Fundamentals of Management

Control Systems

McGraw-Hill/Irwin
Chapter 12
Learning Objectives:
1. Explain the role of a management control system.

2. Identify the advantages and disadvantages of decentralization.

3. Describe and explain the basic framework for management control

systems.
4. Explain the relation between organization structure and
responsibility centers.
5. Understand how managers evaluate performance.
6. Analyze the effect of dual- versus single-rate allocation systems.
7. Understand the potential link between incentives and illegal or
unethical behavior.
8. Understand how internal controls can help protect assets.
McGraw-Hill/Irwin
The role of a management control system
LO1 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.

McGraw-Hill/Irwin
Decentralization
LO2 Identify the advantages and disadvantages of
decentralization.

The delegation to
subordinates of authority
to make decisions in the
organization’s name.

McGraw-Hill/Irwin
Decentralization, Continued. . .

Centralized Organization
Decisions are made by relatively few individuals in the
high ranks of the organizations.
Few decisions are delegated.

Decentralized Organization
Decisions are spread among relatively many divisional
and departmental managers.
Decisions are delegated to
divisional and departmental
managers.
McGraw-Hill/Irwin
Advantages of Decentralization
Better use of local knowledge:
area managers are more aware of local conditions.

Faster response:
local managers respond more quickly to changing environments.

Wiser use of top management:

higher level managers can focus on strategies and industry trends.

Reduction of problems to more manageable sizes:

by dividing large problems into smaller, more manageable parts,
decentralization reduces the complexity of problems.
McGraw-Hill/Irwin
Disadvantage of Decentralization
Dysfunctional decision making
When local managers make decisions in their interest,
which can differ from those of the organization.

Duplication of administration
Local managers make the same
types of decisions made at
headquarters.

McGraw-Hill/Irwin
 Management Control Systems
LO3 Describe and explain the basic framework for
management control systems.
A system designed to influence subordinates to act in the
organization’s interest
Used by principals (owners) to
influence agents’ (managers’)
behavior

Performance
Delegated Compensation
evaluation and
decision and reward
measurement
authority systems
systems

McGraw-Hill/Irwin
Delegated Decision Authority

A management control system

specifies what decisions the
subordinate manager can make
in the name of the
organization.

McGraw-Hill/Irwin
Performance Evaluation and Measurement

The performance evaluation

system specifies how the
performance of the subordinate
manager is to be measured and
how the results will be used in
the evaluation process.

McGraw-Hill/Irwin
Compensation and Reward Systems
A management control
system that specifies how
subordinates will be
compensated for their
performance based on stated
measures.

McGraw-Hill/Irwin
Balancing the Elements
An effective management control system balances
the following three elements:

Delegated decision authority

Performance evaluation and

measurement systems

Compensation and
reward systems

McGraw-Hill/Irwin
 Responsibility Accounting
LO4 Explain the relation between organization structure
and responsibility centers.

Responsibility accounting reports revenues and costs at

the level within the organization having the related
responsibility.

Cost Revenue
center center

Responsibility
Profit
Investment
center
center
McGraw-Hill/Irwin
Cost Center

Cost
An organization subunit responsible
center
only for costs
Managers are
responsible for cost
and volume of inputs
used to produce an
output.

McGraw-Hill/Irwin
Revenue Center

Revenue An organization subunit responsible for

center revenues and, typically, marketing costs

Managers are
responsible for selling
the product.

McGraw-Hill/Irwin
Profit Center

Profit An organization subunit responsible

center for profits and thus, revenues, costs,
production, and sales volume.

Managers are
responsible for
revenues AND costs.

McGraw-Hill/Irwin
 Investment Center

Investment An organization subunit responsible for

center profits AND investment in assets

Managers are responsible for large

amounts of money with which to make
capital budgeting and other decisions
affecting the use of assets.

McGraw-Hill/Irwin
 Responsibility Centers and Organization Structure
Organizational Structure and Responsibility Centers
Group Vice-President a
Investment centers

Division Vice-President Staff managers

Profit centers Discretionary cost centers

Plant managers District sales managers

Cost centers Revenue centers
a
Group refers to a group of divisions.

McGraw-Hill/Irwin
Goal Congruence

Agreement by all
members of a group
on a set of objectives

McGraw-Hill/Irwin
Evaluating Performance
LO5 Understand how managers evaluate performance.

Control based concept

Managers should be held
responsible for costs or
profits over which they have
decision-making authority

Relative performance evaluation (RPE)

Compares divisional performance with that of peer
group divisions
McGraw-Hill/Irwin
Compensation Systems

Fixed compensation
Not directly linked to measured
performance

Contingent compensation
Based on measured performance

McGraw-Hill/Irwin
Corporate Cost Allocation
LO6 Analyze the effect of dual- versus single-rate
allocation systems.
Global Electronics
Latin America Division
Income for the Year (in thousands)
Actual Target
Revenue $ 70,000 $ 70,000
(Percentage of corporate revenue) 16% 14%
Direct division costs1 $ 51,800 $ 51,800
Allocated corporate overhead $ 4,800 $ 3,500
Operating profit $ 13,400 $ 14,700
1
Global Electronics allocates corporate overhead based on relative revenue. Corporate
overhead was $25 million.

McGraw-Hill/Irwin
 Corporate Cost Allocation, Continued. . .
Global Electronics
Latin America Division
Income for the Year (in thousands)

Actual Target
Revenue $ 70,000 $ 70,000
Direct division costs $ 51,800 $ 51,800
My revenue and costs were
on target.

McGraw-Hill/Irwin
Corporate Cost Allocation, Continued. . .
Global Electronics
Latin America Division
Income for the Year (in thousands)
Actual Target
Revenue $ 70,000 $ 70,000
(Percentage of corporate revenue) 16% 14%
a b
Corporate revenue $ 437,500 $ 500,000

I’m not responsible for

corporate revenue.

a
$70,000/16%
b
$70,000/14%

McGraw-Hill/Irwin
Corporate Cost Allocation, Continued. . .
Global Electronics
Latin America Division
Income for the Year (in thousands)
Actual Target
Allocated corporate overhead $ 4,800 $ 3,500
(Percentage of corporate revenue) 16% 14%
a b
Corporate costs $ 30,000 $ 25,000

I’m not responsible for

corporate costs.

a
$4,800/16%
b
$3,500/14%

McGraw-Hill/Irwin
Corporate Cost Allocation, Continued. . .

Dual rate method

Cost
a cost allocation method that
separates a common cost into
Activity
fixed and variable components
and then allocates each
component using a different
allocation base

Cost
Activity

McGraw-Hill/Irwin
Performance Evaluation Systems Incentives
LO7 Understand the potential link between incentives and
illegal or unethical behavior.

1. Does the measure reflect the results of those

actions that improve the organization’s
performance?

2. What actions might managers be taking that

improve reported performance but are actually
detrimental to organizational performance?

McGraw-Hill/Irwin
What pressures can lead to unethical behavior?

Unrealistic budget pressure

HELP!!
This is
impossible

Unrealistic budget pressures, particularly for short-term

results, occur when headquarters arbitrarily determines
profit objectives and budgets without considering actual
conditions.
McGraw-Hill/Irwin
What pressures can lead to unethical behavior?
Financial Pressure
Financial pressure resulting from bonus
plans that depend on short-term economic
performance is particularly acute when the
bonus is a significant component of the
individual’s total compensation.

McGraw-Hill/Irwin
Internal Control
LO8 Understand how internal controls can help protect
assets.

Internal control is a process designed to provide reasonable

assurance that an organization will achieve its objectives in
the following categories:

Effectiveness and efficiency of operations

Reliability of financial reporting

Compliance with applicable laws and

regulations

McGraw-Hill/Irwin
Internal Control – In Practice
Internal controls are detailed methods of protecting assets
and assuring reliable information. Some examples are:

Setting limits on the amount of expenditures

Requiring authorization for the use of assets

Segregation of duties

Reconciling accounts

Rotating personnel

McGraw-Hill/Irwin
Chapter 12: END!!

Sometimes I just
don’t get it.
What do they
want?

McGraw-Hill/Irwin