Chapter 22Control: The Management Control Environment

Alex Co

Betina Jareno

Management Control

• This chapter addresses the control process and the use of accounting information in that process.

• “strategy formulation” develops strategies to attain an organization’s goals.

• “Where do you want to go?”

• “How do you want to get there?”

• Strategies change whenever a new opportunity or a new threat is perceived.

Management Control Process

• Seeks to assure that the strategies are implemented.

• Process by which managers influence members of the organization to implement the organization’s strategies efficiently and effectively.

• Includes planning.

Two Parts of Planning

• A statement of objectives.

• Resources required to achieve those objectives.

Goals and Objectives

GOALS OBJECTIVES

• Broad, usually non-quantitative, long run plans relating to the organization as a whole.

•More specific, often quantitative, shorter run plans for individual responsibility centers.

The Environment

• Four facets of the management control environment:

• Nature of organizations.

• Rules, guidelines and procedures that govern the actions of the organization’s members.

• The organization’s culture.

• External environment.

The Nature of Organizations

• Organization: a group of human beings who work together for one or more purposes.

• Managers or the management: Leaders who perform important tasks.

Tasks of Management

• Determining goals.

• Determining objectives to achieve the goals.

• Communicating goals and objectives.

• Determining tasks to be performed to achieve objectives.

• Coordination.

• Matching individuals to tasks.

• Motivating.

• Observing/monitoring employee performance.

• Taking corrective action as needed.

Organization Hierarchy

• Layers of management with authority running from top to bottom.

• Organization chart.

• Categorized concept subordination of entities that work together to contribute to serve one aim.

• Provides leadership, direction, and division of labor.

Organization Chart

Rules, Guidelines, and Procedures

• Influence the way members behave.

•Written, or verbal; formal, or informal.

Culture

•Norms of behavior determined by:

• Tradition.

• External influences.

• Attitudes of senior management and the board of directors (BOD).

External Environment

• Everything outside of the organization itself.

• E.g., customers, suppliers, competitors, regulatory agencies.

Responsibility Centers and Responsibility Accounts

Responsibility Centers

Responsibility Accounting

• The Management Accounting Construct that deals with both planned and actual accounting information about the inputs and outputs of a responsibility center.

Responsibility Accounting

• Lame Man’s term: It shows if you hit your work quota for the year.

• This definition is not limited to sales.

• You usually know whether you’re doing your job when your boss recognizes you.

• Sales Department

250,000 worth of goods 20,000 selling expenses 600,000 sales target for the year (500,000 units)

• Production Department

150,000 worth of raw materials 50,000 processing cost 250,000 cost of production (500,000 units)

Responsibility Centers

• Commonly perform work related to several products.

• Inputs to a responsibility center are called cost elements or line items (on a department cost report).

• Costs have three different dimensions:

Dimensions of Costs

• Responsibility center. Where was cost incurred?

• Product dimension. For what output was the cost incurred?

• Cost element dimension. What type of resource was used?

Limitations of Actual Costs Compared to Standard

• Not an accurate measure of efficiency for at least 2 reasons:

• Recorded costs are not precisely accurate measures of resources consumed.

• Standard are at best only approximate measures of what resource consumption ideally should have been in the circumstances prevailing.

Terms in Responsibility

Accounting• Line Items

• Effectiveness

• Efficiency

Effectiveness and Efficiency

Effectiveness Efficiency

• How well the responsibility center does its job.

• The amount of output per unit of input.

• Lower cost is more efficient• More output (e.g. sales) is more effective.

Types of Responsibility Centers

• Revenue Center

• Expense Center

• Profit Center

• Investment Center

Revenue Center

• Responsible for outputs of center as measured in monetary terms (revenues).

• Not responsible for the costs of goods or services that the center sells.

• E.g., sales organization.

• Also responsible for selling expenses (e.g., travel, advertising, point-of-purchase displays, sales office salaries, rent).

Expense Centers

• Responsible for expenses (i.e., the costs) incurred but does not measure its outputs in terms of revenues.

• E.g., production departments, staff units such as accounting.

Standard or Engineered Cost Center

• Expense center for which many of its cost elements have standard costs established.

•Differences between standard costs and actual costs are variances.

• E.g., production cost centers, fast food restaurants, and blood testing laboratories.

Discretionary Expense Center

• Also called managed cost center.

•Difficult to measure output in monetary terms.

• Production support and corporate staff.

• E.g., human resources, accounting, R&D.

Profit Center

• If a performance is measured by the revenue it earns and the expenses it incurs, this is the classification of that responsibility center.

• Resembles a business on its own – it has its own income statement.

Profit Center (Criteria)• If the center involves extra record keeping

• If the manager of the center has no deciding authority on quantity and quality in relation to costs.

• If senior management requires the center to use the services of another responsibility center

• If outputs are homogeneous

• If the center puts managers in business for themselves, which promotes freedom and competition

Terms to Remember

• Transfer-price

•Market-based transfer price

• Cost-based transfer price

Transfer Prices

• Price at which goods or services are sold between responsibility centers within a company.

• Revenue for selling center and cost for the receiving center.

• 2 general types of transfer prices:

• Market based price.

• Cost based price.

Market-based Transfer Prices

• Based on price for same product between independent parties, i.e., a market price or, equivalently, an arm’s length price.

• Adjusted for quantifiable differences such as credit costs.

• Where available is widely used.

• Frequently not available.

Cost-Based Transfer Prices

• When no reliable market price is available.

• Cost plus a mark-up.

• If based on actual cost, little incentive to reduce costs.

Transfer Pricing Issues

• Negotiated by responsibility centers or set/arbitrated by top management.

• Should manager have freedom to use alternative source?

• Sub-optimization: maximize profits for a responsibility center may not maximize profit for the consolidated company.

Investment Center

•Managers are held responsible for the use of assets as well as for profit.

• Performance is measured by RESIDUAL INCOME

Measures of Performance

• Return on investment = Profit/Investment

• Return on assets = (net income) / (total assets).

• Split between ROS and Asset Turnover

• Residual income = Pre-interest profit – (Capital charge * investment)

Residual Income

• A.K.A. Economic Profit, Economic Value Added

• Residual Income = (How much you want to earn + Interest expense) – (Cost of capital + Money that you put in)

Residual Income

• Residual income = Income before taxes less a capital charge.

• Capital charge is calculated by applying a rate to the investment center’s assets or net assets.

Advantage of Residual Income

over ROI

Advantage of ROI Over Residual

Income:

• Encourages managers to make all investments whose return is greater than the capital cost rate.

• ROI measures are ratios that can be used to compare investment centers of different sizes.

• Residual income is an internal number that is not reported to shareholders and other outsiders.

Investment Center Issues

• Asset allocation between centers.

• How to value assets (e.g., historical cost or replacement cost).

• Managers focus their day-to-day efforts on managing current assets, particularly inventories and receivables.

•Most companies control investments in fixed assets using capital investment (i.e., capital budgeting) procedures addressed in Chapter 27.

Non-monetary Measures

• Non-monetary as well as monetary objectives.

• E.g., Quality of goods or services, customer satisfaction.

• Management by objectives (MBO) and Balanced Scorecards in Chapter 24.