EPM Lecture 1 Core Control Systems

Sometimes control systems may support or hinder a company if tools/incentives are poorly
selected

Companies must look both internally (what are your PMS and incentive measures?) and externally
(who are your competitors?)

Mgmt Accounting process of gathering, summarising and reporting financial and non-financial
information used internally to make decisions. May include the use of external info related
to markets, customers, competitors, predictive info and informal social controls to manage
the organisation.

Some uses of mgmt accounting:
Direct resources, consider investment opportunities, manage and evaluate risk, evaluate mgmt& sub
unit performance, evaluate and improve production/service delivery, develop suitable
incentives.
FOUR FUNCTIONS OF CONTROL (Flamholtz)

1. Motivate decisions and actions consistent with org objectives directing behaviour,
facilitate decision making
2. Integrate the efforts of different parts of the organisation
3. Provide information about the results of operations and peoples performance facilitate
learning
4. Facilitate the implementation of strategic plans


ENVIRONMENT
CULTURE
STRUCTURE
CORE
CONTROL
SYSTEM
planning
operations
measure-
ment
feedback
evaluation
& rewards
The framework
There are two types of control mechanisms:


3 Core Elements of the FORMAL control system can be a balancing act
- Decision rights
- PMS
- Incentives do not always improve performance
Influences on mgmt
Risk Operational and competitive risk procedures, protocols, changing nature of industries
Incentives- influences behaviour and rewards good performance policies, bonus structures
Sustainability social, environmental & ethical community impact, resource usage, work practices


Key influences on control system design:

Porters 5 Forces Model
1. Buyers and customers
2. Suppliers and inputs
3. Rivalry among existing competitors
4. Substitute products/services
5. Risk from potential entrants to the market


Other factors such as: Strategy, culture, structure, external environment (macroeconomic sensitivity),
market volatility, size, technology

Examples of key considerations may include:
- Revenue vs Costs of production (unavoidable/ avoidable sunk costs)
- Cost leadership/differentiation strategies
- Efficient resource allocation & CVP analysis
- Value-add vs non value-add activities
- Mgmt expertise
- Market share, industry and competitor analysis

Formal mgmt mechanisms Informal mgmt mechanisms
Formal budgeting & planning
process
Observale & rigid
Cost system data for costing &
pricing analysis
Activity-related analysis
Data collection
Formal evaluation procedures
Incentive programs and
reward structures
Informal meetings and social work settings
Shared practices and employee engagement
Recruitment & hiring practices that seek out
suitable employees for the existing structure
Informal feedback process
Employee development and learning
practices
Culture and belief systems

Divide may not be clear cut can be intertwined!!!
Topic 2 Responsibilities, Structure and Sub-unit
Formal structures defines relationship between people, teams divisions etc.
Structure aims to facilitate work flows, and focuses mgmt attention on supporting strategy
Organisation of work flows determine how people communicate and coordinate

Influences on structure:
- Strategy e.g. more market oriented or specialised
- External environment/ industry
- Costs
- Size
- Culture
- Nature of activities/operations are divisions related?

Structure in reality may be different from the org chart

Centralised VS Decentralised both has advantages

Common structures:

Functional change of command, specialisation, economics of scale but may induce silo effect
Divisional geographic, product-based, responsive to market demands but less horizontal info flows
Matrix combined divisional groupings, can be confusing/conflicting, loss of responsibility
Hybrid front end/back end, divisionalised front end, functional centralised backend

Trade off between benefits of specialisation and market responsiveness
Evaluation of new structure should account for time-lag effect (teething & resistance)

Silo effect lack of cooperation between work units/ divisions
Can be broken down by informal social networks, physical office layout or even idea brokers

Responsibility centres (sub-units)

Cost centres costs but no significant revenues (e.g. manufacturing, R&D, HR, Finance)

Revenue centres manager responsible for revenue (e.g. sales, fundraising departments)

Profit centres managers accountable for profits (e.g. decentralised units)

Investment centres accountable for profits or returns on investment (e.g. divisions, projects)

Span of attention of a manager
Influenced heavily by:
- Work-unit design the individual domain they belong
- Span of control the people, functions and resources controlled
- Span of accountability PMS for which the manager is held accountable

Work units tend to be silos as managers focus on own unit and compete with other managers
Can make coordination part of their span of attention by joining structures
Topic 3 Financial-based Performance Evaluation
Measures need to:
- Reflect strategy and key business drivers
- Be relatively objective
- Be consistent with value creation
- Reflect managerial responsibility and accountability
- Be complete and timely
- Be responsive

Challenge: Encourage decisions at the divisional-level to add value to the firm - creating goal
congruence across multiple levels. Poor metric selection= unintended consequences
Traditional Accounting Measures
At an investment centre/profit centre level:
Common Profit Measures include:

Common Profitability Measures include:

- net operating profit after
taxes (NPAT)
- earnings before interest and
taxes (EBIT)
- return on investment (ROI)
- return on assets (ROA)
- residual income(RI)
- Economic value added (EVA)

Variances can be used as a diagnostic tool/ routine PM
ROI
= Profit Margin X Asset Turnover
profit/sales X sales/assets

Issues when used in isolation:
- Which profit? Controllable profit, operating before tax, after tax
- Which assets? Book value, fair value
- May result in ST focus at the expense of LT (cost cutting in R&D/training, defer asset
replacement, underinvestment in projects that may decrease divisional ROI but good for org
overall)
- Goal incongruence due to hurdle rates
- Links to management length of tenure/service (behavioural/mgmt self interest)
Residual income (RI)
= Profit - (required rate of return X investment/assets employed)
- The profit remaining is the residual profit after charging the division for its assets employed
(cost of capital)
- Commonly viewed as measure of adding-value to the firm.
EVA helps overcome goal incongruent decision making
Reflects SH value/wealth returns generated above the cost of resources consumed.
EVA = Economic Profit (Economic Assets * Cost of capital)
Issues: a single finance performance measure subject to manipulation, based on past performance,
doesnt capture growth potential, still encourages ST decisions. $ value size differences