AFM 482

Chapter 1
- Elements of management control systems include:
o Strategic planning
o Budgeting
o Resource allocation
o Performance measurement
o Evaluation and Reward
o Responsibility centre allocation
o Transfer pricing

- Management control is a must in any organization that practices decentralization

- One view argues that strategy is first developed through a formal and rational process, and this
strategy then dictates the design of the firms management systems

- An alternative perspective is that strategies emerge through experimentation, which are
influenced by the firms management systems

- When firms operate in industries where environmental changes are predictable, they can use a
formal and rational process to develop the strategy first, and then design management control
systems to execute that strategy. However, in rapidly changing environments, it is difficult for a
firm to formulate the strategy first and then design the management control systems to execute
it

- Elements of a Control System:
o Every control system has at least 4 elements:
Detector/Sensor: A device that measures what is actually happening in the
process being controlled
Assessor: A device that determines the significance of what is actually
happening by comparing it with some standard or expectation of what should
happen
Effector/Feedback: A device that alters behaviour if the assessor indicates the
need to do so
Communications Network: Devices that transmit information between the
detector and the assessor and between the assessor and the effector

- The management control process is the process by which managers at all levels ensure that the
people they supervise implement their intended strategies

- Management control is not automatic, it requires coordination among individuals. The
connection from perceiving the need for action to determining the action required to obtain the
desired result may not be clear

- A system is a prescribed and usually repetitious way of carrying out an activity or a set of
activities

- If all systems ensured the correct action for all situations, there would be no need for human
managers

- Management control must be differentiated from two other systems or activities that also
require both planning and control: (1) strategy formulation and (2) task control

- Strategy formulation is the least systematic of the three, management control is in between,
and task control is the most systematic

- Strategy formulation focuses on the long run, management control is in between, and task
control focuses on short-run activities

- Strategy formulation uses rough approximations of the future, management control is in
between, and task control uses current accurate data

- Management control is the process by which managers influence other members of the
organization to implement the organizations strategies

- Management Control Activities:
o Planning what the organization should do
o Coordinating the activities of several part of the organization
o Communicating information
o Evaluating information
o Deciding what, if any, action should be taken
o Influencing people to change their behaviour

- Conforming to a budget is not necessarily good, and departure from a budget is not necessarily
bad. If a manager discovers a better approach one more likely than the predetermined plan to
achieve the organizations goals the management control system should not obstruct its
implementation

- Goal congruence means that insofar as is feasible, the goals of an organizations individual
members should be consistent with the goals of the organization itself. The management
control system should be designed with goal congruence in mind

- Management control systems encompass both financial and nonfinancial performance
measures. The financial dimension focuses on the monetary bottom line. But Virtually all
organizational subunits have nonfinancial objectives product, quality, market share, customer
satisfaction, on-time delivery, and employee morale

- In industries that are subject to rapid environmental changes, management control information,
especially of a nonfinancial nature, can also provide the basis for reconsidering new strategies.
This function is referred to as interactive control. Interactive control calls managements
attention to developments both positive and negative that indicate the need for new
strategic initiatives

- Strategy formulation is the process of deciding on the goals of the organization and the
strategies for attaining these goals

- Complete responsibility for strategy formulation should never be assigned to a particular person
or organizational unit

- Strategy formulation is the process of deciding on new strategies; management control is the
process of implementing those strategies

- Task control is the process of ensuring that specified tasks are carried out effectively and
efficiently

- Most of the information in an organization is task control information: the number of items
ordered by customers, the pounds of material and units of components used in the manufacture
of products, the number of hours employees work, and the amount of cash disbursed

- The most important distinction between task control and management control is that many task
control systems are scientific, whereas management control can never be reduced to a science

- The Impact of the Internet on Management Control:
o Instant access
o Multi-targeted communication
o Costless communication
o Ability to display images
o Shifting power and control to the individual
Chapter 3
- Management control systems influence behaviour, good management control systems do so in
a goal congruent manner

- Goal congruence is affected by informal actions and formal systems

- Formal systems can be divided into two categories: (1) rules (2) systematic methods for planning
and for maintaining control

- In a goal congruent process, the actions people are led to take in accordance with their
perceived self-interest are also in the best interest of the organization

- Goals between employee and employer can never be 100% congruent (e.g. employees want
unlimited salary, employer wants to keep the organization economically feasible)

- External factors that influence goals congruence are norms of desirable behaviour that exist in
the society of which the organization is a part. These norms include a set of attitudes, often
collectively referred to as the work ethic, which is manifested in employees loyalty to the
organization, their diligence, their spirit, and their pride in doing a good job

- The most important internal factor is the organizations own culture the common beliefs,
shared values, norms of behaviour; and assumptions that are implicitly accepted and explicitly
manifested throughout the organization

- The internal factor that probably has the strongest impact on management control is
management style. Usually subordinates attitudes reflect what they perceive their superiors
attitudes to be, and their superiors attitudes ultimately stem from the CEO

- Formal systems can be classified as two types (1) the management control system itself, and (2)
rules

- Examples of Rules:
o Physical Controls
o Manuals
o System Safeguards
o Task Control Systems

- Although organizations come in all shapes and sizes, their structures can be grouped into three
general categories
o A functional structure, in which each manager is responsible for a specified function
such as production or marketing

o A business unit structure, in which business unit managers are responsible for most of
the activities of their particular unit, and the business unit functions as a semi-
independent part of the company

o A matrix structure, in which functional units have dual responsibilities

- The skilled specialist should be able to supervise workers in the same function better than the
generalist would, just as skilled higher-level managers should be able to provide better
supervision of lower-level managers in the same or similar function. Thus, an important
advantage of a functional structure is efficiency

- There are several disadvantages to a functional structure:
o There is no unambiguous way of determining the effectiveness of the separate
functional managers (e.g., the managers of marketing and of production) because each
function contributes jointly to the organizations final output. Therefore, there is no way
of measuring what fraction of profit was contributed by each

o If the organization consists of managers in one function who report to higher-level
managers in that function, then a dispute between managers of different functions can
only be resolved at the top

o Functional structures are inadequate for a firm with diversified products and markets

o Functional organizations tend to create silos for each function, thereby preventing
cross-functional coordination in areas such as new product development. This problem
can be mitigated by supplementing the vertical functional structure with lateral cross-
functional processes such as cross-functional job rotation and team-based rewards

- A business unit, also called a division, is responsible for all the functions involved in producing
and marketing a specified product line

- Advantages of the business unit structure
o It provides a training ground in general management. The business unit manager should
demonstrate the same entrepreneurial spirit that characterizes the CEO of an
independent company

o Because the business unit manager is closer to the market for its products than
headquarters is, its manager may make sounder production and marketing decisions
than headquarters might, and the unit as a whole can react to new threats or
opportunities more quickly

- Disadvantages of the business unit structure:
o Each business unit staff may duplicate the work that in a functional organization is done
at headquarters. The business unit manager is presumably a generalist, but his or her
subordinates are functional specialists, and they must deal with many of the same
problems addressed by specialists both at headquarters and in other business units as
well

o Disputes between functional specialists in a functional organization may be replaced by
disputes between business units in a business unit organization

- The controller is the person who is responsible for designing and operating the management
control systems, however in many organizations, the title of this person is Chief Financial Officer
(CFO)

- The controller usually performs the following functions:
o Designing and operating information and control systems

o Preparing financial statements and financial reports for shareholders and other parties

o Preparing and analyzing performance reports, interpreting these reports for managers,
and analyzing program and budget proposals from various segments and consolidating
them into an overall annual budget

o Supervising internal audit and accounting control procedures to ensure the validity of
information, establishing adequate safeguards against theft and fraud, and performing
operational audits

o Developing personnel in the controller organization and participating in the educations
of management personnel in matters relating to the controller function
Chapter 4
- A responsibility centre is an organization unit that is headed by a manager who is responsible for
its activities. In a sense, a company is a collection of responsibility centres

- Cost is a monetary measure of the amount of resources used by a responsibility centre. Note
that inputs are resources used by the responsibility centre (patients in a hospital or students in
a school are not inputs, rather the resources a hospital or school uses to accomplish its objective
of treating patients or educating students)

- It is much easier to measure the cost of inputs than to calculate the value of outputs (e.g., a
university can easily measure the number of students graduated, but they cannot measure the
amount of education they have received)

- Many organizations do not even attempt to measure the outputs of such responsibility centres.
Others use an approximation, or surrogate numbers, while acknowledging its limitations

- The concepts of input, output, and cost can be used to explain the meaning of efficiency and
effectiveness, which are the two criteria by which the performance of a responsibility centre is
judged

- Efficiency is the ratio of outputs to inputs, or the amount of output per unit of input

- In many responsibility centres, efficiency is measured by comparing actual costs with some
standard of what those costs should have been at the measured output. Though this method
can be useful, it has two major flaws: (1) recorded costs are not precise measures of the
resources actually consumed, and (2) the standard is merely an approximation of what ideally
should have happened under the prevailing circumstances

- Effectiveness is determined by the relationship between a responsibility centres output and its
objectives (i.e., the more this output contributes to the objectives, the more effective the unit)

- Efficiency and effectiveness are not mutually exclusive; every responsibility center ought to be
both efficient and effective

- In summary, a responsibility center is efficient if it does things right, and it is effective if it does
the right things

- A major objective of any profit-oriented organization is to earn a satisfactory profit. Thus, profit
is an important measure of effectiveness. Furthermore, since profit is the difference between
revenue (a measure of output) and expense (a measure of input), it is also a measure of
efficiency. This, profit measures both effectiveness and efficiency

- There are four types of responsibility center, classified according to the nature of the monetary
inputs and/or outputs that are measured for control purposes:
o Revenue centers
o Expense center
o Profit centers
o Investment centers

- Each type of responsibility center requires a different planning and control system

- In a revenue center, output (i.e., revenue) is measured in monetary terms, but no formal
attempt is made to relate input (i.e., expense or cost) to output

- Typically revenue centers are marketing/sales units that do not have authority to set selling
prices and are not charged for the cost of the goods they market. Actual sales or orders booked
are measured against budgets or quotas, and the manager is held accountable for the expenses
incurred directly within the unit, but the primary measurement is revenue

- Expense centers are responsibility centers whose inputs are measured in monetary terms, but
whose outputs are not

- There are two general types of expense centers:
o Engineered
Engineered costs are those for which the right or proper amount can be
estimated with reasonable reliability (e.g., a factorys costs for direct labour,
direct material, components, supplies, and utilities)

Output multiplied by the standard cost of each unit produced measures what
the finished product should have cost. The difference between the theoretical
and the actual cost represents the efficiency of the expense center being
measured

In summary:
their input can be measured in monetary terms
their output can be measured in physical terms
their optimum dollar amount of input required to produce one unit of
output can be determined

o Discretionary
Discretionary costs (also called managed costs) are those for which no such
engineered estimate is feasible. In discretionary expense centers, the costs
incurred depend on managements judgment as to the appropriate amount
under the circumstances

Discretionary expense centers include administrative and support units (e.g.,
accounting, legal, industrial relations, public relations, human resources)

The work done by discretionary expense centers falls into two general
categories (1) continuing and (2) special
Continuing work is done consistently from year to year, such as the
preparation of financial statements by the controllers office

Special work is a one-shot project (e.g., developing and installing a
profit-budgeting system in a newly acquired division)

A technique often used in preparing a discretionary expense centers budget is
management by objectives, a formal process in which a budgetee proposes to
accomplish specific jobs and suggests the measurement to be used in
performance evaluations

Incremental budgeting: in this model, the discretionary expense centers
current level of expenses is taken as the starting point. This amount is adjusted
for inflation, anticipated changed in the workload of continuing job, special job,
and if the data is readily available the cost of comparable jobs in similar units
Drawbacks of incremental budgeting:
o First, the discretionary expense centers current level of
expenditure is accepted and not re-examined during the budget
preparation process

o Second, managers of these centers typically want to increase
the level of services, and thus tend to request additional
resources, which if they make a sufficiently strong case are
usually provided (Parkinsons Second Law: overhead costs tend
to increase, period.)

Zero-Base Review: An alternative budgeting approach is to make a thorough
analysis of each discretionary expense center on a rolling schedule, so that all
are reviewed at least once every five years or so
Zero-base reviews are time-consuming, and they are likely to be
traumatic for the managers whose operations are being reviewed (this
is one of the reasons for scheduling such reviews so infrequently)

Unlike costs in engineered expense centers, which are strongly affected by
short-run volume changes, costs in discretionary expense centers are
comparatively insulated from such short-term fluctuations. This difference
stems from the fact that in preparing the budgets for discretionary expense
centers, management tends to approve changes that correspond to anticipated
changes in sales volume (e.g., allowing for additional personnel when volume is
expected to increase, and for layoffs or attrition when volume is expected to
decrease)

- Administrative centers include senior corporate management and business unit management,
along with the managers of supporting staff units. Support centers are units that provide
services to other responsibility centers

- The control of administrative expense is especially difficult because of (1) the problems inherent
in measuring output and (2) the frequent lack of congruence between the goals of departmental
staff and of the company as a whole

- In many companies, two very different types of activities are grouped under the heading of
marketing, with different controls being appropriate for each. One group of activities relates to
the filling of orders. These are referred to as logistics activities and, by definition, take place
after an order has been received. The other group of activities relates to efforts to obtain
orders, and, obviously, take place before an order has been received. These are true marketing
activities

- In summary, there are three types of activities within a marketing organization, and,
consequently, three types of activity measures. First, there is the logistics activity, many of
whose costs are engineered expenses. Second, there is the generation of revenue, which is
usually evaluated by comparing actual revenue and physical quantities sold with budgeted
revenue and budgeted units, respectively. Third, there are order-getting costs, which are
discretionary because no one knows what the optimum amounts should be. Consequently the
measurement of efficiency and effectiveness for these costs is highly subjective
Chapter 5
- When a responsibility centers financial performance is measured in terms of profit, the center is
called a profit center

- A functional organization is one in which each principal manufacturing or marketing function is
performed by a separate organization unit. When such an organization is converted to one in
which each major unit is responsible for both the manufacture and the marketing, the process is
termed divisionalization

- Two conditions should exist before it is safe to entrust a lower-level manager with
expense/revenue trade-off decisions:
o The manager should have access to the relevant information needed for making such a
decision

o There should be some way to measure the effectiveness of the trade-offs the manager
has made

- Advantages of Profit Centers:
o The quality of decisions may improve because they are being made by managers closest
to the point of decision

o The speed of operating decisions may be increased since they do not have to be
referred to corporate headquarters

o Headquarters management, relieved of day-to-day decision making, can concentrate on
broader issues

o Managers, subject to fewer corporate restraints, are freer to use their imagination and
initiative

- Disadvantages of Profit Centers:
o Decentralized decision making will force top management to rely more on management
control reports than on personal knowledge of an operation, entailing some loss of
control

o If headquarters management is more capable or better informed than the average profit
center manager, the quality of decisions made at the unit level may be reduced

o Friction may increase because of arguments over the appropriate transfer price, the
assignment of common costs, and the credit for revenues that were formerly generated
jointly by two or more business units working together

- To realize fully the benefits of the profit center concept, the business unit manager would have
to be as autonomous as the president of an independent company. As a practical matter,
however, such autonomy is not feasible. Consequently, business unit structures represent trade-
offs between business unit autonomy and corporate constraints. The effectiveness of a business
unit organization is largely dependent on how well these trade-offs are made

- It is useful to think of managing a profit center in terms of control over three types of decisions:
o The product decision
o The marketing decision
o The procurement (outsourcing) decision

- The constraints imposed by corporate management can be grouped into three types:
o Those resulting from strategic considerations
o Those resulting because uniformity is required
o Those resulting from the economies of centralization

- A marketing activity can be turned into a profit center by charging it with the cost of the
products sold. The transfer price provides the marketing manager with the relevant information
to make the optimum revenue/cost trade-offs, and the standard practice of measuring a profit
centers manager by the centers profitability provides a check on how well these trade-offs
have been made

- There are two types of profitability measurements used in evaluating a profit center, just as
there are in evaluating an organization as a whole:
o First, there is the measure of management performance, which focuses on how well the
manager is doing. This measure is used for planning, coordinating, and controlling the
profit centers day-to-day activities and as a device for providing the proper motivation
for its manager

o Second, there is the measure of economic performance, which focuses on how well the
profit center is doing as an economic entity

- The performance of the profit center manager may be evaluated based on five different
measures of profitability:
o Contribution margin
o Direct profit
This measure reflects a profit centers contribution to the general overhead and
profit of the corporation
o Controllable profit
Headquarters expense can be divided into two categories (1) controllable and
(2) noncontrollable. The former category includes expenses that are
controllable, a least to a degree, by the business unit manager
o Income before income taxes
o Net income

- Managers should be measured against those items they can influence, even if they do not
have total control over those items
Chapter 6
- If two or more profit centers are jointly responsible for product development,
manufacturing, and marketing, each should share in the revenue generated when the
product is finally sold. The transfer price is the mechanism for distributing this revenue

- The transfer price should be designed so that it accomplishes the following objectives:
o It should provide each business unit with the relevant information it needs to determine
the optimum trade-off between company costs and revenues

o It should induce goal congruent decisions that is, the system should be designed so
that decisions that improve business unit profits will also improve company profits

o It should help measure the economic performance of the individual business units

o The system should be simple to understand and easy to administer

- The term transfer price refers to the value placed on a transfer of goods or services in
transactions in which as least one of the two parties involved is a profit center

- The fundamental principal is that the transfer price should be similar to the price that would be
charged if the product were sold to outside customers or purchased from outside vendors

- When profit centers of a company buy products from, and sell to, one another, two decisions
must be made periodically for each product:
o Should the company produce the product inside the company or purchase it from an
outside vendor? This is the sourcing decision

o If produced inside, at what price should the product be transferred between profit
centers? This is the transfer price decision

- An idea situation to induce goal congruence by implementing a market price based transfer
price will include the following conditions:
o Competent People
o Good Atmosphere
o A Market Price
o Freedom to Source
o Full Information
o Negotiation

- Constraints on Sourcing
o Limited Markets
o Excess/Shortage of Industry Capacity

- When using a cost-based transfer price two decisions must be made: (1) how to define cost and
(2) how to calculate the profit mark-up
o The usual cost basis is standard costs. Actual costs should not be used because
production inefficiencies will be passed on to the buying profit centre. If standard cost
are used, an incentive is needed to set tight standards and improve them

o When calculating profit mark-up, there are two decisions: (1) what the profit mark-up is
based on and (2) the level of profit allowed

o The simplest and most widely used base is percentage of costs. If this base is used,
however, no account is taken of capital required. A conceptually better base is a
percentage of investment, but calculating the investment applicable to a given product
may pose a major practical problem. If the historical cost of the fixed asset is used, new
facilities designed to reduce prices could actually increase costs because old assets are
undervalued. The second problem with the profit allowance is the amount of profit

Chapter 7
- A unit where profit is compared with the assets employed in earning it is referred to as an
investment centre

- In the real world, companies use the term profit centre instead of investment centre. It is agreed
that an investment centre is a special type of profit centre, rather than a separate parallel
category. However, their complexity warrants additional analysis

- The sum of the principal assets employed in an investment centre is called the investment base

- Two methods is relating profit to the investment base are: (1) Return on Investment, and (2)
Economic Value Added

- Return on Investment (ROI) is a ratio; the numerator is income, as reported on the income
statement. The denominator is assets employed

- Economic Value Added (EVA) is a dollar amount, rather than a ratio. It is found by subtracting a
capital charge from the net operating profit. This capital charge is found by multiplying the
amount of assets employed by a rate, which will be discussed later

- EVA is conceptually superior to ROI, however, based on surveys, ROI is more widely used in
business than EVA

- Assets:
o Cash: Most companies control cash centrally because central control permits use of a
smaller cash balance than would be the case if each business unit held the cash balances
it needed to weather the unevenness of its cash inflows and outflows. Actual cash
balances at the business level tend to be much smaller than would be required if the
business unit were an independent company

o Receivables: Business unit managers can influence the level of receivables indirectly, by
their ability to generate sales, and directly, by establishing credit terms, and by their
vigor in collecting overdue amounts

o Inventories: Inventories ordinarily are treated in a manner similar to receivables that
is, they are often recorded at end-of-period amounts even though intraperiod averages
would be preferable conceptually

o General Working Capital: Treatment of working capital items varies greatly, at one
extreme; companies include all current assets in the investment base with no offset of
any current liabilities. This method is sound from a motivational standpoint if the
business units cannot influence accounts payable or other current liabilities. It does
overstate the amount of corporate capital required the finance the business unit,
however, because the current liabilities are a source of capital, often at zero interest
cost. At the other extreme, all current liabilities may be deducted from current assets.
This method provides a good measure of the capital provided by the corporation, on
which it expects the business unit to earn a return. However, it may imply that the
business unit managers are responsible for certain current liabilities over which they
have no control

o Property, Plant, and Equipment: Most companies use the depreciation system in
calculating the profitability of the business units asset base. This causes some serious
problems in using the system for its intended purpose, problems such as:

Acquisition of New Equipment: EVA calculations may signal that profitability of
buying a new machine that produces cash savings may decrease even though
the economic facts are that profitability has increased, because depreciation has
a negative effect on EVA

Gross Book Value: he fluctuation in economic value added and return on
investment from year to year can be avoided by including depreciable assets in
the investment base at gross book value rather than at net book value

Disposition of Assets: The drastic difference between depreciated old
equipment and undepreciated new equipment may overstate the EVA
calculation. This may encourage managers to replace old equipment with new
equipment, even when replacement is not economically justified. Furthermore,
business units that are able to make the most replacements will show the
greatest improvement in profitability

Annuity Depreciation: If depreciation is determined by the annuity, rather than
the straight-line method, the business unit profitability calculation will show the
correct economic value added and return on investment. This is because the
annuity depreciation method actually matches the recovery of investment that
is implicit in the present value calculation
- EVA vs. ROI
o ROI Pros:
It is a comprehensive measure in that anything that affects financial statements
is reflected in this ratio

ROI is simple to calculate, easy to understand, and meaningful in an absolute
sense (e.g. ROI < 5% is considered low absolutely, ROI > 25% is considered high
absolutely)

It is a common denominator that may be applied to any organizational unit
responsible for profitability, regardless of size or type of business

o EVA Pros:
With EVA all business units have the same profit objective for comparable
investments

Decisions that increase a centres ROI may decrease its overall profits

Different interest rates may be used for different types of assets (e.g., low rate
used for inventories while a relatively higher rate may be used for fixed assets)

In contrast to ROI, it has a stronger positive correlation with changes in a
companys market value. Three reasons why shareholder value creation is
critical for the firm are:
It reduces the risk of takeover

It creates currency for aggressiveness of mergers and acquisitions

It reduces the cost of capital, which allows faster investment for future
growth

- OR
( )

-

- The following actions can increase EVA:
o Increase in ROI though business process reengineering and productivity gains, without
increasing the asset base

o Divestment of assets, products, and/or businesses whose ROI is less than the cost of
capital

o Aggressive new investments in assets, products, and/or businesses whose ROI exceeds
the cost of capital

o Increase in sales, profit margins, or capital efficiency (ratio of sales to capital employed),
or decrease in cost of capital percentage, without effecting the other variables of the
equation

- EVA solves the problem of differing profit objectives for the same asset in different business
units and the same profit objective for different assets in the same unit

- Although superior, EVA does not solve all the problems of measuring profitability in an
investment centre. In particular, it does not solve the problem of accounting for fixed assets,
unless annuity depreciation is also used, which is rarely done in practice

- Management reports are compiled regularly (annual, quarterly), while economic reports are
done at irregular intervals. Economic reports are a diagnostic instrument. They indicate whether
the current strategies of the business unit are satisfactory and , if not, whether a decision should
be made to do something about the business unit expand it, shrink it, change its direction, or
sell it

- Economic reports are also made as a basis for arriving at the value of the company as a whole.
Such a value is called the breakup value that is, the estimates amount that shareholders would
receive if individual business units were sold separately

- The most important difference between the two types of reports is that the economic reports
focus on future profitability rather than current or past profitability. The book value of assets
and depreciation based on the historical cost of these assets is used in the performance of
reports from managers, despite their known limitations. This information is irrelevant in reports
that estimate the future; in these reports, the emphasis is on replacement costs
Chapter 8
- Strategic planning is the process of deciding on the programs that the organization will
undertake and on the approximate amount of resources that will be allocated to each program
over the next several years

- There is a distinction between Strategy Formulation and Strategic Planning:
o Strategy Formulation is the process of deciding on new strategies, whereas Strategic
Planning is the process of deciding how to implement the strategies

- In the strategy formulation process, management arrives at the goals of the organization and
creates the main strategies for achieving those goals. The strategic planning process then takes
the goals and strategies as given and develops programs that will carry out the strategies and
achieve the goals efficiently and effectively

- The document that describes how the strategic decision is to be implemented is the strategic
plan

- A formal strategic planning process can give to the organization
o Framework for developing the annual budget
An important benefit of preparing a strategic plan is that it facilitates the
formulation of an effective operating budget

An important benefit of strategic planning is to facilitate optimal resource
allocation decisions in support of key strategic options

o Management development tool
Formal strategic planning is an excellent management education and training
tool that provides managers with a process for thinking about strategies and
their implementation

o Mechanism to force managers to think long-term
Formal strategic planning forces managers to make time for thinking through
important long-term issues

o Means of aligning managers with the long-term strategies of the company
The debates, discussion, and negotiations that take place during the planning
process clarify corporate strategies, unify and align managers with such
strategies, and reveal the implications of corporate strategies for individual
managers

- There are several potential pratfalls or limitations to formal strategic planning:
o Danger that planning can end up becoming a form filling, bureaucratic exercise devoid
of strategic thinking

o An organization may create a large strategic planning department and delegate the
preparation of the strategic plan to that staff department

o Strategic planning can be time consuming and expensive

- A formal strategic planning process is not needed in small, relatively stable organizations, and it
is not worthwhile in organizations that cannot make reliable estimates about the future or in
organizations whose senior management prefers not to manage in this fashion

- Proposals for programs are essentially either reactive or proactive they arise either as a
reaction to a perceived threat such as rumour of the introduction of a new product by a
competitor, or as an initiative to capitalize on an opportunity

- Most proposals require significant new capital. Techniques for analyzing capital investment
proposals attempt to find either (a) the net present value of the project, or (b) the internal rate
of return implicit in the relationship between inflows and outflows

- Analyzing Ongoing Programs:
o Value Chain Analysis: The value chain for any firm is the linked set of value creating
activities of which it is a part, from acquiring the basic raw materials for component
suppliers to making the ultimate end-use product and delivering it to the final
consumers
Linkages with suppliers

Linkages with customers

Process linkages within the value chain of the firm
Efficiency of the inward position (i.e., the portion that precedes
production)

Efficiency of the production portion

Efficiency of the outward position (i.e., from the factory door to the
customer)

o Activity Based Costing

- Strategic Planning Process:
o Reviewing and updating the strategic plan from last year

o Deciding on assumptions and guidelines
Management Meetings

o First iteration of the new strategic plan

o Analysis
Planning Gap: The sum of the individual plans does not add up to the
attainment of the corporate objectives

There are only three ways to close the planning gap: (1) find opportunities for
improvements in the business unit plans (2) make acquisitions (3) review the
corporate objectives

o Second iteration of the new strategic plan

o Final review and approval
Chapter 9
- Budgets are an important tool for effective short-term planning and control in organizations. An
operating budget usually covers one year and states the revenues and expenses planned for
that year

- The process of preparing a budget should be distinguished from (a) strategic planning and (b)
forecasting

- Both strategic planning and budget preparation involve planning, but the types of planning
activities are different in the two processes. The budgeting process focuses on a single year,
whereas strategic planning focuses on activities that extend over a period of several years

- A budget differs in several respects from a forecast. A budget is a management plan, with the
implicit assumption that positive steps will be taken by the budgetee the manager who
prepares the budget to make actual events correspond to the plan; a forecast is merely a
prediction of what will most likely happen, carrying no implication that the forecaster will
attempt to so shape events that the forecast will be realized

- Preparation of an operating budget has four principal purposes:
o Fine-Tuning the Strategic Plan
o Coordination
o Assigning Responsibilities
o Basis for Performance Evaluation

- Operating Budget Categories:
o Revenue Budgets
o Budgeted Production Cost and Cost of Sales
o Marketing Expenses
o General and Administrative Expenses
o Research and Development Expenses
o Income Taxes

- Other Budgets:
o Capital Budget
o Budgeted Balance Sheet
o Budgeted Cash Flow Statement
o Management by Objectives

- Budget Preparation Process:
o Organization
Budget Department

The Budget Committee

o Issuance of Guidelines

o Initial Budget Proposal
Changes from the current level of performance can be classifies as (a) changes
in external forces and (b) changes in internal policies and practices

o Negotiation
Slack: The difference between the budget amount and the best estimate

o Review and Approval

o Budget Revisions
There are two general types of budget revisions (1) procedures that provide for
a systematic (say, quarterly) updating of the budgets (2) procedures that allow
revisions under special circumstances

o Contingency Budgets

- A budget process is either top-down or bottom-up. With top-down budgeting, senior
management sets the budget for the lower levels. With bottom-up budgeting, lower-level
managers participate in setting the budget amounts

- Senior management involvement is necessary for any budget system to be effective in
motivating budgetees. Management must participate in the review and approval of the budgets,
and the approval should not be a rubber stamp

- Quantitative Budget Evaluation Techniques:
o Simulation
o Probability Estimates
Chapter 10
- The analytical framework used to conduct variance analysis incorporates the following ideas:
o Identify the key causal factors that affect profits

o Break down the overall profit variances by these key causal factors

o Focus on the profit impact of variation in each causal factor

o Try to calculate the specific, separable impact of each causal factor by varying only that
factor while holding all other factors constant

o Add complexity sequentially, one layer at a time, beginning at a very basic common
sense level

o Stop the process when the added complexity at a newly created level is not justified by
added useful insights into the causal factors underlying the overall profit variance

- Revenue Variances:
o Selling Price Variance: Difference between the actual price and standard price
multiplied by actual volume

o Mix and Volume Variance: (Actual volume Budgeted volume) * Budgeted unit
contribution

o Mix Variance: [(Actual volume of sales) (Total actual volume of sales * Budgeted
proportion) * Budgeted unit contribution]

o Volume Variance: [(Total actual volume of sales) * (Budgeted percentage) (Budgeted
sales)] * (Budgeted unit contribution)

o Market Share Variance: [(Actual sales) (Industry volume)] * Budgeted market
penetration * Budgeted unit contribution

o Industry Volume Variance: (Actual industry volume Budgeted industry volume) *
Budgeted market penetration * Budgeted unit contribution

- Unit gross margin is the difference between selling prices and manufacturing costs

- In management control systems, the formal standards used in the evaluation of reports on
actual activities are of three types:
o Predetermined standards or budgets

o Historical standards
This type of standard has two serious weaknesses: (1) conditions may have
changed between the two periods in a way that invalidates the comparison (2)
the prior periods performance may not have been acceptable

o External standards

- Even a standard cost may not be an accurate estimate of what costs should have been under the
circumstances. This situation can arise for either or both of two reasons: (1) the standard was
not set properly, or (2) although it was set properly in light of conditions existing at the time,
changed conditions have may the standard obsolete

- Limitations of Variance Analysis:
o The analysis identifies where a variance occurs, but it does not tell why it occurred or
what is being done about it

o Deciding whether a variance is significant

o As the performance reports become more highly aggregated, offsetting variances might
mislead the reader

- One of the most important benefits of formal reporting is that it provides the desirable pressure
on subordinate managers to take corrective actions on their own initiative
Chapter 11
- The goal of performance measurement systems is to implement strategy

- Management needs to look beyond optimizing short-term profitability when designing
performance measures. And they must look beyond just financial measures. Focusing on
financial measures may encourage managers to cut corners or delivery an inferior product just
to meet certain targets, these called Errors of Commission

- Managers may also avoid risky projects for safer ones which may not benefit the company
overall. These are called Errors of Omission

- There is also a greater risk of managers manipulating data if there is only a focus on short-term
measures

- One example of a performance measurement system is the balanced scorecard

- Non-financial performance measures to take into account include:
o Outcome Measures: indicate the results of a strategy (e.g. increased revenue). These
are typically lagging indicators, they tell management what has happened

o Driver Measures: These are leading indicators, they show the progress of key areas in
implementing a strategy (e.g. cycle time)

- Other measures include internal (e.g. manufacturing yields) and external (e.g. customer
satisfaction) measures

- Customer-Focused Key Variables:
o Bookings
o Backorders
o Market share
o Key account orders
o Customer satisfaction
o Customer retention
o Customer loyalty

- Key Variables Related to Internal Business Processes:
o Capacity utilization
o On-time delivery
o Inventory turnover
o Quality
o Cycle time
Cycle time = Processing time + Storage time + Movement time + Inspection time

- Implementation of a performance measurement system involves four general steps:
o Define strategy
o Define measures of strategy
o Integrate measures into the management system
o Review measures and results frequently

- Difficulties in Implementing Performance Measurement Systems:
o Poor Correlation Between Non-Financial Measures and Results
o Fixation of Financial Results
o Measures of not Updated
o Measurement Overload
o Difficulty in Establishing Trade-Offs

- Interactive Control: Frequent new basis for thinking about new strategies In companies which
operate in rapidly changing environments

- Learning Organization: Refers to the ability of an organizations employees to cope with
environmental changes on an ongoing basis

- The main objective of Interactive Control is to facilitate the creation of a Learning Organization

- While Critical Success Factors are important in control system design to implement the chosen
strategy, Strategic Uncertainties guide the use of a subset of management control information
interactively in developing new strategies

- A subsystem should satisfy the following conditions before it can be used as an interactive
control system:
o The data contained in the subsystem should be unambiguous and simple to understand
and interpret

o The subsystem must contain data on strategic uncertainties

o The data in the subsystem should help the firm develop new strategies
Chapter 12
- A positive incentive or reward is an outcome that increases satisfaction of individual needs.
Conversely a negative incentive, or punishment is an outcome that decreases satisfaction of
those needs

- Research has shown that people tend to be more strongly motivated by the potential of earning
rewards than by the fear of punishment

- A managers total compensation package consists of three components: (1) salary, (2) benefits
(principally retirement and healthcare), and (3) incentive compensation

- Short-Term Incentive Plans:
o The Total Bonus Pool
o Increase in Retained Earnings
o Carryovers
o Deferred Compensation

- Long-Term Incentive Plans
o Stock Options
o Phantom Shares
o Stock Appreciation Rights
o Performance Shares
o Performance Units

- Several proposals have been made to ensure that the board of directors acts in the interest of
the shareholders and does not work at the mercy of CEOs:
o Prevent directors from selling their stock for the duration of their term to encourage
them to ask the tough questions of CEOs without fear of adversely affecting short-
term stock prices
o Set mandatory limits on the tenure of directors to avoid their becoming too entrenched
with management
o Hold an annual performance review of directors
o Avoid having the CEO of the corporation act as the chairman of the board

- Types of Incentives:
o Financial Rewards:
Salary increase
Bonuses
Benefits
Prerequisites

o Psychological and Social Rewards:
Promotion possibilities
Increased responsibilities
Increased autonomy
Better geographical location
Recognition

- Size of Bonus Relative to Salary:
o Fixed Pay System
o Performance-based pay

- In a single industry firm where all departments are highly interdependent, it makes more sense
to have a bonus based on total corporate profits. However, in a conglomerate where each
department is highly autonomous it is usually not beneficial to do so, as managers who put in
little effort may still receive a sizable bonus. This is called the Free-Rider problem

- Performance Criteria:
o Financial Criteria
o Adjustments for Uncontrollable Factors

- Agency Theory Concepts:
o Divergent Objectives of Principals and Agents
o Non-observability of Agents Actions

- Control Mechanisms:
o Monitoring
o Incentive Contracting
o CEO Compensation and Stock Ownership Plans
o Business Unit Managers and Accounting-Based Incentives
Chapter 14
- The workforce in the United States has shifted from its beginnings in agriculture in the 18
th
and
19
th
century, to manufacturing in the 20
th
century, and now the service sector in present day

- Characteristics of Service Organizations:
o Absence of Inventory Buffer
o Difficulty in Controlling Quality
o Labor Intensive
o Multi-Unit Organizations

- Special Characteristics of Professional Service Organizations:
o Goals
o Professionals
o Output and Input Measurements
o Small Size
o Marketing

- Management Control Systems:
o Pricing
o Profit Centre and Transfer Pricing
o Strategic Planning and Budgeting
o Control of Operations
o Performance Measurement and Appraisal

- Special Characteristics of Financial Service Organizations:
o Monetary Assets
o Time Period for Transactions
o Risk and Reward
o Technology

- Special Characteristics for Health Care Organizations:
o Difficult Social Problem
o Change in Mix of Providers
o Third Party Payers
o Professionals
o Importance of Quality Control

- A non-profit organizations is defines by law as an organization that cannot distribute its assets
or profits to or on behalf of its members. It can still of course compensate its employees. Non-
profit doesnt mean that the organizations cannot earn a profit, just that they cannot distribute
that profit

- Special Characteristics of Non-profit Organizations:
o Absence of Profit Measure
o Contributed Capital
o Fund Accounting
o Governance

- Management Control Systems:
o Product Pricing
o Strategic Planning and Budget Preparation
o Operation and Evaluation