Fundamentals of Management Control SystemsChapter 12Copyright 2011 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin

Alignment of Managerial and Organizational InterestsL.O. 1Explain the role of a management control system. A management control system is designedto help managers make decisions that willincrease the organizations performance.12 - *

Decentralized OrganizationsL.O. 2Identify the advantages and disadvantages of decentralization. Decentralization is the delegation tosubordinates of authority to makedecisions in the organizations name.12 - *

Advantages of DecentralizationLO2 Better use of local knowledge Faster response Wiser use of top managements time Reduction of problems to more manageable size Training, evaluation, and motivation of local managers12 - *

Disadvantages of DecentralizationLO2 Dysfunctional decision making:Local managers can make decisions in their interest,which can differ from those of the organization. Duplication of administration:Local managers make the same types of decisionsmade at headquarters.12 - *

Management Control SystemL.O. 3Describe and explain the basic frameworkfor management control systems. It is a system designed to influence subordinatesto act in the organizations interest. Principals (owners) use this system to influenceagents (managers) behavior.12 - *

Elements of a ManagementControl SystemLO3 Delegated decision authority Performance evaluation and measurement systems Compensation and reward systems12 - *

Responsibility AccountingL.O. 4Explain the relation between organizationstructure and responsibility centers. Responsibility accounting reports revenuesand costs at the level within the organizationhaving the related responsibility.12 - *

Evaluating PerformanceL.O. 5Understand how managers evaluate performance. Controllability concept:Managers should be held responsiblefor costs or profits over which they havedecision-making authority. Relative performance evaluation (RPE):Compares divisional performance with thatof peer group divisions12 - *

Corporate Cost AllocationL.O. 6Analyze the effect of dual- versus single-rate allocation systems.12 - *

Corporate Cost AllocationLO612 - *

Corporate Cost AllocationLO6Global ElectronicsLatin America DivisionIncome for the Year ($000)Revenue(Percentage of corporate revenue)Corporate revenue$ 70,000 16%$437,500a$ 70,000 14%$500,000bActualTargeta $70,000 16%b $70,000 14%12 - *

Corporate Cost AllocationLO6Global ElectronicsLatin America DivisionIncome for the Year ($000)Allocated corporate overhead(Percentage of corporate revenue)Corporate costs$ 4,800 16%$30,000a$ 3,500 14%$25,000bActualTargeta $4,800 16%b $3,500 14%12 - *

Corporate Cost AllocationLO6 Dual rate method:This is a cost allocation method that separatesacommon cost into fixed and variable componentsand then allocates each component using adifferent allocation base.12 - *

Chart1

25252525

25252525

25252525

25252525

25252525

Total Fixed Cost

Total Fixed Cost

Total Fixed Cost

Total Fixed Cost

Activity Level

Cost

Sheet1

01234

Total Fixed Cost2525252525

Chart1

25

25

25

25

25

Total Fixed Cost

Activity Level

Cost

Sheet1

01234

Total Fixed Cost2525252525

Performance EvaluationSystems IncentivesL.O. 7Understand the potential link between incentivesand illegal or unethical behavior. Fundamental questions regarding a performancemeasurement system: Does the measure reflect the results of those actionsthat improve the organizations performance? What actions might managers be taking that improvereported performance but are actually detrimental toorganizational performance?12 - *

Internal ControlsL.O. 8Understand how internal controls can help protect assets. Internal control is a process designed to providereasonable assurance that an organization willachieve its objectives in the following categories: Effectiveness and efficiency of operations Reliability of financial reporting Compliance with applicable laws and regulations12 - *

End of Chapter 12Copyright 2011 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin

In the previous chapters we considered how information could be developed to help managers make decisions.In this chapter we will discuss the fundamentals of management control systems. *A management control system is designed to influence subordinates to act in the organizations interest.*In a decentralized organization, subordinates have the authority to make decisions in the organizations name. The more decentralized the organization, the further down the organization chart decisions are made.*Moving the decision-making authority to lower levels of management has some advantages. Local managers close to the decision in question have information about the conditions related to the decision and can react more quickly than top managers who may be removed from the information. Allowing the managers close to the issues to make decisions results in job satisfaction for the managers. Also, having local managers make some decisions frees top managers time allowing them to focus on strategically related issues.*However, when local managers make decisions in their interest, those decisions may not be in the interest of the organization. There may also be some duplication of efforts if the same types of decisions are being made at headquarters.*In a decentralized organization it is critical that the management control system is designed to influence subordinates to act in the organizations interest rather than their own.*An effective management control system must allow for delegation of decision authority, performance and evaluation measurement, and compensation and reward systems.*In responsibility accounting, costs and revenues are reported at the level within the organization having the related responsibility. Four types of responsibility centers exist: cost centers, revenue centers, profit centers, and investment centers.*When evaluating managers performance, managers should only be held responsible for costs or profits over which they have decision-making authority.*From previous chapters, we understand that indirect costs must be allocated for product pricing decisions and other management decisions. However, lets look at what happens when costs, which a manager has no control over, are allocated to the managers division. Look at the Latin America Division of Global Electronics where managers are rewarded based on the operating profits of their division. This is one confused manager. Operating profit was $1,300,000 less than target.*Targeted revenues of $70,000,000 and targeted direct costs of $51,800,000 were met. The manager did exactly what was planned.So, why is the manager not rewarded accordingly?*Well, corporate revenue was targeted at $500,000,000 of which the $70,000,000 for the Latin America Division was 14%. Therefore, 14% of indirect costs from corporate overhead were targeted to be allocated to the Latin America Division. However, actual corporate revenue was only $437,500,000 indicating some other division or divisions did not meet targeted revenue, and so the Latin America Divisions revenue was 16% rather than 14% of total corporate revenue. Now the Latin America Division is going to be allocated 16% rather than 14% of corporate overhead. Poof, the Latin America Division does not meet targeted profit!*How can the manager of the Latin America Division be penalized because other managers did not meet target?You see the importance of responsibility accounting and goal congruence here.*When using a dual rate method for allocating corporate costs, the organization separates variable and fixed corporate costs. The costs that vary with activity are allocated based on activity. For example, as activity in the Latin America Division changes, the amount of cost allocated changes. In this case, the actual activity was the same as targeted, so the amount allocated would be the same as the amount targeted. However, the fixed costs that the manager has no control over are allocated as originally targeted. The change in activity at the corporate level does not affect the cost allocated to the Latin America Division.*A performance measurement system should identify what actions can improve the reported performance of the organization and reflect the results of those actions. The system should be structured so that managers have no reason or incentive to use illegal or unethical behavior to improve their performance evaluation and, therefore, their reward.*Internal control is a process which provides top management and investors reasonable assurance that an organization will be effective and efficient, provide reliable financial reporting, and comply with the applicable laws and regulations.**