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Fundamentals of Management
Control Systems
Chapter 12

PowerPoint Authors:
Susan Coomer Galbreath, Ph.D., CPA
Charles W. Caldwell, D.B.A., CMA
Jon A. Booker, Ph.D., CPA, CIA
Cynthia J. Rooney, Ph.D., CPA

McGraw-Hill/Irwin

Copyright © 2014 by The McGraw-Hill Companies, Inc. All rights reserved.

12-3 . The purpose of the management control system is to align more closely the interests of the manager and the interests of the organization.Alignment of Managerial and Organizational Interests LO 12-1 Explain the role of a management control system. A management control system is designed to help managers make decisions that will increase the organization’s performance.

a superior. delegates duties to a subordinate. 12-4 . whom we call a principal.Decentralized Organizations LO 12-2 Identify the advantages and disadvantages of decentraliz Decentralization is the delegation of decisionmaking authority to subordinates in the organization’s name. We find principalagent relationships in many settings. whom we call an agent . When authority is decentralized.

In many conglomerates. in effect. 12-5 . much of the information needed to make the decision is local. Local knowledge is knowledge about these local conditions. it is specific to the local conditions. The military is a good example of centralized authority. that is.LO 12-1 Decentralized Organizations Some organizations are very centralized. especially those that are geographically dispersed. operating decisions are made in the field. Good decisions require good information. In large organizations. Supporting some local variations can capitalize on local knowledge and allow franchisees to earn more than would otherwise be possible. corporate headquarters is. a holding company. few decisions are delegated. At the other extreme are highly decentralized companies in which decisions are delegated to divisional and departmental managers.

Local managers can react to a changing environment more quickly than top management can. Just as local managers have better information about local conditions. evaluation. some problems are too complex to be solved by central management. The complexity of problems that humans can solve has limits. and motivation of local managers . With centralized decision making. • Reduction of problems to manageable size .LO 12-1 Advantages of Decentralization Some of these advantages follow: • Better use of local knowledge . • Wiser use of top management’s time . delays occur while information is transmitted to decision makers. • Training. As companies grow. Top 12-6 . top managers have better knowledge about strategic issues and industry trends. Even with the aid of computers. Decentralization allows managers to receive on-the-job training in decision making. • Faster response . more and more local knowledge needs to be processed in order to manage the business.

A company must weigh the costs and benefits of decentralization and decide on an economically optimal level. 12-7 . well. One can assume that the disadvantages of decentralization for highly centralized organizations outweigh the advantages while the reverse is true for decentralized companies.LO 12-1 Disadvantages of Decentralization Decentralization Decentralization has has many many disadvantages disadvantages as as well. The The major major disadvantage disadvantage is is that that local local managers managers can can make make decisions decisions that that are are not not in in the the best best interests interests of of the the organization’s organization’s top top managers managers and and the the owners owners (shareholders). A A second second cost cost of of decentralization decentralization is is administrative administrative duplication. information. (shareholders). A A third third cost cost of of decentralization decentralization is is the the possibility possibility of of poor poor decisions decisions based based on on incomplete incomplete information. duplication.

it is important to develop a system to reduce the impact of dysfunctional decision making. which is the structure and procedures that the principals (owners) use to influence agents (managers) of the organization to implement the organization’s strategies. Once an organization has decided to decentralize. 12-8 .Framework for Evaluating Management Control Systems LO 12-3 Describe and explain the basic framework for management control systems. This system is called a management control system.

• Performance evaluation and measurement systems. • Compensation and reward systems.LO 12-3 Elements of a Management Control System • Delegated decision authority. 12-9 .

that is. However. well-functioning management control system balances these three elements and defines them consistently. The three elements are not consistent. they are not balanced. 12-10 . it cannot motivate you to make better decisions. You are the manager of a newspaper stand that is par of a national company.LO 12-3 Balancing the Elements An effective. The goal of the organization is to make money (or at least sell newspapers). As the newspaper stand manager. The purpose of the management control system is to influence you to make decisions that further the organization’s goal. you can affect that by making good decisions about the number of papers to order. because the performance measure is completely independent of your decisions.

12-11 . Responsibility accounting reports revenues and costs at the level within the organization having the related responsibility.Responsibility Accounting LO 12-4 Explain the relation between organization structure and responsibility centers.

can can be be specified specified for for each each output. such such as as direct direct materials materials and and direct direct labor. The The production production departments departments of of manufacturing manufacturing plants plants are are examples examples of of cost cost centers. output. labor. centers. inputs.LO 12-4 Cost Centers Managers Managers of of cost cost centers centers are are responsible responsible for for the the cost cost of of an an activity activity for for which which a a well well defined defined relationship relationship exists exists between between inputs inputs and and outputs. Cost Cost centers centers often often are are found found in in manufacturing manufacturing operations operations where where inputs. outputs. 12-12 .

and many other administrative and marketing departments are usually discretionary cost centers 12-13 . a discretionary cost center is established.LO 12-4 Discretionary Cost Centers When managers are held responsible for costs but the input-output relationship is not well specified. Legal. accounting. R&D. advertising.

LO 12-4 Revenue Centers Managers of revenue centers typically are responsible for selling a product. An example of a revenue center is the sportswear department of a large department store for which the manager is responsible for merchandise sales. 12-14 . Consequently. the manager is held responsible for sales price or sales activity variances.

LO 12-4 Profit Centers 12-15 .

assets. center.LO 12-4 Investment Centers Managers of of investment investment centers centers have have Managers responsibility for for profits profits and and investment investment in in assets. responsibility These managers managers have have relatively relatively large large amounts amounts of of These money with with which which to to make make capital capital budgeting budgeting and and money other decisions decisions affecting affecting the the use use of of assets. assets. in 12-16 . other Investment centers centers are are evaluated evaluated using using some some Investment measure of of profit profit related related to to the the invested invested assets assets measure in the the center.

LO 12-4 Responsibility Centers and Organization Structure Groupa vice president – Investment centers a Division vice president – Profit centers Staff managers – Discretionary cost centers Plant managers – Cost centers District sales managers – Revenue centers Group refers to a group of divisions. 12-17 .

an individual behaves in the best interests of the organization regardless of his or her own goals. 12-18 . that is.LO 12-4 Measuring Performance Total goal congruence exists when all members of an organization have incentives to perform in the common interest. In most business settings. however. personal goals and organizational goals differ. Individual goal congruence occurs when an individual’s personal goals are congruent with organizational goals. This results in behavioral congruence. Performance evaluation and incentive systems are designed to encourage employees to behave as if their goals were congruent with organization goals. This occurs when the group acts as a team in pursuit of a mutually agreed-upon objective.

risks. them. the the problems problems inherent inherent in in performance performance measurement measurement complicate complicate such such comparisons. comparisons. 12-19 . considered.Evaluating Performance LO 12-5 Understand how managers evaluate performance. businesses. In In addition. addition. When When comparing comparing the the performance performance of of investment investment centers. It It is is very very difficult difficult to to compare compare the the performance performance of of a a manufacturing manufacturing center center with with the the performance performance of of a a center center that that provides provides a a consulting consulting service service and and has has a a relatively relatively small small investment investment base. base. the the various various centers centers can can be be in in very very different different businesses. As As you you will will see. Investment Investment centers centers operating operating in in different different countries countries face face different different risks. centers. all all such such differences differences should should be be considered. A A company company often often is is tempted tempted to to compare compare the the performance performance of of its its centers centers and and even even to to encourage encourage competition competition among among them. see.

LO 12-5 Compensation Systems An An effective effective management management control control system system provides provides the the appropriate appropriate incentives incentives for for the the manager manager to to make make decisions decisions in in the the organization’s organization’s best best interests. interests. 12-20 . salary. staff. A A good good example example of of fixed fixed compensation compensation is is salary. An An example example of of contingent contingent compensation compensation is is the the commission commission paid paid to to the the sales sales staff. compensation. We We can can classify classify the the compensation compensation into into two two categories: categories: fixed fixed compensation compensation and and contingent contingent compensation. The The compensation compensation system system has has to to reward reward the the manager manager for for measured measured performance performance to to provide provide sufficient sufficient incentives incentives to to influence influence the the manager’s manager’s decisions. performance. Fixed Fixed compensation compensation is is paid paid to to the the manager manager independent independent of of measured measured performance. performance. decisions. Contingent Contingent compensation compensation is is the the amount amount of of compensation compensation that that is is paid paid based based on on measured measured performance.

Fundamental questions regarding a performance measurement system: 1. What actions might managers be taking that improve reported performance but are actually detrimental to organizational performance? 12-21 . Does the measure reflect the results of those actions that improve the organization’s performance? 2.LO 12-6 Performance Evaluation Systems Incentives LO 12-7 Understand the potential link between incentives and illegal or unethical behavior.

particularly for short-term results . This pressure is particularly acute when the bonus is a significant component of the individual’s total compensation. These pressures occur when headquarters arbitrarily determines profit objectives and budgets without considering actual conditions. 12-22 .What Pressures Can Lead to Unethical Behavior? Unrealistic budget pressures. Financial pressure resulting from bonus plans that depend on short-term economic performance .

Companies Companies set set up up internal internal control control systems systems to to deal deal with with problems problems such such as as financial financial fraud. specifically. fraud. internal internal controls controls provide provide management management with with reasonable reasonable assurances assurances that that their their company’s company’s assets assets are are protected protected and and the the company’s company’s accounting accounting is is reliable. At At aa general general level. level. reliable. More More specifically.Internal Controls LO 12-8 Understand how internal controls can help protect assets. internal internal control control is is aa process process designed designed to to provide provide reasonable reasonable assurance assurance that that an an organization organization will will achieve achieve its its objectives objectives in in the the following following categories: categories: • Effectiveness and efficiency of operations • Reliability of financial reporting • Compliance with applicable laws and regulations 12-23 .

However. these benefits come at a cost. An open question is: Do the benefits justify the costs of investing in better internal controls? 12-24 .LO 12-8 Internal Controls U. These included the large frauds and subsequent bankruptcies of Enron and WorldCom. SOX will likely cause improvements in the internal controls—and the documentation of internal controls—in many organizations.S. Congress passed the Sarbanes-Oxley Act of 2002 (SOX) in response to a large number of business and accounting scandals that came to light in 2001 and 2002.

duties. example.LO 12-8 Internal Controls Companies Companies use use many many types types of of internal internal controls controls besides besides separation separation of of duties.Prohibiting 4. prohibiting prohibiting a a company’s company’s purchasing purchasing agents agents from from accepting accepting gifts gifts from from present present and and prospective prospective vendors). example.Setting 1. 3. 2. 1. Here Here are are some some examples.Requiring management management authorization authorization for for the the use use of of a a company’s company’s assets assets (for (for example. customers). example. 4.Rotating personnel personnel and and requiring requiring employees employees to to take take vacations vacations (for (for example.Prohibiting particular particular activities activities or or behavior behavior (for (for example.Requiring 2. car). use use of of a a company company car). 5. requiring requiring the the person person who who reconciles reconciles bank bank statements statements with with the the company’s company’s cash cash accounts accounts to to rotate rotate duties duties so so someone someone else else can can check check that that the the cash cash on on the the books books 12-25 .Reconciling 3. examples.Reconciling various various sets sets of of books books (for (for example.Rotating 5. example. vendors). example. no no more more than than $100 $100 per per person person for for an an expense expense account account dinner).Setting limits limits on on the the amount amount of of expenditures expenditures (for (for example. reconciling reconciling accounts accounts receivable receivable with with the the collections collections of of cash cash from from customers). dinner).

End of Chapter 12 12-26 .