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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.
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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?
III. FRAMEWORK FOR EVALUATING MANAGEMENT CONTROL SYSTEMS
• Organizational Environment and Strategy
• Results of the Management Control System
• Elements of a Management Control System
o Delegated Decision Authority
o Performance Evaluation and Measurement Systems
o Compensation and Reward Systems
• Balancing the Elements
IV. DELEGATED DECISION AUTHORITY: RESPONSIBILITY ACCOUNTING
• Cost Centers
• Discretionary Cost Centers
V. MEASURING PERFORMANCE
• the Two Basic Questions
• Cost Centers
• Revenue Centers
• Profit Centers
• Investment Centers
VI. EVALUATING PERFORMANCE
• Relative Performance Versus Absolute Performance Standards
• Evaluating Managers’ Performance Versus Economic Performance of the
Responsibility Center
• Relative Performance Evaluations In Organizations
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?
X. INTERNAL CONTROLS TO PROTECT ASSETS AND PROVIDE QUALITY
INFORMATION
• Internal Auditing
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Chapter Outline
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
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.
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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.
o The majority of companies fall between these two extremes. For example, a company
may maintain centralized control over financing and R&D while decentralize operating
decisions among business units.
▪ Local knowledge is knowledge about local conditions, markets, regulations, etc.
• Advantages of Decentralization
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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.
▪ Wiser use of top management’s time. Delegation of many decisions allows top
managers to focus on strategic issues.
• 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:
▪ Often in decentralized firms, there are offices and managers making the same
decisions being made at headquarters; administrative duplication results.
• While local information creates a benefit to local decision making, many
decisions made at the local level also affect other parts of the firm.
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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)
of decentralization.
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
o A successful management control system results in higher organization.
o The “right” management control system will lead to the attainment of the organization’s
goals as articulated in its strategy.
• 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:
▪ Delegated decision authority
▪ Performance evaluation and measurement systems
▪ Compensation and reward systems
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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
o Compensation and Reward Systems
▪ The compensation and reward system defines the specification of how the
subordinates will be compensated for their performance based on a stated measure of
performance.
• 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
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o The five basic kinds of decentralized units are cost centers, discretionary cost centers,
revenue centers, profit centers, and investment centers.
• 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.
• Cost centers are often found in manufacturing operations where inputs can be
specified for each output. The concept has been applied to nonmanufacturing
settings as well.
• 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.
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• Revenue Centers
o Managers of revenue centers typically are responsible for selling a product.
• 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.
▪ An investment center is an organization subunit responsible for profits and for
investment in assets.
• Responsibility Centers and Organization Structure
o Exhibit 12.1 shows the relationship between organizational structure and responsibility
centers.
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MEASURING PERFORMANCE
• Total goal congruence exists when all members of an organization have incentives to
perform in the common interest.
• 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.
• The Two Basic Questions
o Managers must address two questions when designing their performance evaluation
systems:
▪ Does the measure reflect the results of those actions that improve the organization’s
performance?
▪ What actions might managers be taking to improve reported performance but are
actually detrimental to organizational performance?
o Ideally, organization managers should design performance evaluation systems to reward
people when they do the right thing. At the most basic level, managers should design
systems that do not punish people for doing the right thing. (See Business Application
box “Teacher Pay and Student Performance.”)
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• 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.
• Companies have tried numerous methods to determine appropriate relationships
between discretionary costs and activity levels and to compare these costs and
activity levels with other firms.
• Relating costs to activity levels remains primarily a matter of management
judgment or discretion. Consequently, managers of discretionary cost centers are
typically given a budget and instructed not to exceed it without higher-level
authorization.
• Revenue Centers
o For revenue centers, the obvious performance measure is the amount of revenue earned.
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• 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
LO 12-5 Understand how managers evaluate performance.
EVALUATING PERFORMANCE
• Relative Performance Versus Absolute Performance Standards
o Performance measurement is followed by performance evaluation.
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• 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.
o Today, the controllability concept is widely used as a basis for managerial performance
evaluation.
▪ The controllability concept is the idea that managers should be held responsible for
costs or profits over which they have decision-making authority.
▪ An interesting problem arises in implementing this concept in a currently operating
division. How does one evaluate the performance of a manager who takes over an
existing division whose assets, operating structure, and markets are established prior
to the manager’s arrival at the helm?
• 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).
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▪ The evaluation of a manager is not necessarily the same as the evaluation of the
responsibility center in which the manager is in charge. As a general rule, managers
are evaluated based on a comparison of actual results to performance targets.
COMPENSATION SYSTEMS
• An effective management control system provides the appropriate incentives for the manager
to make decisions in the organization’s interest.
o Compensation can be classified into two categories:
▪ Fixed compensation is paid to the manager independent of measured performance.
• An important design feature of the management control system is the mix of fixed and
contingent compensation. (See Business Application box “Beware of the Kink.”)
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o Example: A compensation system for a salesperson that includes both the fixed and the
contingent components may be represented by the following formula.
Total Compensation = Salary + Commission
= Salary + p
(Actual sales achieved – Target sales volume)
LO 12-6 Analyze the effect of dual- versus single-rate allocation systems.
ILLUSTRATION: CORPORATE COST ALLOCATION
• If cost allocations are used in part to measure performance, the cost accountant has to
consider the role of cost allocation in the management control system.
• Incentive Problems With Allocated Costs
• Effective Corporate Cost Allocation System
o An effective cost allocation system ensures that the performance of managers who have
decision-making authority over factors that affect the costs will be measured by the costs.
o The dual-rate method is the cost allocation method that separates a common cost into
fixed and variable components and then allocates each component using a different
allocation base.
▪ Under a dual-rate method, fixed and variable costs are allocated using different
allocation bases.
▪ Important points ab out the dual-rate method include:
• First, the fixed costs could be allocated in any way as long as it is done the same
way for the target and for the actual computation of operating profit. The system
See Demonstration Problem
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LO 12-7 Understand the potential link between incentives and illegal or
unethical behavior.
DO PERFORMANCE EVALUATION SYSTEMS CREATE INCENTIVES TO COMMIT
FRAUD?
• If high-pressure performance evaluation systems are adopted, the pressure motivates
employees to perform. The pressure may also drive employees to commit fraud, taking
actions that not only are not in the interest of the company financially, but also illegal or
unethical.
▪ A frequent incentive for fraud in financial reporting was the desire to improve a
company’s financial appearance to obtain a higher stock price or escape a penalty for
poor performance.
▪ Examples of pressures that may lead to financial fraud include:
o Companies’ emphasis on short-term results motivates managers to take a chance on the
future to make the current period look good.
o A large and widely decentralized organization depends on local managers for their
superior local knowledge and may prevent top management from gaining information
about local activities which are fraudulent.
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LO 12-8 Understand how internal controls can help protect assets.
INTERNAL CONTROLS TO PROTECT ASSETS AND PROVIDE QUALITY
INFORMATION
• At a general level, internal controls provide management with reasonable assurances that
their company’s assets are protected and that the company’s accounting is reliable.
o Internal control is a process designed to provide reasonable assurance that an
organization will achieve its objectives in the following categories:
o The Sarbanes-Oxley Act of 2002 requires that management of publicly traded companies
report on the adequacy of their internal controls over financial reporting. It also requires
the company’s external auditors attest to the effectiveness of the internal controls in place.
▪ One key control is separation of duties, which means that no one person has control
over an entire transaction (e.g., one person should not make the sale, prepare the
invoice, deposit the cash payment, and reconcile the bank statement to the company’s
books).
• Employees can collude to beat the internal control systems.
▪ Companies use many types of internal controls besides separation of duties, such as
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• Internal Auditing
o Internal auditors monitor internal controls.
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Matching
A.
Behavioral congruence
N.
B.
Centralized
O.
C.
Compensation and reward system
P.
D.
Contingent compensation
Q.
E.
Controllability concept
R.
F.
Cost center
S.
G.
Decentralization
T.
H.
Decentralized
U.
I.
Delegated decision authority
V.
J.
Discretionary cost center
W.
K.
Dual-rate method
X.
L.
Dysfunctional decision making
Y.
M.
Fixed compensation
Z.
_____ 1. Delegation of decision-making authority to a subordinate.
_____ 2. Information about local conditions, markets, regulations, and so on.
_____ 3. Decisions made in the interests of local managers that are not in the interests of the
organization.
_____ 4. Alignment of individual behavior with the best interests of the organization regardless
of the individual’s own goals..
_____ 5. Organization subunit responsible only for costs.
_____ 6. Organization subunit responsible for profits and thus responsible for revenues, costs,
production, and sales volumes.
_____ 7. Cost allocation method that separates a common cost into fixed and variable
components and then allocates each component using a different allocation base.
_____ 8. Compensation that is based on measured performance.
_____ 9. A process designed to provide reasonable assurance that an organization will achieve
its objectives.
_____ 10. No one person has control over an entire transaction.
_____ 11. Organization subunit responsible for profits and investment in assets.
_____ 12. Organization subunit whose managers are held responsible for costs where the
relationship between costs and outputs is not well established.
_____ 13. Describes those organizations in which decisions are made by a relatively few
individuals in the high ranks of the organization.
_____ 14. Idea that managers should be held responsible for costs or profits over which they
have decision-making authority.
_____ 15. System that specifies how the subordinate will be compensated for his or her
performance based on a stated measure of performance.
_____ 16. Describes those organizations in which decisions are spread among relatively many
divisional and departmental managers.
_____ 17. Compensation that is not directly linked to measured performance
_____ 18. System to influence subordinates to act in the organization’s interests.
_____ 19. Specification of the authority to make decisions in the organization’s name.
_____ 20. Agreement by all members of a group on a common set of objectives.
_____ 21. System and specification of how the subordinate will be evaluated.
_____ 22. Organization subunit whose managers are held responsible for costs and in which the
relationship between costs and output is well defined.
_____ 23. 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.
_____ 24. Relationship between a superior and a subordinate.
_____ 25. Organization subunit responsible for revenues and, typically, marketing costs.
_____ 26. Managerial evaluation method that compares divisional performance with that of peer
group divisions (i.e., divisions operating in similar product markets).
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Matching Answers
1. G
Multiple Choice
1. Which of the following represent a principal-agent relationship?
a. Patient and dentist
b. Worker A and worker B
c. Client and lawyer
d. Both a and c
2. The management control system includes
a. Delegation of decision rights
b. Commitments
c. Pricing decisions
d. Capital budgeting
3. An advantage of decentralization is that it:
a. Pays attention to the company as a whole.
b. Does not waste any of corporate resources.
c. Improves employee morale.
d. Benefits smaller, regulated companies.
4. Decentralization:
a. Takes advantage of local knowledge.
b. Delays response to local problems.
c. Reduces dysfunctional decision-making.
d. Gives top management more control.
5. Delegation of decision authority:
a. Is the essence of decentralization.
b. Is followed by performance evaluation and compensation.
c. Is part of management control system.
d. All of the above.
6. A manager in charge of research and development is likely to be heading a:
a. Revenue center.
b. Profit center.
c. Standard cost center.
d. Discretionary cost center.
7. The manager of a profit center is responsible for all of the following except:
a. Sales revenue.
b. Corporate overhead.
c. Production costs.
d. Marketing costs.
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8. Which of the following statements is correct?
a. When diverse centers exist, management frequently establishes the same target level of
performance for all centers.
b. It is safe to assume that, if the manager is willing to work for the organization, he or she
should be paid more.
c. Managers should be held responsible for costs or profits over which they have decision
making authority.
d. The compensation system cannot be used to align better the risk preferences of the
manager and the firm.
9. Which of the following represents an example of relative performance evaluation?
a. Actual vs. budgeted divisional income
b. Division A income vs. Division B income
c. This year’s income vs. last year’s income
d. Actual vs. standard costs
10. A dual rate method:
a. Allocates costs by separating a common cost into fixed and variable components.
b. Each cost component has a different allocation base and an allocation rate.
c. Transforms variable cost into fixed cost for decision making purpose.
d. Both a and b.
11. If high-pressure performance evaluation systems are adopted:
a. The pressure motivates employees to perform.
b. The pressure is concentrated in middle managers.
c. Fraudulent financial reporting is less likely to occur.
d. There is a desire to stick with the accounting standards.
12. Internal control:
a. Is designed to provide absolute assurance of achieving organization’s goals.
b. Is the responsibility of factory foremen.
c. Helps protect a company’s assets.
d. Is optional for publicly traded companies.
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Multiple Choice Answers
1. d (LO1)
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Demonstration Problem
Archery Equipment Corporation (AEC) manufactures lawn mowers in two divisions:
Commercial and Consumer. Both divisions require the support of Product Development, an
engineering service department that designs new products based on marketing data. The
following annual information is available:
Budgeted fixed costs of running Product Development
$1,500,000
Budgeted variable cost of running Product Development per hour
120
Budgeted usage of Product Development
Commercial Division
4,000 hours
Consumer Division
3,500 hours
Actual usage of Product Development
Commercial Division
4,500 hours
Consumer Division
3,000 hours
Required:
1. Determine the allocation of Product Development costs to the two divisions using the single
rate method where the actual hours of usage will be the allocation base.
2. Determine the allocation of Product Development costs to the two divisions using the dual
rate method, assuming fixed costs use budgeted hours while variable costs use actual hours
of usage as allocation bases.
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Demonstration Problem – Solution
Part 1
The budgeted total costs of running Product Develop can be calculated as:
Commercial Division
$200 per hour × 4,000 hours + $120 per hour × 4,500 hours
$1,340,000
Consumer Division
$200 per hour × 3,500 hours + $120 per hour × 3,000 hours
1,060,000
$2,400,000
Part 2
Under the dual rate method, the fixed cost rate can be calculated as:
Commercial Division
$320 per hour × 4,500 hours
$1,440,000
Consumer Division
$320 per hour × 3,000 hours
960,000
$2,400,000