Chapter 22

Control: The Management

Control Environment
Alex Co
Betina Jareno
Management Control
This chapter addresses the control process and
the use of accounting information in that
process.
strategy formulation develops strategies to attain an
organizations goals.
Where do you want to go?
How do you want to get there?
Strategies change whenever a new opportunity or a new
threat is perceived.

Management Control Process
Seeks to assure that the strategies are implemented.
Process by which managers influence members of the
organization to implement the organizations strategies
efficiently and effectively.
Includes planning.
Two Parts of Planning

A statement of objectives.

Resources required to achieve those objectives.
Goals and Objectives
GOALS OBJECTIVES
Broad, usually non-
quantitative, long run
plans relating to the
organization as a
whole.
More specific, often
quantitative, shorter
run plans for individual
responsibility centers.

The Environment
Four facets of the management control environment:
Nature of organizations.
Rules, guidelines and procedures that govern the actions of the
organizations members.
The organizations culture.
External environment.
The Nature of Organizations
Organization: a group of human beings who work together
for one or more purposes.

Managers or the management: Leaders who perform
important tasks.
Tasks of Management
Determining goals.
Determining objectives to achieve the goals.
Communicating goals and objectives.
Determining tasks to be performed to achieve objectives.
Coordination.
Matching individuals to tasks.
Motivating.
Observing/monitoring employee performance.
Taking corrective action as needed.
Organization Hierarchy
Layers of management with authority running from top to
bottom.
Organization chart.
Categorized concept subordination of entities that work
together to contribute to serve one aim.
Provides leadership, direction, and division of labor.
Organization Chart
Rules, Guidelines, and
Procedures

Influence the way members behave.

Written, or verbal; formal, or informal.
Culture
Norms of behavior determined by:
Tradition.
External influences.
Attitudes of senior management and the board of
directors (BOD).
External Environment
Everything outside of the organization itself.

E.g., customers, suppliers, competitors, regulatory
agencies.
Responsibility Centers and
Responsibility Accounts

Responsibility Centers
Responsibility Accounting
The Management Accounting Construct that deals with
both planned and actual accounting information about
the inputs and outputs of a responsibility center.
Responsibility Accounting
Lame Mans term: It shows if you hit your work quota for the
year.
This definition is not limited to sales.
You usually know whether youre doing your job when your
boss recognizes you.

Sales Department
250,000 worth of goods 20,000 selling expenses 600,000 sales target for the year
(500,000 units)

Production Department
150,000 worth of raw materials 50,000 processing cost 250,000 cost of production
(500,000 units)
Responsibility Centers
Commonly perform work related to several products.

Inputs to a responsibility center are called cost elements or line items (on a
department cost report).

Costs have three different dimensions:
Dimensions of Costs
Responsibility center. Where was cost incurred?

Product dimension. For what output was the cost incurred?

Cost element dimension. What type of resource was used?
Limitations of Actual Costs
Compared to Standard
Not an accurate measure of efficiency for at least 2 reasons:
Recorded costs are not precisely accurate measures of resources
consumed.
Standard are at best only approximate measures of what resource
consumption ideally should have been in the circumstances prevailing.
Terms in Responsibility
Accounting
Line Items
Effectiveness
Efficiency
Effectiveness and Efficiency
Effectiveness Efficiency
How well the
responsibility center
does its job.

The amount of output
per unit of input.
Lower cost is more efficient
More output (e.g. sales) is more effective.
Types of Responsibility
Centers
Revenue Center
Expense Center
Profit Center
Investment Center
Revenue Center
Responsible for outputs of center as measured in monetary terms
(revenues).
Not responsible for the costs of goods or services that the center sells.
E.g., sales organization.
Also responsible for selling expenses (e.g., travel, advertising, point-of-
purchase displays, sales office salaries, rent).
Expense Centers
Responsible for expenses (i.e., the costs) incurred but
does not measure its outputs in terms of revenues.
E.g., production departments, staff units such as
accounting.
Standard or Engineered Cost
Center
Expense center for which many of its cost elements have
standard costs established.
Differences between standard costs and actual costs are
variances.
E.g., production cost centers, fast food restaurants, and
blood testing laboratories.
Discretionary Expense Center
Also called managed cost center.
Difficult to measure output in monetary terms.
Production support and corporate staff.
E.g., human resources, accounting, R&D.
Profit Center
If a performance is measured by the revenue it earns and the
expenses it incurs, this is the classification of that
responsibility center.
Resembles a business on its own it has its own income
statement.
Profit Center (Criteria)
If the center involves extra record keeping
If the manager of the center has no deciding authority on quantity
and quality in relation to costs.
If senior management requires the center to use the services of
another responsibility center
If outputs are homogeneous
If the center puts managers in business for themselves, which
promotes freedom and competition
Terms to Remember
Transfer-price
Market-based transfer price
Cost-based transfer price
Transfer Prices
Price at which goods or services are sold between responsibility centers
within a company.
Revenue for selling center and cost for the receiving center.
2 general types of transfer prices:
Market based price.
Cost based price.
Market-based Transfer Prices
Based on price for same product between independent parties, i.e.,
a market price or, equivalently, an arms length price.
Adjusted for quantifiable differences such as credit costs.
Where available is widely used.
Frequently not available.
Cost-Based Transfer Prices
When no reliable market price is available.

Cost plus a mark-up.

If based on actual cost, little incentive to reduce costs.
Transfer Pricing Issues
Negotiated by responsibility centers or set/arbitrated by top management.

Should manager have freedom to use alternative source?

Sub-optimization: maximize profits for a responsibility center may not
maximize profit for the consolidated company.
Investment Center
Managers are held responsible for the use of assets as well
as for profit.
Performance is measured by RESIDUAL INCOME
Measures of Performance
Return on investment = Profit/Investment
Return on assets = (net income) / (total assets).
Split between ROS and Asset Turnover
Residual income = Pre-interest profit (Capital charge *
investment)
Residual Income
A.K.A. Economic Profit, Economic Value Added
Residual Income = (How much you want to earn + Interest
expense) (Cost of capital + Money that you put in)
Residual Income
Residual income = Income before taxes less a capital
charge.
Capital charge is calculated by applying a rate to the
investment centers assets or net assets.
Advantage of Residual
Income over ROI
Advantage of ROI Over
Residual Income:
Encourages managers
to make all
investments whose
return is greater than
the capital cost rate.
ROI measures are ratios
that can be used to
compare investment
centers of different sizes.
Residual income is an
internal number that is not
reported to shareholders
and other outsiders.

Investment Center Issues
Asset allocation between
centers.

How to value assets (e.g.,
historical cost or
replacement cost).

Managers focus their day-
to-day efforts on
managing current assets,
particularly inventories
and receivables.
Most companies
control investments
in fixed assets using
capital investment
(i.e., capital
budgeting)
procedures
addressed in Chapter
27.

Non-monetary Measures

Non-monetary as well as monetary objectives.
E.g., Quality of goods or services, customer satisfaction.
Management by objectives (MBO) and Balanced Scorecards in
Chapter 24.