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Summaries: Management Control Week 2RN

Management Control (Universiteit van Amsterdam)

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Management Control Week 2

Textbook chapter 16
Davilla & Foster (2007), Sandino (2007), Ittner et al. (2003a) and Dierynck et al (2012).

Contingency theory:
Is a class of behavioral theory that contend that there is no one best way of leading and that a leadership style
that is effective in some situations may not be successful in others. The contingency theory predicts that
choice for a certain MCS are contingent on specific factors. Linked to Sandino (2007): Basic controls do not
depend on specific firm characteristics, but are suitable for all kinds of firms. Therefore the following findings is
not consistent with the contingency theory: Sandino (2007) finds in het paper that basic MCS are used by
almost all firms.
There is no universally best MCS that applies to all situations and all organizations. There are a large number of
situation factors that individually and collectively affect cost and/or effectiveness of various management
controls.
To determine the relevant aspects of the situational context and their effects on MCS elements is difficult
because:
Many of the factors are related
Many of the factors interact with each other to produce MSC related effects.
Traditional contingency (onvoorziene/toeval/toevalligheid) theory address the impact of contingency
variables on MCS design (situational factors):
1. Strategy
2. External environment
3. Technology
4. Organizational structure
5. Firm Size
6. Culture
1. Strategy:
Distinguish between:
1. Corporate strategy level
2. Business strategy level (to what extent the firm diversify).
1.

Corporate strategy refers to type of diversification (i.e. related versus unrelated diversification) and
an organizations corporate strategy determines what business it wants to be in and ow resources
should be allocated among these businesses.
Related diversification= high interdependence between divisions (Divisions that work in the same
industry)
o
o
o

o
o

Do not stray fat from their core business.

They diversify in order to exploit economies of scope schaalvoordelen stemming from relationships
among their entities.
These firms design their MCSs to take advantage of tis interdependence to exploit synergies and reap
economies of scope. They often have relatively elaborate (uitgewerkte) planning and budgeting
systems.
These firms are more likely to use incentive compensation systems that base some portion of business
unit managers bonuses on the performance of the next higher-level gentility in the firm.
These firms are likely to spend considerable resources addressing transfer pricing problems.

Less delegation of decision rights towards divisions

Use higher-level result controls (firm-level summary measures instead of divisional-level
summary measures)
Use less division measurements when there is related diversification

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MORE INTERDEPENDENCIES BETWEEN DIVISIONS MEANS THAT ACTIONS OF DIVIONS NEED TO BE

COORDINATED. THEREFORE MORE DECISION RIGHTS NEED TO BE CENTRALIZED.
Unrelated diversification implies stronger information asymmetry between corporate and divisional
level (divisions working in different industries)
o

o
o
o

2.

Are not concerned with restricting their focus to their core business. They pursue a portfolio of
unrelated business to exploit internal capital market benefits that stem from internal decision
makers relative information advantages for resource allocations.
High information asymmetry because managers are unable to remain well informed about all the
developments in all of their diverse divisions.
Decentralization and heavy reliance on financial results controls are common RESPONSES to
information asymmetry.
Managers will tend to use relatively little subjectivity in their performance evaluations. Division
managers usually have considerable pressure for financial performance, but they also have
relatively high autonomy.

More elaborate delegation of decision rights

Use lower-level result controls (i.e., divisional instead of firm-level summary performance
measures
Less direct monitoring by corporate management (also smaller use of subjectivity in performance
evaluations)

Business strategy refers how to achieve competitive advantage relative to its competitors
Focused on Cost-leadership

Involves offerings or relatively standardized, undifferentiated products; generation of volume

to exploit economies of scale, establishment of a routinized task environment, vigorous
pursuit of cost reduction.

o How to control tight action controls (e.g., geared towards cost)

o How to control tight action controls (e.g., standard operating procedures)
Focused on differentiation
Involves the creation of a product or service that customers perceive as uniquely
differentiated from competitors offerings. Such differentiation can focus on one or
more dimensions, including product innovation, product functionality, quality,
brand image, customization.
o Results control geared towards customers, employees, and innovation (i.e., specific
performance measures)
o Smaller reliance on action controls (e.g., procedures)
o Performance evaluations based on subjective evaluation (e.g., knowledge sharing and
cooperation)
o Stronger focus on personnel and cultural costs.

6. Culture
Countries possess specific cultural characteristics. National culture is the collective programming of the mind
that distinguishes the members of one group or society from another. People have different preferences for,
and reactions to, MC because control problems are behavioral problems. When groups perceive things
differently, different control choices may have to be made.
Classification of cultures according to Hofstede (1984):
1. Individualism See individuals themselves as an individual or as part of a group. Self-interest.
2. Power distance The extent to which members of a society accept that institutional or organizational
power is distributed unequally.
3. Uncertainty avoidance people who score high feel uncomfortable when the situation they face is
ambiguous.
4. Masculinity (preference for achievement, assertiveness, and material success) versus. Femininity
(Emphasis on relationships, modesty, and the quality of life).
5. (Long term orientation)
Traditional contingency theory has lost momentum. The critique is that it is an empty theory. However the
underlying intuition remains appealing. Not as separate stream of research but incorporated in mainstream
research with stronger emphasis on theory building.

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Statements from graph 10: Comparison between Gibbs et al, Jansen et al and another study.
Dutch firms have more base salary (as a % of total compensation) compared to U.S. and China. The
Dutch incentives are more included in the salary, instead of U.S. and China.
U.S. gives more formula bonuses (target bonuses) compared to the Netherlands and China.
In China more discretionary bonuses are given. Some part is judged by the upper manager whether to
get the bonus when the target is reached.
Multinational organizations (MNOs) have many similarities with large domestic organizations in that they are
usually characterized by a high degree of decentralized decision making and by management control through
financial results controls. MNOs face a multidimensional organizational problem: they are organized not only
by function and/or product line, but also by geography. This section provides a discussion of, primarily, three
sets of factors that have been shown to affect MCS choices or outcomes across countries:
National culture;
Institutions; and
Local business environments.
Performance implications:
Why expect performance effects? Good fit means enhanced performance, while poor fit implies diminished
performance.
Equilibrium behavior of firms:
Each firm chooses optimal, given the firms specific characteristics and circumstances (this is why
some behaviors cant be compared).
May be regarded as hyper rationality assumption
Relaxed assumption: some firms off-equilibrium and moving towards equilibrium
Bubbles: firms could deviate from others during a certain period until the bubble burst. This could
seriously affect a firms performance.
You dont always choose optimal, but you move to it and achieve optimal.
Ittner et al. (2003) Performance implications of strategic performance measures in financial
services firm.
This paper focuses on the performance measurement practices within firms.
Two competiting theories:
1. Measurement diversity approach (more is better): firms need diverse set of financial and nonfinancial
performance measures.
a. Use non-financial measures to supplement traditional financial measures.
2. Contingency approach (does it fit): firms need to align performance measures with their specific
strategy/value-drivers.
a. By linking strategy to their underlying value drivers and tying everything to these drivers,
strategic performance measures systems are expected to improve communication of the
specific actions required to achieve the chose strategy, motivate performance, and provide
more rapid feedback on whether the strategy is achieving its objectives.
Survey-based measurement.
Extent to which firms strategy focus on 1) innovation, 2) flexibility in changing offerings in response to market
demands 3) maintaining relationships and offerings with existing customer and markets.
Supplementing traditional financial measures with a diverse mix of non-financial measures that are expected
to capture key strategic performance dimensions that are not accurately reflected in short-term accounting
measures.
Costs of financial measures alone:

Too historical and backward-looking

Lack of predictive ability to explain future performance

Rewards short-term or incorrect behavior

Provide little information on root causes or solutions to problems

Give inadequate consideration to difficult to quantify intangible assets such as intellectual capital.

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As a result many firms are supplementing financial measures with a diverse set of non-financial performance
measures that are believed to provide better information on strategic progress and success.
H1: Organizational performance is positively associated with the extent to which the firm measures and uses
information related to a diverse set of financial and non-financial performance measures.
Implementation of performance measurement systems that are more closely linked to the firms specific
strategy and value drivers. By linking strategies and tying information systems, goals and objectives, resource
allocation, and performance evaluation to these drivers, SPM systems are expected to improve
communication to specific actions required to achieve the chosen strategy, Motivate performance against
strategic value driver goals, and provide more rapid feedback on whether the strategy is achieving its
objectives.
H2: Organizational performance is positively associated with the extent to which performance measurement
practices are aligned with the firms strategy.
H2: Organizational performance is positively associated with the extent to which performance measurement
practices are aligned with the firms Value drivers.
Techniques to improve the alignment between performance measurement systems and the firms
organizational objectives:

Balanced scorecard process method for using financial and non-financial measures to communicate
the multiple, linked objectives that a firm must achieve to satisfy its mission and reach its long-term strategic
goals.

Economic value measurement Creation of long-term shareholder value through the use of residual
income or cash-flow related measures.

Causal business models.

Conclusion: The use of more diversification has significantly more positive impact
Cost Management
Traditional cost models assume that variable costs change symmetrically with changes in activity levels. Recent
evidence suggests cost stickiness:
Costs increase more rapidly with activity increases relative to cost decreases following activity
decreases.
Explanations:
o Reflects managerial trade-off of costs of downward adjustments against costs of keeping
slack resources (e.g. contracts). (Some managers likes to hang on to many resources while
seen the activity this amount of resources is not necessary).
o Agency-based explanations, e.g., empire-building
Dierynck et al. (2012) - Do managerial incentives drive cost behavior? Evidence about the role of
the zero earnings benchmark for labor cost behavior in private Belgium firms.
The authors expect managerial incentives to meet or beat zero earnings benchmark to offset forces that lead
to asymmetric cost behavior.
Zero earnings benchmark is important for these firms because then they can pay dividend and don't get goingconcern opinion of the auditor. Focus on labor costs, which represent major cost item on the income
statement.
The incentive to meet or beat the zero earnings benchmark increases the costs of upward resource
adjustments and decreases the costs of downward resource adjustments.Hence, managers who want to avoid
a loss will be more willing to cut labor costs when sales decrease (staff cheap to fire) and to limit the increase
in labor costs when sales increase.
Firms that meet or beat exhibit less cost asymmetry relative to other firms. Difference between increase and
decrease smaller. They actually exhibit cost symmetry. The change in labor cost in response to an activity

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change doesn't differ between an activity increase and activity decrease. More cost symmetry in the years that
they report a small profit.
Firms with healthy profits have a less immediate need to cut labor costs and are more concerned about
reputation in the labor market. They rather reduce the number of hours than the number of employees.
Activity level increase only focus on B1
Activity level decrease focus on the total formula B1+B2
Expected B1 > B1 + B2, so B2 < 0 has to be < 0 in this case if B1 is bigger than B1 + B2. Due to this formula cost
stickiness is expected, because costs go up easier than they get less.
In the statistics is seen that < 0 so there is a significant evidence that costs go up easier. There is no coststickiness for small-profit firms.
Transfer pricing
Transfer pricing generates revenue for the selling unit and purchase expenses for the buying unit. You use
transfer prices when a sale occurs between two divisions of one company.
The revenue of A is the cost for B.
This can be relevant when you transfer income from one country to another for tax reasons. Transfer pricing
methods may incentivize managers to make decisions that are suboptimal from firm-level perspective.
Transfer pricing methods:
1. Market-based transfer prices
a. Usefull when highly competitive market is available for intermediate product (market
liquidity is important)
b. Deviations from market price incentivizes to trade externally
i. E.g., Transfer price < Market price: selling division prefers to trade outside
c. Facilitates evaluation of economic performance of units
d. Can lead to suboptimal decisions
i. If selling division has idle capacity, but refuses to accept less than the market price.
When Transfer price < Market price. Company B rather sell external so they have a higher revenue.
This method is usefull when: 1) Market liquidity, 2) competitive market is available.
2. Cost-based transfer prices
a. Variable cost-based
i. Coincides with economists view: price at marginal cost
ii. Issues when selling unit approached capacity
1. Additional investments in capacity represent long-run variable cost, but
short-run fixed costs. (Company A cant charge the fixed costs from the
investments of company B0
2. Selling unit has incentives to classify fixed cost as variable costs (e.g.,
external purchasing instead of internal manufacturing)
iii. Sometimes supplemented with flat fee to cover fixed costs + margin.
b. Full (absorption) cost-based = Cost-plus
i. Most prevalent (gangbaar)
ii. Issues with full-cost based transfer pricing
1. Overstates opportunity costs to firm of producing and transferring one
more unit internally (especially if selling division has excess capacity) too
few units traded internally
2. Susceptible to manipulation by selling division (over-allocation of FOH)
a. Company A charge their products in the external market for a
lower price, because they charge the overhead to the internal
company.
3. No incentive for selling division to control costs

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3.

Negotiated transfer prices

a. Transfer price is the result of negotiation process. It preserves divisional autonomy.
i. Issues:
1. Reflect negotiating skills and economic considerations
2. May lead to suboptimal decisions for the firm
3. May consume valuable time and resources.

Lecture example
Moes Food Company recently acquired an olive oil processing company that has an annual capacity of
2,000,000 liters and that processed and sold 1,400,000 liters last year at a market price of $4 per liter. The
purpose of the acquisition was to furnish oil for the Cooking Division. The Cooking Division needs 800,000 liters
of oil per year. It has been purchasing oil from suppliers at the market price less a 10% quantity discount.
Production costs at capacity of the olive oil company, now a division, are as follows:
Variable manufacturing costs
$1.74
Fixed manufacturing overhead
0.40
Total
$2.14
Sales commissions of $0.30 are normally paid for external sales of olive oil, but no commissions will be paid for
any sales done internally. In determining what transfer price to use, the manager of the Olive Oil Division
argues that $4, the market price, is appropriate. The manager of the Cooking Division argues that the cost of
$2.14 should be used, or perhaps a lower price, since fixed overhead cost should be recomputed with the
larger volume. Determine the minimum transfer price under the following assumptions:
(a) The Olive Oil division can only sell 1,000,000 liters to outsiders;
(b) Any output of the Olive Oil Division not sold to the Cooking Division can be sold to outsiders;
(c) The Olive Oil division can sell 1,400,000 liters to outsiders in the coming year.
A)
Variable costs = 1.74, equal to the variable price, because the capacity is 2-1=1 left so overhead is
already made.
B)
Variable + opportunity costs = 1.74+(4-1.74-0.3)=3.70
$ 1,74 + opportunity cost ($4 - $1,74 - $0,30 = $3,70. Opportunity costs made when Oil sells to Cooking instead
of selling it external. Internal Transfer price is $3,60, so this is lower than $3,70.
C)
(800.000*1.74)+(200.000*1.96)/800.000 = $ 2,23

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