Chapter Seventeen
Management Control and
Strategic Performance
Measurement
Blocher,Stout,Cokins,Chen, Cost Management 4e
©The McGraw-Hill Companies 2008
2
Learning Objectives
• Identify the objectives of management control
• Identify the types of management control systems
• Define strategic performance measurement and show
how centralized, decentralized, and team-oriented
organizations can apply it
• Explain the objectives and applications of strategic
performance measurement in three common strategic
business units (SBUs): cost SBUs, revenue SBUs,
and profit SBUs
Blocher,Stout,Cokins,Chen, Cost Management 4e
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Learning Objectives
(continued)
• Explain the role of the balanced scorecard (BSC) in
strategic performance measurement
• Explain the role of strategic performance measurement
in service firms and not-for-profit organizations
Blocher,Stout,Cokins,Chen, Cost Management 4e
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Performance Evaluation and Control
• Performance evaluation is the process by which
managers at all levels gain information about the
performance of tasks within the firm and judge that
performance against preestablished criteria as set
out in budgets, plans, and goals
– Top management, middle management, and operatinglevel personnel should be evaluated
• Management control refers to the evaluation by
upper-level managers of the performance of midlevel managers
Blocher,Stout,Cokins,Chen, Cost Management 4e
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Performance Evaluation
and Control (continued)
• Operational control means the evaluation of operatinglevel employees by mid-level managers
• Management control focuses on higher-level managers
and long-term strategic issues (a broader objective),
while operational control focuses on detailed shortterm performance
• Operational control is a management-by-exception
approach while management control is more
consistent with the management-by-objectives
approach
Blocher,Stout,Cokins,Chen, Cost Management 4e
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6
Performance Evaluation and Control
(continued)
Chief
Executive
Employee
1
Region B
Employee
2
Blocher,Stout,Cokins,Chen, Cost Management 4e
Plant A
Employee
3
Plant B
Employee
4
Operational
Control
Region A
Operations
Management
Management
Control
Marketing
Management
Financial
Management
©The McGraw-Hill Companies 2008
7
Management-by-Objectives
• In a management-by-objectives (MBO) approach, top
management assigns a set of responsibilities to each
mid-level manager depending on the functional area
involved and the scope of authority of the mid-level
manager
• Areas of responsibility are often called strategic
business units (SBUs)
• An SBU consists of a well-defined set of controllable
operating activities over which the SBU manager is
responsible
Blocher,Stout,Cokins,Chen, Cost Management 4e
©The McGraw-Hill Companies 2008
8
Management Control Objectives
• Motivate managers to exert a high level of effort to
achieve the goals set by top management
• Provide the right incentive for managers to make
decisions consistent with the goals set by top
management (that is, to align managers’ efforts with
the desired strategic goals)
• Determine fairly the rewards earned by managers for
their efforts and skill and the effectiveness of their
decision making
Blocher,Stout,Cokins,Chen, Cost Management 4e
©The McGraw-Hill Companies 2008
9
Achieving Management
Control Objectives
• A common mechanism for achieving these multiple
objectives is to develop an employment contract
between the manager and top management
• A contract promotes goal congruence: the contract
specifies the manager’s desired behaviors and the
compensation to be awarded for achieving specific
outcomes by using these behaviors
• Contracts can be written or unwritten, explicit or
implied
Blocher,Stout,Cokins,Chen, Cost Management 4e
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10
Employment Contracts
• An economic model, the principal-agent model, is
a prototype that contains the key elements that a
contract must have to achieve the desired
objectives
• There are two important aspects of management
performance that affect the contracting
relationship, uncertainty and lack of observability
– Managers operate in an environment that is influenced
by factors beyond the manager’s control; there is some
degree of uncertainty
Blocher,Stout,Cokins,Chen, Cost Management 4e
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11
Employment Contracts
(continued)
– Many efforts and decisions made by the manager are
not observable to top management, and the manager
often possesses information not accessible to top
management
• Because of uncertainty and the lack of
observability, three principles should be followed
in the preparation of an employment contract:
– Separate the performance of the manager from the
performance of the SBU
Blocher,Stout,Cokins,Chen, Cost Management 4e
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Employment Contracts (continued)
– Exclude known uncontrollable factors from the contract
– Risk-adverse managers make decisions to avoid risk
when top management might prefer choices that
involve some risk. It is therefore necessary to separate
the value of the outcome from the positive or negative
weight associated with the risk due to uncertainty.
• Management control systems should be designed
to reduce the negative effects of risk preferences
Blocher,Stout,Cokins,Chen, Cost Management 4e
©The McGraw-Hill Companies 2008
13
The Principal-Agent Model
External Factors
Uncertainty
Accounting
Top Management
Prepare
Performance
Report
Pays Manager
on the
Basis of the
Performance
Report
Outcome of manager’s
decision and effort
Risk
Aversion
Decision
Making
Effort
Receives
Pay
Manager
Blocher,Stout,Cokins,Chen, Cost Management 4e
©The McGraw-Hill Companies 2008
14
Designing Management
Control Systems
There are four questions management must ask
when developing a management control system:
– Who is interested in evaluating the organization’s
performance (owners, directors, creditors, employees,
etc.)?
– What is being evaluated (an individual, team, or SBU)?
– When is the performance evaluation to be conducted,
and should it be based on the master budget (resource
inputs –ex ante) or the flexible budget (outputs of the
manager’s effort–ex post)?
– Should the system by formal or informal?
Blocher,Stout,Cokins,Chen, Cost Management 4e
©The McGraw-Hill Companies 2008
15
Types of Management
Control Systems
Informal Systems
Individual
Aspiration Level
Personal Drives
Teams
Peer Norms
Organization Culture
Blocher,Stout,Cokins,Chen, Cost Management 4e
Formal Systems
Hiring Practice
Promotion Procedures
Strategic Performance
Measurements
Keiretsu
Shared Responsibility
©The McGraw-Hill Companies 2008
16
Strategic Performance
Measurement
• Strategic performance measurement is a system
used by top management to evaluate SBU
managers
• Before designing strategic performance
measurement systems, top managers determine
when delegation of responsibility is desirable
– A firm is decentralized if it has chosen to delegate a
significant amount of responsibility to SBU managers
– A centralized firm reserves much of the decisionmaking at the top-management level
Blocher,Stout,Cokins,Chen, Cost Management 4e
©The McGraw-Hill Companies 2008
17
Strategic Performance
Measurement (continued)
• Centralized firms provide more control and the
expertise of top management can be effectively
utilized
• Decentralized firms are able to make more timely
decisions at the operational level; top management
lacks the necessary local knowledge
• Decentralized firms are often more motivating for
employees, are an excellent environment for training
future top-level managers, and are a better basis for
performance evaluations
Blocher,Stout,Cokins,Chen, Cost Management 4e
©The McGraw-Hill Companies 2008
18
Types of SBUs
• Cost SBUs are a firm’s production or support departments
that are charged with the responsibility of providing the best
quality product or service at the lowest cost (examples: a
plant’s assembly department, data-processing department,
and its shipping and receiving department)
• Revenue SBUs focus on the selling function and are
defined either by product line or by geographic area
• When an SBU both generates revenues and incurs the
major portion of the cost for producing these revenues, it is
considered a profit SBU
• Investment SBUs include assets employed by the SBU as
well as profits in the performance evaluation
Blocher,Stout,Cokins,Chen, Cost Management 4e
©The McGraw-Hill Companies 2008
19
Types of SBUs (continued)
The choice of a profit, cost, or revenue SBU depends
on the nature of the production and selling
environment in the firm:
– Products that have little need for coordination between the
manufacturing and selling functions are good candidates
for cost and revenue SBUs
– For products that require close coordination between
these functions, profit SBUs would be the preferred option
Blocher,Stout,Cokins,Chen, Cost Management 4e
©The McGraw-Hill Companies 2008
20
Cost SBUs
• Direct manufacturing and manufacturing support
departments are often evaluated as cost SBUs
since these managers have significant direct
control over costs but little control over revenues
or decision-making for investment in facilities
• Several strategic issues arise when implementing
cost SBUs:
– Cost shifting occurs when a department replaces its
controllable costs with noncontrollable costs (e.g.,
variable costs to fixed costs)
Blocher,Stout,Cokins,Chen, Cost Management 4e
©The McGraw-Hill Companies 2008
21
Cost SBUs (continued)
– Many performance-measurement systems focus
excessively on short-term cost figures, neglecting longterm strategic issues
– The majority of SBUs have some amount of budgetary
slack, which is the difference between budgeted and
expected performance
– Budgetary slack can be good as it reduces risk
aversion, but too much slack can result in reduced
employee effort and (as indicated in Chapter 8) can
complicate the planning process
Blocher,Stout,Cokins,Chen, Cost Management 4e
©The McGraw-Hill Companies 2008
22
Two Methods of Implementing Cost SBUs
in Production and Support Departments
Discretionary-Cost Approach
Costs are mainly fixed, uncontrollable
Firms use an input-oriented planning focus
Outputs are ill-defined
The focus is on planning
Engineered-Cost Approach
Costs are mainly variable, controllable
Firms use an output-oriented evaluation focus
Outputs are well-defined
The focus is on evaluation
Blocher,Stout,Cokins,Chen, Cost Management 4e
©The McGraw-Hill Companies 2008
23
Implementing Cost SBUs in
General and Administrative Departments
These departments have the same two methods to
choose from, but the proper choice may change over
time:
– For example, if cost reduction is a key objective, the HR
department might be treated as an engineered-cost SBU
– Later, it might be changed to a discretionary-cost SBU to
motivate managers to focus on the achievement of longterm goals
Blocher,Stout,Cokins,Chen, Cost Management 4e
©The McGraw-Hill Companies 2008
24
Implementing Cost SBUs in
General & Administrative Departments
Total
Cost
Engineered Cost
4,800
3,600
Cost Variance
2,400
1,200
100
200
300
250
Blocher,Stout,Cokins,Chen, Cost Management 4e
400
Cost behavior in
administrative
support SBUs
is often a
step cost
Cost Driver
(number of applications)
©The McGraw-Hill Companies 2008
25
Cost SBU—Miscellaneous Considerations
for Performance Reporting
• Many firms are choosing to outsource
manufacturing, customer service, engineering, and
other services
• When using a cost SBU, how should the firm
allocate the jointly incurred costs of service
departments to the departments using the service?
– An allocation method should be chosen based on its
ability to motivate managers, encourage goal
congruence, and provide a basis for fair evaluation of
management’s performance
Blocher,Stout,Cokins,Chen, Cost Management 4e
©The McGraw-Hill Companies 2008
26
Cost SBUs—Implementation
Considerations (continued)
• Dual allocation is a useful guide in choosing a cost
allocation method
• Dual allocation is a cost-allocation method that
separates fixed and variable costs; variable costs are
directly traced to user departments, and fixed costs are
allocated on some logical basis
• Indirect costs could be traced to cost SBUs using
activity-based costing (ABC)
Blocher,Stout,Cokins,Chen, Cost Management 4e
©The McGraw-Hill Companies 2008
27
Revenue SBUs
• Management commonly uses revenue drivers in
evaluating the performance of revenue SBUs
• Revenue drivers in manufacturing firms are the
factors that affect sales volume, such as price
changes, promotions, discounts, customer service,
changes in product features, delivery dates, and
other value-added factors
• Revenue drivers in service firms focus on the quality
of the service
Blocher,Stout,Cokins,Chen, Cost Management 4e
©The McGraw-Hill Companies 2008
28
Marketing Departments
Marketing departments can be either a revenue or a
cost SBU:
– The revenue SBU responsibility stems from the fact that
the marketing department manages the revenuegenerating process and produces revenue reports for
evaluation
– This department can also be a cost SBU as it incurs two
types of costs, order-getting (advertising and promotion)
and order-filling (warehousing, packing, and shipping)
costs
Blocher,Stout,Cokins,Chen, Cost Management 4e
©The McGraw-Hill Companies 2008
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Profit SBUs
• The profit manager’s goal is to earn profits
• Three strategic issues cause firms to choose profit
SBUs rather than cost or revenue SBUs:
– Profit SBUs provide the incentive for the desired
coordination among marketing, production, and support
functions
– Profit SBUs motivate managers to consider their
product as market able to outside customers
– Profit SBUs motivate managers to develop new ways to
earn a profit from their products and services
Blocher,Stout,Cokins,Chen, Cost Management 4e
©The McGraw-Hill Companies 2008
30
Cost Leadership,
Differentiation, and SBUs
Cost Leadership
Manufacturing
Plant
Sales
Warehouse
Cost SBU
Manufacturing
Plant
Revenue SBU
Sales
Differentiation
Profit
SBU
Blocher,Stout,Cokins,Chen, Cost Management 4e
Profit
SBU
©The McGraw-Hill Companies 2008
31
Contribution Income Statement
• A common form of profit SBU evaluation tool is the
contribution income statement, which is based on the
contribution margin developed for each profit SBU
and for each relevant group of profit SBUs
• Detail of the statement varies based on
management’s needs
• Contribution by SBU (CSBU) measures all costs
traceable to, and therefore controllable by, the
individual SBU, including traceable fixed costs
Blocher,Stout,Cokins,Chen, Cost Management 4e
©The McGraw-Hill Companies 2008
32
Controllable and
Noncontrollable Fixed Costs
Fixed costs can be either controllable or
noncontrollable from the perspective of each profit
SBU:
– Controllable fixed costs are fixed costs that the profit
SBU manager can influence in approximately a year or
less, such as advertising, data processing, and
management consulting expenses
– Noncontrollable fixed costs are those that are not
controllable within a year’s time, such as depreciation
and taxes
Blocher,Stout,Cokins,Chen, Cost Management 4e
©The McGraw-Hill Companies 2008
33
Profit SBU Performance Evaluation
• Subtracting controllable fixed costs from the
contribution margin results in the SBU’s
controllable margin
• The contribution margin income statement can
also be used to help determine whether a profit
SBU should be dropped or retained
• One complication in the preparation of this
statement is that some costs that are not traceable
at a detailed level are traceable at a higher level
Blocher,Stout,Cokins,Chen, Cost Management 4e
©The McGraw-Hill Companies 2008
34
Contribution Income
Statement Example
This
statement
shows
the
operating
results for
Machine
Tools, Inc.
(MTI) as a
whole
Machine Tools, Inc.
Contribution Income Statement
(000s omitted)
Net revenues
$ 2,000
Variable costs
900
Contribution margin
1,100
Controllable fixed costs
250
Controllable margin
850
Noncontrollable fixed costs
400
Contribution by SBU
450
Untracable costs
200
Operating income
$ 250
Blocher,Stout,Cokins,Chen, Cost Management 4e
©The McGraw-Hill Companies 2008
35
Contribution Income Statement
Example (continued)
This statement shows the operating results by division
Machine Tools, Inc.
Contribution Income Statement
(000s omitted)
Whole
Company Division A Division B
Net revenues
$
2,000 $
600 $ 1,400
Variable costs
900
200
700
Contribution margin
1,100
400
700
Controllable fixed costs
250
100
150
Controllable margin
850
300
550
Noncontrollable fixed costs
400
120
280
Contribution by SBU
450 $
180 $
270
Untracable costs
200
Operating income
$
250
Blocher,Stout,Cokins,Chen, Cost Management 4e
©The McGraw-Hill Companies 2008
36
Contribution Income Statement
Example (continued)
This statement shows the operating results by product
for Division B
Machine Tools, Inc.
Contribution Income Statement - Division B by Products
(000s omitted)
Not
Division B Allocated Product 1 Product 2 Product 3
Net revenues
$
1,400
$
400 $
700 $
300
Variable costs
700
100
350
250
Contribution margin
700
300
350
50
Controllable fixed costs
150 $
(25)
25
100
Controllable margin
550
275
250
50
Noncontrollable fixed costs
280
(20)
10
130
120
Contribution by SBU
$
270 $
(45) $
265 $
120 $
(70)
Blocher,Stout,Cokins,Chen, Cost Management 4e
©The McGraw-Hill Companies 2008
37
Variable vs. Full Costing
• The use of the contribution income statement is often
called variable costing because it separates variable
and fixed costs
• Full costing is the conventional costing system that
includes fixed manufacturing cost as part of “product
cost”
• Full costing, also called “absorption costing,” is required
by GAAP for financial reporting and by the IRS for
computing taxable income
• Full costing satisfies the matching principle while
variable costing meets the three objectives of
management control systems
Blocher,Stout,Cokins,Chen, Cost Management 4e
©The McGraw-Hill Companies 2008
38
Variable Costing
• There is an additional reason for using variable
costing
– Although net income determined using full costing is
affected by changes in inventory levels, net income using
variable costing is not affected
– This is because under variable costing, fixed
manufacturing costs are treated as period costs, not
product (inventoriable) costs
• The following example compares the two costing
methods over two periods, one with increasing
inventory and the other with decreasing inventory
Blocher,Stout,Cokins,Chen, Cost Management 4e
©The McGraw-Hill Companies 2008
39
Variable vs. Full Costing
Example
Inventory
increased
by 40
Data Summary
Units:
Beginning inventory
Price
Sold
Produced
Unit variable costs:
Manufacturing
Selling and administrative
Fixed costs:
Manufacturing
Selling and administrative
Period 1
Period 2
0
100
60
100
40
100
140
100
$
$
30
5
$
4,000
1,200
$
$
Inventory
decreased
by 40
30
5
4,000
1,200
$4000 ÷ 100 units = $40 fixed unit cost
Blocher,Stout,Cokins,Chen, Cost Management 4e
©The McGraw-Hill Companies 2008
40
Variable vs. Full Costing Example (continued)
Period One Income Statements
Sales (60 × $100)
Cost of goods sold:
Beginning inventory
Cost of goods produced
Available for sale
Ending inventory
Cost of goods sold
Variable selling and administrative
Gross margin
Contribution margin
Fixed manufacturing
Variable selling and administrative
Fixed selling and administrative
Net Income
Blocher,Stout,Cokins,Chen, Cost Management 4e
Full
Costing
$
6,000
Variable
Costing
$
6,000
7,000
7,000
2,800
4,200
1,800
3,000
3,000
1,200
1,800
300
3,900
5,200
$
300
1,200
300
$
(1,300)
©The McGraw-Hill Companies 2008
41
Variable vs. Full Costing Example (continued)
Period Two Income Statements
Sales (140 × $100)
Cost of goods sold:
Beginning inventory
Cost of goods produced
Available for sale
Ending inventory
Cost of goods sold
Variable selling and administrative
Gross margin
Contribution margin
Fixed manufacturing
Variable selling and administrative
Fixed selling and administrative
Net Income
Blocher,Stout,Cokins,Chen, Cost Management 4e
Full
Costing
$ 14,000
Variable
Costing
$ 14,000
2,800
7,000
9,800
9,800
4,200
1,200
3,000
4,200
4,200
700
9,100
5,200
$
700
1,200
2,300
$
3,900
Difference in
Beginning
Inventory
$2,800 - $1,200
= $1,600
Difference in
Income
$2,300 - $3,900
= $1,600
©The McGraw-Hill Companies 2008
42
Variable vs. Full Costing
Summary Analysis
• Full (absorption) costing net income exceeds variable
costing net income (by the amount of fixed cost in the
inventory change) when inventory increases, and
variable costing net income is higher than full-costing
net income when inventory decreases
• Variable costing is not affected by the change in
inventory because all fixed costs are deducted from
income in the period in which they occur; fixed costs
are not included in inventory so that changes in
inventory levels do not affect net income
Blocher,Stout,Cokins,Chen, Cost Management 4e
©The McGraw-Hill Companies 2008
43
Strategic Performance Measurement
and the Balanced Scorecard (BSC)
• The BSC measures SBU performance in four
key perspectives:
–
–
–
–
Customer satisfaction
Financial performance
Internal business processes
Learning and innovation
• Cost, revenue, and profit SBUs focus on the
financial dimension
Blocher,Stout,Cokins,Chen, Cost Management 4e
©The McGraw-Hill Companies 2008
44
The Balanced Scorecard (BSC) and
Performance Evaluations
There are several implementation issues when
using the BSC in performance evaluations:
– Measures are difficult to compare across SBUs
– Validation of the links between measures that are
assumed to improve performance throughout the
strategy map is required
– Managers must provide information on the
strategic linkages in the strategy map
Blocher,Stout,Cokins,Chen, Cost Management 4e
©The McGraw-Hill Companies 2008
45
The BSC and Performance Evaluations
(continued)
– Many large firms have installed enterprise resource
planning systems (ERPs) to collect BSC information, but
firms lacking such a system may have trouble collecting
the necessary data
– The nonfinancial information used in the BSC is not
subject to control or audit and may be unreliable or
inaccurate
– Nonfinancial information is often prepared on a weekly
or daily basis while performance reviews are generally
conducted quarterly or annually
– Concern arises related to the timeliness and reliability of
nonfinancial data prepared by external sources
Blocher,Stout,Cokins,Chen, Cost Management 4e
©The McGraw-Hill Companies 2008
46
The Strategy Map
The strategy map uses the BSC to describe the firm’s
strategy in detail by using cause-and-effect diagrams
Goals:
Earnings,
sales, growth
Financial
Customer
Goals:
Staff apply their
competencies and
strategic awareness
Goals:
Customer satisfaction,
better staff response
to customer needs
Operations
Learning and
Innovation
Blocher,Stout,Cokins,Chen, Cost Management 4e
Goals:
Staff competencies,
strategy awareness
©The McGraw-Hill Companies 2008
47
Managements Control in Service Firms
and Not-for-Profit Organizations
• Service firms and not-for-profit organizations
commonly use cost (most common) SBUs and profit
SBUs
• Cost SBUs are used when the manager’s critical
mission is to control costs
• Profit SBUs are preferred when the department
manager must manage both costs and revenues, or
alternatively (in a not-for-profit), manage costs without
exceeding budgeted revenues
Blocher,Stout,Cokins,Chen, Cost Management 4e
©The McGraw-Hill Companies 2008
48
Chapter Summary
• There are formal, informal, team, and individual
management control systems
• The objectives of management control are to:
– Motivate managers to exert a high level of effort to
achieve the goals set by top management
– Provide the right incentive for managers to make
decisions consistent with the goals set by top
management (i.e., to align managers’ efforts with the
desired strategic goals)
– Determine fairly the rewards earned by managers for their
efforts and skill and the effectiveness of their decision
making
Blocher,Stout,Cokins,Chen, Cost Management 4e
©The McGraw-Hill Companies 2008
49
Chapter Summary (continued)
• Strategic performance measurement is a system used
by top management to evaluate SBU managers
• Before designing strategic performance measurement
systems, top managers determine when delegation of
responsibility is desirable
– A firm is decentralized if it has chosen to delegate a
significant amount of responsibility to SBU managers
– A centralized firm reserves much of the decision making
at the top management level
Blocher,Stout,Cokins,Chen, Cost Management 4e
©The McGraw-Hill Companies 2008
50
Chapter Summary (continued)
There are four types of SBUs:
– Cost SBUs are a firm’s production or support SBUs that
provide the best quality product or service at the lowest cost,
such as a plant’s assembly department, data processing
department, and shipping and receiving department
– Revenue SBUs focus on the selling function and are defined
either by product line or by geographic area
– When an SBU both generates revenues and incurs the major
portion of the cost for producing these revenues, it is a profit
SBU
– Investment SBUs include assets employed by the SBU as well
as profits in the performance evaluation
Blocher,Stout,Cokins,Chen, Cost Management 4e
©The McGraw-Hill Companies 2008
51
Chapter Summary (continued)
• The BSC measures SBU performance in four key
perspectives
–
–
–
–
Customer satisfaction
Financial performance
Internal business processes
Learning and innovation
Blocher,Stout,Cokins,Chen, Cost Management 4e
©The McGraw-Hill Companies 2008