Introduction to Management Control Systems (MCS)

Chapter 1 Session 1

Breaking the Ice

Before 17th January 1995, Nick Leeson was a 28year old successful trader (of Japanese stock index futures and options) in Singapore for one of Britains oldest (233 years old) investment banksBarings Plc. Within a few weeks, Leeson alone lost > US $ 1 billion of Barings money (i.e.,twice its available capital) and brought about the collapse of the firm. 2001The dark year of control lapses: 9/11 and WTC; Enron; Tyco International; WorldCom; Arthur Andersen

2 Important Laws
Murphys Law : If anything can go wrong, it will Andersons Law: If you have effective controls, it wont

Our Learning Objectives

To study the significance of management control systems in different activities of organizations To understand the nature of management control systems To study the purpose and types of management control systems

The Discussion Themes

Introduction to MCSThe importance of control in a managerial setting Key Elements of a Control System Nature of MCS Purpose of MCS Domain of MCS Organizational Context of MCS Types of MCSFormal and Informal Control Systems

Managerial Control
Automation Behaviour Correction Discipline Effectiveness Fear Goals Hierarchy Inspection Jeopardy

The Many Images of

Why do Managers need Control?

To provide reassurance to stakeholders that the organization is running smoothly. To provide reassurance to managers that the organization is moving in the chosen directions. To provide guidance to employees for channelling their behaviour in desired directions. To provide guidance from higher management to lowerlevel managers to identify significant problems and opportunities

What is Control?
The essence of control is ACTION, which adjusts operations to predetermined STANDARDS, and its basis is INFORMATION in the hands of managers Doug Sherwin (1956). So, control involves: Deciding acceptability of results Reference to what was planned Information for measurement and comparison Action for correction Effective use of capabilities to achieve goals

1. 2. 3. 4. 5.

What do Managers Control?

Control efforts in 5 inter-related areas:
Money Operations Information Time Behaviour (of people)

Levels of Control
Strategic Linked to strategy formulation Top management Goal-oriented Management Involves translation of corporate goals into objectives Mid-level Resourceallocation oriented Medium-term Combination; ad hoc, summarized and exception reports Operational Ensures functional efficiency

First-line supervisors Task-oriented

Long-term Aggregate performance; unstructured and summarized reports

Short-term Detailed performance in structured reports

What is a MCS ?
A management control system is the process by which managers ensure that resources are used effectively and efficiently in the accomplishment of organizational objectives. (Anthony, Dearden, Govindrajan, 1992) A management control system is a means of gathering and using information. It aids and coordinates the process of planning and control decisions throughout the organization. It guides the behaviour of managers and employees (Horngren, Datar and Foster, 2003).

General Electric (GE) Levels of MCS

Total-organization levele.g., net income, share price; ROI; CF from operations; total employment; pollution control; community investment. Customer/market levele.g., customer satisfaction; cost of competitor products; time to respond to customer requests. Individual-facility levele.g., materials costs; labour costs; rates of accidents and absenteeism in various divisions/business functions. Individual-activity levele.g., time taken and costs incurred for inbound logistics activities; units reworked on production line; number of shipments per employee; revenue generated per salesperson

MCS includes
Financial data

Nonfinancial data
Formal control system Informal control system

Basic Elements of a Management Control System

CONTROL DEVICE
DETECTORObservation and reporting of facts

ASSESSOR-

Comparison with Standard

EFFECTORBehaviour Modification

ENTITY BEING CONTROLLED

Purpose of MCS
Assist in target- setting Collecting information on actual performance Comparing actual performance with targets Reporting the variations Initiating suitable actions to ensure that the targets are achieved efficiently and effectively.

Introduction to Management Control Systems (MCS)

Chapter 1 Session 1A

The Discussion Themes (contd.)

Nature of MCS Organizational Context of MCS Types of MCSFormal and Informal Control Systems Types of Formal MCS Types of Informal MCS

Desirable Attributes of a MCS

An effective MCS ensures organizational success. It enhances the ability and confidence of employees for high performance. 1. Future-orientedseek opportunities 2. Derived from strategyfacilitates implementation 3. Based on clear multiple, balanced, and objectives 4. Multidimensionalfits any functional organization 5. Minimizes control losses (i.e., TPP < REP) 6. Cost Effective 7. Accurateavoids distortions 8. Realisticbased on facts, not assumptions 9. Timelyavailable when needed to take any corrective action

Organizational Context of MCS

MCS helps managers to integrate efforts of internal stakeholders ( sub-units that perform activities) and external stakeholders (outsiders who have a stake and expectations of performance). MCS helps achieve efficiency (performance vs. resource consumption) and effectiveness (purpose vs. performance). Control systems must be adaptive. Organizations Sub-units Effectiveness and Efficiency StakeholdersBuild strong relationships Attracting and keeping the best employees Mutually beneficial relationships with communities To know the customers intimately Trusting relationships with suppliers

Types of MCS

FORMAL MCS Arise out of documentation (e.g., budgets, rules, quotas) Management-initiated mechanism for achieving organizational goals. Policies and procedures to be followed by the members. Assists management in strategy implementation. INFORMAL MCS Arise out of employee behaviour (e.g., group norms, organizational culture) Originate with employees; unwritten; affected by sociocultural factors Interpersonal relationships; emergent roles activities engaged in by the members of the organization Increases organizations ability to make adaptive responses

Types of Formal MCS

Classified as: 1. Input controls:actions taken before implementation of planned activity (selection criteria; manpower allotments; strategic plans) 2. Process controls: involves tracking of relevant variables and taking corrective action when there is a significant deviation from specified parameters of a variable (e.g., adjustment of inventory levels to reduce production due to decline in sales) 3. Output controls: involves evaluation of results when performance standards are set and monitored.

Types of Informal MCS

Classified as: 1. Self-control: involves setting personal objectives by individuals, monitoring their attainment and adjusting behaviour in the organisation to attain them. Self-control is effective if there is goal-congruence. 2. Social controls: the prevailing social perspectives and patterns guiding interpersonal interactions within the organization. They require internalization of values and mutual commitment towards common goals. 3. Cultural controls: involves reinforcing the stories, rituals, legends and other norms of social interaction within the firm.

Components of Formal MCS

Management style and organizational culture Firm infrastructure Rewards systems Coordination and Integration mechanisms Control Process

Components of Informal MCS

Recognition and rewards Informal coordinating mechanisms Style and culture Informal control process

Summary of Chapter 1
Day 1: What is control; why managers need control;what do managers control Levels of control What is MCS; General Electrictypical hierarchy of MCS; elements of an MCS; purpose of MCS Day 2: Attributes of MCS Organizational context of MCS Types of MCS Types of formal and informal MCS

Questions for discussion

Identify organizations which have a proven record of building strong stakeholder relationships. As the Head of an automobile production plant, you intend to institute certain control systems in your factory. What would be the major control systems that you would implement? What control systems are needed by advertising agencies to survive fierce competition? If you were the CEO of a management consultancy firm like McKinsey, which control system (s) would you implement in your organization? Why?

Design of Management Control Systems

Chapter 2

Chapter Highlights
Various approaches to MCS implementation Cybernetic approach Contingency approach Strategic context and MCS design differences Strategy and MCS:Texas Instruments vs. Hewlett Packard case

Alternative Design Paradigms

Cybernetic or general systems approach: focuses upon design of essential elements of the control process in an economical way.
Contingency approach: focuses upon a potential explanation for the diversity of MCS in practice.

The Cybernetic Approach

Cybernetics is the science of communication and control, dealing with the self-regulating properties in different systems (machines, human body). A cybernetic control system is a self-regulatory control system; once it is put into operation it can automatically monitor the situation and take corrective action when necessary (thermostat; radar control; AI and robotics; computerized inventory systems). Cybernetic control systems have built-in monitoring systems designed to alert if things are not progressing as intended.

Cybernetic System Characteristics

Goal-orientedpre-determined goals steer selfregulating system Complex structuresheterogeneous interacting components Mutual interactionmultiple interactions within and among sub-systems Complementary sub-systems comprising multiple structures and processes Evolutionarygrows opportunistically; not static Constructiveincrease in size and complexity result from incremental improvements in existing attributes and development of new attributes

Cybernetic Control Process

1. 2. 3. 4. 5. 6. 7. 8. Setting goals and performance measures/indicators Measuring achievement Comparing achievement with results Computing variances Reporting variances Identifying causes of variances Implementing action to eliminate variances in future Feedback to ensure goal achievement

The Cybernetic Paradigm

Source 1

Initial Data

Predictions and Inferences

Values and Choice Target Values and Choice Target

Initial Action

Source 2

Feedback Data

Predictions and Inferences

Action

Learning from the Cybernetic Approach

When designing MCS: Challenging and attainable standardscontrol is a constructive exercise to enhance employee performance. Measurable objectivesenabling performance evaluation Focus on few prioritized objectives and key results Balanced focus on short-term and long-term performance variables Uni-focal responsibility to avoid work duplication Acceptable range of variation for value of each variable Good feedback mechanism for early prediction Exception reporting Judgment of seriousness of the problem Human insight for interpreting results

The Contingency Paradigm

1. 2. 3. 4. 5. Contradicts the universalistic and mechanistic approach of an optimal design applicable to all settings. Design of control systems is contingent upon strategic context; interaction of organization with environment is important. A continuum exists of firms strategy selection from single industry firms to conglomerates at the two extremes. MCS process differs according to firms strategy selection. Major contingency variables: Technology Organizational structure Unique external environment Top management style Culture

The Logic of the Contingency Approach

Different organizations operate in different strategic contexts. Different strategies require different task priorities, key success factors, perspectives and behaviours for execution. A management control system must influence the behaviour of people whose activities are being measured. Thus, MCS design should be based upon a concern whether control system induces behaviour that is consistent with strategy.

Learning from the Contingency Approach

Strategy and control are interrelated, not separate organizational functions. To gain competitive advantage, the two must be integrated. The MCS is a tool that enables such integration in terms of strategy execution. MCS design must be adapted to the level and type of strategycorporate (organization as a whole), business unit, and functional.

Levels of Strategy
Characteristic
Type Frequency

Corporate
Conceptual Periodic/sporadic

Business unit
Mixed

Functional
Operational

Periodic/sporadic Periodic

Measurability
Adaptability Risk

Value judgment based

Low High

Semi-quantifiable Usually quantifiable

Medium Moderate Medium High Low Small

Profit potential Large

Cost
Time horizon Relation to present Need for flexibility Cooperation required

Major
Long-range Innovative High High

Medium
Medium-range Mixed Medium Medium

Modest
Short-range Supplementary Low Low

MCS Implications for Different Strategic Contexts

Single-industry Strategic planning systems; Vertical-cumlevel of interdependencies horizontal; high Dependence on budgeting as a Low control tool; emphasis on meeting budgetary requirements Importance of transfer pricing Sourcing flexibility High Constrained; synergies important Unrelated diversification Vertical only; low High

Low High; use of arms length market pricing

Incentive compensation criteria Bonus determination approach

Based on financial & Based primarily on non-financial criteria financial criteria Primarily subjective; Primarily formulabased on corporate based; based on performance SBU performance

Texas Instruments vs. Hewlett Packard (1)

Competitive advantage for large, standard markets based on long-run cost position Marketing strategyhigh volume/low price; rapid growth; std. products R&D strategyprocess and product;cost driven;design to cost Manufacturing strategy scale economies & learning curve; large low-cost locations Financial strategy aggressive; high-debt Competitive advantage for selected small markets based on unique high-value/high features product Marketing strategyhigh value/high price; controlled growth; customized products R&D strategyproduct only;quality & features driven;design to performance Manufacturing strategy quality & delivery driven; small attractive locations Financial strategy conservative; no-debt

Texas Instruments vs. Hewlett Packard (2)

Product life cycleearly entry, then expansion & consolidation; dominant market share at maturity Costs and prices (learning curve)aggressive cost improvements with equally aggressive price cuts Product/process matrixcapital intensive, cost-effective production processes ( continuous flow/ assembly line) to match high-volume, standard product needs Portfolio analysis balanced portfolio; mature large cash cow businesses provide resources for young high-growth ones low-growth businesses with dominant market shares Product life cyclecreate new markets for new products, followed by market exit or introduction of new products at maturity Costs and prices (learning curve) less emphasis on manufacturing cost improvements; targeted higher margins; held prices longer Product/process matrixflexible production processes (batch/job shop) to match low-volume, customized product needs Portfolio analysis high growth, new products-new business oriented; high-growth, high-margin businesses with dominant market shares to meet own resource needs; reallocation of resources only to fund new business.

Texas Instruments vs. Hewlett Packard (3)

Do differences in strategy of TI and HP call for differences in design of MCS? Differences might arise in the following areas: Strategic planningimportance of SP; capital projects evaluation criteria; investment appraisal methods; formalization of capital expenditure decisions Budgetingrole of budgets; frequency of feedback; importance of meeting budget; revisions to budget during the year; output vs. behaviour control Incentive compensationbonus criteria; proportion of bonus compensation; frequency of bonus payment; bonus determination approach Reporting systemfrequency of reporting; grouping of expenses and revenue generation; responsibility assigned for cost control Performance evaluationfrequency; tiers of evaluation; performance indicators; linkage with incentives

1.

2.

3.

4.

5.

MCS Design Process

Chapter 3

Chapter Highlights
Pre-requisites of MCS design Factors influencing design of MCS Relationship between style, culture and MCS design Impact of IT on MCS design A TQM-focused culture for MCS

Designing MCSThe Pre-requisites

An understanding of what the organization wants from each individual employee Role identification of each individual employee (at all levels) in achieving organizational goals; use of Key Results (KRs) Identification of key actions (KAs) to be controlled. KAs are firm-specific and person-specific. Specification of choice of controls (standards) for employees . Identification of possible causes of MC problems (what is likely is different from what is desired) 1. lack of direction (lack of knowledge of what is desired), 2. motivational problems (self-interest, fraud and theft) and 3. personal limitations (lack of intelligence, training, experience, stamina, knowledge of assigned tasks.

Choice of Controls
Action controls: ensures employees perform / do not perform certain actions known to be beneficial / harmful to the organization; employee actions are the focus of control; most popular and direct form of controls. Results controls: encourages desirable employee actions by focusing on their consequences; involves rewarding individuals / groups for generating good results / punishing them for poor results; employees empowered to take necessary action for desired results; encourages talent discovery and development. Personnel and culture controls: complement imperfections in action and results controls. They take steps to ensure employees will control their own behaviour / each others behaviour ; sometimes dominant form of control.

Action Controls
4 basic forms: behavioural constraints, pre-action reviews, action accountability, redundancy. Prevention vs. detection based Behavioural constraintsnegative form of control making it impossible/ difficult for people to do things that should not be done. Can be applied physically ( locks, passwords, limits on access, fingerprint/voicepattern/eye-ball pattern/ magnetic identification-card readers) or administratively (restriction of decision-making authority, separation of duties). Prevention-based. Pre-action Reviewsinvolve formal (approval for expenditures, budget process)or informal (discussion to check project progress) scrutiny of action plans of individuals being controlled. Reviewers approve/disapprove proposed actions, ask for modifications/ careful consideration before approval. Prevention-based. Action accountabilityinvolves holding employees accountable for actions they take; rewarding acceptable (good) actions and punishing unacceptable actions. Redundancyinvolves assigning more people or machines to a task than is theoretically necessary (have a back-up task force for security and computing facilities) to ensure task accomplishment; expensive, conflicting, frustrating. Prevention-based.

Results controls
1. 2. 3. 4. Create meritocracies; Used for employees at many organizational levels In decentralized organizational structures Elements of results controls defining performance dimensions; measuring performance; setting performance targets; providing rewards and punishments

Effectiveness of Controls
1. 2. 1. 2. 3. Action Controls: Managers know what actions are desirable/undesirable. Managers can ensure that desirable actions occur and undesirable actions do not. Result controls: Managers know what results are desired in the area controlled Individuals being monitored have significant influence on results in the desired performance dimensions. Managers can measure results effectively.

Control Tightness/ Looseness

Major management decision Tightness of controls is a function of knowledge, cost incurrence, and adverse side-effects; need for adjustment to change Right balance of tightness/looseness of controls ensured by combination of control forms

Factors influencing MCS Design

Managerial style Corporate culture Organizational structure Organizational slack Stakeholders control and communication structures