6: Fundamentals of Results Control

Learning objectives
>Responsibility centres and organizational structure
>Return on Investment v Residual Income
>Forms of non-financial performance measures.

Financial forms of results control

Evolution of management control systems

>Start-up organisations are small, relatively easy to
manage and are mostly centralised
>The MCS/MAS become more complex as the
organisation grows and changes
Economies of scope
>Delegation of decision-making becomes necessary
>Responsibility centres become important

Context: no designed/explicit controls, controls here are

just direct supervision/observation/mutual control
Divisionalisation occurs here: specialisation in different
things e.g. making product, selling product, thinking of
ideas
Development of MCS: start-up more people working
under me distanced from them thus, need controls
to efficiently + effectively align their behaviour with
goals of company
Balance of controls: cant review + measure everyones
performance in the same way, has to be customised to
their function in the company
Economies of scope argument for how MCS has evolved
3 general shapes that all MCS fit into
Structure is the 1st form of control: divisionalisation +
ability to delegate tasks that then allow us to control
people + implement MCS

Delegation
>To what extent can decisions be made by subordinate
managers?
Knowledge/experience of managers.
Type of work/ ability to be subversive.
Reliant on governance structure
o Private v public v partnership

Only through delegation that MCS is necessary/can

happen
Company is a network of business units that relate to
each other in a hierarchy (flat, tall, nature of span of
control, lines of command all relate to tasks/roles of ind)
delegation
Ability to delegate is what will allow me to free myself
up so I can think about strategic things + grow business
E.g. Want to grow business but cant step away from it:
Manager whos as motivated as him to grow that
business while hes not in the store: needs experience,
knowledge + right attitude
Against a situation where theres a great ability to be
subversive: steal, control over cash, lose clients, his
presence means people cant be subversive (to delegate,
need to define + redesign tasks that reduces inds ability
to be subversive)
Governance structure: ownership is an important part of
bonding people to organisational goals to get rid of
agency problems (offer ownership to effectively
delegate: its in their interests to work in the companys
interests), mutual observations in partnerships
Delegation is the movement from centralisation to
decentralisation, decision-making is made by those ind
who know the market + how to make things so it is quick
+ effective

>Centralisation: decision-making powers are centred

within top management and directives are carried out by
subordinates
>Decentralisation: decision- making powers are delegated
to managers at divisional and departmental levels
>Military: centralised
>Usyd: decentralised at subject level
>PwC: centralised b/c huge risk: mistake on the modified
report, sued by SH
>Visy Packaging: decentralised, each factory treated as a
separate business unit/investment

NB: China: size/capacity wasnt an issue, funded on

debt, ROI is a massive need, instead of downsizing +
improving profitability, gov is throwing in more debt that
chases less productivity, labour and market opportunity
(not making market opportunities, making same thing
but more of it, thinking that will make more money), less
ability to service debt, assessing financial results
control

>Behavioural challenge To control but not crush

subordinates.
>To delegate power and release management of certain
burdens but to also prevent an abuse of this power.
>Requires control systems that minimize problems.
McDonalds
Advantages of delegation
1. Improved decision making
2. Utilizing local knowledge of lower levels.
3. May improve autonomy and job satisfaction at
lower levels Increases motivation, self
empowerment
4. Encourages innovation. Through empowering
those at the coal face, who deal with suppliers
and customers. Environmental changes can be
capitalized on as they happen.
5. Provides a training ground. Remember: Theory X
v Theory Y. Give a little bit of power and people
rise to the occasion.
6. Releases middle management to focus on more
strategic issues.

Disadvantages
1. May reduce the ability to connect to broader level
strategic goals. Lack of global perspective
2. Accountability may be lost.
3. Dysfunctional decision making due to lack of
experience.
4. Semi delegation leads to a duplication of decision
making levels (this can be very bureaucratic)

Responsibility Centres
>The establishment of responsibility centres within an
organisation seeks to ensure goal congruence between
these employees and the organisation
>We can break higher-level objectives into sub-objectives
that can be attended to by responsibility centres.
> Responsibilities centre are individual business units,
which are headed by a manager who is responsible for the
centres activities and specified results (financial/nonfinancial). AKA business units
> An organisation can be seen as collection of
responsibility centres.
> All of a sudden control becomes important
Before we control Responsibility Centres we need to
determine what their role is within the organization.
Types of Responsibility Centres
>Four types:
1. Revenue Centres
2. Cost Centres

Action control is not just about specifying for efficiency,

also about reducing risk for bad behaviour: boundary
control
McDonalds: controlled system, delegated making of food
to teenagers, risky yet they do well b/c have controls in
place to get people to apply themselves to jobs + prevent
bad things from happening e.g. likelihood of unhygienic
thing happening: lots of observations, checks, controls.

People who are at the coal face will start making

decisions.
NB: China: state-owned enterprises suffer from a lack of
innovation b/c not enough empowerment at lower levels.
Moving from Theory X to Theory Y.
Most importantly, allows senior and middle managers to
do what they should be doing: thinking about growth
options/strategy.
NB: China: state-owned enterprises dont do it b/c they
lose control. Biggest worry that theyre not aligned with
gov objectives.
Internal accountability to each other. Western context, the
delegating of work means losing visibility + transparency
of what that unit is doing. Therefore, this is sth that needs
to be checked off/encounter with good mgmt controls.
Worst: delegate but dont trust you to do it well so we do
it again. Double everything. Either delegate (+ trust) or
you dont (control). All about MCS allowing us to do
that.
Think of the firm as pieces, little units, RC.
Want to make sure that each RC is contributing to
higher-level objective of the firm. Each of their subobjective will be contributing to our overall objective.
Break firm into RC, delegate away our sub-objectives,
control becomes important.
RC = business unit

Role within organisation design control system

Results control: financially based

Making money for us

Costing us money

 engineered
discretionary
3. Profit Centres
4. Investment Centres
>Revenue centres organisational subunit where the
manager is responsible for generating revenue in an
organisational subunit e.g. Sales department
>Cost centres organisational subunit where the manager
is responsible for the costs and expenses incurred
Cost centres e.g. Production department, where
relationship between inputs and outputs can be
reasonably measured
Discretionary cost centres e.g. R&D, accounting
department

Make profit for us

Investment centre for us
Revenue centres: primary contribution to the firm goal is
sales + revenue so we should assess them on the basis of
their revenue (line item) and also identify the most
important products, volumes, price points, may overemphasise new products b/c they are our growth option,
the stars (BGC matrix).
Cost centres: cost us money. Production side of company
mostly.
2 forms: 1) generic cost centres 2) discretionary cost
centres.
Most cost centres have a direct relationship with
output/production levels, can look at them as a per unit
basis. B/c they are flexible + have a lot of variable cost,
we want to assess them on that basis rather than fixed
cost. Production deps as a cost centre has control over
VC. Factory manager has more say over FC: how big our
factory is, who we use as security company, rent,
overheads as an administrative unit.
Discretionary cost centres more like FC. Comes in big
chunks, accting dep doesnt change its cost on the
business if the production levels of the business changes.
Always have X number of people working for us. No:
downturn in sales, fire 2 people. Interested in service we
get for the money we give them. Not worried about how
much theyre costing us b/c its fixed, rather what service
are they providing.

>Profit centres organisational subunit where the

manager is responsible for managing both revenues, costs
and their difference (or profit) e.g. Family restaurant,
franchisees, University Faculty.

>Investment centres organisational subunits where the

manager is responsible for the profit earned on
investments e.g. Organisations, and organisational
subsidiaries, divisions. Treat a division like a capital
market would.
>E.g. Visy Packaging

Profit centres: bundled revenue + expenses/cost centres

together, ultimate form of assessment of that business
unit is profit. Doing 2 functions, artificial to split it up.
Good example of that would be franchises, faculties, any
dep/RC/business unit that both makes money and has
cost.
Tute: restaurants in diff sectors and fishing fleet. Each
restaurant is a separate unit (trying to attract customers,
produce quality food but has cost of staff working there).
Ineffective to assess you on sales and assess you on
costs, will lead to dysfunctional outcome: assess on
sales: make expensive food to get high sales but make
loss, assess on costs: lowest cost per unit but no one
would eat there, ruin brand. Best: discretion over both
things, find balance, you know the market, develop the
menu and sell at good price, profit is a good measure of
general performance.
Investment centres: scale problem. Instead of having
many restaurants of similar size and markets, we have a
restaurant, construction company, fishing fleet, school
how do we compare performance of these diff
businesses? Investment centre is where we treat each
business unit as the capital market would.
Visy Packaging: make steel drums, containers, foam
packaging, plastic packaging, foil packaging, all have
diff cost structures, market sizes, markets they are selling
to, may sell to each other, each one is assessed as an

investment that the owner has made. High-level strategic

thinking, branding, getting capital ready for expansion,
acquiring other businesses. Let each investment centre
do their own micro-branding, trying to get the clients.
Assessing Responsibility Centres
>Financial performance measures
Revenues
Costs
Profit
ROI
EVA
>Non-financial
Sales and marketing information
Production and quality information
Other indicators
Traditional Financial Performance Measures
>Revenues and Costs for rev and cost centres respectively
>Profit and Loss (Profit Centres)
>These measures on the most part a good way to assess
units/deps from one period to the next.
>But how to we compare different sized units/deps.

Lecture example 1: ROI

>Suncoast Pty Ltd has three divisions
The Gulf Division
Atlantic Division; and
Food Processing Division
>Each division manager has the authority to make
decisions that affect both profit and invested capital.
>The divisions need to be evaluated as investment centres

For investment centres: ROI and EVA (economic value

added, RI).

Add to that, doesnt matter which one it is.

Sales dep of a larger company, we have a divisional

structure, sales being a particular division: sales make
tonnes of sales
Also: what markets do we want to grow into?
Add a weight to those sales of products to those markets
that we want to grow into, change KPIs: we let them be
weighted on the basis of our strategy, mandate behind
KPIs that focus on particular products + markets
Similar to cost: production reduce cost
Time producing sth and a reduction in cost b/c learning
cycle means we get better + better doing it
Innovative company (coming out with new products all
the time): costs per unit will be higher (even if theyre
not very complicated products) than cash cows (same
product: know what theyre doing, should have low cost)
Also, need a balance of other things like quality
measures: if its just cost, people will make the
cheapest/low quality goods
Profit centres
Issue of comparability with size
Size of invested capital: 1) ROI and 2) RI (taking away
an interest charge on the profit we make)
All were doing is adjust income for the size of
investment
3 divisions, each manager responsible for each division
i.e. theyre RC, weve delegated them with the task of
growing their own markets, selling things.

Immediately, we think, A is the best b/c it has the most

money. Actually, no, its also the largest company so it
should be making more money. ROI comes in as being
the quickest and most effective way of seeing scale,
trying to give scale to operating income.

Advantages
1. Focuses on relationships among sales, expenses
and investment
2. Encourages cost efficiency
3. Discourages excessive investment
Disadvantages
1. May favour small projects over larger projects.
What is the problem with this? Big co.s need
big global investments. E.g. Visys sustainability
division.
2. Starving business units for resources and over
working staff in the short term.
3. Reducing R&D and the development of growth
opportunities.
4. Encourage myopic behaviour and investment
decisions.

What happens in large organisations that have many

projects?
>Create ROI requirements
>Efficient way of assessing many potential projects across
as organization.
>E.g. all new projects need to return 15%.
>If all projects return at least 15%. Then logically we can
return 15% to stockholders.

Manager is worried about expansion, need to make at

least 15% on any new project they invest in, discourages
people asking for money without understanding the value
of that money.
Food!
Visy example: Sustainability: smallest division, highest
ROI, steel: biggest division, our vision is a lot more
capital intensive, FC, so of course our ROI is lower.
Common problem with ROI: as we increase in size, it
disfavours us so smaller companies b/c of their less
capital + the nature of numbers: as we move up through
brackets of capital investments, more difficult to
maintain a higher ROI, thus, not totally accurate with
comparing wildly diff sized investments.
Motivate to starve, too scared to take up investments, no
new market opportunities
1 easy way to create myopic decisions: Alpha example:
Increased ROI but all its done is retain same sales +
expenses but not renewed old assets, stopped investing in
capitalised forms of R&D
Not growing business anymore, let capital go to waste,
assets depreciate and get older
While it looks good for 3 years, at 1 point, assets will
come offline, no capacity, will have to make a big capital
jump/dissolve
ROI is subject to manipulation, new managers will come
in and write down assets, artificially reducing net value
of assets to boost ROI
B/c ROI is an accting measure problematic
Internal problems: want to have ROI requirements: want
A to make > 15% so that it grows its ROI with each
investment, if all our projects make 15%, company as a
whole will make 15%

Problem: diff levels of performance for diff divisions

Questioning ROI requirements
>ROI requirements do not take into consideration
operational differences at the divisional level.
>ROI may cause managers to accept unprofitable projects
if the projects increase divisional ROI:
Divisions average ROI = 10%
Firms minimum desired return = 15%
Project ROI = 12%
Flipping the coin
>ROI may also cause managers to reject profitable
projects if the projects lower the divisional ROI:
Divisions average ROI = 20%
Firms minimum desired return = 15%
Project ROI = 16%

B/c were looking in terms of division (myopic), well be

accepting new investments but reducing firms avg ROI.
Problem? Division is still growing but should be
downscaling division, not growing it. Thus, need to
understand diff returns at diff levels of the company.
Taking project would have increased firms ROI on avg.
May be less than that division but maybe that division
should be the 1 thats growing.
Business should move out from unprofitable to profitable
divisions.

Lecture example 4: Misleading signals

>These may lead to:

Non-renewal of old assets
Taking a bath Excessive asset write-downs.
Residual Income (EVA)
Residual income =
Investment centres profit less: [investment centres
invested capital x imputed interest rate]
Imputed interest rate =
The firms cost of acquiring investment capital or the
minimum required rate of return
>Residual income is a dollar amount
Advantages
>Guarantees that investment in the business out performs
same investment in bonds, STMM etc.
>Consistency with how Analysts assess projects.
Example
>What if 500K investment will generate 80K in profit is
an environment which requires a 12% return.
>The residual income is calculated as follows:

Rate should be a sufficient return for that industry for

that business, hurdle rate, minimum required rate of
return

Guarantees the investment is making a return above what

our money would be doing in the short-term money
market, consistent with how analysts would be looking at
our company in terms of a portfolio/against other
companies in the same industry, $ amount for
comparability, can add them up as well??

Investment has generated 20,000 above required rate of

return, say yes to investment
>Investment in new equipment raises residual income by
$20,000
Disadvantages
Residual Income also has problems.
1. Increases likelihood managers will pick risky high
return
2. Does not discourage myopic behaviour
3. It is an absolute measure of return (not
comparative)
4. Bias in favour of larger investment centres.
Example

What about strategy?

How do we know if these investments are contributing to
the greater organizational goals? Are they contributing to
a better product offering or are they a divergence from
these goals?

No risk element to assessment/no risk charge

Cash flow analysis favours projects that make big returns
in the short term, does not encourage long term projects
Opposite bias as ROI, use both ROI and RI for balance

Align business centres to our strategy

Financial controls show our success in the markets +
aggregate measures of what were doing. Inability to
understand inputs into success.
Lag: takes a long time to produce information, markets
change. Need non-financial measures e.g. sales +
marketing info, know how were going in market right

Some sample tools

Non-financial performance measures
Sales and marketing information
>Customer related financial information (CRFI)
Per customer profitability
Repeat sales
>Non-financial customer information
Demographics, satisfaction surveys
Market based information e.g. market size, market
share, market growth
Sales and marketing information

now which will be a lead indicator of how we perform

later on in terms of profitability/sales.
Per customer profitability: arbitrary measure, still
profitability but tells: loyalty, measure of ind customers
perception to product offering/brand. Are they buying it
over + over again? Or buying and bad word-of-mouth?
Can tell if no growth: PCP will tell if its lack of market
share growth or satisfaction/lack of quality problem.
People returning or people returning but not selling to
new people diff strategies in each case
Satisfaction surveys: direct: what they like/dont like
BCG matrix: categorisation of products based on how
beneficial they are to our business. Trying to encourage
not getting stuck on cash cows (high position, low
growth: no future in it for us)
Focus on stars (unlikely) or even ? (likely)
Stars: high market position, high growth
?: low market position, high growth see what it turns
into: dog (doesnt make it in the market) or star!
Why does it matter? Invest in products both in terms of
quality/efficiency in making them + marketing that
contributes the most to our overall profitability + and that
underpin our brand image

Production and quality information

>Work rates
>Machine Downtime
>Absenteeism
>Defect and failure rates
>Learning cycles
Quality information
Quality costs
Prevention = training, process improvement initiatives,
field testing.
Appraising = Post production inspection, end point
product testing.
External Failure = warranties, replacement costs, recall,
reputation costs, FUTURE LOSS IN SALES
Internal Failure = waste, scrap, re-work, failure to deliver
on time.
Reducing cost of quality
>Minimise total cost of quality

Going forward: Being clever with strategic value

measures?

Learning cycle: how fast a team can get on top of new

changes.
Quality info: reducing costs in the short term while also
improving quality
Holistic picture of the company
2 types of quality costs: A+P costs: input cost, making it
+ doing a good job, preventing bad quality from
happening
F cost: not preventing bad quality, both int and ext F
Int failure cost is an indicator of ext failure costs (more
expensive!!!)
Failure of not doing good quality costs us in reworking
things, machine downtime but also costs us in terms of
market perceptions to reduce that, prevent things from
happening + appraise things e.g. spend time training,
employ product testing, field testing, product production
inspection, process of improvement initiatives
As A+P costs increase, proportionately greater impact on
reducing F costs (both int + ext F costs). Thus, TQ costs
decrease with initial efforts.
Certain point where every $1 we spend on A+P costs,
proportionately less impact on reducing F costs
Reality is that we dont just do stuff, spend money +
hope that itll have an impact. Look at failure in market
(e.g. int failure problem), learn form that in great detail +
let that help us redesign production process, improve
A+P techniques so that it doesnt happen in the future.
Theory about learning, qualitative level: improve what
we do.

Midterm: a lot of reading, texts are detailed, like Q2 this tute, long cases, pick out what works with your answer, start
with an answer, go back + add to it, dont try and master it, get a satisfactory answer to each problem, come back and
master it, get out whats immediately apparent, on top of your head + move on, practice written responses and reading
aloud, opinion, dont have to have a solution, problem with transfer price, our capacity, capability, theory:
winning/losing, when is AC, SC, RC effective? Real, not abstract.
Investigative pieces: int mechanisms of company, companys assessment from the markets perspective v internally
assess business units within company