Part Four: Information for planning, control & performance Chapter Sixteen: Management control systems Use with Management and Cost Accounting 8e by Colin Drury ISBN © 2012 Colin Drury

Use with Management and Cost Accounting 8e by Colin Drury ISBN © 2012 Colin Drury 16.1a Different types of controls Action (or behavioural) controls Personnel and cultural (or clan and social) controls Results (or output controls) Action (or behavioural) controls Consist of: Behavioural constraints Preaction reviews Action accountability Focus should be on prevention rather than detection controls.

Use with Management and Cost Accounting 8e by Colin Drury ISBN © 2012 Colin Drury 16.1b Social, personnel and cultural controls Social controls involve selection of people who have been socialized into adopting particular norms of behaviour. Personnel controls build on employees natural tendencies to control themselves (emphasis is on selection, training and job design). Cultural controls represent a set of values, social norms and beliefs that are shared by members of an organization and that influence their actions. In recent years there has been a greater emphasis on cultural controls in the form of employee empowerment.

Use with Management and Cost Accounting 8e by Colin Drury ISBN © 2012 Colin Drury 16.2 Results or output controls The focus is on reporting information about the outcomes of work effort. Results controls involve the following stages: 1. Establishing performance measures that minimize undesirable behaviour. 2. Establishing performance targets. 3. Measuring performance. 4. Providing rewards or punishments. Cybernetic control systems (see above diagram) Results controls resemble a cybernetic (mechanical) control system. Cybernetic systems involve feedback controls (actions after the events) but ideally control should be based on control actions before the events.

Use with Management and Cost Accounting 8e by Colin Drury ISBN © 2012 Colin Drury 16.3 Harmful side-effects of controls 1. Occurs when controls motivate employees to engage in behaviour that is not organizationally desirable (i.e. system leads to a lack of goal congruence). 2. Results controls: Encourages individuals to focus only on what is measured, regardless of whether it is organizationally desirable (see sheet 16.4) Focuses mainly on quantifiable and easily measurable items. Subject to data manipulation. Can lead to negative attitudes towards the control system. 3. Action controls: May discourage creativity 4.Cultural controls: Lack of goal congruence where group goals do not coincide with firm goals

Use with Management and Cost Accounting 8e by Colin Drury ISBN © 2012 Colin Drury 16.4 Fig.16.2 The measurement reward process with imperfect measures

Use with Management and Cost Accounting 8e by Colin Drury ISBN © 2012 Colin Drury 16.5 Advantages and disadvantages of different types of controls Personnel/cultural controls Few harmful side-effects Inexpensive to operate Appropriate only in certain circumstances Action controls Direct link between control mechanism and the action. Measurement problems do not apply. Not feasible where cause-and-effect relationships are not well understood or easily observable. Best suited to stable situations. Results controls Can be applied where knowledge of what actions are desirable is lacking. Focus is on outcomes (individual autonomy is not restricted). Subject to limitations described on slide 5.

Use with Management and Cost Accounting 8e by Colin Drury ISBN © 2012 Colin Drury 16.6 Management accounting control systems (MACS) Tend to be the predominant controls in most organizations because: 1 Monetary measure provides a means of aggregating results from dissimilar activities. 2. Profitability and liquidity are essential for company survival. 3. Financial measures enable a common decision rule to be applied. 4. Measuring results in financial terms enables managers to be given more autonomy. Responsibility accounting Responsibility accounting is a fundamental part of the MACS. Four types of responsibility centres: 1. Cost or expense centres (Two types:standard cost centres and discretionary cost centres). 2. Revenue centres 3. Profit centres 4. Investment centres

Use with Management and Cost Accounting 8e by Colin Drury ISBN © 2012 Colin Drury 16.7 MANAGEMENT CONTROL SYSTEMS The nature MACS Two core elements: 1. Formal planning processes (e.g.budgeting and long-term planning) for establishing performance expectations. 2. Responsibility accounting Responsibility accounting assigns differences from the performance target to the individual who is accountable for the responsibility centre.

Use with Management and Cost Accounting 8e by Colin Drury ISBN © 2012 Colin Drury 16.7b MACS process involves: 1. Setting performance targets. 2. Measuring performance. 3. Comparing performance against target. 4. Analysing variances and taking remedial actions. Responsibility accounting is implemented by issuing performance reports similar to that on slide 11. Issues that must be addressed by responsibility accounting include: 1. Distinguishing between controllable and non-controllable items (i.e. the controllability principle). 2. Determining how challenging the targets should be. 3. Determining how much influence managers should have in the setting of targets.

Use with Management and Cost Accounting 8e by Colin Drury ISBN © 2012 Colin Drury 16.8

Use with Management and Cost Accounting 8e by Colin Drury ISBN © 2012 Colin Drury 16.9a The controllability principle Principle advocates that it is appropriate to charge to a responsibility centre only those costs that can be influenced by the manager of the responsibility centre. Implemented by either eliminating uncontrollables or reporting controllable and uncontrollable items separately. Types of uncontrollable factors: 1. Economic and competitive factors (Because managers can respond to some of these changes most MACS do not shield managers completely from them). 2. Acts of nature (managers normally protected from them). 3. Interdependencies where outcomes are affected by other units within the organization:

Use with Management and Cost Accounting 8e by Colin Drury ISBN © 2012 Colin Drury 16.9b Adjustments for the distorting effects of uncontrollables can be made either before or after the measurement period. Adjustments before the measurement period: 1. Specify which budget line items are uncontrollable (eliminate or report separately in performance report). 2. Insurance Adjustments after the measurement period: 1. Variance analysis 2. Flexible performance standards (e.g. flexible budgeting and ex post budget adjustments) 3. Relative performance evaluations 4. Subjective performance evaluations

Use with Management and Cost Accounting 8e by Colin Drury ISBN © 2012 Colin Drury An example of flexible budgeting Budgeted activity = 20,000 units Actual activity = 24,000 units Budgeted unit variable cost =£5 Actual variable costs = £105,000 Original fixed budget Flexible budget Actual Reported cost variance 20,000 × £5 =£100,000 24,000 × £5 =£120,000 £105,000 £15,000F Ensures that managers are accountable for the conditions applying during the period and not those envisaged when the budget was set.

Use with Management and Cost Accounting 8e by Colin Drury ISBN © 2012 Colin Drury 16.11a Guidelines for applying the controllability principle Price and quantity of service controllable = Controllable expense Quantity controllable but not price = Manager accountable for difference between (actual quantity × budgeted price) and (budgeted quantity × budgeted price) Quantity and price not controllable = Non-controllable expense General principle = Hold managers accountable for performance areas you want them to pay attention to.

Use with Management and Cost Accounting 8e by Colin Drury ISBN © 2012 Colin Drury 16.11b Determining how challenging the targets should be A clearly defined quantitative goal is likely to motivate higher levels of performance. Level of budget difficulty should be related to task uncertainty. Targets must be accepted to motivate managers to achieve higher levels of performance. Literature identifies a theoretical relationship between budget difficulty, aspiration levels and performance (see slide 18). Hypothesized relationships suggest that budget level that motivates best performance is unlikely to be achieved most of the time (do not adopt punitive approach for adverse variances).

Use with Management and Cost Accounting 8e by Colin Drury ISBN © 2012 Colin Drury 16.12

Use with Management and Cost Accounting 8e by Colin Drury ISBN © 2012 Colin Drury 16.13a Arguments in favour of setting highly achievable budgets Conflict between planning and motivational purposes. Psychological benefits (e.g. achievement and self-esteem). Shields managers from adverse impact of environmental changes. Alleviates harmful side-effects of controls. Determining how much influence managers should have in setting standards Advantages of participation in the setting of performance standards: 1. Targets more likely to be accepted 2. Reduces the information asymmetry gap 3. Reduces negative attitudes and dysfunctional behaviour

Use with Management and Cost Accounting 8e by Colin Drury ISBN © 2012 Colin Drury 16.13b Empirical studies provide conflicting evidence on the effectiveness of participation. Factors influencing the effectiveness of participation: 1. Personality variables: 2. Work situation 3. Job difficulty Limitations on the positive effects of participation: 1. Budgetee has the opportunity to negotiate lower targets. 2. Depends on personality traits and work situation. 3. A top down approach may be preferable where a large number of similar units exist.

Use with Management and Cost Accounting 8e by Colin Drury ISBN © 2012 Colin Drury 16.14a Side-effects arising from using accounting information for performance evaluation Hopwood observed three different styles of managerial use of accounting information for performance evaluation: 1. A budget-constrained style 2. A profit-conscious style 3. A non-accounting style Hopwood’s findings Style of evaluation Budget-Profit-Non- constrained conscious accounting Involvement with costs High High Low Job-related tension High Medium Medium Manipulation of accounting information Extensive Little Little Relations with superior Poor Good Good Relations with colleagues Poor Good Good

Use with Management and Cost Accounting 8e by Colin Drury ISBN © 2012 Colin Drury 16.14b Otley replicated Hopwood’s study and found no significant differences in terms of budget-constrained and profit-conscious styles in terms of undesirable behaviour. Conflict in findings attributed to differences in managerial interdependency and task uncertainty.