zation in the Netherlands (see Exhibit l).
The style of Axeon’s top-level managers was to
empha§ize a high degree of decentralization. Hence,
the subsidiary managers had considerable autonomy
to decide what to sell in their territories. For products
produced in the Netherlands’the Axeon Dutch sales
organization would quote the subsidiaries the same
price§ aS theyquoted agents in all countries. The sub-
sidiaries could bargain, but if, in the end, they did not
like the price, they did not have to sell the product.
In some cases, the foreign subsidiaries produced
products that competed with those produced byAxeon
factories in the Netherlands. Tb date, little attempt
had been made to rationalize the company’s produc-
tion. The subsidiaries were allowed to continue to pro-
duce whatever mix of products they deemed
appropriate. The subsidiary managers were also
encouraged to propose the development of new prod-
ucts, and they were allowed to build their own manu-
facturing plants if they could justify the investment in
their own markets.
Management personnel were included in a bonus
plan that provided rewards based on achievement of
divisional revenue growth and ``economic profit’’tar-
gets set as part of the company,s annual planning and
budgeting process. Economic profit was defined as
operating profits less a capital charge on the division’s
average assets, COmPuted monthly. The capital charge
was adjusted annua11y based on Axeon’s weighted aver
age cost of capital. In 2016, the annual charge was set
at lO%. In prior years, it had been as high as 14%.
Achievement of the annual targets could eam divi-
sional managers bonuses of 50% or more ofbase salary.
If they exceeded their targets, they could more than
double their base salaries.
Hollandsworth, Ltd。
Hollandsworth was purchased by Axeon in 2009.
During the first three years of Axeon,s ownership’
Hollandsworth,s sales were in sIow decline. In 2012,
they totaled fill million. Ho11andsworth,s board of
directorsl decided that the company needed a new
management team and a major overhaul・ Mr. Ian Wall-
ingford, a 39 year old with university degrees in
l The outsiders on the Hollandsworth board included Anton van
Leuven from Axeon; Jeremy Noble, a PrOminent London banker;
and James Bedingfield, the managing director of a large industrlal
company loca〔ed outside of Manchester, England.
121
Chapte「 3. Action, PersomeI, and CuIturai ControIs
engineering and commerce, WaS hired. Ian had experi-
ence as a manufacturing engineer, amarketing manager
for a British subsidiary of an Ameriean I‥onPany, and a
PrOfit center manager in a large UK industrial company.
In the first four years of Ian’s presidency, Ho11ands-
WOrth’s sales increased to f160 million, and profits
improved markedly, tO levels that Axeon’s management
deemed acceptable. The board concluded that a num-
ber of factors contributed to Hollandsworth,s tuma-
round. An important part was Ian’s ambition, hard
WOrk, and management skill. Ian made some good per-
SOnnel hires and implemented a number of e任ective
Changes in production methods, marketing strategy,
market research, financial planning, and organization
StruCture. In addition, industrial activity in the United
Kingdom increased signi丘cantly during this period.
In an article in a local English business publication,
Ian was quoted as saying:
This has been an enjoyabie cha=enge, When i took
the job, I had severa1 0ffers from other companies,
and i am sti= getting calis from executive recruiters,
but i thought that Ho=andsworth had potential. The
Axeon management team promised me considera-
bIe freedom to make the changes tha= thought
Were neCeSSary" And I was abie to put into practice
many of the modern management practices that I
learned in my previous jobs. I know that if l do a
good job here, I w肌have the confideれCe Of the
executives in Heerien, and succeeding here wi看I
make me an even better manager.
The proposai
In late 2015, Ian informed the Hollandsworth board that
he proposed to study the feasibility of constructing a fac-
tory in England to manufacture a protective coating
Chemical known as AR-42. He explained that Hollands-
WOrth’s product engineers had developed a new way of
helping users to store and apply this coating. In hisjudg-
ment, Ho11andsworth could develop a market in the
United Kingdom that would be almost as large as Axeon,s
PreSent WOrldwide market for AR-42. Approximately
600 tons ofAR-42 was then being produced annually in
an Axeon plant in the Netherlands, but none of this out-
Put WaS being sold in the United Kingdom. Ian observed
that the board seemed enthusiastic at this initial meet-
ing, but they wanted to see the detailed plan.
Hollandsworth managers developed the proposal
OVer the following six months. They interviewed poten-
tial customers and conducted trials in the factories of
122
three of them and proved that the large cost savings
WOuld indeed materialize. In the end, they estimated
the total UK market potential for AR-42-1ike coatings at
8OO tons per year. If they could sell the product fdr
f3,70O per ton, they would capture half of the total
market, Or 4OO tons per yeaI’, Within a three-year Period.
Ian asked the head of the Corporate Engineering
Division in Heerlen for help in designing a plant to pro-
duce 400 tons ofAR-42 per year and in estimating the
COSt Of the investment. A team comprised of engineers
from both Corporate Engineering and Hollandsworth
estimated that the plant could be built for fl,40O,000.
In July 2016, Ian presented the results of the analysis,
the neトPreSentValue calculations and supporting expla-
nations (Exhibits 2-5) at a Hollandsworth board meeting.
With Ian were his directors of manufacturing, Sales, and
finance. Here are some excerpts from Ian’s presentation:
寧“You can see from the summary chart [Exhibit 2]
that this is a profitable prqiect. We will obtain a rate
Ofretum of 20% and a present value off916,OOO for
an initial investment of fl,400,00O for equipment
and f160,OOO for working capital. I used an 8% dis-
COunt rate because I can borrow money in England
at that rate to fund this prQject …’’
ミ“The second chart [Exhibit 3] shows the operating
CaSh血ows that we expect from the AR-42 prQject in
each ofthe seven years. The sales forecast for the first
SeVen yearS is shown in row (2). We did not extend
the forecast beyond seven years because our engi-
neers estimate that production technologies will con-
tinue to improve, SO m亘ior plant renovations will be
Called for around the end of the seventh year. Actu-
ally, We See nO reaSOn Why demand for this particular
PrOduct, AR-42, Will decline after seven years …’’
¥S` ``The estimated variable cost of f2,000 per ton,
Shown in row (3), is our estimate of the full operat-
ing cost of manufacturing AR-42 in England. This
figure takes into account out-Ofpocket丘Ⅹed costs
SuCh as plant supervision, but excludes depreciation.
These fixed costs must, Of course, be included
because they are incremental to the decision …’’
こ くAs row (4) shows, We are COnfidentthatwe can enter
the market initially with a selling price of f4,000 per
ton, but in order to gain market share and achieve full
market penetration, We Will reduce the selling price
to f3,70O at the beginning ofthe second year …’’
モミ“These figures result in variable profits shown in
rows (5) and (6). Row (7) presents the marketing

expenditures that are needed to promote the prod-
uct and achieve the forecasted sales levels. Row (8)
shows the net operating cash且ows before tax, based
on figures in the preceding columns …’’
l ``The cos〔 ofthe plant can be written offfor tax pu手
poses over a five-year Period. As shown in row (9), the
raxable income figures are computed by subtracting
this amount from the before-taX CaSh組ow. The tax in
row (10) is then subtracted from the before-taX CaSh
frow to yield the after-taX CaSh flow in row (11).. "’’
’型y址rd chart [Exhibit 4] summa正zes our estimates of
混requisite investment in working capital. We’11 need
about f160,000 to start with. We’ll need small addi-
tional amounts ofwo血ing caI克al in the next亡WO yearS.
These amounts are shown in row G). Altogether, Our
working capital requirements will add up to f190,OOO
by the end ofour second full year ofoperations …’’
二“The last chart [Exhibit 5] shows some asset recov-
ery values. At the end of seven years’the plant
§hould be worth f:1,400,000, at the very worst. We’d
have to pay tax on that because the plant would be
fully depreciated, but this would sti11 1eave us with a
positive cash flow of f840’000. The working capital
§hould also be fully recoverable. So the total value at
the end of seven years would thus be fl,O30,000 …’’
二“Gentlemen, it seems dear from these figures that we
canjustify this investment in England on the basis of
sales to the UK market. It meets your policy ofhaving
all new investments yield at least 12%. This particu-
1ar proposal promises to retum 20%. My manage-
ment team and I strongly recommend this p章句ect.’’
Ian and his managers answered the few questions
raised by the board members.
At the end ofthe meeting, Ian and his team went to a
neighborhood pub to celebrate. They all felt that the
meeting went extremely well. Soon thereafter’they
were pleased to leam that the proposal was placed on
the agenda for the next meeting of the Axeon board of
directors, Which was scheduled in three weeks’time.
The boa「d meeting
The presentation to the Axeon board also went well・
Ian explained:
ittook only an hour・ Mr" Van Leuven said in the
meeting that the decision seemed to be clear.
Some board members asked some interesting
questions, mainIy abou=he likelihood that we
Axeon N.V.
WOuId eventua=y be abIe to se= more than 400 tons
Of AR-42 per year and about how we would finance
the project. 1 expIained that we in the UK beiieved
StrOngIy that we wouId reach 400 tons per year
even in the fjrst year, but we felt constrajned to
show a conservative estimate and a conservative
transition period" We also showed how we could
finance furthe「 expansions through borrowings in
the UK. If our 400 tons were reached quickly, banks
would easiIy Iend any further expansion" The UK
member of the board supported ou「 COnCIusion"
At the end ofthe hour, the Axeon board voted unani-
mously to allow construction of the plant・
Dispute between parent and subsidiary
About a week later, Mr. van Leuven called Ian and said,
``Since the board meeting, I have been through
some additionaI discussions with the product and
marketing peopIe here in the Heerien. They agree
With your engineering design and pIan cost p「Ojec-
tions, but they think you are too optimistic on your
Saies forecast, I must ask you to justify this more"’’
Ian pushed for an immediate meeting’Which was
scheduled for the following week. The meeting was
attended by Ian and his key functional directors and
four Axeon managers based in Heerlen: Anton van Leu-
ven, Wi11em Backer (senior VP-Dutch operationS), Marc
Oosterling (director of manufacturing), and Geert De
R執vke (director of sales).
Ian described the meeting from his perspective:
It was one of the most f「ustrating meetings of my
iife, It lasted a= day, Mr, De Rijcke said thatfrom their
SaIes experience in other countries ou「 estimates of
the UK market potential and our share were too opti-
mistic. 1 expIained to him severaI times how we
a「rived at our figures, but he wouidn’t change his
OVer-OPtimism argument, He said that Axeon’s cu「
rent totai wo「idwide market for AR-42 for Axeon was
only 600 tons a year’that it was being produced in
the NetherIands at this Ieve獲, and that it was incon-
ceivabie that the UK alone couId take 400 tons,
Then Mr. Oosteriing started preaching that
AR-42 production is comp=cated and that he had
had d肝icuIties producing it in the NetherIands, eVen
with trained workers who have 10ng eXPerience" I
toId him l oniy needed fjve trained workers and that
he couId send me two men for two months to train
123
Chapter 3. Action, Persomei, and CuIturai Controis

Our PeOPle to do thejob. i toid him that, ``lf you can
manufacture it in the Ne也eriands, yOu Can manu-
facture itfor us in England unti山re iearn, ifyou don’t
have confidence in English technoiogy.’’But he kept
Saying over and over that the d軸Culties in manufac-
turing were great. I stressed to him that we were
SaIes peopIe simpiy want to buiid their own empire
and make the money in Axeon NetherIands, They
don,t care about Ho=andsworth and the UK, Theirs
is a sIippery way to operate. We have the ideas and
initiative, and they are trying to take them and get
the payoff.

PrePared to Ieam and to take the risk, but for some

After Mr. van Leuven received Mr. Noble’s letter, he
reason l just couldn’t get him to unde「stand.
COntaCted Messrs. Backer, Oosterling, and De R恥ke
At 6 p.m,, eVerybody was exhausted. Mr. Backer
and Amold Koonts (Axeon’s VP-finance), He told them
had backed up his two functionai directors a= day,
that the English AR-42 prqject had become a matter of
repeating their arguments, Mr, Van Leuven seemed
key importance for the whole company because of it§ l
just to sit there and listen, OCCaSiona=y asking
implications for company profits and for the autonomy
questions, 1 can’t understand why he did not back
and morale of subsidiary management. He asked them
me up. He had seemed so agreeabIe in the previous
to study the matter and report their recommendations
meetings, and he had seemed so decisive, Not so at
in one month. Meanwhile, he sent Ian the following
this meeting, He seemed distant and indecisive. He
e-mail message: “Various members of the division and
StOPPed the meeting without a soIution and said
COrPOrate headquarters are studying the proposal. You
that he hoped a= concemed wouid do more investi-
Will hear from me within about six weeks regarding my
gation of this subject, He vagueiy refer「ed to the
final decision.,,
fact that he wouId think about it himseif and let us
know when another meeting wouId be heid.

Ian retumed home to London and reported the
meeting to his own staff and to the two English mem-
bers of his board. They were all extremely disap-
POinted. One of the Hollandsworth sta任members said,
`Axeon’s management seem to talk decentralization,
but at the same time they act like emperors.’’
Report of the director of manufacturing
A month later, Marc Oosterling (director of manufac-
turing) sent Mr. van Leuven a memorandum explaining
his reasons for opposing the UK AR-42 proposal, aS
寅)1lows :

Mr. Noble, the English banker on the Hollandsworth At your request, I have reexamined thoroughly a= of

board, eXPreSSed surprise:
I studied this proposal very carefu=y, It is sound
business for Holiandsworth, and AR-42 wiII help to
buiid one more growth company in the English econ-
Omy. Somehow the management in Heerlen has
faiIed to study this, Or they don’t wish the English
Subsidiary to produce it, I have today dictated a Ieト
terto Mr. vanしeuven teIiing him that I recognize that
the Dutch managers have the right to their own
thoughts, but i don’t understand why the proposaI is
being deIayed and possibiy rejected, I am prepared
to resign as a Ho=andsworth director, it is not that I
am angry or that l beIieve i have a right to dictate
decisions for the whoie woridwide Axeon, It is simpIy
that if I spend my time studyjng poiicy decisions and
my judgments do not serve the right function for the
business, then it is a waste of my time to continue,
the cost figures that bear on the AR-42 proposai, i
find it highIy uneconomica=o manufacture this
PrOduct in Eng看and for two reasons: OVerhead
COStS and variabie costs would both be higher than
PrOjected,
As to the former, We Can PrOduce AR-42 in the
Nether看ands with less overhead cost. Suppose that
Hoi看andsworth does se= 400 tons per year so that
Our tOtaI wo「Idwide sales increase to l,000 tons.
We can produce the whole l,000 tons in the Nether-
iands with basica=y the same capitaI investment as
We have now, 1f we produce l,000 tons, Our fixed
costs wi一一decrease by e240 per ton.2 That means
e144,000 in savings on production for domestic
and export to countries other than the UK and
e240,000 for worIdwide production incIuding the
UK (1,000 tons),

In the meeting with Mr, Noble, Ian said:

Whiie I certainiy wouldn’t say this in a broader

meeting, i think that those Dutch production and

124
 Regarding the variable costs, if we were to pro-
duce the extra 400 tons in the Nethe血ands, the
total production of l,000 tons per year wouId.aliow
us to have ionger production runs, Iower set-uP
COStS, and larger raw materiai purchases, Which
iead to mass purchasing and materiai handling and
iower purchase prices, My accounting department
has studied this and conciudes that our average
variabIe costs wiiI decrease from e「,900 to鋤,860
Per tOn (Exhibit 6), This e40-Per-tOn difference
would save us e24,000 on Dutch domestic produc-
tion and e40,00O on totai worldwide production,
assuming that the UK takes 400 tons per year.
There wouId be some addjtional shjpping and duty
COStS, but these would be negligibie. 1ilXeS On
these added p「ofits are aboutthe same in the Neth-
e「iands as in the UK,
So i conclude that that UK pIant shouId not be
bu航, ian is a bright young man, but he does not
knowthe coatings business" He wouid be over his
head with costiy production mistakes from the
Very beginning, l recommend that you inform
HoIiandsworth management that it is in Axeon’s
interest to buy their AR-42 product from the
Netheriands.
Exhibi= Axeon N,V, Organization cha巾
Report of the Vice President-Finance
The same day, Mr. van Leuven received the following
memorandum from Amold Koonts (VP-Finance) :
I am sending you herewith estimates of the working
CaPital 「equirements if Axeon increases its produc-
tion of AR-42 in our Dutch pIant from 600 to l,000
tons per year (Exhibit 7)" 1nitiaIiy we w川need
e120,OOO, mOStIy for additiona=nventories" By the
end of the second year, this w川have increased to
釘60,000. I have also Iooked at Marc’s calculations
for the fixed and variabIe manufacturing costs, and
l am in fuIi agreementwith them・
看an’s thoughts at the time
In an interview about this same time, Ian expressed
impatience.
I have other projects that need deveIoping for Hoi-
1andsworth, and this kind of Iong-range Pianning
takes a Iot of time and energy, it’s no川ke this is aiI l
haveto do, I aiso haveto keep on top ofa Iotof no卜
maI operating probIems. Sometimes I fee川ke giving
up, teIling them just to go and seli AR-42 themselves"
125
Chapter 3. Action, Persomei, and Cuiturai ControIs

Exhibit 2 Axeon N.V- PrOPOSai for manufacture of AR-42 in Engiand - FinanciaI Summary (E:000)

Yea「             ●‥ 0 1 2 3 4 5 6 7 十〇taI

Equipment (1,400)

Workingcapitai (160) (10) (20)

Cashoperatingprofit 196 328 460 460 460 348 348

RecoveryvaIueofequipment andworkingcapital 1,030

7btal (1,560) 186 308 460 460 460 348 1,378 2,040

Exhibit 3 Axeon N.V estimated operating cash fIows from manufacture and saIe of AR-42 in Engiand

(Figures in rows (3)-(5) In $ rows (6)-(11) in 9000)

(1) Yea「 1 2 3 4 5 6 7 丁otai

(2〉 Saies(intons) 200 300 400 400 400 400 400 2,500

(3) Variablecostsperton 2,000 2,000 2,000 2,000 2,000 2,000 2,000

(4〉 Saiespriceperton 4,000 3,700 3,700 3,700 3,700 3,700 3,700

(5) VariabIeprofitmarginperton(4)-(3) 2,000 1,700 1,700 1,700 1,700 1,700 1,700

(6) TotalvariabIeprofitmargin(2)x(5) 400 510 680 680 680 680 680 4,310

(7) Promotioncosts 260 150 100 100 100 100 100 910

(8) Netoperatingcashflowsbeforetax(6)-(7) 140 360 580 580 580 580 580 3,400

(9) Depreciation 280 280 280 280 280 1,400

(10) ーねx40%of(8)-(9) -56 32 120 120 120 232 232 800

(11) NetcashfIowaftertax(8)-(10) 196 328 460 460 460 348 348 2,600
 AxeonN.V,

bit4 Axeon N,V, eStimated working capitaI required for manufacture and saie of AR-42 in EngIand (9000)

Working capital (1) + (2)

Exhibit 5 Axeon N,V, eStimated end-Of-iife vaIue of UK assets

皐

Exhibit 6 Axeon N.V. estimated variabIe cost of manufacturing AR-42 in the Netherlands for shipment
to the United Kingdom

Variabie costs per ton:

Manufacturing
Shipping from NetherIands to United Kingdom
UK impo巾duty
lbtal variabie cost per ton

total variabIe cost, 400 tons to United Kingdom

Exhibit 7 Axeon N,V estimated working capitai required for manufacture of AR-42 in the Netheriands for saIe
in the United Kingdom (9000)

l七a「 0 1 2 3andlater 丁btai

(1) lnventoryatcost 100 110 120 120

(2) Othercurrentassetslesscurrent=ab冊ies 20 30 40 40

(3) WorkingcapitaI(1)+(2) 120 140 160 160

(4) Changefromp「eviousyear 120 20 20 0 160

Thi§ CaSe WaS PrePared by Professors Kenneth A. Merchant and Wim A・ VAn der Stede, With the research assistance ofXiaoling

(Clara) Chen.
Copyright @ byKennethA. Merchant and WlmA. Van der Stede.

127
 CHAP丁ER 4
Contro! System Tightness

The benefit of any management controI system (MCS) is derived from the increase in the likeli-
hood that the organizational objectives will be achieved relative to what could be expected if
the MCS were not in place. This benefit can be described in terms of MCS肩g庇れeSS (or Zoose-

ness). Tighter MCSs should provide greater assurance that empIoyees will act in the organiza-
tion,s best interest.
How tightly to apply management controIs is a m亘ior management decision that has received

relatively little attention in the literature, and when it has, it has been primarily discussed in a
results-COntrOI context. The concept oftight controI can certainly be applied to results controIs.
Tight results controIs might invoIve detailed (often line-by-1ine) and frequent (monthly or even
Weekly) budget reviews of performance as well as appropriately geared incentives.1 But there
are many other ways to e任ect tight management control, both with the other forms of control

and with reinforcing combinations of control types.

Conceptually, e絶頂ive implementation of tight control requires that management has a

good understanding ofhow one or more ofthe controI o切ects - reSults, aCtions, and personnel/
Culture - relate and contribute to the overall organizational ot)jectives. The following section§

describe how each ofthe management control types can be used to generate 〔ight control.

Tight results contro看

The achievement of tight results control depends on characteristics of the definitions of the
desired result areas, the performance measures, and the reinforcements or incentives provided.

Definitions of desired resuits

For management control to be considered tight in a results-COntrOI system, the results dimen-
Sions must be congruent with the “true’’organizational objectives; the performance targets

must be speci缶c; the desired results must be effectively communicated and intemalized by

those whose behaviors are being controlled; and, if results controIs are used exclusively in a

given performance area, the measures must be complete.

Congruence
Chapter 2 discussed congruence as one of the main determinants of the effectiveness of results
COntrOIs. Results-COntrOI systems may suffer congruence problems either because managers do

.細"〆
オ韓
車青鐙
J■
葛ロゼ
 Tight resuits controI

no亡understand the organization’s true o切ectives weH or because the performance dimensions

on which the managers dlOOSe tO meaSure reSults do not reflect the true o匂ectives we11・

For many types of organlZatlOnS and many specific areas within organizations’it is a rea-

sonable assumption that the true objectives are well understood. For example, it is clearly
desirable for production workers to be more e鯖cient and for sales personnel to sell more’all

else being equal. In many other organizations, however, a gOOd understanding of the true
o匝ctives and/Or how they should be prioritized is not a reasonable assumption.2 In many

types of govemment agencies and non-PrOfit organizations, key constituents often disagree as
to the organization,s objectives. Is the primary objective of a govemment agency to provide
more services or to reduce its costs (and tax burden)? Clarity of objectives is a necessary pre-
CurSOr for congruity.
Moreover, Choosing measurable performance dimensions that reflect an organization’s

true objectives is also often challenging. For example, are annual profits a good indicator of
the success of a company with significant growth prospects? Is the number ofpatents granted
a good indicator of a research and development entity,s contribution to its company,s perfor-
mance, Which depends critically on developing commercially successful ideas for new prod-
ucts?3 Is the number of visitors a good indicator of the success of a museum? If the chosen
measurable performance dimensions are not good indicators of the organization’s true objec-

tives, then the results-COntrOI system cannot be tight, regardless of any of the other systems
characteristics.

Specificity
The degree of tightness of results control also depends on having performance expectations
described in specific terms. Specificity of performance expectations’Or targetS, requires disag-

gregation and quantification’SuCh as a 15% retum on assets per year; less than l% customer
complaints; Or $2.29 in labor costs per unit of production. Organizations usually can, and do,
set such specific, quan捕ed targets in丘nancial terms. But in many performance areas, SuCh as

with respect to sustainability and environmental performance, COntrOl is Ioose(r) because

organizations do not set specific, quantified targets and merely evaluate the global performance
area su申jectively. “Profits are easy to measure; the many and often conflicting demands [arising

from corporate social responsibility] are not.,4 control in the difficult-tO-meaSure areaS Can be
tightened by disaggregating the global performance area into its various components’SuCh as

energy usage, VOlume and type of waste generated’and extent of recycling. In some perfor-

mance areas, however, detailed and speci缶c targets and measures are not feasible. It is di飴cult

to be specific about how many cases a lawyer should handle in a year or about what is meant by
ethical behavior or socialjustice. Nonetheless, SPeCi宜city of expectations is one of the elements

necessary for the implementation of tight results controIs.

Communication and inte「naIization

For results controIs to be tight, Perfomance targets must also be communicated effectively and
intemalized by those charged with their accomplishment. Only then can the results controIs
influence performance・ The degree to which goals are understood and intemalized is aifected

by many factors, including the qua皿cations of the empIoyees invoIved, the perceived degree of

controllability over the measured results areas’the reasonableness ofthe goals, and the amount

of participation allowed in the goal-Setting processes. Intemalization is likely to be low when

employees perceive they lack the ability to perform well in the expected perfomance area’

when they consider the desired results to be unduly affected by factors outside of their control’

when they believe the goals are unachievable’Or When they were not allowed to participate in

setting the goals. We discuss the conditions for effective target setting further in Chapter 8.

129
Chapter 4. Controi System Tightness

Comp看eteness

Completene挑is the final requirement for tight results controIs. Completeness means that th

result areas defi読d in the MCS include all the areas in which the organization desires goo

Performance and over which the employees invoIved can have some impact. What is not mea
ured becomes less visible, Or Perhaps even invisible. Thus, When the defined result area§ ar

incomplete, emPIoyees often allow performance in the unmeasured areas to slip. For exampl

PurChasing persomel evaluated solely on meeting cost standards might allow quality to §1ip
Similarly, Salespeople who are asked to meet sales volume quota are likely to strive for volume

POSSibly at the expense of smaller but more profitable sales.

Thus, reSults-COntrOI systems should capture, aS COmPletely as possible, all information
about empIoyees’effects on丘rm value, Weighted properly, SO that empIoyees’efforts are appro

Priately balanced across the multiple dimensions of their jobs. At managerial levels, however
Where jobs are complex, reSults controIs are almost inevitably incomplete. Commonly, then
managers direct their e任orts only to measured tasks and may ignore other important-bul

unmeasured tasks (such as by focusing on improving short-term PrOfits at the expense oflong
term customer relations).5 This is a typical example of m肌ager壬aZ rnyopia due to incomplete

results controIs, Which we discuss further in Chapters lO and ll.

When the results controIs are incomplete, Other types of control, including action and
PerSOnnel/Cultural controIs, Should be designed to try to珊the void left by the incomplete
results controIs. Examples of comPZe肌e庇c[ry COntrOl mechanisms are action controIs tha-

indude quality controIs, Or Cultural controIs that aim to instill a mind-Set tOWard sustainable
Performance or innovation to counter myopic results-driven behaviors.

Performance measu「ement

Tight results control also depends on the adequacy of the performance measures that are used
As discussed in Chapter 2, reSults controIs rely on measures that are precise, Objective, timely.
and understandable, A results-COntrOI system that is used to apply tight control requires that all
Of these measurement qualities are met to a high degree. If the measurements fail in anyoi
these areas, the controI system cannot be characterized as tight because behavioral proble耶

are likely. Chapters lO-12 deal with the complex nature of designing effective performance
meaSurement SyStemS"

lncentives

Results controIs are likely to be tighter if meaning皿rewards are directly and definitely linked to

the accomplishment of the desired results. A dIrec亡link means that the accomplishment of results

translates explicitly and unambiguously into rewards. A d4i南e link between results and rewards

means that no excuses are tolera亡ed. Both elements are pertinently illustrated in a quote from a

former president at Bausch & Lomb: “Once you sign up for your target number, yOu are eXPeCted

to reach it.” Managers who failed to achieve annual profit targets by even a sma11 amount received
``paltry,, bonuses, While those who exceeded them earned “hefty・, payouts"6 Equally, in the public

SeCtOr, the head of the Philippines’Bureau of Intemal Revenue, the tax authority which brings in

most of the govemment’s revenues, reSigned over the agency’s `亀ilure to meet its targets.’’upon

announcing the resignation, the president’s o鯖ce stated: “He has not performed we11 and he said

he takes responsibility for it",,7 And, in the United Kingdom, the gas and electricity markets regu-
lator Ofgem slapped an fll.1 mi11ion丘ne on British Gas because the丘rm failed to meet deadlines

to insulate homes under two energy-e鯖ciency schemes that ran until the end of 2012. Although

British Gas did ultimately reach its targets, the delay meant that thousands missed out on the
measures during the winter of 2O12-13. Sarah Harrison, an Ofgem senior partneI‘, Said: “Briti§h

Gas’s failure to deliver two environmental obligations on time is unacceptable.’’The sector

 Tight action controis

riposted, Saying that they were “deeply disappointed,, with the penalty and that they ``believe the

design of the CESP [CommuHdey Energy Saving Program] was且awed and sign誼cant problems

were encountered wi亡h scheme deHvery.・, However, these arguments - Perhaps eJCCuSeS - did not

sway the regulator in deeming the targets to be均誼。vdy missed’thus warranting the fine.8

Although most organizations’including non-PrOfit and public sector organizations’aPPear

to make the link between incentive compensation and performance more direct and more defi-
nite, there is much debate and controversy about this important topic. We discuss the key fac-
tors that determine the effectiveness of, and issues arising from, Performance-1inked incentives
in more depth in Chapter 9.
Tb end this section with an example, there also is a fine line between tight results control and
results control that is roo tight or ・・too controlling.,, put anotherway’αthere is a fine line between

micromanaging and house arrest’・・ as the Jr王s旧nda叩de庇says when commenting on Ttsco’s

use of Motorola armbands to monitor employees at the large grocer,s Dublin distribution center・

Each armband “measures empIoyee productivity so closely that the company even knows when

they take a bathroom break’’:

The armbands, 0仰CiaI-y known as Motorola arm-mOunted terminaIs, 10Ok Iike something

between a Game Boy and Garmin GPS device" The terminais keep track of how quickly and
competently emp-oyees unload and scan goods in the warehouse and gives them a grade" It
aIso sets benchmarks fo「 ioading and un-oading speed’Which workers are expected to meet・

The monitors can be tumed o什during workers’lunch breaks, but anything eIse - bathroom

trips, Visits to a water fountai= - rePOrtedly 10WerS their productivity sco「e" lt)SCO did not

respond to requests for comment’SO it’s ha「d to know if the arm bands have been a succesS.9

Analytica11y, however’Tesco,s system provides a good example of tight results control. It

pushes its workers hard’but rItsco claims that workers are also well paid and that worker condi-
tions are good. Ttsco compares eaCh worker,s performance every day with a computerized pro-

jection of what performance should have been - the so-Ca11ed bencfumc[rks" Workers who cannot
meet the standards are given suggestions for improvement. Hence’this controI system meets

every characteristic oftight results control. The results measures seem to be congruent with the
company,s goal of efficiency, aS its “el,e7γ脚e he頓" corporate tagline suggests. The measures

seem to be complete at the worker level. Distribution center workers have no other signi宜cant

responsibilities beyond handling merchandise with care and efficiency・ The performance tar-

gets are specific; meaSurement is thorough and done on a frequent basis (in real time’aCtua11y);
and the rewards, Which include job security, are important to the empIoyees invoIved’Where

the company states that the goal is to improve productivity while improving conditions.1O
America,s Wal-Mart, the giant retailer’has similar systems in place to ``have better controI

over operating expenses,, through “improving supply chain efficiency,, and負tight controI over

its distribution and transportation expenses’’:

The retaiIer’s work assignment projects such as MyGuide and Onelbuch have heIped it in

e什ective hand-ing and movement of me「chandise" MyGuide is designed to keep track of

waI-Mart’s emp-oyees’time spent on eaCh task・ As a resuit of these initiatives・ CaSeS han-

dIed per hour increased by 3% in the quarter.11

Tight action controIs

since the action-COntrOl types are quite diiferent from each other’We discuss the ways in which

each action-COntrOl type might be used to achieve tight control separately. Overall’aCtion-COntrOI

systems should be considered tight only if it is highly likely that empIoyees will engage

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Chapter 4. Controi System Tightness

COnSistently in all actions critical to the operation’s success and will not engage in harmful

actions, 」

Behavioral Const「ain鴨

Behavioral constraints, either physical or administrative, Can PrOduce tight control in some
areas of an organization. Physical constraints come in many forms, ranging from simple locks
On desks to elaborate software and electronic security systems. No simple rules can be provided
as to the degree of control they provide except, Perhaps, that extra protection usually costs

Administrative constraints also provide widely varying degrees of control. Restric血g decト

Sforz αut71Ordy to higher organizational levels provides tighter control if it can be assumed that

higher-level personnel will make more reliable decisions than lower-level personnel. At Super
Micro Computer, a California-based computer maker, CO-founder and CEO Charles Liang
“obsesses over every detail of the business, from approving the custom orders that are the com-

Pany’s specialty to dictating the environmentally themed, green neCkties that executives wear
to customer meetings.’’Despite its peculiarities, Super Micro has been a thriving, Publidy

traded business, beating its competitors to market by three to six months and offering the fast-
est, mOSt COmPaCt, energy-e飴cient computers to demanding corporate customers such as eBay

and lねhoo. “[Mr. Liang] is the person who approves and looks at everything the company is

doing - eVery neW PrOduct, marketing effort, Sales e鮒〕rt, anything you want to do or promote,’’

Said Scott Barlow, a former sales manager at Super Micro. “If [Mr. Liang] says a product will be

On SChedule言t will be on schedule;’added Don Clegg, a Vice president. However, despite the

Seemingly e任ective contro量arising from centralized decision-making, Mr. Liang “is considered

SO Vital to the operation that the company wams investors in regulatory創ings that his Ioss

could derail the company’s business, Culture and strategic direction.,,12

Sa叩rα血g血証es between two (or more) employees, anOther type of administrative con-

Strain亡, makes the occurrence of a harmful activity less likely because one person camot com-

Plete the entire task without invoIving another person. Good separations of duties make the
COntrOI system tighter.
Netflix, the global provider of on-demand intemet streaming media, Sued Mike Kail, its for-
mer vice president of information technoIogy (IT) operations, for fraud, breach of丘duciary

duties, and other improper actions, a11eging that Mr. Kail accepted commissions of 12-15%
from the $3,7 million the company paid to IT service companies, Which he then fumeled into
his personal consulting company, aCCOrding to the complaint:

Experts seized on one line from the suit, fiied in Caiifomia Superior Court, Santa CIara
County, that suggests Net晒x may have granted Mr. Kaii too much freedom: “KaiI was a

trusted, Senior-IeveI empIoyee, With authority to enter into appropriate contracts and
app「ove appropriate invoices, 771is ;s a classic segregafion of duties vioIation,’’said

Christopher McCiean, a COrPOrate gOVemanCe analyst at Forrester Research inc,, adding

that `伽dividuaIs shouId not have的e au請ohfy fo both choose and approve payment to a

vendor because ,t opens the door for co仰o伯te ma侮asance.,,13

For administrative constraints to be e飾ective, however, those who do not have authority for

Certain actions or decisions cannot violate the constraints that have been established. Evidence
SuggeStS, however, that both ol,errIdes of intemal controIs and coZZuston among empIoyees con-
tribute significantly to fraud in organizations:

[There is a】 strong correiation between a fraudster’s levei of authority and the financiai
impact of the fraud. ln our 2014 data, OWnerSfexecutives accounted for Iess than one-fifth
Of ail frauds, but the median 10SS in owner/executive cases was $500,000, aPPrOXimateiy

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 Tight action controIs

four times higher than the median ioss caused by managers and neariy seven times that of
emp10yeeS. Au肌Qh‡y fends to be strongly comeIated wi書h /OSS because hjgh-1evel haud-

SterS generaW have greater access to o′ganjZa書ionaI assets and are be請er able to evade

Or OVemide controIs肋an /OWe手IeveI empIpyees. [. ‥] AdditionalfyJ because hjghe手IeveI

舟auds書ers are typicafty /n a better position to circumven書controIs, /t gene帽W takes fonger

for vic拓n organセations to detect勅ese schemes"14

This is echoed by Richard Powell, a Partner at KPMG Forensic in the United Kingdom: “Com-

Panies clearly have a challenge on their hands [when] the perpetrators [of fraud] are members
Of senior management, Whose status in the company makes it easier for them to bypass intemal
controIs and inflict greater damage on the company.・,15

Preaction reviews

Preaction reviews can make MCSs tight ifthe reviews are frequent, detailed, and performed by
diligent, knowledgeable reviewers. Preaction reviews are invariably tight in areas invoIving
large resource allocations because many investments are not easily reversible and can, by them-
Selves, affect the success or failure of an organization. Tight preaction reviews of this kind
invoIve formal scrutiny of business plans and requests for capital by experts in §taff positions,

SuCh as in the Finance Division, and multiple levels of management, including top manage-

But some organizations also use tight preaction reviews before empIoyees can spend even
Sma11 amounts of money. For example, at Amazon, the retailing giant, founder and CEO Je任

Bezos:

[,. ,] keeps an eeriIy tight rein on expenses, eSChewing coIor printers in favor of trusty oid
biack-and-White models, No one仙es fi「st ciass (though Bezos sometimes rents private

jets at his own expense), Experiments are hatched and managed by the sma=est teams
POSSibIe; if it takes more than two pizzas to feed a work group, Bezos once observed, then
the team is too big. O怖ces sti= get cheap desks made of particIeboard door planks, a

1990s ho-dover that Bezos refuses to change"16

But Bezos’s approach is tight not onlyjust in terms of control for control’s sake, but also in the

SenSe Ofbeing consistent with strategy, thus providing ``good control’’as defined above:

Lots of retaiIers taik about hoiding down costs and passing the savings to the consumer,
Few do so as intentIy as Amazon, Where “frugaIity’’is one of eight o冊CiaI company vaIues,

The reward for putting up with cheap o伸Ce furniture: a $90 bi=ion stock market vaIuation

and 35% revenue growth.17

Tight preaction controIs can also be exercised at the level ofthe board ofdirectors. For exam-

Ple, Ted Tumer, While chair of Turner Broadcasting, had made decisions that several times
PuShed the company dose to insoIvency. As a consequence, his board of directors would not let
him spend more than $2 million, a tiny amount for such a large company, Without the board’s

approval・18

The extent to which organizations tighten their controIs also often varies with their fortunes.
For example, aS Citigroup sought to recover from its crippling losses following the 2008 finan-
Cial crisis, it tried many fixes, SOme involving mむor restructurings and consequent layoffs. But

the banking giant apparently was not satisfied. A memo by John Havens, head of Citigroup’s

Institutional Clients Group (ICG), urged employees to be much more frugal in their expenses.
“Managing our expenses is not only a critical aspect of our strategy, it is also an important part

Ofourjobs;’Mr. Havens wrote. “Each ofus must do our part to manage our expenses by chal-

1enging every dollar we spend to ensure that it is truly necessary and in compliance with our

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 Chapter 4. ControI System Tightness

POlicies.,, Many of the policy changes in。ude stricter controIs on how much bankers can spend
On Client m鎚tings and how often executives can call upon management consultants. “Our cu手

rent usage of management consultants is too high;・ Mr. Havens declared. “Management con-

Sultants should only be engaged for those limited instances where a specific expertise which
does not reside within our organization is absolutely required・,, He also noted that “coIor pres.

entations are unnecessary for intemal purposes’therefore […] color copying and printing

Should only be used for client presentations. AIso whenever possible, PreSentations should be
Printed double sided to reduce unnecessary paper usage.,, He emphasized that these “expen§e

POlicies and pre-aPPrOVal procedures will take effect immediately [and tha匝hese policies and

PrOCedures apply to a11 ICG empIoyees and the functional support areas dedicated to ICG, in a11
regions・・,重9

The requirement of reviews by top-level o鯖cers or committees or even the board of directors

does not’howeve串utOmatically signify that the preaction control is tight. Many busy top man.

agers and even capital committees do not take the time to examine carefu11y a11 expenditure

PrOPOSals’Particularly sma11er ones. They merely rrfeber s亡amp them. Or, When cajoled into
Signing off on exceptions such as to allow an “exceptional・, expense claim for a “special,, client,

the authorizing manager caves and the tight poliey loses its bite.

Action accountabiIity
Action-aCCOuntability controIs produce tight control in a manner quite similar to tight results
COntrOIs. The amount of control generated by action-aCCOuntability controIs depends on charac-
teristics ofthe definitions ofdesirable (and undesirable) actions, the effectiveness ofthe action_
tracking system’and the reinforcements (rewards or punishments) provided.

Definitions of Actions
Tb achieve tight action-aCCOuntability controlブthe definitions of actions must be congruent,

SPeCific’Well communicated’and complete. CoJlgruerICe meanS that the performance of the

actions defined in the controI system will indeed lead to the achievement ofthe intended organ-
izational objectives.
Tighter controI can also be achieved by making the definitions of actions spec咋in the form

Of work rules (such as prohibiting alcohol during work) or policies (such as the requirement to
Obtain three compet主ng bids before releasing a purchase ordeD, aS OPPOSed to relying solely on

less specific guidance (such as to exercise good judgment or to treat colleagues and customers
With respect).
Tight action control depends on the棚ders亡a旭rlg and c[CCa匹nCe Ofthe work rules, POlicies,

Or guidance by those whose behav王ors are being controlled. If the empIoyees invoIved do not

understand the rules’POlicies, Or guidance’they wi11 be inconsequential. If the empIoyees do

not accept the rules’they may try to find ways to avoid them. Understanding and acceptance

Can be improved through communication and training and by allowing empIoyees to partici-

Pate in the development of the rules’POlicies, Or guidance.

If the MCS relies extensively on action accountability, the definitions of (un)desired actions
must be co叩Ze亡e" Completeness means that all the important, aCCePtable (and unacceptable)

actions are we11 defined. αwe have procedures for everything,, is an indicative comment from

SOmeOne Who is working in a tight action-aCCOuntability environment. Indeed, in the words ofa
manager at a care home for the elderly:

We have procedures for everything " ‥ including a poIicy on confidentia-ity; a Sta惰com-

Piaint procedure; a COmPrehensive job description; a reCOrd of training in care; and com-
Pany ruIes. [The company rules] incIude a variety of policies from health and safety to
SmOking, and a section on g「oss misconduct,20

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 Tight action cont「ois

The co-OWner at anOther care home for young people stated:

A discipijned e副ironment underpins everything that we do; adherence to reguiations and

procedures is partふid parcel of everyone,s work. Govemment reguIations on care home

and chiId protection require documentary evidence on most aspects of our day to day
OPerations. I can teiI you what a chiId resident ate on a particuIar day six years ago, What
mood he got up in, What sociai worker s/he was with , ‥ The sociaI workers have to write

all this dow申t aII gets typed up. We keep the records for lO years.21

Al血ough tight action controIs can be relied on extensively for the proper functioning of

Organizations in certain environments, SuCh as banks, nuClear power facilities, hospitals, and
Critical healthcare homes, they are not e任ective in all circumstances. In some situations, the

desired actions cannot be de丘ned nearly completely because the tasks are complex and require

COnSiderable discretion or creativity. When the desired actions camot be properly defined,
action-aCCOuntability controIs will not produce tight control; they may even be counterproduc-
tive, aS they are likely to limit professional judgment, Stifle creativity, erOde morale, and cause
decision delays and sIow strategic responses to changing market conditions. At SAP America, a
division of the world’s largest provider of Enterprise Resource Planning (ERP) software, the

tight control exercised by SAP’s headquarters in Gemanywas seen as utterly irr互a血g・22 As an

example of improving strategic responsiveness,

[, ‥] even at companies known for their engaging cuItures, ruIe ki=ing can improve
business - Or eVen Shift business models. 1n the early days of Zappos, the company
focused simpiy on providing the best oniine selection of shoes, But after receiving tons of
CuStOmer feedback, they Iearned that surprise shipping upg「ades and positive customer

COmmunication had a tremendous impact on IoyaIty, So they got rid of approvaIs for free
Shipping and ViP perks so ca=-Center emPIoyees had access to the same tooIs as manag-
ers" Nowadays, Zappos, customer service is as renowned as its product selection.23

But “there is a宜ne line between restoring trust and strangling opportunity through high

COmPliance costs; [. ‥] worse, the environment for bankers has been made so suffocating

that the best leave, desperate to breathe again in a lighter-regulated landscape.,,24 Apply the
reins too tightly, and the controIs become stifling; leave the reins Iooser, and face the risk of
improprieties.

Action巾acking

Control in an action-aCCOuntability controI system can also be made tighter by improving the
effectiveness of the action-traCking system. Employees who are certain that their actions wi11
be noticed, and noticed relatively promptly, Wi11 be a任ected more strongly by an action-

accountability controI system than those who feel that the chance of getting “caught’’is small.

Constant direct supervision is one tight action-traCking method. Detailed audits of action
reports are another (e.g. detailed reviews of expense reports). For example, banks or the regu-
lator can empIoy so-Called cmab′亡tCS - SOPhisticated technological tooIs for analyzing millions

Of trades for pat亡ems that suggest suspIC10uS aCtivity by comparing a broker’s or investment

advisor’s trades against signi宜cant events such as merger announcements to flag possible

insider trading, Say・25

A new generation of workpIace technoiogy is a=owing white-CO=ar jobs to be tracked,

tweaked and managed in ways that were d輔Cuit even a few years ago, Empioyers of aii

types - Old-Iine manufacturers, nOnPrOfits, universities, digitaI starトups and retaiIers - are

using an increasingIy wide range of tooIs to monitor workers’efforts, help them focus,

cheerthem on and just make sure they show up on time,26

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Chapter 4. ControI System Tightness

But there is a catch:

``Peop憶in saIes are continually measured and aiways know where they stand, Now thisi!

happening th’the rest of the white-CO=ar work force,’’said Paui Hamerman, a WOrkplace

technoIogy anaIyst with Forrester Research, “Done properly, it w冊increase engageme[t,

Done in the wrong way, emP-oyees wi一一fee- pressured or micro-managed.,,27

Action Reinforcement
Finally, COntrOI can be made tighter by making the rewards or punishments more significant to
the employees affected. In general, Significance varies directly with the size of the reinforce.
ment. Whereas rewards (incentives) are the most common form of reinforcement that organト

Zations provide in results-COntrOI settings, Punishments (disciplinary actions) are common in

action-COntrOI settings because they often involve empIoyee violations of rules and procedures.
Although, aS With rewards, different individuals react differently to identical punishments, One
type of significant disciplinary action - the threat of dismissal - is likely universa11y understood.
The way commercial airlines control the actions of their pilots provides a good example ofa
tight action-aCCOuntability controI system. The pilots are given detailed checklists specifying
nearly all required actions, nOt Only for normal operations but also for all conceivable contin-

gencies, SuCh as engine failure, fire on board, Wind shear, and hijacking. Intensive training
helps ensure that the procedures are understood, and frequent checking and updating help
ensure that they remain in the pilot’s active memory. The tracking ofirregular actions is precise

and timely, aS all potential violations are thoroughly screened by objective investigator§.

Finally, reinforcement is signi丘cant because pilots are threatened with severe penalties, indud-

ing loss of profession, nOt tO mention the fear for loss of life when accidents do happen.
Even the most detailed action specifications can be undercut by the lack of action tracking
and reinforcement. For example, rules and procedures will not be followed if top management
does not show interest in having them followed, Thus, for action accountability to be tight,
〔班of the elements of the action-COntrOI system - definitions of actions, aCtion tracking, C[rld

reinforcement - muSt be properly designed. Moreover, aCtion controIs are sometimes seen a§

hindering e鯖ciency. As such, reengineering efforts focused on improving e鯖ciency sometimes

imprudently downgrade preaction reviews, Segregation of duties, PaPer trails, and reconcilia-
丁ight噸
tions as r10m,。ZIIe-C[dded. While these controIs might seemingly not add value, they can help

PreVent losses that might arise from accidents or misconduct.

Surveys ofpractice, howeveI’, SuggeSt that sophisticated frauds have been on the rise, in part

explained by an increase in computer-based transactions as part of complex IT systems that

handle virtually all company transactions including sales accounts, COSt aCCOuntS, PerSOmel
administration, and general ledger. Although computer-based transactions are now common-
Place in most organizations, COntrOI of such transactions is sometimes Ioose (compared to con-
troI of “old-eCOnOmy’’paper-based transactions). There is no reason why control of

COmPuter-based transactions cannot be tight, eVen tighter than paper-based transactions; but
due to system complexity, COmPanies do not always fully understand the control risks invoIved.
Moreover, and as a recent study by KPMG pointed out, “although IT systems form a core part

Of [most business], many Organizations suffer from not having people in the business clearly
identified to be responsible and accountable for their usage.’’The study showed that more than

two-thirds of the executives surveyed believe that effective control is hampered because they

Put tOO muCh focus on technoIogy and fail to address the organizational and procedural changes
that are required. Moreover, although more than three-quarterS Of the sampled organizations
Cite that they lack the skills or capabilities in the area of intemal audit of information technol-
ogy, Only one-third bring in extemal support.28 These weaknesses, due to lack ofattention and/
Or reSOurCeS, Can lead to m年jor securityweaknesses, eVen in organizations where one would not

136
 Tight personneI/CuIturaI controIs

expect it. For example, the US Govemment Accountability O鯖ce (GAO) said that the US Securi-

ties and Exchange Commi埜ion (SEC), the stock market watchdog, failed to consistently protect

against possible cyber intrusiQnS Or enCryPt SenSitive data on a key丘nancial system, amOng

SeVeral information security weaknesses:

``CumulativeIy, these weaknesses decreased assurance regarding the reiiabiIity of the data

PrOCeSSed by the key financial system and inc「eased the risk that unauthorized individuals
COuld gain access to criticaI hardware or software and intentiona=y or inadvertentIy
access, aIte「, Or deiete sensitive data or computer p「Og「amS,” the GAO said. Moreover, the

GAO report stated that “whiie the SEC generaIly protected physjcal access to its faciIities,

the SEC didn’t su鮒cientIy controi access to one sensitive computing area at its headquar-

ters, it aiso didn’t update and test its contingency and disaster recovery plans or consist-

ent-y require tough user passwords・29

Several GAO audits have raised concems about the SEC’s intemal controIs over the years. The

latest report quoted above says the information security weaknesses collectively led the GAO to
COnClude that “the SEC had a stgJl殖a庇d4ic王eれey ir高s in柁rrlaZ co庇rO!s ol,erj主naJICZ。ireport-

fng・,,30 Tbp financial institutions face similar vulnerabilities in their IT systems, making them

susceptible to cyber attacks and crime either for financial gain or to disrupt services.31
But the spotlight has been put back on the importance of intemal controIs also following
mqjor corporate scandals in the early 2000s, SuCh as at Enron and WorldCom. For example, Sec-
tion 404 of the Sarbanes-Oxley Act of 2002 (see also Chapter 13) requires that publicly traded
COmPanies in the United States provide in their annual reports a statement by management on
the e任ectiveness of the company’s system of血er朋Z co庇roZs, many Ofwhich are of the action-

COntrOl type. Section 4O4 further stipulates the responsibilities of the company’s independent

auditor in performing an audit of the intemal controIs in cor豆unction with an audit of丘nancial

s亡atements.32 As a consequence of the required compliance with Section 404 of the act, many

Public companies in the United States have both improved the documentation of their intemal
COntrOIs and made them significantly tighter.

Tight personnelhulturai controIs

In some situations, MCSs dominated by personnel/Cultural controIs also can be considered

tight. In charitable and voluntary organizations, PerSOnnel controIs usually provide a signifi-
cant amount of control, aS mOSt VOlunteers derive a keen sense of satisfaction just from doing
a goodjob, and thus are motivated to do well. Tight personnel/Cultural controIs can also exist
in for-PrOfit businesses. They are common in small, family-run COmPanies where persomel/
Cultural controIs may be effective because of the overlap or congruence between the organi-
Zational interests and those of the individuals on whom it must rely for pursuing them.
Some organizations use multiple forms of personnel/Cultural controIs that, in combination,

PrOduce tight control. For example, amOng the controIs used in production areas of Wabash
National Corporation, a truCk-trailer manufacturer loca〔ed in Lafayette, Indiana, are:

c〉 WaZk and調蛇interviews in whichjob applicants get to observe the互erle亡icJirc亡orypace.

。、 Group incentive plans, including a profit-Sharing plan that gives employees lO% of after-taX

eamings and a retirement plan that bases contributions on profit margins.

ニ Required training. New empIoyees are strongly encouraged to take two specified Wabash

improvement dasses on their own time and are rewarded with pay raises for doing so"
Supervisors are promoted only after they take special dasses and pass a test.

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Chapter 4. ControI System Tightness

Visitors to Wabash often remark that they have “never seen a work force that motivated,’’which

the compan畦attributes to its focus on “a strong emphasis on maintaining good empIoyee rela-

tions and develo理ent through competitive compensation and related benefits, a Safe work

environment and promoting educational programs and quality improvement teams.・,33

In a di任erent context - in the wake of the 2008 financial crisis and a series of scandals and

reputational blows - all empIoyees of Deutsche Bank and Barday’s, and a11 senior bankers at

Goldman Sachs, Were taken through programs aimed at reinforcing codes, Values, behavior,
and a strong, POSitive corporate culture,

Given the recent record of the banks, SuCh programs invite skepticism, Even assuming the
COmPanies can cement good behavior, it is hard to guarantee their managers wiII success-
fu=y monito「, meaSure and maintain adherence to the vaiues, Particuiariy when compet主

tive pressure mounts as markets revive. Dan Ostergaard, Managing Partne「 of

integrity-By-Design, a Swiss-based group that advises on cuiture change and ethicai

training, is cautiousIy optimistjc, POinting out that if banks do not address organizationai
StruCture, inciuding the who看e process of recruitment, PrOmOtion, remuneration and how

they take day-tO-day business decisions, it could be “an expensive dog-and-POny Show・,,34

In many instances, indeed, the degree of controI provided by personnel/Cultural controIs

alone is less than tight. In most宜rms, the natural overlap between individual and organiza-

tional ot*ectives is smaller than that in family firms or tight-knit organizations, Moreover, a
divergence between individual and organizational objectives often comes unexpectedly,
although, aS Studies suggest, it is not a rare occurrence. For example, a Surveyby KPMG Forensic
SuggeStS that “the typical company fraudster is a trusted male executive who gets away with

OVer 2O fraudulent acts over a period ofup to five years or more,’’More generally, ``61 percent of

fraudsters are empIoyed by the victim organization; Of these, 41 percent were empIoyed there
for more血an 6 years; in 70 percent of frauds, the perpetrator colluded with others.,,35 The

StePS that might be taken to increase the strength of personnel controIs are di鯖cult to assess

and potentially unreliable. Factors such as education, eXPerience, rank, and tenure are not une-
Conclusi
quivocally reliable predictors of misconduct. Or, tO COmbine the prior section with this one by
Way Of a quote from the KPMG report (p. 6): “Having good intemal controIs is important, but

With any control you are ultimately relying on the human element.’’

CulturaI controIs can help make people more reliable and a飾ect an organization’s ability to

sustainably generate value.36

A strong ethical cuiture at a company is wideiy seen as a buIwark against compIiance faiI-
ures, because it makes empIoyees more prone to question what they see as unethical
behavior, Atthe sametime, it’s hard to go about estab看ishing such aculture. Enron famousIy

had a high-SOunding code of ethics that faiied to deter its executives from an accounting
fraud that brought down the company.37

For example, Kellogg, the cereal maker, decided they needed to embed its code ofethics more
e任ectively within the businesses. In so doing, they wanted to make the code less a series ofrules

and more a means to promote and incorporate its so-Called K-Vafues of integrity, aCCOuntability,

PaSSion, humility, Simplicity, and results through targeted training. The company went through
each section of its ethics code and picked out what was relevant in terms of each K-Value. It then
StruCtured the revised code so empIoyees could refdr to it daily as they worked through ethical
issues, and it included real-1ife examples of situations in which empIoyees could recognize them-
Selves. In addition to a main training for all employees, there is also a targeted training fbr SPe-
Cific roles depending on the level and the audience with which empIoyees in these roles interact.
The idea is that, “tOgetheI’, this should guide empIoyees’decisions, Which should lead to better

outcomes," vice President of Intemal Audit and Compliance Jim Sholl said.38

138
 Conciusion

Dell, the PC maker, also overhauled its ethics code with the aim to get employees to be
“believers’’rather than二9beyers’’:

While both beiievers and吋beyers need to fo=ow the ruIes, having believers makes them

ambassadors for the company’s ethics and vaIues and gets them to inspire others to do

the right thing・傭They feel a sense of pride," De= Chief Ethics and Compiiance O仰Cer Mike

McLaughiin said. ``I think if they’re infused with that kind of pride it heips with their interac-

tions with customers and others. It shows externa=y and interna=y"”39

Tb accomplish that, the company made its code more aspirational in tone. Tb get more empIoyee
buy-in, Dell asked empIoyees worldwide for input; SO When the code was released’it would
偉truly feel to them what we believe in, aS OPPOSed to being told what you should believe in’’’

Mr・ McLaughlin said" The message was spread through various channelsJ including blogs’SOCial

media, and even a game called the HonestyPrdyect. The game was designed to reinforce the les-
sons of why ethics and compliance are important by allowing empIoyees to describe the dam-
age that corruption and bribery can cause’reCOgnize red血ags that may indicate corruption or

bribery, and identify who to contact if they are asked to pay a bribe or witness a bribe being

paid. In the first six days after the game was introduced’mOre than 5’200 empIoyees completed
it - SOme taking it more than once. Is all this effective?

lb measure how e備ective the effort has been, DeII sent out a voIuntary survey to its empIoy-

ees, and 「eceived back more than 33,000 responses, Mr. McLaug輔n said.高In that data we’ve

seen emp-oyees with increased engagement and awareness of these topics,タ, he said"40

All told, however, tight controI probably cannot be achieved with the use ofpersonnel/Cultural
controIs alone, and tight controI will inevitably involve relying on a comb証a亡ion of action’

results, and personnel/Cultural controIs.

Conclusion

This chapter focused on an important characteristic of MCSs: their degree of tightness. We

defined tight control in terms of a high degree of assurance that empIoyees wi11 behave in the
organization,s best interests. All of the control types discussed in Chapters 2 and 3 can be used
to provide tighter control, but none of them in isolation is likely to be su飴cient to provide fully

tight control・ Table 4.1 presents a summary of the characteristics of each of the control types

that can be varied to affi3Ct tight control.

In some organizations, a Particular type of controI can be replaced or supplemented with
another type that provides a better fit with the situation for the purpose of tighter controIs.41
Some organizations, Perhaps because they have suffered ma.jor losses due to breaches ofauthor-
ity and weak intemal controIs, tighten controIs by recalibrating their results controIs toward
using additional detailed, PrOCedures-based action controIs. Others’Often as they grow and

become more decentralized, gO the other direction by placing increasingly more emphasis on
results controIs.

But managers are not limited to tinkering with the characteristics ofjust one form of controI
or to replace one for another. 1b tighten controIs, Organizations must inevitably rely on multiple
foms of controIs and align them with one another. For example, large, decentralized organiza-
tions can develop strong, SuPPOrting ethics codes to guide their largely results-COntrOl-driven
delegated decision-making. The controIs then either reinforce each other or overlap’thus飢1ing

in gaps so that they, in combination, PrOVide tight control over all of the factors critical to the
organization,s success. Lincoln Electric, Whose case study appears at the end ofthis chapter’is a

139
Chapter 4. ControI System Tightness

「略bIe 4・1 A summary of the characteristics that make a controi “tight”

lypeofcontroI Whatmakesittight
Resuitsoractionaccountab冊y Definitjonofdesiredresultsoractions:

●Congruentwithtrueorganizationaisk川s

●Specific

●EffectiveIycommunicatedandinternalized

●Complete(ifaccountabiIityemphasized)

MeasurementofresuItsortrackingofactions:
●Congruent

●Precise

.Objective
.Timeiy
'UnderstandabIe
Rewardsorpunishments:
.Significanttope「son(S)involved

'Directanddefinite=nktoresultsoractions

Behavioralconstraints Reiiabie
Restrictive

Preactionreviews Frequent
Detaiied
Performedbyinformedperson(S)

Personnelhulturalcontrois CertaintyandstabiiityofknowIedgelinkingpersonnelhuiturai
Characterjsticswithdesiredactions

SouICe K A Me「chant, Modem Management Contro/ Systems 7ext and Cases (Upper Saddle BlVer, NJ. PrentlCe Ha=, 1998), P 166.

good example of a company that effectively uses m庇かe-Ol,erIqpp血g and皿血aZb”ei予的rc鴫

results, aCtion, and personnel/Cultural controIs.
It should also be recognized that organizations sometimes deliberately choose to Zooserl their
COntrOIs. They do so because an inappropriate use of controIs causes harmful side e任ects, SuCh

as operating delays or empIoyee frustration and demotivation. These side e任ects cause manyto

have negative feelings when they hear the mere mention oftight control. In the next chapter, We
discuss more fully the costs and negative side effects associated with some control types and,

Particularly, With imperfect, OVerly tight, Or inappropriate uses of controIs.

N otes

I See, for example, W" A. Van der Stede, ``Measuring Tight
Budgetary Control,’’M伽agemerlr Acco肌血g Research,
12, nO. 1 (March 2001), PP. 119-37,
2 For a general discussion on prlOrl〔leS amOng ``stakehold-
ers;’see, for example, ``Shareholders vs. Stakeholders: A
New Idolatry,’’The EconomZsf (Apri1 24, 2010), PP, 65-6.
2OO7), PP. 1O-13; W. A. Van der Stede, “Designing Effec-
tive Reward Systems,’’F誼arlCe & Mar【age耽erl手(October
2009), PP. 6-9. See also J. Roberts, T九e Modern Ffrm
(New York: Oxford University Press, 2004), and other
WOrk by John Roberts and colleagues, aS Well as R.
Benabou and J. Tirole, “Bonus Culture: Competitive Pay,

3 “Patents, Yes; Ideas, Maybe;’T九e Ecor10m短(October 14,
2OlO), PP. 78-9; “Ford Applies for Record Number ofPat-
ents as CEO Eyes Innovation;’Btoo肌berg BzJSiness
(December 22, 2015), Online at bloom.bg/1MterVD.
4 ``Companies Aren’t Charities,”柵e EcoJIO肌is[ (October 21,
2010), p. 82.
5 See,血er c轟a, W. A. Van der Stede, ``The Pitfalls of Pay-
for-Performance,’’Ftrl肌Ce & Marlage肌e庇(December
Screening and Mul亡itask主ng,” wor短ng Paper ]8963
(Cambridge, MA: National Bureau of Economic Research,
2013).
6 “Blind Ambition: How the Pursuit of Results Got Out of
Hand at Bausch & Lomb,’’Bz(S証ess Week (October 23,
199与), p. 81.
7 “Manila’s Tax Chief Resigns for Not Meeting Targets,’’
Fbrbes (November 2, 2OO9), Online (wwwforbes.com).

140

8 “British Gas Tbld to Pay fu.1m Penalty by Ofgem,,, BBC
News (December 4, 2014), Online at www.bbc.co,uk/
news/business-30324764.   J
9 “耽sco Monitors EmpIoyees with Motofbra Armbands,,,
Bu3trleSS Week (February 13, 2013), Online at www.
bloomberg.com/bw/articles/2O13-02-13/tesco-mOni-
tors - emPIoyee s -With-mOtOrOla-arm-b and s.
10 Ibid. See also “Wearables at Work: The New Frontier of
EmpIoyee Surveillance,”丑e F諒cmc融Times (June 8,
2015), Online at on証.com/1IB7dzl.
11 “Wal-Mart’s worth $80 Despite Soft Quarter:, Forbes
(May 22, 2013), Online at onforb.es/1OI鼠JMF.
12 “Super Micro Computer: A One-Man, Or at Least One-
Family, Powerhouse,’’T71e New Ibrた描rleS (November 23,
2008), Online at nytimes.com. See also Sxper嘱cro 20]4
Am皿はeporちParticular看y p. 18, in respect of the com-
Pany’s dependence on Charles Liang’the company presi-
dent, CEO, and chair.
13 “Netflix Complaint against Mike Kail Suggests Govem-
ance Problems, Experts Say,’’T心e W拙Stree上/ournαZ
(November 26, 2014), Online at blogs.wsj.com/
Cio/2014/1 1/26/netflix-COmPlaint-against-mike-kail-
SuggeStS-gOVernanCe-PrOblems-eXPertS-Say.
4 ReportきO tたe賄缶ons oれOccupa亡tonα王Fra標d α融AbαSe
20J4 GZobaZ FrαZJd S弛め′ (Association of Certified Fraud
Examiners, 2014), Online at www.acfe.com/rttn/
doc§/2014 -reP Ort-tO -nation s. pd f.
5 “Adequate Procedures Report - Blessing in Disguise,,,
KPMG Uuly lO, 2OlO), Online at http:〃rd.kpmg.co.uk.
6 `輔Bezos Reveals His No. 1 Leadership Secret;, forbes
IApri1 4, 2012), Online at www,forbes.com/forbes/2O12/
0423/CeO-COmPenSation-12-amaZOn-teChnoIogyjeff-
bezos-getS-it.html.
Ibid.
R. Goldberg and G. Goldberg, C拒zen ntrrler: The W拙
聴e q毎rl A桝ericc[rl tyCOOrZ (New York: Harcourt Brace,
199与).
“砧mming Expenses’Citi Holds Back on CoIor Copying,"
T庇New york T[mes (August 26, 2OO8), Online at
ny亡lmeS.COm.
Quoted in P. Edwards, M. Ram, and J, Black, The加pcIC亡Qf
E肌p砂me競t Legis庇fon oれS耽り亜砧肌s: A Case S弛み
Ar10函s, EmpIoyment Research Series No. 20 (London:
Department of Trade and Industry, September 2003),
p.52.
Ibld., p. 128.
22 “SAP’s U.S. Chief Plans Reorganization of Unit,,,耽e W〔批
S亡reetJo肌証(May 26, 2000), P. B7,
23 “Struggling with EmpIoyee Complacency? Kill Your Stu-
I)id Rules;’Forbes (October 30, 2013), Online at onforb,
es/17wUbzd.
ConcIusion
24 ``Strict Rules Are Changing How Financial Institutions Do
Business,’’The F証ar轟けimes (October 18, 2015), Online
at on.ft.com/1kfJvOR.
25 ``SEC DepIoying New Tbol to Spot Insider Trading, White
Says,’’BJoombe7官(January 27, 2O14), Online at bloom.
bg/1hkUZn.
26 “Data-Crunching Is Coming to Help Your Boss Manage
Your Time,’’771e New Ibr紅tmes (August 17, 2015), Online
at http:〃nyti.ms/1IXM5yx.
27 Ibid.
28 ``Too Much Faith in耽chnoIogy Leads to Lapses,,, KPMG
(June 16, 2008), Online at rd.kpmg.co.uk; KFMG奪2013 JT
I庇ernc[Z Aud正Sl(γγey (KPMG, 2013), Online at www.iia.
nl/SiteFiles/ITA_ Survey_Ok」Web.p df.
29 “GAO Faults SEC for Lax Cybersecurity,,,軌e VI硯Stree亡
Jour朋I (April 17, 2014), Online at on.waj.com/1eF2HkW.
30 Ibid.
31 “Bank of England to Oversee `Ethical Hacking, of Finan-
Cial Groups,’’The用朋rlC融Hmes (Apri1 21, 2014), Online
at on.ft.com/1nDfO6f.
32 Sarbanes-Oxley Act of 2002 (107th Congress of the
United States ofAmerica, January 23, 2002).
33 This example is taken from ``Hard Driving: A Productivity
Push at Wabash National Puts Firm on a Roll,” TJte M硯!
Streef JourrlaZ (September 7, 1995), P. Al. See also
Wabash National Corp. 10-K SEC F拙ng (February 27,
201与), p. 1与.
34 ``Bankers Back in the Classroom;, T九e Fin伽crdZ H肌es
(October 16, 2013), Online at http:〃on,ft.com/19OvxpC.
35 ``profile of a Fraudster: T±usted Male Manager - and Get-
ting Away with It for Years,” KPMG (Apri1 17, 2OO7),
Online at rd.kpmg.co.uk; “GIoba獲Profiles of the Fraudster:
White-Collar Crime - Present and Future” (KPMG, 2013),
On獲ine at assets.kpmg.com/COntent/dam/kpmg/
Pdf/2013/1 1/global-PrO創es-Of-the-fraudster-V2.pdf.
36 “UK Boards Urged to Ttlke ControI of Ethical Values,,, The
Fimrtc融T[meS (July 21, 2014), Online at on.ft.
COm/1ZVgono. See also “The Tbp Companies for Culture
and Values,’’則rbes (August 22, 2014), Online at onforb.
es/11m7hIv,
37 ``Turning EmpIoyees into Ethics Believers," T庇W拙
S亡reef Journd (September 26, 2014), On獲ine at blogs.w?j.
COm/riskandcompliance/2O14/09/26/turning-emPloy-
ees-into-ethics-and-COmPliance-believers.
38 Ibid.
39 Ibid.
40 Ibid.
41 “Siemens CFO: Our Intemal ControI System Works Like a
Charm,’’耽e W拙S亡reet Jounaroanuary 15, 2013), Online
at blogs.w$.com/COrruPtion-CurrentS/2013/01/15/Sie-
mens - Cfo - Our-intemal- COntrOl-SyStem-WOrks-1ike-a- Charm.
141
 CASESTUDY ・ ・‥
ControIs at the Be看iagjo Casino Resort
In our world, gOOd controIs mean good business. A Iot of
Our COntrO獲s are dictated to us by the Nevada Gaming Con-
troI Board, but we would institute most of the same con-
troIs they require anyway. The State wants its share ofthe
revenue. We want to eam profits.
Tteut WaZke7; BeZ血glO Casir10 Cor江ro‖er
MGM MIRAGE and its properties
The Bellagio was one of23 properties ofMGM MIRAGE
(NYSE: MGM), One Of the world’s leading hotel and
gaming companies. In addition to the 23 properties
Shown in Exhibit l, MGM MIRAGE was also developing
a maior resort in Macau (with a joint-Venture PartneI)
and a new multibillion dollar “urban metropolis’’on
66 acres ofland on the Las Vegas strip, At the end of
2005, the company had over 66,OOO empIoyees and
total assets of over $20 billion (see Exhibits 2 and 3).1
MGM MIRAGE operated primarily in one industry
Segment, the operation of casino resorts, Which
included gaming, hotel, dining, entertainment, retail,
and other resort amenities. All the MGM MIRAGE
CaSino resorts operated 24 hours a day, eVery day ofthe
year. Over half of the company’s net revenue was
derived from nongaming activities, a higher percent-
age than many ofMGM MIRAGE’s competitors.
Primary casino operations were owned and man-
aged by the company. Other resort amenities sometimes
Were OWned and operated by the company, OWned by
the company but managed by third parties for a fee, Or
leased to third parties. The company, however, gener-
ally had an operating philosophy that preferred owner-
Ship of amenities, Since guests had direct contact with
Staff in these areas and the company preferred to
⊥重n Apri1 2OO5, MGM MIRAGE acquired Mandalay Resort Group at a
total acquisition cost of approximately $7.3 bi11ion. As a result of the
acquisltion, MGM MIRAGE became a much larger company with, for
example, OVer 66,000 empIoyees versus 40,000 and total assets of
OVer $20 bi11ionversus $11 billion (see Exhibit 3).
142
COntrOl all aspects of the guest experience. However,
the company did lease space to retail and food and bev-
erage operators in certain situations, Particularly for
branding opportunities.
As a resorトbased company, MGM MIRAGE’s operaト
ing philosophy was to provide a complete resort experi・
ence for guests, including nongaming amenities that
COmmanded a premium price based on quality. The
COmPany’s operating results depended highly on亡he
VOlume of customers at its resorts, Which in turn
impacted the price it could charge for hotel rooms and
Other amenities. MGM MIRAGE also generated a sig.
nificant portion of its operating income from the high-
end gaming segment, Which also caused variability in
OPerating results. Results of operations tended not to
be highly seasonal in nature, but a variety of factors
COuld affect the results of any interim period, including
the timing of m勾or Las Vegas conventions, the amount
and timing of marketing and special events for high-
end customers, and the leve獲of play during major holi-
days, including New Year’s Day and the Chinese New
暁ar. However, the company’s significant convention
and meeting facilities allowed it to maximize hotel
OCCuPanCy and customer volumes during off-Peak
times such as midweek or during traditionally sIower ln t!
leisure travel periods, Which also allowed for better
related
labor utilization.
MGM MIRAGE’s casino resorts generally operated in
highly competitive environments. They competed
against other gaming companies as well as other hospi-
tality and leisure and business travel companies. At the
end of2005, Las Vegas, for example, had approximately detail in th
133,2OO guestrooms. ● Ho亡e事reve
The principal segments ofthe Las Vegas gaming mar- 中01ume i冒
ket were leisure travel; Premium gaming customers;
COnVentions, including small meetings and corporate
incentive programs; and tour and travel. The company’s
high-end properties, Which included Bellagio, MGM
Grand Las Vegas, Mandalay Bay, and the Mirage,
appealed to亡he upper end of each market segment, bal-
ancing their business by using the convention and tour

and travel segments to乱I the midweek and o任-Peak
periods.2 The company,s primary methods-j’f compet-
1ng SuCCe§Sfully in the high-end segment consisted.of:
locating resorts in desirable leisure and business
travel markets, and operating at superior sites
within those markets;
constructing and maintaining high-quality resorts
and facilities, including luxurious guestrooms along
with premier dining, entertainment’and retail
amenltle S;
recruiting, training, and retaining we11-qualified
and motivated empIoyees to provide superior and
friendly customer service;
providing unique’高must-See,’entertainment attrac-
〔ions; and
developing distinctive and memorable marketing
and promotional programs.
Akey element of marketing to premium gaming cus-
[OmerS WaS PerSOnal contact by marketing persomel.
DlreCt marketing was also important in the convention
segment. MGM MIRAGE maintained Intemet websites
血at informed customers about its resorts and allowed
customers to book hotel rooms and make restaurant
and show reservations. The company also operated call
centers to service customers by phone to make hotel,
restaurant, and show reservations. Finally, MGM
MIRAGE utilized its world-Class golf courses in market-
1ng PrOgramS. The company’s major Las Vegas resorts
offered luxury suite packages that induded golf privi-
1eges, SuCh as golfpackages at special rates or on a com-
plimentary basis for premium gaming customers.
In this environment, the company’s key revenue-
rela亡ed perfomance indicators were:
Gαming γeVe肌e iれd書cαtOγS, SuCh as table games
drop and slot machines庇rldZe twolume indicators)
and w証or hoZd percentages (profitability indica-
tors). These perfomance indicators are discussed in
detail in the later sections of the case.
矧的te[ reveme indicαtOrS, SuCh as hotel occupancy
(volume indicatoD, aVerage daily rate (ADR - a Price
ControIs at the Be=agio Casino Pesort
indicator), and revenue per available room
(REVPAR - a Sum皿ary meaSure Ofhotel results that
combined ADR and occupancy rate) "
Most of MGM MIRAGE,s revenue was cash-based.
Customers typically wagered with cash or paid for non-
gaming services with either cash or credit cards. The
business, however, WaS CaPital intensive, and the com-
pany relied heavily on the ability of its resorts to gener
ate operating cash flow to repay debt financing’fund
maintenance capital expenditures, and provide excess
cash for future developments.
MGM MIRAGE was making increasing use of
advanced technoIogies to help maximize revenue and
operational e綿ciency. For example, the company was
in the process of combining its player-affinity pro-
grams, the Players Club and Mandalay,s One Club’into
a single program. This integration would link all MGM
MIRAGE,s major resorts and consolidate all sIots and
table-gameS aCtivity for customers with a Players Club
account. under the combined program, CuStOmerS
qua皿ed for benefits (``comps’’) across a11 of the com-
pany,s resorts’regardless of where they played. This
program enabled the company to get to know its better
customers and to market to them more effectively,
A significant portion of the sIot machines at the
MGM MIRAGE resorts operated with the EZ-PayTん-
cashless gaming system, including the Mandalay
resorts that had recently converted their sIot machines・
This system enhanced both the customer experience
and increased the revenue potential of the sIot
machines.
耽chnoIogy was a critical part of MGM MIRAGE’s
strategy in nongaming operations and administrative
areas as well. For example, the hotel systems induded
yield management modules that allowed maximizing
occupancy and room rates" Additionally, these systems
captured most charges made by customers during their
stay, including a11owing customers of any of the com-
pany,s resorts to charge meals and services at other
MGM MIRAGE resorts to their hotel accounts. In short,
this syste平enhanced guest service and improved yield
management across the company,s portfolio of resorts.
丁he Be=agio
The Bellagio, located in the heart ofthe Las Vegas strip’
was widely recognized as one of the premier casino
resorts jn the worId. Insjde the richly decora亡ed resor〔
was a conservatory制ed w血un王que botanica」 dfs〇
㌦坤で血at心aかged諦止血e seas〇九Jn五〇加1γaS紬
143
Chapter 4 ◆ ControI System Tightness
eight-aCre lake featuring over l,OOO fountains that per-
formed a choreographed balEt of water, muSic, and
lights. Amenities and entertainm印t options at the
Bellagio included an expansive pool, a WOrld-dass spa,
exquisite restaurants, a luxuriant nightclub and several
bars and lounges, and shows by Cirque du Soleil, aS
Well as a gallery of fine arts. The Be11agio also featured
200,OOO square feet of convention space.
In the casino operations area, the Bellagio operated
2,4O9 coin-OPerated gaming devices (slot machines)
and 143 game tables (see Exhibit l), Slightly over halfof
Which were blackjack tables. The other table games
included primarily baccarat, CraPS, and roulette. The
CaSino also operated a keno and poker area. The games
OPerated on a 24/7 basis in three shifts per day: day
(8 a.m.- 4 p.m.), SWing (4 p.m.-midnight), and grave-
yard (midnight-8 a.m.) shifts. Approximately l,OOO
PeOPle were empIoyed in casino operations.
As in most companies in this industry, the gaming
(casino) and nongaming operations in each ofthe MGM
MIRAGE properties such as the Bellagio were run as
SeParate PrOfit centers. Exhibit 4 shows the Table
Games Division organization chart. Bill Bingham, Vice
PreSident of table games, rePOrted directly to Bill
McBeath, Be11agio’s president/CEO. The vice president
Of the separate SIot Machines Division of the casino
also reported directly to Bi11 McBeath.
The unique feature of a casino resort organization,
as compared to that in most corporations, WaS the rela-
tively large size of the finance staff. In the Bellagio,
about l,00O of the total of approximately 4,OOO empIoy-
ees were in the finance organization, rePOrtlng m a
direct line to Jon Corchis, eXeCutive vice president/
CFO (Exhibit 5). Strict separation was maintained
between operations and recordkeeping. The finance
Organization was large because it had responsibility for
CaSh control and recordkeeping, both important func-
tions in the casino and food and beverage parts of the
business, Particularly. Thus, the finance organization
included credit operations personnel, CaSino change
PerSOmel (cage operations), Pit clerk persomel, and
COunt rOOm PerSOmel, in addition to people who were
normally part of a finance organization, SuCh as
accounting clerks and financial analysts.
Laws and reguiations over
gaming activities
This case is focused on the controIs used in the casino,
especially in the di鯖cult-tO-COntrOl table games areas
144
SuCh as the blackjack pits. Many of these controIs weIt  崎
legally mandated because the gaming industrywa! "煩
highly regulated. Each company had to maintain it`
licenses and pay gaming taxes to be allowed to con
tinue operations. Each casino was subject to extensive
regulation under the laws, rules, and regulations ofthe
jurisdiction where it was Iocated. These laws, rules,
and regulations generally concemed the responsibility,
financial stability, and character of the owners, manag.
ers, and persons with financial interest in the gaming
OPerations. Violations of laws in one jurisdiction could
result in disciplinary action in other jurisdictions,
Exhibit 6 shows a more detailed description of some of
these regulations as applied in the State ofNevada.
In comection with the supervision of gaming activi.
ties at the company’s casinos, SPeCifically, MGM
MIRAGE maintained stringent controIs on the record・
ing of a11 receipts and disbursements. These controIs
included:
s Iocked cash boxes on the casino floor;
daily cash and coin counts performed by empIoyees
Who were independent of casino operations;
ミ∴COnStant Observation and supervision of the gaming
area;
同時口、両脚
五、品主点用品∵
-こ, Observation and recording of gaming and other
上品ロー凧)ね
areas by closed-Circuit television;
㊨ timely analysis of deviations from expected perfor-
mance; and sk紺ed prof
こ COnStant COmPuter mOnitoring of sIot machines.
Used in the casino, these controIs were intended to
ensure that the casino and the various governmental
entities each kept their fair share ofthe money that was
Wagered.
Some of the regulations required extensive tralnlng
Of casino persomel to ensure compliance. For example,
the last paragraph ofthe regulations shown in Exhibit 6 20-m血u健
dealt with the reporting of so-Called suspfc[ol(S CIC亡諒 en( ta肌es.
ties related to money laundering and/Or the structuring the job w
Of transactions by customers to avoid reporting to the
US Intemal Revenue Service (IRS) tax authority. This
regulation, Particularly, had regained importance sub-
Sequent tO the signing into law ofthe US Patriot Act of
2001 following the terrorist attacks on the United
States. Because a casino is not a bank, Where every
transaction can be more easily traced, and because the
law required the reporting of any cash transaction in
excess of $10,OOO 。S a reS血Qforle Or a CO机b証atIort Qf

批肌拙C正071S OVer a 24五ollr Per王od, the company pro-
vided extensive training to standardize the handling,
aggregation, and reporting of same type. or壇similar
cash transactions by single customers on a single or
multiple visits within a 24止our period.
The company’s businesses were also sut)ject to vari-
ous other federal, State, and loca1 1aws and regulations
ln addition to gaming regulations. These laws and reg-
ulation§ induded, but were not limited to, reStrictions
and conditions conceming alcoholic beverages, enVi-
ronmental matters, emPIoyees, CurrenCy tranSaCtions,
taxation, ZOning and building codes, and marketing
and advertising.
hegame of blackjack and the roIes
f dealers
a short case, it is not possible to describe all of the
any controIs that were empIoyed in the casino. To
mplify the discussion, all references wi11 be to the
ble game of blackjack.3 The following section pro-
ides a brief description of blackjack and the personnel
VOlved in running it.
Blackjack is a very popular card game where up to
ven patrons play against the house. The players’
bect is to draw cards whose total is higher than the
ealer’s total without exceeding 21 ・
Each blac均ack table was run by a dealer whose job
was to sell chips to customers, deal the cards’take los-
ing wagers, and pay winning wagers. Dealing was a
skilled profession that required some training and con-
siderable practice. Experience was valuable, aS the
dealer,§ Value to the casino increased with the number
ofgames that could be dealt within a given time period’
and speed usua11y increased with experience. Experi-
ence was also valuable in identifying players who might
be cheating.
Dealers assigned to a table worked for one hour and
then were replaced by a r描写deαler during their
20-minute break. Relief dealers worked at three di任tr-
ent tables. The frequent breaks were required because
thejob was menta11y and physically taxing - dealers
were required to be standing up while they dealt; they
3 ThlS IS done with little loss of generality・ ControI over all the table
games m the Bellagio was nearly identical. The one m年jor ex⊂ePtion
was that one extra level of supervision (borpersorl) was used at the
crap tables (see Exhiblt 4). In the sIot machines area, COntrOI was
s皿Pler because machines ellminated the human element (dealers).
The machmeS did, however, have to be inspected regularly for
evldence of tampering.
Controis at the Be11agio Casino Resort
had to maintain intense concentration, aS errOrS in pay-
ing off bets were not tolerated; and they had to main-
tain good humor under sometimes di鯖cult conditions
(e.g. dealing to players who became irritable because
they were losing).
Bi11 Bingham, Vice president of table games,
described a good dealer as follows:
A good dealer makes a minimum number of mis-
takes and is productive in terms of hands per hour"
But we don,t ciock our dealers. We beIieve that cus-
tomers gravitate towards a deaIer they are comfort-
abIe with, and that means different things for every
CuStOmer Some piayers prefer a sIower pace.
We onIy hire experienced deaIers, and so we
assume that they have mastered the technical
aspect of dealing・ For us, CuStOmer Safisfaction is
key, meaning that deaIers have to be welcoming
and engaging, They smiie; they make eye contact
and conversation with the players; and they wish
them well. We aiso vaIue attendance. Deaiers with
Perfect attendance over a six-mOnth period earn an
extra vacation day.
Regarding speed, yOu may have noticed as you
WaIked through the casino that some tabies have
Oniy one or two customers. You might ask why I
don’t ciose these tables. As a matter of fact, a low
number of customers at a table doesn’t worry me at
a1=f a good dealer can do 60 hands per hour on a
table with, Say, five customers, then that same
deaIer probabiy can do neariy 300 hands with just
One CuStOmer! And, aS I said, SOme CuStOmerS
don’t like to join a busy table, and so it aIi works out
in the end.
Bellagio dealers were paid well. While they eamed a
base wage of only $6.15 per hour, their total compensa-
tion was usually in the range of $85,OOO-$100,000 per
year, induding tokes (tips), Which were shared equally
among all dealers. Because the total compensation was
high, Perhaps among the top two or three casinos in Las
Vegas, the Be11agio was seen a desirable place to work.
The company hired only dealers with a minimum of
two years, experience. Dealer turnover was Iow - less
than 3%.
The blackiack tables at Bellagio were spread across
six p缶s containing 16-3O blackjack tables each. F!00r
superl,isoIS (also called月00r PerSOus) supervised three
to six blackjack tables, depending on the so-Called [c謝e
机涌mum (i.e. the minimum dollar amount to be
wagered at the table). Each shift was also staffed by
145
Chapter 4. ControI System Tightness
three to five p互mC[れagerS (also ca11ed p克bosses), aS Well
as ash昨肌肌c[ger and哩aSSIs亡c融s71昨肌cmage7∵ Hence,
for example, When fu11y o毘錐ating during a busy day
Shift, Pit number 4, Which contained 30 blackjack tables,
empIoyed about 30 dealers (depending on the number
Of tables that were open in the pit), 1O relief dealers, uP
to lO floor persons, and one pit manager (plus relief).4
In total, the Bellagio employed about 775 dealers,
225 floor (and box) supervisors, and 16 pit managers.
Because they did not share in tokes, floor persons and
Pit managers eamed less than dealers; On aVerage about
$62,00O and $85,00O per year, reSPeCtively.
ControIs over cash and credit
Because most of the casino business was conducted in
terms of cash or cash equivalents (i,e. Chips), having
good controI over the many stocks of cash and chips
Iocated within the casino and over movements ofthese
StOCks without loss was essential. Moreover, because
mc[rker prdy (play on credit) represented a signi宜cant
POrtion of the table games volume at Bellagio, the com-
Pany also maintained strict controIs over lSSumg Credit.
Overall, then, Bellagio’s cash and credit controI system
can be described in terms of four main elements:
(1) individual accountability for cash and (cash equiva-
lent) stocks; (2) formal procedures for transfers of
CaSh; (3) strict controIs over credit issuance; and
色) tight control in the count rooms.
A. /ndividuaI accountabi〃fy for cash stocks
A11 cash stocks - With the exception of those kept at a
game table or those taken from a game or slot machine
for counting - Were maintained on an fmpres亡basis.
This meant that most personnel who dealt directlywith
CaSh, SuCh as change personnel, COin redemption per-
SOnnel, CaShiers, and chip創I bank personnel, Were
held individually accountable for a specific sum of
money that was charged out to them. These personnel
Were required to tum in the exact amount of money for
Which they were given responsibility, and any large
Shortages or persistent pattems of shortages were
grounds for dismissal.
B. FbmaI procedures for fransfers
Strict procedures had to be followed when transferring
CaSh or chips to or from no扉mpres亡funds (e.g. a game
4 This pit also contained a few other table games, SuCh as roulette
wheels.
146
table). All transfers required the creation of forml :¥
transactions signifying the transfer of accoun亡abilit、言、,
for the money involved. These procedures can be ilfu!霊
trated by describing the so-Called drop s亡C肌dclrds an
What was required to move cash or chips to and from
blackjack table.
When the Be11agio casino opened in 1998, the drqu∴黒
box a飴Ⅹed to each table was removed and its conte皿 l`烏
were counted at the end ofeach shift. But little orm∴ふ申
use was made of the shift-by-Shift information, SOin 汗lr`1
2OO4, the practice was changed to just one dropper∴∴ ’一時.
day, a SO-Called 24-710ur drop.
The drop for each table had to be reconciled wi(
Other recorded transactions that occurred during the
day, First, at the cIose of each shift, the incoming and
OutgOing pit managers proceeded through their pits
and counted the chips (for blackjack) on each table,
and recorded them on a mbZe irlVe庇ory s71eet (see
Exhibit 7). Table inventory sheets indicated the date,
Shift, game table number, and count by denomination
and in total. Both the incoming and outgoing pit man.
agers were required to sign the table inventory shee(
Verifying the accuracy of the count. When completed,
One COPy Of the table inventory sheet was dropped in
the pit drop box and the duplicate copywas deliveredto
the casino cage,5 where the cage cashier or cage super.
Visor entered the table inventory amount (by denomi.
nation and in total) for each table into the computer
SyStem. Pit managers did not have access to the com.
Puter SyStem that would a11ow them to add, Change, Or
delete table inventory amounts.
As the game was played, SeVeral transactions could
take place. One invoIved players buying chips from the
dealer for cash or credit. Cash was deposited immedi・
ately in the drop box. Players could not make reverse
exchanges (chips for cash) at the tables. They had to
take their chips to the casino cage where this type of
exchange was made. Credit had to be approved by
Checking the customer’s credit authorization limit
through the use of a computer terminal located in the
Pit. Ifthe credit was approved, a SO-Called markeγ WaS
PrePared. This process is described in the next section.
廿ansfers of chips to and from a gaming table were
also common. Chip transfers to a table took place each
time a table was opened for play or when additional
Chips were needed at an already open table. When the
Pit boss decided to open a blackjack table, Or a floor

son noticed that additional chips were needed at a
le, a requeSt for a particular mix of cI車S WaS input
o the computer terminal in the pit (using a翠2-Called
叫brm) and relayed to the皿bank cashier in the
ino cage, Where a four-Part, Seria11y numbered j甜
was printed (see Exhibit 8). The創I bank cashier
n summoned a security guard and釦1ed the order
he guard,s presence. Both the chip bank cashier and
security guard then signed copies l’2’and 3 ofthe
slip. Copy 4 ofthe糾slip was retained by the cage to
ard to casino accounting daily. The security guard
n transported copies l and 2 0f the創I slip and the
to the table where the fill was required. The chip
kca§hier retained copy 3 of the fill slip. The guard
ngave copies l and 2 ofthe創1 slip to the pit man-
erand placed the釦1 on the table. The dealer counted
fill by breaking down the chips in public view,
agreed the count to the創I slip, and signed copies l and
2 0fthe餌slip. The pit manager also signed copies l
and 2 ofthe fill slip. The dealer then placed the糾in
the table tray and inserted copy 2 of the fill slip and
copy2 ofthe input form into the drop box. Copy l ofthe
f紺slip was given to the security guard who retumed it
to the chip bank cashier in the cage. Copies l and 3 of
the餌slip were later forwarded to the casino account-
1ng department・
A similar process was fo11owed when a table was
dosed or an overabundance of chips had to be trans-
ferred to the cage, in which instance the transaction
wastraced through the use ofan証pu串)rm and cred証
幽(instead of aj班sZゆ・
The so-Ca11ed drop procedure, the process through
whichthe tab看e drop box was removed at the end of
each gaming day, OPerated as fo11ows. At least two
security guards first obtained the soft count room key’
locked storage carts with empty drop boxes, and the
drop box release keys from the cage. They then pro-
ceeded to the table game pits where they unlocked the
cart padlocks utilizing the drop box storage cart keys,
removed the empty drop boxes, and placed them on
their respective table. Pit managers and security
guards observed the empty drop boxes from the time
they were removed from the carts until placed on
their respective gaming table. After setting out the
empty drop boxes, the security guards removed the
剛drop boxes from the table using the drop box
release keys. Empty drop boxes were then locked on
the tables and the full drop boxes were immediately
stored in carts. When the drop was complete but prior
to transport, the carts were secured with a different
ControIs at the Be=agio Casino Resort
padlock designated for carts with full drop boxes. Nei-
ther security guards nor pit managers had access to
the keys for this padlock. At a minimum, tWO Security
guards and one pit manager transported the full drop
boxes in the locked carts to the soft count room where
they were secured until the count took place. Multiple
drop teams were utilized such that each made only
one trip to and from the casino floor for the placement
and collection of drop boxes. The security guards
completed the drop cycle by retuming the keys to the
Cage・
C. Str/c書controIs over credit /ssuance
When players wanted to gamble with money borrowed
from the casino, aS WaS COmmOn, they were issued
what was called a marker (or co肌亡er check). Players’
credit limits had to be preapproved.
Strict controIs were applied over the issuance of
markers. Marker paperwork contained multiple
parts; (1) the original, Which was maintained in the
pit until the marker was settled’after which it was
transferred to the cage; (2) an iss皿rlCe S亡ub, Signed
by the dealer and floor supervisor and inserted into
the table drop box when the marker was issued; and
(3) apqy肌entStub. Ifthe markerwas paid in the pit,
the payment stub was signed by the dealer and floor
supervisor and inserted in the table game drop box・
If paid at the table’there were strict rules for the
dealer to follow when advancing the chips in the
amount ofthe marker to the customer (e.g. the dealer
had to break down the chips in full public view - and,
obviously, in full view of the surveillance camera
overhead - Prior to advancing the chips)・ If the
marker was not paid, the payment stub was trans-
ferred to the cage with the original marker・ All these
documents contained a check number, CuStOmer
number, Shift, Pit number, tyPe Of table game’table
number, date and time, and the approved dollar
amount, in addition to the required empIoyee signa-
tures and ID numbers. There was also a time limit
(30 minutes) within which the marker issuance pro-
cess had to be completed, aS Well as strict rules for
VOiding markers.
Because marker play represented a significant por-
tion of the table games volume at Bellagio’the com-
pany also aggressively pursued collection from those
customers who failed to pay their marker balances
timely" These collection efforts were similar to those
used by most large corporations when dealing with
147
Chapte「 4. Controi System Tightness
OVerdue customer accounts, including the mailing of
StatementS and delinqueney notices, PerSOnal contacts,
the use of outside∴COllectio里.agenCies, and civil
litigation. A significant portion of the company,s
accounts receivable, for amounts unpaid resulting from
markers which were not collectible through banking
Channels, WaS OWed by major casino customers from
Asia. In this instance, the collectability of unpaid mark-
ers was affected by a number of factors, including
Changes in currency exchange rates and economic con-
ditions in the customers, home countries.
D, Tfght secuhfy /n count rooms
Wins (or losses) on a particular game table could not be
determined until the funds in the drop box were
COunted. All counting from table games was done in the
soft count room,6 a highly secure room located adjacent
to the casino cage. Tight security and supervision was
necessary in the count rooms to ensure that the win-
nings were tallied accurately and that all the money to
Which the casino was entitled was added to stores in
the casino cage.
A11 cash and chips inventory storied in the soft
COunt rOOm WaS SeCured from unauthorized access at
all times. Access to the count room during亡he count
WaS reStricted to members of the drop and co皿t
teams, authorized observers, SuPerVisors for resolu-
tion of problems’authorized maintenance persomel,
and personnel performing currency transfers. Access
to stored table game drop boxes, full or empty, WaS
restricted to authorized members of the drop and
COunt teamS. When counts from various revenue cent-
ers occurred simultaneously in the soft count room
With the table game count, eaCh count table could con-
tain funds from only one revenue center and the tables
had to be adequately spaced to prevent commingling
Of funds. During the count, a minimum of three per-
SOnS had to be in the count room until the monies were
transferred and accepted into cage accountability.
Fu11-time count personnel independent of the pit
department and the subsequent accountability of
COunt PrOCeeds had t:O be maintained by the casino to
ensure the sta鯖ng of a count team with at least three
members each day.
6 This moneywas mostlybills and markers亘en⊂e the namesQftco血
room. Coins taken from the sIot machines were counted in the hard
COun rOOm’Which was about to disappear due to the use of s獲ot 7 Numbers in this example were disguised to safeguard company
machine tlCkets, rather than coins.             restrictlOnS On the release of intemal operating data.
148
The count began with the opening of the first tat)1
game drop box and ended when a member ofthe cag
Signed the m。S亡er gCmeS WOrksJleet and assumed
accountability of the drop proceeds. During the actual
COunting process, Very Strict procedures were fo11owed,
as described in Exhibit 9. The counting process was
創med by the cameras Iocated in the room. After the
money was counted, it was transferred to the casino
Cage・
Only after the cash and markers in the drop box
had been counted was it possible to calculate the win・
nings for each table. Spec誼cally, the win for a pa手
ticular gaming table was calculated by determining
the total drop (= CaSh + markers in the drop box)
adjusted for table inventory (= beginning table inven-
tory + f班s - Credits - ending table inventory), aS
illustrated in the following (simplified) example taken
from the Be11agio master games worksheet forJanuar)
17 2006:7
GAME:BJ
SHIFT:ALL
PiT:ALL
DATE:01/17/O6
丁O丁ALBEGINNiNGINVENTORY 29,497,800.00
TOTALFiLLS 3,923,960.00
TO丁ALCREDiTS 21,500.00
TOTALENDiNGINVENTORY 32,548,000.00
TOTALCASHDROP 583,008.00
TOTALCOUNTERCHECKS 626,500.00
WIN(LOSS) 357,248,00
As i11ustrated in this example for the blackjack game,
the results for all games for each shift were reported on
the mas亡er games worksheet, Which was produced daily
and summarized by type ofgame. The uses ofthis doc-
ument as a control report are described further in a
later section ofthe case.

Controi of games
As discussed, the table games and th6寸ot machines
provided the only ways by which the casino made
money. The table games were particularly di航cult to
oontrolbecause ofthe need to rely on people who might
be tempted by the extremely large amounts of money
lhat could exchange hands very quickly.
In response to this di鯖cult controI problem’multi-
ple forms of controI were required by the Nevada
Gaming ControI Board (GCB) and used in the Be11a-
gio to help ensure that the casino kept the cash to
whichitwas entitled, These included: (1) licensing of
casino personnel; (2) standardization of actions of
personnel running the games; (3) careful supervision
and surveillance of the actions taking place at the
table; (4) monitoring of results; and (5) strict audit-
ingprocedures. These are discussed in the following
縄C(10nS.
A, Licensing
AIlemployees ofthe casino (referred to by the GCB as
ga刷g emPkyees)8 had to be registered with the
GCB. The casino was required to submit a report to
〔he GCB containing the name, SOCial security num-
ber, POSition held, and date of hire of each gaming
employee hired during the previous month. In addi-
tion, a registration packet had to be submitted for
each empIoyee. The key contents of the registration
packet were the gcming empZayee reg王s亡rc涌on app庇a-
fro)1 twhich contained a11 the basic information about
the empIoyee [name, address, SOCial security num-
ber] and empIoyer), the gcmiJlg CmPZayee ques亡io乱
柵re (which contained additional information
relating to the background of the applicant), and the
厘e岬r血fbrm. The registration process itself essen-
tiallyinvoIved a background check of gaming emp鵜oy-
ees against police department records. When
applicants did not pass the registration process’they
could not be kept in empIoy by the casino. Successful
registration, On the other hand’reSulted in the issu-
ing of a gaming card (essentially a gaming work per-
mit), Which expired after five years, at Which time a
new application had to be filed.
Similarly, On Or before the 15th of the month after a
calendar quarter, the casino was required to submit a
3 slmPly put, gam証g empkyees essentially included all casino
personnel except bartenders, COCktail waltreSSeS’Or Other persons
engaged exdusively in preparing or servlng food or beverages.
ControIs at the Be=agio Casino Resort
report to the GCB containing the name, SOCial security
number, POSition held, and date of temination of each
gaming empIoyee terminated or separated from ser-
vice within the previous quarter.
The Be11agio, however, Performed its own
employee screenings independent of the required reg-
istration process. The intent of these background
checks was to avoid hiring people who had been
invoIved in crimes or violations of casino rules, Or
those who might be attracted because of a need for
quick cash. In the words of Bi11 Bingham’Vice presi-
dent of table games, αWe know from experience that
dealers with addiction issues, either alcohol, drugs, Or
gambling, are the ones to watch out for; they need
cash to satisfy their addiction, and there is plenty of
cash around here.’’
Moreover, Robert Rudlo任, Vice president of inter-
nal audit, nOted that,高Dealers who’Say, Steal at one
casino could still get in under the radar screen at
another casino if the stealing was not reported to the
police, Which is basically what the GCB checks
against. Our own preempIoyment screening hopefully
can catch this.,, Trent Walker, CaSino controller,
added: ``What we rea11y need though is a casino-Wide
system, kind of like an alert system’that links the
Whole city.’’
While the required background checking for gam-
ing empIoyees was relatively simple’Checks on so-
called key e肌pfoyees were more elaborate. Key
empIoyees included any executive’emPIoyee, Or agent
of a gaming establishment having the power to exercise
a significant influence over decisions conceming any
part of the gaming operation. The GCB required key
employees to be licensed’a PrOCeSS that invoIved com-
prehensive background checks and extensive informa-
tion, including the scrutiny of empIoyment history,
personal financial statementsブand tax retums・
B, Standard元zation of actions af fhe fables
At the gaming tables, mOSt Of the dealers, physical
motions were standardized in order to make supervi-
sion and surveillance easier. For example:
1. All cash and chip exchanges were to be made in the
middle of the gaming table in full public view to
make them easier to see by supervisory personnel
and the surveillance camera overhead.
2, Tips were to be accepted by tapping the cash or chips
on the table and placing them in a clear’locked foke
149
Chapter 4. Controi System Tightness
box attached to the gaming tables. This was done to
distinguish these exch埋geS from wagers.
3" Before dealers left their-tables, they were required
to place their hands in the middle ofthe table and to
Show both the palm and back of their hands. This
WaS done to prevent them from paZ肌ing money or
Chips in order to take it from the table as they left.
Dealers were also required to wear attire that was
designed to make it more di鯖cult for them to pocket
CaSh or chips.
C. Supervision and surveillance
Front-1ine gaming personnel (e.g. dealers) were
Subjected to multiple forms of supervision and
SurVeillance. Direct supervision was provided by the
floor persons and pit bosses. One of their primary
functions was to watch the gaming activity and spot
events that were out ofthe ordinary. As highly expe-
rienced gaming people, they had a keen sense of the
actlVlty gOmg On arOund them and, thus, Were gener-
a11y good at spotting nonroutine events, SuCh as
dealers paying losing bets in blackjack or customers
marking cards in blackjack or switching dice in
erapS・
Extra survei11ance of the table games was provided
through a system of dosed-Circuit cameras, One fixed
above each gaming table. In total, the Bellagio
empIoyed 2,00O cameras Iocated throughout the prop-
erty. The cameras had lenses powerful enough to zoom
in to view objects as small as the date on a dime on the
table. The pictures were viewed in a securi亡y room
located on the mezzanine level of the casino. The sys-
tem provided the capability to record the activities
Shown on videotape for later viewing, Or, if necessary,
as evidence (e.g. if malfeasance was suspected). The
tapes from each camera were retained for a minimum
Ofseven days. But in some cases where problems were
identified, the tapes were retained indefinitely. Tb
ensure that the surveillance was done objectively, Strict
SeParation was maintained between the persomel
working on the casino血oor and those working in the
survei11ance areas.
The Bellagio also used JnyS[ery shoppers to evaluate
the dealers. A mystery shopper evaluated each dealer at
least once every l.5 years" The mystery shoppers evalu-
ated only customer service, nOt SPeed. Each dealer was
rated as superfoJ二expeCted, rreeds i肌prove肌e噂Or
unsc[中旬c亡o7γ Eighty-five percent of the dealers were
rated superior or expected. The mystery shoppers
150
revisited the other 15% at a later time. No dealerw
ever丘red based on the mystery shopper ratings. Ift
POOr Performance persisted, SuPerVisors worked wi[し  帆
the dealer to improve. Dealers that consistentlyper 一¥吊
formedpoorlyusuallydidnotneedtobetold; theyusu 中高
ally did not get as many customers at their table.酬 ‘出
Bingham explained, “The mystery shopper programl¥ し品‘‘、(
geared more towards keeping our customer orientation
in check rather than being a performance evaluatio
tooI of dealers per se.’’
The levels of casino management above the pit
bosses, SuCh as shift managers and the vice presidento!
table games, did little direc亡supervision of the gaming
activity. They were mainly invoIved in trouble shooting
(e.g. resoIving cases ofmalfeasance), keeping good cus-
tomers happy, reSOlving special problems that arose
(e.g. staffing issues), and improving the casino
OPeration s.
D。 Monitohng of resuIts
The mc[S亡er gameS WOr短hee亡provided three key indica.
tors ofthe results ofthe gaming activity: drop, Win, and
hold percentage.
1. The drap, Which was essentially the sum ofcash drop
and credit amounts (markers), WaS interpreted as
the total amount of money the customers were wi‖.
ing to bet against the casino. However, the drop
number had some limitations as an activity indicator
Of some table games (e.g. blackjack) as it was biased
upward when table game players exchanged money
for chips at the table but did not bet, thereby creat-
ing wha亡WaS Called.佃Zse drop; and it was biased
downward when players gambled with chips bought
at another table, Perhaps even on another shift or
day. A better indicator of activity would have been
the庇JldZe, the total value ofwagers made, but there
WaS nO Way tO determine this number for blackjack
and some other table games.
2. The wfn was the casino’s gross profit number. Itwas
Calculated as shown in the example in the previou§
section of the case.
butわnO独
3" The hoZd percentage was the primary measure of ¥
casino profitability. It was defined as the win divided ¥ drop by shift
by the drop. onciled with
ぐaned α血
An example of a mas亡er gcmeS WOrkshee亡summary
report is shown in Exhibit lO. However, a COmPrehen-
sive set of reports also was produced that provided
these performance measures in various levels of detail,

(able, Shift, and time period. One SuCh report is
nin Exhibit ll.
the total drop.and
d number§ Carefu11y. The drop number was the
avallable measure of the volume of betting activ-
and as such, it was useful as an indicator of the
cess of the company,s marketing strategies and
The hold percentage was the best available measure
casino profitability. Using these numbers’Bellagio’s
agement looked for pattems. They knew that each
e game should maintain a certain hold percentage;
example, Bellagio’s nomal table games win per-
鮒-ageS Were in the range of 18-22% of the table
games drop.9 If the hold percentage was Iow across the
casino table games operation’On all shifts and all
[ables, and that pattem persisted for a period of, Say,
several days, the managers in casino operations’
1nduding the vice president of table games, had a hard
look at the operations and controI system to try to tie
細・n the root cause of the unfavorable trend in the
hold percentage. Moreover, the drop’Win’and hold
percentage measures were standard throughout the
gaming industry’and competitive analyses were facili-
融ed because summaries were prepared and distrib葛
uted through several industry sources and trade
a550dations.
The managers in casino operations also Iooked at
the hold generated on each shift in each pit and at each
tab量e, but dealers and floor people were not always
ass鳴ned to the same tables, SO management did not
have information to tie them to hold percentages. AIso,
because of the 24-hour drop procedure described
above, at least six dealers were at a given table during
thattime period (that is, at least one dealer and one
relief dealer during each shift, times three shifts), and
sometimes personnel did not work exact shifts. Thus,
Bellagio management did no analysis of results - hold
percentage - at the table level. Bill Bingham explained’
“we used to monitor the reports on a table-by-table
basis, but we never caught anybody doing anything. We
did use surveillance on one dealer whom we suspected,
t)ut tO nO aVail.’’
Pitbosses had to make independent estimates ofthe
drop by shift for each table in their pit’Which were rec-
ondled with the actual count. This was done on a so-
ca11ed cos九drop γC[riarlCe rePOrf, aS Shown in Exhibit 12.
ControIs at the BeIiagio Casino Resort
When unusual deviations were observed, game table
supervisory personnel, SuCh as the shift manager or
even the vice president of table games’COuld go back
and ask the pit personnel to explain why the deviation
occurred. Sometimes, the reason for the deviation was
just due to a high roller on a hot streak, but if there
were any doubts about the explanation’Or if the devia-
tion could not be pinpointed easily, eXtra SurVeillance
was called in. Estimated versus actual data were also
aggregated on a daily basis for the Table Games Divi-
sion as shown in Exhibit 13・ This report, aS mandated
by the GCB, required that a deviation between the
actual and estimated drop exceeding +/-1O% had to
be investigated and explained.
Finally, the GCB required the casino controller to
investigate on a monthly basis all statistical fluctua-
tions by game type in excess of +/-5% resulting from
the comparison of the previous calendar year to that of
the current month. Reasons for the deviations could
include the activity of customers whose play materially
a任ected the results of the month (the so-Ca11ed航g五
rozler-Orl-a-hot-Streaたexplanation); the e任ects of any
changes to the rules, tyPeS Ofwagers’Or game Play pro-
cedures; the effect of any errors or mistakes made dur-
ing the operation of the game during the month; the
effect of any thefts or other improper acts by empIoyees
or patrons; Or any Other unusual occurrences during
the month being reviewed.
E. Auditing procedures
As a final control mechanism, PerSOmel independ-
ent 。f the transactions and the accounting thereof
were assigned to perform stringent and frequent
auditing procedures. There were audits of a11 types
of transactions and their accompanying documenta-
tion, SuCh as of transfers and their accompanying
fill and credit slips, for one day of each month. The
audits invoIved reconciling each document’s multi-
part stubs, Checking their proper completion and
the propriety of signatures, Verifying their sequen-
tial numbering, and tracing their amounts to the
master games worksheet・ Any issues’SuCh as unac-
counted for slips or variances between the source
documents and the master games worksheet, Were
investigated, documented’and retained. Other
audits involved, for example, the recalculation of
the win (loss) for one day of each week. Because of
the extensive internal auditing procedures, the
intemal audit organization of MGM MIRAGE’
151
Chapter 4. ControI System Tightness

headed by Robert Rudloff, Vice president of intemal table・ We don’t rea=y know how much money順∴∴∴芋

audit, emPIoyed 63 people. _

Bonuses

Results measures were considered in bonuses paid to

management personnel. Most executives received
annual bonuses averaging about 30% of salary based Siot machines because they are machines. 1fasl
On both the bottom-1ine performance of the casino and
machine over- Or underperforms, We Can Shut
a set of individual performance objectives. For exam-
down and fix it, Controis in the siotworld arev活
Ple, Bill Bingham’s annual bonus was based on growth aIiy reaI time.
in volume (dro亘) supplemented with factors that were

more di飴cult to quantify, SuCh as customer relations,

empIoyee relations, and/Or the successful completion

Of a casino floor reconfiguration, depending on the
focus in any given year. For reasons including lack of
COntrOl, nO bonuses were based on win. Bob Rudloff
explained, “We obviously don’t want games where the

Win is foo hfg九, aS that mightjeopardize the eI可oyment

guests derive from gambling and coming into our

CaSino in the first place.’’

Even though the standard measures ofperformance Bill Bingham, Vice president oftable games, added:

Were important indicators of success, COrPOrate eXeCu-

丁here are new technoIogies out there that pote[
tives were careful not to place too much emphasis on
tia=y couId alter and improve the controi envi
them because they did not want to encourage casino
ronment in the table games area, For example
managers to sacrifice everything for annual bottom-
We COuId use RFiD (「adio frequency identifica
1ine growth. A good example of a situation where a tion) technoiogy in ou「 chips, if that techno10gy
Careful tradeoff was required was custo皿er relations.
[was] perfected, that couid a=0W uS tO traCk
If a customer had a complaint, CaSino personnel had to
every transaction by every customer at the gam.
take care to make the customer happy, eVen at SOme ing tabies, Then we’d be abie to capture a 10tOi
immediate cost, SO that the customer would come
information that would be very vaiuable for dec主
back.
Sion-making pu「poses; e,g, aVerage bets, Win§
There were no bonuses for any other casino person-
and losses, time piayed. The better we can iden"
nel, Who received only salary and, Where applicable,
tify piayers’betting patterns, the better we ca[
亡okes (tips). But there were some nonmonetary awards,
market to our better customers. But PFID is now
SuCh as empIoyee of the month and empIoyee of the
OnIy about 75% accurate. We’d need it to be
year. For example, dealers with consistently superior Ciose to (if not exactIy) 100% accurate to makeit
mystery shopper ratings could earn this award.
WO「thwhile,
EmpIoyees of the year were invited to an annual gala
honoring all outstanding empIoyees from across all Bob Rudlof‡ vice president of intemal audit, eXPlained:

MGM MIRAGE properties. We should be able to improve our player ratings.

There a「e essentia=y four parameters to determine

Future controIs PIayer profiies: the theoreticaI odds of the game

(Which we know), the average bet, time played, and
In response to a request for speculation as to what con-
the number of decisions (hands) per hour, With this
troIs in the casino might look like in the future, CaSino
information, We Can determine how much a piayer
COntrOller廿ent Walker responded:
Should have won. We currentIy use this肋eonet/caI

In the tabie games area, We don’t have a detaiIed number to comp pIayers. Tb the extent that we
understanding of what happens at the tables as /t COuId tie these parameters with precision, howeve「,

happens because we can’t track the piay at the the better our comp program wouid perform. A

152

combination of piayer cards and RFID technology,
forexampie, WOuid make that possibieJ￨ We would
al§O be abie to easiIy detect counterfeit-chips.
These are just some of the potentiaI benefits" With
these benefits in mind, SOme CaSinos have aIready
begun experimenting with RFID"
B]t We Cur「entiy have a wait-and-See attitude,
a§ the costs may outweigh the benefits" One
obvious cost is the nontriviaI expense of replacing
a= our chips, But there are probabIy some more
§ubtie, indirect costs too" For example, What wi= be
the customer /mpacf of RFID? Having foo much
information - knowing to the penny who wins or
toses how much - isn’t a看ways the best for the cus-
mer, At some point the customers migh=ose
understand a= the privacy impIications of this just
yet. what if the IRS comes to us and asks for this
lnformation? We are in the entertainment business,
and so we shouidn’t do anything that diminishes
CuStOmer enjoyment.
Contro=ssues and areas for improvement were
always being addressed or contemplated, however.
Trent Walker explained:
in the survei=ance area, Our COntrOIs are possibIy
nowabout as good as they are going to get. We
have cameras trained on every game table, and
we cover just about every square inch of the
casino f10Or. This has aI獲owed us to do away with
certain oid-StyIe controIs such as pocketIess
deaIer uniforms and human supervision from
overhead catwaiks or through one-Way mirrors・ lf
we suspect foui pIay by empIoyees or customers,
we can always go back to the tape a=d verify. We
are currentiy digitizing the surve冊ance record-
jngs" That wi= a=ow us to get rid of the tens of
thousands of tapes we currentIy handie, and it wⅢ
fac=itate the streaming and a「Chiving of the
reco「dings,
In the siot machine area, the hard count is about
to disappear as eve「ything is aImost comp看etely
tickeトbased now, Eliminating the human eiement
i両andling and counti=g COins is both more e冊-
cient from a cost perspective and more e情ective
from a controi perspective,
But, there are aIways the inevitabIe human
errors, SuCh as pit personneI signing a marker fo「
the wrong perso=・ Even though this doesn’t happen
ControIs at the BelIagio Casino Pesort
more than a few times a year, it does happen, and
the risk of it happening is higher when voiumes are
up・ We don’t fire people for making human errors;
instead we work with them to prevent the errors
from happening again,
As i said, however, there always are, and w冊
be, PeOPie trying to rip us o什There are a lot of
hands in the pot - deaiers’COunterS’and money
strappers・ But we are also getting smarter in
catching them" For example’deaiers and custom-
ers working togethe「 have pu=ed o什SCamS Where
the deaIer simuIates the shu冊e so that the cus-
tomer can count cards, We,ve done away with
that probiem through automatic shuffiers and
reguIar updates of the shu冊e programs" Custom-
ers have tried to scratch key cards with a tiny
piece of g獲ass giued to their finger" Improved
camera surve川ance now can catch that too, A旧n
a=, i,d say that our controIs are very good・ We
have gone above and beyond mere compiiance
with what is required by the GCB" We have ieamed
many vaIuabIe lessons where we have been
bumed over the years.
Bob Rudloff concluded with the fo1lowing observation:
The industry has changed a iot in the last decade
or two, Customers used to be interested in the Las
Vegas that o請ered $2,99 buffets and $49"99 rooms,
which were part of a gig to tease peopie onto the
casino f100r tO gambIe. 1n that era’gaming was
where the money was made. Today, mOSt Of the
MGM MIRAGE properties, and many of the p「OP-
erties of ou「 competitors on the Vegas Strip, don’t
offer such deals anymore" Now we have the
$26.99 buffets and $229,99 rooms, yet OCCuPanCy
rates have stayed about the same, Which is
remarkable give= that total room numbers have
gone up dramaticaily. This te=s me that customer
tastes have changed. They don’t just come to
Vegas anymore to gambIe; 「ather’they are
attracted by shopping, dining, SPaS’Shows’and
entertainment■ They want to have a good time;
notjust gambie. This has resuited in a shift in rev-
enues from gaming to nongaming・ Good controis
obviousIy wi= aIways be criticaI in the gaming
side of our business, nO matter What the shift in
proportion of totaI revenues; it’s just good busj-
ness sense. Strategica=y, however’Our business
is not just about controiling the gaming part of
revenues any 10nger.
153
Chapter 4. Controi System Tightness

Exhibit l MGM MiRAGE operating casino resorts

置董葦童謡
Las L侮gas Str毎Nel/ada3

43 72 27 00 88 64 85 73 乃 92
Be=agio
MGM Grand Las Vegas
Mandaiay Bay4
The Mirage
Luxor
Treasure lsland (``Ti”)

New York-New York

Excalibur
Monte CarIo
Circus CIrCuS Las Vegas5

Other Nevada

642,572.71。肌3。。,17。35612。

854369了07137733,1 67099347
2 1 1     1 工′
Primm Va=ey Resorts (mmm)6

2   1   1             1   1
Circus CirCuS Reno (Reno〉

S=ver Legacy - 50% owned (Reno)

Gold Strike (Jean)
Nevada Landing Uean)
Co看orado Belie (Laugh/in)

Edgewater (Laugh/in)
Ra=road Pass (HendeISOn)

Other domestic ope伯f/ons

MGM Grand Detroit (Detro朽Mich匂an)

Beau Rivage (B=ox主Mississippi)7

Gold Strike (丁unica, MississiPPi)

Borgata - 50% owned (Atlantic City,

New Jersey)
Grand Victoria - 50% owned (Eゆin, /Mnois)

Grand totai
Exhibit 2 MGM MiRAGE operating results - detaiIed revenue information
._.書

一YearendedDecembe「31 2005$￣(00e手 Pct,Change 2004$(000) Pct,Change 2003$(000)

Casino「evenue,net: TabIegames $1,140,053 21% $943,343 9% $866,096

Siots 1,科「,556 43% 1,218,589 9% 1,115,029

Other 一一上旦塑聖堂 壁 62,033 坦逃 _堕
Casinorevenue,net 2,981,651 34% 2,223,965 9% 2,037,514

Non-Casinorevenue: Rooms 1,673,696 84% 911,259 9% 833,272

Foodandbeverage 1,330,210 58% 841,147 11% 了57,278

Entertainment,retaiiandother 1,098,612 壁逃 696,117 二塑 647,702

Noncasinorevenue 4,102,518 68% 2,448,523 9% 2,238,252

丁otaIrevenue 7,084,169 52% 4,672,488 9% 4,275,766

Less:Promotionalal10WanCeS (602,202) 39% (434,384) 5% (413,023)

6,481,967 53% 4,238,104 10% 3,862,743

155
Chapter 4. Controi System Tightness

Exhibit 3 MGM M旧AGE seiected financiai data

"●’i∴’ FortheyearsendedDecember31(inthousands,eXCePtPe「Sharedata)

2005 2004 2003 2002 2001

Netrevenues $6,481,967 $4,238,104 $3,862,743 $3,756,928 $3,699,852

Operatingincome 1,357,208 950,860 699,729 746,538 599,892
lncomefromcontinuingoperations 443,256 349,856 230,273 289,476 160,440
Netincome 443,256 412,332 243,697 292,435 169,815

Basicea面ngspershare lncomefromcontinuingoperations 1.56 1,25 0.77 0.92 0.51

Netincomepershare 1,56 1.48 0.82 0.93 0.53

Weightedaveragenumberofshares 284,943 279,325 297,861 315,618 317,542

D血tedeamingspershare lncomefromcontinuingoperations 1,50 1.21 0.76 0,90 0.50

Netincomepershare 1.50 1.43 0.80 0.91 0.53

Weightedaveragenumberofshares 296,334 289,333 303,184 319,880 321,644

Atyearend ￣TbtaIassets 20,699,420 11,115,029 10,811,269 10,568,698 10,542,568

lbtaldebt,incIudingcapita=eases 12,358,829 5,463,619 5,533,462 5,222,195 5,465,608

StockhoIders’equity 3,235,072 2,771,704 2,533,788 2,664,144 2,510,700
StockhoIders’equitypershare 11,35 9,87 8.85 8,62 7.98

Numberofsharesoutstanding 285,070 280,740 286,192 309,148 314,792

各獲  十

〇〇▲

Exhibit 5 Beiiagio Casino Reso由Finance organization chart

i     因
 hjbit6 Description of Regulations and Licensing by the Nevada Gaming Authorities

e regulations promuIgated thereunder (COiiectively, theくくNevada Act”) and various iocai reguIations. Our gaming
t10nS are Sub」eCt tO the licensing and reguIatory controI of the Nevada Gaming Commission (the “Nevada Commis一

the Nevada State Gaming Controi Board (the “Nevada Board”) and various county and city licensing agencleS
bcai authorltieS”). The Nevada CommissiOn, the Nevada Board, and the iocal authorities are coliectively referred to

ーProvldlng reliabie record keeping and requiring the輔ng of periodiC rePOrtS With the Nevada Gaming Authorities;

- The prevention of cheating and frauduient practjces; and

- Providing a SOurCe Of state and iocal 「evenues through taxatiOn and licensing fees,

The Nevada Gamjng Autho「ities may investigate any individuaI who has a materiai relationship to, Or materIai involve-

me∩t With, the regjstered corporations or any of the licensed subsidiaries to determine whether such individuai is suita-

ble or should be licensed as a business associate of a gaming licensee, Officers, djrectors and certain key empIoyees of
the llCenSed subsidiarieS muSt fiie app=cations with the Nevada Gaming Authorities and may be required to be licensed
by the Nevada Gaming Authorities・ O冊cers, directors and key empioyees of the registered corporatiOnS Who are actively

a[d dlreCtiy lnVOived in the gaming actiVities of the iicensed subsidiaries may be required to be licensed or found sulta-
ble by the Nevada Gaming Authorities・ The Nevada Gaming Authorities may deny an app=cation for iicensjng or a finding
Of suitabiiity for any cause they deem reasonabIe・ A finding of suitab冊y is comparable to iiCenSIng, and both require

Submission of detailed personai and finanCia=nformation foliowed by a thorough investigation. [‥.]

lfthe Nevada Gaming Authorities were to find an offlCer, director or key empIoyee unsuitabie for iicensing o「 to continue

havi[g a reiationship with the registered corporations or the licensed subsidlarIeS, SuCh company or companies wouId have
to sever a旧elationships with that person. in addition, the Nevada Commission may require the regjstered corporations or
the =censed subsidiaries to termlnate the empioyment of any person who refuses to file appropriate applications. [...]

Weare required to maintain a current stock ledger in Nevada that may be examined by the Nevada Gaming Authorト
tleS at any time. [‥.]

LICenSe fees and taxes, COmPuted in variOuS WayS depending on the type of gammg Or aCtivity invoIved, are Payable
to the State of Nevada and to Iocai authorities. Depending uPOn the particuiar fee or tax invoIved, these fees and taxes
are [. ‥] based upon either:

- A percentage of the gross revenues receiVed;

- The number of gaming devices operated; Or

- The number of tabie games operated.

The tax on gross revenues received is generaliy 6.75%. A iive entertainment tax is aiso paid on charges for admission
to any fac岨y where certain forms of iive entertainment are provided,

Because we are invoIved in gaming ventures outside of Nevada, We are required [‥ ,] to compiy with certain rePOrting

「equlrementS imposed by the Nevada Act. We wouid be subject to disciPIinary aCtion by the Nevada Commission if we:

- Knowingiy vioiate any iaws of the foreign jurisdiction pertaining to the foreign gaming OPeration;

- Fa出o conduct the foreign gaming operatiOn in aCCOrdance with the standards of honesty and integrity required of

Nevada gaming operations;

159
Chapter 4. Controi System Tightness

Exhibit 6 Continued

- Engage in any actiVIty O子enterinto any association that is unsuitabie because it poses an unreasonable threatto

[‥ "] Pursuant to a 1 985 agreement with the United States Department of the lTeasury (the “ll’eaSury") and provis10n:
Of the Money Laundering Suppression Act of 1994, the Nevada Commission and the Nevada Board have authorit)
under Reguiation 6A of the Nevada Act, tO enforce their own cash transaction reporting laws appIicabIe to casinos wh証
Substantiaily para=ei the federai Bank Secrecy Act. Under the Nevada Act, the iicensed subsidiarjes are required ¥o
monitor receipts and disbursements of currency reiated to cash purchases of chiPS, CaSh wagers, CaSh deposits or caih
Payment Of gaming debts in excess of $1O,OOO in a 24-hour period, and file reports of such transactions with the Un棚
States Intemai Revenue Service, The licensed subsidiaries are required to f帖e suspicious activity reports with the Trea§・
Chapter 4. ControI System Tightness

Exhibit 8 Be=agio Casino Resort: Fi= siip

_」1

COPY I
DOC. # 77343与0

器器珊

0 2BJO 5DD
田 L [且
CLERK 工D: ROA

巳   S
DA廿日: 1/17/06

﹃ T
T
H ェ
工 F
甘エM田: 12:与8P

H
DENOMエNAT工ON AMOUNT
@㊧@@@@@ lOO,000.00 .‥ .00
@@@@@@@ 25′000.00 ‥. .00
@@ 20,000.00 .‥ .00
㊧6@@@ 与,000.00 ‥. .00
@@@㊧@ 1,000.00 .‥ 20′000.00
@@ 500.00 .‥ 10,000.00
@@ 100.00 ... 6,000.00
@@ 25.00 ‥. 1,000.00
与.00 ‥. .00
1.00 ... 40.00
.50 ... .00
.25 ‥. .00
甘OTAL 37.040.00

*** NOTエFY SURVE￨LLANCE *★★

賃膨力め砂あゆ乞タgウノ 牽強形象秘号6亀形
CHエP BANK CASHエER SECURエTY GUARD

貌移∠倭協安め 6タフちぎ 貸毛の雛鳥a参∽4ゑ, 6チタタ乞

DEALER / BOXPERSON

ヲ号榔
No胎: Numbers on this form were disguised to safegua「d company restrictions on the release of intemal
OPerating data,
hibit 9 Beiiagio Casino Reso巾Soft count room procedures

the report. Quarteriy, CaSinO aCCOunting personnei performed unamounced counter tests, the results of which were aiso
documented and maintained,
Each drop box was individua-iy opened and emptied on the count tabIe・丁he contents of the subseque=t drop box to
be opened were p「ohibited from being emptied onto the count tab-e untiI the previOuS box,s contents had been entirely
removed and stored to prevent the comm一=g-i=g Of funds between drop boxes"丁he empty drop box was shown to
another count team member and to the survei-iance camera to verify that the box was empty・ The empty box was then

p煽d -n a StOrage Cart. When the storage cart was fuli of empty drop boxes言t was Iocked w'th a padlock. The count
team members did not have access to the key for this padIock"
Each drop box’s contents were segregated into stacks of currency’Chips・ and documents. The chips were counted
a[d verIfied by two cou=t team members, a=d the chip count was recorded on the back of the so-CaIIed header ca′d・
The header card contained a bar code wherein the tab-e game’s pit’game tyPe’and table game number were encoded.
The bar code on the header cards were then read by the currency counter’s bar code reader and the chip count manuaily
entered lntO the currency counter・

currency was prepared for the curre=Cy COunter and was p-aced in a rack with the header card. When fuii・
the rack of currency was given to the count team membe「 responsibie for operating the currency counter, Who

函ed the currency and header card into the hopper of the cur「ency counter tO Start the counting・ During the opera-
剛ofthe currency counter, COunt team members otherthan the count team member operating the currency counter
had to witness the Ioading and un-oading of ai- currency at the currency counter’inciuding rejected currency.10

丁he drop box count for each drop box was then individua一一y recorded by denomination and in totai in an electronIC
川e generated by the currency counter・

upon compietion of the drop count (CurrenCy and chips)・ the currency counter generated a master games Sheet that
detalied the count by tab-e, denomination’and 'n tOtal. The master games sheet was then forvarded to a count team
member who manua-1y entered the drop count into the computerized master games worksheet・
A count team member aiso皿vIduaIiy traced other documents obtained from the drop boxes (細Slips・ CredIt Slips・
markers) to the master games worksheet・ F川or credit input forms were stapIed to their corresponding f川or credit sIip.

Flil and credit slips aiso had to be inspected for correctness" Similariy’tabIe inventory sheets refiecting chip inventory

counts by tabie game were examined and traced to the master games wo「ksheet.
correctiOnS tO information, OriginaI-y lnPut in the computerized master games worksheet・ Were made by inputting the

correct f'gure" An audit trai- of corrections was recorded in the computer. Count team members did not have access to
the audit traii fife, Cor「ection to information origi=alIy recorded by the count team on manuaI soft count documentation

were made by crossing out the error’enteri=g the correct figure, and then obtaining the initiais of at least two count team

members who verified the change,

upon conciusion of the table games drop count, the soft count supervisor and one other count team member verified
and agreed the currency and chip count to the totaI count as recorded on the master games sheet and master games
workshee=f the totaIs did not agree, the error had to be located’COrreCted, a=d documented. AIi count team members
then signed the master games worksheet certifying the accuracy of the count"
currency transfers out of the soft count room during the table games soft count process were strictiy prohib-
1ted. To prepare a transfer, a three-Part脆nsfer s時WaS COmPieted with the amount (by denomination and in total)
offunds being transferred, dated, and signed (a一一copies) by the soft count supervisor and one other count team
membe「. Part 3 of the transfer s-ip was retained in the soft count room. The cash, Chips, and parts l and 2 of the
transfe「 siip were transferred to the cage where a cage cashier counted the cash and chips’agreed the totai to the
amount recorded on the transfer siip, and signed to verify that the amounts agree・ The cage cashier retained part
2 of the transfer siip, Which was later forwarded to the casino accounting department. Part l was retumed to the
soft count room by a soft count team member, matChed and agreed to part 3’and both forwarded to casino
accounting.

10There were also very stringent procedures to handle reJeCted currency, Which we omlt here due to space constraints.

(Con tinued)

163
Exhibit 9 (Conthued)

The cage cashier then agreed the currency and chiP tranSfers as recorded on the transfer siip to the drop recordeo
On the master games worksheet and signed the master games worksheet verifying that the transfer and drop
amounts agree・ Any variances had to be reconciied and documented. The master games worksheet then had to be
retumed to the soft count room by a count team member. The cage cashier then assumed accountab冊y ofthe drop

PrOCeeds,
Afte「 the entire count was completed, the so償count supervisor locked the soft count room and retumed the drop box
keys and d「op box ca巾keys to the master vauit, after which the soft count supervisor retumed the so什count room keys
and the master vault keys to the cage. A count member team then promptiy transported the master games worksheel
and a= supporting documents incIuding the transfer s=P dlreCtly to casino accounting.

Exhibit lO Be=agio Casino Resort: Master games worksheet summary report

Ex輔bit = Be=agio Casino Beso面-fabIe games da=y operating report

: B丘LLAG/O APRiL12,2006WEDNESDAV

月ESTRICTどD-DAIい/OPERATINGREPORT

2006 2005 BUDGET

CASINOREVENUE 7bd争y M,TD. M.TD. ¥ねhance Vをr% M.TD, l居riance 1ね「%

Pi丁 1,336,818 9,424,151 7,017,092 2,407,059 34.3 8,900,800 523,351 5.9

KENO 2,523 22,835 83,937 (61,102) (72.8) 24,000 (1,165) (4.9)

CASINODA7A TODAY 2006MONTH-71D-DA7f 2005MONTH-TO-DA7E

PITGAMES: D斤OP MN MN% DROP MN MN% DROP MN い〃N%

Baccarat 810,560 511,160 63,1 7,915,818 2,236,938 28.3 7,026,171 2,211,900 31.5
Blackjack 1,240,594 192,664 15.5 23,682,129 2,906,769 12.3 19,770,201 2,268,698 11.5
Craps 762,035 389,435 51.1 8,172,150 2,147,850 26.3 6,825,554 1,376,077 20,2
Min主baccarat 220,602 8,422 3.8 2,303,889 874,109 37,9 1,648,907 268,340 16.3

Wheeis 195,169 39,509 20,2 2,768,677 604,277 21.8 2,070,914 504,128 24.3
SingleWheels 96,865 92,765 95.8 977,110 362,110 37,1 466,963 29,458 6.3
PaiGow 28,245 (16,305) (57,7) 439,714 39,814 9.1 423,369 102,565 24,2
PaiGowPoker 135,457 56,237 41.5 1,078,854 156,774 14,5 865,283 364,233 42.1
Ca「ibbeanStud 20,020 7,465 37.3 321,004 81,570 25,4 384,669 102,279 26.6
Le=tRide 20,140 (1,240) (6,2) 255,806 58,466 22.9 382,297 100,480 26.3
CasinoWar 10,760 3,500 32.5 249,191 67,061 26,9 279,498 80,066 28.6
BlgSix 4,354 434 10.0 67,070 34,010 50.7 70,411 35,467 50.4
3CardPoker 61,780 36,460 59.0 974,149 365,069 37.5 930,783 266,134 28.6
Crazy4Poker 28,645 7,905 27.6 290,074 72,294 24.9 284,393 74,328 26.1
PyramidPoker 0 0 0.0 0 0 0.0 17,443 8,436 48,4
Hold`EmPoker 13,587 8,407 61.9 215,928 61,048 28,3 23,275  0 0 0.0

SicBo TotalPitGames 0 0 0,0 0 0 0.0 0 __旦旦

3,648,813 1,336,818 36,6 49,711,563 10,068,159 20.3 41,470,131 7,792,589 18.8

LESS: DiscountAccruaIs 4,630  0  0 1,336,818 54,5 66,892 (371,008) 34.1 278,971 (775,107) 30.1

Promotionai (273,000) (390)

Expenses NetPitGames KENO 9,424,151 _ヱ旦1Z壁

2,523 22,835 83,937

CREDITDROP% 1,251,500 34,3% 17,935,325 36.1% 14,513,079 35.0%

﹁﹂

165
Chapter 4. ControI System Tightness

Exhibit 12 Be=agio Casino Eeso巾鴫bie games cash drop variance report

Run Date二O4/11/06

Run Time: 10:59:15      CASH DROP VARiANCE REPORT FOR O4/10/06 ALL SHiFTS

PI17GAME ---〇〇〇〇〇〇〇〇〇〇〇〇〇〇〇ESTIMA丁EDDROP一-○○----○○---- ACTUALDROP VARIANCE VAR-ANCE%一

TABLE GRAVE DAY SWiNG 丁O丁A」

02BJO「 0 0 2,500 2,500 1,840 660 35.87

02BJO2 0 0 11,000 11,000 11,030 -30 -0,27

02BJO3 0 0 8,000 8,000 6,630 1,370 20.66

02BJO4 0 0 6,500 6,500 4,720 1,780 37,71

02BJO5 11,000 13,500 6,500 31,000 32,100 -1,100 -3.43

02BJO6 7,000 19,000 12,500 38,500 37,480 1,020 2.72

02BJO7 6,500 17,000 13,500 37,000 39,220 -2,220 -5.66

02BJO8 4,000 11,000 22,500 37,500 40,650 -3,150 -7,75

02BJO9 3,000 9,000 6,500 18,500 21,170 -2,670 -12.61

02BJ「O 6,500 25,000 13,500 45,000 48,680 -3,680 -7.56

02BJ「「 6,000 22,500 13,500 42,000 45,120 -3,120 -6.91

02BJ12 10,500 4,500 11,000 26,000 30,010 -4,010 -13,36

02BJ13 0 4,500 4,500 9,000 7,830 1,170 14.94

02BJ14 0 12,500 4,500 17,000 14,590 2,410 16.52

02BJ15 0 0 0 0 0 0 0.00

02BJ16 0 7,000 6,500 13,500 14,430 -930 -6,44

02BJ17 0 0 0 0 0 0 0.00

02BJ18 0 4,500 11,500 16,000 20,720 -4,720 -22.78

02BJ19 0 2,000 8,000 10,000 13,990 -3,990 -28.52

02BJ20 14,500 2,500 11,500 28,500 34,970 -6,470 葛18,50

02BJ21 12,500 16,000 9,000 37,500 37,400 100 0.27

02BJ22 0 0 4,500 4,500 3,860 640 16.58

02BJ23 0 0 0 0 0 0 0.00

02BJ24 0 0 0 0 0 0 0.00
 Controis at the Be=agio Casino Resort

Exhibit 13 Beiiagio Casino Beso山下lbIe games cash drop estimate vs・ aCtuai comparison

Gaming Date- 10-Apr-06   -.            To書al

CASH WIN

3,679,800 「 ,841 ,800 607,810

3,853,027 2,003,027 784,621

(1 73,227) (161 ,227) (176,811)

-4, 5% -8.0% -22.5%

instructions‥ When the Cash D「op Va「ia=Ce Pe「centage exceeds 「 O%・ the cause for the variance
must be researched and the resuIting fi=dings expiained in the space provided beIow.
Your response shouid be received by Casino Accounting within two (2) days of your
「eceipt of this report.

CashDropVarianceExpianation:

167
 CASESTUDY〇 一‥
PCL: A Breakdown in the Enforcement of Management Control
PCL was a leading European consumer electronics,
lifestyle, and healthcare company that had entered
the Chinese market in 1985. While its consumer elec-
tronics business grew steadily in China, the costs of
returned sets in its TV division amounted to 5% of
the division’s total sales in 2OO8. Even more worry-
ing was that 37% of the retumed TVs were of good
quality and had been returned without good reason.
PCL taskforces set up to study the situation found that
COntrOl measures designed to handle retums were
Simply not being carried out by sta任and third-Party
after-Sales service centers. What could PCL do to rem-
edy the situation?
The consumer electronics industry
in China
With a population of l.3 billion and rising disposable
incomes, China had become the second-largest market
for consumer electronics in the world.1 Analysts fore-
CaSted a compounded annual growth rate of 9.8%
through to 2014 for consumer electronics, With grow-
ing demand for TV sets and computers in smaller cities
and rural areas being the main driver.2 As the market
in the big cities had become saturated, market competi-
tion had moved increasingly to smaller cities and rural
areas. Sales of consumer electronics products in these
markets were further enhanced by the govem皿ent’s
Subsidy program, Which o任ered rebates for purchases
Of consumer electronic goods in rural areas. Another
government program that allowed consumers to trade
in old electronic appliances for new ones in nine pro-
Vincial areas since 2009 had also helped to stimulate
demand.
1 “consumer Electronics in China,,, Euromo融or (Apri1 2OO9), Online
at www.eu romonitor.com/Consumer_Electronics_in_China (accessed
June 20, 2010).
2 “china Consumer Electronics Report Q3 2010,,, Bus肌eSS Mo融or
J面er「融[o棚Z (2OlO), Online at www.pトinside.com/China-COnSumer-
electroni⊂S-rePOrt-q-r19O5491.htm (accessed June lO, 2010).
168
The teIevision market in China
It was no surprise that China, a COuntry that produced
42% of the world,s total shipment of TV sets,3 had a
StrOng TV market. Domestic manufacturers alone
accounted for three-quarterS Of its liquid-CryStal dis-
play (LCD) TV market in 2009.4 Driven by consumers,
Preference for large-Sized TVs and by falling prices,
China was forecasted to surpass North America as the
largest LCD TV market in the world, With sales reach-
ing 29 million units in 2010, tranSlating to more than
30% in growth year-On-year.5 The growth would be
driven by consumers replacing their cathode ray tube
(CRT) sets with LCD sets, eSPeCially in third- and
fourth_tier cities.6 International brands faced fierce
COmPetition from domestic brands, Which enjoyed
advantages in both cost control and distribution, and
Price wars were common as domestic brands Iowered
their prices to increase their market share. Large retail
Chains played a critical role in the retail market for con-
Sumer electronics in China, and competition for shelf
SPaCe in such chains was fierce. Manufacturers became
involved with the promotions, marketing, and supply
Chain management of these chain stores in order to
build relationships with them.7 others opened their
OWn branded stores so they could have a direct hand in
Shaping consumers’purchase experience.
3 K. Zhang, “China TV Market to EIgゆy Solid Growth in 2014,,, lSuppit
(Apri1 26, 2010), Online at www.isuppli.com/Display-Materials-
and-Systems/MarketWatch/Pages/China-TV-Market-tO -EnJOy.
Solid-Growth-in-2014.aspx (accessed June 20, 2OlO).
4Ibid.
5 =Corning: China to Become World,s Biggest LCD TV Market,,・ smo.
Casf BustrleSS Beat (Apri1 14, 2010), Online at www.tradingmarkets
COm/news/S tO Ck- ale rt/glw_dtek_COrni ng- Ch ina -tO -b e come -WOrld-
S-biggesトIcd-tV-market-91O387.html (accessed June 20, 2010).
6 “overview of China,s LCD Market;, G/K Re謝and 7t3(克ndogy
(March 29, 2OlO) online at www.gfkrt.com/news_eVentS/markeし
news/Single_Si亡eS/0056O6/index.en.html (accessed June 30, 2010).
7 I・ B. Von Morgenstem and C. Shu言・winning the Battle for the
Chinese Consumer Electronics Market,’’(September 20O6), Online
at www.mckinseyquarterly.com/High」七ch/Hardware/Winning-
the-battle_foLthe_Chinese_COnSumeLelectronics_market_1855
(accessed June 20, 2OIO).
CL Consumer EIectronics - background
CL was a high-teCh multinational company bas車,in
urope. Since its establishment in the late nineteenth
entury, it had diversified into multiple industry seg-
ents. The diversification strained its resources and,
OnSequently, PCL reshaped the organization to
cus on the healthcare and electronics sectors. In
010, it had a sales and service presence and manu-
cturing sites in more than lOO countries around
eヽVOrld.
PCL’s consumer electronics division (PCL Con-
mer Electronics) was a global player in digital and
lectronic devices, bringing the latest technoIogy
ndhuman-Centered designs to the market. Its prod-
c[ POrtfolio included color TV sets, DVD players,
udio products, PC monitors, and PC peripherals.
CL Consumer Electronics had a sales and service
resence in more than 5O countries and manufactur-
g sites in France, Hungary, Belgium, Brazil, Mex-
0, and Argentina even though it outsourced its
roduction heavily. PCL Consumer Electronics placed
StrOng emPhasis on emerging markets such as
hina and India. It entered China in 1985, and by
OO8, its sa賞es organization on the mainland had
rown to 550 people with annual sales of US$752
111ion (See Exhibit l).
epairjng the broken system
2008, the handHng ofre亡umed TV sets cost PCL an
erage of US$6 million, equal to about 5% of its
皿al TV sales. The costs covered freight from the
aler to PCIJs warehouse, rePair, and refurbishment at
e factory workshop. While PCL spent a hefty sum
chyear servicing retumed goods, about 37% of the
tumed goods were no-fault-found (NFF) returns,
anslating to a loss of US$2.2 million for PCL. NFF
turns also included demo sets and sIow-mOVing
ods血at were not supposed to be retumed (see
hibit2).
heTV retum process
ter-Sales service for PCIJs TV division was handled by
thorized service centers (ASCs), Which were third-
rtyservice centers authorized and managed by PCIJs
ter-Sales service team. Under China’s consumer law,
nsumers could return a defective TV set to the
retailer from whom they made the purchase within five
days or exchange it for a new one within 15 days.
Retailers sent PCL sets retumed by customers to the
COmPany,s ASCs, Which would decide whether to
accept the retum and repair them. If the defect was
serious, the ASC would send the set back to PCIJs fac-
tory for repair.
Investigation
In response to the high volume of returned sets and
high NFF retums, PCIJs management appointed the
product marketing manager of the TV division’Who
was also familiar with the retum process, tO look into
the matter so appropriate actions could be taken. He
formed a task force that brought together the sales
operation manager, the service manager, and the finan-
cial controller of the TV business. The team set out to
investigate the situation and uncovered a number of
CauSeS for the problem.
Neither retailers nor ASCs had been trained in edu-
Cating customers about product performance or the cri-
teria for accepting retums. Retail stores usually used
high-de丘nition signals for product demonstrations’but
most consumers used cable TV at home. As a result,
consumers often became dissatisfied with the picture
quality after they took the TV set home and would try
to exchange it for a new set or simply retum it. While
PCL had established retum criteria that were as strin-
gent as those of its competitors, retailers and ASCs
Often fajled to execute血em properly, aCCeP亡ing retums
Without proper screening.
Chain retailers were significant players in China’s
consumer electronics market, and consumer electron-
ics companies could not maintain their market share
Without selling through them. Because no intema-
tional TV brand possessed unique product features or
technical advantages that differentiated its products in
the market, the manufacturers’best option was to
make concessions in their negotiations with chain
stores in order to maintain good relationships with
them and in tum receive higher visibility at the point of
sale. PCL, for instance, Cut its profit margins and
accepted retums of sIow-mOVing models and demo sets
in order to secure prominent display locations in the
stores. In addition, PCL salespeople had to meet sales
targets and required the support of dealers to achieve
these targets. This made it hard for many salespeople
to say no to unreasonable returns because doing so
might jeopardize their relationship with the dealers.
169
Chapter 4. ControI System Tightness
Moreover, they put little effort into investigating the
retums, despite established approval procedures for
retumed goods.      -..
PCL’s after-Sales service team, Which was respon-
Sible for overseeing the ASCs, did not report to the
TV division directly, but instead reported to the gen-
eral manager of the organization, a line of reporting
that reduced the incentive for the after-Sales team to
COntrOI TV returns or to monitor the third-Party
ASCs stringently. Not only did the ASCs fail to
inspect the returned sets carefully, but they some-
times faked their inspection records instead of
rejecting the retum of TV sets. The situation was
further aggravated by the fact that PCL had no pun-
ishment policy for fraud or incompliance on the part
ofASCs.
Action
The team came up with a series of actions based on
their initial assessment of the situation. The sales
team’s amual performance appraisals would be
linked with TV returns and the cost of servicing
retums, and this new measure was co皿municated
by the TV sales director to all the salespeople. The
SerVice manager also communicated to ASCs a new
POlicy whereby they would be fined three times
the labor charge for each fake inspection record
discovered.
The prqject team forecasted that their plan would
reduce the return rate to 3.5% and the NFF rate to
20% within two months, but their prQjection did not
materialize. In fact, the NFF return rate went up to
40% after two months. Upon further investigation,
the general manager and the production manager of
the TV division discovered two reasons for the rising
rate of NFF retums, despite their efforts. First, the
Sales team was under enormous pressure to meet
their sales targets, Which was set at 132% ofthe sales
Ofthe previous year, a rate that exceeded actual mar-
ket growth. In order to reach their targets, they put
PreSSure On the dealers to increase their purchase
VOlumes, leading to higher inventory levels and
tighter cash flow. Tb counter these problems, dealers
negotiated with salespeople to accept returns and to
allow exchanges of demo sets and sIow-mOVing
goods for new models. The second reason was that
the after-Sales service team had failed to take punl
tive action against the ASCs for fake inspection
records. There was little incentive for the servict
team to respond to the ASCs’transgressions, aS itdid
not report to the TV division and its performance
indicators were not linked to the amount of goods
returned.
Second try
Dissatis丘ed with the outcome, the general manager of
PCL Consumer Electronics appointed the service direc-
tor, Who reported directly to him, tO lead the task force,
The service director was also given the authority to
handle issues that did not usually fall within his scope
Of responsibilities in order to tackle the problem. Once
appointed, the service director put together a new
CrOSS-functional team, With each member responsible
for a specific area for improving the return rate and
NFF retum rate, aS fo11ows:
違 SerVice director- SerVed as team leader;
翁∴ SerVice manager - managed the ASC network;
㊨ Chief financial o鯖cer - reSPOnSible for the financial
results of the team;
ミ「 TV sales operation manager - engaged in dealer
management;
童 SerVice financial controller - Performed service cost
COmPutation and analysis;
lニ TV product manager - COnCerned with proces§
implementation and improvement.
The team set speci丘c targets:
番 TV NFF return rate to be reduced from 40%
亡o 20%三
寒 TV retum and exchange rate to be reduced from 5%
to 3,与%;
S tOtal savings ofUS$1.13 million within six months.
The service director also applied for some US$4,500
as a bonus for the team, tO be used for an outing or
teambuilding exercise if it could meet its targets. The
general manager of the consumer electronics division
endorsed the proposal and also incorporated the pro-
ject targets into the bonus scheme ofthe team members
SuCh that they would lose their amual bonuses if the
targetS Were nOt met.
 The team analyzed the situation and the following
actions were drawn up to remedy the s韮uation:
1 Given that both the sales team and the ASCs were
failing to enforce the established criteria for
accepting retumed goods, PCL had ended up being
more accepting of retumed goods than i亡S COmPeti-
tors. Tb manage the situation, the TV sales operation
manager was put in charge of rotating the regional
Sales managers and salespeople geographically in
Order to prevent the sales team from becoming too
friendly with the dealers.
1 The TV sales operation manager and service direc-
tor were put in charge of ensuring that no models
that had been phased out for more than six months
WOu量d be accepted for retum.
1 The TV sales operation manager and service direc-
tor were also put in charge of de丘ning clear and
sound criteria for the inspection and acceptance of
returned merchandise.
1 The TV product marketing manager and service
director were put in charge of organizing training
On the return process and criteria for all individu-
als invoIved in making decisions in the return
prOeeSS・
The team quickly got to work, defining the criteria and
monitoring measures to control the retum process:
l For goods that were defective upon arrival at the
dealers’warehouses, PCL would accept retum only
if they were functiona11y defective or there were
serious cosmetic failures vis-a-Vis PCIJs standards
for finished goods.
[ For defective goods retumed within 15 days after
purchase by consumers, Only functional failures
would be accepted as grounds for retum.
裏Returned goods were to be accepted only after
approval by cross-functional personnel.
‘ Retumed goods would be required to come in
their original PCL packaging, With all the original
t Models that had been phased out for more than six
months would not be accepted for retum or
exchange.
PC己s regional service managers and engineers would
also visit the top lO ASCs for retumed goods - Which
together were responsible for 40% of monthly retums
- and provide training sessions with detailed working
instructions to the ASCs. A new incentive and penalty
scheme for ASCs was also drawn up, With the following
mandates:
㊥ increased labor charges for inspection of retums;
璽 Penalties for NFF retums;
導quarterlybonuses to those with the highest levels of
COmPliance.
On the sales team side, the TV sales operation man-
ager worked dosely with the TV sales directors to
draw up a detailed rotation plan. Field salespeople
were required to visit top dealers within their respec-
tive regions on a weekly basis to solicit feedback and
to implement follow-uP aCtions. The plan was ful-
fi11ed after seven months and extended to 52% of the
Salespeople.
The prqject team met every two weeks for reviews as
remedy measures were implemented. Immediate
actions were taken to correct any weaknesses that had
materialized and wamings were issued to those
responsible for them. The team was able to adhere
dosely to the prQject schedule.
After six months, the NFF retum rate was reduced
to 12%, SurPaSSing the team’s target of 20%. The
return and exchange rates dropped to 3.2%, SurPaSS-
ing the team,s 3.5% target. The team did not meet the
target of US$1,13 million in savings, though it came
quite close at US$1.1 million, and thus the team was
awarded its bonus.
Epiiogue
After the hard work of PCL’s two taskforces, PCL
finally managed to bring the issue of the high return
rate of its TV sets under control. The work of the two
taskforces had revealed a major issue in enforcement
within the organization. Even the best strategy or
business plan could only be effective if it was prop-
erly executed. What could PCL do to ensure that
internal control measures would be enforced prop-
erly to achieve organizational objectives in the
future?
171
Chapter 4. Controi System Tightness

Exhibit l PCL Consumer Eiectronics in China: Organization chart

Exhibit 2 Fiow of TV sales and retums

Retu「ned丁V sets

(US$6 m冊on)
i________○○______________"

(NFF = 37%)
“N sa略s     三

TVretums 〇〇〇〇〇〇〇+
* Note: Deaier Retums = Demo sets + SIow moving disguised as TV retums
CHAP丁ER 5
OntrOI System Costs

Management cOntrOI systems (MCSs) provide one primary benefit: a higher probability that
employees will pursue organizational of}jectives. Managers are willing to incur sometlmeS Slg-
nificant direct, Out-Of-POCket costs to try to obtain this benefiL But managerS muSt also consider
some other, indirect costs that can be many times greater than the direct costs. Some of these
indirect costs arise from negative side effects that are inherent in the use of spec龍types of

controIs. Others are caused either by a poor MCS design or by implementation of the wrong
type of control in a given situation」b make informed cost-benefit judgments, managerS muSt

understand these side effects, their causes, and their consequences (costs). Finally, COStS may
also arise from the need to adapt MCSs to the context in which they operate’Which is particu-

larly pertinent in multinational operations. Adaptations to Iocal circumstances can be costly’

but not adapting may render the MCSs less effective and give rise to indirect costs.

Direct costs

The direct costs of a MCS include a11 the out-Of-POCket, mOnetary COStS required to design and
implement the MCS・ Some direct costs, SuCh as the costs of paying cash bonuses (arising from

incentive compensation for res近s con亡roZ) or the costs of maintaining an intemal audit staff

(needed to ensure compliance with ac亡ioJ“O庇rOZ prescription3 are relatively easy to identify.

other costs, however, SuCh as those related to the time empIoyees spend in planning and budg-
eting activities or preaction reviews, Can Only be estimated. Even of the time spent, it is hard to
estimate how much of it is “value-added.,・ For example’a reCent SurVey Ofpractice suggests that

of all the time spent on financial analysis and plaming, “Only 28% is spent on the analysis that

drives insigh皿business decisions’,・ with the rest being spent on validating data and adminis-

tering processes.1
Many organizations often are unaware o串r do not bother to calculate accurately the size o‡

all of these direct costs. But all that is required for our purposes is to acknowledge that these
costs are not trivial and, thus, Should be put against the benefits that MCSs have or are expected
to have. This is pertinently illustrated here:

with the process COStS Of internal audit twhich we discuss in more deta旧n Chapter 14] for

the Fbrtune 500 representing between O"026% and O・126% of reve…e (Variabie based on

company size, industry, a=d adoption of leading practices)タeXtraCting greater vaiue from

such an investment is paramount" Mo「eoversince many Chief Audit Executives (CAEs) stⅢ

report administ「atively to the CFO (70% in the Fbr書une 50O’acCOrding to the 2013 Giobai
Chapter 5. ControI System Costs

Audit information Network Amual Benchmarking Survey), it behooves Finance to equip the
functiq虫With capabiiities to de=ver more-informed audit reports" And given the continuing

desire of CFQs to pIay more-Strategic roles, having a forward-Iooking lnternai Audit depart-
ment can be a vaIuabie weapon in their arsena一・2

What is more, there is an intricate link between direct costs and indirect costs, aS the follow-
ing quote suggests with regards to the costs for banks to comply with US regulations on丘nan-

cial transactions with countries on the US sanctions list, Where:

’`The cost of not being squeaky ciean is phenomenaI.’’For example, BNP Paribas’s guiity

Plea to violations of sanctions against Sudan, lran and Cuba was accompanied by a b10Ck・
buster fine of near看y $9bn pius a one-year ban on conducting certain transactions in doIIa「s,3

This is a huge indirect cost of the failure of compliance, Which has led to more direct costs
incurred on internal controIs to enhance compliance:

As a result, COStS are rising fast. BNP Paribas, for exampie, tOOk a E200m charge reiated to
an overhau1 0f compiiance procedures as it responded to its fine by setting up a speciaI
unit in New York, aimed at ensuring that it stays on the right side of US ruies・ Macquarie,

the Australian investment bank, annOunCed in May that its direct comp=ance costs had
tripied in three years, tO A$320m. HSBC took on l,500 extra compIiance sta什in the first

haIf of the year, lifting its compliance spend by about $150m,4

lndi「ect costs

Challenging as estimating the direct costs of control may be, they can be dwarfed by indirect
costs of controI caused by any of a number of harmful side effects, including behavioral dis-

placement, gameSmanShip, OPerating delays, and negative attitudes, aS the example above
illustrates and which we discuss further below. Moreover, Chapters lO and ll discuss in more
detail some of the harmful side effects that commonly arise from the use of financial results
COntrOIs, eSPeCially management short-termism or myopia.

Behaviorai displacement

Be庇γ王oraZ dispねceme庇is a common MCS-related side effect that can expose organizations to

significant indirect costs; it occurs when the MCS produces’and actually encourages’behaviors

that are not consistent with the organization’s objectives. Behavioral displacement is most com-

mon with accountability-tyPe COntrOIs (either results or action accountability), Where the speci-
fication of the results or actions desired is irlCOれgr【⊥erlt. But some forms of personnel/Cultural

COntrOI can also produce the problem.

BehavioraI DispIacement and Results ControIs

In a results-COntrOI system, behavioral displacement occurs when an organization defines sets
ofresults measures that are incongruent with the organization’s “true’’objectives. For example:

`二 When companies give their salespeople monthly sales quotas, the salespeople tend to work

on the easiest sales, Which are not necessarily the most profitable sales or sales with the high-
est priority.

← When brokerage fims reward their brokers through commissions on client trades, SOme bro-

kers respond by c庇rr血g aCCOurl亡S, engaging in more transactions than are in the customers’

best interests and that run the risk of dient dissatisfaction and tumover.

174
 〇 When companies reward their computer programmers for output measured in lines of code

Per day, the programmers tend to generate programs with lengthy code even when the com-
Pany’s problems can b6 better addressed by simpler programs or by off-the-Shelf applications.

S When software testers are evaluated in terms of the number of “bugs,, they find, the bug

COunt gOeS uP. But more ofthe bugs found will be minor. Bug counts also create incentives
for superficial testing, Penalizing testers to take the time either to Iook for the harder-tO-丘nd

but more important bugs or to document their findings thoroughly. Bug counts also penalize
testers who support o血er testers through coaching, helping, and auditing.

ミWhen companies reward their research scientists for the number of patents郎ed, they are

likely to see an increase in the number of patents filed. HoweverJhis incentive may lead to
Patent PrOliferation only and may not enhance, and may even erode, reSearChers, concems
for the eventual commercial success of their discoveries.

Why do organizations, then, uSe meaSureS that are not congruent with their true objectives?
Most commonly, incongruence arises because organizations focus on easily quantifiable results
that lead them to incompZctefy capture all of the desired results. When that is the case, emPloy-
ees are induced to concentrate on the results that are rewarded by the controI system and to
Snub other desired but unmeasured result areas.5 For example, When a major personal com-

Puter (PC) maker started paying its sales reps higher commissions for selling add-On SerVices
than for se11ing PCs, the sales reps became lax about selling no五ills PCs. Sometimes theywould

even hang up on customers who did not want add-OnS. As a result, CuStOmer Satisfaction went
down as did the referral business on which the company had relied for its growth in a highly
competitive market.6
Similarly, When city o飴cials wanted to tackle overtime in their garbage co11ection service,

they offered the garbage collectors an incentive scheme where they would be paid珊1 time

even ifthey reported back early. It worked. Garbage collectors came back consistently early and
received full pay for the shift. Despite this good effect on overtime reduction, however, there
WaS an increase in preventable tra鯖c accidents’missed pickups of garbage, and trucks filled

OVer the legal weight limit. Because the incentive scheme emphasized time, emPIoyees nearly
exclusively focused on time at the expense of safcty’SerVice and obeying work rules.7

Garbage collection is not exactly what comes to mind when thinking of皿庇asたfrIg, yet

even thisjob is presumably complex enough to be su切ect to the eifects ofdis亡or亡e訪lCe融ves (a

fom of behavior displacement, aS We Call it here). Consider, then, the complexity invoIved in
determining appropriate weights on the multiple dimensions of; say, managerial jobs, and one
Can See how easily incentives can have potentia11y displacing effects. All told, there are very few
jobs’eVen PreSumably si皿ple jobs, Where what is counted is all that counts 」n other words,
results controIs are almost invariably諒oompZcte・ If the relative importance of the various

aspects ofthejob is not captured correctly, emPIoyees are unlikely to allocate their efforts prop-
erly’and outcomes will be distorted. Later chapters o節er various possible remedies to this dis-

Placement problem’SuCh as by using baskets of measures (Chapter ll) and/Or relying on

Sut}jective performance evaluations (Chapter 12) to try to cover more completely all the impor-
tant drivers ofperformance. The following example nicely summarizes the crux of the issue:

“Compensation shouid refiect the pe「formance of the fjrm as a who-e’aCCOr。ing fo the

pwhcjbyes. Assessment areas shou看d incIude productivity, teamWOrk, Citizenship, COmmu-

nication and compIiance.一, That was t「ue untii 2005’When the company determined work-

ers’annuai awards ``notjust on how much business you’d brought in, but aiso on how good

yOu Were for the organization," aIieges Greg Smith, a former Vice President, in Mry / Left
Go/dman Sachs: A M/別I Street Sto′γ" “From 2005 unt旧he present day,的e system has

become fa岬ely mathematicaI: yOu Were Pajd a percentage of the amount of revenue next

175
Chapter 5. ControI System Costs

to your name,’ずa figure that could vary from 5 to 7 percent, WrOte Smith"くくThe probIem with

the new eystem was that people would now do anything they couId - anything - tO PumP
up the number next to their name",,8

Behaviorai DispIacement and Action Controis

Behavioral displacement can also occur with action controIs. One form of action control-related
displacement is often referred to as mecms-ends inverston’meaning that empIoyees pay atten-

tion to what they do (the means) while losing sight ofwhat they are to accomplish (the ends).
For example, managerS Who are given an approval limit for capital expenditures have been
known to invest in a series of small pxpjects, eaCh of which fall just within their authorization
limits. Although the action-aCCOuntability controIs may not be breached’the resulting pattern

of small, incremental investments may be suboptimal.

Sometimes action control-related displacement occurs simply because the defined actions
are incorlgrue庇. As with results controIs’this problem arises in an action-aCCOuntability con-

text. For example, the PC maker mentioned above also implemented a policy to put a time limit
on customer service calls. Speci債cally, CuStOmer SerVice reps who spent more than 13 minutes

talking to a customer would not eam their commission. Not surprisingly’SerVice reps began

doing just about anything possible to get customers o任the phone, SuCh as pretending that the

line was not working or just hanging up. As a result, the company’s customer satisfaction raト

ings, OnCe the best in the industry, dropped dramatically and fell below the industry average.9
Some action controIs cause behavioral displacement because they promote compliant yet
rig[d, nOn-adc[P亡ive behaviors, a PathoIogy commonly associated with bureaucrαtfc organiza-

tions. For example, US automobile manufacturers focused on elaborate action prescriptions for
their assembly workers to try to optimize assembly-1ine operations. On Japanese assembly
lines, in contrast, the controI systems in use for assembly workers were much more flexible.
Workers were encouraged to experiment with different ways of doing theirjobs - for example,
by putting the doors on the car before the locks were installed’and then altemating the order to

see which was more e綿cient. By giving their workers more flexibility, the Japanese gained a

competitive advantage. Similarly, at Continental Airlines, there used to be a rule forjust about
everything conceivable in the nine-inch-thick procedures manual known as the αThou Shalt

Not,, book. As one company observer noted, “No one could possibly know everything in [the

book], SO mOSt emPloyees played it safe by doing nothing at all.,, Tb overcome the undesired
rigidity fostered over time by the rule book, the new management team ceremoniously bumed
the “Thou Shalt Not,, book in the company parking lot to provide a clear signal that, from then

onward, emPIoyees had ・・permission to think for themselves.,,1O Action controIs and bureaucra-

tization can be good in stable environments with considerable centralized knowledge about
what actions are desired because they help establish compliant, reliable’and efficient work rou-

tines. In changing environments, however’they may hinder the change that is required to stay

COmPetitive.
A recent study in Australia suggested that the direct costs of red tape also can be significant:

G-oba- accounting firm DeIoitte says intemai red tape and selトimposed ruIes a「e costing

businesses twice as much as govemment regulations. ``Our survey found that the average
worker spends essentialiy a day a week jumping through the hoops of this self-imposed
red tape,,, Chris Richardson from DeIoitte Access Economics observed" ``Much of it is a
good thing. to take a simpIe example, OVe「 the past decade, miners and the construction
sector have become safer, Industriai accidents have gone down,” he said" But not aII of it is

a good thing. “Partly it’s because businesses never 100k back. You know, they don’t do the

audit, and they don,t ask `why are we doing this, yOu know, nOtjust this new rule, but a= our
ru-es, do they actua=y make sense anymore?, What we are saying is that our existing ruIes

176
 indirect costs

are costing us a fortune; they’re not necessariIy making us that much better o什, Or that

much less risky士1

Behavioral Displacement and PersonneI/Cuitura! ControIs

Behavioral displacement can also occur with personnel/Cultural controIs. It can arise from
recruiting the wrong type ofempIoyees or providing insu鯖cient training, and when persomel/

Cultural controIs are implemented in the wrong setting, they will be rendered ine鉦ctive and

encourage unintended behaviors. For example, When Levi Strauss wanted to raise productivity
and reduce costs, Particularly those incurred by iI可ured workers pushing to make piecework

goals’it tumed to feamwork’Which Levi,s felt would be more humane, Safe, and exemplary of
WOrkplace standards in an industry notorious for poor working conditions. The old piecework
SyStem - under which a worker repeatedly perfoms a specialized task (such as attaching pock-
ets or belt loops) and gets paid by the amount ofwork completed - WaS abandoned and replaced
by teams consisting of lO-35 workers who shared the tasks and were paid according to the total
amount of trousers the group completes.
Despite these praiseworthy intentions, however, the nature ofthe work at Levi,s may not be well
Suited for teamwork. Gament manufacturing consists of a series of specific tasks (pocket setting,
belt looping). The speed of these tasks relates directly to a worker’s ski11 for the grueling, rePetitive

motions invoIved in stitching fabric. Some workers are much faster than others. Although team-
WOrk was expected to reduce monotony, enable workers to perfom different tasks, and reduce
repetitive injuries, it failed. When skilled workers were pitted against sIower co-WOrkers, the
WageS Oftop perfomers fd1 while those oflower-Skilled workers went up・ This not only eliminated

SaVings for Levi,s but also caused infighting among co-WOrkers. Longtime fr王endships were dis-

SOIved, and faster wokers tried to banish sIower ones. Morale was damaged, e飴ciency dropped,

and labor and overhead costs surged" The teamwork concept did not fit the context.12

Gamesmanship
We use the term ga肌esmczrlS坤to refer generally to the actions that employees take to improve

their performance indicators without producing any positive e任ects for the organization.

Gamesmanship is a common hamful side eifect faced in situations where accountability forms
Of control, either results or actions accountability, are uSed. We discuss two major forms of
gamesmanship: Slack creation and data manipulation.

Creation of Slack Resources

Slack invoIves the consumption of organizational resources by empIoyees in excess of what is
required to meet organizational objectives. The propensity to create slack often takes place
When tight results controIs are in use; that is, When empIoyees, mOStly at management levels,
are evaluated primarily on whether or not they achieve theirbudget targets (see also Chapter 8).
Managers who miss their target face the prospect of interventions in their jobs, the loss of
Organizational resources, the loss of annual bonuses and pay raises, and sometimes even the
loss of theirjob.
Under these circumstances, managerS may look for ways to protect themselves from the
downside risk ofmissing budget targets and the stigma attached to underachievers. One way in
Which managers keep tight results control from hurting them is by negotiating more easily
achievable targets; that is’targetS that are deliberately lower than their best-gueSS forecast of

the future. This is called budget sZαCk; it protects the managers against unforeseen contingen-

Cies and improves the probability that the budget target will be met, thus increasing the likeli-
hood of receiving a favorable evaluation and associated rewards (such as a raise, a bonus,
recognition, Or a PrOmOtion).

177
Chapter 5. ControI System Costs

On the negative side, the slack obscures true underlying perfomance and’hence’distor亡s

the decisinns based on the obscured information, SuCh as performance evaluations and
resource-aHocadon decisions. That said, Slack should not be seen as producing only negative
effects. On the positive side, Slack can reduce manager tension and stress’increase organiza-

tional resilience to change, and make available some resources that can be used for
imovation.13
In most situations, Slack is nearly impossible to prevent. Theoretica11y, Slack is feasible only
where there is irr句r肌αdon c[aym肌e[7男Where superiors have less-than-COmPlete knowledge

about what can be accomplished in a given area, and where subordinates are a11owed to partic主

pate in setting the perfomance targets for that area. Thus’Where performance can be accu-
rately forecast or be set in a top-down manner’it should be possible to prevent’Or at least

mltlgate, Slack. But these conditions exist only in rare situations - highly stable environments. If
accountability controIs are used in other situations’Slack must be considered almost inevitable.

We discuss various ethical considerations related to slack creation in Chapter 15.

Data Manipuiation
Data manipulation invoIves fudging the control indicators. It comes in two basic forms: fals誼・

cation and data management.弛s昨cα轟on involves reporting erroneous data, meaning that the

data are changed. Dαta榊れageme庇involves any action undertaken to change the reported

results (such as sales numbers or profits) while providing no real economic advantage to the
organization and, SOmetimes, eVen CauSing harm. Data management actions are typically
undertaken to make performance look better, SuCh as to achieve a budget target or to increa§e

stock price. However, data management actions can also be undertaken to make perfomance
look worse. Sometimes managers =save sales,, for a future period when the current-year bonus
has reached its cap. Sometimes they =take a bath,, - that is, they make results Iook worse in bad
times (while there are no bonus payouts, anyWay) to get a head start on recording an improve-
ment in the subsequent period. Sometimes they report abnormally poor results to try to Iower
the stock price to coincide with, Say, a StOCk option grant"14
Data management can be accomplished through either accounting or operating means.
Acco硯血g me鳳ods of data management invoIve an intervention in the measurement pro-

cess. Individuals engagmg m aCCOunting methods of data management sometimes violate

accounting rules; mOre frequently, they use the flexibili亡y available in either the selection of

accounting methods or the application of those methods, Or both’tO負manage eamings,’’as it

is often called.15 Tb boost eamings, for example, managerS might shift from accelerated to
straight-1ine depreciation or change their judgments about accounting estimates (such as
about reserves, allowances, and write-O任s). IBM corporation used revenues from patent

licenses and profits from asset sales to understate the company,s reported general and admin-
istrative (G&A) expenses, tO make the company look “lean’’as observers and investors

expected it to be.16 AFor亡肌e article called accounting treatments like these’Which are con-

sistent with generally accepted accounting principles’・・legal’but lousy・,,17 Another analyst

said: uThey,ve got a lot ofways to beat eamings and they definitely take advantage of it; itis
part of how IBM operates.,・18

qperα亡irlg me亡7tods of data management involve the altering of operating decisions. Tb boost
earnings in the current period, managerS Can’Sayプtry tO delay the timing of discretionary

expenditures (such as maintenance) and/Or try tO aCCelerate sales・ These methods affect the

size and/Or timing of cash flows, aS Well as reported eamings. Several companies have been
charged with booking revenues on sales to distributors (as opposed to waiting until the prod-
ucts have been sold by the distributor), thus taking advantage of the ambiguity in accounting
rules on revenue recognition. This rules ambiguity makes存channel stu綿ng,, tempting by per.

suading distributors to take more product than they really need or want’Particularly toward

178
 the end of a poor quarter’tO help eamings Iook better than they really are. A recent example

OCCurred at Tesco’a large uK grocer, the analysis ofwhich appears to allow for the possibility of

OPerating as we11 as manipuhating causes of the problems:

Suppiiers make payments to supermarkets that meet certain sales targets for their prod-
uCtS, run PrOmOtions or piace the goods in eye-CatChing p-aces, SuCh as at the end of
ajsies」七sco managers appear to have been too ambitious in forecasting these “rebates.,,

They may also have underreported the costs of sto-en and out-Of-date produce. 77?e COm-
plexfty of 7t}SCOS promo的naI deaIs面th supp/iers may have /e航oo much room for dis_
Cretionタand honest mis書akes’aS WeII as de胸erate distortions. Bu=he rjsks around

aCCOunting for such payments are hardly new・ The auditors of severa- big retaiIers have

ampiifjed their warnings in recent years as rebates have taken up more space on balance-
Sheets" In its most recent report・ in May’Tesco,s auditor, PwC, Warned of the “risk of

manipuIation.”19

Because altering decisions can have adverse effects on real economic value, eVen When they
improve reported accounting income, OPerating methods of data management can be harm帥

to the宜rm in the long tem・ The actions can harm customer satisfaction (arising from the

aggressive sales tactics), emPIoyee productivity (arising from the unneeded overtime at quar-
ter’s end)’and/Or quality (arising from postponed maintenance or reduced quality inspection。.

Manipulation is a serious problem because it can render an entire controI system ineffective. If
the data are being manipulated, it is no Ionger possible to determine whether a company, entity,
Or emPIoyee has performed well. The effects of manipulation can also go f壷beyond the MCS

because they affect the accuracy of an organization,s information system. If that is the case,
management’s ability to make good’facts-based decisions will be curtailed. Thus’eVen though

Various data manipulation methods are not i11egal’they can be costly to the宜rm in the long

term. No wonder’then, that an article in the地rVard BusiJteSS Revtet‘′ Called the ・・eamings

game’’something that ``everyone plays, [but] nobody wins.,,2O

Some data manipulation schemes invoIve outright fraud’however. At Sunrise Medical,

four empIoyees at one of the firm,s mgivr divisions’including its general manager, engaged

in falsifying financial reports. The scheme was intended to disguise a deteriorating financial
Situation. The company,s bonus plan was seen as a mgivr cause of the fraud. The plan paid
amual cash bonuses worth up to 50% ofsalary’but it pa主d no bonuses in divisions that falled

to record a year-On-year earnings increase. It shocked many observers that such a fraud
COuld occur at sunrise, Which =has Iong presented itself as a values-COnSCious hea量th-Care

fim whose empIoyees carry lofty corporate precepts about customers, Shareholders and
SOCial responsibility on wallet cards.,,21 when such frauds come to light, their financial
impact can be huge. Reputations are ruined and billions ofdo11ars of shareholder value can
be destroyed.
Despite these costs’data manipulation schemes are often fostered by excessive short-term

Performance pressures and inadequate con亡roIs to prevent the dysfunctional side effects, Which
We discuss further in Chapter 15. In other situations, the blame is laid on the failure of auditors
to perform their functions well・ Auditors do not always understand the company,s business or

its accounting methods well enough, Or they do not pursue some of the observed improprieties
far enough’Perhaps in part because of a lack of independence from their clients. The 20O8

financial crisis has nudged regulators further toward enacting regulatory and legislative
refoms focused on the roles and responsibilities of management and boards of directors in
financial reporting as well as the roles and responsibilities of independent auditors in perform-
ing their audits of the financial reports. This fa11s broadly under the realm of corporate govern-
ance’Which we discuss further in Chapters 13・ The role of auditors is discussed further in

Chapter 14.

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Chapter 5. Controi System Costs

Ope「ating Delays

Operatin挿elays often are an unavoidable consequence of the preaction review types of acti(

controIs and so血e of the forms of behavioral constraints. Delays such as those caused by li

ing access to a stockroom or requiring the typing of a password before using a computer syst
are usually minor and are inevitable (although they can be made more effective and less ti
wasting or cumbersome through the use of technology, SuCh as touch IDs or retina-reCOgn諏

systems). However, Other control-CauSed delays can be major, SuCh as those arising fror
approvals requlrmg multiple signatures from managers at various levels in the hierarchy (
from endless memos through layers of higher-uPS before anything gets cleared. In these c-
cumstances, required approvals sometimes strα喧cたe亡operations and, hence, Curtail ma撮

and customer responsiveness.

Tb enhance the market responsiveness of its North American operations’Tbyota Motor Co

poration,s president Fujio Cho had the following message for its American division: `堀2

yours.・, In response, Jim Press’eXeCutive vice president of Tbrrance’Califomia-based Toyo‘

Motor Sales USA, nOted that, ``These days, We don,t need so many approvals from Japa坤

have more autonomy.,, The American management used to have to go down to the doc缶

greet the boats to find out what the new-mOdel-year CarS looked like. Now’many Tbyota (l
and their interiors are designed in the United States. Tbyota,s president Cho called this a “re

vention,, of the carmaker, neCeSSary because the market, eSPeCially in the United States言s

competitive. ・Any company not willing to take the risk of reinventing itself is doomed,’’c

said.22 This example also dovetails nicely with the next category of MCS costs-adap軸

costs, and benefits, Oftailoring the systems to the local market.

Obviously, Where fast action is important’aS it is in many competitive markets, dedsl

delays can be quite costly. Delays are a m亘ior reason for the negative connotation associaト

with the word bureaucrao′・ In organizations that tend to place greater emphasis on action c(l

troIs and suffer these bureaucratic operating delays as a consequence’many MCS changes

motivated by a desire to reduce the burdens caused by these types of controIs’Which are o

Seen aS k掘れg e庇repreJleurSh小

Control-CauSed operating delays are not an independent problem. They can cause ot
managerial reactions that are potentially harmful’SuCh as game-Playing’Or that are under

ing the behaviors the controIs were designed to keep in check’SuCh as when managers

empIoyees seek the required approvals ・昨er they spend the money in order to speed up

process; that is, they are said to ac担rsちapOfog[ze庇er.

Negative attitudes

Management controIs can also cause negative attitudes, includingjob tension, COnflict, frustr
tion and resistance. Such attitudes are important not only because they are indicatorsl
empIoyee welfare, but also because they are often coincident with other behaviors that cant
harmful, SuCh as gameplaying, lack of e鮒ort, absenteeism and tumover・

The causes of negative attitudes are complex・ They may be precipitated by a large number(

factors such as economic conditions, PerSOnal di綿culties, Or administrative procedures, Whi{

can be cumulative, aS SuggeSted by a recent survey of more than 3’OOO board members’eXe{し

tives, and managers across 36 countries, indicating that ``cumulative pressures’’have se∈

empIoyees engage in accelerating the recording of revenues to meet short-tem financial t&
gets; under-rePOrting costs; and pushing customers to buy unnecessary stock to meet shortte
sales targets. John Smart, Partner and U.K. head of EY,s Fraud Investigation team’Said: “T

incentives for unethical conduct can be strong given the pressure on pay packets, job secu
and demand to deliver growth. At the same time, a focus on cutting costs can also weakent
systems and teams in place to prevent and detect these actions.,・23
 lndirect costs

Negative Attitudes Produced by Results ControIs

Results controIs can pro血ce negative attitudes. One cause of negative attitudes arises from a

lack of empIoyee commitment to the performance targets defined in the results-COntrOI sys-
tem. Most empIoyees are not committed to faI官e亡S they consider too di鯖cult, nOt meaningful,

not controllable, Or imprudent (and, Of course, illegal or unethical)" In the case of a tight
results-COntrOI system at UPS, for example, COmmitment sometimes was Iow because the tar-
gets were too di綿cult, CauSing empIoyees (e.g. delivery drivers, Pilots) to feel too pressured.
The company avoided major labor problems apparently because it provided generous sala-
ries. However, a gradual shift by UPS toward more part-time empIoyment and subcontracting
OVer time has triggered strikes protracted in time across di任erent locations amid ongoing

negotiations.24
Negative attitudes may also stem from problems in the measlげemen亡SyStem. It is common

for managers to complain that their performance evaluations are not fair because they are
being held accountable for things over which they have little or no control. (We discuss this
issue in more detail in Chapter 12.) Other potential causes ofnegative attitudes maybe asso-
ciated with the rewards (or punishments) associated with the MCS. Rewards that are per-
ceived as inequitable, and perhaps most forms of punishment, tend to produce negative
attitudes. Even the target-Setting and evaluation processes themselves may produce nega-
tive attitudes, Particularly when they are implemented with people-insensitive, nOn-
supportive leadership styles. Allowing empIoyees to participate in setting their targets often
reduces negative feelings toward results-Oriented controI systems. (We discuss this further
in Chapter 8.)
The collection of factors a節ecting attitudes is complex. Some evidence suggests that poor

Performers may react more negatively to better controI systems because the limitations in their
abilities are easier to discover. More critical, however, are SyStem皿aws that could cause nega-

tive attitudes in good performers. Attitudes are important MCS outcomes to monitor not only
because they have their own value as indicators ofempIoyee we塩re, but also because the pres-

ence of these negative attitudes may indicate the propensity to engage in any of a number of
hamful behaviors, SuCh as data manipulation or other forms of gamesmanship, Withdrawal, Or
even sabotage.

Negative Attitudes Produced by Action Controis

Most people, Particularly professionals, reaCt negatively to the use of action controIs. Preac-
tion reviews can be particularly frustrating if the empIoyees being reviewed do not perceive
the reviews as serving a useful purpose. For example, the European investment banking
business at Bank ofAmerica Merrill Lynch was Iocked in a dash as former Merrill Lynch
managers and Bank ofAmerica’s top executives argued over how the business should be run.

At stake was whether the combined investment business would use the Merri11 Lynch-Style
decentralized model or Bank of America’s centralized “command-and-COntrOl’’model. Spe-

cifically, attemPtS by global banking head Brian Moynihan from Bank of America to remove
individual managers’power to rule on matters such as staffcompensation and to impose the

Bank ofAmerica model on Merri11 Lynch caused widespread dissent. Prior to the takeover by
Bank ofAmerica, Merrill Lynch’s investment banking business in Europe was largely left to

run itself. One London-based former Merrill Lynch manager said: “Moynihan’s view is `we’ll

do it the Bank ofAmerica way and no other,’even though that got them nowhere in Euro-

Pean investment banking for the past five years, Whereas the Merrill Lynch model, Which
delegated a lot of authority, has proven very successful over the past lO years・,, The spat led

to the resignations ofmore than 40 senior managing directors in London and NewYork, With
more expected.25

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Chapter 5. Controi System Costs

At 7竜Ieven, the global convenience store chain, SOme managerS described the action con.

troIs in use言n the Japanese locations as ``draconian.’’The company’s point-Ofsale computer

SyStem, Which registers every sale at each store location, is used to monitor how much time
each manager uses the analytical tooIs built into the cash register system. Stores are ranked
by how often their operators use the system, and if they are not using it “enough;’the store

managers are told to “shape up.’’One manager complained: “Sometimes I don’t know who’s

really running the store. It・s like being under 24-hour surveillance; it,s like being enslaved.”26

Even though 7-Eleven Japan has been called =the world・s best-run COnVenience store chain,,,27

e任orts to import the computer-focused action controI system to stores in the United States

met with stiff resistance because it “goes against American workers’desire for independ-

ence:・28 Moreover, although employee-mOnitoring software (some call it ・・spyware,,) may

PrOVide what seems useful information, it may undermine empIoyee morale and mutual
trust. “Ifyou have to check up on empIoyees all the time, then you probably have bigger issues

than just productivity,’’notes peter Cheese, managing director of Accenture’s talent and

organization practice.29

Adaptation costs

In addition to direct and indirect costs, further costs related to running effective MCSs may
arise from the need to adapt MCSs to the context in which theyoperate, Which is particularly
Pertinent when operating multinationally, and which we will use as the case in point here.
But adaptation costs are also incurred when firms adapt their MCSs across different strategic
bl上Siness I元証s (SBUs) or across di任erent business or product/SerVice lines because these

have adopted di任erent business unit or competitive strategies. Regardless, adaptations to

local circumstances can be costly, and丘rms may prefer to standardize their systems rather

than to adapt them.30 However, nOt adapting them may render the MCSs less effective and
trigger indirect costs like those we discussed above, for a number ofreasons that we discu§S

in this section.
Adapting MCSs is particularly challenging in multinational environments. Managers of mul-
tinational organizations (MNOs) almost invariably face high垂句rmatioれaSy肌me[ry between

亡hemselves and personnel in the foreign locations. The foreign persomel have specialized

knowledge about their environments (such as about local norms, taSteS, regulations, and busi-
ness risks). The information asymmetry limits the corporate managers’abilities to use action

COntrOIs, SuCh as preaction reviews, because the corporate managers have limited knowledge to
make the needed judgments. MNO managers also face the barriers of distance, time zones, and
language, Which limit the use of direct monitoring. They camot easily visit their foreign-based
Subordinates, although advances in technology have made virtual communications easier. On
top of that, they must deal with the significant problem of measuring performance in multiple
CurrenCies. All this carries extra costs - COStS Of operating and adapting the controI systems in a
multinational environment,
MNOs must understand how they must adapt their management practices, induding manage-
ment controI practices, tO make them work in each of their intemationa1 1ocations. MNOs have
Similarities with large domestic organizations in that they are usually characterized by a high
degree of decentralized decision-making and by management control through丘nancial results

COntrOIs. That said, COntrOlling MNOs is often more di飴cult than controlling domestic organiza-

tions because MNOs face a multidimensional organizational problem: they are organized not only
by function and/Or PrOduct line, but also by geography. Geographic spread requires managers to

182
 Adaptation costs

be sensitive to each ofthe national cultures in which they operate and to appreciate diiferent insti葛

tutional settings and local klSiness e宣rVironments.

Nationai culture

Some of the e任ects, benefits, and costs of management controIs are universal because, at a Cer-

tain basic level, PeOPle in all countries have similar physioIogical needs and desires, Say, for
achievement and financial security. Despite such similarities in people around the world, there
are also many di任erences. One important set of factors with potentially important influences on

MCSs can be explained under the rubric of庇doれC庇u血re・31 National culture has been defined

as ``the collective programming of the mind that distinguishes the members of one group or
society from another.,,32 As such, the national culture concept essentia11y recognizes that peo-
Ple’s tastes, nOrmS, Values, SOCial attitudes, PerSOnal priorities, and responses to interpersonal
Stimuli vary across nations. The notion of these di維ITenCeS is quite powerfully expressed in the

following quote:

“The biggest d冊erence between China and Western countries is that we pursue the goal of

getting rich together,” Fu Chengyu, head of the country’s iargest refiner, tOId reporters, “It
doesn’t make sense to benchmark Chinese executives against Western - and especia=y

American - eXeCutives,’’said Kjeld Erik Brodsgaard, director of Asia research at the

Copenhagen Business Schoo看, ’`They stay in China and move around as civiI servants. In a

Chinese context they are supermanagers〇・,33

An important factor that contributes to the e任ectiveness of MCSs is whether the empIoyees

PerCeive them as cl克ura砂approprlC[亡e; that is, Whether they suit the shared values maintained
by the society in which they operate. When groups of empIoyees perceive things di鮒erently, Or

react to things di任drently, different controI choices may have to be made.

Several taxonomies of national culture have been proposed. The most widely cited taxon-
Omy COnSists ofthe four cultural dimensions identified in a study by Geert Hofstede: individual-
ism, POWer distance, unCertainty avoidance, and masculinity. The Zndil,td関亜s肌(vs.

COllectivism) dimension of national culture relates to individuals’self-COnCePt; that is, Whether

individuals see themselves primarily as an individual or as part of a group. This affects people’s

COmfort levels with selfinterests, their preferences for con飢ct resolution, and their attitudes

toward interpersonal relationships. The power宙stcmce dimension refers to the extent to which

PeOPle accept that institutional or organizational power is distributed unequally. Individuals

Who score high on肌Cer亡atrlty CZγ0[dαnCe feel uncomfortable when the situation they face is

ambiguous. The mascl届申y dimension relates to the preference for achievement, aSSertive-

ness, and material success (traits labeled masculine), aS OPPOSed to an emphasis on relation-
ships, mOdesty, and the quality of life traits labeled feminine).34
Hofstede showed that people from di任erent countries vary considerably on these cultural

dimensions. For example, the US culture is much more individualistic and more masculine,
while the Taiwanese culture is higher in both power distance and uncertainty avoidance.35 If
that is true, then each ofthe cultural dimensions can be said to have MCS implications. Tb name
just one implication, emPIoyees high in individualism are possibly more likely to prefer indi-
vidual rather than group-Oriented work arrangements, Perfomance evaluations, and pay.36
But these four dimensions do not explain all aspects of national culture and their di任erences

across countries. For example, One aSPeCt Of cross-Cultural differences not directly picked up by
any ofthe four Hofstede dimensions relates to corporate goals. Managers in some countries, Par-
ticularlythose in Asia, are Often more concemed with the interests ofnon-OWner grOuPS than are
US managers.37 Tb illustrate, Jack Ma of China,s Alibaba emphatically noted that he had said on

183
Chapter 5. ControI System Costs

numerous occasions that he will put “customers first, emPIoyees second, and shareholders th正

even though心e “Can See that investors who hear this for the first time may find it a bit hard

understand.嘩M秘lagerS running a business for the benefit of many s融ehoZders’and not pl

marily its s庇reho腹ers, Will make different decisions. With regards to MCS design’they are like

to choose, Or reSPOnd better to, different performance measures (e.g. empIoyee safety) and us
di飾erent ways of rewarding empIoyees (e.g. job security and empIoyee benefits).

Loca=nstitutions

Corporate govemance regulations, emPIoyment law, and contract law, aS Well as banking s)丁S

tems and govemance interventions, also vary significantly across nations. Just as with natioml
culture, SuCh institutional factors can influence both the design and eifects of an
MCS. For example, Organizations in countries with strong labor unions may宜nd it difficult t

PrOVide incentive pay as unions often prefer seniority-based pay systems"

One set of institutional factors with potentially important MCS implications consists of those
descriptive of the financial markets in various countries, their importance in raising capitaL
and the extent of disclosures and types of information they demand.39 The state of the capital
markets in various countries may affect the extent to which firms provide stock-based incen.
tives, SuCh as restricted stock or stock options. Where capital markets are less e綿cient and/OI

where trading is thin, StOCk market valuations are less likely to reflect fim value adequately
rendering stock-based incentives impotent. The quality of the required disdosures of (finan.
cial) information by publidy traded firms also varies across co皿tries, in part because of di借er

ences in the organization and regulation of their auditing. Just as poor stock valuations ma)l
hamper the use of stock-based incentives, SO may POOr eamings quality a任ect the use of

accounting-based incentives by the parent company for incentive purposes of its managers in
some of its foreign entities. The strength of regulation, auditing, and enforcement also may
affect managers, abilities and propensities to engage in eamings management. Not all countries
require the reporting of quarterly financial performance, Which may affect managers’

focus on short-term financial performance and, hence, their propensity to engage in myopic
decision-making.

D田erences in locai business environments

Business environments also d描er signi丘cantly across countries. Elements of these environ・

ments can a任ect environmental uncertainty, inflation, and the availability of qualified person・

nel. Each ofthese factors, and many others in this realm, has MCS implications.

Uncertainty
Co肌亡ry-坤eCi柾eJlviroJlme庇‘九皿cer亡air均′ Can be caused by many things・ Some countries are

inherently riskier places in which to do business. Military conflicts’kidnappings’terrOrism’and

extortion threats can create major security problems. Some countries are also prone to corpo-
rate espionage and theft of corporate secrets by local competitors, Perhaps even with the tacit
consent of the host govemment. Risk also di任ers across countries because of the stage of eco-

nomic development. As discussed, developing countries tend to have limited access to capital’

relatively poor accounting regulation and oversight’Weaker legal enforcement of contract vio-

lations, and other obstacles to doing business.

Goverrme面前tervendous also affect business risk. Govemments have, tO a greater Or lesser

extent, POWerS that enable them to serve certain ot)jectives. These powers can have major
effects on the value of companies’assets and the expected retums on those assets" For example,

govemments can exercise bureaucratic control in issuing business permits’COntrOlling prices’

and restricting currency flows. They can implement laws that restrict foreign firms’activities
 Adaptation costs
甘め・町中S e

and/Or favor domestic firms. They can design tax laws that redistribute income or affect the
value of monet型y COmPenSation and other reward arrangements. They can apply constraints

through labor policies.designed to reduce unempIoyment such as by rigid labor laws to restrict
lay〇倍s.

infIation

Inflation and fluctuations in in且ation, Which affect the relative values of currencies, Create

financial risk. Valued in terms ofa fixed currency, high inflation can cause a company’s assets or

an individual,s compensation to deteriorate significantly in value in a short period oftime.

Inflation, eSPeCially when severe, may require the adoption of some form of inflation
accounting, Which invoIves either the expressing of accounts and financial statements in
terms of real (rather than nominal) amounts or expressing all assets and liabilities at cur-
rent (or replacement) values. Or, When less severe, it may require the use ofsome form of
flexible budgeting, tO Shield managers from uncontrollable inflation risk’Or the partial

abandonment of accounting measures of performance in favor of some nonfinancial

meaSureS.

1tllent

Organizations operating in developing countries often face limited availability of skilled and
educated personnel. When empIoyees are not highly educated, decision-making structures are
usually more centralized, and MCSs tend to be more focused on action controIs rather than
results controIs. Small o鯖ces may contain only a few educated people. This makes it di飴cult to

implement one ofthe basic intemal controI principles: SeParation ofduties. All told’When talent

is in short supply, both the fim,s ability to do business and its capacity to affect good control are
more likely to be compromised.
Personnel mobility and retention also differ across countries, Which the following quote
nicely illustrates:

Japanese workers introduce themselves by their company name first and their own name
second, and are far more likeiy to define themseIves by whom they work for than by what
they do"丁his is true even in Japan,s most giobal companies" In the United States you are

always ・dating, the company; in Japan, emP-oyees ・marry・ their company.4O

When personnel mobility is Iow, there is less need for implementing long-term incentive plans
that motivate managers both to think long term and to stay with the firm to eam their
rewards.

Foreign cur「ency transIation

MNOs also face currency exchange and translation problems. At first glance, it is not obvious
that results controIs in MNOs should be complicated bythe fact that the firms, profits are earned
in multiple currencies. Results controIs over foreign entities can be implemented using the
same practices empIoyed in most domestic firms’by comparing performance measured in tems

of the local currency with a pre-Set Plan also expressed in the local currency. However’MNOs

bear economic risk caused by fluctuating currency values. The values of foreign investments
appreciate or depreciate based on the relative values of the home and foreign currencies.
Through their performance evaluation practices’MNOs can make their entity managers bear

this risk or can shield them from it. The issues invoIved are discussed further in Chapter 12
regarding uncontrollable factors" The extra measurement noise caused by uncontrollable for-
eign exchange risk, and various methods of measuring the gains and losses, Can affectjudg-
ments about the entity managers’performances.

185
Chapter 5. ControI System Costs

One could argue that entity managers who can influence the amount ofthe foreign exchange
gains蛸. losses should bear the foreign exchange risk. Some entity managers can take actions
that have foreign currency implications. Some have the authority to make signi丘cant crosi・

border investments, PrOduct sourcing, Or marketing decisions. Some have the authority to write

PurChasing or sales contracts denominated in one currency or another. Some even have the
authority to enter into foreign exchange transactions, SuCh as hedging, CurrenCy SWaPS, Or arb子

trage. But most of these specialized hedging transactions require special skills most opera[ing
managers do not have; thus, authority in this area commonly resides with the finance depart・

ment at COrPOrate.
If corporate managers decide that the managers of their foreign entities should not bear the
foreign exchange risk, they can instead use any of four essentially identical methods:

1 , Evaluate the manager in terms oflocal currency profits as compared to a local currencypla
Orbudget.

2. Treat the foreign exchange gain or loss as “below’’the income-Statement line for which th

manager is held accountable.

3, Evaluate the manager in terms of profits measured in home currency, but calculate a `鮎

eign exchange variance’’and treat it as uncontrollable.

4. Re-eXPreSS the home currency budget for the entity in local currency using the end-Ofyear,
not beginning-Of-year, eXChange rate or some average for the period. This procedure create
a budget that “且exes’’with exchange rates.

These are just some examples of the ways in which d描erent situational factors may requir

adjustments to the MCS, Which wi11 trigger adaptation costs and increase complexity. The5
costs should be outweighed by the benefits of“better’’control, however hard such is to estima(

because these bene缶ts also include the avoidance or mitigation of some dysfunctional sid

effects that may occur if the systems are not adapted.

Conciusion

The implementation of virtually all controIs, aS Well as their adaptation to Iocal or situation
Circumstances, requires companies to incur some direct, OuトOf-POCket costs. But sometime

those direct costs are dwarfed by the indirect costs caused by any of a number of hamful sid
e任ec亡s.

We can make four general observations about the occurrence of these side effects. Fir卵

丁able 5.1 summarizes, the harmful side e任ects are not unique to one form of controL Howeve

the risk of side effects seems to be smaller with personnel controIs. Second, SOme Of the contr
types have negative side e任ects that are largely unavoidable. It is di鯖cult’Or eVen impossible

for people to e可Oy following a strict set of procedures (action accountability) for a long perio

of time, although the negative attitudes can probably be minimized if the reasons for them a
well communicated and ifthe list is kept to a minimum. Third, the likelihood ofsevere hamf
side effects is greatest when there is either a failure to satisfy one or more ofthe desirable desig
criteria or a misfit between the choice of type(s) of control and the situation. Fourth, When co爪

troIs have design imperfections or when they are inappropriately used, the tighter the control
are applied, the greater are both the likelihood and the severity ofharmful side effects.
What makes dealing with these potential side eifects di縦cult is that there is not always

Simple one-tO-One relationship between the control type and the e任ect. The need to adapt MC

to di任erent situations across various business units, With different strategies or operating
 巾bie 5.1 ControI types and possibIe harmful side effects

臆__i暮臆 Behavjorai Gamesmanship Operating Negative

"

displacement deiays attitudes

Resuitscontrois X X X
Resultsaccountabiiity

Actioncontrois X X X X
Behavioralconstraints
Preactionreviews × X

Actionaccountab冊y X

Redundancy X

Personnei/cuituralcontrois X
Seiectionandpiacement
巾aining X

Provisionofnecessaryresources X X
Creationofastrong
OrganizationaIculture
Group-basedrewards

SouI℃e K A. Merchant. Modemル伯nagement ControISysfems 7畝t and Cases (Upper Saddle BlVer, NJ PrentlCe Hall, 1998)’P. 224

di鉦rent regions ofthe world, adds to the complexity. Moreover, the existence ofthe side e任ects

is often di鯖cult to detect. For example, a failure to make the measurement processes more

robust in a results- Or aCtion-aCCOuntability controI system only offas the appor亡肌dy for data

manipulation. ActuaZ manipulation may not occur until an empIoyee has a personal need for
more money; POOr Performance creates additional pressure to perform; there is a lower chance
ofbeing detected or caught; and/Or leadership creates a motivation to manipulate.41 That said’

the better organizations can a11eviate both the opportunity and motivation for undesired
behaviors, the more likely their controI systems will have predominantly desired e任ects and,

hence, 1ower costs.

Even costs can have庇dden or i繭rec亡bene斤ts. For example, managerS in diversified or multi-

national corporations are able to leam from potentially desirable practices used in their various
businesses or foreign countries. Those practices are known by empIoyees in their entities’and

some of those practices can be readily adapted across other entities. Fims that grow by acqulSl-
tion leam from the management systems, including MCSs’being used in the organizations they

acquire. When缶rms grow by acquisition’they are likely to have to use’at least for a period of

time, SeVeral variations ofMCSs. The MCS variations may persist ifthey are superior for control-
1ing the acquired businesses’eVen though it can be costly to maintain multiple sets ofMCSs.

1 20J2 Bndge血g,同reccIS血g, C[rld PZ伽m血g Survey Quantrix, and other work by John Roberts and co11eagues. See also
2012), p. 1与. W. A. Van der Stede, “The Pitfalls of Pay-for-Performance,’’

2 i`CFO Insights: Can Intemal Audit Be a Command Center Fincmce & MrlC[geme柾(December 2007), PP. 1O-13; W A.

for Ri§k?,,, Def証でe (2014), Online at deloi.tt/1OidCMB. Van der Stede, “Designing Effective Reward Systems,’’

3 ‘‘Banks Increase Efforts to Stay on Right Side ofLaw,” The F王rtcmce & MuJIC[geme頂(October 2OO9), PP. 6-9.

軸肌cfa冊mes (September 28, 2014), Online at on.ft. 6 ``I Built This Company, I Can Save It,’’Fo「他rle (Apri1 3O,

COm/ 1 hNpwWl. 2001).

41bid. 7 This examp獲e is taken from J・ Pfeifer and R. Sutton,耽rd

5 This problem is also known as m庇血s妬ng - See J. Roberts’ F(lCtS, Dangerous Ha折T血ths cIrld Tb融州orlSerlSe (Boston,

丑e財oderrlFirm (NewYbrk: Oxford University Press, 2004), MA: Harvard Business SchooI Press, 20O6), P. 12O.

187
Chapter 5. ControI System Costs No(

8 G. Smith, Why JL(舞GoZdmcm ScIC九s: A靴批Stree亡Sfo7γ 28 ``power Struggle at BofA Merrill Lynch,’’op. cit.

(New York: Grand Central Publishing, 2012). 29 “Big BrotherBosses;’耽eEcono扉st (September lO, 2009),
9 “I BuiltThis Company, I CaヰSave It,’’op. cit. PP. 71-2. See also ``Monitoring the Monitors:’T71e W謝
10 `Uust Think: No Permission Neeaed,,, fort硯e (January 8, Sけee[JourmZ (August 16, 201O), Online at online.w可.com.

2001), pP. 190-2.
11 “Business Costs Itself Billions in Intemal Red嶋pe,’’ABC
(October 28, 2014), Online at www.abc.net.au/
news/2014-10-29/business-COStS-itse14billions-in-inter-
nal-red-taPe/5849994.
12 `'eans Therapy: Levi’s Factory Workers Are Assigned to
漢でams, and Morale Takes a Hit,’’TJle WaZ! Streef Jo工Jr71aZ
(May20, 1998), PAl.
13 See W. A. Van der Stede, “The Relationship between Two
Consequences of Budget ControIs: Budgetary Slack Crea-
tion and Managerial Short十℃rm Orientation,’’Acco肌で証g, 32
30 See W. Van der Stede, “The Effect ofNational Culture on
Management Control and Incentive System Design in
Multi-Business Firms: Evidence of Intra-Corporate Iso-
morphism,’’E【IrOPeCm Acco肌亡ing Revfew, 12, nO. 2
(2003), pp. 263-8与.
31 National culture has been deemed an important factor in
SeVera獲literatures, including finance - See, for example,
1t was th重
C. S. Eun, L. Wang and S. C. Xiao, “Culture and R2;’Jour-
Phoeni主も閤
mZ qfFinc肌C証Economics, 115, nO. 2 (February 2O15),
brbke重a謹言
pp. 283-303,
G. Hofstede, C融ure七CorlSequertCeS二hltermtio朋Z D娩r- econferen(

Ongc融zc誼OrlS aJtd Society, 25, nO. 6 (August 2000).
14 For various manifestations of such practices, See, for
example, M. Jones, Creative Accol川面g, Fraud肌d血ter-
mtZomZ Acco肌亡frIg ScarIdaZs (Chichester, UK: Wiley,
2010). See also I. Dichev, J. Graham, C. R. Harvey, and S.
Rajgopal, “The Misrepresentation of Eamings:’瑞mrlC融
ArlatyS亡Jour朋Z, 72, nO. 1 (2016), PP. 22-35, aS Well as 33
ences in M)rk-Re庇ed l届ues (Beverly Hi11s, CA: Sage Publi- again his t'
Cations, 1980), P. 25; G. Hofstede, C血ureもCouseqlJerlCeS: Cific produ
Compartng Vi血e$ Beha高oJちJrlS亡血tわrlS伽d OJga血n犯亡ious Sales budg
Across Na亡fous (Thousand Oaks, CA: Sage Publications,
Side produ
2OOl). See also www.geerthofstede.nl/dimensions-Of-
lnSuranCe
nationa」Cultures @ccessed December 2015).
``China’s state sector Leaders Embrace Pay Cuts of Up to PrlOr mOnt

Other work by these authors on this issue. 6O%,’’The瑞narlCiaZ nmes (October 12, 2014), Online at ing equlty
15 See, for example, M. Nels()n, J. Elliott, and R. Tarpley, On.ft.com/1fBoBqu. Parent宜rIl
`くHow Are Eamings Managed? Examples from Auditors,’’ 34
Hofstede, Cl庇【JrC烏Consequerzces:血ter71C証o朋Z D搬r- earlier; ar
Acco【mで説g Hor竜;Ous, 17 (Supplement 20O3), PP. 17--35. e競ces, Op. Ci亡.
balance of
16 ``Fu11 Disdosure;’Fbrbes (Apri獲, 2002), PP. 36-8.
number of
17 “Lega宣, but Lousy,’’for如le (September 2, 2002), P. 192.
had been s
18 “IBM Uses Dutch Tbx Haven to Boost Profits as Sales Slide,’’ M. Shields, and A. Wu, “The Importance of National Cuし
increased.
BZoo桝beγg (Febmary 3, 2014), Online at bloom.bg/1iVouId, ture in the Design of and Preference for Management
19 “Tesco’s Accounting Problems Not So Funny,’’棚e EcorIO- ControIs for Multinationa量Operations,’’Accour血ng, able to jusl
mZs亡(September 27, 2014), Online at econ.st/1qxwvPw. Onga扉2;atforlS C[rld Socteり′, 24, nO. 5/6 (July-August the丘rm ha
20 H. Co11ingwood, ``The Earnings Game: Everyone Plays, 1999), PP. 441-61; and E. P. Jansen, K. Merchant, and W. Phil be!
Nobody Wins,’’HclrVa「d Bl⊥S[JleSS RevZe明79, nO, 6 (June Van der Stede, ``National Differences in Incentive Com- first job w{
2001), pp.与-13. PenSation Practices: The Differing Roles of Financial Per- man. He s「
21 “Sunrise Scam Throws Light on Incentive Pay Programs,’’ formance Measurement in the United States and the
tWO yearS,
The LosAJlgeZes n机es (January 15, 1996), P. Dl. Netherlands,” Acco肌血g, O7gar高za肩orlS CmCZ Society, 34,
22 “In the Driver’s Seat at Tbyota: U.S. Execs Get more Inde-
the opport
no. 1 Uanuary2OO9), PP. 58葛84.
See, for example, “Shareho獲ders vs. Stakeholders: A New ents, Phil l
丁he LosArlgeZes Tfmes (October 19, 20O4), P. Cl. Idolatry,”柵e EcorlOmisr (Apri1 24, 201O), PP. 65-6. for宜nanci
23 ``Squeezed U.K. EmpIoyees under Increasing Pressure to 38 “Dear Investors: Letter from Jack Ma as A獲ibaba Prepare§ that woul〔
Commit Fraud,” Ernsf &拘棚g (May 7, 2013), Online at Roadshow:’棚e F玩αnC融Hmes (September 5, 2014), Just five m
WWW.ey.COm/UK/en/Newsroom/News-releases/ 1 3 - O5 - O7- Online at on.ft.com/1.IATJ7z.
in the brok
& Co. Al亡h
COmmit-fraud. POrate Reporting Regulation: How Jurisdictions Differ
WOrking vI
24 See, for example, “UPS Pilots Union Ca11s for Strike Vote,’’ and Why,’’Acco血dng硯d軌S高leSS ReseclrCh, 40, nO. 3
丁71e W拙Stree亡JourrlaZ (September 9, 2015), Online at on. (Special Issue, 201O), PP. 229-56.
the job we
Wミj.com/1hXhnli. 40 “Insiders and Outsiders;’The Economfs亡(November 18, turned oul
25 “Power Struggle at BofA Merrill Lynch,’’Marke亡Wa亡c九 2010), pp. 7-9. as a hard-V
(Apri1 19, 2009), Online at www.marke亡WatCh.com. 41 B. Litzky, K. Eddleston, and D. Kidder, “The Good, the and an etI
26 “7-Eleven Operators Resist System to Monitor Managers;’ Bad, and the Misguided: How Managers Inadvertently
his career;
耽e l晩Z【 S亡reetJourrIaZ (June 16, 1997), P. Bl, Encourage Deviant Behaviors,’’The Academy QfM伽αge-
him. He dj
27 A. Ishikawa and T. N匂O, 77ze SzJCCeSS Qf7LEleven Japa批 me7近Per坤ec肩ves, 20, nO. 1 (February 2006), PP. 91-103,
that his jot
Discovering誼e Secrets Qfthe Wo「l蛮BesトRlm CorlVeJ亮eIICe

Sfore C庇血(Singapore: World Scientific, 20O2). wondered

Phil sta
largest firr
 C飽SE STUDY
P佃p Anderson
Itwas three days to month end. Philip Anderson’the
Phoenix branch manager of Stuart & Co., the largest
brokerage firm in town, WaS dreading the monthly tel-
econference meeting with his bosses in NewYork. Once
again his team had failed to deliver on some of the spe-
cificproduct sales targets set for them in the company’s
sales budget. Specifica11y, the ratio of in-house to out-
side product sales of items such as mutual funds and
insurance product offerings had not improved from the
prior month亘is team had not been successful in push-
ing equity issues syndicated or underwritten by the
parent firm to the levels set by his boss a few months
earlier; and his team had not increased the overall
balance of margin accounts. On the positive side’the
number ofmargin accounts had increased’neW Clients
had been signed up, and overall branch revenues had
increased. But Phil questioned how long he would be
able to ju§tify not meeting some of the specific targets
血e fim had given his branch.
Phil began his sales career right after college. His
firstjob was with a cereal producer, aS an inside sales-
man. He switched to the brokerage business after just
two years, lured by the potential for higher income and
the opportunity to have direct contact with retail cli-
ents. phil was an outgoing individual who had a talent
for financial matters, and he looked forward to a job
血at would allow him to interact with clients directly,
Just five months ago, Phil had celebrated his 30th year
in the brokerage industry and his 21st year with Stuart
姓0. Although he truly ertjoyed being a manager and
working with his team, SOme Of the other demands of
血ejob were beginning to wear on him. Things had not
turned out as he had expected. Phil thought of himself
a§ a hard-WOrking and loyal empIoyee, a gOOd manager,
and an ethical businessman. The “compromises’’that
his career seemed to demand were beginning to trouble
him. He did not consider himself a saint, and he knew
d融hisjob required balancing conflicting goals, but he
ondered how far he could bend without breaking.
Phil started his brokerage career with one of the
largest firms in the industry. He moved to Stuart & Co.,
then a boutique firm, in the hope of breaking free from
the high-PreSSure Sales-Oriented attitude prevalent in
the industry. He thought that the perception that the
large firms tried to perpetuate - that their advisors are
experts at providing unbiased financial advice - is for
the most part wrong. Phi=earned firsthand that bro-
kers are paid, first and foremost’tO Sell products and
services. Meeting the financial needs of their dients
WaS nOt ParamOunt.
Stuart & Co. seemed to be di縦:rent. It was a firm
that emphasized the development of long-term dient
relationships based upon rendering expert independ-
ent financial advice. Its investment advisors were to be
trusted counselors to dients on all financial matters.
But Phil was also lured by Stuart,s compensation pack-
age, Which included a relatively large fixed salary and a
bonus based upon overall branch revenues’grOWth in
the number of ties or relationships (宜nancial, insur-
ance, investment) developed with each customer, and
the number ofbusiness referrals to other branches.
However, things had changed since he had joined
the firm. As the investment and analysis units
expanded, the demand on the branch managers to push
spec誼c products began to be incorporated into their
annual sales budgets. Phil felt that those changes had
compromised his ability to deliver investment options
suited to his clients,丘nancial situations. They risked
the many long-term relationships with dients that he
had worked hard to develop and created ethical dilem-
mas for him and his sta鱒i Phil felt that pursuing some
of the new budget goals could result in future financial
losses for some ofhis clients. However, Phil had worked
in the brokerage industry and at Stuart & Co. long
enough to knowthat it was dangerous to openly express
those concems to his boss. Additionally, Phil was trou-
bled with the recent scandals in the industry. It was
mostly low-1evel empIoyees like him who were the
ot)ject of criminal prosecution, nOt the top executives.
As Phil saw it, his job was to develop and nurture
profitable relationships with as many clients as possi-
ble, and the specific products and services sold to
189
Chapter 5. Controi System Cos亡s
Clients should be dictated by the needs of those clients.
Consequently, he could neyer bring himself to pushing
his team to adhere to the fiロn directives, and this
approach had negatively impacted his total compensa-
tion in the last few years. Invariably, his amual bonus
lagged behind those of other managers at Stuart & Co.,
even though his branch was one of the largest in the
缶rm in terms of clients, Sales volume, and net profits.
Phil felt his current situation was unfair. He also was
beginning to worry that his failure to meet specific
PrOduct sales targets was eroding whatever measure of
job safety his overall results had given him. To com-
POund the situation, Stuart & Co. had recently been
bought by one of the largest brokerage firms in the
COuntry, and it seemed that the new hierarchy did not
take well to independent-minded managers like Phil
Who did not aggressively pursue the objectives set out
by corporate.
Phil was getting tired of the game but could not see
how he could avoid playing it. He was almost 54 years
Old and was the sole provider for his family. His wife
had retired a year before from her teachingjob to take
CASE S丁UDY
Sunshine Fashion二Fraud, Theft, and Misbehavior among Emp看oyees
Shenzhen-based Sunshine Fashion was a Sino-Japanese
Venture that had grown from merely an OEM export
manufacturer of cashmere sweaters to also a retailer
With a chain of 220 retail points across China in 201O.
In order to manage its retail operation, it had set up
regional as well as branch o鯖ces to handle stock as
Well as support and monitor its retail points. Nonethe-
less, fraudulent behavior among empIoyees had cost the
retail chain almost 5% of its domestic sales revenues.
The implementation of an ERP system for tracking
goods and sales had improved the situation somewhat.
What were the cha11enges that Sunshine faced in trying
to control fraudulent behavior among its staff? What
190
Care Of their three teenage sons. They had just recently
bought a 4,000-Square-foot home in an exclusive neigh.
borhood of Scottsdale. And last fall, Phil had ful創1ed a
COllege dream by buying for himself a brand-neW red
Corvette. Phil feared that if he allowed his team of
advisors to continue focusing on meeting their clients’
needs with little regard for corporate targets, mOre
than his discretionary compensation would be at risk.
Phil had many questions and doubts, and few
answers. Was he right in allowing his clients’financial
goals to take precedence over his own family’s financial
SeCurity? Was he being unreasonable, naive, Or imprac.
tical? Was there somewhere a proper balance? Wa§ he
being too ethical at a time when his family’s future
Should be his primary concem? Or perhaps it was time
for him to find another empIoyer that shared Phil’s phi.
1osophy, if one existed in the brokerage industry? But
COuld he find another good job at his age? Or should he
even bother? After all, he had done his part. Maybeil
Should be the job of some younger managers to cham.
Pion the cause of service to clients and continue the
battle.
additional measures should the management under.
take, and how should the remedial measures be imple.
mented to achieve its target?
Company background
Shenzhen-based Sunshine Fashion Co, Ltd. was a Sino-
JapaneseJOmt Venture founded in 1993. It started out as
an oEMl export manufacturer of cashmere sweaters and
eventua11y grew to become an integrated manufacturer
and retailer with activities that included material sourc.
ing, SPinning, dyeing, design, distribution, marketing,
and retailing. By 2010, it had three factories, located in
shenzhen, Shanghai, and Taiyuan of Shanxi province;
220 sales counters in departmental stQreS aCrOSS the
ountry; and a workforce of more than l,OOO empIoyees.
sunshine produced some 300’000 pieces a year for
ome§tic sales, Which eI可oyed a considerably higher
roft margin than its export business. With a tumover of
B 150 million, domestic sales made up more than two-
irds of Sunshine,s business. Sunshine was positioned as
high-end fashion brand in the domestic market with
esignbeing the leading factor in detemining the sales of
s goods. At RMB 3’000 apiece,2 sunshine,s cashmere
eater§ Were COnSidered a luxurious item in China.3
we are concemed with the price at which we se11’nOt how
many garments we sell. Volume is nothing for us. Ifwe sell
alotofgarments but at a very low price’there is no profit.
K子的′ LらSa上es Mαnαger qfS直れ弱れe
since the customers of Sunshine were fashion conscious,
thevalue of out-Ofseason items could fall to as Iow as
one-third of their original price. Sunshine,s vertically
integrated organization gave it a competitive edge over its
competitors.一t could complete the product cycle from
design to distribution within 20 days’aS COmPared with
the three months it took for its major compe血or Edor.
The operation
sunshine,s 220 retail counters in departmental stores
across the country were managed by 14 branch o鯖ces
that reported to three regional offices in Be卸ng, Chong-
qing, and Nanjing. The three regional o飴ces were all
former branch o鯖ces promoted to regional o飴ces"
Before the head o鯖ce contro11ed almost everything’the
price, the quantity’Which branch office was to be allocated
howmuch goods … These decisions and coordination was
concentrated with one person. With three regional compa-
niesJthe work] can be separated and it reduces the load
On this one person.
K拒y LらSα】es財伽age「 q手S直れs航e
sunshine had franchised some retail points outside of
the mgivr cities but remained cautious about expand-
ing its franchise network out of concem for operational
control and brand integrity.
oEM stands for original equlPment manufacturer. It refers to manu-
racturer§ who produce products for another ⊂OmPany that wlll be
retailed under the brand name of that company.
‥ RMB 3,000 = US$451.35 at an exchange rate of$USl = RMB 6.65.
3 chlna’s natlOnal average GDP per capita of 20O7 was RMB 18’665・
Iiource: StatlStlCal Communiqu6 of the People,s Republic’February
28,2008.)
Stock
At the beginning of each season’Sunshine,s head o鯖ce
would prepare the stock, tagging each item with bar-
codes with prices’and send it to the branch o飴ces. The
branch offices were responSible for distributing the
sweaters to the 220 retail counters and for replenishing
the stock at each counter throughout the season. The
head o飴ce sent the goods to the branch offices by air
and sometimes also by courier・ Roughly 3% of the
goods was Iost during transportation. At the end of
each season, the branch o鯖ces were required to retum
al1 1eftover stock to the head o鯖ce and they would be
refunded the cost of the returned goods. Over a two
month period each year the head o飴ce would put ten
people to work’COunting and inspecting the retumed
items, rePaCkaging them, and changing the barcodes to
a new price if necessary ready for sale in the following
season (see Exhibit l).
Sa看es
The branch o鯖ces and retail points reported informa-
tion about stock and sales to the head o鯖ce manually
until 1998 when Sunshine implemented an RFID/ERP
system・ The system networked the branch o綿ces and
head o鯖ce together, and this allowed the head o鯖ce to
receive updates on sales at all the retail points every
four hours. Sunshine,s RFID/ERP system also stored
infomation about inventory at the branch o飴ces and
retail counters, but the information had to be input
manually by sta任・
丁heft and fraud by empIoyees
In 2008, Sunshine faced serious fraud and misbehavior
problems by empIoyees with estimated losses of
between RMB 9.3 million and RMB IO.5 million’tranS-
lating to more than 5% of Sunshine’s total domestic
sales. Although Sunshine,s RFID/ERP system provided
the head o飴ce with an updated point-OfLsales situation
every four hours’managerS Who wanted to cheat took
advantage of the head o鯖ce’s inability to control dis-
counts and stock at the local level. Sunshine,s head
o飴ce was responsible for setting the price and deter-
mining promotional time frames but these time frames
were not necessarily followed by all the branch manag-
ers, Some branch managers postponed the start date of
the promotional period without informing the head
office so they could sell sweaters at the original price
and pocketed the difference between the sale price and
191
Chapter 5. ControI System Costs
the discounted price, Which was remitted to the head
O飴ce. Other branch manage撃rePOrted a higher dis-
COunt rate tO the head office than叫lat WaS aCtually the
CaSe and pocketed the difference. The situation was
further complicated by the fact that the market situa-
tion varied widely across China, and each department
StOre had its own policy with regard to the timing of
Sales promotions.
It depends on the different department stores. They each
have different sales and celebrations and other things.
It’s hard to con亡rOl from the head o鯖ce, they are far away
from the o鯖ce.
K高!y克SaZes MαrZage「 qfS肌S厨ne
Sunshine had no choice but to allow some autonomy for
decisions over promotions and discount rates at the
loca=evel’a PraCtice that increased the risk of manag-
ers engaging in fraudulent behavior. The branch o飴ces
also engaged in a small amount ofcash sales and there
WaS nO Way for the head office to controI such sales. The
branch managers had total discretion over how much
discount they wanted to give in such instances.
Fraudulent behavior was also encouraged by the fact
that Sunshine had no mechanism in place to controI
StOCk at the loca=evel. While the head o鯖ce knew how
many pieces it sent out to each branch o綿ce at the begin-
ning ofthe season, it had no information on how many of
those pieces were at the branch o鯖ce and how many had
been distributed to each retail point at any moment in
time. The branch o航ce sent pieces to the retail points
almost every day depending on their needs. This made it
di飴cult for the head o鯖ce to controI promotions.
To check the stock before each promotion is impossible.
The promotion each time depends on the different holi-
days and the policy of each departmental store … It’s hard
to take stock before each promotion. We only control the
inventory.
臓t少LらSo!es MaれOger qfS此れs見とれe
Sunshine’s ERP system could not update stock informa-
tion automatica11y. It stored stock information, but tha亡
information had to be inputted and updated manually.
This meant that staff could input the stock information
Only after a promotion started, giving them an opportu-
nity to sell the sweaters at the original price and pocket
the difference. Loss arising from such misbehavior was
estimated to cost Sunshine RMB 3 million.
While barcoding the sweaters helped Sunshine to
track its products言t had found that the barcodes of
SOme Of the sweaters had been changed, Which altered
the price upward by as much as 50% when the unsold
192
goods were retumed to the head o鯖ce at the end ofthe
For example, given two garments priced at l,000 yuan
and 50O yuan, reSPeCtively, the salesman might sell one
Piece of l,000 yuan, and retum 500 yuan piece to the head
O鯖ce at the end ofthe season. The head o鯖ce knows that
the sa宣esman has l,000 yuan eaming. But, ifthe salesman
Changes the barcode ofthe 500 yuan garment to the l,000
yuan barcode, then on retuming the garment and barcode
to the head o飴ce, the head office thinks that the salesman
has only 50O yuan earning (cash). When auditing at the
end of the season, the total quantity is not less, but the
amount di任erence who knows?
Every year we have a big quantity and amount of sale,
and the price changes all the time (because of festival§,
Shop anniversary, discount season …) it’s a huge workload
to check everybarcode, Or the boss thinks that is it worth
to do so? It’s anotherbigcost..,
K【rO′均Sα工es財a7調ger qfS直れ届彫
Loss due to changed barcodes was estimated at RMB
l.5 mi11ion. Sunshine’s accounting department visited
the branch o鯖ces once or twice a year during the sales
SeaSOn tO Check their stock and their accounts, and the
head o鯖ce also arranged random visits to the retail
COunterS, but to little avail.
Another misbehavior that Sunshine encountered
WaS managerS Who used the relationship they built up
With departmental stores as Sunshine managers to se11
their own goods or brands,
… these managers, they use their own relationship wi〔h
the department store manager to begin their own brand
and business. Maybe they give money to the manager
every year, but this money is from Sunshine, yOu know, SO
they use the company’s money to set up their own relation.
Ship. That’s the problem.
K珪砂Li, SαIes Manager qfS肌sh耽
Tb counter such misbehavior, the president of Sunshine
regularly visited department stores with Sunshine
retail counters around the country to reinforce the
Sunshine brand and to build up a personal relationship
With the department stores himself.
We don’t want the branch managers to get too dose to one
StOre manager. Once they have good relationship [with
the departmental store manage巾even better relationship
亡han the general managers from our head o鯖ce … they
Can begin their own brand easily, uSe this relationship to
begin their own business may be at the same time.
K庇y互Scz!es Marlager q手Surl新高e
Sunshine rotated the branch managers among the dif
ferent branches periodically to control their power.
 A number of organizational factors also contributed
to the rampant fraudulent misbehavior among empIoy-
ees. Guarl高or relationship, With the departmental
stores was critical for brands to set up retail points
‘▼lthin departmental stores in China’and Sunshine
branch managers were often recruited based on the
strength of their relationships with the departmental
stores rather than their management ability or integ-
rlty. With branch managers having an average tenure
Oftwo years and a yearly tumover rate of 20%, their
¥一eak sense of belonging and loyalty to Sunshine
encouraged greed and opportunistic behavior. Branch
manager§, leveraging the relationships they built with
department stores while they worked at Sunshine,
often became agents of other brands when they left,
皿ing into competitors of Sunshine.
Branch managers received a fixed monthly salary of
between RMB 3,000 and RMB 4,000 and a year-end
bo皿s that was decided solely at the discretion of the
general manager. While the standard of living and
¥¥age level varied widely across China, the salary of
Sunshine’s branch managers was generally set on par
唖h Shenzhen, Where Sunshine’s head office was
located and which had one ofthe highest wage levels in
Chlna.4 Nonetheless, the year-end bonus was decided
solely at the discretion of the general manager, and the
lack of transparency into how decisions over the
bonuses were made gave branch managers little moti-
¥ation to act in the best interest of the company. Tb
remedy the situation, Sunshine had begun setting sales
targets for the branch managers each June based on
their location, and the square footage and sales history
of the retail points, and awarding year-end commis-
sions to branch managers who could meet their sales
target. under the new system’branch managers could
receive commission that was as high as their annual
salary if their sales performance was good.
Annual review
Sunshine,s management was due to meet soon for its
amual review meeting, and employee fraud and mis-
behavior was on the meeting’s agenda. The CEO had
decided on a target ofreducing the fraudulent behavior
to 2% of retail sales. The implementation of the ERP
SyStem had given the head o鯖ce better controI over its
retail operation, but fraud and misbehavior among
employees continued. Li knew that it was impossible to
COntrOl everything.
If the manager knows you are to come, he will do some-
thing about it. Everything we do is to reduce risk but we
cannot controI perfectly. If you control them perfectly,
they will resign.
K串y LL SaZes Ma皿ger QfS柵s届ne
But there must be more that could be done to contro獲
such misbehavior. What were the root causes of the
staff七misbehavior? What were the strengths and weak-
nesses of Sunshine’s current intemal controI system?
Most ofall, What could Li propose to the management to
improve the situation? What measures should the man-
agement undertake, and how should the remedial
measures be implemented? In what order would you
implement the recommended actions for Sunshine?
193
Chapter 5. ControI System Costs

Exhibit l Sunshine’s operationaI flow for its retaii business

Heado施e Regiona/O筋CeS BIanCho櫛ces Reね〃pom鰭

Fiowofgoodsat Preparestockwith Brancho鮒ce

thebeginningofthe SeaSOn barcodesandsend Outatthestartof responsibiefor repienishingretaii

eachseason. POintsthroughout
theseason.

Fiowofgoodsnot Headofficeinspects, Brancho情cessent i 音 音 音

SOldattheendof COuntS,andchange goodsnotsoldback
theseason ba「COdesifnecessa                =Oheado冊cea=he
afterreceivinggoods 「etumed. endoftheseason,

FIowofretaiisaies Receivesinformation Receivesinfo「mation Receives informationvia ERPsystemrecords Saiesinformation. iinvento「yinformatio[ hastobeinput/ iupdatedmanua=y.
jnformation ViaERPsystem, ViaERPsystem.

ERPsystem,
雨曇雪雪雪雪雪雪雪雪雪雪雪雪雪雪雪王雪雪雪零

Discounts/PrOmOtions Determinesdiscounts B「anchofficesengage Departmentstoresin

andp「OmOtions, insomedirectsales Whichreta=points
andbranchmanagers arelocatedaIso
havediscretionin maketheirown
givingdiscountsin discounts/PrOmOtion
SuChsaies. POilCies.

CASE S丁UDY
Better Beauty, lnc,

In Apri1 2013, Ted Wi11iams, PreSident of Better

Put Cost Improvement Programs (CIPs) in place both
Beauty, Inc. (BBI), WaS reViewing the details of his
to help offset some raw material price increases and
COmPany’s performance for the year 2012 and the
to offset the effects of price pressures in an increas.
first quarter of 2013. Overall, Performance had not
ingly competitive marketplace. Initially, these pro・
been good. One of the major causes of the poor per-
grams had been quite successful, but in recent years,
formance was that the company was mlSSlng ltS COSt
failure had beco皿e the norm.
improvement targets by substantial margins. BBI had
 Better Beauty, lnc,

One m恥r CIP known as the A-53 prQject, Which and other health and beauty care products). It also

was the most important CIP for 2013ブ描id not only shifted attention away from the company’s prior focus

iled to provide the prQiected savings, but accd-ding to on top-Ofthe-1ine’Or ``prestige,, products, Which earned

Bryant Richards’the company controller, it might even a premium price in the market, tO a mOre mid-Price

endup co§ting the firm money・ It was a major cause of strategy that emphasized mass market products. The

B眺南ilure to meet its overa11 CIP goals. new strategy required an increased focus on the cost

Ifthe A-53 prQject had been only an isolated inci- e鯖ciencies needed to generate the desired profits.

dence, Mr. Williams would not have been quite as wor- At first the change in strategy looked promising’but

融. In reality, however, it was just one of a long string then the company reported operating losses in 2OO6-

ofCIP prQject failures" Mr. Williams was convinced 2008. In more recent years BBI had been profitable (see

that he had to determine the root cause for these m亘ior Exhibit 2). During this period of strategic change, for-

ぬortfalls. He addressed his staff:

mal cost reduction and financial targeting procedures
were introduced in order to try to keep the BBI’s gross
What is going wrong? We,ve had probIems with a marginsl above 60%’eVen in a period where some
new assembly in toiIetries’the starトup of our lean
costs were increasing rapidly.
management initiative on the pIant fioor’and the
The ueasy,, cost reductions and improvements
[eW formuiations for our Iatest shampoos. These
caused a significant bump in profits in 2Oll・ But
arejust this yea「’s prob看ems. Are ou「 problems in
Mr. Williams was concemed that if the company did
the design, teSting, andfor implementation of the
not find some new cost reductions, PrOfits might tum
CIPs? Or perhaps we shouId reconsider the totai
down again. He was even more COnVinced that cost
cost reduction concept itseif" Maybe it has r… its
improvement prQjects were the key to maintaining a
course; maybe we,ve gathered a= of the 10W-
profitable future for BBI.
hanging fruit" lf we cannot do something to reverse
this pattern of fa冊re’We Wi= have no chance of
lndust「y t「ends
achieving our goais!

In 2013, analysts were estimating that profits in the per-

sonal care industry, While sluggish’WOuld improve
The company modestly・ Industry volume was expected to rise to

$29.2 billion, uP about 5% from the $27.8 billion spent

BBI was a personal care company that sold its products
at retail in 2012. The 2012 total reflected activity in the
internationally. In the past’the company’s primary
major categories of: COSmetics (35%), hair products
focus had been on the manufacturing and sales of cos-
metics and fragrances" In the last five years’however’
(24%), Shaving products (14%), tOilet soaps and deodor-
ants (13%), fragrances (9%), and hand products (5%).
in direct response to shifts in the overall market for
While the 1990s had witnessed robust growth, the
health and beauty products, mOre and more ofthe com-
recent trends had not been as favorable. Real (inflation-
pany’s revenue had come from toiletries’hair coloring
adjusted) shipments had declined, and price competi-
options, and beauty care tooIs. In 2O12, OVer half (60%)
tion had increased. Demand for personal care items,
ofBBIis total revenues ofjust over $1 billion were in the
considered to be a discretionary purchase, WaS hurt by
mestic markets (which included Canada and Puerto
the sluggish economic activity in the 2008-2012

d Latin America through a direct sales force, and in period, aS Well as by the secular changes in the product
markets. With less discretionary income available, COn-
e Middle East via a broker network.
sumers had cut back on the impulse buying that had
Up unti1 2003, BBI, like many cosmetic-focused
been responsible for up to two-thirds of all cosmetics
ompanies, WaS managed by its founder・ Claudette
and personal care purchases. The market had improved
Beauford" Upon Ms. Beauford,s retirement, the man-
over the 201O-2012 period, retuming BBI to profitabil-
gement and focus of the company changed substan一
ity, but margins were still slim.
し11y. The new president, Ttd Williams, had a financial
Relatively flat sales in the 2010-2012 time period
ckground. He formalized the organizational struc-
had made it possible for BBI and its competitors to
re along functiona=ines’aS Shown in Exhibit l.

nder its new management team’BBI,s strategy broad-

I GrossIncome ÷ NetSales.
ed to include an expanded product line (toiletries

195
 Chapter 5. Controi System Costs

manage their inventories. That said, there was still
intensified competition and p瓦ce discounting in many
lines as competitors sought to gainせhigher share ofthe
Stagnant PerSOnal care market. The discounting at the
COmPany level was being augmented by inventory liq-
uidation moves at the retai1 1evel, aS StOreS COmbated
OVerStOCking and decreases in overall consumer
demand (inflation-a句usted). BBI had sold off one of its
OPerating divisions in 2011 to a competitor, reSulting in
a one-time improvement in its bottom line. Once the
impact of this sale was over, however, BBI,s profit
trends largely mirrored those ofthe industry.
The overa11 softening of consumer demand for cos-
metics and fragrances resulted in a sIowdown in new
Still done informally at the top corporate level, and the budget, eSPt
COmPany’s Iong-range gOals and strategies were not and new pro
COmmunicated in detail to all functional managers.
Capacity exI
The annual budgeting process, however, invoIved
those absd「
SeVeral levels ofmanagement. Budgeting began in mid- and sales g〔
July when top management gave each functional area the criteriol
Preliminary targets for its operating and capital budg- returnS ln a
ets. Included in this package was a set of other perfor-
3. Cost reduct
mance measures specific to the function. For example,
ity. Howevc
marketing managers were given preliminary sales
COrPOrate
growth targets for each of the various categories of
approval is
existing products’manufacturing managers were
4. Spending
given preliminary cost targets by product category, and
R&D managers were given cost improvement targets deferred u]

PrOduct development activity throughout the industry. and timetables for the introduction of new products. is threaten-
While established fims were moving to secure their The f皿ctional managers and their subordinates were 5. Spendingf
market position’Intemet-based sales competitors were expected to coordinate their plans with those of other ered only j
SPrlngmg uP With new lines of cosmetics produced in functional managers and to prepare their plans down affi∋Cted,
Asia that competed effectively with the traditional per- to the product level. A series of budget reviews wa§
6, All non-re!
SOnal care companies, integrated production and sales held in October and early November, and債nal budgets
Of new pr(
models. In response’many Ofthe traditional companies and performance targets were丘xed by mid-November.
cation and
had implemented lean manufacturing programs in the During the year, formal performance reviews were
executlVe.
eff。rt tO improve their operating margins. This Iow- COnducted on a monthly basis. Managers were expected
COSt, low-WaSte focus was seen as one way to increase to be able to explain any m年jor variances in actual ver-
lncentive
the competitive power of a firm because it provided for SuS Planned performance to a top executive committee.
greater pricing leverage and the ability to purchase If significant variances were expected to continue, the Incentive cor
market share through pricing policies. The mature budgets were revised, although it was understood by agers down t
nature of the industry was being re血ected in increased all the managers involved that the original budget zationa1 1eve]
COmPetition based on price, the predominant role WOuld be the standard used to evaluate individual audit was fir
Played by Intemet start-uPS in setting the trends in new manager’s performance at year end. pre-eStablisll
PrOduct areas’and an overall profit squeeze. Exhibit 3 February, ju
Shows a retail sales analysis for the personal care indus- meetings, a t
try for the years 2009-2O12.
CapitaI budgeting
Pany O航cers
The main trends in the personal care industry, then, Capital budgeting reviews took place in mid-Septem- The evaluati
reflected the fact that the industry was in the mature ber. Functional managers presented formal capital but based he
Phase of the industry life cyde. It also re皿ected a shift appropriation requests to a top management commit- In normこ
away from fragrances to cosmetics and hair products as tee. For several years the company had published dents were ;
the primary areas of competition and growth" While years’the b
guidelines suggesting that each prQject being presented
the ``prestige,, products had held their own during this Should be justified by showing a two-year Payback2 0n The averag(
Period, the mid-Price product lines were hurt as econ- invested funds. This short-term focus was emphasized PerSOmel (l
Omy-minded consumers traded down to Iower priced or On a COntinual basis given the increasing price and of those for
generic products. BBI, having a majority of its products PrOfit squeeze facing the丘rm. The guidelines for devel-
dependent l
in this mid-Price range’WaS Particularly challenged by OPing and presenting a capi〔al appropr重atlOnS requeSt the director
Were formalized in the budget manual and induded
the following instructions for 2013:
Cost rec
PIaming and budgeting 1. Budgeted capital spending proposals must be guided
An importa
by the general trends indicated in the operating
Since he assumed the presidency, Mr. Williams had man ageme
taken steps to formalize some of BBI,s administrative mal cos亡-r
2 Apaybackperiod is the period oftime required to recoup the investment.
PrOCeSSeS and procedures. Long-range Planning was managem(

196

budget, eSPeCially as regards unit (volume) growth
and new product introduction. -
2. Capacity expansion prQjects should be res宙eted to
those absolutely necessary to achieve 2013 profit
and sales goals and objectives. They must also meet
the criterion of providing the appropriate economic
retums in a timely fashion.
3. Cost reduction prQjects should be given a high prior-
i〔y. However, Serious consideration will be given by
corporate to business constraints at the time
approval is requested.
4‘ Spending of a replacement nature should be
deferred unless a serious impediment to operations
is threatened.
5' Spending for quality improvement should be consid-
ered only if the product’s marketability is seriously
a鮪ected.
6. Åll non-reSearCh expenditures related to marketing
of new products are to provide an economic justifi-
cation and reflect approval by the appropriate senior
incentive compensation
Incentive compensation was provided annua11y to man-
agers down to the director level in the fim (one organi-
zatlOnal level below vice president). In January, after the
audltWaS finalized, a bonus pooI was established as a
pre-eStablished percentage of corporate net income. In
February, just after the annual performance review
meetings, a bonus committee, COnSisting of the top com-
panyo鯖cers, allocated this pool to individual managers.
The evaluations of performance were done subjectively,
but ba§ed heavily on objective measures of performance.
In normal years, aVerage bonuses for vice presi-
dents were approximately 50% of base salary. In good
years, the bonuses could range up to IOO% of salary.
The average and maximum bonuses for director-level
personnel (one level below vice president) were 60%
oftho§e for the vice presidents. Formal performance-
dependent bonuses were not paid to personnel below
the director level.
Cost reduction program
鉦mportant part of Mr. Williams’s upgrading of BBI’s
皿anagement systems was the implementation of a for-
mal co§t-reduction program supported by a lean
management philosophy.3 cost reductions were
Better Beauty, 1nc.
deemed to be of two basic types: COSt aVOidance pro-
jects (CAPs) and cost improvement prqiects (CIPs)・
Any prQject designed to reduce direct materials
costs without a related change in existing products or
manufacturing processes was designated as a CAP. The
company,s CAP goal was an annua1 5% reduction in
materials costs.
CIPs were prQjects designed to effect cost reductions
through process or product changes, SuCh as reformu-
lation of a product to incorporate less expensive ingre-
dients. The company’s budgeting manual explained the
CIP goal:
Each manufacturing location is to deveIop and
impIement Cost Improvement Programs (CIPs) as
Part Of their annual budget package・ CiPs are spe-
Cific action programs directed towards a measura-
bie reduction in existing manufacturing cost leveIs.
The amuaIized savings from these CiPs should be
equal to or greater than 5% of the prior year’s totai
COSt Of goods manufactured, adjusted for the vol-
ume and mix changes. The action programs shouId
encompass aiI facto「S Of manufacturing, incIuding:
了‘ a= labor costs associated with manufacturing
蚤 aIi overhead expenses associated with manu-
facturing
ぅ onIy those material costs resuIting from:
一 reduced usage and improved yields
- reduced freight-in costs,
The Purchasing and Value Analysis departments
were most directly responsible for identifying CAP pro-
jects. R&D and Engineering were the departments who
were directly charged with identifying CIP prQjects.
The CIP ideas, however, had to be implemented by the
operating manager most directly affected. In most
cases, this manager was in manufacturing.
The CIP/CAP prQjects were expected to achieve a
One-year Payback where possible. CIP/CAP prQjects
that did not promise to meet this payback criterion
were sut)jected to close scrutiny by Mr. Williams’s staff
before approval would be granted.
When the cost reduction program was first intro-
duced, the company realized many important and sig-
nificant cost savings. In recent years, however, the
3 Managers fo11owing a lean management phllosophy consider a11
expenditures of resources for purposes other than creation of value
for end customers to be wasteful and, hence, targetS for reduction or
elimination.
197
Chapter 5. ControI System Costs
COmPany had not been achieving its cost improvement
targets. The targets and acttIal results ofthe cost reduc-
tions achieved for each of theγearS 2009-2013 are
Shown in Exhibit 4.
An examp!e: The A-53 project
Some of the major problems in the cost reduction pro-
gram can be illustrated by describing one large CIP pro-
ject ca11ed the A-53 prQject. The A-53 prqject invoIved
the substitution of an aqueous aerosol, Dymel-152a/
Hydrocarbon, for the existing且uorocarbon mixture.
As a liquefied gas prope11ant, Dymel-152a had obvi-
OuS Safety and quality benefits over the existing com-
PreSSed gas fluorocarbon being used. Designed for the
low-PreSSure SPray that de宜ned perfume propellants,
Dymel-152a had a much lower fi11 pressure when mixed
With fragrance concentrate than the currently used
COmPreSSed gas altemative. This meant that BBI could
eliminate the use of bottles with relatively expensive
Plastic coatings that had been necessary with com-
PreSSed gas fluorocarbon currently in use. The plastic
COating had been required to ensure the bottles’integ-
rity and to pass industry safety standards, SuCh as sta-
bility when placed in a warm water bath. The other
advantage was that Dymel-152a was less血ammable
than the current fluorocarbon blend, PrOViding advan-
tages in both safcty and in the production procedures
that could be used.
BBI and the other firms in the fragrance industry had
used fluorocarbons as propellants almost exclusively up
until the mid-197Os, When fluorocarbons were banned
by the US govemment because of concems about their
destroying the ozone layer of the atmosphere. The pro-
Pellant suppliers who had relied on fluorocarbons as
their m亘ior sources of revenues were severely a任ected
by the ban. Immediately following the ban, these com-
Panies aimed much of their research toward developing
a new ozone-Safe fluorocarbon propellant. One of these
improved gases was currently in use at BBI. That being
Said, hydrocarbons, eSPeCially products like Dymel-
152a, Were Still deemed superior in many ways.
Personnel in BBI’s R&D department noted the devel-
OPment Of Dymel-152a and immediately saw its poten-
tial advantages. They tested the new propellant in
Simulated production settings and found it superior to
the propellants being used. Based on these results, they
PrePared a Capital Appropriation Request, the sum-
mary page ofwhich is shown in Exhibit 5. A summary
Oftheir investment analysis is shown in Exhibit 6.
198
On January 14, 2013, BBI’s capital appropriations
COmmittee met and approved the money for the A-53
PrQject. Mr. Wi11iams’s initial reaction to the prqiect
WaS Very enthusiastic, aS indicated in the memo shown
in Exhibit 7. Shortly thereafter, Don Jacobi (VP-R&D)
had people in his department draw up speci丘cations for
the use of Dymel-152a on the production line. The pro-
Pe11ant switchover was scheduled to take place on
March l, 2013.
Right from the start, the A-53 prQject ran into sev-
eral serious problems, One problem was a production
delay喜the implementation could not be effected
until the middle of April. More seriously, though,
WaS When Dymeト152a was put into bottles that were
not properly filled with fragrance, it became very
unstable. The pressure inside the larger bottles then
rose from 40 pounds per square inch (psi) to over
200 psi, a level that the larger-Sized bottles (2 oz.
and larger) without a plastic coating could not
always withstand. As a result, quality control had to
reject many bottles because of cracking, and several
bottles had even expIoded while sti11 in the produc-
Review of the A-53 project
In late Apri1 2013, Mr. Williams called a meeting with
his top executives to review the problems with the A-53
PrQJeCt.
Don Ke11ey (VP-Finance) started the meeting by
Showing the丘nancial picture. As he handed out the
analysis, PreSented in Exhibit 8, he noted:
Bryant Richards [BBI ControI看er] has been fo=ow-
ing this project very cIoseIy, He now estimates that
because of the probiems we are a= aware of -the
implementation delay, reduced voiumes, higher
bottle prices, the probiems with the Iarge bottles,
and the lost Iabor e仰Ciency - the 2013 savings w帥
be $319,900, down from the original estimate of
$599,600. But if we have to write o情Our inventoryof
3% oz, botties, We Wi= actua=y iose aimost $82,000
0n this project this year,
Ttd Williams (president) :
丁his is obviousIy not good news. Who can expIain to
me why we’ve missed the forecast so badly? I wouid
like a few ciarifications" First, are these labor charges
noted as ``additionaI’’going to continue? And, What
are we pianning to do with the 3% oz. bottIes?
 Better Beauty, lnc"

Frank Martin (VP-Operations) : Don Jacobi:

This project has been a disaster from「he begin- Rea=y, ai=his taik about dropping the ba= and
ning. 1 was invoIved in this project at the C血ciaI gIass handiing is not addressing what I see as our
POint - implementation. 1 heard of the proposed major concem. If production, namely the machine
switch from our standard fIuorocarbon to Dymel- tenders and line persomei fo獲iowed our specifica-

152a from Don [Jacobi, VP-R&D]. He had pin- tions, these issues wouid not come up" We’ve

POinted it as his major cost reduction program for known that the glass handIing techniques were a
theyear. Then when it came time to put the pian in long-Standi=g PrOblem, but it wasn’t criticaI before"

action, reSearCh dropped the bail - it became the Ail the new prope=ant has done is to decrease our

Plant’s responsibility to impIement the p「Oject"

margin of error and it has pinpointed operating
Research was cIaiming the cost reduction but tak- deficiencies as a resuIt.
1ng nO leadership roIe in putting it in pIace・
These comments brought the meeting to a boiling
R&D insisted that the gIass botties be handIed
POint, aS Frank Martin expIoded:
morecarefu=yto minimize the rubbing of one bottie
OnanOther. They said that rubbing is weakening the Boy! it)s easy for R&D to point to us as the reason
botties and making them expiode more easiiy. ! for the glass probIems. I’ve aiready aIte「ed my

think we now know that the rubbing has nothing to Whole decorating and giass process. But the reaI
do with the probIem. Some of the P&D engineers PrObiem here is the gas, nOt the glass-handling
just made that excuse up to cover their faiIures. techniques or the way my machine operators do
They did=,t have to bear the incrementai costs. We theirjob! You guys in research sti= don’t know how

bear the costs of the new procedures they have sensitive this propeilant is to variations in the con-
forced us to foI10W (See Exhibit 9). Centratelprope=ant ratio, yet yOu’re running

=hink we have to continue to incur the addi- around changing procedures in the entire pIant
tio[a=abor costs untiI we get a new piece of equip- without first documenting the characteristics of
ment that will check the fiIi heights of the bottles this gas!

before they enter the gas house. We’ve had some

Mr. Williams was disturbed by the conflict
expioding bottIes, and I have concluded tha=he
between individuals in his top management team, SO
Safety factor had to come first, SO I’ve had some
he thought it was best to adjoum the meeting until
PeOPIe visua看Iy checking the fragrance levels
the next day to allow tempers to cool. He asked each
before we add the Dymei-152a. We estimate that
manager to consider not only the key issues of con-
equipment that would automatica=y eject low fiIis
cem in his own area, but also the future prospects of
wouId cost app「oximately $25,000 per line, SO for
the company and their role in making this current
Oureight iines that wouid be an additional capitai
problem an exception rather than a rule. As they left,
expenditure of $200,000, 1f we had this equipment,
Ted sat back and wondered once again where his
冊ink we couid save the additiona=abor costs.
company was going, and why these CIP prqiects had
FinaIIy, aS tO the 3% oz" botties, I,m afraid we’re
begun to go sour:
facing a direct write-Off here. Whiie we may be abte
to siphon off some of the product into stronger We have to stop this pattern of faiiure, Whether it is
glass bottles, the 「ework’SCraP’and other prob-
due to impIementation probIems, Iack of adequate
iems here wiIi undoubtedly 「esult in significant testing, Or the CIP/CAP concept itseif" Where are
expense, We’re stili working on this issue, looking We rea=y headed? What has gone wrong with the
for the best answe「, COSt reduction program?

199
卜⊃
⊂)

⊂〕

.し

Exhibit l Better Beauty, Inc., Organization chart

Ted WiIiiams
President

Don Jacobi E=en James

Frank Martin Don Keiiey
Vice President Vice President
Vice President Vice P「esident
Research & Marketing &
Operations Finance
DeveIopment Saies

New Vaiue Materials & Manufacturjng

Adve面sing Contro=er M看S
Products Anaiysis Logistics Engineering

B ryant
Richards
Exhibit 2 Better Beauty, Inc., Summary lncome Statements (in m輔0nS)

_‥       YearsEndedDecember31

2012 2011 2010 2009 2008 2007 2006

Netsaies $1,036.1 $ 991.1 $ 971.9 $1,010.1 $1,025,3 $998.6 $999.2

CostofGoodsSold Grossincome Se冊g,Generai&Administrative $ 369.5 $ 341,5 $ 356.0 $ 368,2 $ 379,3 $409,1 $ 381.1

$ 666.6 $649,6 $ 615.9 $ 641,9 $646.1 $ 589.4 $ 618.2

$ 292.7 $283,1 $ 281.0 $ 318.6 $ 318.2 $ 347.1 $ 618,2

AdvertlSing $ 203.6 $198,9 $172.9 $195.2 $ 215.3 $ 241.2 $ 217.0

Research&Development $ 17,9 $ 18.0 $ 179 $ 18,2 $ 18,3 $ 18.3 $ 19.6

ProfitfromOperations $152.5 $149,6 $144.1 $110.0 $ 94.3 $(17.1) $ 49.8

i[tereSteXPenSe $  0,9 $  0.5 $  0.4 $ 1,4 $ 1.5 $  0.8 $  4.4

Totalincome $153.4 $150,1 $144,5 $111.4 $ 95.8 $(16.3) $ 54,2

l[tereSteXPenSe $ 63.7 $ 67.9 $ 69.8 $ 89,8 $102.4 $111.6 $ 97.5

Misceiianeous $ 1.1 $  0,9 $  0.4 $  0.3 $ (0.3) $  2.9 $  6.4

i[COmetaXeS $ 27,6 $(185.4) $  6.2 $ 12.1 $  5,6 $ 15.1 $  6.4

Netincome $ 61.0 $ 266.7 $ 68.1 $  9.2 $(11.9) $(145.8) $(49,4)

201
Chapter 5. Controi System Costs

Exhibit 3 Better Beauty, lnc., Retaii Saies of Seiected lt)iietries and Cosmetics (in m輔ons of doliars)

一つ重富 Products   2009 ′●●′ 2010 2011 2012

HairProducts Shampoos $  2,366.3 $  2,703.2 $  2,980.5 $  3,201.8

Rinses,tints,dyes $   904.4 $ 1,014.6 $ 1,454,1 $ 1,697,3

Men’sspray&dressings $  197,6 $  189.7 $   207,8 $   220.3

Women’shairsprays $   872.6 $   928,3 $ 1,047.1 $ 1,084.6

Homepermanentkits $   235.5 $   242,7 $   266,1 $   290.9

HandProducts Lotions $   471,7 $   518.8 $   568.2 $   822.8

Nailpoiishandenamel $   625.4 $   561.8 $   601.2 $   648.5

Cosmetics Facecreams $ 1,051.5 $ 1,209,2 $ 1,324,2 $ 1,456.9

Makeupbase $  1,137.8 $ 1,190.2 $ 1,238.7 $ 1,395.6

Facepowder $    42,2 $   260,8 $   262.0 $   218,4
Eyemakeup $  2,823,4 $  3,490.2 $  3,411,1 $  3,701,7
「faIcandbodypowder $  138.4 $  138.4 $  138,4 $  145.2

Ljpsticks $ 1,897.8 $  2,028,4 $  2,221,5 $  2,399.2

LiquidfaciaicIeansers $  185.5 $  194,8 $   408.7 $   421.0

FragrancePreparations Perfumes $   274,8 $   285.6 $   300,0 $   339,4

lt)=etwater&coiogne $ 1,443,7 $ 1,539,3 $ 1,633,9 $  2,124,0

Other￣foiietrjes 丁biletsoaps $  2,325.2 $  2,453.9 $  2,682.9 $ 1,638.8

ExternaipersonaIdeodorants $ 1,463.6 $ 1,710,6 $ 1,844.1 $  2,034.1

ShavingProducts Shavingpreparations $   576,0 $   615.6 $   641,1 $   671.8

After-Shaveiotions $   414.2 $   455.6 $   473.8 $   497.6

Men’scoIogne $   528.1 $   580.9 $   633,2 $   677,6

Shavingaccessorjes $ 1,749.4 $ 1,909.5 $ 1,942.1 $  2,112.6

Exhibit 4 Better Beauty, Inc., COSt reduction program performance 2009-13

(in OOOs of do=ars)

lCostBeductions 2013 2012 2011 2010 2009

Costimprovementprograms: ￣rarget $  4,388 $  4,452 $  4,293 $  4,039 $  3,752

ActuaI $  2,520★ $  3,922 $  4,198 $  4,049 $  3,752

Costavoidanceprograms: 「rarget $  3,465 $  3,528 $  3,402 $  3,203 $  2,982

Actual $  3,455★ $  3,570 $  3,381 $  3,203 $  2,993

 Exchange Rate U.S. $1 ・00

Cost PeductIOn
C囚(Profit E□謀討
l m provement)

1. FIXED CAPITAL

2. WORKING CAPITAL
3, RELATED EXPENSES (CapitaIized)
4, TOTA」 CAPITAしAPPROVAL

5. ANNUAL LEASE PAYMENTS NO OF YEARS

6. TO丁A」 PROJ王CT

7. BELATED RETiREMENTS

onversatlOn the flrSt year after tax savings is estimated to be $476,500 due to bulk savings and the el面natiOn Of piastiC
Oatlng On the bottie which was previousiy required on fiiis greater than 「 oz・ Equipment to handle the new bottles wiii
Ost aPPrOXimateiy $108,000 and wiii be purchased through cont「act with our TooI and Die SuppIier" This particuIar cost
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203
Chapter 5. ControI System Costs

Exhibit 6 Bette「 Beauty, lnc., A-53 project investment analysis

(annuaiized- retumS, $000s)

MateriaIsavings $ 878.8
Additionaldepreciation _旦○○。」土工旦二塑

Netincomebeforetax $ 768.6
「ねx(38%〉 $ 292,0
Netincomeaftertax $ 476.5

Add:Depreciation $ 110,3
Netcashgenerated $ 586,8
ーfotaIP「ojectExpenditures $ 392.3

Paybackperiodinyears 0.7
Returnoninvestment 150%

Exhibit 7 Better Beauty, Inc., PreSident’s initjal reaction to A-53 project

lN丁EROFFICE MEMO
DA丁E: Aprii 14, 2013

丁O: Don Keiley IVice President, Finance]

FROM: l七d W帥ams [President]

SUBJECT: Cost Reductions

I was delighted to hear from Don that we have certain annuai savings of aimost $1 m冊on as a resuit of a new prope=ant
Ca=edA-53.
Frank Martin and Don Jacobi are gOIng tO make ce巾ain this occurs on a timeiy basis, Please put this down on ou川st of
201 3 savingS. Don aiso beiieves that we have a prospect to reduce cost on severa† other products, Which on a totaI sav-

IngS basis wiIi amount to a iot of money,

Attn: Frank and Don:

Most essentiai that we find thiS kind of savings in order to provide the money necessary to buiId the business in 2013・
Please make certain that we take the necessary steps now in order to reaiize the fuil effects starting with the end of this year.

Exhibit 8 Better Beauty, Inc., COntrO=er’s anaIysis of A-53 project (Aprii 2013)

OriginaI,2013Iabcommitment $ 586.8
impIementationdeIayedtoApri125th $ (36,5)

Productionvoiumereduction $ (54.8)

MateriaIsavingsbeloworiginaIprojection $ (29.6)
Problemswithlargerbotties $ (73.0)

Additiona=aborcosts 岨
Netcashflowsavings-Aprilrevisedforecast $ 319.9

Memo: $ 40工8
inventoryexposure

(115Mpiecesof馴ed3-1/4oz.bottIes)
 Better Beauty, lnc,

軸bit9 Better Beauty, Inc., intero冊ce memo

Date:AprIi 20, 2013             -.

to Fra[k Martin NP-Operations)

F「0皿Don Jacobi NP-R&D)

Subject: Revised Giass Handiing LechniqueS

「, lncoming giass shipments from vendor to be pressure-Checked by Q.C, aS Part Of incoming inspection procedure-

2. Ali approved giass receipts reieased to Container Decorating to be handIed in the folIowing manner:
a. AII containers to be removed from corrugated nests言.eっCOrrugate neStS tO be removed from shipping cartons

Only after aiI gIass has been removed.

b. Containers to be handled through decorating process avoiding contact with metaI edges and minimizing s而ace
COntaCt.

C. Decorated containers to be piaced on Iehr belt so as to be able to be packed at discharge end directiy off Iehr belt
avoldlng PiowIng Off beit or eIiminating need to transfer onto packing belt"

d. Decorated giass to be spray-COated at discharge end with MYRJ 52S stearate spray beIng CarefuI to spray only
aerosoi glass,

e. Aii decorated giass to be packed back into corrugate nests言.e., neStS are tO be inserted into shipping carton

before giass is Ioaded into carton・

3 1叩rOCeSS PreSSure Checks w紺be performed by Qua旧y Controi after decorating to assure minimum pressure
requirements exist in decorated glass. A= decorated lots wiii be reIeased to f冊ng fIoor based upon those in-PrOCeSS

audits.

4 Decorated giass to be handied on fiiiing floor in the foIiowing manner:

a Ali containers to be removed from corrugated nests and inserted directiy into pucks,主e., COrrugate neStS tO be
removed from shipping cartons only after a= gIass has been removed.

205
 CASE STUDY
Fit Food, lnc,
Our shareholders are demanding better performance from
us. Our market valua亡ion has been basically flat for most
Of the last decade. At the same time, We need to be making
larger investments in our future, tO develop new products
and to augment our sources of organic ingredients. So we
need to ratchet up the performance pressure. We need to
do better.
Se伽W「ig7互C倍q Fl亡Food, I朋.
Sean made this pronouncement in May 2008 at a
management meeting held just after the Fit Food
annual shareholders’meeting. The division managers
responded to Sean’s call to action, but not a11 of their
responses were what Sean had in mind.
The company
Sean Wright founded Fit Food, Inc. (FFI) in 1972. Sean
had been working as the VP R&D in a large food com-
Pany, but he had always wanted to start his own busi-
ness. In his spare time, he developed a new line of
COOkies, Ca11ed “Smart Cookies;’that he could adver-
tise as being healthier because they were lower in fat
and calories. After many struggles to get Smart Cookies
Placed in major supermarket chains, by 2000, Sean and
his growing team were able to declare proudly that the
Smart Cookie brand was being distributed nationa11y.
With more products in development, and taking advan-
tage of the good stock market environment in 2OOO,
Sean launched an FFI IPO. The company’s stock was
listed on NASDAQ.
By the year 2009, FFI was a medium-Sized food com-
Pany that targeted “tasty-but-healthier’’market seg-
ments. In 20Ol, Sean introduced several new snack
PrOducts and started a Savory Snacks Division. In
2003, he acquired an energy drink company, Which
became FFI’s Sport and Energy Drinks division. By
2009, FFI’s annual revenues were approaching $500
million. The company was consistently pro丘table but
heavily leveraged, aS Sean had funded the energy-
drink acquisition by increasing the company’s debt load
S ign ificantly.
206
FFI used a divisionalized organizational structure
(See Exhibit l). The general managers of the three rela・
tively autonomous divisions喜Cookies & Crackers, Savory
Snacks, and Sports & Energy Drinks - rePOrted directly
to Sean, the CEO. Each division had its own sales and
marketing, PrOduction, and R&D departments and a
COntrOller. The corporate staffinduded human resources,
MIS, finance, R&D, and legal departments. FFI did no[
have an intemal auditing function. It had outsourced the
documentation and testing work needed to comply with
the Section 4O4 requirements of the Sarbanes-Oxley Act・
Recently, however, Joe Jellison, FFI’s CFO, had suggested
that the company was becoming large enough that it
Should start bringing this work in house.
In 2008, Kristine廿Odden was assigned as the exter.
nal auditing firm partner on the FFI account. Kristin
COnSidered FFI not to be a particularly desirable die
because of persistent requests to reduce auditing fee;
amid threats to solicit bids from competing firms.
FFI’s board ofdirectors included丘ve members. Sean
was the chair. The other outside directors included(
Small-COmPany CEO, a CFO of a medium-Sized pu批
COmPany, a Vice president ofmarketing at a large supel
market chain, and a practitioner in holistic nutrition
A11 ofthe outside directors had been suggested by Sea「
but approved by the board’s nominating and gover「
ance committee. The board met in person four timei
year and also by conference call as needed.
Pians, reViews, and incentives
FFI’s planning process began in August when corpor
managers sent to each division economic forecas
Other plaming assumptions, and preliminary sales
gets. The sales targets reflected investor expectati
Of steady growth.丁ypically, eaCh division was expecir
to increase annual revenues and profits by at least 59
Over the following two months, division manag¥
ment created formal strategic plans, Which indud(
both a strategic narrative and a high-level summa:
PrOfit and loss statement. The strategic plans wel

a胆工ed by corporate managers in early October.
帖division managers developed the「剖ements of
証¥nnual Operating Plans (AOP) for the tもming
朝日・・ hich included detailed marketing and new prod-
し壷velopment plans and pro forma income state-
「耶and balance sheets.
事¥@loping the AOPs required many discussions
D[∵細COrPOrate and division management. The divi-
nagers typica11y argued that they needed to
theirexpense budgets to be able to achieve their
es goals, and corporate typically wanted to squeeze
XPenSeS tO generate increased profits. A fairly standard
Plannmg exercise was to ask each division what pro-
grams or plans they would cut if their profit budget was
両y lO%. Once these programs were identified, the
hision managers had to justify adding them back into
亜budget. Tchsions between division and corporate
anagement increased in 2008 because corporate was
king the divisions to increase their growth rates to 7%
alhw some new corporate investment initiatives to be
nded intemally. At the end of the negotiation pro-
SSeS, the AOPs were presented to the board of directors
・ aPPrOVal at its meeting held in early December.
During the year, Performance review meetings were
held quarterly. The focus of the meetings tended to be
On eXPlaining variances between revenue and profit
Pe血mance goals and actual performance. The meet-
gs were quick and painless when performance
a血ed or exceeded expectations, but the tone was
amatically different when the quarterly profit goals
ere not achieved. Catherine Elliott (marketing man-
ger, Cookies & Crackers Division) explained:
Corporate pushes us hard to make our numbe「s,
There is never a good reason for not making our
goaIs, We’re paid to be creative and come up with
SOlutions, nOt eXCuSeS. Sean ca=s it “no excuses
ivision presidents and their direct management
orts could earn annual bonuses based on achieve-
t ofAOP profit targets. The target bonuses ranged
25% to lOO% of the manager’s base salary,
ending on organization level. No bonuses were paid
ivision profits fell below 85% ofAOP plans. Maxi-
m bonuses of 150% of the target bonus amounts
Were Paid if pro丘ts exceeded AOP by 25%. Average
bonuses exceeded target bonus levels in seven of the
firsteight years ofFFI’s history as a public corporation.
Some corporate managers and division presidents
順e also included in a stock option plan. FFI stock had
Fit Food, inc,
Performed well in the early 200Os, but virtually all of
the gains were lost in the stock market downtum of
2008-2009. Most ofthe options were underwater.
The recession of 2008葛2009 stressed company oper-
ations at the same time that Sean was calling for better
financial performance, The Savory Snacks Division
Performed well and achieved the higher growth rates
called for in both 20O8 and 2009. The other two divi-
Sions experienced more cha11enges, however, aS is
explained below. (Summary income statements for
these divisions are shown in Exhibit 2.)
Sports & Energy Drink Division
The Sports & Energy Drinks Division (Drink Division)
WaS formed in 2003 when FFI acquired a successful,
regional energy drink brand. As part of the deal, Jack
Masters, the former CEO of the acquired company,
became president of the division. Performance in the
first few years after the acquisition was good. The tar-
geted drink categories continued to grow; tWO brand
extensions were successfully launched; and Drink Divi-
Sion sales nearly doubled between 2003 and 2006. The
division achieved its AOP profit targets easily, and Jack
WaS able to operate without much interference from
COrP Ora亡e.
By early 2OO7 however, Jack saw some cIouds on the
horizon. The energy drink category was becoming
more and more competitive as more players, including
SOme large, We11-CaPitalized corporations, entered the
CategOry. At the same time, retailers were consolidat-
ing and becoming more powerful, increasing pressure
On manufacturers to Iower prices. Jack began to worry
that he might not be able to deliver the growth that was
expected of his division.
2007
Despite Jack’s worries, 2OO7 was another ste11ar year,
With sales growth exceeding even Sean’s increased
expectations. The category momentum continued, and
Jack’s brands gained market share, due in part to a suc-
CeSSful grassroots advertising campaign.
With performance far exceeding the AOP targets
and excellent bonuses assured for the year 2007, Jack
thought it would be prudent to try to position the divi-
Sion for success in the future. He met with his manage-
ment team to discuss hi§ COnCemS and to come up with
ideas to get better control over reported profits. Jack
and his team decided on three courses of action. The
first was to declare a shipping moratorium at the end of
207
Chapter 5. Controi System Costs
the year, Which shifted some sales that would norma11y
have been recorded in 200チinto 2008.
Not all ofJack’s managerS were happy with the ship-
Ping-mOratOrium plan of action. The production team
WaS unhappy because the moratorium would cause
SCheduling problems. Some empIoyees would have to
be furloughed temporarily at the end of the year to
minimize the buildup in inventory. Then, in early 2008,
they would have to incur some overtime costs both to
accelerate production and to ship the orders that had
accumulated. The sales department was concerned
that they would have to deal with customer complaints
about shipment delays and product outages. Neverthe-
less, Jack decided to move forward with the shipping
moratorium regardless of the costs, Which he consid-
ered relatively minor.
The second plan was to build up accounting reserves
against accounts receivable and inventory balances. In
2007 the Drink Division controller was able to provide
ajustification for increasing reserves by $1 mi11ion over
2006 levels.
The third plan was to prepay some expenses that
WOuld have normally been incurred in 2008. Among
Other things, SOme facility maintenance programs
Were aCCelerated, and supplies inventories were
replenished before the end of the year. These items
Were nOt material, amOunting to expenditures of only
about $100,000. But, aS Jack noted, “Every little bit
helps.’’
2008
In 20O8, SOme Of Jack’s fears were realized. As the
economy sIowed down, COnSumerS became more fru-
gal, The once-eXPIoding energy drink category began
to stagnate; COmPetition for market share grew丘erce;
and margins declined. In addition, there were rum-
blings of an impending soft drink ``obesity’’tax that
COuld put even more pressure on profits.
The division was able to make its annual revenue
targets in 2008, but the division managers did so by
Offering an “early order program’’developed by the
Sales and Marketing Department. Customers were
O任ered discounts and liberal payment terms if they
Placed orders scheduled to be delivered before the year
ended. Discounts ranged from 5%亡0 20% and custom-
ers were given 12O days to pay their invoices without
incurring interest, rather than the traditiona1 30 days.
However, Jack leamed later that some of the more
aggressive salespeople had told customers to accept the
208
Shipments now and `just pay us whenever you se11 the
PrOduct.’’
While sales remained strong, PrOfit margin!
decreased significantly. In order to make sure the div主
Sion would hit its AOP profit target, Jack and his con.
troller began to liquidate some of its accounting
reserves in the third quarter, and by the end ofthe year,
the reserves were reduced by a total of $1.7 million,
The auditors noticed and questioned the change, and
brought it to the attention ofJoe Jellison, FFI’s CFO. Joe
looked into the issue and concluded that the new
reserve levels seemed justified based on historical pe手
formance levels.
2009
Sales started out sIowly in 2OO9, but in the second qua手
ter, the sales team landed a m亘ior new national account.
Because ofthe uptake in demand, Jack had now become
more concemed about meeting production schedules
than he was about achieving sales goals. Thus, the
early order program and a鵜most all other promotious
and discounts were eliminated.
Jack also told his controller to rebuild reserves, and
a total of $2 mi11ion in reserves were restored in 2009.
Once again the auditors questioned the change, but the
COntrO11er provided a justification based on uncertainty
in the economy and irregularities in some new custom-
ers’payment pattems, Jack believed that his division
WaS Well positioned for success going into 2010.
Cookies & Crackers Division
The Cookies & Crackers Division (Cookie Division) was
built around the ``Smart Cookie’’product, OnCe F郎
flagship brand. But the Smart Cookie product had been
Struggling for the last several years. Cookies was a low-
growth, low-margin product category with a strong
Private label presence, though quality health-Oriented
brands commanded a small price premium. The biggest
PrOblem for the Cookie Division, however, WaS a S唖
江¥¥し1¥廿0皿籍で
in consumer mindset. In recent years, “healthy’’was ¥¥.1ヽ圧点で正
less likely to be associated with low fat, and more likely 1正トさく1バ
to be associated with healthful ingredients such as 同時間油トし
Whole grains, nutS, and natural antioxidants, a trend し、¥口、面上
that the Cookie Division management had largely (品¥P庫∵
missed. 小川冊h申
Scott Hoyt, the Cookie Division president, had been (-( 、画調e上
With FFI since its inception. Scott had a strong back・ 白=hぐ昔
ground in sales and was credited with selling Smart

ie to national accounts, but he was perceived as
tant to change’and his accounting and finance
ledge was relatively weak.      - ’’
e Cookie Division traditionally relied heavily on a
tyofseasonal trade promotions to achieve their
e targe〔s. By 2008, Catherine Elliot亡, head of the
eting Department, WaS COnCemed that the new
・ed 7% growth rate was probably not attainable
ut both some aggressive marketing and develop-
皿卸Of 50皿e g○○d皿eW耳「O血仁王s- D虹i喀血e a曲り出
Planning process’She made a case for increasing the
division,s advertising and new product development
indge〔串ut her requests were denied. Sean explained
血he did not think the advertising was necessary. He
also believed that the prqiects being funded at the cor-
叩rate level would yield better returns than the pro-
畔d investments in Cookies, and FFI could not a任ord
恥th inve stments.
間脳
鮎ecame obvious early in the first quarter of 2008 that
Cookie sales were falling well below the levels forecast
nthe AOP. The Cookie sales department initiated a
PrOmOtion to meet the first quarter goals. The specifics
Ofthe program were similar to those of the early order
P【Ogram being used in the Drink Division - generOuS
杭untS and extended payment terms for early
O「ders. The early order program was implemented
aggressively. The sales team was told to contact all of
蘭r cu§tOmerS and convince them to take early deliv-
eryofproduct. Many of these contacts were successful.
in most cases, the sales sta任received written authori-
Za[10n from their customers, but in some cases the
a血orizations were only verbal.
【n the血al days of the first quarter, Catherine and
¥岨Michaels, head of the Sales Department, aSked
油ing to work around the dock to ship as much prod-
しCtasPOSSible before the quarter end. In the last hours of
厘quarter, truCks filled with cookies drove a few blocks
描y from the loading docks and parked, SO that product
朝eChnically “shipped’’and sales could be booked.
The heavy sales volume at the end of the quarter
紺acted the auditors, attention. They concluded, how-
’、er言hat the accounting treatment conformed to
AIP (generally accepted accounting principles) since
吉nerShip of the product o鯖cially changed at the time
亜pment.
h the second quarter of 20O8, Scott, Catherine, and
血h knew they had a problem. Second-quarter Orders
Fit Food, lnc.
Were Predictably sIow given the amount of extra prod-
uct that had been shipped in the first quarter. The three
managers then decided to ship additional, unOrdered
PrOduct to their customers. The additional order voト
umes were generated either by increasing the quanti-
ties of actual orders or by entering orders jnto血e
COmPany’s billing system twice. When customers com-
Plained about the unordered shipments, blame was
attributed to human errors, and the sales team was
也a重こ発心扇出血e鍛瓦訪越a駐韓・過重幽α出色r想並車-
ments ``stick.’’They were offered a number of tooIs
toward that end, SuCh as special pricing and credit
terms and product exchanges.
The program worked surprisingly well. Retums
increased, but the program still effectively increased
revenue by $2.3 million and profit by $460,OOO. Scott,
Catherine, and Mitch were encouraged by the results
and praised the sales team for their heroic efforts. They
COntinued the program throughout 20O8, being careful
to rotate the “mistaken’’shipments between customers,
At the end of the year, the team managed to deliver
97% ofthe AOP sales and profits,
2009
During the 20O9 AOP process, Scott, along with Cathe-
rine and Mitch, made a strong plea to reduce the Cookie
Division’s revenue goals. They argued that given the
Weak economy and sluggish category growth, a flat rev-
enue goal, Or at mOSt 2% growth, WaS a mOre reaSOnable
target. However, Sean was unwilling to Iower the goal.
He understood the di鯖culties in the category, but he
believed that the setting of aggressive goals and a com-
mitment to achieve them were cornerstones of FFI,s suc_
CeSS OVer the years, and he knew that FFI shareholders
WOuld be demanding better performance than that.
After the disappointing AOP meeting, Scott called a
meeting with his management team to develop new
ideas for increasing sales. He thought if the division
COuld make it through 2009 successfully, they would
face smoother sailing in 2010 because some neW prom-
1Smg PrOducts would be ready for launching. A decision
WaS made to continue the programs used in 20O8.
Irene Packard, head of the Production Department,
Came uP With another idea. She thought she could
decrease expenses signi丘cantly by rewriting contracts
With suppliers who supplied both machines and parts.
If she could convince suppliers to decrease the costs of
Part§, and charge the difference to machines, She
WOuld be able to capitalize costs that would otherwise
209
Chapter 5. Controi System Costs
have been expensed. Irene estimated that she could
reduce expenses by $2.3 millioh, Or $2 million after
depreciation. Scott thought this waS ’a good idea. He
noted that the cost savings could bring them within
Striking range of the division’s profit goals.
In September, however, One Of the junior account-
ants in the division was feeling unduly pressured to
make accounting entries that she felt were not good
PraCtice, Particularly related to some of the billings
that seemed to lack adequate supporting documenta-
tion. The managers’justifications for these entries
Exhibit l Fit Food, lnc.: Organization chart
210
且xhlbit 2 「l(
seemed to her to be caprlCIOuS rather than facts-based.
FYs ending
She took it upon herself to discuss the issue with Joe
Jellison, FFI’s CFO, Joe had one ofh王s assistant control.
lers examine the accounting practices in the Cookie
Division, and he reported finding multiple problems
With potentia11y material丘nancial statement effects.
Joe had to decide what to do next. Should he have his
PeOPle calculate the size of the errors, make the adjust・
ing entries, and fix the processes, Or Should he, at this
POint, inform the extemal auditors and/Or the audit
committee of the board of directors?
 FitFood,Inc.

bit2 Fit Food, inc.: lncome statements for Spo巾S & Energy Drinks and Cookies & Crackers Divisions,
e[ding December 31 ($ mi=ions)

墓園寓
窒
47・。
00蓋

211

In late 2011, managerS at Atlantis Chemical Industries
Qtlantis) were debating whether the company’s man-
agement systems needed to be changed in response to a
m亘ior strategic shift that the companywas making. The
Strategic shift invoIved a significant redepIoyment of
assets away from commodity chemical businesses and
toward the discovery of new technoIogically advanced
PrOducts that promised higher margins and growth
rates,
James Rockman, COrPOrate Senior vice president of
R&D and chief scientist, WaS an OutSPOken critic of the
COmPany’s current management systems:
Our system of evaiuating performance based on
Short-term financial resuits has t「ained ou「 OPer-
ating managers not to take risks, They wiII not bet
On a horse untiI the race is aImost finished and
the horse is ieading, They tend to think onIy about
the current year’s profits, and tha=s naturai
because they are rewarded fo「 onIy incrementai
improvements. They are penaiized for missing
budget targets but do not get big rewards for
going way over plan,
Others, however, defended the company’s systems,
Which, they noted, had served the company we11 over
the years. They noted that Atlantis was making large
investments in R&D despite the need to maintain a
SOlid eamings record. They were convinced that scien-
tists’natural optimistic biases had to be tempered by a
business-Oriented focus on the prqiects’potential for
COmmerCial success. These managers suggested that
PeOPle with market knowledge should be invoIved
intensively and early when new R&D investments were
being considered to increase the likelihood that R&D
efforts lead to commercial success.
Since the intensity and rancor of the debate had
been increasing, it was decided to put this issue on the
agenda for discussion at the December 2011 meeting of
Atlantis, Executive Committee.
212
萱 pIan画
へ正Il両用最
中-1剛狐
面だ、柄「明
白¥点上澄雄〈
Company background 川」剛で葛
Atlantis, headquartered in Indianapolis, Indiana, WaS a 出回、高庇
large, Publicly listed corporation engaged in
developing, manufacturing, and marketing a broad
range of high-quality chemicals and materials. Itf
Sales reached $6.9 bi11ion in 2010, and it employed
42,000 people in lOO countries.
In 2011, the company had six operating companie5
(see Exhibit l for a partial corporate organizatioh
Chart). The largest group was Atlantis Chemical Com
Pany, the original business, Which still accounted fol
about 5O% oftotal corporate sales.
The Atlantis Agricultural Company, the second-larg
est group, aCCOunted for 17% oftotal sales. As shownin
器霊掌諾:三豊等霊‡器器藍
Crop Chemicals Division was a leading worldwide pro
ducer of herbicides. The Animal Sciences Division
focused on animal nutrition and growth products, Onl
a few ofwhich had already been introduced to the ma
ket. Exhibit 2 provides summary financial data abo
these two divisions.
The strategic shift toward faster-grOWing market
away from the commodity chemicals that had histori
Cally provided most of the company’s sales and pro
its, Started in 20O5. The 201O Annual Report state
that:
AtIantis is determined to be a ieader in its chos飢
markets, but we must deliver resuits in the shor¥
用い八時間Ia
term as we= as generate the resources needed foT
同点¥凧l潮
the coming decades, We wi= achieve this by aggres・
間出血岬
Sively managing good businesses, by inventing a[d
licensing new products that meet customer needs,
同州。し.)同時
and by moving out of businesses that prove unable
間しい、・1¥用‡用
to meet targets,
()川面l
One of these targets was explicitly mentioned in both 中日I言用「甲
the 2009 and 201O letters from the CEO to the share. l、同や( 0開∵
holders: “For the shareholders … this promise meam 川「川¥出口ト掛
i i旧i=占用当)仁

1ngfor a retum on equity year after year in the 20%
ge.’’
nning and budgeting
antis used two distinct plaming cycles, long-range
nning and annual budgeting. The long-range Plan,
1Ch covered a horizon of lO years, Prqiected growth
s for operating income, WOrking capital’R&D’and
d assets for each planning entity.
n June, after senior managers had reviewed and
roved the long-range Plan, they sent the guidelines
tained in the long-range PrQjections to the operating
tsThe managers of the operating units would then
t preparing the fo11owing fiscal year’s budget twhich
cided with the calendar year). The corporate phi-
Phy was that budgets should reflect stretch targets
1ng aPPrOXimately a 50% chance of being achieved.
lng October and November, the budgets the operat-
units submitted were consolidated and presented to,
tinized by, and negotiated with, Senior manage-
nt. In December, Senior management, and then the
rd of directors, aPPrOVed the final budget.
rformance measurement
operating units, primary financial measures of per-
ance were (1) net income, (2) retum on capital
ployed (ROCE), and (3) net cash flow. Net income
s defined as operating income less corporate
rge§, interest, and taxes" ROCE was computed as
lnCOme Plus after-taX interest expenses divided by
rage capital empIoyed. Net cash皿ow was calculated
a formula that adjusted the net income number to
ect actual cash uses and sources (e.g. depreciation,
ital expenditures). These measures were intended
eflect the performance of each business unit as if it
e a stand-alone compa宣ry
he weightings of importance among these meas-
s could vary from year to year, depending on the
as that corporate management identified as critical
each operating unit to focus on. For example, the
phasis on cash flow was higher in the commodity
mical businesses, and that emphasis had been
reasing ln reCent yearS.
uarterly performance review meetings focused, in
t, On rePOrtS COmParing actual results to date with
get. Quarterly review meetings were also an oppor-
ity for the managers of the operating units to give
update on any ongoing strategic initiatives, aS Well
Atiantis Chemica=ndust「ies
as to report any issues affecting the business. The
budget served as the basis for incentive compensation
and promotions.
lncentive compensation
Atlantis had used a formal annual Performance Incen-
tive Plan (PIP) since 2004. The first step in determining
the PIP bonuses was to calculate the size of the bonus
POOl. This was done by comparing corporate net income
with the target set as part of the annual budgeting pro-
cess. If corporate net income fell below 90% of target’
the bonus pooI was zero・ If performance exceeded the
targets by a significant margin’the pooI could be as
large as 8-10% of corporate net income.
Second, the CEO would provide recommendations
regarding allocations of the bonus pool to each profit
center to the Compensation Committee of the Board of
Directors. These recommendations were based on how
we11 each operating unit in terms of its three financial
measures, Which were weighted in importance, aS COm-
Pared to its financial targets.
Finally, the bonuses were allocated to individual
empIoyees. The employee’s job level determined the
maximum percentage of salary that could be paid out
as bonus, although the CEO could grant exceptions in
unusual circumstances, The actual allocation depended
on the degree of attainment of annual personal goals.
rypically, bonuses for division managers did not exceed
50% of their base salary.
The PIP established that the bonuses would be paid
two-thirds in cash and one-third in restricted stock.
The restrictions on the company stock continued until
Atlantis, total shareholder retums performed at least as
well as the average of the Standard & Poor’s 5OO com-
Panies for a subsequent three-year Period.
In 2OO5, the Board approved a new Long-Term
Incentive Plan (LTIP), Pursuant to the LTIP, incentive
payments depended on the corporation,s achieving its
goals for eamings per share and ROCE over overlap-
ping three-year Perfomance cycles. The first perfor-
mance cyde was 2006-2008. However’because of the
severe recession that began in 20O8, COrPOrate Perfor-
mance had not reached the goals stated in the ITIP, SO
no payment oflong-term aWards had been made.
Research and Deveiopment Process
As an aid in managing its sizable R&D effbrt, Atlantis
dassi丘ed R&D activities into three categories. Class I
213
Chapter 5. ControI System Costs

was dedicated to maintaining existing businesses and DecentraIization of R&D activities

the supply oftechnical services. Class II included efforts and assignment of costs
to expand business assets and-markets and to reduce
An R&D decentralization study conducted in 2008 con
COStS Of existing processes. Class III activities focused
Cluded that the company should continue to conduc
On developing new products. Exhibit 3 illustrates how
the company had been increasingly moving its empha-
R&D activities in emerging fields, SuCh as biotechnol
Ogy, at the corporate level, but that the operating unit¥
Sis from Class I to Class IⅡ R&D activities, reflecting a
Should undertake an increasing role in the effort. As8
growing focus on the introduction of new products.
R&D activities in Class III norma11y went through result, Atlantis management started a major effort to

three phases of development before commercializa- Place as much of the R&D activity as possible directl¥
under the controI of the operating unit whose busine!(
tion. The first phase began when scientists discovered a
WOuld benefit from the R&D investment. The general
new product lead. In biotechnoIogy, a major R&D
managers in charge of the operating units would
thrust, this phase invoIved the mdyor technical efforts
become responsible for their unit’s R&D activities and
to isolate the specific gene responsible for the bioIogical
COStS.
Phenomenon under study (e.g. the gene responsible for
The study also developed better bases for furthe
growth in human ce11s, for disease resistance in plant
Cells, Or for production of a certain hormone). Once the asslgnmg COrPOrate R&D costs to the operating unit
Unti1 2OO8, for example, mOSt Ofthe R&D costs associ
gene had been isolated, the process ofduplicating it in a
ated with biotechnoIogy were fully retained at the co
laboratory setting was greatly facilitated. Laboratory
duplication still invoIved gene splicing techniques, but POrate level; but after the changes, a larger part
these costs were assigned to the operating units.
Atlantis scientists had leading expertise in this area.
By 2010, the R&D staffs at the operating unit leve¥
The first phase of research for new product develop-
were capable of performing most types of R&D act柄
ment could take two or three years to be completed. If
ties that were based primarily on exIStmg teChnoIogie5
SuCCeSSful, it generated a new probe.
The second phase of discovery invoIved applying the
When it came to developing new biotech-based tech
noIogy, however, they were still dependent on corpo 用用い、l割出
new technical concept or probe to the development of a
new product candidate. The discovery phase of R&D rate R&D. Corporate R&D also provided the operatins ¥¥同上oI)個・
units some support services, SuCh as bioprocesく 時点I¥肌用団
WaS the most technically challenging, and it could take
research and use of analytica1 1aboratories and an
as long as four years. Only ifthis phase was satisfacto-
information center, On a fee-for-SerVice basis.
rily completed would the R&D activity constitute an
Exhibit 4 shows where Atlantis’R&D costs wert
OngOmg Prq)eCt・
incurred. The operating units directly controlled abou〔
In the third phase, R&D for a new product became a
multi-year PrQject focused on commercial and regula-
80% of total R&D costs. Corporate R&D contro11ed thc
tory issues. On the commercial side for biotechnoIogy remaining 20% of total R&D costs, 10% of whichwa(
retained at corporate level in 2010 and the other lO航
PrOducts, the emphasis was on de丘ning delivery sys-
which was charged back to the operating units, either or
tems (e.g. spray, tablet, Or iI可ection), Creating market-

ing programs, and minimizing production costs. On a fee-for-SerVice basis (9%) or as an allocation based orl
the regulatory side, the tests involved meeting all
net investment (1%). As shown in Exhibit 4, there wasz
marked increase in the extent of costs charged on a fee
Safety and clinical standards set by regulatory agencies
m-e「e§(eご↑
basis to the operating units between 2OO9 and 2010.
until the product was finally approved for consumer
R8D柄物ヾ
The R&D costs retained at corporate related to ba証
use. Compared with the two other stages, the third
research, Which served primarily the chemical and
Stage Of development was by far the most expensive
agricultural co皿panies, and within the latter, the A証
and also the longest, Often taking five years or more to
COmPlete. mal Sciences Division. The retums from most corpo-
rate R&D investments were quite uncertain. It could be
R&D costs typically increased sharply as develop-
a decade or more between the time of initial invesト
ment moved doser to the testing stage for commercial
ments and the completion of tests required to obtain
applications. As John Dover, R&D director of the Ani-
final regulatory approvals. The regulator demanded
mal Sciences Division, nOted: ``It is at least ten times
extensive, multiyear trials to guarantee that the prod-
Cheaper to discover a new concept than to make it into
uct would not adversely affect safety when consumed
a product:’

214

mans, Most prQjects also presented signi丘cant
On Other dimensions, including上echnoIogical
ainties, POtential competition from￣OtIur chemi-
mpanies, and the inherent丘nancial hazards asso-
Cl猶d with substantial investments. As Ron Stovall,
COn[rO11er for the Agricultural Company, eXPlained:
With many of our projects, We Wi‖ probabIy have to
川vest seve「al hundred mi川On doiIars before we
have a commerciai product. A product has to be a
real commerciai hit to pay off such major invest-
me[tS. Biotechnoiogy is the highest risk this com-
Pany has ever taken,
The operating units were not charged for R&D in
emerging areas for two main reasons. One was that
muchofthis kind ofresearch was generic. It potentially
benefitted several operating units simultaneously. For
instance, reSearCh on technology for gene splitting
COuld benefit product lines in either agriculture or
healthcare and possibly other businesses in ways that
Were d雌cult [o anticipate.
The other reason for retaining controI over biotech-
nology expenditures at the corporate level was that this
証estment was crucial for the company’s Iong-term
future, and there was a concem that these R&D invest-
menus should not be entrusted to the operating units,
"「hlCh operated under short-term PreSSure. As James
Rockman explained:
Corporate can’t afford to fund a= the R&D efforts
aio[e, We need to push these costs down to the
OPerating groups that generate enough cash flow to
SuStain these major investments. The ideal wouid
befor corporate to engage only in the very basic
research and to hand a project to the respective
OPerating unit as soon as it reaches a stage when
We Can Staれtaiking about commercialization. The
PrObIem is that l have to be sure that there are
enough peopie at the operating Ievei who are reai菓y
lntereSted in the project. Otherwise, they w川Cut the
轍Dfunding for the project as soon as they start to
feei budget pressure. Operating managers often
like to treat P&D expenditures as variabie costs.
帥ect of profit pressures on R&D
When the consolidated initial budget submissions from
庇operating units did not reach the corporate profit
Objectives, aS WaS uSual, Senior management had to
negotiate revisions with the operating unit managers.
Atiantis Chemica=ndustries
In December 20O9, for example, Greg O’Connor, Atlan-
tis’chairman and CEO, had to raise most operating
entities’profit budget targets for 201O as well as to cut
SOme COrPOrate eXPenSe budgets. The operating man-
agers had the discretion to decide how the profit
increases would be achieved (e.g. through sales promo-
tions, reductions in the cost of goods sold, Or CutS in
R&D expenditures).
The corporate R&D group, Which was operated as a
COSt ⊂enter, WaS affected. James Rockman had to
reduce the 201O budget for corporate R&D from nearly
$93 million to $90.5 mi11ion, Exhibit 5 shows the final
breakdown of the 2010 R&D budget by cost category.
Most of the operating units also concluded that they
had to reduce their R&D budgets to meet the tougher
bottom-1ine targets. For example, John Pastor, PreSi-
dent of Atlantis Agricultural Company, reduced his
R&D budget by $15 mi11ion to a total of $135 million
(about 12% of sales). The Agricultural Company
divisions-Crop Chemicals and Animal Sciences-in
tum revised their R&D budgets to adjust to the new
targets. As was his practice, however, Pastor kept a
reserve in his budget, This reserve could be used either
for important purposes not foreseen at the time the
budget was finalized or to cover budget overruns by his
OPerating managers.
When deciding which R&D prQjects to cut, Pastor, in
COnSultation with his operating managers, COnSidered
SeVeral aspects ofthe future potential ofthe prQiects in
PrOgreSS. A primary criterion was the level of capital
requirements and how they affected the total portfolio
Of prQjects. He also assessed qualitative aspects, SuCh
as the probability of technoIogical success, the total
market potential for the new product, the market share
that Atlantis could expect, and the regulatory require-
ments for final approval. He based his judgments on
reports from the operating managers. Current prQjects,
being cIoser to completion, uSually had priority over
new ones, Which typically represented higher risks to
the company.
In his origina1 2OlO budget, Itzhak Rubenstein, gen-
eral manager of the Animal Sciences Division, Submitted
a budget proposing additions of 25% in technoIogy
expenses. John Pastor vetoed the additions because he
felt that, tO meet his宜nancial goals, he could not afford
any more increases. The Agricultural Company had
SPent mOre than 12% of sales on R&D in 2008, and cor-
POrate had asked for tighter controI over these costs. As a
COnSequenCe, the Animal Sciences Division was asked to
limit its R&D expenditures to a maximum of 5O% of its
215
Chapter 5. ControI System Costs

Sales. Exhibit 6 shows that even after these budget cuts, rather than the iong-term POtential of some艦

the Animal Sciences Division had $35 million in losses in investments. 1f Ieft on their own to fund innovativ
20O9 and a budget of $43 milliori in bsses for 2010. and risky R&D projects, they wouId simpIy choos
During the fiscal year, if division managers wanted not to, We couid possibiy change this shorトterr

to spend more on R&D than budgeted, they would first focus, Or myOPia, if we were wiiIing to deemphasiz
have to consult with their company’s president before budgets, but we don’t seem to want to do that.

making any commitments. On the other hand, if the

OPerating managers had unexpected gains during the
General controversies about
year, they could negotiate to invest the additional R&D funding
income in prqiects beyond the original R&D budget, aS
Iong as the financial performance targets were met and Atlantis’chairman/CEO, Greg O’Connor, WaS Pe即

the actions taken did not result in permanent additions ally committed to making the company a leader in bjl
to R&D expense (e.g. people). technology, but he was also under pressure fromll
financial community to ensure that Atlantis woul
report adequate eamings-Per-Share growth. O’Conn

Funding new P&D p「ojects commented on the balance that must be struck betwe,

PrOfit goals and R&D requirements:

Generally, the doser a prQject was to the commerciali-
Zation stage, the more the operating unit bore its costs. We keep teiling scientists that we’re in businessf:

However, in the case ofpioneering R&D prqjects, Which the pursuit of products, nOt knowIedge. At thee「

required developing new technologies, COrPOrate R&D Of the Iine, eVerything has to tum into a produc
funded the prQjects directly, With no charges to the Unless we seII products, nOthing happens.帥

笥 音   、   ‖     ﹁     よ   っ     ︻         ﹁     よ   ︰ -   ,     )       し     、   ト       `         - . ∴ ∴ ・
OPerating units. In 2010, for instance, COrPOrate R&D aIso know that good research doesn’t happE

budgeted $42.9 million in R&D costs that it would OVernight. i teiI researchers i pray for patien:
retain - under the controI of James Rockman - tO fund every night-and l want it right now.
new product discovery (Exhibit 6).
Greg O’Connor maintained that overfunding is one
There was considerable discussion among the operat-
the primary mistakes to avoid in industrial R&D:
ing units about the use of corporate resources for a cen-
tralized R&D effort. The managers in the chemical if =ook back on the research mistakes we ha,
businesses often felt that corporate management r匂ected made, it was usuaIiy due to overfunding. Ifweag作

高∴ i‖
their capital requests and favored the divisions engaged to pay $25 mi=ion over three years to see their
in, Particularly, biotechnology research. Some Atlantis tangjbIe accompIishment, and after that time¥
Chemical Company managers, Who generated substan- don’t get it, I don’t want that project any more'B

tial cash flow from their mature businesses, had been OnCe the project has surfaced and has gottenし

known to wish secretive獲y that biotechnoIogy efforts there, it is in the annuaI report, and it is hard
WOuld fail so that corporate R&D would release more admit faiiure,
resources for them to invest in their own businesses.
Greg and other ⊂OrPOrate managerS Were Partiし
Some managers of the growing businesses also were
Iarly concemed about the net unallocated R&D cl
Critical of the commitment of funds to corporate R&D
retained at the corporate level. This was the numl
eff。rtS. Theywould have preferred to fund and manage
that would become part of extemal reports and油
R&D, eVen the technically sophisticated biotechnoIogy
WOuld be cIosely monitored by the financial analll
discovery efforts, With their own resources. They
COmmunity. Atlantis, With a reputation for ma虹
argued that only with direct responsibility for R&D
SOund investments in R&D, Wanted to ensure invesh
COuld they ensure that the prQjects being worked on
WOuld not draw the erroneous impression that Rl
Were COmmerCially relevant.
expenditures were getting out of control just becau
James Rockman felt differently, however. He com-
more R&D was being funded at the corporate level.
mented on the need for managing emerging technoIo-
Atlantis had to discontinue a few prQjects afterye,丁
gies such as biotechnoIogy at the corporate level:
OfR&D investments because they failed at the com
Operating managers have a strong incentive to Cialization stage. One example occurred in 2008, W
think shor=erm, tO focus on this year’s income, a sign誼cant prqiect focused on development of a p

216

Wth regulator was terminated. In general, however,
Whole area of genetically engineered plants had
lded very impressive scienti丘c progress. The Crop
emicals Division, for example, had developed some
nts that were genetically resistant to common dis-
eswithout the need for herbicides,
Itzhak Rubenstein (general manager of the Animal
己nCeS Division) commented on how the uncertainty
OCiated with R&D exacerbated the conflict among
Various o切ectives he had to face:
Ontheone hand, l am supposed to invest in the Iong
「un and keep deve10Ping new products. 1 aIready
§Pend 50% of my total revenues on R&D, But I also
have a long-run target tO reaCh a 20% retum on
equity, and I’m running sizable iosses now. So i need
tobevery carefui when aIIocating current resources"
i wish we had a system to evaluate the commercial
POtentiaI of new R&D investments more thoroughiy,
Some peopIe beIieve that if you do good science,
the market wiIl fo=ow, but it’s not always true.
e corporate R&D group maintained dose contact
ith the operating units to assess the new products’
tentials for commercial success. One alternative for
CreaSing discussions of commercial viability earlier
the R&D funding process was to form a commercial
evelopment group reporting directly to the CEO (at
e same level of authority as Corporate R&D). This
mmercial group would get involved in all decisions
about which research prQjects to fund. It would raise
COnSiderations about market needs, the company’s
marketing competitive advantages, and assessment of
COmPe〔itive products at the earliest possible stages of
(he R&D process. Another altemative was to place a
COmmerCial staff function at the operating unit level,
reporting to the operating general manager. The man-
agers who defended this suggestion asserted that the
Operating unit was the most knowledgeable about spe-
証u customer needs and maintained relationships with
POSSible distribution channels thus being in the best
POSition to assess market potential for new products,
R&D personnel were generally opposed to either of
the aforementioned altematives. They argued that if
Atlantis allowed commercial emphasis to interfere
With R&D prqiects at too early a stage, it would thwart
most of it§ OPPOrtunities for innovation. As John Dover,
director of R&D for Animal Sciences, COmmented:
The peopie responsibIe for current products are
theones who bring in the cash so that they are also
Atiantis Chemica=ndustries
the ones with the most power, The peopie who do
exp10ratOry R&D have ve「y iittIe bargaining power.
1t is obvjous that today’s products w川always get
the division manager’s attention, PotentiaI prod-
ucts just don’t provide enough motivation,
Other managers defended the current system. Will
Carpenter, R&D director in the Crop Chemicals Divi-
Sion, argued that:
R&D can’t be an end in itself. It is a means to get new
PrOducts so that you can keep growing" But one wi=
aIways need the financial discipIine of contro=ing
COStS. And good financial controis are not incompat-
ibie with good R&D; they actua=y force us managers
to estabIish priorities and focus our deveIopment
efforts in products with the highest potentiai,
The multiyear nature of R&D prqiects posed some spe-
cial丘nancial problems. Some R&D people criticized
the current process ofannual R&D budgets. John Dover
explained :
A= my projects have at Ieast a four-year horizon"
Y七t, it seems that every year i have to justify myself
byasking forfunding. Whatam I supposed todo if i
don’t get funding for my projects? Why don’=hey
give me funding for four years?
The assignment of corporate R&D costs also was prob-
lematic. In 2010, for example, there was considerable
debate about how Atlantis would fund the maintenance
of the corporate bioprocess development facility, Which
COnducted basic research for several operating units. As
stated in the 2OlO丘rst quarter report, the Atlantis Life
Sciences Research Center, Which housed the bioprocess
development facility, WaS “One Of the largest and most
sophisticated facilities in the world devoted to under-
Standing the chemistry and biology of lifむ’This $150
million facility was dedicated in 2007 and empIoyed
approximately l,200 scientists and support persomel.
Unti1 2OlO, the bioprocess development facility had been
COnducting research related to several prQjects that were
later handed over to the operating units. Yet, the prob-
lem remained about how corporate R&D would allocate
the costs of that facility. The Animal Sciences Division,
Which typically had used more than half of the bio-
PrOCeSS development facility’s capacity, nOW had fewer
PrQjects in progress, and its managers argued that they
Should pay only for the facility costs directly related to its
OWn PrQjects. From a corporate perspective, however,
the facility had to be fully maintained in a state of
217
Chapte「 5. Controi System Costs

readiness because Atlantis was deeply committed to bio- try Ieader in innovative, high-qua=ty products? l Exhibit 2 Fin

technoIogy research and the ∽mPany had to keep its know the「e is pressure to leveI o備our R&D spend-

SCientists motivated and fully occしLPied. The company ing across the company, incIuding corporate P&D.
could not aff0rd to have its scientists sit idle or leave We have got to make sure we get more bang for our
When there was not enough volume to keep the facility R&D buck in terms of priorjtizing those efforts to go
fully operative. After several rounds of negotiations, COr after the most promising commerciaI opportunitie§

POrate R&D, after curtailing other important research if we are going to achieve our new product goais.

PrQjects, decided to absorb the bioprocess development How can we be sure we have the right incentive sys-
facility costs that could not be charged to the operating tem in piace so that the operating managers wi= pri.

units on a fee-for-Service basis, oritize these efforts toward increased commerciaI

Don Pattison, the controller for corporate R&D, WOn- SuCceSS?

dered how the operating unit managers’increasing

These questions re且ected senior management’s con.
influence on R&D expenditures would affect the balance
cem about whetherAtlantis had a problem in the wayit
between the shorトterm PreSSure tO meet the annual
funded R&D. If there was really a problem, What
budget targets and the long-term need to invest in R&D:
Changes should be made to the company’s management

Does increasing operating unit infiuence on our key SyS亡e皿S?

R&D growth programs enhance o「 mitigate our

Chances of meeting our goai of becoming an indus-

Exhibi= Partiai corporate organization chart

Cont「o=ed an

218
醐t 2 Financiai hig帥ghts of the two divisions of At-antis Ag「icuitural Company ($ m冊OnS)

ー CropChemicals AnimalSciences

Sales 1,067 86
2010

2009 1,073 79
2008 1,256 82

Operatinglncome(Loss〉 318 (35)

2010

2009 177 (92)

的08 438 (49)

R&DExpenses 94 41
的10

2009 110 32
2008 107 22

帥bit 3 Corporate R&D costs by major category (%)

2010 2009 2009 2007 2006

C!assi 26% 27% 29% 32% 32%

C獲assii 30 23 22 23 24

Ciass用 40 42 40 35 30

0油e「★ 4 8 9 10 14

丁otal 100% 100% 100% 100% 100%

「掴es corporate unClassifed adm-nlStratlVe COStS言e・g , malntenanCe Of the centraI 「esearch laboratory

Exhibit 4 Distribution of R&D costs between corporate and operating units

2010(%) 2009(%)

D嶋ctlycontro=edandadministeredbytheoperatingunits 80% 80%

Contro=edandadministeredbycorporateR&D: 9 4
ーChargedtooperatingunjts:

-Onafee-for-SerVicebasis
ーallocatedasa“corporatecharge,,basedonnetinvestment 1 6

ーReportedaspartofcorporateB&D 10 10

丁otaiR&DCost 100% 100%

219
 一種.嶋  ○○∴●● 2010Budget 2009Actuai 2010Budgetm血s 2009ActuaICo§(S  $2.3

BiotechProductDiscovery「 $42.9 $40.6

TechnoIo Management2
gy DistributedResearchandDevelopment3 2,4 ○○生豊里
上韮 2.4 」勉0

TotaicorporateR&D $90,5 $92,9 $(2.4)

AP丁ER 7 ・
。nCial Pesponsib冊y Centers

The vast m年jority of organizations control the behaviors of many of their empIoyees, Particu-

larly their managers, through珂arlC証res血s co庇roZ eys亡e肌s. In financial results controI sys-

tems, reSults are defined in monetary terms, mOSt COmmOnly in tems of accounting measures
such as revenues, COStS, PrOfits, Or retumS (e.g. retum on equity). At higher organization levels,
亀nancial results controI systems often are the most pervasive and dominant form of control・

Financial results controI systems have three core elements: (1) frαrlCicIZ respons油揖ty ce庇-

ers, Which define the apportioning of accountability for financial results within the organiza-
tion; (2) p血m血g arld budgedng sys亡e肌s, Which are used for a number of control-related

purposes induding the setting of performance targets for evaluating perfomance; and
(3) ince融ve pZarlS Or CO庇raCts, Which define the links between results and various rewards.
This chapter describes the advantages of血ancial results controI systems and then discusses

in depth one important element of these systems‥ financial responsibility centers. It also

describes one common problem faced by organizations using multiple financial responsibility
centers: the transfer pricing problem. We discuss the other two financial results controI system
elements (planning and budgeting systems and incentive systems) in Chapters 8 and 9,
respe ctively.

ntages of financial resuIts controI systems

Several good reasons explain the ubiquity of financial results controI systems in organizations.
First,缶nancial objectives are paramount in for-PrOfit firms. Profits and cash flows provide

retums to investors and are among the primary measures outsiders use to evaluate for-PrOfit
fim perfomance. Thus, it is natural that managers of for-PrOfit fims monitor their success in
financial terms and use the financial measures to direct their empIoyees’actions toward impor-

tant organizational ends. Managers of non-PrOfit organizations’tOO’muSt mOnitor finances

closely because cash flows usua11y create significant constraints for their organizations.
Second,丘nancial measures provide a szmmary meaSL‘re Of performance by aggregating the

effects of a broad range of operating initiatives across a possibly broad range of markets’

products/SerVices, Or aCtivities into a single (or a few) measure(s). In so doing, they enhance the
comparability of the effects of the initiatives and reduce the possibility of conflicting signals
about their importance. The financial measures remind empIoyees that the various operating
initiatives they take on, SuCh as initiatives to improve response times’defect rates’delivery reli-

ability, Or CuStOmer Satisfaction ratings, benefit the organization only if they result in improved
Chapter 7. Financial Responsibility Centers

financial performance. Because financial measures are a comprehensive summary measure o[

perf宙mance, they provide a relatively easy, Standardized, and inexpensive way for the organi
zation. to evaluate the results of a variety of operational initiatives without necessarily needing
to obtain and evaluate the intricate detail ofeach of the initiatives.
The ubiquity and usability of丘nancial measures is particularlyvaluable for the managemenl

Of complex, diversified firms (as we also discussed, and listed several examples, in Chapter 2).
Management in these organizations can usually set corporate goals in financial terms, decom
POSe the corporate goals into multiple financial responsibility centers, and then monitor onl!
One (orjust a few) results measures - SuCh as, aCCOunting profits or returns and their compo.
nents (revenues, COStS, aSSetS, and liabilities) - Which provide a good summary of the effects of
most of the actions or decisions needing to be contro11ed. The managers then do not needto
track either the actions that are affecting丘nancial performance (e.g. how time was spent, ho¥‘

SPeCific expenditures were made) or the speci丘c line items that comprise the summary meas

ures of performance (e.g. revenues by product line, COSt line item?) until problems (such as fail・

ures to achieve performance targets) appear in the summary measures. The process of getting
invoIved only when problems appear is also known as mcmc[ge肌erlf-め′一eXCePtZorl. In this way

financial results controIs reduce the amount of information that top managers need to process
and evaluate. At the same time, financial results controIs provide a relatively unobtrusive form
Of management control; that is, they provide controI while allowing those being controlled con.
Siderable autonomy.
Third, mOSt financia鵜measures are relatively precise and objective. They generally provide

Significant measurement advantages over sQ斤qualitative or subjective information and over

many other quanti丘able altematives (e.g. quality or customer satisfaction measures). Cash flow -

the primitive financial measure - is relatively easy to observe and measure. Accounting rules,
On Which most丘nancial measures are built, 1imit the managers’measurement discretionl

improve measurement objectivity, and facilitate the verification of the resulting measures.
Finally, the cost of implementing financial results controIs is often small relative to that of
Other forms of management control. This is because the core financial results control measure-
ment elements are largely in place. Organiza亡ions already routinely prepare and transmit elab・

Orate SetS Of accounting information to govemment agencies, Creditors, Shareholders, and other
COnStituencies on either a mandated or voluntary basis. This information can be readily and
inexpensively adapted for control uses. In Chapter lO, We PrOVide a further in-depth analysis of
the features, aS Well as the limitations, Of financial measures of performance.

lypes of financiaI responsib皿y centers

Financial responsibility centers are a core element of a financial results controI system. The
term resporlSZb誼ty ce庇er mcmC[geme庇denotes the apportioning of responsibility (or accounト

ability) for a particular set of outputs and/Or inputs to an empIoyee (usually a manager) in
Charge of an organizational entity (the respo71Sめ班ty centeγう. Responsibilities can be expressed

in terms of quantities of inputs consumed, Physical units of output generated, Particular char.
acteristics of the production or service process (e.g. defects, SChedule attainment, CuStOmer
Satisfaction), Or financial indicators of performance in these areas.
FinarlCZaZ re呼orlSめ据ty centeγS are reSPOnSibility centers in which the assigned responsibili・

ties are de宜ned at least partia11y in月融71CtaZ fer肌s. There are four basic types of financial

responsibility centers: investment centers, PrOfit centers, reVenue CenterS, and cost centers,
Table 7.1 shows that these centers are distinguishable by the financial statement line items fo「

Which the managers are held accountable in each type of center.

262
 Types of financial responsibiiity centers

’fable 7,1 1ypicai exampies of financiai responsibiIity centers

ー三愛 .SeiectedfinanciaIstatement t .Bevenue Costcente「 Profitcenter lnvestment

iineitems Center Center

1ncomestatement Revenue X X X

Costofgoodssold X X X
Grossmargin X X
Advertisingandpromotion × X X

Researchanddeveiopment X X X
Profjtbeforetax 菓臆臆臆漢書臆臆漢 X X
Income書ax X ×

Profitaftertax X X

BaIancesheet AccountsreceivabIe X

lnventory X
Fixedassets X
Accountspayabie X
Debt X

Note x slgnlfleS that the responslblllty Center manager iS (Or COUld be) held accountable for some elements lnCluded ln that
financlal statement =ne ltem
SouI℃e・ K A Merchant, Modem Management Contro/$ystems 7t㍍tand Cases (Uppe「 Saddle RNer, NJ. PrentlCe Hal上1998), P 303

Revenue centers

Revenue centers are responsibility cen亡ers whose managers are held accoun亡able for generating

revenues, Which is a丘nancial measure ofoutput. Common examples are sales managers and, in

noniITOfit organizations, fundraising managers.

Revenues, rather than profits, PrOVide a simple and eifective way to encourage sales manag-
ers to attract and retain customers. However, it will encourage them to make prQβ亡abZe saZes if,

and only if, it can be ascertained that all sales are approximately equally profitable. But if all
revenues are not equally “endowed,” controlling with a revenue center structure can encourage

employees to make “easy’’sales rather than those that are most profitable.

Most revenue center managers are also held accountable for some expenses. For example,
many sales managers are accountable for their salespeople’s salaries and commissions and per-

haps some travel, advertising, and promotional expenses. These managers could be said亡O

manage a Jlet reVerⅢe Center, But while these managers are held accountable for both revenues

and some costs, they should not be considered profit center managers because there is no profit
Calculation relating outputs to inputs; that is, these revenue centers are not charged for the cost
Ofthe goods or services they sell.

Cost centers
Cost (or expense) centers are responsibility centers whose managers are held accountable for
some elements of cost. Costs are a financial measure ofthe inputs to, Or reSOurCeS COnSumed by,
the responsibility center.1 In s亡c[rldclrd cost ce庇ers (sometimes called engineered cos亡ce庇ers),

SuCh as manufacturing departments, the causal relationship between inputs and outputs is
direct, and both inputs and outputs are easy to quantify. Thus, COntrOI can be exercised by com-

paring a standard cost (the cost ofthe inputs that shouZd have been corlS“肌ed in producing the
output) with the costs that were ac亡ua埋亘ncurred. Students of cost or management accounting

will recall that these comparisons are typically done by way of so-Called vαricmce肌adys[s.

263
Chapter 7. FinanciaI Responsibility Centers

In discre亡iorlCny COSt Ce庇erS (sometimes called marlClged cos亡ce庇erO, SuCh as research and

development〇五epartments and administrative departments (e.g. persomel, PurChasing,

accounting, eStateS), the outputs produced are di鯖cult to value in monetary tems. In addition,

the relationship between inputs and outputs is not well known. Thus’eValuations of discretion-

ary cost center managers’performances often have a large s巾iective component to them. Con-

trol is usua11y exercised by ensuring that the discretionary cost center adheres to a budgeted
level of expenditures while successfully accomplishing the tasks assigned to it.
That said, firms often tum some oftheir ``service departments’’such as, Say, human resources,

into profit centers by allowing them to charge the other divisions for the services they provide
(e.g壷r hiring empIoyees or running training programs).2 This works we11, however, Only when
the non葛SerVice departments (that is, the customers of the service departments) have the free-

dom to contract these services from extemal providers; that is, When they are not capt±γe tO the

intemal service provider. When this is the case, the service centers have an incentive to provide
good service at competitive prices, Where this discipline is imputed merely from setting them up
as profit centers and thus making them instantly focused on being competitively responsive to
the demand for their services (which generates their revenues) in an e飴cient (cost effective)

way. As we will see next, PrOfit responsibility makes managers focused on bo軌revenues and

costs, and not on each singularly as is the case in revenue and cost centers’reSPeCtively・

A good example of this is Cisco, the large technology丘rm’Which in 2014 embarked on the

concept of寝revenue marketing,, aimed at making marketing a revenue center rather than a cost

center. Karen Walker, Senior vice president of marketing at Cisco, Said that ``the goal was that
making Cisco’s marketing division a profit center would drive $10 billion in sales-qua皿ed lead§

and contribute lO percent to company,s global sales revenues.,, Simply put’the idea was that

marketing would see revenues allocated from generating JleW aCCOuntS, but also the cost of

generating them, Where accounts already mapped to Cisco account managers would not count
as net-neW business.3
Another example can be found in some banks. The Royal Bank of Scotland runs its tuma-
round division, an entity focused on businesses in default that it has lent to, aS an “intemal

profit center’’called the GIobal Restructuring Group (GRG), With its own profit and loss account
based on the incremental income that it generates for the bank less its operating costs. Some
have expressed concem about this as “there is dearly a risk that the [profit-driven] interests of

the bank will take precedence over those of customers in financial di鯖culty, Particularly in

times of limited liquidity and capital constraints,’’Simon Hart, a banking litigation partner at

law fim RPC, Said. The assertion is that, “On OCCaSion, although purporting to be acting in the

interests of a turnaround, GRG may in fact be acting to retrieve the maximum value for the
bank by initiating a recovery or resolution process and thereby actually hastening the failure of
businesses.珂

Profit centers

Profit centers are responsibility centers whose managers are held accountable for some meas-
ure of pro丘ts, Which is the difference between the revenues generated and the costs of generat-

ing those revenues. Business terminoIogy often is not precise’and many firms refer to their

investment centers as profit centers. But there is a conceptual distinction between profit and
investment centers (which we discuss below): PrOfit center managers are held accountable for

profits but not for the investments made to generate them.

Pro丘t and investment centers are an important control element of the vast majority of

firms above minimal size. Profit centers, however, COme in many different forms, SOme Of
which are considerably more limited in scope of operations than others. In deciding whether
or not a responsibility center manager truly has profit center responsibility, the critica1

264
 丁ypes of financiaI responsib冊y centers

question to ask is whether the manager has significant influence over bo亡九revenues and costs.
Tdke Bonnaroo, a lOO-b型Idjamboree music and ar亡S fest土vaI on a farm outside ofNashviHe,

Which is run as 16 0n-Site prQ缶t centers, including concessions, merChandise, and even paid

Showers. The managers of each of the on-Site profit centers are responsible not only for gross
revenues, but also for the costs they incur to generate the revenues. Maybe due to linking
revenues and costs so directly, and assigning responsibility at the profit level, Bonnaroo has
been one of the most financially successful music festivals in North America during the last
decade.5
However工here are variations of full-fledged profit responsibility that organizations can

できこミ這ふて蕊. ㊦艇言霊もでき濃孟衰え屯に五重芯乎議誌謎糠章五誌積読添冥途や三波ミニヱぎ亘ここミミふ蚤主蓮淀ミ竜三を
made into profit centers by charging the entity managers the standard cost ofthe products sold,
thus making them accountable for gross maγg証. Even this limited assignment of costs provides

the manager with useful information. Decisions, SuCh as about sales and marketing direction
and intensity, Wi11 be made based on the incremental contribution to the firm (i.e., grOSS mar-

gins) rather thanjust gross revenues.

Another limited form of pro丘t center is created where cos亡二句cused entities are assigned

revenues based on a simple function of costs. A typical example exists where manufacturing
and administrative departments supply I元ique products or services, for which sometimes

extemal market prices cannot be determined, tO intemal customers only. Revenues for
these entities might be calculated as cost plus a markup. Are these cost-focused entities
PrOfit centers? As we have discussed above, it depends on the extent to which the buying
entities are captive, Which they may we11 be due to the lack of an outside market altemative
for these services. But when the assigned prices are reasonably, although imperfectly, Set Or
benchmarked on a value-for-mOney basis, the service departments will at least be more
motivated to produce quality intermediate products, PartS, Or SerVices; tO PrOVide superior
delivery schedules; and to provide friendly, hassle-free customer service to generate the
aZ!oca亡ed or assigned revenues lest their “intemal customers’’start complaining about the

POOr SerVice or make noises to search for altemative suppliers. Thus, eVen though the reve-
nues are artificially imputed in these cost-focused pro宜t centers, the main idea is to transmit

the competitive pressures faced by a firm in the marketplace to its intemal service groups.
Intemal profit centers that do not directly interface with the market and have no controI
over revenues in a competitive sense are also sometimes called融cro profit centers.6 If the

entities do not have significant control over the revenues assigned, however, they are merely

PSeudo profit centers. Assigning revenues to these entities to allow a profit figure to be shown
is merely a way to charge the buying entities a cost-based approximation ofa market price so
that their profits are not overstated and can be compared more easily with entities that
SOurCe eXtemally.
In deciding whether an entlty lS a PrOfit center, it is not important to consider either whether
the entity’s goaI is to maximize profits or whether any revenues are generated from outside the

firm, however. The financial goal ofprofit centers, SuCh as those in not-for-PrOfit organizations,
Can be merely to break even. For example, hospitals can adopt a ``profit center’’structure to

relate the costs of patient care in various clinical groups directly to revenues received either
from the patient, through insurance payments, from govemment subsidies, Or Via other sources
(e.g. grants). The primary goal of the “profit centers’’in this case is not to maximize profit;

instead it is to assess and manage the costs ofmedical care within the constraints applied by the
funds available. Because the managers of these entities allocate resources (costs) in relation to
the funds available (revenues), and thus essentially make cost-reVenue tradeo任i, they should be

COnSidered “profit center” managers, eVen though that term is rarely used in the notfor-PrOfit

SeCtOr. Similarly, it is not necessary that a profit center generates revenues from outside the
Organization. Many profit centers derive most, Or eVen all, Of their revenues by selling their

265
products or services to other entities within the same organization. These sales are made ar E Choic
fr肌的・Prices, Which we discuss in detail later in this chapter.

lnvestment centerS

Investment centerS are reSPOnSibility centers whose managers are held accountable for bot
some income statement and some balance sheet line items; that is’for both the accountin

returns (profits) arld the investments made to generate those retums. A corporation is an lnVeSt
ment center, SO tOP-level corporate managerS, SuCh as the chief executive’Often are investmen

center managers. so are the managers of many subsidiaries’OPerating groups, and divisions in

large,decentralizedorganizations.                . _ 「

Accounting retums can be defined in manyways, but they typically invoIve a ratio ofthe pro[
its eamed to the investment capital used. The varying definitions cause many different lat)e雨

be put on the investment centerS, bo亡亡om軸o’SuCh as retum on investment (ROI)’return On

equity (ROE), retum On CaPital empIoyed (ROCE), retum On net aSSetS (RONA), return On tOtal
capital (ROTC), risk adjusted return on capital (RAROC)’and many other variations.7

Variations

Although the conceptual delineation of the four categories of financial responsibility centers is
clear, there can be considerable variation within each丘nancial responsibility type. For exam-

ple, Table 7"2 shows four quite different responsibility centers’eaCh of which is a profit center
even though the breadth of responsibility’aS reflected in the number of income statement line

items for which the managers are held accountable’Varies considerably. Gross mα7官in center

managers may be salespeople who se11 products of varying margins and who are charged with
the standard cost of the goods they sell. The “profit” measure gives them an incentive to sell

higher-margin products rather than merely generating additional’POSSibly unprofitable’reVe-

nues. The incomp厨e pr堆ce庇er managerS may be managers of product divisions but without

authority for all of the functions that affect the success of their products or product lines’SuCh

as research and development or advertising. Co'xpZe亡e prQ斤亡cer蛇r managerS may be business

unit managers who are accountable for all aspects of the worldwide performance of their busi-
ness segment. similar variations are also common among the other responsibility center types’

as the managers are held accountable for more or fewer financial statement line items.

1fabie 7・2 Four types of “profit’’center

Seiectedfinanciaistatement Grossmargin lncompiete Before-taX Complete

iineitems Cente「 PrOfitcenter PrOfitcenter PrOfltCenter

Incomestatement X X X X
Revenue
Costofgoodssold X X X X
Grossmargin X X X X
Advertisingandpromotion X X X
ResearchanddeveIopment X X
Profitbeforetax X X
Incometax X
Profitaftertax X
 Choice of financial responsibiIity centers

hoice of financial respon…jbility centers

The four financial responsibility center types can thus be contrasted in a hierarchy reflecting
the breath of financial responsibility’Or the number of financial statement line items for which

the manager is held accountable, aS Shown in Table 7.1. Revenue and cost center managers are
held accountable for only one’Or SOmetimes a few, income statement line items. Profit center

managers are held accountable for some revenue and some expense line items. Investment
Center managers are held accountable for a measure of profit that is related directly to the
reSOurCeS COnSumed by their entity as reflected by line items on the balance sheet.
One important point to keep in mind is that the lines between the financial responsibility
Center tyPeS are nOt always easy to discem, SO reSPOnSibility center labels are not always
主nformative. In actual practice, financial responsibility centers can be arrayed on an almost

Seamless continuum from cost or revenue centers to invesment centers. For example, ∞nSider

the case of manufacturing managers who are held accountable for meeting customer speci丘ca-

tions, PrOduction quality standards, and customer delivery schedules, in addition to costs. In
COmbination’these non-COSt factors may largely detemine the company,s success in generating

revenues’and these managers 。early have to make tradeoffs between costs and factors that

aifect revenues. But’teChnically, these managers are cost center managers.

Much more important than the labeling of financial responsibility centers are the decisions
that have to be made in designing financial responsibility structures. The important question to
answer is: Which managers should be held accountable for which specific financial statement
line items? These choices are obviously important because they affedt behavior. Managers pay
attention to the measures for which they are held accountable.8 Thus’from a behavioral angle,

the answer to the question is relatively straightforward: Hold managers accountable for the line
items you want them to pay attention to.
Tb a large extent’firms, financial responsibility center structures are coincident with the

managers’areas of authority・ Areas of authority are defined by organization structures and

POlicies that define managers’decisio涌g庇. In a typica皿nctional organization (Figure 7.1),

none of the managers has signi丘cant decision-making authority over both the generation of

revenues and incurrence ofcosts’SO reVenueS and costs (including the costs ofinvestments) are

brought together in a retum measure only at the corporate level・ The manufacturing, engineer-

ing’and administrative functions are typica11y cost centers, and the sales function is a revenue

Cen[er. Jn a亡ypjca] divjs王onaJized o重ganjza亡jon (Figure 72らd上visjon managers are gjven

authorjtjes to make decisions jn aI]’Or a亡Ieas〔 many’Of the func〔ions that aifect the success of

Figure 7.1 1油cal fina=Ciai responsib冊y centers in a functional organization

Key: lC = investmentcenter

RC = Revenue center
CC = Cost center
Source K A Merchant’Modem ManagementContro/$ystems・ 7款tandCases (Upper Sadd'e BlVer, NJ Prent'Ce Hall, 1998), P 308

267
Chapte「 7. Financiai Responsib冊y Centers

Figul.e 7.2 1ypicaI financiaI responsibility centers in a divisionaiized organization

The tr

Key: IC = Investmentcenter
PC = Profit center
RC = Revenue center
CC = Cost center
Source K A Mercha=t,肋olemル加agement Co励つI Sysfems・ 7謝and C2SeS (Upper Saddle RlVer. NJ膏rentlCe HalI, 199鋸霊

their division. Consistent with this broad authority, eaCh division is a profit center (or invesト

ment centeI) comprised of multiple cost and revenue centers.

Decisions about an organization,s structure do not necessarily precede decisions about the
type of responsibility centers that should be used; the responsibility structure decision can
COme first. For example’the desire to have managers make tradeoffs between revenues and

COStS may lead to the choice of a divisionalized organization structure, As such, there should be
a 。ose relationship between decisions about organizational structure and responsibility cenト

ers, aS that is where decisfo棚uthordy and res庇s acco肌でa掘ty meet.

The desire to have managers pay attention to a particular line item does not necessarily
mean that the managers need to have direct and compZcte coritroZ over the item, although it
Should mean that the managers have so耽e砂地erlCe OVer the line item. Some managers are p皿

POSely held accountable for line items over which they have no direct control, SuCh as corporate
administrative expenses’tO emPOWer them to influence the behaviors of the managers with

direct control. We discuss this further in Chapter 12.

Specific strategic concems sometimes also aifect the choice of responsibility center struc-
ture. A strategy focused on providing superior customer service may dictate that the managers
Of responsibility centers with direct customer interfaces (such as customer support) should be
held accountable for revenue or profit because having these managers focus just on costs could
CauSe behaviors that conflict with the company,s strategy (such as behaviors that reduce costs
by skimping on customer service). Altematively, these managers could be held accountable for
COStS Plus a measure of customer satisfaction.
Some strategies might even suggest that managers not be held accountable for line items ove「

Which they dearly have in血uence. It may be desirable no亡to charge entity managers for the costs
 The transfer p「icing problem

Ofcertain activities (such as research and development costs or information technoIogy costS) in
Order to stimulate greater u鍵, Or at least not to discourage use, Ofthese services at the detriment

Of, Say, business development or innovation. If the entity’s strategy depends on technoIogica1

1eadership, for example, COrPOrate managerS might not want the entity managers to make rigid
COSt-benefit tradeoffs on every expenditure in this critically important strategic area.
Finally, aS business models change, SO Should responsibility center structures. For example,
imovative corporations today are starting to look at energy management in an era of sustaina-
bility in a different way, focusing on how energy management can help the business rather than
treating itjust as a cost. Specifically, COmPanies are丘nding that they can reduce energy use by

investing in prqjects that can eam tax incentives, Create neW lines of business, and, in many
COuntries, qualify as a tradable asset in financial markets. A shift in energy management from
an “environmental cost’’to an “environmental asset’’ca11s for tuming a cost into a profit through

recyding waste into a source of energy (the excess ofwhich can be sold) as well as through
reducing energy usage, Which not only saves costs, but also can eam tax incentives and carbon
Credits worth millions a year. This approach to energy management, in tum, CreateS the need
for a profi[ Center StruCture Where there were previously only costs and risks.9

The transfer prlClng P「Oblem

Pro丘t (or invesment) centers often supply products or services to other profit centers within the

Same firm. When that happens, SOme meChanism for determining the prices of the transfers
must be established.10冊r血昨r prices directly affect the revenues of the selling (supplying)

PrOfit center, the costs of the buying (receiving) profit center and, COnSequently, the profits of
both entities, thus essentially making transfer prices subject to “zero-Sum’’considerations (that

is, mOre reVenue for one is more cost for the other). The impact ofthese transfer prices depends
largely on the number and magnitude of intemal transfers relative to the size of each entity.
When the amount of transfers is significant, failure to set the right transfdr prices can signifi-
Cantly affect a number ofimportant decisions, including those regarding production quantities,
SOurCing, reSOurCe allocations, and evaluations of the managers of both the selling and buying

PrOfit centers. Put simply, When this is the case, it ups the stakes in the zero-Sl」m game amOng the
transfdrring entities.

Purposes of transfer p「lCIng

Transfer prices have multip量e organizational purposes, and these purposes often con血ict. One

PurPOSe Of transfer prices is to provide the proper economic signals so that the managers
a節ected wi11 make good decisions. In particular, the prices should properly influence both the

Selling profit center managers’decisions about how much product/SerVice to supply intemally

and the buying profit center managers’decisions about how much product/SerVice to buy inter-

na11y. Ideally, then, the decisions that the transferring entities make should be “optimal’’not

Only at their own entity level, but also for the corporation as a whole. Ill-devised transfer prices
Often do not achieve a global optimum even while being locally optimal - for example, because
they cause the buying profit centers to source extema11y while there is excess capacity for the
inputs in the supplying entities elsewhere in the corporation.
Second, the transfer prices and subsequent profit measurements should provide information
that is useful for evaluating the performances of both the profit centers and their managers.
Transfdr prices directly a縦にt the profits of both the selling and buying entities. Ideally, the

transfer prices should not cause the performance of either entity to be either over- Or under-
Stated. Misleading profitability signals can adversely affect allocations of resources within the

269
Chapter 7. Financial Responsibiiity Centers

firm’thus rendering them sul,apdmc[Z. They can also severely undercut profit center manage

motivations because the managers will argue that they are not being treated fairly.
￣ Third, tranSfer prices can be set to purposely move profits between firm locations. Seve

factors can motivate managers to use transfer prices in this way. When firms are operating
multiple taxjurisdictions (countries or states), their managers might be motivated to use t
fer prices to move profits between jurisdictions to minimize taxes. Corporate income tax ratt
differ signi宜cantly across countries, and managers can set transfer prices to eam profits in relz

tively low-taX Iocalities to maximize after-taX WOrldwide profits. Although this particulz
aspect of the transfer pricing problem is beyond the scope of this chapter, eVidence sugge§l

that the maximization of global profits remains a critical consideration of transfer

Cies in multinational corporations.11 clearly, SuCh transfer pricing arrangements that dete
mine how firms, taxable profits are αallocated" between countries is politica11y controversi

They often make headlines in the press, Where Apple, Google, Starbucks, Fiat, and other bi
name companies are chastised as tax dodgers, irking their customers and damaging their rep
tations as socially responsible corporations.12
Profit repatriation limitations also may encourage companies to use transfer prices to m
PrOfits between entities across country borders. For a number of reasons, including balance
PaymentS PrOblems and a scarcity of foreign currency reserves, SOme gOVernmentS PrOhjb
repatriation of profits, either directly or indirectly. Indirect forms of restrictions
torted exchange rates or high withholding tax rates. When companies are unable to repatria
PrOfits from their enti亡ies in foreign countries’they are motivated to set transfer prices to mi
mize profits in those countries.
Companies also sometimes set transfer prices to shift profits between who11y owned subsi
aries and entities where the profits are shared with, Say, joint venture partners. As a matter
fact’tranSfer prices are for this reason often strictly induded and set out in great detail in t

joint venture contract to avoid possible expropriation. Sometimes transfer prices are set
move profits to an entity being positioned for divestment in hopes of increasing its valuati
and, hence, its selling price.
These multiple transfer pricing purposes often conflict.13 Except in rare circumstanc
tradeo任s are necessary because no single transfer pricing method serves a11 the purposes we

The usual desire to have transfer pricing mechanisms operate automatically between entiti
Without frequent interventions from corporate management, PrOVides another transfer prid
COmPlication. Transfer pricing interventions undermine the benefits of decentralization. Th
reduce profit center (entity) autonomy and cause decision-making complexity and dela
They also increase organizational costs, Particularly in terms of the management time need
to review the facts and to reach a transfer pricing ``ruling,, acceptable to all entities involve
Thus, fims seek to set transfer pricing policies that work without producing m亘ior exceptio

and disputes.14

巾ansfer prlClng aItematives

Most firms use any of five primary types of transfer prices" First, tranSfer prices can be bas
On mC[rketprtces・ The market price used for intemal transfers could be the listed price of

identical (or similar) product or service, the actual price the se11ing entity charges extern
CuStOmerS (perhaps less a discount that re且ects Iower selling costs for intemal customer§),

the price a competitor is o任ering. Second, tranSfer prices can be based on maIginaI costs, Whi

are approximated as the variable or direct cost of production. Third, tranSfer prices can
based on the利きcosfs ofproviding the product or service. Both marginal and full cost-basci

1:ranSfer prices can reflect either standard or actual costs. Fourth, tranSfer prices can be set

J珊! cos亡pZus a棚rkap. Finally, tranSfer prices can be negot血ed between the managers oft
 The transfer pricing probiem

Selling and buying profit centers. Information about market prices and either marginal or full

PrOduction costs often哩ovide input into these negotiations, but there is no requirement that
they do so.      . ‥

On balance, SurVeyS Of practice across sources and time seem to suggest that transfers at
marginal cost are rarely used and that most companies intemally transfer goods or services at
either market prices or variations of full costs (e.g. full cost plus markup). In other words, What
emerges is that both market price and ``cost-Plus’’methods are the most widely used. Perhaps

due to the increased scrutiny and enforcement by the tax authorities of the presumed armt-
ZeJlgt九principle (see below), mOSt COmPanies use market-based transfdr prices for international

transfers more often than either cost-based or negotiated transfer prices.15 we discuss each of
the transfer pricing methods next.

Markeトbased transfer prices

In the relatively rare situation where a perfectly (or at least highly) competitive extemal market
exists for internally traded goods or services, it is optimal for both decision-making and perfbr-
mance evaluation purposes to set transfer prices at competitive market prices. Aper毎dy com-

Petitive market exists where the product is homogenous and no individual buyer or seller can
unilaterally aifect its price.
The case for using market-based transfer prices under competitive conditions is apparent. If
the se11ing profit center camot eam a profit by se11ing at the extemal market price, then the
firm is better off shutting that profit center down and buying from an outside supplier, all else
equal. Similarly, if the buying profit center cannot eam a profit by buying its inputs at the pre-
Vailing market price, then the firm should shut that profit center down and have its se11ing profit
Center Sell all its outputs to outsiders in the market. Hence, iftransfer prices are set at market
Price, managerS Of both the selling and buying profit centers are likely to make decisions that
are optimal from the firm’s perspective, and reports of both of their performances wi11 provide

good information for evaluation purposes.

Entities within organizations, however, rarely operate as they would as stand-alone firms in
the open market.16 Therefore, many fims use qzJaSf market-based transfer prices by a11owing
deviations from the observed market prices. The deviations allow for a句ustments that reflect

differences between intemal and external sales. These di任erences can reflect the savings of

marketing, Selling and co11ecting costs, the costs of special terms oifered only to extemal cus-
tomers (e.g. warranties), Or the value of special features, SPeCial services provided, Or differ-
ences in quality standards. Adjustments in market prices also may reflect the belief that the
Price quoted by the extemal supplier is not a sustainable competitive price. The price quoted
mightjust be a low-ball bid designed merely to get the first order. The greater the number and
size of these adjustments, however, the more the market-based transfer prices are like cost-
based prices, and the more di鯖cult the transfer pricing tradeoffs become.

Marginal-COSt tranSfer prices

When intermediate products and services are exchanged intema11y at marginal cost, it is easy
to determine the total contribution generated by the final product or service to the firm as a
whole. The total contribution is simply equal to the selling price of the final product or service
minus the marginal cost of the last production or service process stage・ Although this might be

appealing from a cost accounting perspective, and sometimes from a price-Setting perspective
for short-term Pricing decisions, it creates a problem when viewed from a responsibility center

PerSPeCtive. The reason is that the total contribution is not easily traceable to each of the sup-
Plying entities, nOr do any of the supplying entities even recuperate their full costs, Which
makes it unfeasible to evaluate them as profit centers. At best, they can be st肌dclrd varfabZe cos亡

ce庇ers; that is, their performance evaluation depends on the extent to which their cICmd

271
Chapter 7. Fina=Ciai Responsib冊ty Centers

variable costs for a given output are at or below the standard variable cost. As we have dis-
cussed aboVe, this obviously is a very limited form of financial results accountability・

This pe血aps.ckplains why the survey sources mentioned earlier indicate that companies

rarely use marginal-COSt tranSfers. Indeed’the rarity of use of this method is likely due to the

fact that marginal-COSt tranSfers provide poor information for evaluating the economic perfor-
mance of either the selling or the buying profit center・ The selling profit center will typically

have to record losses because it bears the full cost of production or provision while recelVmg in
revenue only the marginal costs. Conversely, the profits of the buying profit center will be over-
stated because it does not have to pay for even the full cost of the transferred goods or services.
Marginal-COSt tranSfer prices also are sometimes di鯖cult to implement. Relatively few com-

panies can measure marginal costs accurately. Direct costs (direct material, direct labor) are
not the problem; indirect costs are. Companies that use marginal-COSt tranSfer pricing usually
define marginal costs as standard variable costs’but there is no clean break between variable

and丘xed indirect costs. Indirect cost a11ocations sometimes are quite arbitrary. Marginal costs

also are not always constant over the range of output. Sharp increases in marginal costs may
occur if the selling profit center is operating near a capacity constraint.

FuIt-COSt tranSfer prices

Transfers at理cosf Or珂cos亡p虹s a mc[rkup are more widely used. Full-COSt tranSfer prices

offer several advantages. First, they provide a measure of long-run Viability. For a product or
service to be economically sustainable, its餌I cost - nOtjust its marginal cost - muSt be recu-

perated, aCtua11y even generating a margin above full cost. Second’full-COSt tranSfers are rela-
tively easy to implement because firms have systems in place to calculate the full costs of

produc[ion (goods) or provision (services). Finally’full-COSt tranSfers are not as distorting for

evaluation purposes since the selling profit center is allowed to recover at least the full cost of

production or provision.
Full-COSt亡ranSfer prices are not a panaCea’however・ Fu11 cost rarely reflects the actual, C皿

rent cost of producing the products or the services being transferred. Some of the distortions
are caused by poor cost-aCCOunting systems that invoIve arbitrary overhead cost allocations. In
addition, Strictly fu11-COSt tranSfer prices do not provide an incentive for the se11ing profit center
to transfer internally since they in。ude no profit margin. If internal transfers are a significant

part ofthe selling profit center,s business, then that entity,s profit will be understated. Transfers
at重出cos申us fl榊rkup’however’do a11ow the selling profit centers to earn a PrOfit on inteト

nally transferred products or services. They also provide a crude approximation of the market

price that can be used in situations where no competitive external market price exists・ But
because the markup is internally set, SuCh transfer prices are not resPOnSive to changes in ma手

ket conditions.

Negotiated巾ansfer Prices

Another transfer pricing altemative is to a11ow the selling and buying profit center managerS tO
negotiate between themselves. This policy can be effdetive only if the profit centers are not Cap-
亡ive to one anOther; that is, the selling profit center has some possibilities to sell its product out-

side the company, and the buying profit center has some outside sources of supply・ Captivity

obviously erodes bargaining power and undermines the negotiations.

Aside from that, negOtiated transfer prices often cause several other problems. Negotiating a
potentially large number of transactions is costly in tems of management time. Negotiation
often accentuates COnflicts between profit center managerS’and resolution of the conflicts often

requires mediation from corporate management. The outcome of the negotiations often depends
on the negotiating ski11s and bargaining power of the managers invoIved’rather than its likely

being economically optimal. If one of the entities has reasonably good outside selling or sourcing
 The transfer pricing problem

POSSibilities but the other does not, the bargaining power will be unequal. The unequal bargain-
ing power will be magn誼ed if the transaction is a relatively small proportion of the business of

one of the entities and a relatively krge proportion ofthe business ofthe other. The managers of
the small-PrOPOrtion entity will have considerable bargaining power because they can walk
away from the transaction without bearing serious consequences. And managers, egos and self-
interest can sometimes lead them to try to gain an upper hand in the negotiations over peers
with whom they compete for recognition, bonuses, and promotions, eVen at the expense of the
COrPOration’s best interest.

Variations
Researchers have proposed several variations of one or more of the primary transfer pricing
methods. All of these variations have some merit and so are worth mentioning, although their
actual usage may vary m lmPOrtanCe and with circumstances" One possibility is to transfer at
ma7名inal costs pZL[S C[j千JCed血mp-Su肌Jte. The lump-Sum fee is designed to compensate the sell-

ing profit center for tying up some of its fixed capacity for producing products that are trans-
ferred intema11y. This method has some obvious appeal. It preserves goal congruence because
additional unit transfers are made at marginal cost. It preserves information for evaluation pur-

poses because the selling division can recover its丘Ⅹed costs and a profit margin through the
lump-Sum fee. It also stimulates intra-fim plaming and coordination because the selling and
buying entities must discuss the bases for the lump-Sum fee.
The m亘ior problem with the marginal-COSt-Plus-1ump-Sum method is that the managers

invoIved must predetermine the lump-Sum fee based on an estimate of the capacity that each
internal customer will require in the forthcoming period. If these estimates are incorrect, then
the charges will be inaccurate, and the capacitywill not be assigned to the most profitable uses.
If the se11ing entity changes all the lump-Sum Charges after the fact to reflect each customer’s

actual use of capacity, then the result will be nearly identical to transferring at the full cost of

PrOduction.
DuaLrafe fr伽垂rprfces are anothervariation. In this case, the selling profit center is credited

with the market price (or an approximation of it), but the buying profit center pays only the mar-

ginal (or fu11) costs ofproduction. This scheme double counts the profits the corporation eams on
each transaction. The accounting entries are balanced by putting the d肺erence in a holding

account at corporate, Which is eliminated at the time of financial statement consolidation.

Dual-rate tranSfer prices have two basic advantages. First, the managers of both the se11ing
and buying profit centers receive the proper economic signals for their decision-making. The
seller receives the market price and is thereby not discouraged to transact intemally. The buyer
pays only the marginal (or fu11) cost and, thus, Should normally be encouraged to buy inter-
nally・ As such, the dual-rate tranSfer prlClng method almost ensures that intemal transactions

will take place, making it possible to maintain a vertically integrated production process.
However, dual-rate tranSfer prices have disadvantages・ Dual-rate tranSfer pricing can

destroy the internal entities, proper economic incentives. Since the buying profit centers pay
only marginal (or full) cost, they have little incentive to negotiate with outside suppliers for
more favorable prices. Hence, the selling pro紐centers find it easy to generate intemal sales

because the transfer pricing policy shields them from competition. Many corporations also dis-
1ike to double count profits because it is often di鯖cult to explain to the profit center managers

how the double counting has overstated their entity profits. Equally, When the dual rates invoIve
bookings across intemational borders’the corporation may wish to avoid alaming the tax

authorities by the double counting and the retrospective adjustments to the accounts. What
may seem merely to be an intemal accounting adjustment may not be seen this way by the tax
authorities or the regulators and, for this reason’may also not be favored by the firm,s extemal

auditors.17

273
Chapter 7. Financial Responsibility Centers

Simultaneous use of multip!e transfer prICing methods

One potent直response to the need to serve multiple transfer pricing purposes is to use multiple

transfer pricing r請hods at the same ti皿e. Howeve亘t is virtually impossible to use two differ-

ent transfer pricing methods and simultaneously serve both the decision-making and evalua-
tion purposes because managers make decisions in light of the numbers for which they are
being evaluated. Tradeoffs here are usually inevitable.
When丘rms do use multiple transfer pricing methods, they typically use one method for

intemal purposes - both decision-making and evaluation - and another method to affect taxa-
ble profits acrossjurisdictions.18 But the countries in which multinational corporations operate
obviously have incentives not to a11ow these firms to “optimize’’reported profits through trans-

fer prices, aS theywill suffer tax Iosses ifprofits are moved out oftheirjurisdiction. Or they may
suffer decreased market competitiveness if the firm manipulates its transfer prices to maintain
a monopoly position as a supplier. Therefore, 1aws often require an clrm畠eng亡h transfdr price;

that is, a Price charged to the associated entity as the one between unrelated parties for the
same transactions under the same circumstances. The United States has no restrictions on
domestic transfer pricing methods, but the Intemal Revenue Service (the US tax authority) dis-
a11ows the shifting of income with intemational subsidiaries to avoid US taxes. This is true for
many other countries as well" All told, then, it is easier for managers to claim that they are not
manipulating reported income to evade taxes if they use the same transfer pricing method for
tax purposes as for intemal purposes. For this reason’and for reasons ofsystem simplicity’mul-

tinational firms sometimes avoid using different transfer pricing methods for domestic and
international transfers.

Conciusion

This chapter has provided an introduction to宜nancial responsibility centers and transfer

pricing. Financial responsibility centers are one of the core elements of financial resu獲ts con-
troI systems. The definitions of financial responsibility centers are important because they

provide managers signals about what宜nancial statement line items they are expected to pay
attention to. We discussed how the financial responsibilities usually are congruent with the
managers, authorities or decision rights, but there are exceptions・ Sometimes managers are

held accountable for financial statement line items over which they have no direct authority
because the accountability empowers them to influence the actions of those who do have
direct authority.
This chapter also discussed how the pricing of goods or services that are transferred from
one organizational entity to another often causes problems in the measurement of an entity’s

financial performance. Except in the rare situation where there is a perfectly competitive exter-

輩
nal market for the intemally traded good or service, nO tranSfer pricing approach can guide
pro丘t center managers to make decisions that are optimal from the corporation’s perspective
and simultaneously provide good infomation for evaluation. Incentives to move profits
between firm locations with different taxjurisdictions cause additional transfer pricing consid-
erations.廿ansfer pricing methods based on market prices or full costs, and variations thereof,

are in common use, but some companies also use negotiated transfer prices. No method is supe-
rior in a11 settings; eaCh has its advantages and disadvantages.
m鰍叫
﹂ iわ St

The next chapter discusses plaming and budgeting systems, the second core element of
ke Cu an

financial results controI systems. Planning and budgeting systems also have several controI

purposes, SOme Ofwhich, 1ike transfer pricing purposes’SOmetimes conflict.

274
Notes

I The term cos亡cerlfer also has a cost accountlng meanlng

standard cost or at full or variable cost between cost cent-

that i§ different from its meaning here in the context of

ers. However, Since most transfer pricing problems
responsibility center management. Most firms are com- invoIve profit (or investment) centers, for reasons of sim-

prlSed ofmany cost centers set up for cost accounting pur- plicity, this chapter refers to both the supplying and buy-
ing entities as prq庫cerlters.
poses to collect like-tyPe COStS and assign them to
11 See, for example, Gfoba冊arl華r Pr[cirlg SL[rγey (Emst &
products and services’but these are not responsibility
centers because they focus on cost categorizations rather Young, 2016)・
12 Examples are numerous, but for some recent cases’See
than lines of authority over expenses by managers in
・・Brussels Opens Tax Probe into Apple’Starbucks and
charge of organizational entities with accountability for a
Fiat,” The F庇mcicIZ Times (June ll, 2014), Online at on.
cost budget・ Firms typically use many more cost centerS

for cost accounting purposes than for responsibility ft.com/1hJ2Ne7

13 M. CooIs and R. Slagmu獲der,召Tax-Compliant Transfer
center controI purposes.
Pricing and Responsibility Accounting,’’Jourrd Qf晩n-
2 See, for example, “Study Finds Companies Profit When
age肌entAcco肌血gReseαrCh, 21 (2OO9), PI). 151-78.
They Track Product Parts;, Forbes (December 20ブ2013),
14 See, for example, C. X. Chen’S. Chen, F. Pan’and Y.
online at onforb.es/18W丁巧T.
Wang, ・・Deteminants and Consequences of Transfer Pric-
3 “Cisco India,s New Marketing Initiatives Ramp Up Lead Gen-
ing Autonomy: An Empirical Investigation,” Jourr証qf
eration,,, CRN Uanuary 15, 2015), Online at www.cm.com"
M。朋geme庇Acco肌血g Research’27’nO. 2 (2015)’
4 “RBS Finds ItselfBack in Hot Water,’’T子le W謝S亡ree亡Jo【Jr-

旭(November 25, 2O13), Online at on.w?j・COm/1ekyZO4. pp. 225-59・

5 “Who Says the Music Industry Is Kaput’7,鎚Siness Week

15 GfobaZ T沌u頭rPricing S“rv切OP. Cit.
16 “The Nobel Prize for Economics: The Bigger Picture,’’The
(May 27, 2010), Online at www.businessweek・COm.
EcorlO肌Zst (October 12, 2OO9), Online at econ.st/
6 R. Cooper and R. Slagmulder’``Micro Profit Centers’’’

肱ⅢOge肌e柾Acco肌血g, 79, nO. 12 (1998), PP. 16-18. JwMIwM; ・・The Man Who Showed Why Firms Exist’,, The
EcorlO肌王st (September 7, 2013), Online at econ.
7 For a further discussion of retum measures and their
St/161DL8M・
eifects, Which we also treat in more detail in Chapter lO,
17 For a recent academic treatment of dual transfer prices’
§ee W. A. Van der Stede,寝Discussion of `The Role of Per-
see E. Johnson, N. B. Johnson, and T. Pfeiffer,寝Dual
formance Measures in the Intertemporal Decisions of
Transfer Pricing with Intemal and External Trade・”
BuslneSS Unit Managers,,,, Co庇emporc[ry Acco肌血g
Reγiew QfAcco肌血g S他dies, 21, nO. 1 (March 2016), PP.
Reseo「崩, 30, n○○ 3 (2013), pP・ 962-9・
8Ibid. 140-64.
18 See, for example, S. Anderson’B. Zhou’R. Ghayad’and
9 `▲Why Energy Management Matters to CIOs,,7 Forbes
M・ Cragg, ・・The Interaction of Managerial and Tax Trans-
(September 15, 2010), Online at wwwforbes.com.
fer Pricing,”耽lX晩rmge肌e庇Trdrl垂r Pγicirtg Repor亡・ 24’
10 Transfer pricing also applies to transfers invoIving cost
centers. Transfers can be made, for example, at aCtual or no. 17 Uanuary 2016).

CASE STUDY
K「anworth Chair Corporation

In July 2003, Kevin Wentworth’CEO of Kranworth

saIes" My belief was that if you do that, eVerything

Chair Corporation (KCC), WaS COnSidering a major
reorganization - a divisionalization - Of his company’s
Organization structure:
Like many entrePreneurS, i have always been
focused on top-1ine sales growth’and l have con-
stantly been impressing on my managerS tO drive
eIse takes care of itseIf. Up untii recentIy, l think our
approach made sense・ We had very little competi-
tion, and our margins we「e huge・
Now things a「e changing" We’ve got some malOr
competitors who are making headway. i think we
needed to take a fresh management aPPrOaCh to

275
Chapte「 7. FinanciaI Responsib冊y Centers
find opportunities to do things better. Our new divi-
SionaIized organization stru嶺ure shouId heIp us
SerVe Our CuStOmerS better and nTaybe force us to
eIiminate certain markets or products that a「e not
PrOducing resuits.
But I’m not sure it’s working very we=. We’re
Seeing some finger pointing between the managers
Of the newly created divisions and the managers in
Charge of corporate departments, There is a lot of
POlitics invoIved in defining the roies, reSPOnSibiii-
ties, 〇〇〇 and rights, Of each of the responsibiIity
CenterS, and it’s not clear to me yet exactiy where
to draw the iines.
丁he company
In the early 1980s, Weston Krantz, an aVid outdoors per-
SOn, developed a new design fbr a lightweight, POrtable
Chair that could be stored in abag and carried anywhere.
Convinced that his design had commercial value, in
1987 Weston cofounded Kranworth Chair Corporation
(KCC) with his Iongtime friend, Kevin Wentworth, Who
had an MBA degree and宜nancial expertise. (The corpo-
ration’s name was a contraction of the founders’names:
Krantz and Wentworth.) KCC was headquartered in
Denver, CoIorado, in the foothi11s of the Rocky Moun-
tains. KCC produced a broad line of high-quality and
fashionable portable, folding chairs, Which were branded
as various models ofthe Fold-it! brand. In its earlyyears,
KCC sold its products exclusively to distributors.
Since its inception, KCC had been organized func-
tionally, In 2003, rePOrting to the cofounders were vice
PreSidents in charge of sales, SuPPly chain, and finance
and administration, Plus staff managers responsible for
advertising and research and development (Exhibit l).
Over the years, KCC expanded its product oiferings.
In 2OO3, it offered an extensive line of folding chairs.
The chairs were produced in various sizes and models,
including both adult and child chairs, Single chairs and
loveseats, and full- and beach-height chairs. Some
Chairs had additional features, SuCh as cup holders,
StOrage POCkets, and trays. The chairs were produced at
SeVeral price points, With varying fabrics, designs (e.g.
Single vs. double layeI), and frame materials. KCC also
Offered some related products, SuCh as folding tripod
StOOIs, OttOmanS, COtS, and stadium seats. KCC also pro-
duced custom-designed products. It empIoyed screen-
Printing artists and seamstresses who applied custom
logos, graPhics, and lettering to the nylon. KCC
PrOducts were often seen at corporate trade shows and
276
tailgate parties at sporting events. The company kep亡 M otivation
track of approximately l,500 stock keeping units
In 2002, Kevi
(SKUs) - finished products and various piece parts that
might stem fro
the company sold - although about 85-90% ofthe sales
He thought th
Stemmed from only about 40 ofthe SKUs.
more on the qu
Gradually, KCC built sales by investlng m mOre
To illustrate th
advertising and by adding other distribution chamels.
Which KCC pe
By 20O3, it sold some products directly to m勾Or retail
Chains (Wal-Mart, K-Mart, Target), aS Well as other
retailers (e.g, SPOrting goods stores) of various sizes. It
for Target and
SOld to retailers using the KCC sales force, OutSide reps,
and distributors. It also sold custom products directly grOSS margln'
Chairs, they did
to corporations and high schooI or university book-
the poor salesw
StOreS and athletic departments. The retail channels
display the Fold
PrOVided the highest sales volumes, but those sales
Were made at lower margins. Playing them in
shelved them
In the 1990s, KCC moved its core manufacturing
explained, ``I w2
facilities to Mexico and China to take advantage of lower
Denver and fou[
labor rates. Only some assembly (“kitting’’) and custom-
bottom shelf h(
izing fa臆Cilities were retained in the Denver location.
Automotive De[
In the company’s first decade of existence, KCC had
them!” Because
little competition. Its chair designs were protected by
KCC incurred !
more than 20 patents. Sales grew rapidly, and average
marketing cost!
margins were high, in the range of 40-5O%, although
Of inventory; SC
SOme margins were sacri丘ced in later years in order to
Others like it, l
generate sales from large retail chains.
more focus onl
In 1999, KCC borrowed $3O million because the
a StrOnger CuSl
founders, Particularly Kevin, Wanted to take a sign誼-
tomers, needs
Cant amOunt Of cash out of the company. Kevin had
service levels.
become interested in ranching, and he wanted to buy a
Kevin also t
Significantly larger ranch. Ranching had become his
men亡ed proper
PaSSion, and he was spending less and less time at KCC.
and asset utiliz
(For years Weston had spent only a sma11 portion of his
customer focus
time at KCC as he traveled and pursued his various avo-
Cations.) The debt service on the loan reduced KCC man- Pany COuld re(
functions, and
agers’margin for error. Cash flow was tight, Particularly
better while ty
at the sIow time ofthe year - October to January.
Starting in the late 199Os, SOme Significant competi-
tors, mOStly from Asian countries, entered the market
Divisionaliこ
With comparable chair designs. Despite the fact that
most customers perceived KCC as having superior What kind of
designs and higher quality, and customer satisfaction thought first at
WaS high, the higher competition and the worldwide Of merely makj
recession of the early 2000s caused sales to flatten and approach woし
PrOfits to drop. The company’s management incentive COStS (Or, Perh:
Plan did not pay out in either 2001 or 2002. In 2003, ucts they sold.
Performance was slightly improved. KCC’s total reve- CuStOmizing ]
nues were prQjected to be approximately $70 million, approach woし
up from $68 mi11ion in 2002, and profits were expected implications o
to be slightly positive. Vated to gener
 Kranworth Chair Corporation

Motivation for divisionalization But Kevin conduded that KCC should probably go
further to create true product divisions. The KCC man-
In 2002, Kevin began to think about c蛇丘ges that
agers had frequent debates about what products and
might stem from a change in organization structure.
Sales channels were mos〔 profitabIe, but those debates
He thought亡ha亡the KCC managers needed亡O foc.us
Were nOt informed wi亡h hard data. A divis上onaIization
more on the quality, and notjust the quantity, Of sales.
WOuld require some disaggregation of total costs and
To illustrate the point, he described an example in
WOuld facilitate profitability analyses.
which KCC personneI had aggressively sought business
If this was done’however, the KCC managers would
from Target, the large retail chain. In order to develop
have to consider how selfcontained the new operating
his retail account, KCC designed a special chair model
entities should be. Kevin wondered, “Should [the prod-
for Target and offered a special price with a lower
uct divisions] each have their own supply chain man-
gross margin. While Target did sell some Fold-it! agement, Sales force, R&D, and human resources
Chairs, they did not sell many. Part of the reason for
functions, Or Should those resources be shared?,,
thepoor sales was that many ofTarget’s outlets did not
The obvious product split in KCC was between Retail
display the Fold-it! chairs effectively. Instead of dis-
Products and Custom Products. The Retail Division
Playing them in the sporting goods department, they
WOuld focus on the higher volume, Standard product
庇lved them wherever they had room. Kevin
Sales to retail outlets. The Custom Products Division
explained’“I walked into a Thrget store in a suburb of
WOuld focus on the smaller-VOlume custom sales.
Denver and found that our products were slttmg On the
In the approach that Kevin was planning to present
bottom shelf horizonta11y in the back comer of the
to his management team, the two product divisions
Automotive Department, Where nobody could ever see
Were tO become profit centers. Each entity would be
them!” Because of the αgrowth at a11 costs,, philosophy,
dedicated to its focused core business, but their manag-
KCC incurred significant product development and
ers would be free to choose how they did business and
marke血g costs and ended up carrying a large amount
What they incorporated into their business model.
Ofinventory; SO, OVera11, the Target account, and some
Reporting to each of the division managers would be
Others like it’Were Very unPrOfitable. But to develop
managers responsible for sales and marketing, Pur-
more focus on the quality ofsales, KCC had to develop
Chasing and inventory control, and finance and
astronger customer focus, tO understand better cus-
accounting. Supply chain, R&D, human resources, and
(OmerS’needs and wants, and to improve customer
advertising would still be centralized, although these
鮒Viぐe levels.
functions would dearly have to work dosely with divi-
Kevin also thought that divisionalization, if imple-
Sion managers.
mented properly’COuld help KCC improve its e飴ciency
Kevin hoped that this new structure would allow the
andasset utilization. He thought tha〔 with an improved
Retail and Custom Products divisions to make some
oustomer focus, it was almost inevitable that the com-
bold, neW decisions・ The new company focus would
Pany COuld reduce its SKUs, POSSibly outsource more
also be on creating value, rather than merely growing・
function§, and generally leam to serve customer needs
For the divisions’Creating value could easily mean con-
betterwhile tying up less capital・
tracting sales to eliminate unprofitable or marginally

PrOfitable products and customers. The best customers,

Divisionalization altematives
What kind of divisionalization would be best? Kevin
「血亡hrst about the relatively conservative approach
relymaking the sales function a profit center. This
OaCh would invoIve charging Sales for the full
(or, Perhaps, full costs plus a markup) of血e prod-
theysold. Sales would have to pay for the costs of
mizing products and holding inventory. This
OaCh would make Sales more aware of the cost
ations of their decisions and, hence, mOre mOti-
〔O generate PrOfitable sales.
for example’Were PrObably those that bought the most
PrOfitable products, Placed inventory requirements on
KCC that were reasonable and predictable, had a strong
Credit standing and payment history, and were rela-
tively easy to serve. The divisions might also decide
that they should outsource some functions, SuCh as
Warehousing, Which might allow KCC to provide better
CuStOmer SerVice during the busy seasons and to
empIoy fewer people and assets in the low seasons.
On July 28, 20O3, Kevin presented his divisionaliza-
tion ideas to his management team. Figure l shows an
excerpt from the presentation he gave.

277
 繋霊蒜薬
Chapter 7 e Financiai Responsib冊y Centers

rate
expen
Figure l Excerpt from presentation given by Kevin Responsibilities of top management and corporate

d
ivisions.
We ntwo rth             ￣暮

indud
sta任:

ed
co§(
1" Overall vision and strategy for the company

Robert
propo
The new product diVisiOnS W川be lean, mean fighting
machines with a direct purpose and the vision to carry 2" Financing and other high-1evel financial mat亡ers

嵩謹詩誌紫電
that purpose out" With our [corporate managers’]
3" Engineering, design, and R&D
help, they w剛ook at how they do buslneSS nOW and
4. Facilities

葦
What they can do better, They wi= have the
OPPOrtunity to dream. 1f we were to start a new
5・ Legal and intellectual property
PrOduct-iine business, think of the questions that
WOuId have to be answered二 6" Supply chain and quality

輩
1. How shouid we staff?
7" Corporate identity (e.g. public relations, SOme gen-
eral advertising)
2, How should we source?

3, How should we warehouse? 8. Human resources

護
4, Howshould we seii? 9・ Information technoIogy

5. How shouId we ship? 「O" Acquisitions andjoint ventures

6. How shouId we finance?

Responsibilities of division management:

憲
These are just some of the many questions that a new
COmPany has to address. 1" Overa11 vision and strategy for their respective
We have a certain advantage since we already have m arkets
a baseline" But we aIso carry along a disadvantage,
2・ Development and implementation of divisional
We have become entrenched in our ways and are the

輩
COStliest product in the market, If we forced ourselves annual budgets
to compIeteiy reevaluate the business, COuid we
3" S亡a飾ng
SignifiCantiy reduce costs, PrOVide better customer
Service, and yieId higher operating profjts? That 4・ Operations, including purchasing ofparts and mate-

藷
answer must be “yes’’in order to stay in business in rials specific to respective markets, reCelVlng, Ware-

e
n
i
b
y
l
a
the future, Think of the fabuious business opportunity housing, Shipping, and inventory management
in front of us!

し1
expens鉦
5. Controllership and accounting

Otal
I
V
S
r
e
g compe︼ 輩
6. Product-SPeCi宜c advertising and collateral materia1

a
n
m bonus,
Sinc had
7" Information technology support
Some of the KCC managers were enthusiastic about

not
pail
With this general understanding of the distribu-

毒
鷲二警護
the proposed change. Others thought that the ideas

Robert
tho
Were radical. A few managers were bewildered, aS they tion of responsibilities in the company in place, the

l
t
i
w
e
c
n
r
had never worked in an organization with a divisional next task was the development of ideas regarding
StruCture and had trouble visualizing how it would Performance measurement and incentives. This task

薬
WOrk. In the ensuing discussion, many queStions arose, WaS aSSigned to Robert Chang, VP - Finance and
SuCh as relating to the specifics as to who would Administration,
be responsible for what and how performance would be

語
measured and rewarded. It was decided that the idea
Pe「formance measurement
needed more specifics.
A follow-uP meeting was held two weeks later. By
and incentives
then most of the managers realized that top manage- Robert developed a measure that he ca11ed coJt亡rOZ妃e!e
ment had already made this decision; the company was

going to be divisionalized. They then became highly

ret【JrれS, Which was de丘ned as operating income (before

tax) divided by controllable assets. Tb get to operating

葦
interested in shaping the details of the change. The income, all the division direct expenses were sub-
focus of the second meeting was on defining division tracted from division revenues, aS Were aS many Of the
management responsibilities.
蒜
軸

After considerable discussion, there was general

l If the division (COrPOrate) plan was met, but the corporate (division)
agreement regarding the following general division of
Plan was not, division management would still receive the divisional
responsibilities: (corporate) portion of the bonus.

278

COrPOrate eXPenSeS that could be reasonably allocated
to the divisions. The assets deemed controllable by the
divisions included their receivables, inventories, and
an assigned cost of facilities they used.
Robert proposed an incentive plan that provided 22
managers, down to the director level (one level below
division manageD, With a cash award based on achieve-
ment ofamual targets set for con亡rOllable retum at the
divisional and corporate levels. For corporate manag-
ers, the bonuses would be based solely on corporate
Performance. For managers assigned to a division, the
bonuses would be based 75% on division perfomance
and 25% on corporate performance.
Robert proposed that the expected payouts be set
lnitially at relatively modest levels. If the amual per-
formance targets were achieved, Kevin and Weston
WOuld be paid an award of 40% of salary, division
managers would be paid 30%, and managers lower in
[he hierarchy would be paid 15-20%. No payouts
WOuld be made if actual performance was below
plan.1 If actual performance exceeded plan, the pay-
OutS COuld be increased by up to 50%, at the discre-
博n of top management and the company,s board of
direc亡ors.
Robert explained that he proposed the relatively
modest awards because the costs of this plan would
PrObably be in excess of $50O,000, a Significant addi-
t10nal expense for the company. Maintaining competi-
tive total compensation levels was not an issue because
KCC managers were currently no亡accustomed亡O eam一
皿ga bonus’Since the oId sales growth-based incentive
P看anhad not paid out anything in ei亡her 2001 or 2002.
Plu埴Obert thought the company needed to get some
叩erience with setting division-level performance
rargets and measuring and evaluating perfbrmance in
a new way before ratcheting the perfomance-depend-
ent rewards upward while probably reducing the pro-
POrtion of total compensation paid as fixed base
5alaries.
These suggestions were discussed in a staff meeting
held on October 13, 2003・2 The mqjor point of dissen-
S10nWaS regarding the proposed assignment ofsome of
-he corporate expenses to the divisions. Some of the
PerSOnnel who were slated for assignmen亡to a division
COmPlained that they could not control the tems of
Sales personnel were still induded in a sales-based commission
PIan. At this meeting the idea came up亡ha亡the sales commissions
Should be weigh亡ed based on product profitabillty, but de亡ailed
dlSouSSion of this ldea was deferred.
Kranworth Chair Corporation
deals that corporate sta任negotiated for them, SuCh as
for insurance. Kevin headed off this discussion by
explaining that these cost assignments would be built
into the performance targets, SO they would not affect
the actual vs. targeted retum comparison. Further,
division managers would have near complete freedom
Of sourcing. If血ey did not like the services provided to
them by corporate staffs, they were free to purchase
those services from outside the company.
A follow-uP meeting was scheduled for October 27,
20O3・ That meeting was intended to be used primarily
to design the new organization - Who would be
assigned to what division and in what role (see
Exhibit 2). It was hoped that the new divisionalized
StruCture WOuld be completely in place by January l,
2004, and the first incentives based on controllable
retum would be paid based on 2004-Performance.
Hopes and concems for the future
Kevin was convinced that the new divisionalized
Organization structure would give KCC its best chance
for future success:
Most of us are now convinced that this is a good
idea" AIthough it creates a more compIex organiza-
tion’it wilI make most of our managers feei more
empowered. It wi= also force us to be more focused
On retumS, rather than reVenueS and cost controi.
Prjva亡e上y, however, Kevjn expressed concer皿that
this major tuming point in the company,s history was
quite risky.
i’m delegating conside「ab-e decision-making
POWer tO the divjsion managers〃 lf they make mis-
takes, Our business can go down the tubes. The
managers wiIi make out ail right; they can go find
another job" Bu=he fortunes of my famiIy and
those of the other major owners wouid be
devastate d ,
He had a specific concem about one manager, Joe
Yarmouth, the current vp-Sales who would be
appointed as generaI manager ofthe Retail Division.
Joe is in his earIy 50s, and he has a -ot of experi-
ence. But most of the experience is in sales, ra書her
than marketing and other functjons, and a= of his
experience before KCC was in big companies -
Ciorox’Hershey,s" Cuitura一一y he does not have the
Sma= company mindset" He has no experience in
279
Chapter 7. FinanciaI Responsib冊y Centers
understanding costs’CaSh fiows, and retums. I
think he should have been abIe to set up more
deals that don’t require any‘wo軸ng capita=nvest-
ment, but he just doesn’t think that way.
So Kevin, and indeed most of the KCC managers,
looked to the future with both eager anticipation and
trepidation.
EarIy experiences
KCC・s early experiences with the divisionalized struc-
ture created more concem. The first m亘ior initiative of
Ed Sanchez, the manager of the new Custom Division’
was to propose the procurement of a more sophisti-
cated fabric-Cutting machine. This machine would
allow the fabric to be cut more e綿ciently and lower
both material and labor costs slightly. A discounted
cash且ow analysis suggested that this machine was a
worthwhile investment. But, Kevin explained:
In my opinion, this investment does not address the
rea=ssue in the Custom Division, Ou「 rea=ssue is
tuma「ound tjme, We have pIenty of margIn In CuS-
tom work, but we need to reduce our tumaround
time to serve our customerS better, i think Ed is
tuming the wrong diais"
Kevin also knew that in Retail, the newly installed
division manager Joe Ybrmouth’Who had good con-
tacts in the advertising world through his prior jobs,
was talking with a new advertising agency about the
possibility of a new campaign to advertise retail prod-
ucts more aggressively. Kevin wondered whether this
was in the best interest ofthe company・ He commented:
l’m worried about iosing economies of scaIe from
deaiing with different ad agencies and about what
this ‖go-iトaIone,, advertising wi= do to our corpo-
rate identity" And in any case, iack of advertising
was not the problem we faced at Target; it was
PrOduct placement!
Joe, in tum, had already been grumbling to Robert
about late deliveries and missed sales as well as prod-
uct returns due to quality problems, Which were
caused, in his opinion, by vendor problems that were
under the purview of Carrie Jemings, the corporate
head of Supply Chain and Quality. In the new organiza-
tion structure, Supply Chain was responsible for
obtaining and maintaining an adequate vendor group’
primarily in Asia and Mexico’tO SeCure both high-qual-
ity subassemblies and on-time delivery, While reducing
280
dependency on any given vendor. The divisions had over which
responsibility only for placing the day-tO-day purchas- Yarmouth coI
ing orders (POs) with these vendors. Joe complained: There ist(
ideas tha
看f l keep havi=g delivery and qua看ity issues due to
done wit「
probIems with our overseas vendors, OVer Which l
have no controI, i,m sure going to miss my perfor- ing, andl
mance target for the year. / am the one - nOt Cahie- [Krantz].
who feeIs the pain of Iower saIes and higher costs know ou)
COmPan)
due to product returns, because it directly a情ects
the numerator of my contro=able retums measure, [the divis
and thus, my bonus that is tota獲Iy based on it. I have
budget. l
rate R&[
already iobbied corporate to let me have controi
that? An
over vendor negotiations" lf they won’t do that’they
Share th
shouid at least adjust my targets so that my evalu・
Custom
ations aren’t a什ected by others, fa冊res" But so far
they don’t seem to want to Iisten to me.
Certainl
We’re nl
Robert estimated that the divisions had about 85%
controI over their own P&L results. He believed that
was significant enough:
Joe’s arguments have some merit’but no manager Exhibit l
ever controIs everything" Our manage「S need to
work with others in the organization within the con-
straints in which they are piaced’tO reaCt tO a iot of
changing conditions, and to deIiver the needed
results. if Joe can,t do this, then we’= find someone
eIse who can.
Robert did not think that corporate managers should
make any changes either to the assigned responsibili-
ties or the bonus plan.
Joe had also proposed some other ideas for a leaner
Retail business that could potentia11y affect the design of
the Supply Chain function. He wanted to enter into
arrangements with large retailers that would provide
favorable pricing in retum for commitments to take
delivery of full containers of丘nished products right at
the port of entry (from either Asia or Mexicb). This would
eliminate further kitting in the Denver plant and reduce
inventory significantly. Kevin thought this could be a
good idea, but he was not sure who should take responsi-
bility for working out the details. He was also worried
about the politics involved in redrawing the lines of
responsibility so early into the new divisionalization.
Another issue that had arisen invoIved the R&D
function. Corporate R&D was responsible for new prod-
uct designs and re丘nements. Even though most ideas
for new products or product improvements came from
the division managers and their sales people in the
field, division management did not have much control

OVer Wh王ch R&D initiatives received priority. Joe
Yarmouth commented:
There is too much fjitering by corpor蒸らR&D of the
ideas that we feed them" We ca=,t get anything
done without Ken Simmons’[R&D manager] bless-
ing, and Ken 「eaiiy takes his orders from Weston
[Krantz]. We ough=o have more infiuence. We
know our markets better than anyone else in the
COmPany, and we are paying for the function, We
[the divisionsi each fund 50% of the corporate R&D
budget. l’m about to take a $150,000 hit for corpo-
rate P&D in my 2004 P&L, and what do I get for
that? And why do we [the divisions] each have to
Share the burden equalIy? I’m aiso annoyed that
Custom is getting a lot more R&D support than l do,
CertainIy Reta旧s much larger than Custom, but
We’re not getting much support from R&D, A=
Exhibit l Kranworth Chair Corporation: 2003 organization structure
Kranworth Chair Co「poration
they’re doing for us are a few tweaks on our stand-
ard products.
Ed Sanchez (Custom), in tum, WaS COmPlaining that
R&D was much too “reactive’’to new product features
already introduced by competitors, despite the fact that
he and his sales people has proposed many ideas for
more radical changes.
Under this pressure from the division managers,
Kevin was considering whether KCC should allow the
divisions to do their own R&D. He knew doing so would
SOIve the problems the divisions managers were com-
Plaining about, but he wasn’t sure which new problems
it might create. Kevin did not like the whining. But he
also did not want to undercut the local initiative that
the new organization promised to bring to KCC. And in
any case, there were presslng lSSueS tO attend to on his
new ranch.
281
Chapter 7. Financjal Besponsib冊y Centers

Exhibit 2 Kranworth Chair Corporation: 2004 organization structure

臆_」!

In Augusl
managerS
Mr. RolfI
had to de(

丁he co

Zumwald
produce d
ing systeI
mentatio
OPeratin,
Slightly IT
Zumw
decentra
were all(
manCeS ly
ated, an(
on each (
return O
Even thc

grated, l
their co
so chose
I nv〇五
This case was prepared by Professors Kenneth A. Merchant’Wim A" Van der Stede’and research assistant Clara (Xiaoling)

Chen. of the co
copyright ④ byKenneth A. Merchant and WimA. Van der Stede. sion (IS]
the Elecl

蒜慧皿脚
]
、岬 ISD s

282
 CASE STUDY
ZumwaId AG

University of Southem California 邁ECD sold application-SPeCific integrated circuits and

Marshall SchooI of Business Subassemblies・ ECD was origina11y established as a

Leventhal SchooI of Accounting CaPtive supplier to other Zumwald divisions, but in

A203-01 the last decade its managers had found external

Reγ. 7-31-ヱ5 markets for some of the division’s products. Because

Of this’ECD,s managers were given profit center

In August 2015, a Pricing dispute arose between the
re sp on s ibility.
managers of some of the divisions of Zumwald AG.
Mr. Rolf Fettinger’the company,s managing director,

had to decide whether to intervene in the dispute. 丁he dispute

ISD had recently designed a new ultrasound imaging

丁he company SyStem Called the X73. Hopes were high for X73. The
new system offered users advantages in processing
Zumwald AG’headquartered in CoIogne, Gemany,
SPeed and cost, and it took up less space. Heidelberg
PrOduced and sold a range of medical diagnostic imag-
engineers participated in the design ofX73, but Heidel-
ing systems and biomedical test equipment and instru-
berg was compensated for the full cost of the time its
mentation. The company was organized into six
employees spent on this prqject.
OPerating divisions. Total annual revenues were
After the specifications were set, ISD managers
Shghtly more than f3 billion.
SOlicited bids for the materials needed to produce
Zumwald managers ran the company on a highly
X73 components. Heidelbergwas asked to bid to sup-
decen亡ralized basis. The managers of each division

Were allowed considerable autonomy if their perfor- Ply the displays needed for production of the X73
SyStem. So were two outside companies. One was
mances were at least on plan. Performance was evalu葛
Bogardus NV, a Dutch company with a reputation for
ated, and management bonuses were assigned, based
On eaCh division,s achievement of budgeted targets for PrOducing high-quality products. Bogardus had been
a longtime supplier to Zumwald, but it had never
return on invested capital (ROIC) and sales growth.
before supplied display units and systems to any
Even though the company was partly vertically inte-
Zumwald division. Display Technologies PIc, WaS a
grated, division managers were allowed to source
British company that had recently entered the mar-
their components from extemal suppliers if they
ket and was known to be pricing its products aggres-
so chose.
Sively in order to buy market share. The quotes that
Involved in the dispute mentioned above were three
ISD received were as follows:
Ofthe company,s divisions - the Imaging Systems Divi-
Sion (ISD), the Heidelberg Division (Heidelberg), and
the Electronic Components Division (ECD).

ISD sold complex ultrasound and magnetic reso-

nance lmaglng SyStemS. These systems were expen-
Sive, tyPica11y selling for f:500,00O to fl million.

Heidelberg sold high-reSOlution monitors, graPhics

COntrO11ers and display subsystems. Approximately
halfof its sales were made to outside customers. ISD Af亡er discussing the bids with his management team,

WaS One Of Heidelberg’s m句Or inside customers. Conrad Bauer, ISD’s managing director, annOunCed that

283
Chapter 7. Financiai Responsib岨y Centers

ISD would be buying its display systems from Display In the ensuing discussion, the following facts came
耽chnoIogies PIc・ Paul Halperin,-Heidelberg,s general

manager, WaS livid・ He immediately ・COmPlained to

1. ISD’s tentative target price for the X73 system was
Mr. Bauer, but when he did not get the desired response,
蟻40,000.1
he took his complaint to Rolf Fettinger’Zumwald’s
2. Heidelberg’s standard manufacturing cost (mate-
managing director. Mr. Fettinger agreed to Iook into the
rial, 1abor, and overhead) for each display system
situation.
was flO5,00O. When asked, Mr. Halperin estimated
A meeting was called to try to resoIve the dispute.
that the variable portion of this total cost was only
CASE
Mr・ Halperin asked Christian Sch6nberg’ECD’s GM, tO

attend this meeting to support his case. If Heidelberg

f5O,OOO. He treated Heidelberg’s labor costs as fixed GIobal
because German laws did not allow him to lay off
got this order from ISD, it would buy all of its electronic
empIoyees without incurring expenses that were
COmPOnentS from ECD・
“prohibitively’’high"
At this meeting, Mr. Bauer immediately showed his
anger: 3. Because ofthe global business sIowdown, the produc-
tion lines at Heidelberg that would produce the sys-
Paul wants to charge his standard markup for these tems in question were operating at approximately
displays. i can,t afford to pay it. I,m trying to se= a 70% of capacity. In the pre ceding year, mOnthly pro-
new product (X73〉 in a very competitive ma「ket・ duction had ranged from 60% to 9O% oftotal capacity.
How can I show adecent POiC if I haveto pay a
4, Heidelberg,s costs included f21,600 in electronic sub-
Price for a major component that is way above mar-
assemblies to be supplied by ECD・ ECD,s full manufac- Bob Mascola,
ket? l can’t pass on those costs to my customers.
turing costs for the components induded in each last look athj
PauI shouId rea=y want this busi=eSS" I k=OW things
system were approximately fi8’000’Ofwhich approx- room where
have been relatively sIowfor him" But a= he does is
imately half were out-Ofpocket costs・ ECD,§ Standard fer prlClng ta
quote iist prices and then compiain when i do what
policy was to price its products intemally at full manu- GI’s CEO. The
is best for my division,
facturing cost plus 20%. The markup was intended to Mascola was
We,re wasting our time here" Let’s stop fighting
give ECD an incentive to supply its product intemally・ est transfer I
amongst ourselves and instead spend our time fig-
ECD was currently operating at 9O% capacity. bers had iden
uring out how to survive in these d珊Cuit business
result in afi
COnditions. Near the end of the meeting, Mr. Bauer reminded
method that (
everybody of the company,s policy of freedom of sourc-
Mr. Fettinger asked Mr. Halperin why he couldn’t
subsidiaries.
ing. He pointed out that this was not such a big deal’aS
Mascola k】
match Display耽chnoIogies, price. Paul replied as the volume of business to be derived from this new
follows :
On repeated
product was only a small fraction (less than 5%) of the
transfer prici
revenues for each of the divisions invoIved, at least for
Conrad is asking me to shave my price down to Davis, had e
the first few years. And he also did not like the potential
beIow cost, If we start pricing our jobs this way, transfer prici】
it won,t be long before we,re out of business" We precedent of his being forced to source intemally
chairman/CI
because it could adversely affect his ability to get
need to price our products so thatwe eam afair regional offic
thoughtful quotes from outside suppliers in the future.
return on our investment. You demand that of should be tre
us; Our PIan is put together on that basis; and I so that the¥
have been pleading with my saies staff not to The decision reflected in t喜
offer deaIs that wi= ki= our margins, Conrad is
As he adjoumed the meeting, Mr. Fettinger promised to GI’s corporatl
forgetting that my engineers helped him design Virtually all l
consider all the points of view that had been expressed
X73, and we provided that heIp with no mark-uP age the clier
and to provide a speedy judgment. He wondered if
over our costs, Fu「ther, yOu Can eaSiIy see that team locate
there was a viable compromise or if, instead, there were
Zumwald is better off if we supply the dispiay believed tha
some management principles involved here that should
systems for this new product. The situation here activities sh(
be considered inviolate.
is clear. If Conrad doesn’t want to be a team few investm
Player, then you must order him to source inter- 1 The cost of the other components that go into X73 is f:72,OOO. ISD’s o鯖ce. The e!
na=y! That decision is in the best interest of conversion cost for the X73 system is f144,00O, Of which fi17,700 is expressed in
a= ofus, 缶Ⅹed.

284
 CASE S丁UDY
GIoba=nvestors, Inc,
I have a basic =gut・, discomfort with the proposition that
investment management as a PrOfitmaking function exists
only in New York.
A【しStα置「 Ho諒lれS, C庇章rmα職/℃EO,
GfobaZ JnγeStOrS, London
Bob Mascola, CFO ofGIobal Investors, Inc. (GI), tOOk a
la§t look at his notes as he walked into the conference
「oom l竜e重合産鏡彊d露悟の瓦合す座り左曇辺庇搭鍼で出金搬一
fer pricing task force wo山d mee〔 w融Gary Spencer,
GIis CEO. The transfer pric王ng亡ask force superv上sed by
Mascola was meeting with Spencer to discuss the laト
es=ransfer prICmg mOdeIs that the task force mem-
bers had ident描ed. Mascola hoped血e meeting wou]d
「esult in a final decision about the transfer pricing
method that should be used to recognize profits in GI’s
subsidiaries.
Mascola knew that the meeting would be di鯖cult.
On repeated occasions, tWO Of the members of the
伽Sfer pricing task force, AHstair Hoskins and Jack
Davis, had engaged in heated debates about which
transfer pricing model should be selected. Hoskins, the
chalrman/CEO of GI’s London office, believed that
regional offices - Or at leas亡the regional o億ce he led -
hould be treated as largely autonomous profit centers
SO[hat the value created by these offices would be
「eflected in their flnancja] statemen〔s. However, Davis,
Grs corporate vice president of operations, argued that
Ⅴ血ally all of the investment strategies used to man-
e庇dienrs’funds were des上gned by亡he research
」ocated in New York. Consequen亡功Davjs
3(圧hat the revenues generated by inves亡ment
高畠es s心o山d be recognized jn New Ybrk, eVen jfa
鉦nvestment services were oifered by a regionaI
航e. The essence of Hoskins,s reply to Davis was that
XPreSSed in the epigraph.
The company
GIobal Investors, founded in 1965, WaS a Privately
owned investment management COmPany headquar-
tered in New York. A number of directors and execu-
tives based in New York, Spencer among them, held
majority ownership of GI’s outstanding stock・ GI,
started as a domestic equ主ty investment management
免夢見姦斜。脚砂皿薮磁携U期6音O地先釦餌a明けjeサ
of d王ents, jnc血djng corpora亡jons, insurance compa-
nies, PubHc and prjvate pension f皿ds, endowments,
foundations, and high-neトWOrth individuals.
GI focused on two actjvjties言nvestment manage-
ment (which induded research, POrtfolio manage-
ment, and trading) and client services (which
included marketing and investor advisory services
PrOVided to institutional investors and independent
brokers/dealers). Although the company initially
focused on direct sales to institutional investors
(such as endowmen〔s and pension funds)言でWaS
increasingly selling its investment products through
independent brokers/dealers who both served
Wealthy individual investors and invested in GI funds
On theirbehalf (see Exhibit l), GI generated its invesト
ment management revenues by charging a percent-
age fee for the amount each of its clients invested in
GI funds.
GI’s investment philosophy diiferentiated the宜rm
from most of its competitors. Since its inception, GI
based aりof瓦s誼ves〔皿e血書sげa亡豆es on血amja」 ma手
ke亡theories emergjng from academic research. The
COmPany developed a prominent New York-based
research亡eam composed mos〔Jy of PhD-quaHfied
investment experts’Who were supported by contracted-
for advice from some of the world,s most highly
regarded academic financial economists.
285
chapter 7. Financial Responsibility Centers

The company’s investment philosophy revolved GI’s subsidiaries were separately incorporated com-
A reporto(
around the theory that markets a撃affected byjudgmen- Panies. Their ownership composition resembled that of
sented in Exhl
tal biases ofthe market partlCIPantS: Th卯is, under certain GI’s parent company, but additional shares were issued
method resul(
Circumstances and for certain time periods, investors, and to the subsidiaries’chairmen/CEOs. The chairman/
This profit gua
hence markets, OVerreaCt Or underreact to information CEO of GI London (Hoskins) owned 23% ofthe London
Ply with capitl
that is publicly available regarding companies’expected Subsidiary; the chairman/CEO of GI Tokyo (Paul
cial authoritie
risks and retums. Instead of focusing on the valuation of Hashi) owned 5% of the Tokyo subsidiary; and the
reports both (
individual securities and actively selecting securities Chairmen/CEOs of GI Singapore and GI San Francisco
and as disdosl
based on their estimated value (as most of its competitors each owned 3% of their respective subsidiaries.
ested in learn
did), GI developed its different funds by focusing more GI’s subsidiaries had historically been treated as
Sidiary holdin
directly on the types of securities that academic research COSt-focused profit centers, While the administrative
where GI exe(
had shown to be undervalued by the market. departments providing support were treated as cost
the宜rmora:
As part of its strategy, GI was also committed to Iow- CenterS. Expenses and revenues were recorded accord-
Sidiary profits
ering its trading costs through economies of scale, ing to the following accounting model:
of each subsi
technological investments aimed at increasing liquid-
1. Expenses (see Exhibit 4, PreSenting the format of a EBITDA).
ity, and crossing activities (that is, matChing clients’
COnSOlidated s亡atement) : Subsidiar)
buy and sell requests).
managers’co
㊥ Any expenses that could be廿aced directly to the
GI focused mostly on equity investments in coun-
subsidiaries or the cost centers were recorded total profits v
tries committed to free markets and with reasonably
in the Direct Controllable Cost category. When the relative ]
We11-functioning capital markets, but it also invested in
expenses could not be directly traced, an alloca- earned, The
fixed income and commodity securities. Over the years,
tion method was followed. (The last column of three membe
GI had expanded its activities throughout Asia, Europe,
Exhibit 4 describes the allocation bases.) PreSident of i
and the Americas (as shown in Exhibit 2).
POints to ead
㊥ Royalty expenses (paid to academics for develop-
based on itss
ing trading strategies) were charged to the New
GI,s subsidiaries tive’s perform
York o綿ce, the center of the firm’s investment
tribution to tI
Most of GI’s 415 empIoyees were located in New Ybrk, management activities.
but GI also offered its services through four remote sub-
㊨ Allocations from the cost centers were based on
Sidiaries (see Exhibit 3). The largest subsidiaries AitemativI
COSt Center manager eStimates of the proportions
Iocated in Tokyo and London employed 52 and
of the cost centers, services that were consumed
40 empIoyees, reSPeCtively. The other two subsidiaries Some subsidil
by each of the center’s intemal “clients’’(other
Way the firm ‘
Iocated in Singapore and San Francisco empIoyed
COSt CenterS Or Subsidiaries).
fewer than a dozen individuals each. About 80% of the the last quart(
㊥ After the proportions ofeach cost center’s expenses VOCal in point
PerSOnnel empIoyed in these o鯖ces were dedicated to
trading financial assets following guidelines estab-
Were eStablished, GI u亡ilized a reciprocal cost al- sidiaries as c(
location method, uSing a system of simultaneous argued that t]
1ished by headquarters, 15% were dedicated to se11ing
equations, tO identify the total costs incurred by Picture of the
GI’s funds, and the rest were invoIved in operations,
each cost center and the dollar amount that should
Recently, three highly competent senior portfolio man-
be allocated from each cost center to its “intemal
agers in Tbkyo and four in London had started both to
dients,’’both cost centers and subsidiaries.
act as subadvisors for the Japanese, Pacific Rim, and
European portfolios and to manage a series oftrusts for
2, Revenues
their regional clientele. Many of the sales personnel at
those subsidiaries were using these local funds to ㊨ GI NewYorkretained all ofthe revenues generated

attract new clients. However, all clients attracted by WOrldwide (from fixed fees charged to the clients
the subsidiaries, regardless of the location of the sub- based on the amount of money they invested in
Sidiary or the fund they invested in, Were aSSigned a GI) and assigned GI’s subsidiaries a portion ofthe

COntaCt PerSOn in New York in addition to their local revenue based on local costs (direct controllable
representative. They also received timely information COStS and other costs allocated to the subsidiaries)
resulting from the intemal and sponsored research Plus a lO% markup over the direct controllable
generated in New York. COS亡S.

286

A report of GI subsidiaries, profits for 2OO6 is pre-
Sented in Exhibit 5. The costplusievenue-allocation
method resulted in a small profit for a航ubsidiaries.
This profit guaranteed that the subsidiaries would com_
Ply with capital requirements imposed by local宜nan-
Cial authorities. The subsidiaries also used these profit
reports both as a benchmark to calculate their taxes
and as disdosures to institutional investor clients inter_
ested in leaming about the financial health of the sub-
Sidiary holding their investments. On a few occasions
where GI executives discussed the possibility of selling
the firm or a subsidiary, the executives also used sub-
Sidiary profits to obtain a rough estimate of the worth
feach subsidiary (calculated as a multiple of their
BITDA).
Subsidiary profits were not explicitly tied to the
anagers’compensation. A bonus pool based on GI,s
Otal profits was allocated to each executive based on
e relative number of bonus points that each had
arned. The compensation committee (comprising
ree members of the board of directors and the vice
resident of human resources) assigned these bonus
int§ tO eaCh executive at the beginning of the year
Sed on its subjective assessments of both the execu-
e’s perfomance in the prior year and his or her con-
ibution to the company.
Itemative transfer pr-C-ng mOdels
me subsidiary CEOs expressed discomfort with the
aythe fim was calculating their units, profits. During
the last quarter of 20O6’Hoskins had been particularly
VOCal in pointing out to Spencer that treating GI,s sub-
闘iaries as cost-focused profit centers was wrong. He
argued that the resulting profits did not portray a falr
Picture of the subsid王aries, performance, Which could
Gioba=nvestors, lnc,
have an adverse effect on the subsidiaries・ sales prices,
if they were ever spun o任・ The inaccurate profits also
COuld be viewed negatively by financial and tax regula-
tors in亡he countries where the subsidiaries were
located.3
Gary Spencer was not convinced that the current
StruCture Created problems that were worth fixing.
However’in December 20O6, Primarily to appease
Hoskins, he asked Mascola to create a committee to
evaluate the situation, tO address both Hoskins, and the
tax concems and’if appropriate, tO PrOPOSe an
improved transfer pricing system. Mascola was selected
to lead the evaluation process because of his financial
expertise, his independence (he did not own any GI
StOCk), and his personality (he was widely regarded as
being thoughtful and impartial).
Right after his meetingwith Spencer, Mascola began
recruiting血e people that he believed needed to par-
ticipate in the process if a new transfer pricing model
Were tO be both we11 designed and successfully imple-
mented throughout the company・ Every person invited
accepted the invitation to become part ofwhat became
known as the Transfer-Pricing Model Task Force.
Mascola chaired the task force, Which also induded
Jack Davis (operations vice president), Michael
Freeman (research director), Hashi (GI Tokyo), and
Hoskins (GI London).
The task force met periodically over a seven-mOnth
Period・ During that time, they evaluated a number of
different transfer pricing alternatives. In an early
meeting’Hoskins took the initiative by proposing that
GI revenues should be allocated to the subsidiaries
using “assets under management,, as the a1location
base and that the subsidiaries pay a royalty of (around)
50% to New York as compensation for the R&D and
trading strategies developed by headquarters. Accord-
ing to his model, the London o鯖ce would receive 20%
Of total revenues, Since it managed $32 b皿on of the
$160 billion of assets under management at GI (see
Exhibit 2). Thus, aCCOrding to Hoskins, the London
O鯖ce would have been allocated the fo11owing reve-
nues in 2006:
Londonsubsidiary
「evenues($000)
Aliocatedrevenues 20%★619,949,1二123,989,8
Minusroyaltyexpense 50%★$123,989.8二61,994.9
Netrevenues 61,994,9
287
Chapte「 7. Financiai Responsib冊y Centers

However, Davis and Freeman did not agree that London based on the origin of dients, Which were directly pro- We ha
Should record all of those「evenues. They argued that OVerSく
POrtional to the revenues in each subsidiary), While the
the fact that London was managihg those funds did not 5O% assigned to Investment Management be allocated the Ui
mean they were generating a significant proportion of based on assets under management. He proposed still t「ish fl

the value associated with them. Davis argued that, in to pay a 50% royalty to New York. Under this proposed Ofalc

fact, mOSt Of the assets managed by the subsidiaries SCheme, Hoskins calculated GI London’s 2OO6 revenues activil

belonged to New York clients. Further, to manage those as follows: po!香c)

assets, the subsidiary employees were just following o「ig川

instructions from headquarters, Since the investment Londonsubsidiaryrevenues($000)

爪ost i

management research group in New York was the unit adde(

Clientrevenues 1.375%★50%★619,949,1=4,262,1

黒岩請書
in charge of developing GI’s trading strategies. Instead
Hashi su
Of allocating revenues based on assets under manage- investment management reVenueS 20%★50%★619,949.1二61,994,9

ment, Davis believed a more accurate way of allocating

revenues would be based on the origin ofthe clients (the
SOurCe Of the fixed fee revenues generated at each sub- Minusroyalty eXPenSe 50%★$61,994.9二30,997.5
Sidiary), distributed as follows in 2006:

Netrevenues 35,259.6

Subsidiary Originoftheclients($bn)
Assetdistributionbasedonthe

NewYork 150,6
Hoskins’s new proposal also met with the disap-

」ondon 2,2 PrOVal of most of the task force members. Although Hosk
most agreed with the concept of the subsidiaries’ that not
丁bkyo 4,2
recording of revenues from Client Services, Davis reit- nues at

Singapore 1,0 erated that Investment Management should be consid- Parties.

ered a New York business unit only, Since almost all of might d
SanFrancisco 2,0
the investment strategies were developed at headquar- from iⅡ
Totai 160,0 ters. Consequently, Davis and Freeman proposed that COnStra

the fee revenues corresponding to Investment Manage- tice, it s

ment (50% oftotal revenues) be fu11y recognized by the those p

Under this proposal, GI London’s 2006 revenue
headquarters office. The subsidiaries, On the other ferred z
would have declined from its actual $26.5 mi11ion to a
hand, WOuld be reimbursed by headquarters for any forme d
mere $8.5 million and would have resulted in a subsidi-
expenses related to investment management activities client !
ary loss of over $16 mi11ion.
in their units plus a lO% markup ifthese expenses qual・ exPeCt(
Tbtally dissatisfied with Davis’s counterproposal,
i宜ed as direct controllable costs. Using the 2006 finan- of reve
Which he considered ridiculous, Hoskins decided to
Cial results, Davis and Freeman estimated that the Depart
COnduct some research to leam whether (and how) GI’s
OPeratlng mCOmeS reCOrded for the different subsidiar- Pre亡ed
COmPetitors were allocating revenues to their subsidi-
ies under their proposed model, WOuld be those shown taxablc

圏星図
aries. Hoskins leamed that the industry standard was
in Exhibit 6. explain
to split fee revenues 50-5O between Client Services
This model was unacceptable to Hoskins. He argued
and Investment Management. Thus, he proposed, GI’s
that the London and Tbkyo subsidiaries were actively
business units should be split into these two categories.
Participating in investment management, and they
Half of the revenue would be allocated to Client Ser-
should be rewarded for the value these activities cre-
Vices (including two business units: Institutional Inves-
ated. He explained:
亡or Sales, and Independent Broker/Dealer Sales), and

the other half would be allocated to the Investment CIeariy there is activity under the broad bamer of
Management unit. This would allow GI to treat both Investment Management in London and tokyo, The
activities separately. issue is whether our o冊CeS add vaiue or not. We

Hoskins went on to propose that 5O% ofthe fee rev- are building resources in London on the basis that
enues be assigned to Client Services based on the reve- GI 」ondon is at Ieast responsibie for the investment

nues generated in each subsidiary (or equivalently, management function for Ioca=y sou「ced ciients,

288

We have estabiished an lnvestment Committee to
OVerSee POiicies for our fixed incomさportfoiios in
the UK and continental Europe as weIl泰’for the
lrish funds, and we have injtiated the deveiopment
Of a Iocal research function. I accept that the local
activity is primariiy, though not exclusiveiy, One Of
PO=cy tailoring and implementatjon rather than
Originai inteIIectuai capitaI investment, but
most companies wouid regard this as a source of
added vaiue,
ashi supported Hoskins by adding,
Local vaiue-added is not the same for a= products
Orfor a= ciients, It is clear, for exampie, that Gi
tokyo adds Iittle when it simpiy implements pro-
grams of trades suggested by GI New Ybrk, but it is
aIso ciear that it adds a significant share of value
When it js managing money for its own c=ents in
PrOducts designed specifica=y for them using Iocal
inputs.
Hoskins also expressed a concem about the eifect
that not recording the investment management reve-
nues at the subsidiary level would have on extemal
Parties. Hoskins believed that local tax authorities
might disapprove such treatment, aS the profitability
from investment management operations would be
COnStrained to lO% or less. He claimed that, in prac-
[ice, it seemed acceptable that support services (such as
those provided by the cos亡CenterS) would be trans-
ferred a[ cost (or a亡a sIigh[ markup), bu亡血nctions tha〔
fo皿ed part ofa group’s offering to clients (in this case,
dient services and investment management) were
expected to be transferred in exchange for a proportion
of revenues, following an αarm,s-length standard.函
Departures from arm’s-1ength prices could be inter-
Preted by the local authorities as an attempt to shift
taxable income out of their countries. Hoskins
explained:
Our main competitors in the UK a=ocate revenues
to the iocatjon actua=y carrying out the fund man一
言Arm,s-length,, prices are those charged after bargaining between
unrelated persons or those charged between related persons that
approximate the result of independent bargaining.
Gioba=nvestors, Inc,
agement. The aItemative of a cosトPIus arrange-
ment, SuCh as we have historica=y maintained, is
PrObably no Ionger tenable where we now have
IocaI cIients from whom we are 「eceiVlng reVenueS
for locai investment activities.
Another extemal party that Hoskins worried about
WaS his own clients. Hoskins believed that key local cli-
ents would be hesitant to appoint GI London to manage
their assets ifthey knew their funds were considered to
be managed in New York.
Davis disagreed with Hoskins’s and Hashi’s conten-
tions. He believed that the contributions made to the
local investments managed in London and Tbkyo were
minimal. Davis argued that the mヰiority of operations
at the subsidiaries consisted of selling the investment
funds managed in the headquarters or executing a few
inves亡men亡OPerations, foHowing s亡rategies and guide-
1ines developed by the investment management unit in
New York.
Although Freeman agreed that the transfer pric-
ing model should adhere to tax regulations, he
believed that the model he and Davis proposed was
appropriate. It should not trigger regulators’con-
CernS Since it already a1lowed the subsidiaries to
record revenues for the services provided to institu-
tional investor and independent broker/dealer cli-
ents (which he considered the main value-added
activity performed by the subsidiaries). Additionally,
GI’s executives believed that the model used to pre-
Pare血e subs上djarjes碕nancja」 stateme皿でS WaS nO〔 aH
that crucial to other financial regulators since GI was
required to report consolidated (rather than subsidi-
ary) financial statements.
丁he meeting
As Mascola prepared for the meeting with Spencer, he
recognized the tensions among the task force mem-
bers. He had carefu11y considered the advantages and
disadvantages of the models proposed by Hoskins and
by Davis and Freeman. He wondered how he cou]d
direct the meeting toward a final selection of a trans-
fer pricing model that would both benefit the firm and
be accepted by all, Or at least most, members of the
task force.
289
汁apter7.FinanciaIResponsibiiityCenters E) In

Exhibit「Giobailnvestors,lnc.:.fotaiassetsundermanagement

$180 青$160 ⊂ ≡$140 .重⊃ 忘$120 ∈ 嵩$100 ⊂ 呈$80 ○○章  一●●’ 6 l

臆漢音
呈 $60
二) 臆漢書臆臆漢音 ■漢書菓臆臆臆臆墓園
霊 $40
U) くの 臆獲星
臆臆面臆∃臆冒臆漢 掃患種菓臆8冒漢書臆臆■
■墓園王音量臆∃■漢音
臆菓臆漢音臆臆 漢音臆漢音
< $20 『 臆漢音看臆Ill1看l

19951996199719981999 2000 20012002 2003 20042005200

GIob
Exhibit2 くn .宣$60 alinvestors,Inc,:lypesoffunds(December2006)
亘 盲$50 ① ∈ 急$40 くe ⊂ 呈$30 ① □InstitutionaIchanneI     □independentb「Oke「/dealerchanne

2$20 =】 竃$10 雀 $0

「十「
Eq=ity    Fixedincome   Commodities

口US  □Regiona一(non-US) 固G-oba-i

Assetsun ermanagementbysubsidiary(inb冊onsofdo=ars.asofDecember2006)

Subsidiarymanagingtheassets Equity Fixedincome Commodities 丁otal

NewYork 70.2 36.3 5.9 112,4

」ondon 14.5 14.5 3,0 32,0

丁okyo 6.2 4.0 2.2 12,4

Singapore 2,1 0.3 0,0 2,4

SanFrancisco 0.0 0.2 0.6 0.8

丁btai 93.0 55,3 11,7 160,0

290
帥ibit 3 GIoba=nvesto「s, lnc.: Organizational structure

￣ GIobaIlnvesto「s, inc,

investment Management

星星星 Resea rch

Human ResourcesI
Communications
GiしOndon
(A. Hoskins)
(M, Freeman)
Financiai/Admin, GI Tokyo
Se rvices (P, Hashi)
(R. MascoIa)

」egai GI San F「ancisco

Operations
GI Singapo「e
(J. Davis)

TechnoIogy

291
捻 Exhibit 4 Consoiidated statement fo=owing traditionaI transfer prjcing modei
N

Businessunits Costcenters Ai10CationifactuaI

Headqua「ters Trading Research Techno10gy Financial Legal Operations Admin. HR&

andsubsidiaries SerViceS cOmmun, isnotava=abie

Feerevenue yyy n/a n/a n/a n/a n/a n/a n/a n/a 斤xedpercentageoffee revenL/eSWYoHlceon勅

Less:rOyaities ZZZ n/a n/a n/a n/a n/a n/a n/a n/a

Directcontro=abiecosts Saiescommissions XXX XXX XXX XXX XXX XXX XXX XXX XXX 50%of鵬c〃ent士 #rstyearfees Actua/l

Salaries XXX XXX XXX ×XX XXX XXX XXX XXX XXX

Bonuses XXX XXX XXX XXX XXX XXX XXX XXX XXX ActuaI
Payrolltaxes XXX XXX ×XX ×XX XXX XXX XXX XXX XXX ActuaI

EmpIoyeebenefits XXX XXX XXX XXX XXX XXX XXX XXX XXX ActuaI
Professionaifees Occupancy (rent/ut冊es) Depreciationoffice equiPment ×XX XXX XXX ×XX ×XX XXX ××X XXX XXX Actua/

XXX XXX XXX ×XX XXX XXX XXX XXX XXX Ftorafabasedonsq.肥

XXX XXX XXX XXX XXX XXX XXX XXX XXX Actua/
Maintenance XXX XXX XXX ×XX XXX XXX XXX XXX XXX Actua/

Travelexpenses Otheradm面Strative: Equipmentrentals XXX XXX XXX XXX XXX XXX XXX XXX XXX XXX XXX XXX ×XX XXX XXX XXX XXX XXX BasedprImar/小′ OnI℃aSOnforfrゆ Actua/

Advertising XXX XXX XXX XXX XXX XXX XXX XXX XXX ActuaIore/sepro-伯ね basedonrevenue

Bankcharges XXX XXX ×XX XXX XXX XXX XXX XXX XXX ChargetoHnancia/ar

Stationery&supp=es XXX XXX XXX XXX XXX XXX XXX XXX XXX Proratabasedonsq,
Meetings XXX XXX ×XX XXX XXX XXX XXX XXX XXX Proratabasedonsq.

Gifts XXX XXX XXX XXX XXX XXX XXX XXX XXX Pro伯tabasedonsq

Postage XXX XXX XXX XXX XXX XXX XXX XXX XXX Proratabasedonsq
Misce=aneousadmin. 塑 」逆送 上玉室 XXX XXX XXX XXX 巻巫 XXX PI℃ratabasedonsq.#

Totaidirect
controIIabiecosts DCCbu「:DCCbu5 DCCtr DCCres DCCtech DCCfin DCCleg DCCop DCCad DCChc

Exhibit 4 Continued
 Costcenters Ai10CationifactuaI
Headquarters andsubsidiaries Trading Research TechnoIogy FinanciaI SerViCeS 」egai O erat’ Ad. HR&

Othera11ocatedcosts p IOnS min. COmmun. lSnOtaValiabIe

Tradin 1・ Legal
g Research 「七ChnoIogy Financjalservices a,a5 b「:b5 C「:C5 d「:d5 e「:e5 b6 C6 d6 e6 a7 C7 d7 e7 a8 b8 d8 e8 a9 b9 C9 e9 a「O b「O C「O d「O a「「 b「「 C「「 d「「 a12 b12 C12 d12 a13 b13 C13 d13 G/emp/oyedarec佃roca/ a//ocat/Onmethod伝 SyStemOfsimu/taneous equat/OnS)to”nd招e COSta//OCat/ons伝了,…,

Operations Administration HR&communicatjons TbtaIdirectand a=ocatedcosts Reimbursement tocostcenters f「:f5 g「:g5 h「:h5 TCbu「:TCbu5 f6 g6 土色 A 二生 f7 g7 旦乙 B ーB f8 g8 土星 C ーC f9 g9 上巳 D ーD f「O g「O _出旦 E ーE e「「 g「「 哩⊥ F e12 f12 _吐主 G e13 f13 g13 H ::∴∴∴∴∴ ‥,劫us/lngforeach COStCenterthefo〃owing equation.’7bfa/Costs= p/rectcontrolたto/e Costs)+xpthera〃oc. A-DCCt

Profitorioss Profitorloss 皇 ￣す 皇 ￣㌻ 0 二L 旦 二重。 皇 二世_ 皇 Costs)e.g・-r十 b6+C6+d6+e6+f6+ g6+h6./nfum,eaCh COStCentergOt rehbursedbya//ocathg /tsfota/COStSto/ts ‘7ntema/’’c〃ents 但USinessun/tsorother COStCenterS)e.g.A=a了 十a2十a3十…+a13
 Exhibit 5 Operating income using traditional transfer pricing modei ($000)

Businessunits Costcenters Tot

Headquarters OrSubsidiarjes Trading Research Technoiogy Financiai SerVICeS Legal Operations Admin, HR& COmmuniC,

NewYork Giobaifeerevenue 619,949.1 (27,654.1) (10,519,1) (5,966.5) (6,287.1) (12,283,7) (4,620.2) (2,399.5) (58,943.0) 619,949.1

Reimbursementtosubsidiaries (59,529.0) (59,52

RoyaItiesexpense (41,587.0) (41,5
Directcontroiiablecosts (151,411.0) (280,08
OtheraIiocatedcoststo (111,650.5) (6,766,5) (6,315.4) (2,968.4) (3,529.5) (8,866.5) (2,938.3) (2,040,5〉 (13,071.2) (158,146.8)

OtheraIiocatedcostsaway Operatingincome 0,0 34,420,6 16,834,5 8,934.9 9,816.6 21,150.2 7,558,5 4,440,0 72,014.3 175,1β9.5

255,771.6 0,0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 255,771,

London Rejmbursementfromparenta 26,507.0 (5,231.7) (163.3) (23,4) (1,494.0) (647,5) (33.3) (402.7) (1,686.4) 26,507,0

Directcontroilabiecosts (7,903.7) (17,58

Otherallocatedcoststo (16,844.6) (664.0) (72,3) (3.6) (11,7) (15.8) (4.0) (113.1) (330.8) (18,059,9)
OtheralIocatedcostsaway Operatingincome 0.0 5葛895.8 235,6 27.0 1,505,7 663.3 37.3 515.8 2.017.2 10.897.6

1,758,6 0,0 0,0 0,0 0,0 0.0 0.0 0,0 0.0 1,758

Tokyo Reimbursementfromparenta 20,180.1 (6,165.6) 0.0 0.0 (1,028.0) 0,0 (565.3) (290.6) (2,707.2) 20,180.1

Directcontro=abiecosts (6,452.2) (17,20

OtheraiIocatedcoststo (12,007.0) (113.9) (89.3) (67.6) (232,8) (1,080,2) (417.1) (96.8) (1,465.0) (15,569,7)
Otherailocatedcostsaway Operatingincome 0.0 6,279.5 89.3 67,6 1,260.8 1,080.2 982.4 387.4 4,172,2 14,319.4
1,720,9 0.0 0.0 0,0 0,0 0.0 0.0 0.0 0,0 1,720

Singapore Reimbursementfromparenta 4,776.1 0.0 0.0 0.0 0.0 0.0 0,0 0,0 0.0 4,776.

Djrectcontroliabiecosts (1,613.0) (1,61

Othera=ocatedcoststo (3,001.8) 0.0 0.0 (16.9) (58,2) (270.1) (104.3) (24,2) (366.3) (3,841.6)
Othera=ocatedcostsaway Operatingincome 0.0 0.0 0,0 16.9 58.2 270.1 104.3 24.2 366.3 839.9
161,3 0.0 0.0 0,0 0,0 0.0 0.0 0.0 0.0 161

SanFrancisco Reimbursementfromparenta 8,065,9 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 8,065,

DirectcontroIlabIecosts (2,233,5) (2,23

Otheraliocatedcoststo (5,609.0) 0.0 0.0 (1,1) 0,0 (289,7) (3.6) (56.0) (178.6) (6,138.0
Otheraliocatedcostsaway Operatingincome Consoiidatedoperating Inc○me 0,0 0.0 0.0 工1 0.0 289,7 3.6 56.0 178.6 529.0

223.3 0.0 0.0 0.0 0.0 0.0 0.0 0,0 0.0 223
259,635,7 0,0 0,0 0,0 0.0 0.0 0.0 0,0 0,0 259,635,

Exhibit 6 Operating income using Davis and Freeman,s proposed transfe「 p「icing modeI ($000)

Fee revenues by subsidiary

 l costs of the subsidiaries lus lO% of the total direct contro=abIe costs incurred in t

NewYork 227,003.4 356,370.6

London 7,512,0 1,110.5

丁okyo 3,630.4 12,620.6

Sjngapore 907,6 3,155,2

SanFrancisco 4,342.3 3,296.5

TotaIfeerevenues 619,949.1

) Businessunits Costcenters

institutionaI Sales indep,Brokei! deaIersaIes lnvestmentmanagement

GeneraI Trading Research Technoiogy Fjnancia看 SerVICeS しegaI Operations Adm活. 白R& COmmuniC. TotaIs )

NewYork Feerevenues Commissionrevenue/(expense)a lnvestmentmanagement reimbursementtosubsidiaries Roya剛esexpense DjrectcontroiIabiecosts 113,501.7 (38,897.6) 178,185.3 (53,415.7) 619,949.1 (309,974.5) (19,027.7) (41,587.0) (59,097.7) (27,654.1) (10,519.1) (5,966.5) (6,287.1) (12,283.7) (4,620。2) (2,399.5) (58,943.0) 619,949。1 (18,287.6) (19,027.7) (41,587.0) (280,084.2)

Otheraliocatedcoststo (23,922.9) (19,229.3) (68,498.3) (6,766,5) (6,315.4) (2,968.4) (3,529.5) (8,866.5) (2,938.3) (2,040.5) (13,071.2) (158,146.
OtheraIIocatedcostsaway 0.0 0.0 0.0 34,42○○6 16,834.5 8,934.9 9,816.6 21,150.2 7,558,5 4,440.0 72,014.3 175,16

Operatinginome 50,681.3 105,540.2 121,763.8 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 277,

」ondon Commissionrevenue/texpense)a lnvestmentmgmtrelmbfrom parentb Directcontro=ablecosts 3,756.0 (3,829.5) 555.3 (4,074.2) 11,068.5 0.0 (5,231.7) (「63.3) (23.4) (1,494.0) (647.5) (33.3) (402.7) (1,686.4) 4,311.3 11,068.5 (17,586.1)

Otheraiiocatedcoststo (2,735.7) (3,579.9) (10,529.0) (664.0) (72.3) (3,6) (11.7) (15.8) (4.0) (113.1) (330.8) (18,059
OtheraiIocatedcostsaway 0。0 0.0 0.0 5,895。8 235.6 27.0 1,505.7 663.3 37.3 515、8 2,017.2 10,8

Operatinginome (2,809,3) (7,098.9) 539.5 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 (9,3

(Con tinued)
慈 Exhibit6 Continued

Businessunits Costcenters

instjtutionai SaIes indep,Broker/ dealersaies Investmentmanagement

General Trading Resea「ch Technoiogy FinanciaI SerVICeS LegaI Operations Admin, HR& COmmuniC. Totais

Tokyo Commissionreve…e/(expense)a lnvestmentmgmtreimbfrom 1,815.2 6,310.3 4,906.1 (6,165.6) 0.0 0.0 (1,028.0) 0.0 (565.3) (290.6) (2,707.2) 8,125.5 4,906.1

parentb Directcont「oiiabiecosts (1,862.4) (4,589.7) 0.0 ,(‡7,2

Otherallocatedcoststo (2,682.6) (5,034.8) (4,289.6) (113.9) (89.3) (67.6) (232.8) (1,080.2) (417.1) (96,8) (1,465.0) (15,569
Othera=ocatedcostsaway 0,0 0.0 0.0 6,279.5 89.3 67.6 1,260.8 1,080.2 982.4 387.4 4,172.2 14,3
Operatingincome (2,729.8) (3,314.3) 616.6 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 (5,42

Singapore Commissionrevenue/(expense)a lnvestmentmgmtreimb 453.8 1,577.6 1,072.4 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 2,031.4 1,072

fromparentb Directcontroliablecosts (465.6) (1,147。4) 0.0 (1,

Otheraiiocatedcoststo (670.6) (1,258.7) (1,072.4) 0.0 0.0 (16.9) (58.2) (270.1) (104.3) (24.2) (366.3) (3,841
Othera=ocatedcostsaway 0.0 0。0 0.0 0,0 0.0 16.9 58.2 270.1 104.3 24.2 366.3

Operatingincome (682.4) (828.6) 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 (1,

SanFranci§cO Commissionrevenue/(expense)a investmentmgmtreimb 2,171.1 1,648.3 1,980,7 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 3,819.4 1,980

fromparentb DirectcontroliabIecosts (18.6) (2,214.9) 0.0 (2,

Othera=ocatedcoststo (192.2) (3,436.1) (1,980.7) 0.0 0.0 (1.1) 0.0 (289.7) (3.6) (56.0) (178.6) (6,13
OtheralIocatedcostsaway 0.0 0.0 0.0 0.0 0.0 1.1 0.0 289.7 3.6 56.0 178.6
Operatingincome 1,960.3 (4,002.7) 0.0 0.0 0,0 0.0 0.0 0.0 0.0 0.0 0.0 (2,0
Consoiidated OperatinglnCOme 46,420.1 90,295.8 122,919.8 0,0 0,0 0.0 0,0 0.0 0,0 259,

acommiSSIOn reVenue is equaI to 50% of the fee revenues generated by the ci-entS Ofthe subsldiary. in New York, the commission expense -S equal to 50% of the totai fee revenues (allocated
tothesubsidiarleS).
叶he lnVeStment management reimbursement from parent ‘s equai to the totai lnVeStment management COStS Of the subsidiarleS Pius 10% of the inVeStment management direct
contro=able costs (general/trading)
﹃こ﹁poS①S
 C晴AP丁ER- 8
P!am音ng and Budgeting

Planning, and especially budgeting systems, Which are the focus of this chapter, are a Pivotal
element offinancial results controI systems. One important output of a plaming and budgeting
SyStem is a written plan that clarifies where the organization wishes to go (objectives), how it
intends to get there (strategies), and what results should be expected (performance targets).
Planning and budgeting systems vary considerably in form and use across organizations,1
but nearly all commonly invoIve the setting of financial performance targets used for perfor-
mance evaluation and incentive purposes, although we wi11 discuss various other purposes of
budgeting as well.
According to extensive research by two economists - Nicholas BIoom of Stanford and John
Van Reenen ofthe London SchooI of Economics - Setting targets (Chapter 8), reWarding perfor-
mance (Chapter 9), and measuring results (Chapter lO) are key to m肌。geme庇. Their study of

more than lO’000 organizations in 20 countries suggests that these factors are tightly linked to

improved performance measured in terms ofproductivity, PrO宜tability, grOWth, and survival.2

But not every organization does their planning and budgeting well, and not all benefits, and
also several issues, arise around the tc[7官ets-証Ce砧γeS-meaSure肌e庇triad, although this triad

Wi11 be our focus. Some ofthe organizational benefits ofplanning and budgeting come from the

PrOCeSSeS Of developing the plans. Planning processes force managers and empIoyees to think
about the future, tO discuss their ideas with others in the organization, tO PrePare their prQiec-
tions carefully, and to commit to achieving objectives that will serve the organization’s inter-
・〇もり㌫呈雷撃Pu雷鳥吉富茎雲︺⋮・}義

ests. For plans and budgets to serve a useful role, then, the issue is not whether to prepare a plan
or budget, but rather how to do it・3

Purposes of plaming and budgeting

Planning and budgeting systems serve four main purposes. Obviously, the first purpose is prdrl-
証rlg; that is, making decisions in advance. EmpIoyees tend to become preoccupied quite natu-

ra11y with their seemingly urgent, day-tO-day exigencies. Unless they are encouraged to engage
Su飴ciently in strategic, 1ong-term thinking, they often fail to do so. Planning and budgeting

斗地盤与P砂坑抜上壷庭幽雌雄方墳隔摺翠邦雄親子」動物妬め〃形鵜t切,勿㌘〇
三二盈撃髪質二㌔箸縫年秘で、〆諸物了解紹雛碑㌢捌魂施解党馳拷`鋤磁棚や歓雄雌SS
PrOSPeCtS・ reSOurCe COnStraints, and risks. In doing the forward thinking・ the managers develop
急転敵襲Ⅷ忠敬細雨軽震団扇∝8a血乙証壷s o押Om融es and thTeaしS, Stren恥s and wea亙
腿ssesごand心胆e触弐S Ot pOSS肌e st譲e忠にand ope丁a心mふd襲しsio唯■ Th、s (orwaね-高説椋鳥
もモdふon-m孤inさp{oCeSS甜a丁PenS心e oてさa琉乙a丘〇五s {eSpOnSeS {O iしs competl心ve envi【Onment.
Chapter 8. Pianning and Budgeting

Decisions regarding strategies, Sta鯖ng, and operational tactics can be ndjusted based on

predictions of outcones before the organization suffers mqjor problems" This is a classic exam-
ple of what is called和djorward corltrOZ. Effective plaming processes make controI systems

proactive, nOtjust re。c亡ive. They help managers shape the future, nOtjust respond to the condi-
tions they face and performance they observe.
For example, Berendsen (previously called Davis Service Group)’a large public UK-based

service contractor that sources, Cleans, and maintains industrial textiles’PrOteCtive dothing,

and textiles, COnSiders its good business perfomance to be’at least in part, uthe result ofcareful

budgeting, twhich] invoIves making detailed financial plans for every aspect of the business,
identifying risks and ensuring that managers are committed to the outcomes that they have
agreed.’4 similarly, the success of Zara,在the fast expanding’亀shion-right, company headquar-
Plaming cy
tered in the remote northwest comer of Spain in La Coruna,,, suggests that負if a retailer can

forecast demand accurately, far enough in advance’it can enable mass production under push

control and lead to well managed inventories, 1ower markdowns, higher profitability (gross
margins), and value creation for shareholders in the short- and long-term.,,5 These examples
suggest that planning and flexibility or responsiveness do not have to repel’although as we will

see, this will depend on the rigidity in the planning and budgeting process; that is, how the

plans and budgets are used or how the plaming and budgeting is done’rather than the plans
and budgets themselves.6

i         : d
A second purpose of planning and budgeting is coo融血王orl. The plaming and budgeting

processes force the sharing of information across the organization. The processes involve a top-
down communication of organizational obiectives and priorities, aS Well as bottom-uP COmmu-
nication of opportunities, reSOurCe needs, COnStraints’and risks. They also invoIve lateral

communication that enhances the abilities of organizational entities (e.g. business units, divi-
sions, functional areas, and administrative units) working together toward common objectives.
Everyone involved becomes more informed’SO the process is more likely to result in decisions

that consider all perspectives. The sales plan is coordinated with the production plan so that
shortages or surpluses of inventory and personnel are less likely and resources are synchro-
nized as needed. The production plans are coordinated so that the potentials for bottleneck
constraints are minimized. Plans for growth and investments are communicated to the finance
function, Which takes steps to ensure the needed capital. And so on.
A third purpose of planning and budgeting arises from facilitating fap mcmagemen亡OVer-

t
szg庇・ This oversight occurs in the form ofpreac[ior汀eV王eWS (a type ofaction control discussed in

Chapter 3) as plans are examined, discussed’and approved at successively higher levels in the

e∴∴∴∴皿完auy曲面-的中
organization before actions are taken. Top management also uses plans as the performance
standards used to implement the marlOgeme庇dy-eJfCeP亡Ion form of control (a type of results

control discussed in Chapter 2). The plaming and budgeting processes provide a forum that
allows the organization to arrive at challenging but realistic perfomance targets by balancing
top managers, wishes for desired performance with lower-1evel managers, information about

possibilities. Negative variances - that is, meaSured performance below target levels - PrOVide
top managers an early waming of potential problems and justification for either reconsidering
the organization,s strategy or for interfering in the business of subordinate managers.
The final purpose related to planning and budgeting is mo亡i庇ion. The plans and budgets

become targets that affect manager motivation because the targets are linked to performance
evaluations and, in tum, Various organizational rewards. As mentioned briefly in Chapter 2’

merely telling empIoyees to ・`do their best,, is not nearly as motivating as asking them to attain

speci丘c performance targets that are neither too easy nor too di鯖cult to achieve. In an interview

with T7Ie EcorlO肌isちGary Latham of Locke and Latham,s original Goarse由ug耽eo7γ fame noted

that ・・there is a wealth of evidence that setting welトdesigned targets does improve empIoyee

performance - there have been more than l’OOO academic experiments in goal-Setting, Ofwhich

298
 Pianning cycies

OVer 90% have produced positive results.’’Latham added, “The studies show that an employee

With a goal thatjs clear and simple, and challenging yet attainable, Wi11 perfom better than one
Whose only instruction is to do as good a job as possible. Among other things, SuCh a goal helps
an individual or team to focus, tO eValuate performance, tO aSSeSS Whether to maintain or change
course, and to eIjoy a sense of achievement when they succeed:,7
While all performance targets can provide these benefits, this chapter focuses on financial
Performance targets, Which are the most common type of targets derived from firm’s annual
budgeting processes.

Plaming cycles

Organizations often use three hierarchical, Sequential planning cycles, Which are ca11ed
S亡ra亡egtC PZcm証ng, CaP克aZ blldge亡i71g (or program肌証g), and (叩era亡IorzaZ) bl上dge血g,

S軒割鳥かC plan高いg

Strategic plaming includes the relatively broad processes of thinking about the organization’s

missions’Objectives, and the means by which the missions and objectives can best be achieved,

五重言∴翻せ三幸む湘鵜苫ね車軸松丘はぶ辛瀾ごま采、さも直な主的￣圭ぬもて症で淀鎚斑亡やぐ的訪台C㊨亭甲⑤戴芭ビ血腫d
entity managers who are the most broadly informed. They also consider both analyses of the

PaSt and forecasts of the future. Although a detailed treatment is outside the scope ofthis chap-
ter, Strategic planning typically invoIves developing (1) an overarching vision or mission and
Objectives for the organization as a whole; (2) an understanding of the organization’s present

POSition, its strengths and weaknesses, and its opportunities and risks; co an agreement about
the types of activities or businesses the organization should (and should not) pursue; and (4) a
Strategy for each of the core activities or businesses the organization has decided to pursue -
that is, a Plan that sets out the path of action bywhich each business or entity,s objectives wi11 be
achieved building on its strengths.8
A complete’formal strategic planning process leads to the establishment of the organization-

Wide strategy as well as’aS aPPlicable’Strategies for various entities within the organization;

identification of resource requirements; and statements of tentative performance goals, uSually

PrQjected 3-5 or lO years into the future. Strategic planning provides a framework for the more
detailed planning that takes place in the planning cycles that follow, although there is some
Variation in practice. Recent survey evidence, for example, SuggeStS SuCh variation at least in
terms of company size. Not surprisingly’Perhaps, the larger the company, the more likely it will

engage in both strategic planning and developing or integrating a budget with it each year;
Whereas 26% of companies with fewer than 50 empIoyees use a budget only, involving (as we
Wi11 see later) a detailed丘nancial plan with a one-year-Only horizon.9

CapitaI budgeting
Capital budgets are situated between long-range’Strategic plans and annual budgets. Capital

budgeting (also sometimes called progra肌ming) involves the identification of specific action

PrOgramS (prQjects to be implemented or investments to be made) over the next few years (usu-
ally l「3 or 5 years) and speci宜cation of the resources each wi11 consume. Programs should

translate each entity,s strategy’Which is generally focused extemally, into an intema11y focused

Set Of activities designed to implement the strategy and, in tum, lead to the achievement of the
entity’s goals. Programs can be developed at various levels ofdetail, ranging from that ofa com-

Plex program covering all the activities necessary for an entity to sell its products in a new

299
Chapter 8. PIaming and Budgetjng

geographical territory, down to that of simply purchasing a single new machine for an exIStlng
production line. Capital budgeting is constrained in that the program options considered must
be consistent With the tentative agreements reached during the strategic plaming process. Cap-
ital budgeting often invoIves many people with expert knowledge in areas such as investment
analyses, forecasting, and丘nancing. Capital budgeting also typically requires substantially

more planning detail than does strategic planning.

The capital budgeting process usua11y starts with discussions between the entity managers
and their subordinates about the programs needed in the near future. As part of this process,
managers must inevitably review ongoing programs to judge whether they are fulfi11ing their
intended purposes and whether they should be modified or discontinued. Scarce resources are
then allocated to specific programs. Much of the existing theory of resource allocation focuses
on allocation ofcapi亡aZ旬Jlds, Where the screening and comparisons of potential investments is

structured in financial terms using discounted cash flow or similar finance-based analyses, ltlrget Se
again with some variation in method usage in practice.1O
However, rarely is resource allocation a mechanical process dependent solely on the finan-
cial calculations. Other resources, Which maybe scarce in the time period being considered and
which are more di鯖cult to quantify in financial terms (such as mZe庇(human resource§),

essence of fi加ng to reap potential first-mOVer advantagesブand concerns arising from escc証証ng

com肌zt肌e庇due to prior investments), Often also influence the final allocation decisions.11

Moreover, the outcomes of capital budgeting processes are likely also dependent on the track
record, PreParation, arguing ski11, and political power of the managers involved. Managers
have to compete for resources. Those making the most persuasive arguments and presentations
are genera11y those whose requests are supported.
A subset of corporate managers is usually involved in reviewing larger program or invest-
ment proposals, Often as part ofa capital or resource allocation committee. These reviews allow
the corporate managers another opportunity to communicate corporate priorities to entity
managers (helping to alleviate potential Zc[Ck-QfdZrec亡Iorl PrOblems) and to exercise another

preaction review (an action control). They also serve to help lower-1evel managers, Particularly
functional managers, understand how their activities fit into the organizational portfolio of
activities and how they influence or relate to initiatives in other parts ofthe organization (again,
addressing potentia=ack-Qfdirec亡iorl PrOblems)" But the reviews also have an important bot-

tom-uP COmmunication function: they serve as a forum for lower-level managers to communi-
cate opportunities, threats, and requests for capital funds to the corporate managers. If capital
budgeting is done well, the programs recelⅤmg reSOurCeS are individually consistent with cor-

porate o切ectives and strategies and mutually consistent with other related programs.

(Operational) budgeting
Operational (or amual) budgeting - bαdge血g for short - invoIves the preparation of a short-

term financial plan, a budget, uSua11y for the next丘scal year" Budgets match the organization’s

responsibility structure (see Chapter 7) and provide as much revenue, eXPenSe, aSSet, and lia-
bility line-item detail as appropriate. This, unSurPrisingly’is how budgeting is defined in a

recent survey of practice - aS a One-year宜nancial plan of detailed revenues and expenses by

organizational entity (responsibility center), Where budgeting is shown to be used by 93% ofthe
sampled companies.12 we suspect that the remaining 7% either comes from survey measure-
ment error or indudes responses from companies that have presumably負replaced’’budgets or

have gone “beyond budgeting;, which we discuss later in this chapter.13 In budgeting’quantita-

tive (particularly丘nancial) data are emphasized.

Every effectively run organization perfoms the functions of each of the three planning
cycles - Strategic planning, CaPital budgeting (programming), and budgeting - although the

300
 Target setting

formality and distinguishability of the cydes vary greatly from one organization to the next. In
Smaller firms, Partic山arly, One Or mOre Of these cycles are usually relatively infomal, and

many fims combine two, orSOmetimes all, Of these cydes as part of one plaming or budgeting
PrOCeSS, Which they typically do annually. As organizations grow, however, a mOre elaborate
and formal plaming process evolves, One doser to a full three-CyCle system. In non-PrOfit
organizations, the planning processes may be less focused on capital funds, although capital is
often a m亘ior constraint for them as well, forcing them to consider tradeoffs among various

programs and designate available funds amually in their operating budget to well-Chosen
courses of action that help further their charitable ot)jectives (see Chapter 16).

farget setting

Beyond producing written plans that clarify the organization’s goals, Strategies, and expected

results, Plans and budgets become血JgetS that affect managers’motivation because the targets

are linked to performance evaluations and, Often, Various incentives (which we discuss in
Chapter 9). The use of pre-Set Performance targets in business organizations is almost univer-
Sal. We quoted Professor Latham earlier on the robust evidence supporting the positive motiva-
tional effects of targets.14 In addition, budgets are the primary performance target to evaluate

Performance at managerial levels and to award incentives. Review discussions, Which tend to
focus on variances between actual performance and targets, Can lead to improved understand-
ing ofwhat is, and what is not, WOrking and provide a useful forum for intra-Organizational
COmmunication. Even in the absence of explicit incentives, managerS are mOtivated to achieve
their performance targets if for no other reason than to avoid having to explain to their bosses
and colleagues why they missed their targets. For example, China’s Haier, the large consumer

appliances company, eXtenSively uses a rlC[肌e-Cmd-Sha肌e approach. Photographs of managers

are prominently displayed throughout the company with a red smiley face for good perfor-
mance and a ye11ow frowning one for those doing poorly.15 Moreove亘n committing to a target,

managers direct attention toward goal-relevant activities. Targets also motivate managers to
use the knowledge they have, Or discover the needed knowledge, tO help them attain the goal,
The most commonly used performance targets at management levels in for-PrOfit organiza-
tions arise during the budgeting process, the last stage of the three-CyCle planning system. As
mentioned earlier, budgeting targets typically are financial in nature, eXPreSSed on a宜scal-year

Or annual basis, matCh the firm’s responsibility center structure, and tie into the annual perfor-

mance reviews and incentive plans of their managers. For example, the financial targets of

PrOfit center managers are defined in terms ofprofit, Or at least in terms of selected line items of
COntrOllable revenues and expenses in some combination. For these reasons, Our focus in this
廃と立教車お手堆′素謡稲毛を読経琉管絃璃離孟省み蜜で確〔働種筏錐:

坤pes of軸ancjaI performance targets

Financjal performa皿Ce fa重gefs can be djs[ingujshed jn a number of wa坊血js,庇ther庇

〔aきgefs are (リmode出ased, historica串megoでiated;のfixed or征xib」e; and G) intema」 or

Modei-based, historica一, and negotiated targets

Performance targets can be (1) derived from a quantitative model ofwhat performance should
be’(2) based on historical performance’Or (3) derived from a process of negotiation between

lower- and higher-1eveI managers.

301
Chapter 8. PIanning and Budgeting

財odeI-based targets are derived from predictions of possible performance in subsequent

measur邸1ent Periods. When model-based targets are used in areas where activities are pro-

gra肌肌ab!e avhere there is a direct and relatively stable, deterministic causal relationship
between inputs and outputs) they are said to be eれgineered targets. For example, in production

departments, Which are often cost centers, input-OutPut relationships for materials and labor,
Say, Can Often be derived directly from the product(ion) specifications. The physical quantities
for material and labor requirements can then be tumed into financial targets by multiplying the
Standard quantities by their standard unit costs. But models are also used to try to derive per-
formance targets in contexts other than standard costing applications. For example, firms often
develop quantitative models of profit plans at the organization or entity levels, Which are built
on a financial accounting model and other inputs. Such models inevitably require many fore-
CaStS and plaming assumptions, SuCh as about the total available market, COmPetitor actions,
PrOduct mix, Prices, and so forth. However, the target that is ultimately adopted arising from
such models is often negotiated (which we discuss later in this section) based on the range of
outcomes that the model predicts before managers commit to it as the “final’’target.

Historica圧c[rgets are derived directly from performance ln PrlOr Periods. They sometimes

involve what is called rcI亡Cねe血g, SuCh as when, for example, a PrOfit center manager is asked to

increase profits by lO% over last year,s numbers.16 when budgets are set without taking history
as a reference, they are called zero-based. Under so-Called zero-bc[Sed budge亡証g, managerS muSt

build budgets from scratch rather than base them on the previous year,s plan’requiring the

justification of every expense. Zero-based budgeting is not commonly used, although it is the
preferred budgeting method of private equity companies or activist hedge fund investors after
they take controI of a company in which they seek major e鯖ciencies through cost cutting - they

want every line item and each expense to bejustified.17

At managerial levels, however, mOSt Performance targets are rlegO亡融ed between hierarchi-

Cal superiors and subordinates, SuCh as when division managers negotiate their profit for inve§t-

ment) center budgets with corporate. Negotiation is common due to the limitations of
model-based approaches and the planning assumptions that they inevitably incorporate (see
earlieI), aS Well as due to i郎)rma亡ion cIry肌耽e亡ry in decentralized organizations. Higher-level

managers generally are more knowledgeable about the overall organization’s o巧ectives and

resource constraints. Lower-1evel managers generally have superior knowledge about the busi-
ness prospects and constraints at the operating level. Negotiations about performance targets,
therefore, Should allow for making use of each level’s relative information advantage and

induce superiors and subordinates to share at least some of their information.

Tight results control is easiest to implement when targets are engineered because the link
between effort and results is direct. Consumption of inputs greater than, Or PrOduction of out-

PutS Iower than, an engineered target indicates a performance problem with little ambiguity.
Managers can also use historical targets to affect tight results control if the processes being
COntrOlled are stable over time. Tight results control is more di鯖cult when important assump-

tions about the future are necessary or if negotiation is used, unless the negotiation is tightly
constrained by good performance models or good historical performance data. In these latter
Situations, Performance variances from the target might indicate a performance problem, but
they also might indicate that the original assumptions were wrong or that the negotiation pro-
cess was biased.

Fixed versus fIexibie targets

Another way to distinguish targets is in terms ofwhether they are丘xed or flexible. FiJCed targets

do not vary over a glVen tlme Period. FZex謝e targets are changed according to the conditions

faced during the period. The targets may be set to vary, for example, With changes in the volume
Of activity, the price of inputs (e.g. oil or rare minerals), interest rates, Or CurrenCy eXChange rates.

302
 farget setting

Surveys of practice suggest that firms typically use fixed targets (that is, targetS that remain
CO肌m証耽erltS fg江the yeaD, but these surveys also suggest that such fixed, amual budget targets

Can inevitably become obsolete, eSPeCially in rapidly changing, COmPetitive environments. In

the Ql」a庇r諒survey, three-quarterS Of the sample companies reckon this to be the case, With
リ S

more than half the respondents saying they reach that point within the丘rst six months. One-

eighth of the respondents even suggest血at their budget targets have already become obsolete
e ト n.忙∴㌻∴㌔

before the start of the year, Whereas one-quarter Of the respondents feel that their targets
remain useful throughout.18
For this reason, many firms ``recast’’their budget during the year (monthly or quarterly).
“Recast’’means r?旬recast; nOt re-blJdge亡- that is, the original budget targets are not being re-

Set. Instead, firms reforecast at regular intervals to be able to compare their budgets with the
most recent, uPdated information available, While usually expecting their managers to remain
COmmitted to the original budget target. The Qua庇r諒survey suggests that, On aVerage, 58% of
弄∴∴おへ︺V St le le訂y-ィふ追Of鷲d追・虹甘言皿∴高二田町n g平時別冊

the sample firms recast their budgets quarterly, With larger宜rms doing this more frequently,

Where about one-third of the firms with more than l,OOO empIoyees recast budgets monthly
compared to only 19% of companies overall.19
Clearly, then, financial targets are fixed in most firms, at least at profit center levels and
above. This means that managers are held accountable for achieving their budgets regardless of
the business conditions they face, and if they fail to do so, they stand to Iose some important
forms of rewards, SuCh as their annual bonus.
Where targets are made flexible, this tends to be done at lower organizationa=evels.
Manufacturing (standard cost center) managers, for example, are uSually not held account-
able for achieving a fixed total cost budget, Instead, their total cost budgets are typically
flexible, meaning that their budget varies with the volume of production (e.g. $35O,OOO
for production of lOO,OOO皿its) or invoIves the use of unit cost standards (e.g. $3.50 per

unit). This is easily demonstrated with an example from the service sector, Where the
budget (for soap, Say) ofthe manager in charge ofthe room service unit ofa hotel property
Will be adjusted upward or downward depending on a decline or increase in occupancy
relative to the budgeted number ofvisitors, The hotel manager, however, Will not normally
have that budget adjusted for variability in occupancy; instead, that person will be
expected to manage the property effectively to “hit’’the occupancy target and generate

the budgeted profit.

嶋rgets can also be made且exible by stating them in terms of re庇証e pe所)rm。朋e; that is,

relative to the performance of others facing identical, Or at least similar, COnditions. Any given
manager’s performance is evaluated not in terms of the absolute level of his or her own perfor-

mance, but relative to the performance ofothers. Most typica11y, the comparisons are relative to
managers in the organization in charge oflike entities (e.g. fast food outlets or bank branches of
Similar size in similar demographic Iocations). We discuss relative performance evaluations in
more detail in Chapter 12.

1ntemaI versus extemaI targets

Almost all planning and budgeting processes invoIve target-Setting approaches that are血er-

朋的y focused. Managers consider what is possible within the organization and focus on period-

OVer-Period, COntinuous improvements. But planning and budgeting processes can also invoIve
target-Setting approaches that are eJC亡er朋担y focused. This is the case when an organization

uses relative performance evaluations and benchmarks its performance and practices with
those of other organizations. For example, VoIvo, the large truck maker, Said that it will set tar-
get operating margins for trucks and buses based on the performance of Scania, Daimler, MAN,
and Iveco, and its construction equipment and marine engine business operating targets will be
benchmarked against those of Caterpillar, Deere, and CNH.20

303
Chapte「 8. Piaming and Budgeting

One would expect that丘rms in competitive environments would engage in at least some

form ofben証mq頭rlg. Corus, a large steel makeI., uSed to rely on “tons ofsteel rolled’’as the key

measure ofperforma即e in its steel plants. This measure, however, did not show whether it met

customer needs or whether the steel needed rework because it did not meet quality standards.
Therefore, Corus started to monitor and measure how its operations compare with other pro-
ducers and competitors in the steel industry. This process of benchmarking means that Corus
continually reviews its activities to try to become best-in-in血sfry instead ofjust meeting inter-

nally generated, Often historically determined targets.21

Benchmarking can invoIve comparing the organization’s performance against the bes由-

証血stIγ (direct competitor;), aS in Corus, Or bes轟rl-CZass (companies generally recognized for

superior performance on the dimension ofinterest; that is, COmPanies known for their bestprac-
轟ce). Many aspects of performance can be benchmarked, including specific product or service

characteristics (e.g. mean time between failures), SPeCi丘c activities or processes (e・g. CuStOmer

service), Or OVera11 organizational outcomes (e.g. return on assets). When the benchmarking
focus is on organizational outcomes (pe所)γ肌anCe), rather than on bes[prac亡[ces, aS in the VoIvo

example, the benchmarks are often used as performance standards for purposes ofrelative per-
formance evaluations. The idea is that if one aspires to become the best, Performance should be
COmPared with the best. (In Chapter 12, We discuss the use of relative perfomance evaluations
for another purpose, that of filtering uncontrollable factors from measured perfomance.)

Common financial performance target issues

The e任ects ofany results-COntrOI system can be undermined ifthe wrong targets are set or ifthe

targets are not set properly. Two of the most important financial performance target issues are
related to (1) the appropriate amount of challenge in a target, and (2) the appropriate amount
Of influence to a11ow subordinates in setting targets.

How chailenging should financiai performance targets be?

The first丘nancial performance target-Setting issue is how di鯖cult, Or Challenging, tO make the

targets. should targets be set at stre亡c机evels, Should they be a bescguess as to what will happen

in the forthcoming periods, Or Should they be set corrservαt王l,ely to help ensure that they will be

achieved? The answer to this question depends on the planning process purpose(s) that are
emphasized.
For planning purposes, budget targets should be an unbiased best-gueSS・ They should equal

expected performance; that is, in probabilistic terms, With a 50% chance ofachievement - thus,
as likely to be missed as to be exceeded. As such, the targets will provide the best decision-
making guidance for managers who are plaming resource levels without (or less) risk of over-
Or under-COmmitting resources (such as empIoyee hiring numbers, PrOduction levels, and
宜nancing) due to either optimistic or conservative performance expectations that may subse-

quently be eithemot forthcoming or overshot,

For motivational purposes, however, aPPrOPriate target levels should have at least some
stre亡ch in them. The theory regarding the effects of performance targets on motivation is com-

plex・ As management gurus such as Jack Welch and Gary Hamel as well as other pundits have

pointed out, iforganizations do not set high performance expectations, their empIoyees will not
produce superior results.22 cha11enging or stre融perfomance targets push empIoyees to per-
form at a higher level. They lead to imovation, rather thanjust incrementalism.23
On the other hand, Performance targets can be set too high. Research in psychoIogy has
shown a fairly consistent, nOnlinear relationship between target di鯖culty and motivation (and,

hence, Perfomance), aS Shown in Figure 8.1・24 If the targets are perceived as quite easy to

achieve, there is virtua11y no relationship between target di綿culty and motivation. People’s

304
 Target setting

Figu「e 8"1 Belationship between performance target achievability and motivation/performance

○○こ高重し〇七のdJuo焉>革o≡

Easy A impossibIe
Performance target aChievabiIity

source K. A Merchant, Modem Management ControI Sysfems膏ext and Cases (Upper Saddle BlVer’NJ・ PrentlCe Hall’1998), P 388

levels of aspiration (and, hence’mOtivation and performance) are low because they are able to

achieve their targets with a minimum of effort’PerSistence’Or Creativity・ Above a threshold

level ofdi飴culty, mOtivation seems to increase with target di鯖culty up to the point where peo-

ple approach the perceived limits oftheir ability・ After that’the relationship levels o任and even-
tually tums down. At high levels of difficulty’mOSt PeOPle get discouraged’lose their

commitment to achieve the target, and exert less effort - they give up trying. Motivation is high-
est when performance targets are set at an intermediate level ofdi飴culty, POint A in Figure 8.1’

which can be called c庇Zlerlging bu亡ac柾eγabZe・

where, SPeCifically, is the point of optimal motivation - the inflection point in the target dif
ficulty-Performance relationship? In other words’Where do perceptions of excessive di綿culty

and, hence, lack of commitment to achieve the target set in? The point varies undoubtedly
depending on such things as the personalities (such as the degree of con触ence and risk toler-

ance), CaPabilities, and experiences of the individuals invoIved. As we will see’it also depends

on the setting (such as the degree of uncertainty or the prevalence of uncontro11able factors).
This is why some research findings’Or SOmetimes merely anecdotal claims’Vary Widely in the
“recommended・, 1evel of challenge that targets should have for負optimal,, motivation, ranging

from as Iow as a 25賀40% chance ofachievement, tO aS high as an 80-90% chance.

studies of practice suggest that at corporate and entity (profit centeD levels in firms’mOSt

annual profit targets are set to be highly achievable. The budget targets are set to be achievable
80% to 90% of the time by an effective management team.25 These targets should not be
described as ea切because they require competence and a consistently high level ofeffort. These

highly achievable budget targets have many motivation, Planning’and control advantages’aS

discussed next: increased manager commitment, PrOteCtion against optimistic prqiections’

higher achievement, reduced cost of interventions’and reduced gameplaying.

/ncreased manager commitment〃 Highly achievable budget targets increase managers’com-

mitment to achieve the targets. Most managers oPerate in conditions of considerable uncer-
tainty; their performance is affected by many unforeseen circumstances. Highly achievable
targets protect the managers to a considerable extent from the e鉦cts of unfavorable’unfore-

seen circumstances and allow them few, if any, rationalizations for failing to achieve their tar-

gets. They have no choice but to co柵it to achieve their targets regardless of the business

305
Chapte「 8. PIanning and Budgeting

conditions faced. This increased commitment causes the managers to prepare their budget

Plans IIEre Carefully and to spend more of their time managing rather than preparing ration-
alizations to 9xplain away failure to meet them.
Because of the lengthy budget performance period - tyPically one year in most firms - the
costs of a lack of commitment to achieve budget targets are high. If highly di億cult targets are

set and some negative circumstances arise early in the year, the loss of commitment and
decreased motivation may persist for many months. In contrast, if the budget targets are highly
achievable, managerS Can Withstand some adverse circumstances’eVen quite early in the

period. They retain the motivation to try to make up for the unforeseen negative effects and are
more confident that they wi11 be able to get back on track.
Corporate managers have other possibilities for insuring managers against the effects of
unforeseen, negative circumstances. They could shorten the planning horizon and set targets for

periods shorter than a year. However, budget target-Setting processes are expensive’and profit
measures for short-time periods require many inter-Period revenue and expense allocations.
Another possibility is toj7eJC the budget when unforeseen effects arise. However, mOSt PrOfit cenト

ers, and sometimes even cost centers, are aifected by many unforeseen events, SOme POSitive and
some negative. It is costly to analyze the effects of each unforeseen effect and make ajudgment
as to whether and to what extent it should be corrected, For these reasons, highly achievable tar-

gets are o庇en seen as the more workable, though imperfect’aPPrOaCh. Here’managerS are leftto
deal both with “the rough’’and “the smooth’’themselves while maintaining a reasonable expec-

tation, and motivation, that they can meet the target in the end, uPS and downs notwithstanding.

Protec書ion against op書imistic prq/ections. Highly achievable budget targets protect the

organization against the costs of optimistic revenue pl句ections. The宜rst step in budgeting is

usually preparation of sales forecasts. Production (or service) levels are then geared to the fore-
casted level of sales. If the budgets have optimistic revenue prQjections, managerS Will be
induced to acquire resources in anticipation of revenue (activity) levels that may not be forth-
coming. Some ofthese acquisition decisions are at least partially irreversible. It is often difficult
and expensive to shed people and specific assets. It is usua11y safer to forecast sales and profits
relatively conservatively and acquire additional resources only when their need is assured. This
conservatism implies that budget targets should be highly, Or at least reasonably, aChievable.

Higher manager achievemen書・ In the minds of most managers, budget achievement defines

the line between success and failure. Highly achievable budget targets are motivating; they
make most managers feel like winners. Managers who achieve their budgets are given a pack-
age of rewards - bonuses, autOnOmy, and higher probability of promotion - and their self-
esteem is given a boost. Organizations derive advantages when their managers have good
self-eSteem and feel like winners. Managers who feel good about themselves and their abilities
are more likely, amOng Other things, tO be eager to work hard’tO be entrepreneurial, and to

increase their levels of aspiration for the future. In contrast, When managers fail to achieve
their budget targets, they live with that failure for an entire year and even beyond, due to the
stigma often associated with failure; SuCh frustration is likely to undermine their confidence
and commitment, Which can be quite costly to the organization. When Tesla, the manufacturer
of electronic cars, faced disappointment from analysts about its 2016 forecast for production of
l,600 to l,8OO vehicles per week when the company has said production capacity would be
2,000 per week, Elon Musk, Ttsla,s founder and chiefexecutive’Said‥負We don’t want to set high

expectations - We Want Winning to feel like winning, ifthat makes sense.・,26

Reduced costs of /ntervenfions, Highly achievable budget targets reduce the costs of needed
interventions from higher up in the organizational hierarchy. Most corporations use a manage-
mer虻ZD′-eXCq,轟oれPhilosophy. Higher-level managers intervene in the affairs oftheir subordinate

306
 farget setting

Figure 8"2 Probab冊ty distributions of forthcoming profits for effective and ineffective managers

Fo巾hcoming profits

SouICe. K A Merchant, Modemルはnagement Con庇)/Systems 7extandCases (Upper Saddle BIVer, NJ PrentlCe Hal=998), P 390.

managers only when unfavorable variances from budget signal the need, When 80% to 90% of
the managers are achieving their budgets, tOP management attention is directed to the relatively
few situations where the operating problems are most likely and most severe.
Figure 8.2 i11ustrates this point by showing two probability distributions of forthcoming

PrOfits, One for an e節ective, COmPetent, hard-WOrking manager and one for an ineffective man-
ager. Because the scaling shows better performance to the right, the distribution for the ine任ec-

tive manager is to the left of that for the effective manager. If the budget target is set at point A,
the vast majority, Perhaps 90%, Of effective hard-WOrking managers will achieve their targets.
But a much smaller proportion of ineffective managers, Perhaps only 2O% given the way this
CurVe is drawn, Wi11 1ikely achieve their targets. Thus, higher-level managers wi11 spend rela-
tively little time intervening in the affairs of effective managers; instead, mOSt Of their interven-
tion eff。rtS Will be directed at ineffective managers, Where it probably should be directed.

Reduced gameplaymg. Highly achievable budget targets also reduce the risk of gameplaying.
The stakes associated with budget achievement in most firms, Which include bonuses, PrOmO-
tions, and job security, are SO Significant that managers who are in danger of failing to achieve
their budget targets have powerful motivations to play games, either with the numbers or
through foolhardy decisions fthat is, either through accounting or operating methods as dis-
CuSSed in Chapter 5). In other words, and in those circumstances, managerS may engage in
manipulative actions and decisions to make their performance ind主cators Iook more favorable,

knowing that their actions or decisions are having no positive effects on real performance and
might actua11y be harming it.27
However, the primary risk organizations face by setting highly achievable budget targets is
that manager aspirations, and hence motivation and performance, might be lower than they
Should be, thereby causing the managers to not perform at their best. Tb mitigate this, Organiza-
tions can provide incentives to exceed budget targets. Figure 8.3 shows a typical results寸eWard

function for entity (profit center) managers. It shows that managers eam all (or sometimes
most) oftheir bonuses by exceeding their budget targets (up to a pre-SPeCified maximum). Ifthe
rewards given for exceeding budget targets are su鯖ciently high relative to those given merely

for achieving the budget targets, managerS Will have incentives not to retreat after the achieve-
ment oftheir budget targets is assured.

307
Chapter 8. PIanning and Budgeting

Figure 8,3 1ypicai rewards/resuits function for a profit center manager

Low profit Budget High p「Ofit

ResuIts (PrOfit)
SouICe・ K A Merchant, Modem Management Contro/ $ysfems・ 7ext and Cases (Upper Saddie印Ver, NJ● PrentlCe Hall, 1998), P 391

While the use of highly achievable budget targets is the typical observed practice’nOt a11

budget targets should be set to be highly achievable. If the fim is in danger of failing or default-
ing on a significant loan, COrPOrate managerS may Set highly challenging pro丘t targets to signal

to operating managers the short-term eXigency.28 Tbp managers sometimes also set high profit
targets to limit managers, discretionary investments, both to signal to lower-level managers
that the strategy has changed (that is, that short-term PrOfits now have priority over growth)
and to enforce that change. They sometimes set high targets because they suspect organiza-
tional舟t or because theywant to set up a rationale to replace a manager・ They may also set high

targets to penalize managers for eaming high bonuses or αwindfall gains,, in prior periods

based on good fortune rather than good e任ort.

Another budget target-Setting possibility is to set multiple levels of targets’SuCh as optimis-

tic, realistic, and worst case, eaCh designed to serve a different budget purpose (motivation,

planning, Or COntrOl). This is a budget-focused approach to co庇誼gerley, SCerlarIo, Or W庇中f

planning・ The key tension that these approaches try to address is’On the one hand, enSuring
that target setting is flexible enough to incorporate uncertainty (to serve the plaming purpose)
while, On the other hand, PreSerVing the motivational e任ects of fixed targets (to try to meet the

motivational and controI purposes).29

How much infiuence should subordinates have in setting their targets?

Another important issue in designing a丘nancial results controI system when targets are negoti-

ated is the extent of influence subordinates should be a11owed in setting their targets; that is, tO
what extent should the planning and budgeting process be fap-down or bo請o肌-岬? Many organ-

izations lean toward bottom-uP target-Setting processes at manageria=evels. For example, the
Quarltr涼Survey COndudes that “the financial planning and analysis (FP&A) process extends far
beyond the FP&A team, aS SurVey reSPOndents report a broad range of managerial input. While
it,s expected to find heavy invoIvement from C-level executives and financial executives’COmPa-

nies Iook for input from departmental, regional, Channel’and product managers.,,30 A11owing

empIoyees to partlCIPate in, and to have influence on, the process of setting their performance
targets can have several benefits.
InvoIvement in the setting of targets enhances the focal manager,s co肌肌互肌e庇rO aC庇eve丑e

亡cnget・ Those who are actively invoIved in the process of setting their perfomance targets are

308
 Target setting

more likely to understand why the targets were set at the levels they were, SO they are more likely
to accept the targets and be committed to achieving them. A second benefit is i碕rmc正on s庇ring.

As discussed above, target setting in most firms invoIves a process of sharing information about
local business possibilities and corporate objectives and resources. Managers who are cIosest to
the local business can provide useful information to superiors about both business potentials and
risks. Corporate managers can provide information about corporate priorities and constraints. A
third benefit is cog証ive・ Allowing participation in target setting has the beneficial effect of clari-

fying expectations and encouraging managers to think about how best to achieve their targets.31
However’all empIoyees, and not even a11 managers, Should always be highly invoIved in

Planning and budgeting processes and’in particular’the setting ofperformance targets. situa-
tions where target-Setting processes can be completed effectively in a predominantly top-down
manner include the following. First’targetS Can effectively stem from a top-down process when

COrPOrate management has su鯖cient knowledge of their entity business prospects and issues

for setting properly challenging performance targets’Or When corporate management has the

knowledge that essentially subsumes the knowledge possessed by the entity managers. This
OCCurS mOSt COmmOnly when a given activity or operation is programmable, Where targets can
be engineered or set with great reliability by prqjecting historical trends. Related to this, knowl-
edge can also be su鯖cient for setting performance targets when corporate managers have a

good understanding of the local business, Perhaps because they formerly ran it and conditions
are stable. But even when budgets are prepared in a seeminglybottom-uP PrOCeSS, When higher-
level managers have this knowledge, they exert greater in肌ence on the宜nal decisions about

Perfomance targets’thereby shifting the balance ofpower in the target negotiation process.
Second, tOP-down targe亡Setting can be effective when higher-level managers have the infor-

mation available for evaluating perfomance on a relative basis. For example, they may be man-
aging a large number of relatively homogenous entities operating in a stable environment.
These situations exist in some industries’SuCh as where firms manage large numbers of like-

COnCePt retailing outlets’including fast food restaurants, Car dealerships, Or bank branches.

Third’tOP-down target setting can be effective’and should even be preferred, When lower-

1evel managers are not good at budgeting. Tbp-down target setting is common in small busi-
nesses forjust this reason. Small-business operating managers are often technically ski11ed, but
their management and financial education and experience might be limited.
Fourth・ tOP-down target setting should be preferred when lower-level managers, thinking is

dysfunctionally bound by historical achievements. Corporate management may know how to

Set Standards according to a learning curve model that has proven accurate in the past; Or they
may know that a new technoIogywill cause structural changes in the business’thus obsolescing

historical performance standards.

Finally, tOP-down target-Setting can be used to try to mitigate biases that lowerLlevel manag-
ers are prone to impart to the budgeting process" Biases can lead the organization to set perfor-
mance targets either higher or lower than is desired. Most operating managers have a
COnSerVative biasブand they use the opportunity of invoIvement in the target-Setting processes

to set lower targets. Lower targets increase the probability of target achievement, enhance the
managers’reward potentials’and make it possible for them to achieve their targets with less

effort. But some operating managers, Particularly entrepreneurial and sales-Oriented manag-
ers, may have an optimistic bias. Some managers want a challenge that will give them a feeling
Of accomplishment. Some want to signal to their bosses that they are aggressive, Perhaps to
COmPete for additional resources. Neither such optimism nor pessimism is desirable, and
higher-1evel managers may have the perspective or experiences to mitigate these biases,
While top-down target setting has advantages in some settings, Organizations who rely on
this type ofprocess must be careful not to forego too many ofthe benefits ofa bottom-uP PrO-
CeSS. Perhaps most importantly, they risk losing their managers・ commitment to achieve the

309
Chapter 8. Pianning and Budgeting

targets. Corporate managers may set targets that capable and consistently hard-WOrking man-
agers should be able to achieve with high probability, but if those asked to achieve those tar-

gets do not share that perception of achievability, they may be discouraged.32 The resulting
lack of motivation may lead to a low probability of achievement, in which case perception
becomes reality.

Plaming and budgeting practices, and criticisms

The ways in which planning and budgeting systems are used reflect the outcome of a large
number of management design and implementation decisions. Planning and budgeting sys-
tems can vary in terms of their planning horizon. Most firms’plaming horizons are relatively

short: One yearOrless (22%), tWOyearS (10%), three years (29%), four or more years (39%).33
0ne key factor affecting firms’plaming horizons is the length of the business cycle; that is,

the lag between investments and their payoffs. Firms in different industries have very diifer-
ent planning horizons. Those in the power utility industry, Say, Often plan quite far in the
future, 25 years or more. Firms in the retail industry, Say, might consider a one- Or tWO-year

Plan to be adequate. Another key factor in determining the proper planning horizon is uncer・
tainty. Sometimes the future is so uncertain that only short-term Plans can be made. For
example, a firm in the fashion industry might be able to plan only a season or two ahead,
although the example of Zara, the “fast fashion’’retailer we mentioned before, is an interest-

ing case in point.

There is also variation across firms in the timing of, and the time devoted to, Plaming and
budgeting. Firms run their long-range Plaming with greater variation than they run their
budgeting, Which follows a rather standard, annually recurring pattem familiar to most in
large角rms. Most丘rms start their budgeting process four to six months before the end ofthe

fiscal year and complete it during the last two months of the year. The budgeting process takes
about four months to complete in most firms. This suggests that budgeting consumes a non-
trivial portion oftime, OVer a Significant time period each year, Of many managers and employ-
ees in both line and sta任positions. This is confirmed in the Ql[a庇r諒survey. What is more, the

larger the company, the more people that are invoIved. For companies with fewer than
50 empIoyees, 92% report that between l and lO people are invoIved; for companies with more
than 5,OOO empIoyees, 31% rely on more than lOO people in the process.34
Once the budget is set, firms are unlikely to revise it during the year for evaluation purposes,
although they may frequently update it for planning purposes. In the Q関所riJC SurVey, the

majority of respondents reported that they provided “ad-hoc scenarios,’’a fancy term for revised

Or additional analyses during the year: 32% reported that they provided between four and six
per year, and another 29% reported that they provided one to three per year.35 But as we dis-
CuSSed earlier, despite these revised, additional, Or ad-hoc analyses or scenarios, COmPanies
typically require that their managers remain focused on achieving their original budget targets
no matter which business conditions they face. This is also the idea behind the use ofthe term
“ad-hoc scenario’’by Ql上a庇rtJC: an ad-hoc plan to analyze variation to budget or plans and/Or tO

a speci丘c business event or request.36

Budgeting is thus costly, Particularly in terms of management time. It is not uncommon to

hear managers complain that they spend so much time with the budget that they have litt獲e

time to do any work. They never stop budgeting. That said, it is hard to envision any other way
to run large, decentralized organizations with complex reporting structures that inevitably
have a high need for coordination and that are managed mainly by the numbers (using results
COntrOIs) through a management-by-eXCePtion approach.

310
 Pianning and budgeting practices, and criticisms

Relatively recently, however, there has been a spate of criticisms of planning and budgeting

PrOCeSSeS, Par虫cularly by the Bの′Ond B【Jdge血g movement, aSSerting, Obviously with some jus-
tification, that budgets:

㊦ Are rife with politics and gameplaying;

㊨ Produce only incremental thinking and minor modifications to the plans and budgets pre-

Pared in the preceding periods;

藩一Lock血e organiza〔fon into a ‘.丘recf pjan>、 and are no responsfve 〔O changes血〔OCfaJ唇fd料

mOVlng eCOnOmy;

㊧ Centralize power in the organization and stifle initiative;

㊥ Separate planning (thinkers) from execution (doers);

㊨ Cause too manycosts for too fewbenefits; and so on.

The more moderate critics make a number of suggestions for improvement involving (rela-
tively minor) mod脆cations to traditional planning and budgeting processes, SuCh as updating

Plans more frequently (roZ航g pZ肌processes) and using re庇ive pe所,rmanCe S亡肌dards and
S均ec亡fve pe加rmc[rlCe eVαfua轟orlS rather than relying exclusively on fixed budget targets and

Pre-agreed incentive formulas. But some of the critics go further, impIoring managers to aban-
don traditional budgeting and to move bの。Jld bL‘dge血g・37

One of the budgeting-abandonment success stories cited by many critics is that of the
Swedish-based Svenska Handelsbanken, Which eliminated budgets in 1972 and has never
looked back to reintroduce them. Svenska Handelsbanken has no annual budgeting process,
and it produces no budgets; instead, it evaluates the bank’s and its managers’performances by

COmParing them with measures of competitors’performances on key performance dimensions,

SuCh as retum-On-CaPital, COSt-tO-income ratio, and profit-Per-emPIoyee. Whereas Svenska

Handelsbanken has been successful in managing the firm without budgets, it must be noted
that most firms are not in an industry with such homogeneous entities as banking. Therefore,
many firms do not have such good relative performance data avai量able to them. Moreover,

Svenska Handelsbanken sti11 has to engage in many of the standard planning and budgeting
elements described above to ful創I all the other purposes, Other than motivation, SuCh as plan-

ning, COOrdination, and facilitation of top management oversight.

The critics are correct, however, that many fims’plaming and budgeting processes are inef-

fective.38 Designing and implementing plaming and budgeting systems is complex and di鯖-

Cult. The purposes for which the systems are needed often conflict, neCeSSitating some di鯖cult

tradeoffs.39 Business conditions are prone to shift’yet it is di鯖cult to adapt plans and budgets

quickly. In any case, it is sometimes counterproductive to set performance targets because they
Can focus empIoyees unnecessarily narrowly, and they can encourage unethical risk taking or
eamings management (as wi11 be discussed further in Chapter 15).40
The spirit of the beyond-bndge血g management model can be seen perhaps more as a man-

agement philosophy rather than a mere issue ofplanning and budgeting, Or Plaming and budg-
eting alone. Its key aim, instead’is to increase the adaptability of organizations. Companies

that fallow the beyond-budgeting principles tend to have simple organizational structures (or
aim to simplify them), flat hierarchies (or aim to make them flatter, less hierarchical), and flex-
ible pee手to-Peer netWOrks used to provide and exchange the benchmarking data and share best

PraCtices. They operate with an assumption that organizations, like natural systems, are CaPa-
ble of selforganization and selfregulation. Their managers do not require negotiation of fixed

Performance targets’aS is done in a亡raditional budgeting system. Allocations of resources are

event-driven, nOt Calendar-COnStrained. Allocated resources are not treated as entitlements
that must be spen亡・ Unconstrained by a fixed and outdated plan, emPIoyees strive to improve

311
Chapter 8. Piaming and Budgeting

their performance relative to their peers or some other benchmark. Creativity and rapid
response to cu蓬Omer needs and unpredicted events are encouraged.

HoweveI’, there秘‘e nO ``quick fixes’’when it comes to improving an organization’s adaptability

and responsiveness in highly competitive, unCertain, and turbulent environments. Tb improve

the design of a planning and budgeting system, Or anything that presumably takes its place,
managers must be aware of all of the purposes for which the systems can be used and wisely
Choose the combinations of system elements that best serve these purposes in their settings.
The beyond-budgeting ``management model’’has been developed and refined as its use has

spread to several organizations around the world.41 That said, many Organizations continue to
consider budgets as indispensable,42 although many of them also continually struggle to make
them more e任ective.43

The key di綿culty is to get the needed flexibility while maintaining the features ofplans and

Planning that stem from drawing managers away from fighting day-tO-day fires, enCOuraging
them to think about the future, and helping them shape that future. But as useful as plans and

Planning can be, When they becomej‡m亡ed on a single number or target, they can hinder rather
than help and even become detrimental. Even the best laid plans must allow for some, Or eVen
any, Carefully considered a句ustment and flexibility to respond to any of a number ofchanges in N otes
the environment. This can be done, aS SuggeSted earlier, and as the setting requires, through
I See,允rexaⅡ
updating budgets more frequently, uSjng su吐jective performance evaIuations, rOlling forecas亡S,
証ng S即リサ((
and possibly other means, SOme Ofwhich we discuss in later chapters, eSPeCially Chapter 12. A
2 In additionto
SurVey Of over 50O senior finance professionals by Deloitte, however, SuggeStS that striking this
PaPerS by Blo
balance is inevitably di綿cult, aS gleaned, for example, from the following two points:44 uring Manag
online at eco1
加塵grαting pね柵Jlg, bndgedng andjbrecas血g - 37% of respondents admitted to a failure to
3 See, forexar
align their planning, budgeting and forecasting effectively. In these circumstances there is a risk
The W(調S亡「e
that the activities of the organisation will be misdirected, lack focus, alignment and cohesion. COm/10帥R

Us証gjbrecc厨ing properly - 61% of survey respondents recognised the importance of fore- 4 “Planning a

CaSting as a way of compensating for the static nature of budgeting. However, there is a fa11- (2010), Onlln(
5 “Zara’s Secrel
ure to appreciate how forecasting can enhance corporate agility and specifically a lack of
Fbrbes (Oぐto七
understanding of how it fundamentally d推ers from planning, budgeting and target-Setting.
6 SeealsoM.[

P α競れ【ng諒
As we said at the start of this chapteI’, SOme Of the organizational benefits of planning and
(New York: R
budgeting come from the processes of developing the plans. For plans and budgets to serve a
7 Quoted fror
useful role’then’the issue is not 14,he崩er to prepare a plan or budget, but 7tow.45
(March 7, 20
8 Inlarge,dlVe
busines§eS th

often referre
Conclusion The indlVidu
the corporatl
Planning and budgeting systems are potentially powerful management tooIs that serve multiple to as ``(strate(

9 20」2B種dg帥
PurPOSeS. They provide a way of converting managers’visions into an organized set of tactics that
10 See, forexa
are empIoyed throughout their organizations. They provide a standard that can be used to judge
Budgeting PI
Organizational success or progress" And they have many behavioral implications, SuCh as regarding
Cha nged,’用
the effbrt invested in thinking about the future and commitment to achieve performance targets.
(2002), pp∴
Many ofthe criticisms ofplaming and budgeting systems, SuCh as those made by devotees of P. Schuster,
the so-Called bのりれd-b Jdge血g movement, focus on the組aws of negotiating performance tar- (He idelb erg,
11 See, forexal
gets. It is true that allowing target negotiations has drawbacks. The negotiating processes are
M. Young, “l
COStly, Particularly in management time. Hence, firms are willing to engage in the processes
Evidence fr(
relatively infrequently, 〔ypically annually. Thrgets that are丘xed that far in advance can easily
ra7γ Acco肌(
become obsolete, Particularly in fast changing environments. Moreover, allowing negotiation
12 20」2B標dge亡
Of targets can also enhance gameplaying, SuCh as the reluctance to share private information to
pp. 3,与・

312
 Notes

be able to create budgetary slack and to maximize incentive payouts associated with achieving
the targets. Still, negOtiating targets has its advantages, aS this chapter has described. Although
annual budgets haVe been criticized for inducing gameplaying behaviors and for being incapa-
ble of meeting managers’needs in rapidly changing environments, eVidence suggests that they

remain in widespread use and continue to play a crucial role in coordinating and motivating
empIoyee actions and behaviors.
However, just because an organization prepares a plan does not mean that it is engagmg m
useful plaming. Frequent criticisms voice that strategic planning is overly bureaucratic and
absurdly quantitative. Often plans are prepared but not used; theyjust take up shelf space. For
Plans to be effective, they must match the business conditions the firm is facing so that they can
be used as a near-COnStant guide for employee actions. The plans should also assign responsibil-
ity and accountability for performance. This is an important role for budgets. Budgets turn

Plans into performance targets that a任ect employee motivation, Particularly because the tar-

gets are often linked to performance evaluations and rewards, Which we discuss in the next
Chapter, and which must be implementedjudiciously as well to have good e任ect.

Notes

I See, for example, 20]2 Budget証g, Forecas由ng,伽d動d乱 13 See also T. Libby and R. M. Lindsay, ``Beyond Budgeting or

ing S工JrVey (Quantrix, 2012). Budgeting Reconsidered? A Survey of North-American

2 In addition to the original academic articles and working Budgeting Practices,’’MarlC[ge肌e庇Acco肌房ng Research,

PaPerS by BIoom, Van Reenen, and co11eagues, See “Meas- 21, nO. 1 (March 2010), PP. 56-75.
uring Management,” TJte EcorlO扇s亡(January 18, 2014), 14 “The Quanti丘ed Serf,’’op, Cit. See also A, Locke, “Goal-

online at econ.st/1b4aTUl. Setting Theory and Its Applications to the World of Busi-
3 See, for example, ``Companies Get Budgets All Wrong;’ ness,’’Academy Qf Ma朋gemerlt Execl‘[ive, 18, nO. 4

T71e WdrZ S亡ree亡JoIJrmZ Uuly 22, 2013), Online at on.w争i. (November 2004), PP. 124-25.
COm/1OfjJaR. 15 ``Grow, Grow, Grow,’’軌e Economist (April 17 2010), P. 13.

4 “Plaming a Budget (Davis Case Study),’’H肌es ]00
(2010), Online at www.thetimesIOO.co.uk.
5 “Zara’s Secret to Success: The New Science of Retailing;’
Forbes (October 14, 2013), Online at onforb.es/16ZsH74.
6 See also M. D. Mumford and M. Frese, The Payc心ofogy Qf
16 For a recent series ofpapers on the issues oftarget ratchet-
ing, See J. H. Evans, `A Forum on Ratcheting and Incen-
tives,”耽eAcco肌血gRevie男89, nO. 4 Uuly2O14), P. 1195;
C. Aranda, J. Arellano, and A. Davilla, ``Ratcheting and the
Role of Relative嶋rget Setting,’’The Acco[仙南g Revfet4;

現〔刷れ諒g誼O7官α証如亡ioれS: ReseαrC九αnd AppHca亡王ons 89, nO. 4 Ouly 2014), PP. 1197-1226; R. J. In4jejikian, M.
(New York: Routledge, 2015). Matejka, K. A. Merchant, and W. A. Van der Stede, “Eam-

7 Quoted from ``The Quantified Serf,’’T九e EcoれOmisf ings Tatgets and Annual Bonus Incentives,’’耽eAcco肌でi7章g

(March 7, 2015), Online at econ.st/1GZAcbw. Rev[e叫89, nO. 4 Uuly2014), PP. 1227-58; R. J. In句ejikian,

8 In large, diversified corporations, the question as to which M. Matejka, and J. D. Schloetzer, ``丁hrget Ratche亡ing and

businesses the corporation should (and should not) be in is Incentives: Theory, Evidence, and New Opportunities,’’

Often referred to as “(corporate) divers㌍c誼orl Strategy.’’ 柵eAcco肌血gRe高e1生89, nO. 4 Uuly 2014), PP. 1259-67
The individual stra亡egies for each of the businesses that 17 See, for example, “Burger King Chief Takes Aim at

the corporation has decided to pursue are, in tum, referred McDonald’s,’’軌e FfrlarlCiaZ Hmes (August 26, 2014),

to as ``(strategic business unit) compe証fve sfra亡egies.’’ Online at on.ft.com/1tHvCIY; ``Hedge Fund Manager Bill
9 20ユ2 B可se血g, forecas血g, Cmd PZ肌証ng SzJrV勤OP, Cit., P. 5. Ackman Seizes 7.5% Mondelez Stake,’’The瑞n肌cfaZ
10 See, for example, P. A. Ryan and G. P. Ryan, ``Capital 丁i肌es (August 6, 2O15), On宣ine at on.ft.com/1DsumCk.

Budgeting Practice of the Fort皿e lOO: How Have Things 18 20ユ2 BIJdge亡irzg, Forecasting, a71d P!cⅢm血g Surγey, OP.

Changed;’Jour71d QfBl上Siness arld Mcmageme庇, 8, nO. 4 Cit., p. 8.

(2002), PP. 355-64. See also U. G6tze, D. Northcott and 19 Ibid.,P.6.
P. Schuster, hlVeSt肌e庇AppraisaZ: Met九ods餌d ModeZs 2O “VoIvo Aims for Profit Margins at Top of Heavy-Equip-

(Heidelberg, Germany: Springer, 2015). ment Industry,’’Bfoo肌be7g (September 22, 2011), Online

11 See, for example, J. J. Gong, W. A, Van der Stede, and S. at www.bloomberg.com.

M. Young, “Real Options in the Motion Picture Industry: 21 ``Continuous Improvement as a Business Strategy: Target
Evidence from Film Marketing and Sequels,” CorltemPO- Setting (Corus Case Study);’Times JOO (2010), Online at

「oryAcco【側面gResec[rCh, 28, nO. 5 (2011), PP. 1438-66. www.thetimeslOO.co.uk.

12 20ユ2Bndge血g, Forecas血g, arldP妃伽血gS研V勤OP. Cit., 22 J. Welch, Jac亙S亡raig加重・Om油e G虹(New York: Warner

pp・3,5・ Business Books, 2001); G. Hamel, Leading丑e Revo庇fon

313
Chapter 8. PIanning and Budgeting

(Boston, MA: Harvard Business SchooI Press, 2000); S. O7官C肌[2;C証ons cmd Society, 24, nO. 2 (February 1999),

Kerr and S. Landauer言`Using S虫etCh Goals to Promote pp・ 125-37.

Organizational Effectiveness and-Per雪印al Growth: Gen- 33 20]2Bl」dge亡ing, forecc[誼ng, andP血m血gSurγ切OP. Cit.,
era看Electric and Goldman Sachs,’’Academy QfMcmc[ge- p.与. CAS各
me庇放ec[l[iγe, 18, nO. 4 (November 2004), PP. 134-8. 34 Ibid., P.13.
23 ``Grow, Grow, Grow,’7 0P. Cit., PP. 12-13. 35 Ibid.,P. 7.
Royal W
24 As mentioned earlier in this chapter, Edwin Locke and 36 Ibid.,P.3.
Gary Latham are renowned researchers in the area of 37 See, for example, J. Hope and R, Fraser, Beyond Budgeト

goal setting theory. For a recent re組ection by them on ing: How M肌agers Ccm Break Freefrom fhe AJl皿d Per-

research in the target-Setting area, See E. Locke and G.
Latham, “Building a Practically Useful Theory of Goal
Setting and Task Motivation: A 35-Year Odyssey,’’A肌er子
C復職Pycho!og王sち与7 (2002), pp. 70与-17,
25 See, for example, K. A. Merchant and J. F. Manzoni, ``The
Achievability of Budget Targets in Profit Centers: A Field
Study,’’The AccoIm訪1g Re高ew, 64, nO. 3 (July 1989),
JbrmaれCe Ttap (Boston, MA: Harvard Business SchooI
Press, 2003); B. Bogsnes,加pZeme証血g BeyO融Budget- In early Febrし
irlg: UrlZocking丑e Pe所orm肌ce Pote柾iaZ (London: John
Europe at Roy
Wiley & Sons, 2008). For an academic perspective, See S.
budget for the】
C. Hansen, D. T. Otley, and W. A. Van der Stede, “Recent
tegic outlook f《
Developments in Budgeting: An Overview and Research
Perspective,’’Jou「rlCZZ Qf Mcz朋ge肌erl[ Acco章川面g Of strategic unl

PP. 539-58; and K. A. Merchant, “How Challenging Research, 15 (2003), PP. 95-116; T. Libby and R. M. arose not onl
Should Profit Budget Targets Be;’M伽agemerlt Accour正 Lindsay, “Beyond Budgeting or Budgeting Reconsid- resulting in lc
ing (November 1990), PP. 46-8. ered? A Survey of North-American Budgeting Practices,’’ recent COrPOra
26 “Tesla Wams Vehicle Sales Target at Risk;’Ifle F玩arlC融 MarlC[ge肌e庇Accourlting Research, 21, nO. 1 (March
Strategy・
丁主mes (August 5, 2015), Online at on.ft.com/1W2HaVR. 2010), pp.与6-7与.
Since the la
27 See also M. Jensen, ``Corporate Budgeting Is Broken: Let’s 38 “Companies Get Budgets A賞l Wrong;’op. cit.

Fix It,’’Harvclrd Bl(Siness Re高ew (November 2001), 39 S. C. Hansen and W. A. Van der Stede, “Multiple Facets of
Organic food

PP. 94-101; and M. Jensen, “Why Pay People to Lie?,’’
丁he W拙S亡ree亡JoIJrnCIZ (January 8, 2001), P. A32.
28 See, for example, M. Matejka, K. A. Merchant, and W. A,
Van der Stede, ``EmpIoyment Horizon and the Choice of
Performance Measures: Empirical Evidence from Amual
Bonus Plans of Loss-Making Entities;’MclⅧgeme庇Sc子
erlCe, 55, nO. 6 Uune 20O9), PP. 890-905.
29 See, for example, W. A. Van der Stede and T. Pa獲ermo,
“Scenario Budgeting: Integrating Risk and Performance,’’
瑞nczrlCe & Mαmgemeγ江, nO. 184 (January 2011),
PP. 10-13. See also N. Frow, D. Marginson, and S. Ogden,
“Continuous Budgeting: Reconciling Budget Flexibility
With Budgetary Control,” Accou庇Zng, Org伽fzc[tious仰d
Socie助35, nO. 4 (May 2010), PP. 444-61; “Managing in
the Fog,’’T心e EcorIO証st (February 26, 20O9), PP. 67-68.
30 20ユ2BIJdgedrlg, Forecasting, CmdP!伽n血g S【JrVey, OP. Cit.,
Budgeting: An ExpIoratory Analysis;’Marlage肌e所Accou柾 growth at we
irlgResea7ch, 15, nO. 4 (December 2004), PP. 415-39. growth began
40 L. Ordonez, M. Schweitzer,A. Galinsky, and M. Bazeman, 5%, thereby n
``Goals Gone Wild: The Systematic Side Effects of Over-
tions. Worse,
PreSCribing Goal Setting,’’Academy q手MczⅢge肌e庇 ment to believl
Perspec証ves, 23, nO. 1 (2009), PP. 6-16,
in the market
41 For more information, See the Beyond BI上dge亡irlg Ins庇L[te,
level of uncert
Online at bbrt.org (accessed December 2015).
Of negative gr《
42 Libby and Lindsay, “Beyond Budgeting or Budgeting
Reconsidered?’’Op. cit. See also B. Ekholm and J. Wallin, OPing an alte
“Is the Annual Budget Really Dead,’’耽e軌rOpe伽
account a “wl
Acco【Jrlt王rlg RevIet生9, nO. 4 (200O), PP. 519-39; T. Libby nues. But to
and R. Lindsay, “Beyond Budgeting or Better Budgeting?’’
needed the su
S亡rα亡egic FirlarlCe (August 2007), PP. 47-51.
utive Board.
43 J. Orlando, ``Thrning Budgeting Pain into Budgeting
Gain,’’S亡rc江egic Ftrtcmce (Mar⊂h 2009), PP. 47-51; ``How

p.12. to Better Connect Planning, Forecasting, and Budgeting;’

Royai Wes
31 There is an extensive stream ofresearch in the area of JourrmZ QfAcco【J庇arley (February 20, 2014), Online at
budget participation going back nearly half a century. For shar.e s/ 1Gxnwf. In the sevenl
a study that speaks to some ofthe benefits discussed here, 44血tegraとed Pe頑〕rmanCe Ma朋gemerlt (Deloitte, 2014), Netherlands l
among many other studies too numerous to list here, See Online at www.planbudgetforecast.com/report.
trading natio
M. Mah量endorf, U. Schaffer, and O, Skiba,くAntecedents of 45 For an academic study on the use and usefulness ofbudg-
ried new and
Participative Budgeting: A Review of Empirical Evi- eting (in times of economic crisis, for example), See S. D.
the far-flung
dence,’’in M. J. Epstein and J. Y. Lee (eds.), Advances諒 Becker, M. D. Mahlendorf, U. Scha任er, and M. Thaten,
Marlageme庇Acco肌t誼g, 25 (2015), PP. 1-27.
“Budgeting in Times of Economic Crisis:’Co庇empora7γ Caribbean a]
32 T. Libby, “The influence ofVoice and Explanation on Per- Acco肌亡ZngResearch (2016), in press, this trading a
formance in a Participative Budgeting Setting,”Acco肌ti喝 and unloade(
lined the Ri「

warehouses
trader oftha(
Sanen teame
Laan, tO trad

314
 CASE S丁UDY
Royal Wessanen NV
In early February 2009, Sjoerd Schaafsma, CFO
Europe at Royal Wessanen, WaS POndering on the
budgetfor the remainder of20O9 as well as the stra-
tegic outlook for 2010 and beyond. An era with a lot
Ofstrategic uncertainty laid ahead. The uncertainty
arose not only from the global economic∴Crisis
resulting in lower revenue growth, but also from
recent corporate decisions to change the company’s
Strategy・
Since the late 1990s, Wessanen’s main market of
organic food had shown a very satisfying amual
growth at well above lO%. Since 20O8, however,
growth began to sIow and had stabilized at less than
5%, thereby no Ionger meeting corporate expecta-
tions. Worse, the economic recession led manage-
mentto believe that 20O9 was likely to show a decline
in the market for organic food. Because of the high
level of uncertainty, and not ruling out the possibility
Of negative growth, Mr. Schaafsma considered devel-
OPing an altemative forecast for 2009 to take into
account a “worst-CaSe SCenario’’of declining reve-
nues. But to effectively pursue this, he knew he
needed the support and commitment ofthe fu11 Exec-
utive Board.
Royal Wessanen NV
In the seventeenth and eighteenth centuries, The
Netherlands was one of the world’s most prominent
trading nations, With a huge merchant fleet that car-
ried new and exotic materials between Europe and
the far-flung ports of the Far East, the Americas, the
Caribbean and Africa. Amsterdam was the hub of
this trading activity where many of the ships docked
and unloaded their cargoes into the warehouses that
lined the River Zaan. One of the owners of those
warehouses was Adriaan Wessanen, a renOWned
trader ofthat time. In 1765, the 41-year-Old Mr. Wes-
Sanen teamed up with his 31-year Old nephew, Dirk
Laan, tO trade in “Mustard, Canary and other seeds.’’
The then-neW COmPany WaS Called Wessanen &
Laan.
By about two-and-a-halfcenturies late扉n 2008, Royal
Wessanen NV developed into a group with operations in
seven countries in Western Europe and North America.
Royal Wessanen NV was listed on the Midcap Euronext
stock market in Amsterdam. Revenues were fl.6 bi11ion
SPlit 4O-6O over Europe and North America’reSPeCtively.
(See Exhibit l for a combined overview of the revenues
and EBIT ofWessanen by business and location.)
Wtssanen had a two-tier board structure. The Board
consisted of the chief executive officer (CEO), Chief
financial officer (CFO), and president of the North
American operations. The CEO also acted as president
Of the European activities. Under the Executive Board,
there were two leadership teams: One for the European
and one for the North American markets, reSPeCtively
(see Exhibit 2).
In the second half of 2008, reVenue groWth dropped
from lO% to below 5%. Key challenges were to keep
growing the top line while protecting margins. Stalled,
or even declining, grOWth became a serious business
reality. The existing strategy set out to cope with these
cha11enges focused on three di縦rentiating capabilities:
寧 Strong and focused brands and excellent branding
Skills;
s Best-in-dass distribution services;
曾 Excellence in category management.
2009 - a year Of transformation
In February 2009, the CEO left the company. A member
of the Supervisory Board filled the CEO position
c[d in柁rtm, While the search for a new CEO was on. At
that time, a radical change in the global strategy was
announced to increase the company’s focus on the Euro-
Pean market and concentrate on its leading brands in
Organic foods. In Europe, Wessanen aimed to become a
負one-SyStem,, company with considerably more
315
Chapter 8. Pianning and Budgeting

harmonized brands and centralized sourcing. The plan and concentration of activities resulted in an expected
請謁5幻亡母で塑誼盤超す守亜重樺す虚Iとち魂藤並仁緩雷冬冒l馳糊彊- 血霊妙壷1電場で盛り筏五0歴∠霊,6虎必o分立ロ型擢ガ慣重態a車￣
Sisted of four ent王ties, nameIy Pahos㌻ I.iberty Rich〔er, f70O miH王on by血e compIetion of血e divestment pro-

Ttee ofLife, and American Beverage Company (ABC). CeSSeS (Exhibit l). That said, it would also result in a
TWo business lines - Organic and Frozen - Were tO Strengthened balance sheet due to an improved debt-
COnStitute the core of the company’s operations in equity ratio and lower working capital.
Europe. First, Wessanen Europe was a dedicated player The new strategy of less diversi宜cation also intro-

in organic food with a strong presence primarily in the duced a stronger dependency on a few core markets,
Benelux (including, Chiefly, Belgium and the Nether- both business- and location-Wise. HoweveI., StOCk mar- (FDs), and co
lands), the United Kingdom, France, and Germany. The ket analysts pointed to the risks associated with such Wtlrdt’s Cor

Strategy for this business line consisted of a so-Called COnCentration especially due to the large uncertainty in These corpora
“multichannel approach with channel-SPeCific solu- targets (see
the development of the organic food market which had
tions.’’Wessanen Europe’s two sales channels were not yet taken up much space in a typical consumer’s

grocery stores on the one hand, and Health Food Stores grOCery Cart.
(HFS) on the other hand, With channel-SPeCi宜c solu-
tions ranging from Wessanen-OWned brands to private
Piaming and controI
labels. Innovation was key at this time. New brands
Were launched and existing product ranges were Tb enable the Executive Board and the management of budget year (t

extended or changed with high frequency, With mixed the operating companies (OPCOs) to manage and con- (亡十2;t十3).

levels of success, however, aS is common in宜ercely trol the organization, Wessanen’s intemal govemance was referred to

COmPetitive consumer product markets. StruCture WaS based on a performance framework that updates were

Frozen Foods, the second main business line, WaS COnSisted of annual budgets and a monthly and quar- Strategic plan

invoIved in the distribution and marketing of snack terly review cycle. A11 planning and performance both the threa

foods. The Wessanen brand in the Benelux for this was reporting was done in Hyperion, an Enterprise Perfor-
Beckers. Private labels were distributed and sold mance Management (EPM) tool from Oracle.
through the Dutch-based Favory Convenient Food Budgeting was essentially a bottom-uP Planning updates were

Group, a joint venture with Rabo Private Equity. The with substanti
PrOCeSS, Which was guided by the Executive Board with
activities of the companies in Germany and Italy - Karl SPeCific targets on the three KPIs that formed the back- required for bu

Kemper and Righi, reSPeCtively - Were deemed low on bone of the reporting in this company: Net Sales (and The budget

by comparison to prior periods, the expected growth in imately six we

POtential synergies with the Benelux frozen food oper-
ations. For this reason, they were sold. Net Sales), Eamings Before Interest and Taxes (EBIT), year. As partof
In the latter half of the year, the American Panos and Working Capital. the local mana
brands and Liberty Richter were sold, tOO. The sale of Net Sales were essentially Gross Sales adjusted for ness challenges

廿ee of Life was announced in December 20O9, 1eaving discounts. Net Sales were also sometimes referred to as gets. Mr. Scha
ABC the main operation to divest in the United States. In the “Tbp Line” or simply “Revenues.’’ had αan informa

the summer of 2009, however, irregularities were dis- EBIT was calculated from Net Sales by subtracting tant performan(

COVered in ABC’s books, reSulting in a restatement of its Cost of Goods Sold (COGS),1 Marketing, Advertising & folio, PrOduct po

accounts. During that period, the local management Promotion costs, and Sales, General & Administrative quality of the pc
team was restructured and a recovery plan to regain COStS (SG&A). What is broadlyknown as SG&A induded PrOCeSSeS,’’

many detailed line-item accounts, Often referred to as The budget「

PrOfitability was established. The turmoil, however,
“0Verheads’’although not all ofthese costs were宜Ⅹed. based on Hyperi
meant that ABC’s divestment plans had to be put on hold.

Evaluating 2009, it seemed that after two di綿cult Working Capital conformed to its usual accounting bled the Corpor
to roll up thefin
years, including poor growth, CEO tumover, and fraud definition, including inventory, aCCOuntS Payable旬en-

in the American operations, Wessanen had tumed a dors), and accounts receivable (debtors). Working Capi- POrate Perfom
COmer and was back on track with a clear strategy going tal was tumed into a KPI by dividing it by the last three Point reportin

forward. The company had transformed from a widely months of Net Sales that was extrapolated for the year overviews froⅡ

diversified conglomerate with many house brands, by multiplying it times four. This method was chosen COmmentary Hl
COCktails, SnaCks, and bioIogical food, tO a mOre focused ysis on the cha
COrPOration concentrating chiefly on the European l As was customary in accounting terms, reVenueS minus COGS was sumed risks an(
Organic and frozen food markets, The reorganization also separately reported as Gross Margln. in their forecas(

316

and introduced in the budgeting process of 2009 to get
the best possible match betwee打the working capital
Closing position of a specific quarter,創igned with the
re§PeCtive Net Sales, and taking into account seasonal-
ityeffects (see Exhibit 3).
Each September,バCorporate Guidelines for the Prep-
aration of the Royal Wessanen Budget,, were issued to
the managing directors (MDs), financial directors
(FDs), and controllers of the OPCOs by Dick van der
Wardt’s Corporate Accounting & ControI Department.
The§e COrPOrate guidelines communicated the top-1evel
targets (see Exhibit 4). The guidelines also set out the
PrOCedures and timetable for t:he budgeting process as
Well as the specifications for use of Hyperion. Technical
information about interest rates, CurrenCy rateS, taX
rates, and capital expenditures were also provided. The
time horizon for the planning process covered the
budgetyear (亡+ 1) as we11 as the two subsequent years
(t+ 2; f + 3). Plaming for the second and third years
WaS refdrred to as the存Strategic Update.,, The strategic
updates were designed to corroborate the espoused
Strategic plan and to inform corporate management on
both the threats and opportunities for the coming years,
induding their potential e紙3CtS On P&L and cash flows
Ofthe OPCOs in light of their strategic plan. Strategic
updates were reported (and entered into Hyperion)
With substantially less detail than the detail that was
required for budgets.
The budget had to be prepared in a period of approx-
imately six weeks during SeptembeトOctober of each
year. As part of this process, Mr. Schaafsma met with
the local management teams to discuss the m句Or busi-
ness challenges on how to establish the required tar
gets. Mr. Schaafsma noted that these meetings usually
had “an informal character and were all about impor-
tant performance drivers, Such as the customer port-
肌o, PrOduct portfdio, OPerational excenence and血e
quality of the personnel invoIved in the local business
processes・’’
The budget was reported via two formats. One,
based on Hyperion including all the financial data’ena-
bled the Corporate Accounting & Control department
to roll up the financials of the different OPCOs to a cor-
porate performance overview. The other was a Power
Point reporting format which included the main
overviews from Hyperion, but also allowed for more
commentary・ Here the OPCOs had to report their anal-
y§i§ On the changes to prior years and both the pre-
sumed risks and upside potentials that were embedded
in their forecasts.
Royal Wessanen NV
In early November ofeach year, the MD and FD of
each OPCO presented their budget to the Executive
Board. It was not unusual within Wessanen that corpo-
rate “upped’’the initially proposed targets by the OPCO
managers" In the end, however, the targets were set in
agreement with the Executive Board, COntaining what
they believed was the ``optimal’’amount of stretch.
OPCO managers, however, COnSidered their targets
“challenging’’in most of the years.
The targets for Net Sales, EBIT, and Working Capital
Were uSed for the bonus schemes of the MDs of each
respective OPCO. Specifically’the annual bonus pay-
ments ofMDs reflected their OPCO,s actual results rela_
tive to these targets, induding minimum, On-target and
StretCh target levels. Bonus payouts were calculated as
Shown in Exhibit 5. The minimum target level was set at
9O% of the on-target level, Whereas the stretch target
level was set at llO% of the on-target level. The three
Performance targets were weighted 20-40-40 in the
bonus scheme; that is’20% of the bonus potential was
based on target achievement ofNet Sales, 40% on EBIT,
and 40% on Working Capital. Target achievement on
each performance measure was independent from tar-
get achievement on any of the other two performance
measures. In other words, target aChievement on each
Perfomance measure was strictly cumulative in the
determination of the overall bonus payout. Seventy per-
Cent Of an MD’s incentive pay was determined in this
Way喜that is, based on meeting the targets, and hence,
determined formulaica11y. The other 30% was based on
an MD’s “individual performance;’which was assessed
Sut2jectively (see Exhibit 6).
The base amount ofthe incentive pay was IO% of
annual salary. The maximum bonus for MDs was set at
25% of salary or 250% of the incentive pay base
amount. Thus, for the formulaic part of the incentive,
at target performance, an MD eamed 7O% of lO% of
salary・ On average, incentive awards at Wessanen
amounted to between 5% and lO% ofsalary. As is cus-
tomary in most organizations, the remuneration com-
mittee (a committee ofthe Supervisory Board) reserved
the right to cap or change incentive payouts on a discre-
tionary basis, but this was done only rarely.
During the budget year, OPCOs had to submit
revised forecasts each quarter to provide the Executive
Board with a latest estimate of the prQjected financials
for the year. These forecasts were reported next to the
budget, Which was considered the ufixed plan:’This
was all done in Hyperion in order to provide the com-
pany its αintegrated), EPM for which the system was
317
Chapter 8. PIaming and Budgeting
designed・ The reforecast for the third and fourth quar-
ter (done at the end of the secohd quarter, Or end of
June) also required an update fof the如bsequent two
years on the three KPIs. In September, then, COrPOrate
guidance was established for the upcoming year’Which
was the starting point for the upcoming budget discus-
Monthly, aCtual financial perfomance was reported
against the budget-tO-date and the latest forecast-tO-
date. Variances were discussed monthly during half-
hour conference calls between the Executive Board,
Mr. Schaafsma, and the respective OPCO,s MD and FD・
Much more extensive face-tO-face discussions took
place among the same group of people each quarter in
order to vet the performance of the previous quarter
and the forecast for the remainder of the year. This
was ca11ed the Quarterly Business Review (QBR).
Mr. Schaafsma commented:
Our QBRs are not just “talking shops・’’We require
the OPCO managers to make detailed 「eports in
preparation for these meetings■ These meetings
eastry last for two hours, and they are ``honest’’-
sometimes bruta=y honest・ We discuss perfor-
mance on the financials, based on reporting formats
in Hyperion, but we also d「ili deep into nonfinancial
perfo「mance indicators to discuss and grasp the
current state of the business, These nonfinanciais
can have to do with credit notes, CuStOme「 COm-
p-aints, Sick-Ieave percentageS and empIoyee turn-
over, Any and a一一exceptions are flagged up and fair
game for discussion. Ou「 QBRs are, however・ nOt
just about operationai perfo「mance" We also use
them to discuss, and decide as app「OPriate’the
launch of new brands; tO eValuate progress On PrO-
jects; tO aSSeSS key investments and/or to raise
other issues we suspeCt may be Iurking in our
OPCOs, Al看told, the QBRs a=ow us to spend some
・・quaiity time" with our OPCO managers …
Finally, tWO Other components of Wessanen’s inter
nal control and governance structure were the com-
pany-Wide Framework of Intemal Control (FIC) and
the Wessanen Company Code (WCC). The FIC provided
a clear overview of the control activities applied to the
most important process-level risks of the main business
functions. The purpose of these control activities was
to ensure e任ective and e鯖cient operations, reliable
financial reporting, and compliance with laws and reg-
ulations. In May of each year’the OPCOs were required
to perform their amual controI selfassessments based
318
on the FIC. The results were communicated to Internal
Audit and the Executive Board. A summary was cOm- what they ha
municated to the Supervisory Board. For any identified gories. These
had a fixed
controI weaknesses, an aCtion plan was put in place by
were deem
management. progress on these action plans and fol-
low-uPS On any intemal audit issues were reported and POtential g
ing, andpr
discussed during the QBRs. A risk and control databa§e
was kept to keep track of all the reported risks and the top lin
improvement or寝mitigation,, plans.
The WCC provided empIoyees with a set of moral ther reduci
s ut)j ug ated
and ethical guidelines for how to do business and how
to achieve results in an appropriate manner. It included
Wessanen,s Mission, Core Values, Business Principles, ParameterS
and Guidelines. The Guidelines dealt with several top- der Wardt
accountmg P
ics, induding information security’insider trading’
in Hyperion
gifts and favors, bribery and corruption. The WCC also
referred to Wessanen,s whistle-blowing policy, fraud Ward analyz
policy, SuStainability policy and applicable authority
limits.
Chailenging times (ea「ly 2009) shipping. As it
Put down a ta
Tb get the management support he knew was required,
Mr. Schaafsma urgently requested a meeting with the
new interim CEO, The CEO supported the idea to
develop a cost-Cutting scenario that would ‖stress test’’
a possible drop in revenues of lO%. The idea had been
floated before in 2008 by the former CEO. At that time,
韻
however, the implementation was not pushed through.
But by this time around, the economic situation had
deteriorated more than it had then, SO Mr. Schaafsma
felt that it was now-Or-neVer tO PreSS On With the idea:
Look血g back, and happy about having convinced schaafsma expl
the new CEO, l knew that a= eyes were trained on
丁he in¶ueno
me to take charge of what turned out to be a fre・
clear here. 1
netic process to imp看ement a ``hurricane proof”
understood
scenario, I was happy to have joined forces with
eve車軸印Ⅵ
Dick [van der Wardt, VP Corporate Accounting &
nario that l
ControI]. The two of us together, With our teams’
jeopard由n(
worked hard to get this done as swiftIy as possibie"
Sateguard l
Time was running short, though, because revising heads, The
an annual plan made little sense the further they were approach, (
down into the year. This was March 20O9. The primary the manag
objective was to keep EBIT at budget level while antici-
OPCO MD
pating a drop in revenues of approximately lO% rela-
ance with th葛
tive to the original budget. Given that Net Sales
come back w
prQjections were revised down, and given that EBIT
targets stayed the same’that implied that budgeted
levels. Durin
talks with th
costs had to come down.

Mr. Schaafsma,s team developed a model based on
What they had determined to be血e relevant cost cate-
gories. These categories induded all e童enditures that
had a fixed component in them, but at the same time
Were deemed to have minimal negative impact on
POtential growth in Net Sales. The marketing, advertis-
1ng, and promotion budgets were ring-fenced to protect
the top line. During this period, management・s atten-
tion was primarily focused on Net Sales and EBIT. Fur_
ther reducing Working Capital was, While important,
Su助ugated to the focus on Net Sales and EBIT.
The financial modeling taking into account these
ParameterS WaS done in dose cooperation with Mr. Van
der Wardt who facilitated the technical management
accounting part of the process by working out the details
in Hyperion and Excel. Messrs, Schaafsma and Van der
Ward analyzed all cost accounts per country primarily in
the SG&A category, and contemplated new targeted cost
levels on a line-by-1ine basis. For example, they scruti-
nized travel, Car fleet’PerSOnnel, advisory services, and
Other expenses related to costs such as warehousing and
Shipping. As it turned out’On mOSt aCCOuntS血ey simply
Put down a target to reduce the spending by lO-2O%.
They also reviewed all Capital Expenditure (CAPEX)
prQjects. For new prqjects, they kept those that they
deemed offered a su鯖ciently compelling business case
to improve EBIT. Most ongoing prQjects were continued.
The last thing they wanted to do was to upset high-
皿PaCt Change programs that focused on improving
longer-tem PrOfitability. An example of one of the ongo-
1ng Prqiects was the European rollout of the ERP system.
Based on the modeling and analysis, guidance was
WOrked out for the local management teams. Mr.
Schaafsma explained:
The influence of our newiy instailed interim CEO was
Clear here. He’but also the other board members,
understood cIearly that action was required. How-
ever; they were resolute in their desire to see a sce_
nario that reflected the economic crisis whiie not
jeopardizing potential growth. Their idea was also to
Safeguard the margins, by 「educing SG&A and oveト
heads. The CEO feIt strongIy that this was the right
approach’and somehow reckoned that it wou-d keep
the management teams in the OPCOs on board, tOO,
OPCO MDs and FDs were asked to discuss the guid-
ance with their respective management teams and to
COme back with plans to meet the targeted lower cost
levels. During this process’Mr. Schaafsma had lengthy
talks with the local management teams to discuss the
RoyaI Wessanen NV
impact of the many tough decisions that had to be
made. Examples of the actions taken were the renego-
tiation of vendor contracts’Salary freezes, and leaving
VaCanCies open. In some cases, eVen layoffs were on the
table’Which made the process in one or two of the
OPCOs rather painful for those invoIved. Mr. Schaafsma
Observed:
How the teams handied this cha=enge varied
CiearIy between those who had dealt with this
before and those who had ijttle or no experience
Wjth cost cutting" Interestingly, and fortunate看y to a
degree・ many Of our managers had been groomed
in successful companies, and made great ca「eers,
du「ing times of mainiy growth・ They had gotten
used to `the-Sky-is-the-1imjt, sorts of attitudes,
They were now facing a new reality・ For them, the
rather hard-nOSed meddIing from Corporate came
as somewhat of a surprise,
That said’Mr" Schaatsma gathered from the discus-
Sions with the vast majority of the management teams
that the purpose of the exercise was, all things consid-
ered’quite well understood and its necessity not
doubted, at least not in conversations with him・ =Maybe
there is some truth in the proverbial wisdom that
`necessity is the mother of …;,, he mused.
The Executive Board was very serious about the pro-
CeSS - they considered the space for negotiations as
quite limited. For most OPCOs’the負hurricane proof,,
SCenario was completed after only one round ofdiscus-
Sions and negotiations. In other cases’the cost saving
Plans developed bythe OPCO,s did not meet the Board,s
expectations. In these cases, Messrs. Schaafsma and
Van der Wardt guided the management teams of the
respective OPCO to reach the savings in alternative
accounts and asked them to stretch further, thus requir-
ing an additional round to converge on an agreed plan.
The numbers were compiled in Excel outside of
Hyperion. With the new numbers now available, how-
ever, tWO issues had to be addressed. First, it was not
dear how’and as what, tO uPIoad the revised numbers
into Hyperion. The Hyperion version that the Corpo-
rate Accounting & Control department was running
COuld not accommodate two budgets. An upIoad, there-
fore, WOuld require an override of the original budget
With the newly developed scenario. If the original
budget was not replaced’the only way to proceed
WOuld be to report the altemative scenario outside of
the system by way of an ``extra,, set ofbooks. But evalu-
ating actual results versus the latest forecast and two
319
Chapter 8. PIaming and Budgeting

budget versions across two systems seemed almost like the second halfofthe year to try to grow this business in Exhibit2 0
“too much of a good thing,’’sighed Mr. Van der Wardt,
the face of negative “publicity’’from the discontinued

The second and possibly more cbntentious quandary brands, Which had by themselves, however, helped to
WaS Whether to change the targets in the OPCO manag- streamline costs.
ers’bonus schemes. After an already tough reporting for The divestments in North America had been
most cost line-items even against the original budget, delayed.廿ee ofLife was eventually sold, but later than

the Executive Board decided to drop the original budget
and to宜x the altemative ``hurricane proof’’scenario
into the systems and bonus schemes. “The original
budget was history,’’said Mr. Schaafsma. “It was now
hurricane season, and the correspondingly named `hur-
ricane scenario’became the new plan for 2009.’’
Fiscal Year 2009 0Perational results came in cIose to
the hurricane budget. It helped that reorganization
COStS Came in lower than expected. These costs were
related to re-Organizing the legal entity structure fol-
1owing the split of business lines into Organic and Fro-
zen. Moreover, 1ocations had been rejigged yielding
further e鯖ciencies. On the other hand, SOme layo紐汗o
help reduce overhead had caused one-Off staff-related
redundancy costs. Advertising and promotion expendi-
tures also were substantially higher than forecast. This
WaS mainlybecause the interim CEO and Mr. Schaafsma
felt the need to boost the retained frozen food brands in
Planned, The fraud case that had surfaced in ABC in
the summer of 2009 required a restructuring, Which
delayed the timing by which this business could be
even put up for sale,
The future
Mr. Schaafsma and Mr. Van der Wardt contemplated on
how they could possibly better translate business
uncertainty into altemative scenarios of the budget:
Shouid we deveIop these altemative scenarios
beforehand rather than during the year? Wouid there
be enough support in the operating companies to do
this even if there was no ``hurricane’’coming?
What they obviously could not know is whether the
budget would have been met even if it had not been
reset … but would that have been a good thing?

Exhibit l Keyfigures, FY 2008 and FY 2009 (in C mi=ion), Royai Wessanen NV

Structure2008 Structure2009
Revenues Ebit

WessanenEu「ope(BioIogicai Food) Continued 2009 2008 2009 2008

France Beneiux UnitedKingdom WessanenEurope ∈493 ∈ 501 C  3- e 41

FrozenFoods ∈120 C123 C  3 ∈ 2

Germany itaIy ABC ∈ 90 さ てO2 ∈ 30- ∈ 2

FrozenFoods Non-allocated ∈703 e 725 ∈ 14- C 8-

FoodGroup Benelux:Backers 7b書alCon書inued ∈ 44- ∈ 37

Exhibit 3 Wo

許諾KariKempeiミミミゝ NorthAmerca AmericanBeverage Company(ABC) PanosBrands LibertyBicher Discontinued 2009 2008 2009 2008
New Wo「kln
FrozenFoods ∈ 30 C 35 乞 2- ∈1-

PanosBrands TreeofLife C36 e817 ∈35 C802 ∈3 e「 モ3 C」「

TreeofLife 7bfaIDidcont/nued C883 ∈ 872 e  3 e14

SouI℃e, Royal Wessanen NV, AmuaIReport 2009, PP 12-13

320
Exhibit 2 Organization chart, Royai Wessanen NV

Supervisory Board
Four (non-eXeCutive) members

Executive Board
CEO (PreSident Europe), CFO,
President North America (NA)

European Leadership l七am

President Europe and CFO
Europe (Mr. Schaafsma)

Exhibit 3 Working capitaI as percentage of sales - neW definition for the 2009 budget, Royai Wessanen NV

IActuai Month Third Party Net SaIes + Prior 2 Months Third Party Net Sales)*4

321
Chapter 8. Pianning and Budgeting

Exhibit 4 General budget guideIines for the 2009 budget, RoyaI Wessanen NV
臆臆臆臆臆〇二〇、臆 Autonomous,SalesGrowth 巨BI丁

in% Branded Distribution Branded Distribution

Europe 7-8% 5-7% BasedonROS>10% BasedonROS>5,5%

NorthAmerica 7-8% 7-8% BasedonROS>10,5% BasedonROS>2.3%

Exhibit 5 Financial targets incentive calcuiation scheme RoyaI Wessanen NV

Exhibit 6 Distribution of incentive payment, Royai Wessanen NV

TSC’s person

Viding dust cont

Cations. The sy
Which generate

PaSSed the cle;

15 years TSCr
PrOfits from clil
Exhibit l sh
tem COmPOne]
Other system c
This case was prepared by Professor Wim A. Van der Stede (London SchooI of Economics) and Dimitri Kruik (Erasmus University
ized product
Rotterdam).
depending on
Copyright ◎ byWimA. Van der Stede and Dimitri Kruik.

322
 CASE STUDY
丁he Stimson Company
Henry Stimson, PreSident/CEO ofThe Stimson Company,
a small engineering company and manufacturer of dust
controI systems and equipment, eXPlained the problem:
We have a considerable amount of tension present
in our professional staff now’With most of the dis-
satisfaction focused on the project budgeting sys-
tem, Everybody has strong feeiings on the subject"
The project Ieaders and operations peopIe feeI
that the original estimates made by the saies engi-
neers are not very reaiistic and, therefore, nOt Very
usefuI for pIanning workloads and schedules" The
Saies engineers, On the other hand’feeI that a iot
Of the budget changes are motivated onIy to pro-
duce a zero variance, and that there is not enough
thought or effort invested to try to meet the budget"
The company
The Stimson Company (TSC) was founded by Henry
Stimson,s grandfather. The company was privately
held, With the Stimson family sti11 contro11ing nearly all
ofthe stock. In 2015, annual revenues were approxi-
mately $15 million, and the company had just under
130 fu11-time empIoyees. In the recession of the late
2000s, TSC’s丘nancial position was weak, but under
Henry Stimson,s leadership the finances had strength-
ened to the point where the company had no long-term
debt and was eaming modest profits.
TSC,s personnel had a particular expertise in pro-
viding dust controI systems for general industrial appli-
cations. The systems filtered the air from machines
which generated dust or particulate air pollution and
pa§Sed the clean air back into the plant. In the past
15 years TSC had generated most of its revenues and
profits from dients in the paper industry・
Exhibit l shows a picture ofa core dust controI sys-
tem component: the separator. Separators and some
other system components were more or less standard-
ized products, although they varied somewhat
depending on the type of dust generated’the size of
the application, and the desired methods of emptying
the dust bags. The other components, SuCh as main
and branch pipes, hoods and conveyers’had to be cus-
tom-designed to fit the customer,s equipment and
Plant layout.
TSC managers preferred to sell complete systems,
meaning that company personnel would handle thejob
all the way from design through installation and test.
TSC was the dominant supplier of such systems to the
paper industry in the Northwest region of the United
States, but company managers were begiming to con-
sider diversifying both into other industries and into
other products that would utilize their engmeermg
expertise.
Project management
Because a large proportion of TSC’s revenues were
derived from a limited number of large-SCale prQjects,
prQject management was very important to the com-
pany・ Two roles in the organization were specifically
prQject-Oriented: Sales engineers and prqiect leaders
(see organization chart in Exhibit 2). The sales engi-
neers were responsible for the initial customer contact,
analysis of the problem, definition of the system con-
cept, Selling, Original job cost estimating, and pricing.
The p垂ect leaders were responsible for the detailed
technical development aesign) of the prQject and the
management of the job from time of order entry to
completion. Throughout the remainder of this case’
PrQject 14321 will be used to illustrate the functioning
of these roles and the company’s management systems.
Project 14321
In 2014, TSC was asked by the Oregon Paper Corpora-
tion (OPC) to submit a proposal for a complete dust
controI system for the converting area of a toilet葛PaPer
processing plant. The machines in the converting area
took tissue paper from the mill’rO11ed it into Iogs
96 inches wide, Slit it into widths of 414 inches’and
323
Chapter 8. Piannjng and Budgeting
packaged it for sale. OPC was interested in a dust controI
system because it would reduce Imintenance on the con-
verting machines, make a less dusty product’and keep
the plant safely within federal safety standards.
TSC submitted an estimate for the entire job, but for
their own intemal reasons, OPC asked that the prQject
be broken into two phases. Thus, TSC submitted a
phase I proposal for part of the job. This proposal was
accepted and TSC began the work. The request for a
proposal for phase II, a job which eventually was
assigned number 1432l, followed as expected.
ProposaI
For a11 potential jobs where the customer was consid-
ered serious about adding equipment, the sales engi-
neer prepared formal estimating sheets. These required
detailed estimates for each element of direct cost, built
up by pounds of material and hours of labor for each
system component. These units were converted to doト
1ars by multiplying by standard costs’Which the
accounting department updated every six months, and
by getting quotes for special materials or service.
Tb get to aj珊Z-COS亡eStimate, OVerhead was applied
based on pounds of material or hours oflabor. Account-
ing personnel updated annually the 16 overhead rates’
eight each for variable and fixed overhead categories.
The price was determined by adding a profit percent
onto the full-COSt eStimate. The company’s goal was to
maintain a lO-15% net profit margin on sales (before
tax). Because time was often limited, Jonathan Hem-
mer, Sales engineer, uSed a rough rule-OfLthumb based
on dollars per required volume of air (cubic feet per
minute) to estimate the total cost and price for Prqject
14321. For the breakdown in costs, Jonathan compared
this job with a similar, large job completed the year
before. Steve Davis, PrOPOSals manager’eXPlained:
First of all, yOu have to reaIize that these estimates
invoIve a lot of guesses, This project is now being
instalied, but portions of the new OPC buiiding a「e
being remodeied’and the work is not yet finished.
Their equipment is not in Iocation・ So with this as
with many other jobs, We had to estimate it based on
their drawings・ For more or less standardized com-
POnentS, SuCh as separators, those do not cause a
big problem. But fo「 customized components’SuCh
as branch iines, the estimates are onIy guesses.
Tb protect the company against these prQject uncer
tainties, Sales engineers typically added a “contingency’’to
324
the estimate. The contingency was done on an entirejob deslg掴:し
and not on an individual component unless the risk was 1ng‡ 「ep丁い、
high on a particular section of the job, Pe血aps because of thaし¥1〇五」
lack ofinformation about it. The contingencywas intended
to protect TSC from cost uncertainties. It was not affeded
by what the market would bear. However, SOme eXtra reV・
enue dollars might be added ifTSC managers felt the com-
Pany WaS in a strong compe血ive position.
The proposed price of $3,197,640 for the Phase II
work was presented to OPC. It was accepted on
November 12, 2014, and that is when the prqject was standard
assigned number 14321・ standard
Project kicko情
On November 13, the prQject kickoff meeting was held.
The primary purpose of this meeting was to transfer the
responsibility for the job from the sales engineer, Jona-
than Hemmer, tO the prqiect leader assigned to the job,
Sarbiv Kumar. AIso in attendance at the meeting were
Steve Davis (proposals manageD, Bob Stimson (design
manager), Bruce McIntosh foperations manageI), Mike
Giordano (plant manageI), Gary Blasiar (a separator spe-
cialisO, and Mary Fiore Oob cost accountant). Most of the
discussion at the two-hour meeting was on technical sub-
jects, SuCh as about what触er media and fan size were
required, and the expert team provided their inputs. example, a
After this meeting, SaI可iv, the pr匂ect leader, Planned Plete with
the prQject, broke the tasks into wo水orders starting with more like
the design work, eStal)lished the schedule’and began the foremen亘
process of coordinating manpower and material needs. most OPtl
Project cont「oi
ControI ofthe prQject was an ongoing process, With fre-
quent communications required between Sa坤v, the
prQject leader, and personnel in both OPC and the vari- COmPlete wa§
ous TSC work areas: design, OPerations, and installa- monthly repo
tion. Each month, Sanjiv was required to assemble a Report showe
Job Status Report which showed the percent physical
completion at the end of the month and the predicted
dollar variance to completion for each element of cost.
This report was built up from the work order level and COmPOnent and
summarized by the prQject leader to the level of detail to - COmPletion:
provided in the original prQject budget. summarized va
The estimates of percent complete were an impor- ances to date fo
tant part of the controI process because they directly The pr句ecI
a絶頂ed the percent of the budget used for comparison Shortly after l
with actual expenditures to date and’therefore’the job cost accou
variances. In estimating the percent complete in the nations of cos
 The Stimson Company

de§ign area’Sa坤v used drawings as his gauge. Draw-

appearing during the month and of any obvious errors
1ng§ rePreSented a relatively smaIfelement ofwork, and
fe.g. expenses incurred but showing zero percent com-
that work did not norma11y stretch t証over several
Pletion). She was trying to determine whether an
reporting periods" It was generally not difficult either to
actual problem existed or whether’for example, the
estimate how long the work represented by a drawing
Variance was merely a timing problem or was the result
Should take or tojudge whether that work was done.
Of a recording error. Any large input errors were cor-
In the fab area, Sa坤V relied on inputs from the fabrica-
rected before the financial statements were produced.
tion department. Based on their experience and accumu-
Around the lOth working day of each month, a COm-
lated records’the fabrication department broke down the
Pany-1evel financial review meeting was held with the
WOrk orders into individual operations and established
key managers in attendance‥ Henry and Bob Stimson,
Standard hours fdr each operation to come up with a total
Charles Cowsill・ Bruce McIntosh’Kristina Boyd and
Standard for each work order. Then they looked at how
Steve Davis. About 30 minutes of this meeting was
much they had accomplished and calculated the total peト
devoted to a review of the top 6 to lO prqiects, Which
cent complete on each work order. Sa坤V believed their
typically covered about 80% of the costs incurred dur-
estimates were generally quite good, better than he could
ing the month. Mary Fiore would present a summary of
make’but he noted that errors could occur on occasion:
the prqject variances with the explanations provided by

For instance’they may say their fabrication is so the prQject leaders. The discussion would focus mostly

many PerCent COmPlete on a given work order but l On OVera11 performance, nOt the specifics ofthejobs.

know we have aIready shjpped aIi of jt. Orthe records

mayshow oniy 50% ofthe materia- on ajob has been Budget adjustments
Withdrawn’but they are indicating lOO% fabrication.
A number of budget adjustments were made for prQject
Field installation was a bigger problem, Sjnce TSC 1432l. A押endix A expIa血s the rationale and general pro-
"’as on」y begjnning 〔he estab]ishment of standards for
Cedure for budget a卸stmen亡S. The fo]lowing are two iIIus-
installation. Sa坤v had to rely on the estimates of instal-
trative examples ofbudget a匂ustments for prQject 14321:
Iation foremen who were generally optimistic. For
example, a foreman might say that he was 99% com- A" BIow-back dampers
Plete with a work order when the reality was perhaps
In December and January’WOrk proceeded on pr(桓t
more撮e 85%. Since Sa坤v often worked with new
14321, mOSt重y on prQject design. On January 23, 2015,
foremen, it was impossibIe for him tojudge which were
Sa坤v Kumar submitted a budget a勘stment for $7613
mOSt OPtimistic and which were re工atively pessimistic.
for the in。usion of three blow-back dampers. Nomally,
岨e foremen were able亡O tell SaI垂v which items on
the blow-back dampers had to be specifica工ly called out in
awork order were complete, SO Sa坤v had some infor
血e budget, Since they were unique and required a certain
mation on which to applyjudgments on the estimates.
amount oftime to be fal)ricated- HoweveちSales engineer
The Job Status estimates were input to the computeち
ing a11ocated亡he dollars for the blow-back dampers to M
and the portion of the budget detemined by the percent
(Main Line)’instead of separa亡ing them under V (VAIve9
伽plete was compared with actual costs
to date. Three Or SOme Other designation. But because the blow-back
nthly reports were produced. The Detailed Job Cos亡
dampers were shown in the drawing as part ofA anani-
rt showed a comparison of actual costs伍nd labor
fold)’Sargiv released them on an A wo血order. (He later
) wit旺action ofbudget ftotal budget multiplied by
admitted that he should have gone back to sales engineer
nt complete) fdr variable cost categories only. The
ing and requested that the blow-back dampers be shown
ary Job Cost Report summarized variable costs by
aS Part Of the manifold.) On the job cost report, these
Onent and showed variance-tO-date and forecasト
Choices made A Iook bad and M Iook unnaturally good.
mpletion. The Job Cost Fully Accounted Summary
Sa坤v observed, howeverJhat “Even with th。S。 d。ト
marized variances by component and showed vari_
Iars allocated to the manifold・ the sales engineering
ances to date for variable cost’餌I costブand net profit.
estimate was extremely low",, It did not include enough
The pr垂cts were monitored by accounting staffl
POunds for the three blow-back valves. Based on actual
Shor[ly after the reports were produced’Mary Fiore,
drawings’Sa坤v submitted the budget a担stment.
」Ob cost accountant’aSked the prQject leaders for expla-
Even after the budget revision, however, When fab
nations ofcost category variances greater than $2,500
actually built the dampers’the actuals were way off

325
Chapter 8. Piaming and Budgeting
budget. Sanjiv guessed that the material requirement
Calculation done in design frorrmctual drawings failed
to include scrap, Or it may have“been,based on metal
Cuttings of sizes of sheets that did not exist. These dif-
ferences between estimate, design, and fab showed up
as budget variances because a budget a句ustment could
not be made after work was started. Jonathan Hem-
mer, the sales engineer, COmmented:
I agree that in comparison with what was actua=y
bu冊, the materiai estimate was iow, Howeve「, it’s
my contention that the manifoid was over-designed
and thus over-bu冊for this appiication, Before this
happened, design shouid have met with saies engi-
neering to discuss the anticipated va「iances to
attempt to develop corrective action,
B, P漢atforms
On June 16, a SeCOnd formal meeting was held. Design
had progressed to the point where it was possible to te11
OPerations that they could look for speci缶c work orders
On a SPeCific schedule, In attendance at this meeting
Were Sa巾iv Kumar, Bob Stimson, and Bruce McIntosh.
The next day, because ofwhat he learned at the meeト
ing, SaIjiv submitted an adjustment which increased
the budget by $38,17O, the details ofwhich are shown
in Exhibit 3. SaI可iv elaborated on the largest item,
Which individually caused a $39,910 increase:
In order to estimate accurateiy, We Can’t extrapoIate
directIy from past data. We need to Iook more
CioseIy at what’s required from the current job" Last
year we buiit a very simiiar co=ector and used that
as a gauge for estimating. But this co=ector required
a minimum of four piatforms that weren’t in the esti-
mate … I think sales engineering basica=ytook their
estimate from their oid estimate, But not only did
they overiook the pIatforms, We OVerran their origi-
nal estimate. They shou獲d have looked at the actu-
aIs on thatjob and not rep「oduced a bad estimate,
Jonathan Hemmer explained from his perspective:
We have to use last year’s job as a guide. Both coi-
iectors have 18 hoppers, The configuration is siightIy
d珊erent, and the size of the OPC coIIector is a little
SmaIler, l checked against the actuals on看ast year’s
job when that job was about 98% complete, and the
SeParatOrS Were lOO% compiete at that time Based
On that check l estimated we shouId come in at
about 135,000 pounds of materiaしAliowing for some
additionaI bracing and reinforcing, I fo「ecast the
326
actuaIs wouId come in cIoser to 140,OOO po…ds.
But we are predicting this job wiIi come in at about
165,000 pounds. Not onIy is the materiaI way off, but
instaiIation on last year’s job took 2,300 hou「s, and
We’「e now forecasting 2,800 on this job. The p看at"
form wiiI make a di惰erence, but not 500 hours,
We did inciude some hours for the piatforms in
the originaI estimate, although i admit we didn’t
量書寡漢○○寡
have anything specific in mind, and that’s an obv主
OuS Shortcoming, We certainly didn’t think in the
d
O
n︰
grand scaIe that was eventuaily drawn up" l
know how to expIain the extra 25,000 pounds of
material, There must be some over-designing. But
Our OriginaI estimate for fab hou「s was 3,864, a[d
On the latest cost sheets we’re 「uming at about
3,OOO hours, That’s obviousIy to the good, and it’s
not consistent with the materia1 0Verrun.
a句usしnle冊
Scope changes/budget revisions
monthS点画
When a scope change required the customer price to be
renegotiated, a budget revision was also required.
Appendix B describes this price renegotiation and
budget revision process in general and the rationale for
invoIving the sales engineer in it. The fo11owing are two
examples ofbudget revisions for Prqiect 14321.
A, Move co=ectors
In February, after the manifold was released for fabri-
Cation, Sanjiv, the prQject leader, PrOVided OPC some On June 24
additional information about where the collectors OPC insisted
would be located on the roof and the static and wind ard, eVen th
loads that would be imposed on the roof. OPC decided try standar
that these loads were unacceptable and asked that the be made
COllector be shifted 150 feet north and to the grade total job
level of the building, Even though TSC was we11 into erS PrOteS
PrOduction at that point, an aCCePtable altemative for a pnCem
the collectors could not be found. Substantial modifica- however,
tions were required to incorporate the existing mani- around $4
fold with some additional piping that had to be
installed. This necessitated a re-eStimate of the job,
agreement on a new price, and revision ofthe budget.
Jonathan Hemmer, the sales engineer, WaS reSPOnSi-
ble for negotiating the price change. OPC accepted the
PrOPOSed price increase of $203,50O, and Jonathan
revised the budget to reflect the needed changes.
A short time later, SaI可iv also submitted two a句ust-
ments which increased the budget by just under
Wi= be, So
$47500 because the亀nal drawings showed thejob had
expanded beyond where sales engineering had丘gured.

e血s occurred after TSC had received the addi-
al money from the customer, SaItjiv had to adjust
budget. He explained:
Where the manifold le什o情and where the main pipe
began, l may report the costs against the manifoid,
Whiie the saies engineer had figured the budget in the
main, The sum totai forthe manifoid and main may be
the same, but we would show a variance for each.
We also had a p「oblem with the totaI do=ars
budgeted. This is oniy specuIation, but what may
have happened here is that saIes engineering fig-
ured we couidn,t ask the customerfor aIi of the dol-
iars for the change and they decided that TSC
WOuid absorb part of the cost.
Jonathan Hemmer was not aware of this budget
a句ustment at the time but he commented on it several
months later:
l wish Sanjiv had let me know what was happening"
There is nothing worse than knowing after the fact
that, for example, yOur manifoId is lO,000 pounds
OVer budget, lt may have ended up that way any-
Way, but we can’t provide suggestions or leam from
PrOb!ems if we don’t know about them.
B. Pipework supports
On June 24, anOther budget revision was necessary.
OPC insisted that the pipework did not meet their stand-
ard, eVen though TSC maintained that it met the indus-
try standard. OPC managers felt that the change should
be made at no cost to them, Since they gave TSC the
totaljob without soliciting competing bids. TSC manag-
ers protested. The disagreement was finally settled with
aprice increase ofjust $15,000. The total cost estimate,
however, Which went through as a budget revision, WaS
around $42,500. Sapjiv Kumar commented:
This revision is a good example of a major probIem we
have with saIes - their budget changes are often pain-
fu‖y siow. in this case, We had known for months that
the budget needed revising, and I had to keep prod-
ding them to make the change, These expected
Changes can often span severaI repo巾ng periods, and
it creates confusion as to whethe「 we shouid be report-
jng against the budget or what we expect the budget
W航be, Sometimes the revision takes so Iong that the
WOrk is done before the revision comes through.
The Stimson Company
Status at August 2015
From the begiming, PrQject 14321 had had its share of
PrOblems as reflected by the numerous budget adjustments
and budget revisions. The Summary Job Cost Report for
14321 at July 31 showed a small unfavoral)le total variance
versus the budget at the estimated 43% complete, CauSed
mainly because of the problems in the collec亡or part of the
separator component. SaI直v Kumar described the current
PrOblems and his remammg COnCemS:
A gross estimation error has just recently surfaced"
The budget for ``Material-Sundry’’in the S (SePara-
to「) component is $41,865. We have ai「eady spent
OVer $45,000, and our forecast to complete is in
excess of$67,500, It couid be argued that we shouId
have recognized this probIem earlier, but this is also
a notabIe exampIe of poor estimating. i’m gojng to
have to adjust the budget upwards in this area.
We couId aiso have more troubie with the budget
for management hours. Each addition to project
SCOPe Or eXtenSion of the project schedule extends
the number of 「eporting periods and increases
management time. Since the company has grown,
We have progressed from just ``doing’’a project to
`くmanaging” a project, but the budgets haven’t
refIected this. On a large project, management time
can be 20%-22% of the total design budget, but
the originaI budget for 14321 ai看owed onIy 4%-5%.
In addition, l’m a iittIe worried about the esti-
mates for getting painting and pneumatic piping
done on this particuiar project. We’re not as good
as we couId or shouid be at estimating othe「trades,
SuCh as printing, Piumbing and eIectricaI, and I’m
not sure there are enough do=ars in there to get the
job done 〇〇〇 And fina=y, We COuld aIways run into
SOme PrOblems in instalIation,
Since the budget changes had increased the planned
COStS muCh faster than the price had been negotiated
upward, the prQject’s planned profit margin had slipped
from an origina1 11% to less than 6% (see Exhibit 4), a
level considered below the company’s desired range of
between lO% and 15%. The margin would slip even
lower if the budget had to be a句usted upward any fur-
theI; and SaItiiv seemed to think it would have to be. Steve
Davis Iooked back at the job and summarized his feelings:
I don’t think this was a particuIa「ly d櫛cuitjob. I stiIi
feeI that in an overa= sense our originai estimate
WaS aCCurate, although I wi= agree that there were
numerous discrepancies in the components. At this
327
Chapter 8. Pianning and Budgeting

point’howeve「, it's even hard to tell that. We may be

seeing va「iances because cchservative estimates
霊宝霊宝豊露悪禁書誓書易巨剛
of percent COmPlete are making t胎jobs Iook worse
tuted a budget adjustment proCedure to allow the pro-

than they 「eaIly are" Design and fabrication seem tO ject leader to change the budget to reflect a realistic
看ike to hoid back a few percent aS a hedge against
standard, but with the following constraints:

something going wrong Or just the unknown.
But more importantly’What seems tO be missing
is a commitment to bring ajob in at the minimum
cost possib-e" lf we invoIved the various grouPS in
setting the budgets’the numbers would be so
super-COnSerVative that they would be meaning-
Iess, We’d either be pianning p「ojects at a loss or
we,d be prici=g OurSelves out of the market. Not alI
of the budgets set by sa-es eng-nee「一ng are tight"
1 , No budget a句ustments were allowed once workwithin
a labor category (e.g. design, fal〕rication’insta11atioh)
was started within a job section te.g・ SeParatOrS, main)
exhausterS), With the exception of general job costs.
2. No budget adjustments were a11owed unless the
adjustment totaled at least eight hours and lO% of
the total hours in the work order.
3, All budget adjustments had to be approved by the

They shou-d be a target tO Shoot for; an incentive for

OPerations manager.

superior performance, SO We are mOtivated to

search for creative solutions to our prOblems" We’ve Appendix B Budget revisions
got to get this commitment internaIized because
If for any reason the customer price had to be renegoti-
standards of performance aren’t avaiIabie for eve-
ated, SuCh as for a scope change or customer-CauSed cost
rything we do" We’re not trying to punish anybody’
overruns (e.g. schedule delay)’the sales engineer wa§
but the company does have to exist, after a="
notified to prepare a budget revision. This involved a re・

estimate of costs, uSing the same Estimating Sheets used

Appendix A Budget adjustmentS when the prQject was proPOSed’and a renegotiation of

over time, many Changes were likely to be made to the price. When the price change was agreed upon, the new
c。St eStimate was entered as the revised prQiect budget・
system as it was origina11y planned and estimated.
Even though at the time of most of these budget revi-
More information would be gathered as to the precise
sions, the prQiect leader,s detailed knowledge far exceeded
customer requirements’SuCh as for the layout of the
that 。f the sales engineer on the job, because they had
exhaust piping, and as company persomel reviewed
been following progress daily’it was seen as desirable to
the technical design, SuggeStions would be made to
invoIve the sales engineer in the budget revision because:
improve performance or cut costs.
In addition, While the sales engineers were conSid- 1, More realistic estimates were likely・ The sales engi-
ered excellent at estimating the total cost of a job, Very n。erS had been exposed to a broader range ofjobs, and
often their estimates for specific phases of a job (e.g. they had begun to accumulate a database of standards
main, eXhausters) were very inaccurate’OVereStimated for recurring operations that could facilitate the esti-
for some parts and underestimated for others’and the mating process. They were also more skilled at prepar
dollars in the budget would have to be moved between ing estimates at the concept stage; i.e. before detailed
components. The custom elements of the systems, SuCh drawings and speci丘cation sheets were availane.
as branch piping, PreSented the greatest estimating
2, It was a goOd opportunity to develop the sales engi-
uncertainty. Some definitional problems also existed’aS
neer/CuStOmer relationship because it was a chance to
the boundary between components WaS nOt Clear. A pro-
meet without a new sale being the explicit intent. In
ject leader might build on a branch line work order what addition, it would provide a relationship conti皿ity for
a sales engineer estimated as part ofthe main piping.
the customer as the sales engineer may have made
The job budgets were intended to reflect the compa￣
agreements regarding the specifications of the system
ny’s best estimate of what it should cost to do the work
that were not put explicitly in the written agreement.
described. This was because while the prQjects were in
3, It was a good leaming opportunity for the sales
process, the budgets were important tooIs fdr planning
engineers. By getting out in the field and seeing how
and control, and after a job was completed, budgets
the prQject was progreSSing’they could leam’both
which proved to be accurate were use餌as an aid for
technically and in their estimating.
estimating future similarjobs. As the prqiect unfolded,

328
Exhibi= Anatomy of the Stimson lype C Separator
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護国翼菜園園

Co=ectecfdust。 O
O o
Optionai bagging
SyStem for dustless,
0niine emptying
Without 「otary value
Or Other powered
equipment
 ○プap{♀∞・P-a⋮i⊃ga⊇富里dgの⋮g
Exhibit 2 Organization structure
hibit 3 June 1 7, 1980 budget adjustment - Projec=4321

lncrease

(Decrease〉 in Budget

hibit 4 PIan and forecast for Project 14321

$3,1 97,640 $3,426,248

$1 ,287,352 $1 ,300,568

$ 353,750

CASE S丁UDY
Multiple Versions of the Plan
It was a Sunday. The first day of the annual Strategic
Planning retreat of the Board of Directors of Anderson
Industries, Inc. had fina11y arrived.
Anthony Rizzo, a yOung financial analyst, had
been working for Thom Thomson’Anderson’s
recently-aPPOinted chairman/CEO’for the last six
months. He had been given the assignment to present
the newly developed Corporate Restructuring Pro-
gram to the Board. Anthony was both excited and
The Corporate Restructuring Program was one of
Mr. Thomson,s key management initiatives’largely
because Anderson had frequently been criticized for
having unusually high expenses. Composed of 83 pro-
jects, the program was complex, With many moving
parts. However, a key element of the program was to
reduce expenses by $100 million while maintaining
current revenue levels, thus providing dramatic
improvement in a key metric known as the operating
expense ratio (operating expenses/revenues). Manage-
ment viewed this expense reduction goal to be a
stretch, but they also considered it necessary’and they
wanted to build credibility by demonstrating the com-
pany’s ability to meet an important goal. The Board of
Directors was aware of the program and its obje⊂tives,
but Anthony,s presentation was intended to provide
much deeper insight.
The prior week had been unexpectedly easy. Because
of Mr. Thomson,s desire to avoid any surprises, all of
the presentations had been finalized by Wednesday,
and the dry run took place on Thursday" On Sunday,
Anthony planned to arrive at the hotel early to have a
chance to check the meeting room before the presenta-
tion. The meeting was to start at 2‥OO p.m.’and
Anthony was one ofthe first presenters.
廿affic was light, and Anthony was well ahead of
schedule. Upon arriving at the hotel, he checked to see if
his room was available. He leamed that he could not
check in for a few hours, but the front desk delivered an
urgent message asking him to call Sharon Carpenter,
Anderson,s head of financial plaming, aS SOOn aS POSSible.
332
would血e
strated? Ho
during the
Anthony
who was m
On the call, Sharon explained that she had received
the newest budget submissions from the business
units just before leaving the o飴ce on Friday after-
noon. wanting to get a head start on next week’s
work, She began her review of the company-Wide roll-
up on sunday morning. Initia11y, eVerything looked
fine, but she noticed that a few ratios were a little o鮒
One was the operating expense ratio, SO She wanted
to inform Anthony before his presentation to the
Board. Sharon and Anthony discussed some of the
most likely explanations for the exceptions’but lacked
the data to reach any conclusions. Sharon commented
that the budgeting process tended to be somewhat
iterative this early in the cycle, SO She almost regret-
ted her decision to take a quick look on Sunday morn-
ing. Nevertheless’Sharon and Anthony both knew
that some very ambitious goals had been set causing
them to be concemed that real slippage had occurred.
Focusing on Anthony,s presentation’the potential
impact was clear. To meet the targeted operating
expense ratio, either revenues would have to increa§e
by $25 million, Which was unlikely given the current
economic∴COnditions, Or the expense reductions
would have to increase by an additional $15 mi11ion,
which was slightly less than 2% of total company-
Wide expenses.
After speaking with Sharon’Anthony asked if the
hotel could provide him with space to work・ He was led
to the hotel engineer,s o鯖ce, a Very Small o鎖ce deep in
the guts of the hotel. There’he got back on the phone
with Sharon, and they considered the altematives. The
focal point ofAnthony,s presentation could be impacted
in a small, but still material, Way; they could only spec-
ulate about the reasons for the change in prQjections;
and they could not reach Mr. Thomson. Further’time
was very short. Should Anthony simply proceed with
the presentation as previously approved’Should he try
to incorporate the new prQjections into the presenta-
tion, Should he “hide,’the slides showing numbers and
try to丘nesse his way around the issue, Or Should he be
upfront about the uncertainty in the numbers? How

WOuld the Board react if uncertainty was demon-
Strated? How would Mr・ Thomson respond静surprised
during the Board meeting?         - ‥
Anthony tried again to speak with Mr. Thomson,
Who was meeting with the Audit Committee of the
CASE S丁UDY
Vitesse Semiconductor Corporation
n the semiconductor industry, Picking the right
&D investments and then turning those invest-
ents into successful products largely determines
uccess. To help with that decision process atVitesse
emiconductor Corporation, Marty McDermut
(CFO) and Patty Heinen (manager of Financial
1anning and Analysis) had spent the last several
Onths developing a business model designed to
ut R&D successes at Vitesse in the proper perspec-
l¥’e. The model showed that the company would
Chieve its Iong-term gOals only if R&D prQjects
enerated at least 35% returns. They proposed
mplementing a minimum IRR hurdle rate of 35%
Or R&D investments.
Inthe first resource allocation meeting after they
ade their proposal, however, Marty and Patty
ere disappoin亡ed tha=he senjor management
eam had just approved one par亡jcufar R&D pro-
尋.to build a new Carrier Ethernet product, With
forecast that was much lower than the desired
洲RR. Mar亡y and Pa〔ty trjed亡O make亡he case
galnS白nves[工ng jn thjs prqjecらbu亡they 」ost the
Vitesse Semiconductor Corporation
Board, but that Committee meeting ran longer than
expected. Mr. Thomson rushed to亡he Board Meeト
ing, flanked by a few ofthe Audit Committee mem-
bers, getting there just in time for the scheduled
Start.
1ndustry background
Firms in the semiconductor industry face some unique
Challenges. Significant R&D spending is necessary to
drive future revenues and profits. Because new products
have limited life cycles, Chip manufacturers must continu-
OuSly develop new products to replace revenues from
declining products. In order to grow, they must accelerate
new product growth or improve the retums that the new
Products generate. Most of the spending is focused on
applying and extending existing technoIogies, but occa-
Sionally investments are made to try to develop ground-
breaking technoIogies that might open new maIkets,
Semiconductor chips are components in customers’
PrOducts, SO Chip design is guided by the technoIogical
advances and changing requirements of those custom-
ers. Marke〔jng and sales persomel work cIosely wjth
existing and potential customers to understand their
needs. “Design wins’’are often secured before chips are
fully developed and available for sale. At the design-Win
POint, CuStOmerS design the chips into their products, SO
the c埋) manりfacturers begin to have an jdea abou亡how
much revenue and profit a specific prqject wi上I generate.
Some risk sti11 exists even after a design win. The
333
Chapter 8. Planning and Budgeting
CuStOmerS Can drop a product, miss a product cycle, Or
even introduce new technoIogy too early. Vitesse miti-
gates its risk by collaborating cIosely with customers.
Revenues from new products ramp up slowly. Using
Vitesse Semiconductors’product lines as examples: Chips
SOld to phone carriers to include in their routers and
SWitches typically have a lOYear life cycle, With revenues
Peaking in years 5, 6, and 7. Chips designed for enter-
prise-level networking devicesl have shorter, quicker rev-
enue cycles, but revenues typica11y still do not peak until
three years after the product is introduced. (See Exhibit l
for Vitesse’s carrier and enterprise revenue cycles.) Oper
ating margins are lower in the first few years of a prod-
uct’s life cycle because the R&D expenses are recognized
immediately, Whereas the revenues come later.
Many new products are fo11owed by ``derivative’’
PrOducts that build on the earlier technoIogy but are
SOmehow improved in subsequent iterations, for exam-
Ple, With more features, better performance, lower
POWer COnSumPtion, and/Or lower costs. It is not unusual
for a new product platform to generate four to six deriva-
tive products. The first product is typically the least prof-
itable because of the high initial development costs, but
PrOfit often increases with each derivative. When a new
PrOduct platform is launched, the rough plan for deriva-
tive products is outlined in a “product roadmap.’’
Chip costs decline over time. The most dramatic cost
reductions take place between the first and second year
Of production. Yields, Or the proportion of chips that
are found to perform properly, tyPica11y improve with
VOlume and experience and can increase by as much as
50% in the second year ofproduction. Costs are often
reduced further by lowering material costs and by
transferring processing and testing functions overseas.
Vitesse Semiconductor
Vitesse Semiconductor Corporation, headquartered in
Camarillo, California, designed and marketed advanced
Semiconductor chip solutions for the growing network
and communication industries. Founded in 1984, Vitesse
COntinued to innovate in response to its customers’
demands for more data and more sophisticated devices.
The company was known for engineering excellence and
developed several industry leading technoIogies. Vitesse
StOCk was traded on NASDAQ under the symboI VTSS.
1 Enterprise-1evel networking devices are used in large companies
Or enterPrises. The word enterprise implies multi-Site, multi-SerVer
applications. Cisco is an example of an enterprise customer.
334
In 2006, SOme former executives at Vitesse were
indicted for backdating stock options. The charge§
were resoIved with a $3 million settlement with the
SEC. Although there was no guilty verdict or admi§Sion
Of guilt, the scandal was distracting and expensive.
About that same time, the telecom industrybegan to
Shift to packet-based Ethernet networking technolo-
gies. Vitesse brought in a new management team that
included Marty McDermut as its CFO. The new team
Shut down development of many legacy products and
focused its R&D spending on the development of a new
line of products based on Ethemet technoIogies. The
move was risky, aS Marty explained:
There were no new products for three to fou「 yea「s,
and Vitesse had to continue servicing its signifjcant
debt ioad at the same time that revenues from its
existing legacy product iines were deciining. The
Strategy ki=ed ope「ating margins for a wh=e
because a= the new products were at the same
eariy stage of the be=-CurVed revenue cycle,
The shift to Ethemet tumed out to be a good decision,
and by 2O13, the investment began to pay off. Marty and new techl
the rest of the new management team successfully
explained the tumaround story to Wa11 Street analysts Curre[
by categorizing Vitesse’s products as new, mature, Or
In 2013,「
end-Oflife, and by demonstrating strong revenue growth
from new products. Revenues from new products dou- ally on R(
aries, 20勺
bled in 2012 and were prqiected to double again overthe
next two years, tO apPrOaCh $60 million by 2014. was foru
The communications industry was seeing exponen-
tial growth on public and private communications net-
works. These networks included those used by
long-distance, local exchange service providers and R&D凄
Wireless service providers (“Carriers’’), aS Well as spe- PrQleCtS t
Cialized networks, SuCh as those used by Internet ser- CeSS. Eve
Vice and over-the-tOP (“OTT’’) content providers. PrOduct
Driving the tra描c growth was the rapid adoption of
ally. (Se(
data-intensive applications and services such as web PrOCedu]
access, Web-delivered content, Internet Protocol (``IP’’)
and theく
Video conferencing and telepresence, IP television and, it before
more recently, CIoud storage, CIoud computing, and Prqie(
reSPOnS〔
Software-aS-a-Service (“SaaS’’) by Enterprises. Power-
ful mobile devices like smartphones and tablets that Pline wa
rivaled and often exceeded the capabilities of desktop BPRs in(
machines also consumed these types of services. In the M arketi]
not too distant future, the industry expected that a Part, by'
majority of devices, aPPliances, SenSOrS, maChines, ter- enue an(
no clear
minals, Vehicles, aS Well as public and private power
distribution systems (“Smart-Grid’’) would all be 」eCtS, Or

to these ever-eXPanding worldwide commu-
networks, leading to what is commonly
as the Intemet of Things (“IdT’’). While all
nt, this expanding conglomerate of networks
mon challenges: how to provide service
nchronization and timing, and security.
ess the cha11enges, PaCket-based Ethernet
g technologies increasingly formed the basis
these new applications and services. Long
Enterprise networks, Ethernet was expand-
y in both Carrier and Industrial networks’
1der technoIogies. In addition, SO-Ca11ed vir-
technoIogies that started in Ethemet-based
a centers were making inroads into Enter-
Carrier Ethemet networks, PrOmlSmg eVen
ient network resource utilization. Even in
Process Control, Smart-Grid Energy Distri-
ansportation and Automotive networks’the
ansition from proprietary legacy networks to
Ethemeトbased networks was taking place.
1 portions of the Carrier, Enterprise and IdT
were expected to be rebuilt based on these
01ogies over the next 5 to lO years.
Business Plan Peview Process
itesse spent approximately $40 million annu-
D. CIose to 60% of that spending was for sal-
va§ fnr nrher T)rOject_SDeCi丘c costs. and 2O%
se of shared resources, SuCh as engmeermg
Only the “other prqiect-SPeCi丘c costs’’could
d w蘭hout taking drastic皿eaSureS With long-
equences, SuCh as layoffs.
sets and spending were allocated to specific
rough the Business Plan Review (BPR) pro-
y product derivative was considered a new
nd went through the BPR process individu-
言xhibit 2 for excerpts from the o鯖cial BPR
document.) Marketing initiated the BPR,
tlre eXeCutive team was required to approve
PrQject could move forward.
s were initiated throughout the year, Often in
to a customer’s need. Some financial disci-
designed into the pr(加Ct Selection process;
uded detailed revenue and cost prQjections.
department performance was evaluated, in
hether or not new products delivered the rev-
profit prQjections in the BPRs. But there was
nanclal measure or criteria for selecting pro-
or ensuring that a prQject’s financials were
_ ‥        Vitesse Semiconductor Corporation
consistent with short- Or long-term business plans. Gen-
erally, PrQjects were expected to have a 4-5 times ROI2
or positive NPV at a 20% discount rate’Which was
thought to be dose to the cost of capital for Vitesse.
Marty acknowledged, however, that this rate was
somewhat arbitrary; 20% was a commonly used hurdle
rate, but it was not based on any current analysis spe-
cific to Vitesse. The positive NPV guideline was not
dosely adhered to in the BPR processes, either. Every-
one understood that new prQjects usua11y returned less
than future derivatives, eVen though that was not
explicitly stated or quantified with a lower hurdle rate.
Most of the scrutiny during the BPR process was on the
marketing and engineering design data’nOt On the
financial data.
The current issue
In 2013, Vitesse was er互oying strong revenue and profit
growth driven by R&D investments from prior years.
However, the number of new product launches had
slowed down signi丘cantly in 2012, from an average of
3O new products to less than lO. Management knew that
the company had a few αgrace,, years during which it
would continue to realize growth driven by the increas-
ing revenue stream of current products. But a board
member asked Marty if the current portfolio of R&D pro-
jects could be expected to drive long-term reVenue
growth at the rates that were forecasted in the long-term
business plan. It was a good question・ Marty explained’
P「ojects are apprOVed one at a time, but someone
needsねbe ○○ncemed糊肋的e b脚pわ的吟的e
financiai impIications of the compiete product porト
foiio. 1n this industry you can make big decisions
that dig big holes" You might be OK for a few years・
but if you don’t have enough new products in the
Pipeli=e, yOu WOn,t be abie to sustain g「OWth.
The difficulty was that the BPR process was some-
what disconnected from the company’s business model.
Vitesse’s business model assumed that new, yet unde-
fined prQjects would be introduced regularly to replace
revenue from obsolete prQjects. However, the prQject
selection process did not guarantee that revenue from
selected prqjects would be su綿cient to meet those long
term revenue goals. The 4-5 times ROI and 20% hurdle
rate was not informative. Marty and Patty wondered if
2 ROI was calculated as the 15-year Cumulative gross margin divlded
by R&D investment.
335

‘Cted to these ever-eXPanding worldwide commu-
1OnS netWOrks, leading to what is commonly
led to as the Intemet of Things (“IdT’’)・ While alr
endent, this expanding conglomerate of networks
common challenges: how to provide service
籾SynChronization and timing’and security・
address the challenges, PaCket-based Ethemet
)rking technoIogies increasingly formed the basis
liver these new applications and services. Long
nt in Enterprise networks, Ethemet was expand-
apidly in both Carrier and Industrial networks’
cing older technoIogies. In addition’SO-Called vir-
ation technoIogies that started in Ethemet-based
data centers were making inroads into Enter-
and Carrier Ethemet networks, PrOmising even
e鯖cient network resource utilization. Even in
trial Process Control, Smart-Grid Energy Distri-
n, Transportation and Automotive networks’the
nt transition from proprietary legacy networks to
itous Ethemet-based networks was taking place.
antial portions of the Carrier’Enterprise and IdT
orks were expected to be rebuilt based on these
echnoIogies over the next 5 to lO years.
rent Business PIan Review Process
13, Vitesse spent approximately $40 mi11ion annu-
nR&D. CIose to 60% ofthat spending was for sal-
20% was for other prQject-SPeCific costs, and 20%
for use of shared resources, SuCh as engineering
are. only the ``other prQject-SPeCific costs’’could
duced without taking drastic measures with long-
consequences, SuCh as layoffs.
D assets and spending were a1located to specific
cts through the Business Plan Review (BPR) pro-
Every product derivative was considered a new
uct and went through the BPR process individu-
(See Exhibit 2 for excerpts from the o鯖cial BPR
edure document.) Marketing initiated the BPR,
the entire executive team was required to approve
fore a prQject could move forward.
rQjects were initiated throughout the year, Often in
。nSe tO a CuStOmer,s need. Some financial disci-
was designed into the prQject selection process;
§ induded detailed revenue and cost prQjections.
keting department performance was evaluated’in
bywhether or not new products delivered the rev-
and profit prQjections in the BPRs. But there was
1ear financial measure or criteria for selecting pro-
or for ensuring that a prqiect’s financials were
Vitesse Semiconductor Corpo「ation
consistent with short- Or long-term business plans. Gen-
erally, PrQjects were expected to have a 4葛5 times ROI2
0r POSitive NPV at a 20% discount rate’Which was
thought to be close to the cost of capital for Vitesse.
Marty acknowledged’however, that this rate was
somewhat arbitrary; 20% was a commonly used hurdle
rate, but it was not based on any current analysis spe-
cific to Vitesse. The positive NPV guideline was not
dosely adhered to in the BPR processes’either. Every-
one understood that new prQjects usually retumed less
than future derivatives, eVen though that was not
explicitly stated or quan捕ed with a lower hurdle rate.
Most of the scrutiny during the BPR process was on the
marketing and engineering design data, nOt On the
financial data.
The current issue
In 2O13, Vitesse was er可oying strong revenue and profit
growth driven by R&D investments from prior years.
However, the number of new product launches had
sIowed down significantly in 2012’from an average of
30 new products to less than lO. Management knew that
the company had a few =grace,, years during which it
would continue to realize growth driven by the increas-
ing revenue stream of current products. But a board
member asked Marty if the current portfolio of R&D pro-
jects could be expected to drive long-term reVenue
growth at the rates that were forecasted in the long-term
business plan" It was a good question" Marty explained,
Projects are aPPrOVed one at a time, but someone
needs to be conce「ned with the bigger picture, the
financia=mp-ications of the compiete p「Oduct port-
foIio. In this industry you Can make big decisions
that dig big holes. You might be OK for a few years’
but if you do亜have enough new products in the
pipeline, yOu WOn’t be able to sustain growth"
The di鯖culty was that the BPR process was sOme-
what disconnected from the company,s business model・
vitesse,s business model assumed that new, yet unde-
fined prQjects would be introduced regularly to replace
revenue from obsolete prQjects. However, the prqiect
selection process did not guarantee that revenue from
selected prQjects would be su航cient to meet those long
term revenue goals. The 4-5 times ROI and 20% hurdle
rate was not infomative. Marty and Patty wondered if
2 ROI was calculated as the 15-year Cumulative gross margin divided
by R&D investment.
335
Chapter 8. Pianning and Budgeting

they could develop a more useful benchmark to guide 鴫ble l Revenue-nOrmaiized business modeI

PrQject selection decisions and皿ake sure that invest-

P&LModei ModeI Minimum Mid High 1O-year inco
ment decisions were consistent￣With.the company’s
inve stments
long term business model. Was there a straightforward Revenue 100% 100 100 100
Way tO COmmunicate whether or not a prQject was
acceptable?
CostofGoods SoId 38-43% 43 41 39 (See the IRR
Pany Wanted
GrossMargin 5T-62% 57 59 61 to be evenhi
and estimated
lRR target deveiopment R&D 25-28% 28 27 25
to 43%-47%
Marty and Patty’s solution was to calculate the IRR SG&A 15-19% 19 17 16
on R&D project spending that was assumed in
Operating income 15-21% 10 15 20 Results of
Vitesse’s Iong-term business model. Then they could

compare the IRR they calculated from the model to Patty thought
the IRRs that the current portfolio of R&D prQjects e nlighte ning.
was forecast to generate, If the IRR assumed in the Eventually, the R&D manager provided the needed Cantly higher
business model was dose to the IRR of actual pro- information. He estimated that 6O% of total R&D spend- the current B
ing was direct spending on prQjects. Patty was able to actual IRRne
jects, they could infer that they were on track to
achieve the model’s revenue goals. Perhaps more Verify that these numbers tied, mOre Or less, tO the total Patty went

importantly, the IRR calculated from the model could R&D spending reported on financial statements.
become a functional hurdle rate for future R&D pro- Patty used two different models for the timing ofpro-

jects that would link prQject selection to Iong-term ject investment. In Model l the entire investment takes as forecasts t

business goals. Place in Year O, the year before the investment began gen- expected, the I
The IRR calculations were based on several assump- erating revenue. In Mode1 2, the investment is incurred below Pattyis t
tions. Patty began with Vitesse’s revenue-nOrmalized 20% inYear -1, 70% inYearO, and lO% inYear l. derivative. (S
business model, Shown in Tbble l. PrQiec亡Irtvest肌eJl亡Ti肌ing Es亡[mate:
Platfom IRRs.)
Patty wanted to calculate the IRR on the model’s roadmaps, the
Yea「: -1 0 1
direct R&D spending, nOt tOtal R&D spending, Since Platfom, and
Only the direct spending was used in the BPR process. Mode= 100% Exhibit 5 forI
Unfortunately, however, that information was not
Modei2 20% 70% 10%
readily available.
Recommen
She asked the R&D manager to estimate the per-
Centage Of R&D that was direct spending. R&D per- Tb calculate IRR, Patty also had to make some Marty and Patty
sonnel had been resistant to collecting information assumptions about how prQject revenue was distrib- executive teaus

for the IRR calculation. They did not want to spend a uted over time. Patty followed current prqiections and lnCreaSe mlnlm

lot oftime gathering data ifno one was going to use assumed that 56% of prQject revenue followed the that a minim皿

it. The senior vice president ofR&D told Patty, “Unless quicker enterprise revenue distribution pattern, and ness modelwasI
We uSe the IRRs to drive behavior, it’sjust a collection 44% of prQject revenue followed the slower carrier rev- essary to achi
Of pretty pictures.’’Marty and Patty did not disagree; enue distribution pattern. She weighted revenue pat- recommended t
they hoped their analysis would indeed change tems accordingly, tO develop a blended lO-year reVenue derivative at a ti
behavior. d i stribution. be approved, bu
target. Martybく
Prqiec亡Rel,e皿e T書肌ing Es亡[mc[te:
to sayno tobad

Year: 1 2 3 4 5 6 7 8 9 Marty
10 also su
nue foreca§tS in
Enterprise 30% 75% 100% 75% 50% 30%
evaluated agaim

Carrier 0% 30% 50% 50% 100% 100% 100% 50% 50% 30%
the higher hurd】

On a PrQ]eCttOC(
Biended 17% 55% 78% 64% 72% 61% 44% 22% 22% 13%
how to deliver tl
NormaiizedtolOO% 4% 12% 17% 14% 16% 14% 10% 5% 5% 3%
markets, Or incr(

336

Patty subtracted the investment from the revenue
Ch year and calculated the IRR on血e resulting
-year income stream. she conduded thaでR&D prqject
estments should yield IRRs between 35% and 40%
achieve the profit prQjections in the business model.
e the IRR model in Exhibit 3.) Obviously if the com-
y wanted profit growth rates, the IRRs would have
be even higher. Patty used the same methodoIogy
d estimated that target IRRs would have to increase
43%-47%亡O aChieve 20% profit growth.
Suits of the analysis
tty thought that the results of the analysis were
ightening. The target IRR she calculated was signifi-
tlyhigher than the 20% hurdle rate that was used in
Current BPR process, and often higher than the
al IRR new products were generating.
Patty went on to calculate the IRR for all new prod-
S and platforms currently on the market. The calcu-
OnSWere based on actual revenue and costs as well
forecasts taken from platform roadmaps. As
ected’the IRRs of new platfoms were always well
OW Patty’s target, but the IRRs increased with each
ivative. (See Exhibit 4 for one example: Ethemet
tfom IRRs.) Patty also calculated IRRs for entire
dmaps’the weighted IRR for every derivative in a
tfom, and several fell below the 35% target. (See
ibit 5 for IRRs of a11 current platform roadmaps.)
COmmendation
tyand Patty took their results to the marketing and
Cutive teams and made a strong recommendation to
ease minimum prqject hurdle rates. They argued
a minimum 35% IRR tied to the company,s busi-
model was required. This higher IRR rate was nec-
ry to achieve long-term PrOfit plans. They
mmended that instead of approving one prQject
VatlVe at a time, entire platform roadmaps should
PPrOVed’but only if the platfom met the 35% IRR
et. Marty believed that management had to leam
yno to bad investments.
arty also suspected that marketing low-balled reve-
forecasts in the BPR because their performance was
uated against the BPR revenue targets. Marty hoped
higher hurdle rate would compel everyone invoIved
prQject to commit to higher retums and to figure out
to deliver them’either by reducing costs, expanding
et§, Or increasing the number of derivatives.
Vitesse Semiconductor Corporation
Response
Vitesse’s CEO and marketing team were intrigued by
the analysis. The actual IRRs of some prQjects sur-
Pr主sed them. Their sense of a prQject,s retum had been
largely informed only by anecdotal results, SO they
Were interested to leam that’amOng Other things, One
large and popular prQject was not as financially suc-
CeSSful as they had prev王ously believed, But even
though everyone understood the analysis and its impli-
Cations’nO One Seemed in any hurry to formally adopt
the 35% IRR 〔arget as a new prqject hurdle rate.
Carrier Ethemet p「oject
The first test came when a BPR for a new carrier Ether-
net product landed on Marty,s desk. This was a new
PrOduct that’if approved’WOuld be Vitesse,s first entry
into this aspect of the Carrier Ethemet market. Marty
and Patty were both in the BPR meeting and argued
against i亡s approval because the prqject did not have a
POSitive NPV even at the 2O% hurdle rate, let alone the
more meaningfu1 35% hurdle rate. Even future deriva_
tives were expected to be low margin, falling below the
35% IRR target.
Marketing pushed back, arguing that it was neces-
Sary tO aPPrOVe the prQject for “strategic reasons.,, If
Vitesse did not enter this aspect of the Carrier Ethernet
market now’they argued, Vitesse would miss an entire
generation ofproducts. It was necessary to take a loss in
the short term, SO they could build a customer base and
keep the door open for more profitable derivatives in the
future. patty understood this argument and did not
think it was unreasonable, but she did not want to
approve the BPR as it had been presented. She explained:
l wasn,t compieteiy against moving forward with
the new Carrier Ethernet project, but i thought that
marketing shouid take another iook at the numbers
and commit to higher revenues (and profits), Their
forecasts are typica=y too conservative, And since
marketing claimed that earnings from future deriv-
atives wouId justify the initiaI 10SS On the project, i
thought they needed to document that. i wanted to
See a rOadmap,
As the discussion continued it became evident that
no one was willing to ki11 the prqiect. In addition to the
Strategic reasons for approving the prQject, marketing
argued that engineering resources were not totally fun-
gible. Di飾erent groups had different expertise, and the
engineers who would be assigned to this prQject could
337
Chapter 8. PIanning and Budgeting
not be redepIoyed immediately to other prqjects. Marty
and Patty eventually concede虫but they insisted that
the marketing team at least serioudy consider how to
increase the prcject’s IRR. Marketing agreed to study
the issue, but they made it very clear that they were not
committing to a higher revenue forecast in the BPR.
Concems
Marty and Patty were disappointed that the prQject was
approved even though it did not meet the IRR bench-
mark that they had worked so hard to develop" It made
them evaluate whether or not the IRR benchmark was
useful as a tool to assess prqjects. The IRR calculations
relied on forecasts and assumptions, SO nO One COuld be
Exhibit l Carrier and Enterprise Revenue Cycies
①つとo>〇回とeOd○○}に〇〇〇〇回
%  %  %  %
0 0   0 0   仰   2 0
338
sure they were lOO% accurate. And even assuming the Exhibit 2
IRR targets were accurate, Marty and Patty knew that
there might be legitimate strategic reasons for pursu-
iii﹂叩i州﹁同州
ing a prQject. If so, COuld those be quantified? Certainly
a new prQject could not be expected to meet the same
hurdle rate as a later iteration. That was understood by
everyone in the organization. Marty and Patty won-
dered how they could include those considerations into
the decision process with an objective measure.
Marty and Patty conceded that IRR target might not
be appropriate as a hard cutoff for prQjects, but they
still believed it was a useful tool that could add disci-
Pline to the BPR process and could better position
Vitesse to meet both its short- and long-term financial
goals・
W
※蒜重篤蒜
G白∵a十二封h.仁子k上m乱d
轟
ibit 2 Excerpts from the BPR procedu「e document

VSC Procedure VQPR-1001

i●● ● ’

fen書

e fo=owing而ormation provided by the Product Marketing Manager (PMM) sha= be presented using the tempiate

arket conditions and target customers

uaiitative descriPtion of the product and opportunity

ted on a scaie of l-5:

a. Bevenue and Profit
b Qua航y of Forecasting Methods (Siiding scaIe with BPR ievei O-2)
CI Strategic Aiignment
d. Customer Needs
e Standards or Compliance Issues
’1教. 、 1職場   一志も
fl CompetItive Anaiysis
g. Product Positioning
! - i l 長 竿 書 ¥

h. Key Requirements & PrIOrities

二」
i. Risk Management 里      長ヨ賢

」 Market ChanneIs & Key Contacts

k Management Suppo直
上 Resource Availab冊ty

m. Core Competencies
n. Dependency Management
O. SWOT anaiysis

CtOrS Of revenue (CuStOmerS, unit voiumes, ASPs and timing of ramps) can lead to resuits that miss or exceed p「edic-
ns by a factor of two or more. Optimism in forecasting tends to make most products miss rather than exceed their
als. The presenter of a BPR is responsibie for forecastjng the target revenue within reasonabIe limits of accuracy.

339
Chapter 8. PIanning and Budgeting

Exhibit 3 iRR modei

P&しModel Model. Mjnimum Mid Hgh Breakeven

Revenue 100% 100.0 100.0 100.0 74.6

COGS 43,0 41.0 39,0 30.6

GM 57-62% 57,0 59.0 61.0 44.0

R&D 25-287% 28,0 27.0 25.0 27,0

SG&A 15-197% 19.0 17,0 16.0 17,0

Opinc 15-21% 10,0 15.0 20,0 0,0

iRR ROI NPV -1 0 1 2 3 4 5 6 7 8 9 10

Minimum, 34% 2.04 $7.36 (3,36) (17) 2,14 7.02 9.92 8,14 9.16 了,74 5.60 2.80 2.80 1.68
Modeil Minimum, ModeI2 33% 2.04 $5.86 (11,76) 0.46 7.02 9.92 8,14 9,16 7,74 5.60 2.80 2.80 1.68

Mid,Mode= 37% 2.19 $8.61 (3,24) (16) 2.21 7.27 10,27 8,43 9.48 8.01 5,79 2,90 2,90 1.74
M d,Modei2 35% 2.19 $6.91 (11.34) 0.59 7,27 10.27 8.43 9.48 8,01 5.79 2.90 2.90 1.74

H H gh,Mode11 41% 2,44 $10,36 (3.00) (15) 2,29 7,52 10.62 8.71 9.80 8.28 5,99 3.00 3,00 1.80
gh,Mode12 39% 2.44 $8.39 (10.50) 0.79 7.52 10.62 8.71 9.80 8.28 5,99 3,00 3,00 1.80

Breakeven 26% 1.63 $2.99 (3.24) (16) 1.65 5,42 7,66 6,29 7.07 5.97 4,32 2,16 2.16 1.30
Breakeven 25% 1,63 $2.23 (11,34) 0,03 5,42 7.66 6.29 7,07 5.97 4.32 2.16 2.16 1.30

340
 China. Hi
themselve

CASES丁UDY “
VisuSon, Inc.二Business Stress丁esting growth dro

cal ultrasou

decade. Ce
called hand-
On the evening of Friday, October lO, 2008, Linda flow and VSI’s own access to financing as much as cus- tO grOW mu
Ott sat alone in her o鯖ce contemplating the year to tomer demand. As Linda pored over the numbers and industry an
COme. Linda was the founder ofVisuSon, Inc. (VSI), a COnSidered various scenarios, She wondered whether accounted f

Sma11 manufacturer of medical ultrasound equipment, Jon皿ight be right. reached §a

and the only CEO the company had ever had. Linda 01der technoI
re且ected on the meeting she had had that aftemoon world were e
Uitrasonography
With Jonathon Foley, VSI’s CFO. At the meeting, they for at least th
reviewed the company’s results for the third quarter Medical devices for ultrasound imaging (ultrasonogra-
just ended and discussed prQjections for the rest of Phy) use high-frequency sound waves to generate Company
2008 and for 2009. The last item on the agenda - the graphical representations of soft tissue, OrganS, and
look at 2OO9 - dominated their discussion and now blood flow. This often can be accomplished non-inva- VSI manufacI
OCCuPied Linda’s thoughts. Sively through the application of probes, Called tran§- Plant in Apple
Sales were at a record high in the third quarter of ducers, tO the surface of the patient’s skin. In some Wide through
2008. Furthermore, the company’s book of confirmed important applications, tranSducers are inserted into The firm beg2
Orders provided ample assurance that the fourth quar- body cavities or even into blood vessels to produce beト Cializing and

ter, and 20O8 as a whole, WOuld continue VSI’s estab- ter images. Modern ultrasonography equipment is ualization al!

1ished pattem of double-digit growth (see Exhibits l-3). CaPable of producing moving 3-D images of internal academic res(
But there were dark douds on the horizon. The Dow body structures in real time. With the use of so-Called After sevei
Jones Industrial Average hadjust dosed at 8,451, nearly Doppler technoIogy and coIor display, the speed and Ⅱedglin8正調

20% below its level of a week before and down 4O% direction of且uid flow can be accurately measured and bridge Manu
from a year ago. Of more direct importance to VSI, the displayed. Ultrasonography is generally a less expen- COntraCt man

February collapse of the auction-rate SeCurities market Sive form of radiology than magnetic resonance imag- ultrasound IT

PrOduced some delays in orders and collections, While ing (MRI) and computed tomography (CT). In contrast turing expert

many US hospitals, VSI’s largest group of customers, to CT and X-Ray imaging, ultrasonography does not own. Bainbril
SCrambled to replace their auction-rate debt with alter- expose the patient to potentially harmful radiation. move up丘0Ⅱ

native sources of capital. Both Linda and Jon believed Consequently, ultrasonography has developed into the the more pro
that this one problem had reduced sales growth for the most common form of radioIogy for some areas ofmed- Phy systems.
year by several percentage points from what they had icine. CardioIogy and obstetrics/gynecoIogy, for exam- WOn aPPrOV乙

PrQjected at the same meeting a year ago. Both Linda Ple, PrOVide important applications for ultrasonography. tion, Visute(
and Jon agreed that a wider credit crisis would nega- By 2OO8, the global macket for ultrasonography equip- forming VSI
tively impact 2009 sales, but there was no historical ment was dominated by four large medical device manu- former head

PreCedent on which to base a reliable forecast. factures that were themselves divisions of global Pendent fim
Linda worried about the near-term impact on eam- COnglomerates. Industry analysts estimated that Philips Principal re
ings and the long-term Strategic impact of a sIowdown Healthcare, Siemens Healthcare, GE Healthcare, and retained as [

While VSI prepared to release its丘rst entirely new prod- Tbshiba together controlled approximately 80% of the As a new
uct platform in several years. The new platform worldwide market. But the medical ultrasound market larger firm
accounted for nearly 30% of VSI’s research and devel- remained quite dynamic and innovative with more than a focused on (

OPment budget plus more than $10 million in capital dozen smaller competitors vying for the remaining share. PrOPrletary
expenditures over the last two years. Jon, however, had In addition to new and niche competitors from North tage. VSI ta
Cautioned against “fixating on sunk costs,” as he put it. America and Europe, neW entrantS into the global ma正et 丘rst six yea

He believed the company should be focused on cash Were emerging from other parts of the wo血d, Particularly medical pra

342

reason for the failure, named the department and/Or
individual(s) responsible, and prescribed corrective
action. CARs linked to an individual“empIoyee became
Part Ofthat empIoyee’s permanent record.
Kevin also managed a World Wide Knowledge Base
that gave empIoyees around the world access to the
most recent work instructions, Checklists, forms, and
POlicies. He discouraged empIoyees from sending out-
dated emails or storing outdated instructions on their
PCs. Often when CARs were issued, the failure was at
least partially addressed by updating instructions in
the Knowledge Base. Kevin believed in knocking out
failure modes with smart controIs, Or, aS he explained,
“I minimize discretion so that a process cannot con-
tinue until the right choices are made. I try to force
things to be right.’’
B輔ngs and revenue recognition
G§I prQject managers (PMs) were responsible for man-
aging customer prQjects from start to finish・ Their
responsibilities induded bi11ing. Most PMs had no
financial or technical background. All were high school
graduates, and some also had a college degree, uSua11y
in a liberal arts丘eld. The best of the PMs were smart
generalists who were able to juggle multiple priorities.
In addition to the PM, a tyPical prQject invoIved at
least eight employees, mOSt Of whom had a technical
SPeCialty such as video compositing. PrQjects required
quality controI persomel as well, uSually two focused
On the incoming stage of the prQject and two or three
focused on the outgoing stage. Quality controI checks
Were built into the process.
GSI’s policy was that no pr匂ect was to be started
Without first securing a purchase order (PO) from the
CuStOmer, The PMs regularly violated that policy, how-
ever, With tacit approval from corporate. As one PM
explained, ``[The big customers] are temperamental.
We don’t want to upset them.’’Even starting a prqiect
with a PO in hand did not soIve a11 the billing problems.
Not all the prQject contingencies could be foreseen, and
OVerageS above the amount specified in the initial pur-
Chase order were common in the industry.
Revenue was recognized when it was eamed. PMs
WOuld estimate the amount they would eventually bill
for the work that had been done to date and enter it as
accrued revenue. Once the prQject was billed, the
amount changed from accrued revenue to an account
receivable. Each PM was responsible for tracking time
SPent On Prqiects, Changes to the prqjects, and overages.
Game Shop, inc.
Once the prQiect shipped, the PM was also responsible
for compiling a billing packet that the billing depart-
ment sent to the customer for approval and payment.
Bills, and in some cases even the bi11ing processes,
Were tailored to each customer. For example, One CuS-
tomer did not allow overages, SO they would not sign a
PO until the prqiect was completed. The PO, Shipping
document, and invoice were all sent to this customer at
the same time. In a practice somewhat unique to the
industry, many CuStOmerS Were nOt billed when the
Prqiect shipped, but were given a period of time to
review and approve charges after the prQject was
Shipped. The period of time allowed varied by cus-
tomer. Kevin noted, “Sometimes it’s as di描cult to bill
the thing as to build the thing:’
Accuracy and timeiiness issues
Billing accuracy and timeliness had become increas-
ingly important as the company matured. Kevin was
COnCerned that GSI’s reputation for billing was not up
to par with its reputation for delivering quality prod-
ucts, and billing problems were causing frictions with
important customers. Partly because of the丘nancial
reporting and intemal control requirements of the Sar-
banes-Oxley Act of 2OO2, mOSt CuStOmerS Were nOW
requesting better invoice accuracy. In addition, aS GSI
grew, its need for working capital also grew, SO it was
imperative to get invoices delivered and receivables
COllected as promptly a§ POSSible.
Friction with large customers had revealed some
bi11ing issues, and there was additional evidence that
PrOblems existed, The PM’s accrual estimates could be
Wildly inaccurate, and there were often several months
Of accrued revenue sitting on the books. In late 201O,
GSI had over $5 million of working capital “trapped in
accruals older than 60 days;’almost twice GSI’s aver-
age monthly revenue.
The improvement process
David was assigned the task of improving the bi11ing
system. He was given dear prqiect goals: aChieve 98%
accuracy in accrued revenue calculations and reduce
accruals to a maximum of 30 days of sales. If David’s
PrQject was successful, the accrued revenue amount
would decrease from over $5 million to $1.3 million.
In early 2010, GSI management had a brainstorming
session to identify the issues. They found that a lot of
COntrOIs were mi§Sing. As a result, SOme billings were
243
not being turned in. Many that were tumed in were
inaccurate. Sometimes customef言were double billed.
PMs were a major cause of the prot丸ems. This was
understandable, aS Kevin noted, “They are busy peo-
Ple. Sometimes they don’t get all the details right.’’
Tb understand all the root causes of the problem,
David built a `亀ult tree’’(see Exhibit 2). The purpose of
the fault tree was to diagnose the problem in enough
detail so that the solutions would follow from the detailed
diagnoses. David’s fault tree exercise exposed nearly lOO
CauSeS Ofthe inaccuracies and revenue accrual build-uPS.
These issues could be categorized as system or process
issues, CuStOmer issues, and management issues.
System/process issues
The billing system had several flaws. Billing paperwork
COuld only be submitted once a week, and reports could
take upwards of lO minutes to download onto a PM’s
COmPuter. There was also no redundancy in the pro-
CeSS. A single empIoyee’s vacation could hold up the
entire company’s billing cyde.
Theoretically, these issues could be addressed with
Changes to the system, but both the billing and IT
departments were resistant to change, David thought
that billing department resistance stemmed both from
familiarity and comfort with the existing system and,
PrObably, fear ofjob loss. Bi11ing department personnel
had also been bumed once by the IT department when
it tried to force a new alpha version of a system on
them. This system was untested and full of bugs, SO
hard feelings had been created. The IT department had
always given billing prQjects Iow priority. Historica11y,
the IT focus had always been on systems designed to
improve operations. Financial systems had always
been an afterthought,
Customer issues
GSI’s policy was that nothing could be shipped without
a PO, but some customers refused to issue a PO. They
Wanted to make changes along the way and have the
bill from GSI reflect what was actually shipped. Even
Where POs were used, they often quickly became obso-
lete as changes were made to the work orders. Some
CuStOmerS insisted on a lengthy review process before
they would approve a bill even though the order had
already shipped. Some prQjects shipped over a long
Period of time, uPWards of one year, but customers
WOuld not accept a bill until the final stage ofthe prQject
WaS COmPlete.
244
David accepted that customer behavior could not be in large part
COntrOlled completely, but he also believed that PMs and
managers could do more to try to influence customer
behavior. PMs could try to insist on getting a customer PO.
Performance
They could also try to get authorization to bill for parts of assessing the
a job instead ofwaiting for the entire job to be complete. The Billin
For example, One BU was able to persuade a customer to BU’s billing
Pay for intemational dubbing before the Japanese ver (described bel
Sion, by far the most technical and time-COnSuming dub- into a O-tO-4・
bing task, WaS COmPlete. This shortened the bi11ing cycle
1, Percent of
On this job from over a year to just four months.
Management issues A perfect s
SOld was al
Perhaps the biggest issue was that many GSI PMs did
into a grade
not track prQject changes and simply did not tum in
bi11ing paperwork in a timely manner. Some just 2" Adjusted n
accrued things randomly. For example, they would ae⊂ruals/(3
declare certain tasks as having been completed, forget
A week
What they had done in the prior period, and then bill for
13-Week ave
them again.
WaS a句咽ed
David discovered several causes of this problem. GSI
Sped鉦toさ
did not have a set of written bi11ing instructions, and
approval de
manymanagers did not know how to use the billing tooIs
allowed the
available to them. In general, PMs did not understand
bi11s before
the importance of correct and timely billing, and often
a句usted nu
Were nOt aWare that there was a problem; they assumed
by subtracti
SeVeral months of accruals were the norm. Managers
Were also not terribly motivated to spend time on billing.
example, ifa
They were much more focused on production. The prob-
accrued, but
lem was aggravated during the busy season when some
Weeks to app
managers complained that they were already in the
accruals wo
O鯖ce until past ll p.m. every night making sure orders
allowed one
Were Shipped. Forced to choose between spending time
Or fraction th
On Shipping or billing issues, they chose shipping.
from a perfe
While some ofthe problems could be seen as failures
grade. So us
Of specific individuals, David decided to focus on
WOuld prod眠
improving the process, rather than focusing on specific
individuals’failures. He provided training sessions that 3, Percent ofs
included instruction on billing and time management,
and he added detailed billing instructions to the World
Wide Knowledge Base.
BilIings Scorecard Shipped without
a grade bysub
Tb focus attention on billing performance, David devel-
result by 4,
OPed a new ``Billings Scorecard,’’a monthly report that
tracked each BU’s billing performance. David hoped the 4, Percent ofaccr
Billings Scorecard would provide increased visibility This measure w
about billing performance. Many PMs, and even their A perfect score
bosses, had not cared about billing-related performance WOuld mean th
 VisuSon’inc・: Business Stress lesting

efore December when the budgets were fin車zed and

SPreadsheet produced by the Accounting Department.
en approved by vsI七board of directors.
The design of the spreadsheet largely automated the ro11-
刷e engineering was navigating the approval pro-
up of deparment budgets to higher organizational lev-
ess and manufacturing was developing cost estimates,
els. But in the budgeting review processes’Changes were
fell to sales to begin working with the distributors.
inevitably suggested, fdrcing negotiations and revisions.
岨gh most distributor agreements were renewed
The budgeting review effort was intensive, but the pro-
ach December as part of the quota commitment pro-
CeSS WaS nOt OVerly cumbersome because vsI,s manage-
S5ysales worked with the distributors throughout the
men亡COnSisted of fewer than 2O individuals. Finally, in
ar. In addition to monitoring current sales activity and
December, VSI,s execu亡ive committee, and then the
hleVements toward quota’the sales department
board of directors, aPPrOVed the consolidated budget.
Orked through a formal review and evaluation process
Managemen亡Of cash and working capital was a criti-
l[h each distributor of the partnership,s performance
Cal issue fdr this small・ raPidly growing company. vsI
’erthe previous year. At the same time, the distributors
management and its bankers agreed that the fim should
O‘-ided feedback on developing sales leads for the com_
typica11y hold six weeks of operating expenditures in its
gyear・ Tbgether with the distributors, Sales would for
CaSh accounts. In an effort to be responsive to the needs
late plans to support these sales efforts with VSI
Of its distributors and customers’VSI maintained a pol-
monstration and training staff as well as evaluation
icy of holding 30-40 days, forward sales in finished
uipment. sales would also begin providing distribu-
goods inventory. Finished goods accounted forjust more
S With advanced marketing infomation conceming
than 40% of the total value of inventory, With the
thcoming offerings in order to elicit feedback on
remainder split about equally between work in process
ti。pated voIume and market pricing. Though most
and raw materials. At the other end of its operating
tribution and sales agreements induded confidentiaト
CyCle, VSI,s accounts receivable balance hovered
Clauses’the distribution network was a valuable
between 6O and 80 days oftrailing sales. In an effort to
rce of competitive intelligence regarding expected
mmmlZe net OPerating capital, VSI maintained accounts
tures and pricing by competitors. This information
Payable and accrued liabilities at the highest levels pos-
COmbined into a preliminary sales forecast provided
Sible while still taking advantage of all available trade
e budget committee by mid-August of each year.
Credits for prompt payment. Likewise, eXPenSeS Were
n the basis of the preliminary forecast from sales
Only prepaid when required. Nonetheless’its Iong oper-
their own planning effort for any new products,
ating cy。e and high growth rate required VSI to finance
ufacturing developed and submitted a draft labor
this growing investment in working capi亡al through
get to human resources (HR). The o血er deparト
Short-term borrowing against the value of its accounts
ts also submitted sta鯖ng requests at this time, but
receivable and inventories. Thus, before any budget
manufacturing labor budget was the most critical.
COuld be considered viable, it required review and
WaS reSPOnSible for developing the staffing and
approval by the finance department.
ing schedule for the coming year. As part of this
Anywhere from one-third to one-half of the manag-
eSS’HR reviewed the salary and wage surveys it
ers’cash compensation was tied to achievement of
hased from consultants to ensure that vsI kept
O巧ectives set by the executive committ。。 and th。
With the competitive labor markets. salaries and
board at the start ofeach year. For firsト1evel managers,
eS Were a significant cost category for vsI. This
One-third of cash compensation was considered
mation was critical for developing department “at-risk’,, with the level rising to 50% for Linda. For

agers’merit pay budgets for the coming year as well

mOSt managers’aChievement of budget o亘jectives was
r refining the direct labor budget. The most inten-
Weighted 5O% in importance for determining the
Phase of the budget process took place each annual bonus. The remaining 50% was based on
mber. By this point in the year, the volume ofsales
achievement of other quantified goals and/Or a Suhec-
roduct mix for the coming year was relatively pre-
tive evaluation of perfomance.
ble. Combining the updated sales forecast distrib-
by the sales department at the beginning of the
h with salary’Wage, and staffing infomation pro- The new cha=enge
by HR, department managers developed detailed
The budget that Jon Foley delivered to Linda earlier in
ts for their departments using a standardized
the day was based on an assumption of lO% revenue

345
Chapter 8. Pla=ni=g and Budgeting
growth for 2009 (see Exhibits 6 and 7)’a level that had
been considered quite conservative just a month ear-
1ier, It included plans to boIster Asia/Paci宜c and Latin
American sales support by hiring more account manag-
ers and sonographers and by devoting additional dem-
onstration equipment to these markets. While it
included no plans for major product releases in 2009,
engineering and marketing planned to begin the FDA
510(k) process for approval of the new hand-Carried
ultrasound (HCU) platform targeted for release in
2010. Recently, the HCU market had grown faster than
the cart-based segment where VSI currently competed.
Analysts were forecasting an acceleration of the shift
toward greater use ofHCUs. Linda and the board were
eager to enter this new market segment.
With the assumption of lO% growth’mOSt first-level
management perceived that they would face tight
resource constraints. Manufacturing headcount and
manufacturing compensation were budgeted to grow
by only 6.4% and 9.0%’reSPeCtively. Capital expendi-
tures were actually budgeted to fall significantly as the
firm more fully utilized existing capacity・ Additional
investments were expected to accompany the new HCU
platform introduction in 2010. By far the most signifi-
cant growth in operating expenses would come from
expansion of the sales sta埠with total compensation
expense in sales and marketing budgeted to increase
by slightly less than 40%. This was considered an
investment required to maximize the potential growth
from new product introductions in subsequent years.
Growth in engineering head count of 12% and engi-
neering compensation ofjust over 15% was in equal
parts justified by growth in manufacturing capacity
and the installed base and by development of the new
product line. Finally, the roughly 12% growth in head-
count and compensation expense within finance was
deemed necessary to support growth in the other three
functions.
However, While the strategic importance of growing
into new markets and keeping ahead of the technoIogy
would not change, COntinuation of the market,s and
VSI,s high rates of growth could not be assured. The US
domestic market was dominated by private not-for-
profit hospitals, Which rely in part on endowments like
those of some private universities. The nearly 40% fa11
in equity market values was sure to adversely affect
such investment portfolios. Govemment-OWned hospi-
tals were already anticipating funding shortages
because the sIowdown was reducing tax revenues. In
addition, the crisis was likely to reduce demand for
346
Exhibitl l
elective procedures’further reducing all hospitals’rev-
enues and spending. Consequently’analysts were
income sl
beginning to speculate about a decrease in capital
spending by US hospitals of as much as 14% in 2009.
Yet, it was unclear how capital spending on radioIogy
generally’and sonography in particular, might be
a任ected. As the bulk of sales in the domestic market
were replacements for older technology, many CuStOm-
ers could defer purchases.
Customers had already shifted purchases to later in
the year during 2008. Linda and others at VSI feared
that this pattern could become more pronounced due
to the developing recession" With limited workforce
flexibility, VSI would be forced to choose between
Income [
building inventory early in 2009 or risking stocking
E xt rao rd
out later in the year. Fortunately’the sales mix was Net incoI
expected to remain essentially fixed’aS it was driven
by customers, clinical requirements rather than by
financial factors. Exhibit 2
As Linda reviewed the spreadsheet Jon Foley had
prepared for the 20O9 budget’She considered his
words of caution, Jon believed that in the short term
VSI,s fate could be determined by how well they man-
aged cash and by their ability to access bank financing.
He felt that a11 plans should be built upon an assump-
tion of reduced gross debt levels and improved debt
ratios. He suggested that they ``prepare for the worst
器国師皿
and hope for the best,・, and advocated beginning a pol-
N
icy of “deferring expenditures and wringing cash out
of the working capital accounts.,, Jon argued that com-
mitting to plans for growth was risky and that umodest
cuts now [could] avert severe cuts later.’’While Linda
had come to rely on Jon,s financial expertise’her
trusted friend and collaborator, Simon Lee, had pri-
vately criticized the CFO as overly cautious and Peter
Beeson had on more than one occasion dismissed him
as `just a bean counter・’’In contrast, Tbm Nelson, VSI’s
COO, Who had worked with Jon at Bainbridge’neVer
made a significant proposal without having Jon first
vet the numbers.
Linda knew that deferring planned investments’let
alone cutting back, WOuld limit the company,s capacity
for growth in 20O9 and beyond. Recognizing that any
⊂OurSe Of action would create some controversy Within
the management team, She wondered how exposed VSI
was to a decrease in sales, Which might be imminent. How
great a downtum could the company endure without hav-
ing to make the sort of deep cuts that would choke off
future growth? And might VSI,s own survival be threat-
ened if market conditions became really unfavorable?
 ibi= income statements

串estatement  二_". 2008(estiT碧ted〉 9monthsended9/30/08 2007 2006

Revenues(net) $59,766 $44,227 $52,994 $47,443
Oostofgoodssoid 27,269 20,224 24,806 22,930
Grossmargin 32,498 24,003 28,188 24,513

Ope「atingexpenses 紺‖[g 10,663 7,921 9,581 8,705

恥D 7,566 5,744 6,646 5,856

Generaiandadmjnistrative 7,458 5,611 7,028 6,673
Operatingincome 6,811 4,728 4,933 3,279

冊erestexpense 1,060 773 886 653

I[COmebeforetax 5,751 3,955 4,046 2,626
血 2,013 1,384 1,416 919

l[COmebeforeextraordinaryitems 3,738 2,570 2,630 1,707

帥aordinaryitems(netoftax) ー ー 年型土壁
Ne自ncome =零壁壁 =。壁壁型 聖堂

敵hibit 2 Baiance sheets

Baiancesheet 2008 (estimated) 9monthsended9/30/08 2007 2006 2005

Currentassets Oash $5,930 $5,448 $5,258 $4,701 $4,178

Accountsreceivable(net) 12,898 12,153 11,436 10,238 9,093

l[VentOries 6,767 6,216 6,000 5,371 4,770
Prepaidexpenses 〇三土壁塑 1,835 1,800 1,611 1,431

Totaicurrentassets 27,625 25,652 24,494 21,922 19,472

Non-CUrrentaSSetS Property,PIant,andequipment 26,531 26,945 24,108 21,583 19,167

Lessaccumulateddepreciation 6,323 _哩 ○○旦L墜喧 ○○旦皇塑 ○○旦生皇室

20208 20,592 17,752 15,152 12,685
Otherassets 4,282 4,209 3,522 2,988 2,466

totalassets 壁乙1坦 $50,454 堂垂堅 塾迎壁 聖堂些

Currentliab冊ies Accountspayabie 4,496 4,348 4,423 3,960 3,516

Notespayabie 14,860 14,640 12,040 9,470 6,210

Taxpayable 384 253 368 239 111
Accruedliab紺ties 2,437 2,357 2,397 2,146 1,906
Currentportionoflong-termdebt 339 339 339 339 339
Totalcurrentiiab=ities 22,516 21,938 19,568 16,154 12,083

No[-Current=ab=ities Long-termdebt 348 433 687 _」坦2乙 _」遡

Tota川ab帥ties 22,865 22,371 20,255 17,180 13,448

Owners’equity Commonstock 189 189 189 189 189

AddittonaIpaid-jn-CaPitai 4,546 4,546 4,546 4,546 4,546

Retainedeamings 24,516 23,348 20,777 18,147 16,440
TotaIowners’equity 29,251 28,083 25,512 22,882 21,175
Tofa=iab冊tiesandequity 堕型 遡 塾量三壁 壁土聖堂塗 $34,624
Chapter 8. Pian=ing and Budgeti=g

Exhibit 3 Statements of cash flows

Exhibit 4

Statementofcashfiows     ‥ 2008(estimated)  9monthsended9/30/08  2007   2006

OPERATiONS: $3,738 $2,570 $2,630 $1,707

Netincome
Adjustmentstoreconcile:
Depreciationandamortizatjon 5,182 3,836 4,275 3,813
AccountsreceivabIe (1,462) (717) (1,198) (1,146)
Inventories (767) (216) (628) (601)
Prepaidexpenses (230) (35) (189) (180)
AccountspayabIe 73 (75) 463 443
Taxpayabie 15 (115) 129 128
Accruedljabiljties 40 _」全曲 251 240

Cashfiowfromoperatingactivities _旦星型 __星型 5,734 4,405

lNVESTiNG"
AdditionstoPP&E 6,509 5,845 5,978 5,482
Acquisitionsoftechnoiogylicenses 〇二L室塑♀ 1,519 1,430 1,321

Cashf10WuSedforinvestingactivities 8,398 7,364 7,409 6,803

FINANCiNG: 14,860 11,510 12,040 9,470

Borrowingofnotespayabie
RepaymentsofnotespayabIe Lon-termborr (12,040) (8,910) (9,470) (6,210)

g OWmg Repaymentoflong-termdebt Cashdjvidendspaid (339) (254) (339) (339)

Cashflowfrom(usedby)fjnancing 2,481 2,346 2,231 2,921

Netincrease(decrease)incash $673 $190 $557 $523

Cashpaidforincometaxes 2,481 2,346 2,231 __生き塑1

一重1、621 重工」三三 $1,287 $791
Cashpaidforinterest $1,054 〇〇〇」退塾 」堕 」壁坦

348
it 4 VisuSon, inc.: Organization cha直
Exhibit 5 Budget timeIine

Nov Dec Dec Jan Feb Mar Apr May Jun Jui Aug Sep Oct Nov Dec

P    lndustryAnalystReports

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hibit 6 Staffing
Chapter 8. Plaming and Budgeting

Exhibit 7 Summary budget

CHA
2009Budgetedincomesummary 賃● ●l Commentsandanalysis

Revenues(net〉 $65,743 1O%growth

Costofgoods 8ncent
DirectmateriaIs 12,742

DirectIabor 6,959 incIudes$160formanagementbonuses

Manufactu「ingoverhead

Salaryandwages 4,078
Depreciationandamortization 3,148 lnciudes$596on2009investments
MisceIianeous 2,919 10,145 29,846 lncludesindirectmateriais,ut冊ies,and
maintenance:74%fixed
Grossmargm 35,897

Operatingexpense lncIudesestimatedcommissionsof$965+$190
Seliing
Salaryandwages 2,807
managementbonus
Marketingandadvertising 5,036 85%discretionary/15%variabie
Shipping 1,747 95%variabIe,basedonestimatedforwardrates
SaIespromotionfunding 1,972 11,562 Discretionary-Va「iabIe

Researchanddevelopment Includes$210formanagementbonuses
Saiaryandwages 4,934
DepreclationandamortlZation 1,712 lnciudes$430on2009investments
Consuiting 1,640 Discretionary
Misce=aneous 39 8,325 Djscretionary
GeneraIandadmin,
Saiaryandwages 6,567 includes$445formanagementbonuses
ll’aVeIandtraining 2,060 Discretionary

Depreciationandamortization 791 incIudes$105ofcont「actlabor:2O%variabie

MisceIianeous 395 哩 壁哩塑

Operatingincome 6,197 AtassumedrateofworkingcapitaIgrowth
Interestexpense 1,250
Beforetaxincome $4,947
Capitalexpenditure $5,96092%forreplacementsand=censerenewaIs

This case was prepared by Research Assistant David P. Huelsbeck and Professor Kenneth A. Merchant.
Copyright @ by Kemeth A. Merchant・

352