Chapter 12
Fundamentals of Management Control Systems
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.
Chapter Overview
I. WHY A MANAGEMENT CONTROL SYSTEM?
• Alignment of Managerial and Organizational Interests
• Evolution of the Control Problem: An Example
II. DECENTRALIZED ORGANIZATIONS
• Why Decentralize the Organization?
• Advantages of Decentralization
• Disadvantages of Decentralization
III. FRAMEWORK FOR EVALUATING MANAGEMENT CONTROL SYSTEMS
IV. DELEGATED DECISION AUTHORITY: RESPONSIBILITY ACCOUNTING
• Cost Centers
• Discretionary Cost Centers
• Revenue Centers
• Profit Centers
• Investment Centers
• Responsibility Centers and Organization Structure
V. MEASURING PERFORMANCE
• Two Basic Questions
• Cost Centers
• Revenue Centers
• Profit Centers
• Investment Centers
VI. EVALUATING PERFORMANCE
VII. COMPENSATION SYSTEMS
Chapter Overview, continued
VIII. ILLUSTRATION: CORPORATE COST ALLOCATION
• Incentive Problems with Allocated Costs
• Effective Corporate Cost Allocation System
IX. DO PERFORMANCE EVALUATION SYSTEMS CREATE INCENTIVES TO
COMMIT FRAUD?
LO 12-1 Explain the role of a management control system.
WHY A MANAGEMENT CONTROL SYSTEM?
• Alignment of Managerial and Organizational Interests
o An important but generally implicit assumption in our discussion so far is that if the
manager receives better information, he or she will make better decisions.
o The purpose of the management control system is to align more closely the interests of
the manager and the interests of the organization.
• Evolution of the Control Problem: An Example
o When business is growing and professional managers are hired to handle new product
development, deploy a distribution network, promote products, and so on, the decisions
they make are no longer guaranteed to benefit the organization.
DECENTRALIZED ORGANIZATIONS
• The primary managerial function is decision making.
o Decentralization is the delegation of decision-making authority in the organization’s
name to subordinates.
o When authority is decentralized, a superior (called a principal) delegates duties to a
subordinate (called an agent). This is known as the principal-agent relationship.
Centralization: Concentration of decision-
making authority at the top
Decentralization: Decision-
making authority permeates the
organization
LO 12-2 Identify the advantages and disadvantages of decentralization.
• Why Decentralize the Organization?
o Being centralized describes those organizations in which decisions are made by a
relatively few individuals in the high ranks of the organization.
o At the other extreme, being decentralized describes those organizations in which
decisions are spread among relatively many divisional and departmental managers.
• Advantages of Decentralization
o The larger and more complex an organization is, the more advantages decentralization
offers.
o Advantages of decentralization include:
▪ Better use of local knowledge. By delegating decision authority to local managers, top
managers are delegating decisions to the managers more likely to possess this local
knowledge.
▪ Faster response. Local managers can react to a changing environment more quickly
than top management can.
• Disadvantages of Decentralization
o Disadvantages of decentralization include:
▪ The major disadvantage is that local managers can make decisions that are not in the
best interests of the organization’s top managers and the owners (shareholders).
• Dysfunctional decision making arises when decisions made in the interests of
local managers that are not in the interests of the organization.
• Decentralized organizations incur the costs:
Even with the best of intentions and with aligned incentives to pursue what is
best for the business unit and the firm, incomplete information can make it
difficult to make decisions that have global consequences on the basis of local
information alone.
o The advantages (disadvantages) of centralization mirror the disadvantages (advantages)
Decision Making”).
LO 12-3 Describe and explain the basic framework for management control
systems.
FRAMEWORK FOR EVALUATING MANAGEMENT CONTROL SYSTEMS
• A management control system is the structure and procedures that the principals (owners)
use to influence agents (managers) of the organization to implement the firm’s strategies.
o It is a system to influence subordinates to act in the organization’s interests.
• Organizational Environment and Strategy
o Decentralization necessitates the development of a management control system to reduce
the impact of dysfunctional decision making.
• Results of the Management Control System
• Elements of a Management Control System
o Organizational economics is the study of how firms are structured and operated. From
the organizational economics literature, management control systems consist of three
elements:
o Delegated Decision Authority
▪ Delegated decision authority is the specification of the authority to make decisions
in the organization’s name. This is the essence of decentralization.
o Performance Evaluation and Measurement Systems
▪ Performance evaluation and measurement system is a system that specifies how
the performance of the subordinates will be measured and how the results of the
measurement will be used in evaluating the subordinates. Performance measures do
not have to be financial or objective.
• Balancing the Elements
o An effective, well-functioning management control system balances these three elements
and defines them consistently.
LO 12-4 Explain the relation between organization structure and
responsibility centers.
DELEGATED DECISION AUTHORITY: RESPONSIBILITY ACCOUNTING
• Responsibility accounting is a system of reporting tailored to an organizational structure so
that costs and revenues are reported at the level within the organization having the related
responsibility.
o The five basic kinds of decentralized units are cost centers, discretionary cost centers,
revenue centers, profit centers, and investment centers.
▪ The responsibility accounting classification is useful because it suggests the type of
performance measure appropriate for a center.
• Cost Centers
o Managers of cost centers are responsible for the cost of an activity for which a well–
defined relationship exists between inputs and outputs.
▪ A cost center is an organization subunit responsible only for costs.
▪ A standard cost center is an organization subunit whose manager is held responsible
for costs and in which the relationship between costs and outputs is well defined.
• Discretionary Cost Centers
o When managers are held responsible for costs but the input-output relationship is not well
specified, a discretionary cost center is established.
▪ A discretionary cost center is an organization subunit whose manager is held
responsible for costs when the relationship between costs and outputs is not well
established.
• Revenue Centers
o Managers of revenue centers typically are responsible for selling a product.
▪ A revenue center is an organization subunit responsible for revenues and typically,
marketing costs.
▪ Managers of revenue centers are responsible for selling a product and its associated
sales price or sales activity variances.
• Profit Centers
o Managers of profit centers are held accountable for profits.
• Investment Centers
o Managers of investment centers have responsibility for profits and investment in assets.
• Responsibility Centers and Organization Structure
o Exhibit 12.1 shows the relationship between organizational structure and responsibility
centers.
MEASURING PERFORMANCE
• Total goal congruence exists when all members of an organization have incentives to
perform in the common interest.
o Goal congruence occurs when the group acts as a team in pursuit of a mutually agreed
upon objective.
o Individual goal congruence occurs when an individual’s personal goals are congruent
with organizational goals.
• Behavioral congruence exists when individuals behave in the best interest of the
organization regardless of their own goals.
o Some managers may have incentives to not take risks that might benefit the firm; other
managers may have incentives to take excessive risks that can threaten the existence of a
firm.
▪ Although such conflicts cannot be totally removed, they can be minimized if they are
recognized.
• Two Basic Questions
o Managers must address two questions when designing their performance evaluation
systems:
• Cost Centers
o The performance of cost centers is typically measured based on the costs incurred.
o It is often more difficult to define performance measures for discretionary cost centers,
which include research and development, accounting, and so on, because it is difficult to
tie costs to output.
▪ For discretionary cost centers, the relationship between costs and output is not clear
and the performance measures are difficult to define. Therefore, it is difficult to
provide incentives for employees to perform at the levels that best achieve
organization goals. For the same reason, it is difficult to evaluate the performance of a
discretionary cost center manager.
Such situations invite suboptimal behavior. Managers have incentives to
spend all of their budgets even if some savings could be achieved in order to
support their request for the same or higher budgets in the following year. The
quality of services provided and their costs are not clearly linked.
• Ideally, performance should be measured in a well-specified way by comparing
actual inputs to standard inputs in a cost center. It is very difficult and costly,
however, to measure the performance of the manager and workers in a
discretionary cost center.
• Revenue Centers
o For revenue centers, the obvious performance measure is the amount of revenue earned.
• Profit Centers
o In profit centers, we encounter the usual problems related to measuring profits for the
company as a whole plus an important additional one: How are the company’s revenues
and costs allocated to each profit center?
▪ A profit center that is totally separate from all other parts of the company operates
like an autonomous company. The profits of that type of center can be uniquely
identified with it.
o There are no easy ways to determine how to measure performance in a profit center.
Much is left to managerial judgment.
• Investment Centers
o Effective performance measures for investment centers (commonly called business units)
combine both a measure of profit and a measure of asset usage, a topic to be covered in
Chapter 14.
LO 12-5 Understand how managers evaluate performance.
EVALUATING PERFORMANCE
• Relative Performance Versus Absolute Performance Standards
o Performance measurement is followed by performance evaluation.
ones. This is known as the absolute performance evaluation.
• Evaluating Managers’ Performance versus Economic Performance of the Responsibility
Center
o The evaluation of a manager is not necessarily identical to the evaluation of the cost,
profit, or investment center.
▪ As a general rule, managers are evaluated based on a comparison of actual results to
targets. A manager who meets or exceeds that target would be rewarded.
• However, top management would also like to reward the manager who performs
well in an adverse situation.
o Today, the controllability concept is widely used as a basis for managerial performance
evaluation.
As a general rule, evaluating the manager on the basis of performance targets
overcomes this problem. The new manager establishes a plan for operating the
division and works with top management to set targets for the future. Those
targets are compared to actual results as the plan is enacted, and the manager
is evaluated based on those results.
• Relative Performance Evaluations in Organizations
o When the responsibility centers are homogeneous in the sense that they are of the same
level, in the same line of business, located in similar geographic areas, facing similar risk
factors, or operating in similar product markets, etc., a company can compare the
performance of its centers and even encourage competition among them. This is known
as the relative performance evaluation (RPE).