Management

Control
System
Sistem Pengendalian Manajemen

Dosen : Dr. Ir. Mombang Sihite, MM

References
1. Management Control System ,
Performance Measurement, Evaluation
and Incentives (Kenneth A. Merchant &
Van der Stede)
2. Performance Management, Key
Strategies and Practical Guidelines
(Michael Armstrong)
3. Management by Measurement,
Designing Key Indicators and
Performance Measurement Systems,
(Fiorenzo Franceschini, Maurizio Galetto,
Domenico Maisano)
Subjects:
1. Management and Control
2. Result Control
3. Action, Personnel and Cultural
Controls
4. Control System Tightness & Cost
5. Designing, Evaluating Management
Control System
6. Financial Responsibility Centers
7. Planning and Budgeting
8. Mid Test
Subjects:

9. Incentives System
10. Financial Performance Measures & Their effect
11. Remedies to The Myopia Problem
12. Corporate Governance & Board of Directors
13. Controllers and Auditor
14. Management Control – Related Ethical Issues
15. Management Control in Non-Profit Organization
16. Final Test
 Management
Control System
System Pengendalian
Manajemen

#10 Financial Performance Measures & Their effect

Dosen : Dr. Ir. Mombang Sihite, MM
Financial Performance
Measures and Their Effects
The primary objective of for-profit organizations is to
maximize shareholder (or owner) value, or firm value for
short. Thus, the results-control ideal would be to reward
employees for their contributions to firm value.
However, because direct measurements of the contributions
by employees to value creation are rarely possible, firms have
to look for measures that proxy for this ultimate objective and
resort to results-control alternatives to either reinforce
desired behaviours where the proxies leave gaps or mitigate
undesired consequences that may arise from relying on the
proxies.
The first category of summary measures contains
market measures; that is, those that reflect changes
in stock prices or shareholder returns.
The second category contains accounting measures,
which can be defined in either residual terms (such
as net income after taxes, operating profit, residual
income, or economic value added) or ratio terms
(such as return on investment, return on equity, or
return on net assets).
These two categories of summary financial (market-
based or accounting-based).
The third measurement category consists of
combinations of measures. These combinations
can involve the use of either type of summary
measures, or both, plus some disaggregated
financial measures (e.g. revenues, expenses) and/or
nonfinancial measures (e.g. market share,
customer satisfaction, employee turnover).
Value creation

It is generally understood that the primary objective

of for-profit organizations is to maximize the value
of the firm, subject to some constraints, such as
compliance with laws and adequate concern for
employees, customers, and other stakeholders.
As Michael Jensen, a financial economist, phrases it,
“200 years’ worth of work in economics and finance
indicate that social welfare is maximized when all
firms in an economy attempt to maximize their own
total firm value.”
Ideally, then, to reflect success properly,
performance measures should go up when
value is created and go down when it is destroyed.
Market measures of
performance
One way of assessing value changes is by using market
measures of performance, which are based on changes in the
market value of the firm or, if dividends are also considered,
return to shareholders.
The value created (return to shareholders) can be measured
directly for any period (yearly, quarterly, monthly) as the sum
of the dividends paid to shareholders in the measurement
period plus (or minus) the change in the market value of the
stock.
For publicly traded, exchange-listed firms whose stock is
traded in actively traded and properly regulated capital
markets, the market value of the firm is generally viewed as
the closest, although imperfect, measure of (hence, proxy for)
the firm’s true intrinsic value.
Market measures do have limitations, however.
First, market measures suffer from controllability problems. They
can generally be affected to a significant extent only by the top few
managers in the organization, who have the power to make
decisions of major importance.
Second, market values do also not always reflect realized
performance; instead, the values merely represent expectations,
and it can be risky to base incentives on expectations because
those expectations might not be realized.
A third and related problem with market measures
of performance is actually a potential
congruence failure.
Markets are not always well informed about a
company’s plans and prospects and, hence, its
future cash flows and risks.
This hampers the use of market valuations
as a proxy for firm value.
For competitive reasons, companies may treat
information about R&D productivity, pricing and
sourcing strategies, product and process quality,
and layoff intentions, say, as confidential.
Market valuations cannot reflect information that is
not available to the market. If sizable rewards are
linked to market valuations, managers might be
tempted to disclose this information to affect
valuations, even if such disclosures could harm
their company.
Accounting measures
of performance
Traditionally, most organizations have based their managers’
evaluations and rewards heavily
on standard accounting-based, summary financial measures.
Accounting-based, summary or bottom-line performance
measures come in two basic forms:
(1) residual measures (or accounting profit measures), such
as net income, operating profit, earnings before
interest, tax, depreciation and amortization (EBITDA), or
residual income;
(2) ratio measures (or accounting return measures), such as
return on investment (ROI), return on equity (ROE),
return on net assets (RONA), or risk-adjusted return on
capital (RAROC). These measures are typically derived
from the rules defined by standard setters for financial
reporting purposes.
Summary accounting-based measures have some
appealing advantages.
First, accounting profits and returns can be measured on a
timely basis (in short time periods) relatively precisely and
objectively. Accounting rules for assigning cash inflows and
outflows even to very short measurement periods have
been set and described in great detail by accounting rule
makers, such as the International Accounting Standards
Board (IASB) accounting profits in short time periods, such
as a month, with considerable precision.

Second, as compared with other quantities that can be

measured precisely and objectively on a timely basis, such
as cash flows, shipments, or sales, accounting measures
are at least conceptually congruent with the organizational
goal of profit maximization, where profit is an archetypal
accounting construct.
Third, accounting measures usually can be largely
controlled by the managers whose performances are
being evaluated.
The measures can be tailored to match the authority
limits of any level of manager, from the CEO down to
lower management levels.

Fourth, accounting measures are understandable.

Accounting is a standard course in every business
school, and managers have used the measures for so
long that they are well familiar with what the
measures represent and how they can be influenced,
at least at a conceptual if not fully accounting-
technical level.

Finally, accounting measures of performance are

inexpensive because most firms have to measure
and report ifnancial results to outside users already,
certainly when they are publicly traded, but also in
many countries when they exceed a certain size and
require auditing
There are thus various reasons why accounting profit
measures fail to reflect economic income perfectly.
Many things affect accounting profits but not economic
income, and vice versa.

First, accounting systems are transactions-oriented.

Accounting profit is primarily a summation of the effects of
the transactions that took place during a given period.
Most changes in value that do not result in a transaction are
not recognized in accounting profit.
When a firm receives a patent or regulatory approval for a
new drug, the expectation of economic income is affected;
but there is no transaction, no accounting entry, and, thus, no
effect on accounting income.
Second, accounting profit is highly
dependent on the choice of measurement
methods.
Multiple measurement methods are often
available to account for identical
economic events.
Depreciation accounting choices (straight-
line vs. accelerated methods) are but one
example.
Third, accounting profit is derived from
measurement rules that are often conservatively
biased.
Accounting rules require slow recognition of gains
and revenues but quick recognition of expenses and
losses.
For example, accounting rules define strict criteria
that must be satisfied before revenue (and the
associated proft) can be recognized, and
expenditures on intangible assets are generally
expensed immediately.
Fourth, profit calculations ignore some economic
values and value changes that accountants
feel cannot be measured accurately and objectively.
Investments in major categories of companies’
intangible assets, such as research in progress,
human resources, information systems,
and customer goodwill, are expensed immediately.
The omission of intangible assets occurs even
though, for many companies, these types of assets
are much more important than the old industrial-era-
type assets of property, plant, and equipment
Fifth, profit reflects the cost of borrowed capital (through
interest deductibility) but ignores the cost of equity capital.
Firms earn real income only when the returns on capital are
greater than the cost of that capital, and ignoring the cost of
equity capital overstates the difference between returns and
costs (that is, profit).
This omission is serious because equity capital is typically
more expensive than borrowed capital, and the cost of
equity capital is even higher for companies with risky
(volatile) stocks.
Failure to reflect the cost of equity capital also hinders
comparisons of the results of companies with different
proportions of debt and equity in their capital structures.
Sixth, accounting profit ignores risk and
changes in risk. Firms, or entities within firms,
that have not changed the pattern or timing of
their expected future cash flows but have
made the cash flows more certain (less risky)
have increased their economic value, and vice
versa. This value change is not reflected in
accounting profits.
Finally, profit figures also focus on the past.
Economic value is derived from future cash
flows, and there is no guarantee that past
performance is a reliable indicator of future
performance.
Growth Profit

Cash Flow
The multiple reasons why accounting income and
economic income diverge have caused some critics
to make strong statements against the use of
accounting performance measures.
Most managers, however, have found that the
advantages of accounting measures outweigh
their limitations, and they continue to use them.
But they must be aware that motivating
managers to maximize, or at least produce,
accounting profits or returns, rather than
economic income, can create a number of
behavioural displacement problems.
Myopia is probably the most potentially damaging.
Managers who focus on accounting profits or
returns measured in short periods tend to be
highly concerned with increasing (or maintaining)
monthly, quarterly, or annual profts.
Investment and operating
myopia
Accounting performance measures can cause managers to act
myopically in making either investing or operating decisions.
Holding managers accountable for short-term profits or returns
may induce managers to reduce or postpone investments that
promise payoffs in future measurement periods, even when
those investments have a positive net present value and meet
other criteria to make them worthwhile. This is investment
myopia.
Investment myopia stems directly from two of the problems with
accounting measures described above: their conservative bias
and their ignoring of intangible assets with predominantly future
payoffs.
Accounting rules do not allow firms to recognize gains until they
are realized; that is, until the critical income-producing activities
(such as a sale) have taken place and the earnings can be
measured in an objective, verifiable way
Return-on-investment
measures of performance

Divisionalized organizations are comprised of

multiple responsibility centers, the managers of
which are held primarily accountable for profit or
some form of accounting ROI.
The divisionalized form of organization dates back
to the 1920s, when it was introduced in the
DuPont Company, but its use spread particularly
quickly after World War II as one response to
increased organizational size and complexity.
To this day, the divisionalized form of organization
is used by many firms above minimal size
requiring delegation of decision authority
Formula chart showing relationship of factors
affecting ROI
Problems caused by ROI-type of measures
Relying heavily on ROI measures in a results-control system can cause some
problems, however. One problem is that the numerator in the ROI measure
is accounting profit.
Thus, ROI has all the limitations of profit measures, such as the tendency to
produce management myopia, the common form of behavioural
displacement.
A narrow focus on ROI can lead division managers to make decisions that
improve division ROI even though the decisions are not in the corporation’s
global best interest; that is, decisions that appear locally optimal (in
the division) may not be globally optimal (for the firm).
Finally, ROI measures sometimes provide misleading signals about the
performance of the investment centers (divisions) because of
dificulties in measuring the fxed asset portion of the denominator.
Example showing ROI overstatement when denominator is measured in terms of
net book value
Example showing increase in ROI due merely to
passage of time
Example of suboptimization with residual income:
failure to invest in a worthwhile project
 • The primary goal of managers of for-profit firms should be to

conclusion maximize shareholder or firm value, which is a long-term, future-

oriented concept. Short-term accounting proft and return measures
provide imperfect, surrogate indicators of changes in firm value.
Corbridge Industries, Inc
CASE
In 2016, Corbridge Industries, Inc. (Corbridge) was
starting a process that could lead to major changes in
its planning and measurement systems. Chantal
Coombs, vice president of planning, explained:
The basic thrust of what we are starting to do is
very simple, although it has potentially major
ramif cations. We are changing the basic decision
rules by which we evaluate our plans and our
accomplishments. We have become convinced
that for Corbridge, at least, the traditional
accounting measures such as net earnings or
return on net assets, are neither good criteria on which
to base decisions, nor reliable indicators of
performance.
The primary objective of our company is to
create value for our shareholders. We believe that
stock values, like the values of all economic
resources, depend on investors’ expectations of
future cash flows, discounted for time and risk.
Consequently, we think that in evaluating possible
actions, it is more important to focus on the
possible impacts of our decisions on future cash
flows and risk, rather than estimating the impact
on the accounting indicators. In addition, we think
that it makes sense to judge our performance
based on what we accomplish for our shareholders—
meaning the amount of value we generate
for them.
Subjects:
9. Incentives System
10. Financial Performance Measures & Their effect
11. Remedies to The Myopia Problem
12. Corporate Governance & Board of Directors
13. Controllers and Auditor
14. Management Control – Related Ethical Issues
15. Management Control in Non-Profit
Organization
16. Final Test