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Fundamentals of Management
Control Systems
Chapter 12
PowerPoint Authors:
Susan Coomer Galbreath, Ph.D., CPA
Charles W. Caldwell, D.B.A., CMA
Jon A. Booker, Ph.D., CPA, CIA
Cynthia J. Rooney, Ph.D., CPA
McGraw-Hill/Irwin
Copyright © 2014 by The McGraw-Hill Companies, Inc. All rights reserved.
Learning Objectives
LO 12-1
LO 12-2
LO 12-3
LO 12-4
LO 12-5
LO 12-6
LO 12-7
LO 12-8
Explain the role of a management control system.
Identify the advantages and disadvantages of decentralization.
Describe and explain the basic framework for management
control systems.
Explain the relation between organization structure and
responsibility centers.
Understand how managers evaluate performance.
Analyze the effect of dual- versus single-rate allocation systems.
Understand the potential link between incentives and illegal
or unethical behavior.
Understand how internal controls can help protect assets.
12-3
Alignment of Managerial and
Organizational Interests
LO 12-1
Explain the role of a management control system.
A management control system is designed to help
managers make decisions that will increase the organization’s
performance. The purpose of the management control system is
to align more closely the interests of the manager and the
interests of the organization.
12-4
Decentralized Organizations
LO 12-2
Identify the advantages and disadvantages of decentralization.
Decentralization is the delegation of decision-making
authority to subordinates in the organization’s name.
When authority is decentralized, a superior, whom we call
a principal, delegates duties to a subordinate, whom we
call an agent . We find principal-agent relationships in
many settings.
12-5
LO
12-1
Decentralized Organizations
Some organizations are very centralized; few decisions are delegated. The
military is a good example of centralized authority. At the other extreme
are highly decentralized companies in which decisions are delegated to
divisional and departmental managers. In many conglomerates, operating
decisions are made in the field; corporate headquarters is, in effect, a
holding company.
Good decisions require good information. In large organizations, especially
those that are geographically dispersed, much of the information needed to
make the decision is local; that is, it is specific to the local conditions.
Supporting some local variations can capitalize on local knowledge and
allow franchisees to earn more than would otherwise be possible. Local
knowledge is knowledge about these local conditions.
12-6
LO
12-1
Advantages of Decentralization
Some of these advantages follow:
• Better use of local knowledge . As companies grow, more and more local knowledge needs
to be processed in order to manage the business.
• Faster response . Local managers can react to a changing environment more
quickly than top management can. With centralized decision making, delays
occur while information is transmitted to decision makers.
• Wiser use of top management’s time . Just as local managers have better information about
local conditions, top managers have better knowledge about strategic issues and
industry trends.
• Reduction of problems to manageable size . The complexity of problems that humans can
solve has limits. Even with the aid of computers, some problems are too complex to
be solved by central management.
• Training, evaluation, and motivation of local managers . Decentralization allows
managers to receive on-the-job training in decision making. Top management
can observe the outcome of local managers’ decisions and evaluate their potential for
advancement.
12-7
LO
12-1
Disadvantages of Decentralization
Decentralization has many disadvantages as well. 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). A second
cost of decentralization is administrative duplication. A third cost of
decentralization is the possibility of poor decisions based on incomplete
information.
A company must weigh the costs and benefits of decentralization and decide
on an economically optimal level. One can assume that the disadvantages of
decentralization for highly centralized organizations outweigh the advantages
while the reverse is true for decentralized companies.
12-8
Framework for Evaluating Management
Control Systems
LO 12-3
Describe and explain the basic framework
for management control systems.
Once an organization has decided to decentralize, it is important
to develop a system to reduce the impact of dysfunctional
decision making. This system is called a management control
system, which is the structure and procedures that the
principals (owners) use to influence agents (managers) of the
organization to implement the organization’s strategies.
12-9
LO
12-3
Elements of a Management
Control System
Three elements of a
management control system
• Delegated decision authority.
• Performance evaluation and measurement systems.
• Compensation and reward systems.
12-10
LO
12-3
Balancing the Elements
An effective, well-functioning management control system
balances these three elements and defines them consistently.
You are the manager of a newspaper stand that is par of a national
company. The goal of the organization is to make money (or at least sell
newspapers). As the newspaper stand manager, you can affect that by
making good decisions about the number of papers to order. The purpose
of the management control system is to influence you to make decisions
that further the organization’s goal. However, because the performance
measure is completely independent of your decisions, it cannot motivate
you to make better decisions. The three elements are not consistent; that
is, they are not balanced.
12-11
Responsibility Accounting
LO 12-4
Explain the relation between organization
structure and responsibility centers.
Responsibility accounting reports revenues and costs at the level within
the organization having the related responsibility.
12-12
LO
12-4
Cost Centers
Managers of cost centers are responsible for the cost of an activity for
which a well defined relationship exists between inputs and outputs. Cost
centers often are found in manufacturing operations where inputs, such
as direct materials and direct labor, can be specified for each output. The
production departments of manufacturing plants are examples of cost
centers.
12-13
LO
12-4
Discretionary Cost Centers
When managers are held responsible for costs but the
input-output relationship is not well specified, a
discretionary cost center is established. Legal,
accounting, R&D, advertising, and many other
administrative and marketing departments are usually
discretionary cost centers
12-14
LO
12-4
Revenue Centers
Managers of revenue centers typically are
responsible for selling a product. Consequently, the
manager is held responsible for sales price or sales
activity variances. An example of a revenue center is
the sportswear department of a large department
store for which the manager is responsible for
merchandise sales.
12-15
LO
12-4
Profit Centers
Managers of profit centers are held accountable for profits. They manage
both revenues and costs. For example, Home Depot could operate its
warehouses as cost centers but its retail stores as profit centers. Managers
of profit centers have more autonomy than do managers of cost or
revenue centers.
12-16
LO
12-4
Investment Centers
Managers of investment centers have responsibility for
profits and investment in assets. These managers have
relatively large amounts of money with which to make capital
budgeting and other decisions affecting the use of assets.
Investment centers are evaluated using some measure of
profit related to the invested assets in the center.
12-17
LO
12-4
Responsibility Centers and
Organization Structure
Groupa vice president –
Investment centers
a
Division vice president –
Profit centers
Staff managers –
Discretionary cost centers
Plant managers –
Cost centers
District sales managers –
Revenue centers
Group refers to a group of divisions.
12-18
LO
12-4
Measuring Performance
Total goal congruence exists when all members of an
organization have incentives to perform in the common interest.
This occurs when the group acts as a team in pursuit of a mutually
agreed-upon objective. Individual goal congruence occurs when an
individual’s personal goals are congruent with organizational goals.
In most business settings, however, personal goals and organizational
goals differ. Performance evaluation and incentive systems are
designed to encourage employees to behave as if their goals were
congruent with organization goals. This results in behavioral
congruence; that is, an individual behaves in the best interests of
the organization regardless of his or her own goals.
12-19
Evaluating Performance
LO 12-5
Understand how managers evaluate performance.
A company often is tempted to compare the performance of its centers and
even to encourage competition among them. As you will see, the problems
inherent in performance measurement complicate such comparisons. In
addition, the various centers can be in very different businesses. It is very
difficult to compare the performance of a manufacturing center with the
performance of a center that provides a consulting service and has a
relatively small investment base. Investment centers operating in different
countries face different risks. When comparing the performance of
investment centers, all such differences should be considered.
12-20
LO
12-5
Compensation Systems
An effective management control system provides the appropriate incentives
for the manager to make decisions in the organization’s best interests. The
compensation system has to reward the manager for measured performance
to provide sufficient incentives to influence the manager’s decisions. We can
classify the compensation into two categories: fixed compensation and
contingent compensation.
Fixed compensation is paid to the manager independent of measured
performance. A good example of fixed compensation is salary. Contingent
compensation is the amount of compensation that is paid based on
measured performance. An example of contingent compensation is the
commission paid to the sales staff.
12-21
Corporate Cost Allocation
LO 12-6
Analyze the effect of dual-versus single-rate allocation systems.
* Global Electronics allocates corporate overhead based on relative revenue.
Corporate overhead was $25 million.
12-22
LO
12-6
Corporate Cost Allocation
My revenue
and costs
were on target.
12-23
LO
12-6
Corporate Cost Allocation
Global Electronics
Latin America Division
Income for the Year
($000)
Actual
Target
Revenue
$ 70,000 $ 70,000
(Percentage of corporate revenue)
16%
14%
Corporate revenue
$437,500a $500,000b
a
b
$70,000 ÷ 16%
$70,000 ÷ 14%
I'm not
responsible for
corporate
revenue.
12-24
LO
12-6
Corporate Cost Allocation
Global Electronics
Latin America Division
Income for the Year
($000)
Actual
Target
Allocated corporate overhead
$ 4,800 $ 3,500
(Percentage of corporate revenue)
16%
14%
Corporate costs
$30,000a $25,000b
$4,800 ÷ 16%
b $3,500 ÷ 14%
a
I'm not
responsible for
corporate
costs.
12-25
LO
12-6
Corporate Cost Allocation
• Dual rate method:
This is a cost allocation method that separates a
common cost into fixed and variable components
and then allocates each component using a
different allocation base.
Alternative
1
Alternative
2
12-26
LO
12-6
Performance Evaluation
Systems Incentives
LO 12-7
Understand the potential link between incentives
and illegal or unethical behavior.
Fundamental questions regarding a performance
measurement system:
1. Does the measure reflect the results of those actions
that improve the organization’s performance?
2. What actions might managers be taking that improve
reported performance but are actually detrimental to
organizational performance?
12-27
What Pressures Can Lead
to Unethical Behavior?
Unrealistic budget pressures, particularly for short-term results .
These pressures occur when headquarters arbitrarily
determines profit objectives and budgets without
considering actual conditions.
Financial pressure resulting from bonus plans that depend on
short-term economic performance .This pressure is particularly
acute when the bonus is a significant component of the
individual’s total compensation.
12-28
Internal Controls
LO 12-8
Understand how internal controls can help protect assets.
Companies set up internal control systems to deal with problems
such as financial fraud. At a general level, internal controls provide
management with reasonable assurances that their company’s
assets are protected and the company’s accounting is reliable.
More specifically, internal control is a process designed to provide
reasonable assurance that an organization will achieve its
objectives in the following categories:
• Effectiveness and efficiency of operations
• Reliability of financial reporting
• Compliance with applicable laws and regulations
12-29
LO
12-8
Internal Controls
U.S. Congress passed the Sarbanes-Oxley Act of 2002
(SOX) in response to a large number of business and
accounting scandals that came to light in 2001 and 2002.
These included the large frauds and subsequent
bankruptcies of Enron and WorldCom. SOX will likely
cause improvements in the internal controls—and the
documentation of internal controls—in many
organizations.
However, these benefits come at a cost. An open
question is: Do the benefits justify the costs of investing
in better internal controls?
12-30
LO
12-8
Internal Controls
Companies use many types of internal controls besides separation of duties.
Here are some examples.
1.Setting limits on the amount of expenditures (for example, no more than
$100 per person for an expense account dinner).
2.Requiring management authorization for the use of a company’s assets (for
example, use of a company car).
3.Reconciling various sets of books (for example, reconciling accounts
receivable with the collections of cash from customers).
4.Prohibiting particular activities or behavior (for example, prohibiting a
company’s purchasing agents from accepting gifts from present and
prospective vendors).
5.Rotating personnel and requiring employees to take vacations (for example,
requiring the person who reconciles bank statements with the company’s
cash accounts to rotate duties so someone else can check that the cash on
the books is actually in the bank).
12-31
End of Chapter 12
12-32