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Chapter 15
Financial accounting elaborates information contained in financial statements created mainly for
parties outside the firm: shareholders, potential investors and creditors. Financial statements are
mainly prepared for the use of outsiders, but are also very useful for the management sector. They
provide an overall picture of an entity’s financial condition and the results of its activities.
Management, however, needs much more detailed financial information than that contained in the
financial statements. Therefore, in this course we will focus on this additional information.
In this lesson we will distinguish management accounting information from other kinds of
information and we will compare and contrast management accounting information from information
used for financial reporting; we will describe the three main uses of management accounting
information and also the use of database systems; finally, we will conclude with some general
observations regarding the management use of accounting information.
What is Management Accounting?
The term management accounting includes a set of techniques, processes and practices designed to
assist management in the formulation and implementation of the organization strategies.
Management accountants, that are the principals operators that process management accounting
activities, are deeply involved in processes related to the identification, measurement, accumulation,
analysis, preparation, interpretation and communication of the information needed by management to
perform its functions.
Historically, management accountants have been primarily concerned with preparation and use of
monetary information and plans. Over the years, however, the conception of management accounting
has broadened to also include the preparation and use of many types of non monetary information,
such as involving product or service quality, operations effectiveness and customer satisfaction.
Imagine also the need to operationalize sustainability, that is a main topic very hot in this moment,
characterized by plural dimensions: sustainability issues are characterized by qualitative and also
quantitative information and data that management accountants have to collect and to identify, to
analyze, to measure, and also to communicate. The evolution of management accounting is ongoing,
it is not a stable matter, because management accounting is a dynamic phenomenon in terms of time
and also space: in fact, the anthropological culture that persists in certain geographical areas could
dramatically affect management accounting activities and the behavior of people that stay in certain
corporate communities and in general the behavior of the firm.
Main Management Accounting Information and Data Used
Management Accounting provides some of the information that helps managers to do their jobs.
Information is contained in any fact, datum, observation or perception that serves either decisionfacilitating or decision-influencing purposes.
Decision facilitating information improves specific decisions: it could lead, for example, managers to
set better prices, to cut cost productively, or to make better allocations of resources.
Decision-influencing information, on the other hand, affects employees’ behaviors in positive ways:
for example, it could motivate employees to make decisions that are in the organizations’ best interest.
Main Management Accounting Systems Activities
These are the main phases that could characterize management control and then these phases are
strictly related to main activities that management accounting system could process.
1. Planning, that is the activity through which the top management identifies strategic midterm or
long-run goals, allocating resources and defining actions in order to elaborate corporate strategies
in a medium or long term. This activity leads the definition of corporate plans that contain
quantitative, qualitative, monetary, non monetary data and information that could be economic,
for example the elaboration of the Income Statement, which collects information, data related to
costs, revenues, profit losses, or the Capital Structure, a document that collects information, data
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related to assets, liabilities, owners’ equity, or Investment Plans that could be for example
dedicated to analyze the fixed assets and the assets turnover, and then there are also documents
that are more based on a financial point of view, such as the Statement of Cash Flows.
2. Controlling, this is an activity characterized by a set of process activities aimed at ensuring that
resources allocated are used effectively and efficiently in order to achieve the planned goals in the
planning process. Such activities are usually implemented in the following phases: programming,
execution and monitoring. To support these phases, management accountants need information
and data that could be financial, non monetary, also qualitative and if we focus in a specific sense
to
a) programming, it is the activity that defines short-term objectives, which are generally aligned
with the strategic ones defined in planning and translates such goals into
operational quantitative
information and data management programs that are so-called “budgets”.
b) execution, is another activity that follows programming and it is the activity that implements
managerial actions in order to operationalize what is defined in programming activities, such as in
budgets.
c) monitoring, is the last activity that is very useful to compare the actual or real results achieved
by a corporate unit or the company in general with the expected standard performance reported in a
certain budget carrying out a “variation analysis”, i.e. certain changes that the operational activities
produced in terms of performance and of results, so the comparison between performance in time
achieved with budgeted performance aligned with the objective that a specific unit aimed to achieve in
planning and also in controlling activity; this is the variation analysis sense.
In order to facilitate the transition from the study of Financial Accounting to Management Accounting
analysis, it is useful to identify some similarities and differences between such different processes
Management Accounting vs Financial Reporting processes, Similarities
Some important similarities between Financial and Management Accounting do exist.
Most elements of Financial Accounting are also found in Management Accounting. There are two
reasons for this:
1. The same considerations that make GAAP sensible for purposes of Financial Accounting are also
found in Management Accounting. For example, management cannot base its reporting system on
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unverifiable, subjective estimates of profits submitted by lower echelons; for the same reason,
Financial Accounting adheres to the cost and realization concepts.
2. Summaries of the documents or computer records of operating results (such as of orders placed,
filled and shipped; customer billings; warranties made; customer payments received; invoices
received; checks written; labour used; amounts borrowed;) provide much of the raw material used
in both Financial Reporting and Management Accounting in terms of data and information.
There is a presumption, therefore, that the basic data will be collected in accordance with the
generally accepted financial accounting principles. To do otherwise would require duplication of data
collecting activities.
Maybe the most important similarity between Financial and Management Accounting information is
that both are used in decision-making and this information collected and elaborated by Financial and
Management Accounting processes could help managers to implement and operationalize such
decisions. Management Accounting information is used in a wider array of decisions made by
managers including, but by no means limited to, decisions about products, pricing, raw materials
sourcing, personnel staffing, investing in long lived assets and evaluating performances of individual
entities and managers.
Differences
Management Accounting vs Financial Reporting processes, Differences
Management Accounting differs in several ways from the financial reporting process analyzed in the
accounting course. To facilitate the transition from Financial Accounting to Management accounting it
is useful to facilitate these differences.
There are 12 differences between Management and Financial Accounting:
1. The category of necessity, necessity in terms of data available, data collecting, data analysis,
data communication, with a different approach from Financial Reporting processes. Financial
Accounting must be done, it is an activity for which enough effort must be expended to
collect the data in acceptable form and with an acceptable degree of accuracy to meet the
requirements of the Financial Accounting Standard Board (FASB) or the Securities and
Exchange Commission (SEC) if you consider the US, and other outside parties, whether or
not the management regards this information as useful. Management Accounting, by contrast,
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is entirely optional: no outside agencies specify what must be done or that anything need be
done, because these activities are completely optional, there is no point in collecting piece of
management accounting information unless its value to management is believed to exceed the
cost of collecting it. So the Management Accounting processes follow internal codes and
procedures that are mainly customized by the top management and managers that process this
activity that characterizes the management accounting system. No criteria, no principles are
defined and set by external organisms,
The second point of difference is purpose: the purpose of Financial Accounting is to produce
financial statements for outside users, such as investors, creditors, customers. When the
statements have been produced, this purpose has been accomplished. On the other hand,
Management Accounting information is only a means to an end, the end being the planning,
implementing and controlling functions of management.
Then there are differences between the users: the users of Financial Accounting information,
other than management itself, often are essentially a faceless group. Managers or most
companies don’t personally know many shareholders, creditors or other stakeholders that play
a crucial role outside of the firm by affecting its behavior. This category of stakeholders who
use information in Financial Statements in order to support the company, for example
investors, could change preferences and support the company A or B depending on the
performance disclosed through financial statements by the company A and the company B, so
they diverge the allocation of capital from one company or the other in line on the
assumptions based on the financial information and data delivered by company A or B in
producing their financial statements. Moreover the information needed by most of these
external users must be presumed: most external users do not individually request the financial
information they would like to receive. By contrast, the users of Management Accounting
information are known managers plus the people who help these managers to analyze the
information. Internal users’ information needs are relatively well known because the
controller’s office solicits these needs in designing or revising the management accounting
system.
From the point of view of the underlying structure, Financial Accounting is built around one
fundamental equation: assets equal liabilities plus owner’s equity. In Management Accounting
there are three primary purposes of accounting information, each with its own set of concepts
and constructs.
The source of principles are completely different. Financial Accounting information must be
reported in accordance with the GAAP principles: the outside users need assurance that the
financial statements are prepared in accordance with a mutually understood set of ground
rules, otherwise they cannot understand what the numbers mean. GAAP provides these
common ground rules. An organization’s management, by contrast, can employ whatever
accounting rules it finds most useful for its own purposes, therefore a company’s management
accounting information system may include data and unfilled sales order, even though orders
are not financial accounting transactions; it may omit certain production overhead costs for
inventories; it may record revenues before they are “realized”. This is a crucial difference:
rather than asking whether it conforms with GAAP, the basic question in Management
Accounting is pragmatic: is the information useful to make a certain decision? This is the
general rule to collect, to measure and to use some data and information, just to support a
specific decision-making process. No GAAP could rearrange the process of the collection, of
measurement, of analysis and of communication of management accounting information and
data, because this is an internal system that observes some internal standards and rules that
are mainly defined by the organization.
The time orientation in Financial Accounting consists in reporting the history of an
organization: entries are made in the accounts only after transactions have occurred. Although
Financial Accounting information is used as a basis for making future plans, the information
itself is historical. The objective of Financial Accounting is to "tell it like it was”, not like it
will be. On the other hand, Management Accounting includes in its formal structure numbers
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that represent forecasts, estimates and plans for the future, as well as information about the
past.
Talking about information content, the Financial Accounting system captures only a few
characteristics, for example date, account and amount in currency, about only a subset of
organizational events, those defined by financial accountants to be “accounting transactions”,
so financial reports summarize the effects of these events in primarily monetary form. On the
other hand, Management Accounting reports summarize many different kinds of information,
information that is useful for decision makers: they include no monetary as well as monetary
information, they show quantities of materials as well as their monetary costs, number of
employees and hour worked, for example, as well as costs of units of products sold. Some of
the information is strictly non monetary: for example, a new product developing time,
percentage of shipments made on time, number of customer complaints received and
competitors’ estimated market shares.
Another certain difference between Management Accounting information and data collected
and Financial Accounting information and data collected is the information precision
required. Management needs information rapidly and it is often willing to sacrifice some
precision to gain speed in reporting; therefore in Management Accounting approximations are
often as useful as, or even more useful than, numbers that are more precise. Although
Financial Accounting cannot be absolutely precise either, the approximations used in
Management Accounting are broader than those in Financial Accounting.
The report frequency is another aspect that could produce differences between Management
Accounting and Financial Accounting: corporations usually issue detailed financial statements
only annually and less detailed interim reports quarterly. By contrast, fairly detailed
management accounting reports are issued monthly in most larger organizations, and reports
on certain activities might be prepared weekly, daily or even more frequently. Some
Management Accounting information must even be constantly updated and made available to
managers on an instant access (real-time) basis.
The report timeliness is another important difference between Financial Accounting and
Management Accounting: because of the need for precision and a review by outside auditors,
plus the time requirements of printing and distribution, financial accounting reports are
distributed several weeks after the close of the accounting period.Larger corporations’ annual
reports for a fiscal year ending December 31 are often not received by shareholders until
March or April. By contrast, because management accounting reports may contain
information on which management needs to take prompt action, these reports are usually
issued within a few days and the end of the month, or next morning for a daily report. The
deadline of dynamics in producing reports is completely different between Financial
Accounting and Management Accounting.
Talking about the report entity, financial statements describe the organization as a whole.
Although companies that do business in several industries are required to report revenues and
income for each industry, these are large segments of the whole enterprise. Management
Accounting, by contrast, focuses on relatively small parts of the entity: corporate units,
individual products, individual tasks, individual operational processes, individual division
department and other responsibility centers. The necessity for dividing the total cost of an
organization among these individual parts creates important problems in Management
Accounting that don’t exist in Financial Accounting. In Management Accounting we need
very detailed information and very detailed data that are strictly related to individual tasks,
actions, strategies implemented, monitored in real time processing period. The Financial
Statement is an overall picture of the entire activity produced in very long periods with
respect to management accounting processes.
The last difference between Financial Accounting Processes and Management Accounting
processes is the liability potential point of view. Although it happens infrequently, a
company may be Mm
issued by its shareholders or creditors for allegedly reporting misleading
financial information in its annual reports. By contrast, as previously stated, Management
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Accounting reports don’t need to be in accord with GAAP and are not public documents, so
although a manager may be held liable for some illegal and unethical actions and
management accounting information may have played some role in his or her taking that
action, it is the action itself, not the management accounting documents that gives rise to the
liability.
Types of Management Accounting Information and their uses
Financial Accounting is essentially a single process, governed by a single set of GAAP and unified by
a basic equation. Management Accounting is more complicated. Many companies have a single
management accounting system, but information in that system is used for three quite different
purposes:
1. Measurement process: measurement of revenues, costs and assets.
2. Control process: control of the activity implemented and possible variance between budgeted
costs or revenues and actual costs or revenues.
3. Alternative choices process: choosing among alternative courses of action, these alternative
courses of action are so-called “alternative choice problems”. This is a scenario that daily,
systematically, periodically a manager has to face. The information used for this purpose cannot
come directly from the management accounting system because each alternative choice, problem
requires its own arrangement of accounting information, and a formal system cannot feasibly
provide for all these variations.
Management Accounting does not have a single unifying equation similar to the equation that governs
all Financial Accounting. This is a very difficult approach, because it is more difficult to manage. It is
more customizable if I have to manage a detailed, specific task, collecting specific information and
data related to it and also to process variance analysis elaborating certain specific data collecting with
specific costs or revenues, for example, it is a very tricky game for management accountants.
The uses of the information for each of the three purposes of Management Accounting are
summarized as follows: some of these uses are related to historical information and others to estimate
the future. The former is a record of what has happened and the latter is an estimate of what is going
to happen.
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In Herbert Simon’s useful characterization, historical data tends to be “score-keeping information”,
that means: how are we doing? What problems require looking into?, on the other hand, future
estimates tend to be “problem-solving information”, and the manager asks himself: what is the best
way to deal with this problem?
The reporting of either historical information or future estimates tends to influence the actions of
managers as they perform day to day activities. The accounting information used for each purpose can
be revenues, costs, assets and liabilities. For convenience, now we’re focusing on costs.
1. For the measurement purpose the Management Accounting system focuses on the measurement of
full costs. Full costs accounting measures the resources used in performing some activity: the
full cost of producing goods or providing services is the sum of (1) the costs directly traced to the
goods and services, called “direct costs” plus (2) a fair share of costs incurred jointly in
producing these and other goods or services that are called “indirect costs”. Full costs accounting
measures not only direct and indirect costs of producing goods or providing services, but also the
direct and indirect costs of any other activity of interest to management, such as performing a
research project or operating an employee cafeteria. Full cost accounting is not restricted solely
on measuring the cost of manufactured goods, as some people usually assume. Historical full
costs are used in financial reporting. In many sales contract the buyer agrees to pay the seller the
cost of goods produced or of services rendered plus a profit margin. Cost, in this context, usually
means full cost. Lastly, estimates of full costs are used in some types of planning activities,
particularly in the type of long-range planning called “strategic planning”.
2. The Management Accounting system is structured so that it measures costs by responsibility
centers. A responsibility center is an organization unit headed by a manager who is responsible
for its operations and performance. Such a structure is necessary because control can be exercised
only through people. Estimates of future responsibility costs are used in the planning process
particularly in the annual planning process called “budgeting”. Historical records of actual costs
incurred in responsibility centers are used in reporting and analyzing their performance. Such
reports are useful because they are aligned with the organizational structure of managers who are
responsible for their performance and the performance of the unit that they manage. Corrective
action can be taken only by individuals, so if any performance is unsatisfactory, the personal
responsible must be identified before corrective action can be taken.
3. Many decisions involve the comparison of the estimated costs to be incurred and also the
revenues to be realized and assets to be employed for each of the alternatives being considered.
This information cannot be taken directly from the management accounting system because the
relevant costs are specific to what is being considered. These costs are always estimates of future
costs, they are sometimes derived from historical costs records. Because these estimates describe
how costs would be different in the alternatives being considered, they are often called
“differential costs”.
Concluding Remarks
1. Spreadsheets and Database as main Management Accounting collecting data & information
tools Spreadsheets provide two-dimensional arrays of data and they consist in rows identified by
numbers and columns usually identified by letters. Database systems come in multiple forms but
most of them provide the capability of storing data in n-dimensional arrays and then producing
reports tailored to specific decisions that must be made. It is useful to contrast the capabilities
afforded by the old ledger systems and the new systems because advances in information
technologies have important effects on Management Accounting systems. Database systems
which usually include all the mathematical functions of spreadsheets are even more powerful. If
the data are properly coded, these systems can store an organization’s raw data in an ndimensional matrix. Sales and margins can then be easily calculated and reported on the basis of,
for example, customer, region, distributor.
2. Different numbers for different purposes The field of mathematics has definitions that are valid
under a wide variety of circumstances. Such is not the case with most accounting definitions.
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Each of the several purposes previously described requires a different accounting approach. Since
these different numbers may superficially resemble one another, one may easily be confused.
Different meanings with same terminology , e.g the term “cost” , because in Management
Accounting there are a lot of definitions of cost, such as historical cost, standard cost, marginal
cost; some of these terms are synonyms, other sure not. You always have to allocate the term
speaking about the term that you want to deal with in order to minimize some mistakes.
Accounting numbers are approximations The management accountants elaborate management
information and data and must acquire an understanding of the degree of approximation of the
data when presenting them. Some accounting numbers may be accurate within very narrow limits,
others may be highly approximated. The degree of approximation is higher in the case of numbers
used for planning purposes because these are always estimates of what will happen in the future.
It’s the future analysis that the manager has to implement in order to estimate the market
dynamics or the competitive approach of the competitors of these dynamics.
Working with incomplete data In a management problem, one almost never has exactly the
information one would like to have. The person struggling with the problem usually can think of
additional information that, if available, would be useful. Conversely, there are many decisionmaking situations in which pages of numbers are available but only a small portion is truly
relevant to the problem at hand. Management decisions must be made and the decision often
cannot be delayed: we do the best we can with what we have and then we move on to the next
problem.
Accounting evidence are only partial evidence Few accounting problems can be solved solely
by the collection and analysis of numbers. Usually there are important factors that cannot be or
have not been reduced to quantitative terms.
People, not numbers get things done An obvious fact about organizations is that they consist of
human beings. Anything that an organization accomplishes is the result of human actions.
Although numbers can assist people in an organization in various ways, the numbers by
themselves accomplish nothing. A management accounting system may be well designed and
carefully operated, but the system is of no use to management unless it results in action by human
beings.
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Chapter 16
This lesson aims to alight some fundamental principles which are basic requirements of Management
Accounting information. We want to study and understand the interaction between cost and
production volume, in other words how costs behave as the level of production activities change. It is
necessary for understanding the various uses of Management Accounting information. In this lesson,
therefore, we will present the concepts of fixed and variable costs as well as step-function costs.
Subsequently this contribution we will be able to focus on how cost behavior information can be
combined with revenue information to develop a profit graph. This last point will be deepened in the
next lesson.
Relation of Costs to Volume
The production volume can be defined in two different manners:
1.
It can be defined and measured in terms of inputs, i.e. the resources used to activate a production
cycle. Resources are used in a Responsibility Center, which is a production unit in a certain
company;
2.
It could be also defined and measured as the overall output, namely the goods or services
produced or provided by a certain Responsibility Center.
The question that at the end of this lesson we will be able to reply is: how costs behave in line with
possible changes in activity?
If a production unit significantly increases the amounts of goods or services it produces then the
amount of resources required to produce desired volume also should increase, that is higher volume
causes higher costs. Is there, proportionately speaking, a direct interaction? In many instances,
however, the percentage increase in costs in less than the percentage increase in volume. To
understand how this happens, it is necessary to focus on the different concepts of costs. Then, to
understand how the variable of cost could vary in line with a certain level of production volume there
are some different categories or components of costs that follow different trends in line with changes
in production volume.
We will analyze the definition of variable costs, fixed costs and semi variable costs.
Variable Costs are items of cost that vary in total directly and proportionately with the amount of
volume of production. Therefore, if production volume increases 10%, the total amount of variable
cost also increases by 10%. The table shows the total variable cost of flat panel displays used in
producing computer monitors:
In this example we shall note two things. First, the volume measure, i.e. the measure of the level of
activity, is specified. In this case, volume is measured as the number of monitors produced. When
labeling a cost as variable, the activity level with which the cost item varies must be clear. Second, the
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total cost is variable because the cost per unit of volume remains constant: $240 per monitor in the
example. To avoid confusion, remember that the term variable cost refers to costs whose total varies
proportionately with volume.
Fixed Costs are items of costs that in total do not vary at all with the production volume. Building
rent could be an example, just like also property taxes, management salaries. These costs may increase
with time, but they do not vary because of changes in the level of activity within a specified period of
time. Because of inflation a restaurant’s rent for next year may be higher than it is in the current year,
but within this year the rent of this activity is unaffected by the day to day changes in the restaurant’s
production volume, i.e. number of customers.
Because the amount of fixed costs is constant in total, the amount of fixed costs per unit of activity
decreases as volume production increases, and conversely fixed costs per unit increases as volume
production decreases.
Although the term fixed cost may imply that the amount of cost cannot be changed, the term itself
refers only to items of cost that do not change with changes in volume.
E.g. If a salaried salesclerk is paid 300$ a week and waits on 400 customers in a certain week, the
“average” cost per customer is 300/400= 0.75£. If the following week the activity engages 500
customers the unit average fixed cost in 300/500= 0.60$, so this is a decreasing value.
Semivariable Costs are those costs that include a combination of variable cost and fixed cost items.
The total amount of a semi variable cost item varies in the same direction as, but less than
proportionately with, changes in production volume.
For example, if volume increases by 10%, the total amount of a semi variable cost will increase by
less than 10%. Semivariable costs are also called semi-fixed, partly variable or mixed costs.
The cost of operating an automobile is semivariable, with respect to the number of kilometers driven,
gasoline oil, tires and servicing costs are variable, whereas insurance and registration fees are fixed. In
most manufacturing firms, electricity costs are semivariable with the volume of goods produced: the
cost of powering production equipment is variable, whereas the cost of lighting the premises is fixed.
Since semivariable costs can be split into fixed and variable components of total cost, the behavior of
total cost can be described in terms of only two components:
1. a fixed component, which is a total amount per period;
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a variable component, which is an amount per unit of volume;
E.g. In the figure below we tried to simplify how to allocate the semivariable component of total fixed
unit variable costs. Remember that part of semi variable costs being combined with unit variable costs
and the remaining being combined with fixed costs components.
Cost-Volume Diagrams
Just to have also a mathematical and also graphical approach, the cost-volume interaction could be
also represented by a diagram.
This diagram is based on the equation of the line that is typical,
Y= mX + b
where
Y= cost at a certain level of production volume of
X= units;
m= is the rate of cost change per unit of volume changed, or the slope of the line;
b= the vertical intercept, which represents the fixed costs component;
Cost per Unit Behavior
We want to explain how the average unit cost works in relationship with total cost and how the total
cost is linked with the total production volume.
The average cost per unit is simply total cost/volume. We emphasize again that the cost per unit of
volume behaves quite differently than those total costs. As volume goes up, total cost remains
constant for a fixed cost item, whereas the total increases for variable or semivariable total cost items
because additional volume causes additional variable costs to be incurred. By contrast average unit
cost remains constant for a variable cost item, whereas the per unit cost for fixed and semi variable
costs decreases as volume increases, because fixed costs per unit decreases as the fixed costs are
averaged over increasing volume.
Note how the unit cost decreases in this example as the 400$ fixed cost is averaged over increasing
volume. As volume increases without limit the unit cost will approach more or less 6$, the unit
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variable cost. This is because the average fixed cost per unit approaches 0 as the volume increases
without limit.
Realizing that unit costs are affected by volume is more than being aware of a mathematical fact. This
is important to understand because it is a fundamental managerial insight. Unit costs play an
important rule in many decision making processes, including production pricing decisions. If someone
says: “Our cost of producing and selling Product X is 15$ per unit”, the question should be
immediately be raised: “At what volume is our unit cost at 15$?”
Unit costs are averages, therefore a unit cost amount is meaningful only in the context of the volume
over which the total costs were averaged in calculating the unit cost.
0
We reported a table where we have the average unit cost at certain level of production volume and of
course the total fixed costs and the related unit variable costs. The trend of average unit cost is a
decreasing trend in terms of an increase in production volume levels, so it is different speaking in
terms of unit variable costs because the unit variable costs are proportionately linked with the increase
of production volume, the average unit cost is an explanation of how the total cost could vary in
scalability with the volume of production.
It is very important to understand that every cost-volume diagram is based on certain inherent
conditions. They include a (1) range of volume, (2) the length of the time period, (3) the stickiness of
costs and (4) the environment, each of which is described below. In many cases these are not stated
explicitly. Failing to recognize these conditions can cause some serious misunderstandings.
Relevant Range
When we speak about the variation of production volume and the effects of these variations on total
fixed costs and unit variable costs and the total cost overall in the amount, we could use our cost
volume diagram in order to understand that there are some hypothesis to take in mind in order to
process choices, decisions making outputs, and our decision maker that often is a manager could
understand in a certain relevant range of production volume how the total fixed costs and the unit
variable costs could vary too.
For example, at zero volume (i.e. when facilities are not operating at all), a managerial decision to
shut the plant down could cause costs to be considerably lower than total fixed costs. This is the first
hypothesis.
In hypothesis 2, when the volume gets so high that a company requires a second shift, costs may
behave quite differently from how they behave under one-shift operations. Even within the limits of a
single shift, costs usually will behave differently when the facilities are very busy from the way they
behave under low-volume operations.
This is not so realistic but it is useful to understand how the decision making process could be
characterized and also the decision maker could understand how the quantity of production volume is
scheduled in a certain plan.
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A single straight line gives however a good approximation of the behavior of costs only within a
certain range of volume and this range is referred to as the relevant range because it is the range that
is relevant for the situation being analyzed.
We just need a clear framework in front of our eyes in order to understand the more estimated
changing in total costs related to changes in production activity of volume outputted and processed.
So the decision makers know perfectly that to process a decision in terms to vary a production volume
from the level 1 to the level 2 it’s more realistic analyzing the trend of total fixed costs and the unit
variable costs comparing the starting point 1 and the ending point 2 in line to understand perfectly the
effects that the production volume could affect on the level of costs.
Relevant Time Period
The amount of variable cost depends on the time period over which cost behavior is being estimated.
Higher the time we have to implement certain production activities, the higher could be the level of
the variable cost that a company could reach.
If in one day few costs are variable, for example in most companies workers are payed daily
independently by the volume of fluctuation occurred in such a short period in terms of production
volume, in one month more costs become variable, for example the size of workforce can vary
according to the volume of the activity planned for a month and this implies a higher level of unit
variable costs that a company has to take in mind. In one year, more costs are variable, for example in
budgeting process a manager could decide changes in the amount of overhead costs according to the
volumes estimated for the year.
Some cost elements that could not be variable in a one-year horizon are the salaries of “cadre of top
managers”, certain base levels of utilities expenses, such as heat, light, security, maintenance,
housekeeping, groundskeeping, depreciation expense, etc.
Particular Variable Costs: Sticky Costs
There are some particular categories of costs that are defined as “Sticky Costs”: they are an example
of costs that generally are considered to be 100% variable, and are, in actuality, less than 100%
variable on the downside. These costs fall less with decreases in volume or activity than they rise with
increases with volume or activity. They are considered to be sticky because managers tend to increase
resources more rapidly when volume increases, then they reduce them when volume decreases.
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E.g. Factory managers add workers when production volumes increase, but when production volumes
decrease, they are reluctant on lay off employees. In some countries labor costs are considered almost
fixed on the downside. It is expensive to lay off excess employees, rather than hiring new employees
when production is upside.
Step-Function Costs
These are some items of costs that may vary in “steps”. The step-function cost incur when resources
are used in discrete chunks, such as when one supervisor is added for every additional 10 workers.
Because they are people intensive, service organizations and the administrative and support functions
of all organizations experience step-function costs. When a person is added to a service or support
activity, its costs step up (increase) by the wages and fringes of that additional employee. At the same
time, adding that person has increased the capacity of the activity to handle more volume of
production and then this decreases the entity of cost.
The height of a stair step (“riser”) indicates the cost of adding this increment of capacity, and the
step’s width (“tread”) shows how much additional volume of that activity can be serviced by this
additional increment of capacity.
Estimating the Cost-Volume Relationship
Any of several methods may be used to estimate the cot-volume relationship, that is, to arrive at the
total fixed cost and the unit variable cost in the equation
TC= TFC + (UVC * X)
There are four main approaches usually used by decision-makers to estimate cost-volume interaction:
1. Judgement, the approach in deciding how each item or category of cost will vary with volume
and what the amount of fixed costs will be. This method is appropriate when the results will be
used to estimate costs in a situation in which historical data are non relevant, such as a proposal to
introduce a new product made with a new process. It is also used when employing a more
expensive or time consuming method is not worthwhile. The reliability of results depends on the
skills and on the experience of the estimator. This approach is also called the account-byaccount method because the analyst considers each account in the cost structure and judges
when the costs in the accounts are variable, fixed or semivariable.
2. High-Low Method, this approach estimates total costs at each of two volume levels, which
establishes two points on the line. This approach is called the high-low method because one of the
volumes selected is likely to be quite high and the other quite low. The upper and lower limits of
relevant range are often selected for this purpose. Then proceed as follows:
a. Subtract total cost at the lower volume from total cost at the higher volume
and subtract
the number of units at the lower volume from the number of units at the higher volume.
b. Divide the difference in cost by the difference in volume; this gives UVC, the amount by which
total cost changes with a change of one unit of volume (i.e. the slope of the CV line).
c. Multiply either of the volumes by UVC and subtract the result from the total cost at that
volume, thus removing the variable component and leaving the fixed component, TFC (i.e. the
vertical intercept).
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A variation of this method is to estimate total costs at one volume and then estimate how costs will
change with a unit increase from this volume; that is, estimate one point on the line and then estimate
its slope (UVC). TFC can be then found by subtraction, as described above
3. Linear Regression, approach characterized by a statistical technique called method of least
squares or linear regression. This procedure gives total fixed costs and unit variable cost values
directly, but take in mind that estimating the cost volume relationship by means of linear
regression is a common practice and the results could be misleading because there are some bias
into the analysis of the relation between cost and volume, because this technique shows at the
best the interaction between cost and volume how it was in the past, whereas managers are
usually interested in what the relation will be in the future. The future is not necessarily a mirror
of the past. Also the relationship we seek is the prevailing under a single set of operating
conditions, whereas each point on a linear regression may present changes in factors other than
the two being studied.
4. Scatter Diagram, allows the decision maker or the analyst to produce a diagram in which actual
costs recorded in past periods are plotted on the vertical axis against the volume levels in those
periods on the horizontal axis. Data on costs and volumes for each of the preceding several
months might be used for this purpose. The line of best fit is drawn by visual inspection of the
plotted points, then at the end total fixed costs and unit variable cost values are determined by
reading the values for any two points on the line and using the High-Low method described
before.
We’re going to introduce “Break-Even Analysis”. This contribution is based on the second part of
chapter 16 and this lesson follows what we analyzed in the previous contribution as regards the
behavior of costs. In the last lesson we understood how the level of volume has an important effect on
costs. We clarified that there are different categories of items that compose the category, the
information of total costs. We learnt that total variable costs change in direct proportion with volume,
whereas unit variable costs are a constant. We also clarified that total fixed costs do not vary with
volume, but unit fixed costs decrease as volume increases. Semi-variable costs, that are another item
of total costs, could be decomposed into a variable cost and a fixed cost component. We learnt and
deeply analyzed that the effect between total cost and production volume could be investigated into a
diagram format, if the relationship could be also approximated in a linear form by the equation of total
costs at any volume that are realized by the sum of the fixed costs plus the product of unit variable
costs and the number of units of a certain level of production volume. This relationship holds only
within a certain range of volume, the so-called “relevant range”, for a relevant given time period and
for a relevant set of given environmental conditions.
In the previous lesson we also analyzed step-function costs. Step function costs occur when a
significant chunk of costs must be incurred to create and additional increment of productivity, or
better, capacity of productivity about a certain unit production and company in general. Depending on
the height of the step, its relevant range of volume and relevant time period in some instances, it is
possible to approximate these costs as variable costs, and in other instances as fixed costs.
Today we want to integrate the cost-volume diagram we analyzed in the previous lesson with another
entity, the so-called “revenue”.
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In general the cost, as a definition, measures the monetary amount of resources used for some
purpose. The purpose is called the “cost object”. The cost objects, in a manufacturing company, are
its products, organization units, projects implemented or scheduled to develop, and any activity for
which cost information is desired.
Full cost means all the resources used for a certain cost object, to produce a specific product, as
regards an organization’s unit and the development of a certain specific project or a certain specific
activity. The full cost is the sum of the cost object’s direct costs, that are costs directly traced to it, and
a fair share of the indirect costs, those costs incurred jointly for several cost objects.
The system in management accounting that collects information as regards full costs and elaborates
data and information in ongoing process is so called “cost accounting system” that routinely collects
costs and assigns them to cost objects.
Measures of volume
So far most of our C-V diagrams have described a single-product organization for which aggregate
volume can be measured by the number of units produced.
In the more common case of an organization that produces several products, it is unlikely that the
number of units produced can provide a reliable measure of activity because some products cost more
per unit than others. Therefore, these organizations must use other measures of volume or activity.
Presumably, a certain measure is selected because it most closely reflects the conditions that cause
costs to change.
In selecting a volume measure, two basic questions must be answered: (1) Should the measure be
based on inputs or on outputs? (2) Should the measure be expressed in terms of money amounts, or in
terms of non monetary quantities?
1. Input versus Output Measures Input measures relate to the resources used in a responsibility
center. Examples include labor-hours worked, labor cost, machine-hours operated, kilowatt hours
of electricity consumed or pounds of materials used. Output measures relate to the goods and
services that flow out of the center. For C-V diagrams that show the relationship between
manufacturing costs and volume, an input measure such as labor-hours or machine-hours may be
a good measure of volume because many elements of manufacturing costs tend to vary more
closely with input factors than with output. Other costs, such as inspection and shipping costs,
might vary more closely with the quantity of goods produced (i.e. with output). A C-V diagram
for a retail store or other merchandising organization normally uses sales revenues, an output
measure, as the volume measure.
2. Monetary versus Non Monetary Measures A volume measure expressed in non monetary
quantities, such as labor-hours or tons, is often better that one expressed in dollars, because a non
monetary measure is unaffected by changes in prices. A wage increase would cause labor costs to
increase even if there were no actual increase in the volume of the activity. If volume is measured
in terms of labor dollars, such a measure could be misleading.
In general, the volume measure chosen should be related to the activity that causes the cost to be
incurred. The more items of cost that are combined in the total cost function, the more difficult it is to
relate the causality of the mixture of costs to a single activity measure. Also, the appropriateness of a
particular measure may change over time. For example, a factory becomes more highly automated,
machine-hours tends to become a more valid volume measure than the traditionally used labor-hours
or labor dollars because increased use of the automated equipment causes increases in the factory’s
variable and step-function costs.
The Profit-graph
We are ready to introduce a new variable in our cost-volume diagram, that is called revenue line, in
order to define the so-called “profitgraph” or “cost-volume profit graph”, or shortly “CVP graph”.
A profit graph shows the expected relationship between total costs and revenue at various volumes. A
profit graph can be constructed either for the business as a whole or for some segment of a business,
such as a product, a product line or a division.
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On a profitgraph, the measure of volume may be the number of units produced and sold or it may be
euros of sales revenue. We have already states in the previous contribution the formula for the cost
line, i.e. TC = TFC + ( UVC*X ). The new entry in this diagram is revenue that is plotted on the profit
graph assuming a constant selling price per unit. That assumption results in a linear revenue graph
whose slope is the selling price per unit. If volume is measured as units of products sold and it is
designed by the variable X (a certain amount of production volume) and if the unit selling price is
designed as UR (unit revenues), then the total revenue (TR) equals the unit selling price (UR) times
the number of units of volume production (X).
That is, TR=UR*X. (For example, if the unit selling price is $8,50, the total revenue from the sale of
200 units will be $1,700).
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8%001-6 ✗
→
8,5×-6 ✗
=
400
→
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This example is useful to understand how we could elaborate a certain profit graph below the
numerical example. It is very fundamental and important to understand that the profit graph is a useful
device for analyzing the overall profit characteristics of a certain business or segment of a business.
To illustrate such analysis we could assume in the example that a certain business unit or production
unit could account for $400 total fixed costs per period, then variable costs equal to $6 per unit and
the decision maker set previously a selling price equal to $8.15 per unit of output produced and sold.
At the break-even volume, total costs equal total revenue, as you could realize looking at the graph.
The line of costs and the line of revenue cross at a certain point and this point is mathematically
described in terms of break-even point. The break even point is of little practical interest in a
profitable company because the company focuses on the profit region, which should be considerably
above the break-even volume.
The break-even volume is computed as it follows:
Since revenue (TR) at any volume (X) is
TR = UP * X
And cost (TC) at any volume (X) is.
TC = TFC + ( UVC*X )
And since at the break-even volume,
costs = revenue, or
TR=TC
Then the break-even volume is the volume at which.
UP * X = TFC + ( UVC*X )
In this example, the breakeven volume is quantified in terms of 160 units to produce and sell in order
to cross the line of zone losses and in terms to go through the red line that is the so-called profit zone.
At the lower of break even volume a loss is expected, at higher volume a profit is expected.
The amount of loss of profit expected at any volume is the vertical distance between the points of the
total costs and the total revenue lines at that volume, in this case 160.
The equation for the break-even volume, X(b), also can be stated in the following form: the breakeven volume can be found by dividing the fixed costs (TFC) by the difference between selling
price per unit (UP) and variable cost per unit (UVC).
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In this case we have another numerical example to understand how we could realize the level of the
break even volume, how could we reach the targeted level of break even volume in order to
understand the red zone of losses or the green zone of profits in our profit graph diagram.
If we want to understand which is the perfect amount of break even volume in order to achieve the
equal distribution between total costs and total revenues we just need to have in mind that there is a
possibility to set a selling unit price in terms of $8.15 multiplied by our quantity that we want to
verify, in order to obtain this equation between total costs and total revenue knowing that our total
fixed costs are equal to $400 and knowing that our unit variable costs are equal to $6 multiplied by a
certain amount of the assumed break-even volume that we want to investigate.
At the end, the equal distribution of total fixed costs and total revenue is set at a certain break-even
volume, that is quantified in $160 for which we have $1360 of revenue and $1360 of costs.
This is very interesting also not only to achieve the information about break-even volume, but also to
take in mind which could be the Margin Safety, namely in other words the amount by which the
current volume has to exceed the breakeven volume in order to avoid losses.
Break Even Analysis: The Target Profit
Imagine that a manager has to set a specific unit selling price, he needs an important approach that is
fundamental in order to compare this variable with the unit variable costs, an important analysis that
could affect the final results in order to achieve a profit or In order to avoid losses. It is easy to extend
break-even analyses to calculate the volume necessary to earn a target profit level, T.
This kind of difference between unit selling price and unit variable costs is so-called “unit
contribution margin”.
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Break Even Analysis: The Contribution Margin
Although profit per unit is different at each volume, another number is constant for all volumes within
the relevant range. This number is so-called unit contribution margin or marginal income.
The Unit Contribution Margin is the difference between the unit selling price and the variable cost
per unit.
In our example, this difference was set in terms of $2.15, that is the difference between $8.15-$6.
Because this number is a constant, it is an extremely useful way of expressing the relationship
between revenues and costs at any volume. For each change of one unit of volume, profit will change
by this amount, by the contribution margin, in our example by $2.15. Starting at the lower end of the
relevant range, each additional unit of volume increases the profit amount of unit contribution margin.
This is an important and fundamental information in order to understand how unit selling price could
be set by our decision maker in order to avoid also losses. The concept of contribution is a very
important one in business and many definitions of contribution cannot rightly contain the concept and
the reason why this word is used for the difference between revenue and variable costs.
Each “spurt” labeled UR represents the revenue from the sale of one unit of product. Part of the
revenue proceeds from the sale of each unit must be used for its variable of costs. These are the UVC
spurts shown as outflows.
What remains from each unit’s revenue after providing for its variable costs is the unit contribution
depicted by the spurs labeled C. The size of fixed costs “pot” into which the unit contributions are
flowing represents the amount of fixed costs of period. If the period’s unit contribution just fill the
fixed cost pot, the break even operations have been achieved.
Note that if the size (capacity) of the fixed costs pot is divided by the size of each unit contribution
spurt, then the results will be how many unit-contribution spurts are needed to just fill the pot, that is
the break-even volume.
Break Even Analysis: The Operating Leverage
Using the profit graph presented before we can demonstrate how the average profit per unit changes
with volume.
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This table shows an example in which as a first raw we set 200 units per production volume, revenue
equal to $1,700, costs that are equal to $1,600. Profit at the end is equal to $100.
In the second row, we scheduled that the amount of units to produce is equal to 250. Revenues are
equal to $2,125, costs are equal to $1,900 and profit is equal to $225, for an average profit of 0.90 per
unit. This increase in per unit profit is caused by a specific phenomenon: unit cost decreases as
volume increases. That is, if volume increases, average per unit cost decreases because the average
fixed cost of each unit decreases. This phenomenon is referred to loosely as spreading the fixed costs
over a higher volume, or more formally, this phenomenon is called operating leverage. So to
understand why the term leverage is used, consider that when we have a volume in first row that is
scheduled to 200 units, the expected profit is at the end 100. But when volume goes up by 50 units to
250, we have an increasing effect of 25% in terms of profit, because profit goes up by 100 to 225, an
increase of 125%. In particular in this example the leverage factor was 5, i.e. profit went up 5 times
as much as volume. Of course, leverage works both ways, which is why business became so
concerned about volume decreases of only a few percentage points.
The interactions, in our formula, are strictly linked, variable per variable and we need to understand
how to fix the perfection amount of production volume and how to fix the unit price selling in order to
have a scalable effect. Take in mind also the effect of operating leverage and the effect of total cost in
particular the effect of the unit cost that decreases as volume increases and this is very important to
understand how as volume increases average per unit cost decreases because the average fixed cost of
each unit that we want to improve decreases. It’s important to rearrange or ti better set in an optimal
way the decision making process that stays in the background of certain lines of production in order to
schedule better the implementation of the activity.
The Contribution Profit graph
At the endow our Break Even Analysis, now we are able to include the concept of total income
understanding that the total income at any volume is unit contribution times volume minus fixed costs,
(UR-UVC)*TFC=I
Recalling the numerical example we previously made, the contribution was $2.15 per unit, times 250
units minus the fixed cost of $400, this formula gives the total income of $225.
Stated in another way, this formula permits us to consider that if the unit contribution in $2.15 per unit
and fixed costs are $400 per period, then 160 units must be sold before enough contribution will be
earned to recover fixed costs. Then, if using the unit contribution concept over a range of volume is
valid, it is possible to construct another useful form of profit graph, and thanks to these considerations
we have to take in mind that the income line has a value of zero at 160 units that is the break even
point. The slope of this line is 2.15 per unit of volume, that is the unit contribution, and finally this
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graph shows a loss of 400 at 0 volume, because 400 is the amount of fixed cost for which we will
have no contribution to observe at 0 volume.
Cash versus Accrual Profitgraphs
The revenue and cost numbers used in profit graphs and break-even calculations may be either cashbasis or accrual-basis amounts. The choice in a break-even analysis depends on whether the analyst is
interested in determining (1) the volume at which cash inflows from sales equal related cash outlays
for operating costs or (2) the volume at which reported revenue equals the related expenses. Although
revenue and cash inflows from sales (i.e. collections) tend to be about equal in a given time period, the
non cash nature of depreciation will cause the period’s reported fixed expenses to be larger than the
related cash outflows. Thus, when using a profit graph, it is important to know whether the underlying
numbers are cash flows or accrual-basis amounts.
For profit graphs to be meaningful on a cash basis, one must assume that the period’s sales volume
and production volume are equal.
For example, suppose that May sales were 200 units but that May production output was 250 units. It
is not meaningful to call May’s profit the difference between (1) the cash receipts from 200 units and
(2) the cash costs of producing 250 units plus May’s selling and administrative costs; this is because
the company produced 50 units for inventory and the cash costs of these units were not associated
with May’s sales. Hence, the profit graph implicitly assumes sales volume and production volume
equality for cash-basis numbers. However, with accrual accounting’s matching concept, if 200 units
are sold, then 200 units’ costs are charged as the related expense (i.e. cost of goods sold is based on
200 units), and the costs of the other 50 units are held in the asset account, Finished Goods Inventory.
Thus, one need not assume production and sales volume equality for an accrual-basis profit graph to
be meaningful, provided one remembers to interpret total cost as the period’s cost of goods sold plus
selling and administrative costs, rather than the period’s production costs plus selling and
administrative costs.
Improving Profit Performance
Continuing to discuss about relationship that are investigated with the profit graph approach and the
reloaded formula we presented before we could have four basic ways in which the profit of business
that makes a single product can be increased:
1. “Increase” Selling Price per unit (UR)
2. “Decrease” Variable Cost per unit (UVC)
3. “Decrease” Total Fixed Costs (TFC)
4. “Increase” Volume (X)
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We’ll report another numerical example that is also easy tor read and to study.
The separate effects of each of these possibilities are analyzed in a numerical manner using this table.
Each starts from the assumed present situation that selling price is set at $8.50 per unit, variable cost
at $6, fixed cost at $400 and volume at 200 units and hence profit is elaborated at 100 because the
contribution unit was 2.15 multiplied by 200 minus 400.
An increasing selling price by 10% implies any increase of revenue of +170. No variance of costs is
registered, but an increase in new income that becomes $270, that has increased 170 of percentage.
A decreasing variable cost by 10% implies no variance in revenues and a decrease in costs of -$120
and a new income that is $220, that has increased 120 of percentage.
Decreasing fixed costs by 10% implies no variance in revenues but a decrease in costs in terms of $40 and to a new income level of $140 that has increased from the starting point in terms of the 40%.
An increase in volume by 10% implies an increase of revenues of +$170 but in general this implies
at the same moment an increase of costs of +$120 and then we could realize that the new income level
is configured in $150 that is an incremental trend from the starting point of the 50%.
This foregoing calculation assumes that each of the factors is independent from the others, a situation
that is really the case in the real world. An increase of the selling price for example is often
accompanied by decreasing volume, therefore it is essential to study changes in the factors together
than separately.
Concluding Remarks
Cost volume diagrams and profit graphs show only what total costs are expected to be at various
levels of volume. There are many reasons, other than the level of volume, why the cost in one period
are different from those in another period. These are some:
1. Changing in input prices: one of the important causes of changes in cost and volume diagrams
is that prices in input factors change. Inflation could play a critical role, and it is a persistent and
probably permanent phenomenon over time. Wage rates, salaries, material costs and costs of
services all go up. Then a cost volume diagram or a profit diagram can be misleading if not
adjusted for the effects of these changes due to the inflation phenomenon.
2. The rate at which volume changes: rapid changes in volume are more difficult for personnel to
adjust with respect to moderate changes in volume. Therefore, the more rapid the change in
volume, the more likely it is that the costs will depart from the straight line cost-volume pattern.
3. The direction of change in volume: when volume is increasing, costs tend to lag behind the
straight line relationship, either because the organization is unable to hire the additional workers
that are assumed in the cost line, or because supervisors try to get by without adding more costs.
Similarly, when volume is decreasing, there is a reluctance to lay off workers and to shrink other
elements. Of course, this also causes a lag.
4. The duration of change in volume: a temporary change fo volume in either direction tends to
affect costs less than changes that last a longer time, for much the same reason we have discussed
above.
5. Prior knowledge of the change: If managers have an adequate advance notice of a change in
volume they can plan for it. Actual costs therefore are more likely to remain close to our cost and
volume line than is the case when the change in volume is unexpected.
6. Productivity: we assume a certain level of productivity in the use of resources. As the level of
productivity changes, costs change as well. Labour productivity rates also vary across industries
and companies in terms of units and in terms of time, how we realized speaking about the
phenomenon of inflation.
O
7. Management discretion: the management discretion could play a crucial rule
in affecting all
variables that we analyze. Some costs and items change because management decided they
should change. Some companies have relatively large headquarters staffs, while others have small
ones. The size of these staffs and hence the costs associated with them can vary within fairly wide
limits, depending on management’s judgement as their optimum size. Such types of costs are
called discretionary costs.
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Studies have shown that reductions in unit productions associated with increased productivity has in
many situations, and this is another important principle, a characteristic pattern that can be estimated
with a reasonable accuracy. This pattern is called “learning curve” or “experience curve” and it is
fundamental to understand how the learning by doing effect is also to be included in this context of
analysis when we have to understand and to analyze findings produced by and overall break even
analysis.
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Chapter 22
This part of the course will be characterized by three lessons on which we will focus on the nature of
the management process and the use of the accounting information in that process. In particular we
will understand the environment in which management control takes place, the organization, the rules
and procedures governing its work, the organizations’s culture and the organization external
environment in which the company plays a crucial rule in order to support the economic development
on a certain geographic area. Then we will focus on the contingency, internal and external, and how
these contingencies could affect management control systems, mechanisms and practices of a certain
firm.
:
Management control: the evolution of definitions
The first author that defined the term of Management Control was Anthony in a publication of 1965,
in which he defined Management Control as the process of assuring that resources are obtained
and used efficiently and effectively in the accomplishment of the organization’s objectives.
Therefore, Management Control system could be intended as a link between
1. Strategic Planning, the process of deciding on the long-term goals of the organization and the
strategies for attaining these goals.
2. Operational Control, concerned with ensuring that immediate tasks are carried out.
The definition of Anthony is more characterized by a rational approach, it is very focused on the
allocation and the use of resources in order to implement a certain process that is useful to achieve
certain objectives. In that period the author focused more on the efficient and effective use of
resources, neglecting some important components and dimensions that characterize the overall
management control process and system. This definition, in other words, is based on the rational
assumption that management control refers to the efficient use of resources. It is a definition that puts
emphasis on bureaucracy, hierarchical levels, centralized planning and formal structures and rules, but
neglects any other organizational and contextual factors such as people, culture, environment.
Following the definition of Anthony, Ouchi & Maguire in 1975 overcame such limited definition of
management control highlighting two other dimensions of control,
1. Behavior Control, based on personal surveillance and exerted when means and relations are
known and thus appropriate instruction is possible.
2. Output Control, based on the measurement of outputs and occurs in response to a manager’s
need to provide legitimate evidence of performance.
Not only the allocation of resources is important, but there are other components that could play a
crucial rule in order to affect the real behavior of the single individual, components, mechanisms,
practices, tools used in the decision making process of a certain firm and affect the overall behavior of
a certain specific firm.
Hopwood, contextually, in 1974, distinguished other dimensions of Management Control that could
describe the real functioning of a certain management control system or management control process:
1. Administrative Control, according to Hopwood management control could be characterized by
a certain set of formal rules and procedures and this set is the background of the definition of
plans, budgets, operating manuals and formal patterns of a certain organization. Then the
administrative control is designed to provide structure to decision making process,
specifying and limiting alternatives thus guiding managers and employees’ actions.
2. Social Control, it is referred to the shared values that are norms and commitments of
organizational actors. Social controls develop through two forms of socialization: internally
speaking, in a certain corporate environment, the formal system of beliefs and the meaning
designed by managers and the spontaneous social interaction.
3. Self-Control, constituted by a set of personal motives of individual members. Self-controls are
based on the internalization of norms embodied in administrative and social controls.
The evolution of the concept of Management Control is also supported thanks to the publication
written by Otley & Berry (1980). These authors elaborated another concept of Management Control
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that opens scenarios in terms of studies, practicalities, that are more focused on contextual factors
influencing the control procedure adopted by a certain firm. This is strictly related to the
contingency theory, that is the biggest umbrella that stays on top of this vision of management
control, confirmed also by Merchant (1984) that highlighted that context variables may be
systematically related to differences in approaches to management control tools. According to
Merchant, a management control tool, such as a budget, could be affected by certain contextual
factors such as departmental size, functional differentiation and the degree of automation of
production processes.
In another sense, looking at Management Control as a component in formulating strategies, another
well known economist that studied the firms and the behavior of the firms was Simons (1995) that
identified Management Control as a system used not only to monitor the outcomes that are in
accordance with plans or not, but also to motivate the organization to be fully informed
concerning the current and expected state of strategic uncertainties.
Simon indicates four possible levels of control that allow managers to implement strategies
successfully and to reconcile the tensions between innovation and efficiency.
1. Diagnostic control systems, that are formal information systems that managers use to monitor
organizational outcomes and correct deviations from pre-set standards of performance.
2. Interactive control systems, that are formal information systems that managers use to involve
themselves regularly and personally in the decisions of subordinates. Through them, senior
managers participate in the decisions of subordinates and focus organizational attention and
learning on key strategic issues.
3. Beliefs systems, that embody the values and direction that senior managers want their employees
to embrace. Company’s purposes and missions fall within this form of control providing patterns
of acceptable behavior that must be fully understood by employees in order to act as desired by
the top management, achieving corporate’s interests.
4. Boundary systems, in order to achieve superior results, individuals sometimes choose to bend
the rules. Therefore, boundary systems set limits on opportunity-seeking behavior and are mainly
composed of standards of ethical behavior and codes of conduct.
More recently, publications by Merchant & Riccaboni (2001) and Merchant & Van Der Stede
(2007) summarize the whole emphases that have been highlighted by prior studies before,
highlighting three macro controls that could characterize a management control environment:
1. Action control, the physical and administrative activities and mechanisms capable of ensuring
that employees perform, or do not, certain actions, deemed beneficial or harmful for the
organization.
2. Results control, the mechanisms which link remuneration to the performance achieved based on
empowering individuals on the results of their activities, so sanctions plans in order to diverge
some unexpected behavioral approaches, implemented by individuals, that could affect the right
development of certain activities, and remuneration plans that could support the right behavior
adopted by individuals in order to process rightly certain activities to achieve the expected
objectives or goals.
3. Personnel and culture control, the initiatives, situations and tools capable of ensuring that each
employee controls its own behavior or that they control each other, so self-control or control
groups.
In the light with this framework Management Control could be identified as a set of formal and
informal controls that are aimed to align the behavior and the actions of business actors with
the organization’s objectives and strategies (Merchant and Riccaboni, 2001). This definition that
comes from single control procedures to a comprehensive definition of management control is the
most appropriate.
According to Malmi & Brown (2008), Management Control can be defined as a “package” that
encompasses formal as well as informal controls and that can be structured around five groups:
planning, cybernetic, reward and compensation, administrative and cultural controls.
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The Management Control
Management control is on top a pyramid and is characterized by
- Conditions of both feasibility & effectiveness, just like the point of view of Anthony;
- Dimensions, the point of view of Merchant & Ricaboni and also Malmi & Brown;
- Institutional and cultural characteristics;
- The control process.
These control processes are characterized by the implementation of certain activities more focused on
programming and budgeting that comprehend
- Fundamentals of Budgeting;
- Typologies, characteristics, aims, defining of sectorial budgets and the master budget;
At the bottom of this pyramid there is strategic planning and the management system, that is
fundamental in order to realize also how the programming and budgeting activities are strictly related
to the main goals that are long-midterm objectives that top management aims to achieve, and how the
annual activity could support the implementation of these strategies and this set of annual activities is
focused on programming and budgeting. This level of the pyramid comprehends
- The evolution of Management Systems, i.e. time extension and organic expansion;
- Suitable tools, e.g. BSC, MBO, focused on non-monetary/qualitative information.
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Summing up we could say that management is the process of dealing with or controlling things,
people, tasks, actions and performances, and control is a term that could be interpreted according
to two different points of view:
1. In French “controle” stands as “verification and inspection process”, that is inspection control or
formal verification for compliance purposes with established rules and procedures. This suggests
a focus on the actions taken, to support purposes and to implement established rules and
procedures in order to achieve certain scheduled goals and objectives. In French “control” is
intended more as “bureaucracy”, in terms of written procedures and formalization
2. In English “control” stands as “guidance” and “governance” of certain processes: so it is used in
the context of power to direct, to guide, to arrange and prevent something, focusing on
performance achieved in line with programmed objectives and scheduled goals.
The Management Control could be based on both
1. Internal corporate performance measurement and monitoring;
2. Accountability defined in line with the achievement of predefined objectives, often related to the
attribution of monetary incentives or sanctions in order to avoid some negative behavioral
approaches adopted by individuals or groups of individuals that operate in a certain business unit.
The Management Control mainly aims to
1. Guide and encourage the individual and the organization’s behavior in order to boost the
achievement the firm’s objectives;
2. Foster within the company culture focused on performance and the financial as well as nonfinancial strategic issues to the firm development.
The strategy formulation is not a systemic activity because strategies change whenever a new
opportunity to achieve goals arise. And opportunities do not appear according to a regular schedule.
Formally speaking, Management Control is defined as the process by which managers influence
members of the organization to implement the organization’s strategies efficiently and
effectively.
Control is a term that could suggest activities that ensure that the work of the organization proceeds
as planned, which is certainly part of the management control function. Nevertheless, Management
Control involves planning which is deciding what should be done: the organization will not know
how to implement strategies unless plans are developed to indicate the best way to do so in a certain
time horizon.
Goal: long-run perspective and primarily qualitative considering the firm as a whole, cfr. Planning.
Objective: short-run perspective and primarily quantitative defined to implement a specific business
activity operationalizing a strategy, cfr. Programming
Management control is not focused only on the allocations of resources and on the achievement of
goals in terms of efficiency, but there are also components that are intangible, different from
performance and from resources. There is another component that we emphasized before, that is the
human component, very important when we’re speaking of management control.
The control process is characterized by those activities that ensure the correct functioning of the firm
in line with what planned. The control could process as ex-ante (feed-forward control) activities, in
which managers compare “planned” with “desired” results, and ex-post activities, in which managers
compare “planned” with actual results.
Nevertheless, Programming is another issue of Management Control activities. Such activity is a
preparatory process to define plans. Plans could be defined as a combined set of
1. Objectives, such as the expected results that managers should achieve implementing required
strategies;
2. Resources required to attain the objectives;
Management Control is a process which takes place in a well-defined environment characterized by
the following facts:
1. The specific “nature” of a certain organization;
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2.
3.
4.
Management Control
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Rules, guidelines and procedures;
Culture;
An external environment, that in the contingency theory plays a crucial rule
( i.e. how the external
0
environment and also the internal contingencies could affect the real functioning of management
control processes).
Management Control: main characteristics and components
In a visual perspective, the Organization Chart is the main visual or graphical representation of how
a certain company is structured, internally speaking. It is also an important visual archetype that
describes the set of responsibility centers or different types of organizational units that are internal in a
certain firm, and a way to understand how the accountability is defined and distributed by managers
and by subordinates while processing certain business activities.
The management control process is another component of the nature of Management Control and it
is more focused on the sequential activities in which the operations of the system are implemented.
Then we have the technical Management Accounting system that consists in the set of performance
measurement and monitoring practices, mechanisms and tools; in reporting models implemented; and
in the overall data/information analysis carried out.
The Organization Chart
Firstly, we want to state that the organization is a community of people that cooperate to pursue
one or more common goals to satisfy certain human needs. Secondly, the members of such
community work together and play a well-defined role processing specific tasks. An organization has
one or more leaders, so-called managers, who collectively compose the management.
•
A manager plays a crucial rule
in order to support the real functioning of the decision making process.
Managers, in fact,
1. Decide what the organization’s goals should be and decide the objectives that should be achieved
in order to move towards these goals provided in a certain set of strategies formulated in strategic
planning.
2. They communicate these goals and objectives to members of the organization that operate in
specific production units.
3. They define tasks to be performed in order to achieve these objectives and the resources that need
to be used to carry out these tasks.
4. They are responsible to ensure that the activities of various organizational parts are coordinated.
5. They are also going to match individuals to tasks for which they are suited.
6. They are responsible to motivate these individuals, the subordinates, to carry out these tasks.
Each organization has a structure characterized by a top unit and subordinate units placed in several
layers. This authority runs from the top management down to successive layers. An arrangement of
such structure is called organization hierarchy.
The formal representation of an organization structure is called Organization Chart which
generally identifies the following main organization dimension as well as different accountability
levels, starting from
1. The Board of Directors
2. The President (CEO)
3. The Lines (such as Divisions) that characterize the sub levels of a certain company and the Staff
Units that constitute a more traversal activity.
An organizational chart commonly identifies
- How the decision-making powers have been distributed in a firm within different organization al
hierarchy levels between the business areas;
- The Responsibility Centers (RCs) and the Accountability levels, namely, how the responsibilities to
manage and use certain productive resources and to achieve a specific set of objectives have been
allocated to leaders (or teams) which are playing a crucial role within an organization.
A standard Organization Chart
-0--80
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This is a standard Organization Chart representation: on top there is the organism of Board of
Directors, with the President, the CEO, the executive leader that stays on top of all lines that are
divisions, departments, sections. As the chief of each of the the sub-levels, we'll find a manager, that is
responsible for the achievement of the objectives scheduled, for the allocation of human, economic
and material resources and for the technology implemented to activate certain production processes.
Each manager as chief of the division, department or section, is also responsible for eventual
misalignments between the achievement or partial achievement of the actual performance with
predefined goals.
We want to }alight in blue color some activities that stay in a horizontal manner to support the whole
production activities carried out by divisions, departments and sections. These staff units are
commonly defined as the control area, the financial area, the human resources management area, the
legal affairs area, the research and development area and so on.
E.g. FCA group Organizational Chart
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Remember that all the divisions, departments and sections are managed by managers, who are the
main responsible for all activities implemented for the achievement of all objectives that are
predefined and then the performance achieved by the division, department or section, and all of these
subunits are responsibility centers, just like the staff units could be identified as responsibility centers
too.
The behavior of the overall organization and of its community members is regulated by formal and
informal control forms and mechanisms. The organizational chart also identifies how formal and
informal control forms are organized among certain levels that characterize the internal structure of
the company.
The rules, guidelines and procedures represent formalized (physical, written, oral and/or visual
codes) control mechanisms.
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Each firm has a culture which is characterized by unwritten norms of behavior that derived from
tradition, the external influences and from the attitudes of senior managers as well as of board of
directors.
If we analyzed the relationship of the company with the external environment, we would have to
focus on this model, taking in mind that the firm could change also the modes of its activities, the
decision making processes, the set of goals in strategic planning activity, the setting of objectives in
programming and planning activities and also the use of performance measurement tools because of
the contingencies that externally and internally could happen.
These are some interactions with main stakeholders that could affect the functioning and also the
behavior of the firm in terms of commercial exchange, economic exchange, transactions between
suppliers and customers, the dynamic competition of the market that is affected by the market
strategies implemented by competitors, the financial supports that are processed by investors that
could change the operating activities and also the management control activities in terms of financial
and economic availability of resources.
o
Investors could play a crucial rule
in terms of the acquirement of new financial and economic
resources to activate new production cycles and new production activities, also in order to support
staff units activities of course. The society in general, the market and public authorities also affect the
production of new infrastructures and the enactment of new normative acts. Imagine that a stronger
endorsement to fight against climate change could affect the operating activities, the strategic planning
and the budgeting activities implemented by a company that cooperates in energy sectors. The
necessity for carbon mitigation, or the mitigation of climate change could imply a change in strategie.
This is how external contingencies could affect the behavioral approach adopted by a firm and also,
internally speaking, the management control phases and processes.
The Management Control process
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This graph could resume what we analyzed in previous explanations. There are certain external and
internal factors that could affect the functioning of management control systems and also the
functioning of planning.
There are some internal factors, such as human components, culture, internal stakeholders, such as
the decision-making apparatus or shareholders, that could also diverge the strategy formulation in a
short-term approach in order to enhance the profit level and enhance the payoffs, dividends, i.e. the
gain that could satisfy the expectations of the firm’s shareholders.
•
The availability of resources could play a crucial rule
in the definition of all phases of our
management control process. Some interests that could diverge the attention, the emphasis of certain
control activities, like self-interest, an opportunistic behavior of managers, that is another example of
how an internal factor could play a determinant role in defining certain planning, programming and
execution activities of management control. There are also other factors that internally speaking could
influence the management control process functioning, such as the technology adopted, such as the
effects of digitalization to support vastly the decision-making process and to support the trustiness of
information shared along the decision making process. There is also an emphasis on power
distribution in the decision making process and in the organization chart and on production, i.e. the
decision to produce certain goods against the need to invest in another production line. Then the
influence of directors and senior managers, the strategy changes could also other determinant
levels of planning, programming, evaluating certain activities, also the definition of certain
organizational structure could affect the development and implementation of certain activities. Then
the corporate governance, i.e. the rules that stay in the background of this topic, experiences
reached, modes of stewardship, firm history, remuneration plans, the individual attitude to the
risk and so on.
Another important category that could play a determinant role in affecting management control
processes is the external factors, i.e. factors external to the environment of the firm. Market
dynamics, globalization, climate changes and the availability of environmental resources,
financial markets, specific characteristics of the geographical area in which the firm operates,
stakeholders’ pressure/interaction, regulation and anthropological culture.
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In this graph we’re summing up the Management Control process. The Management Control process
is focused on programming, execution, measurement and evaluation phases that are consequentially
speaking the second step of the strategic planning formulation that is focused on mid and long-term
goals.
1. Programming is the alignment of midterm or longterm goals that we want to achieve
implementing strategies in three, five years, with objectives to achieve in a very short-term
time space. The output of this phase is the definition of budgets.
2. Execution of budgets, the activity that carries out decisions and actions planned in the
programming phase.
3. Measurement activity, in which we elaborate information and data, a more quantitative
approach, in order to understand the entity of results achieved by a certain production unit, a
division, a department or a section.
4. Evaluation is the activity in which we compare actual performance achieved with objectives
scheduled in the programming phase and so if there is a misalignment or a perfect alignment with
objectives scheduled in programming, performance achieved and strategies implemented. The
feedback moves along with a just operation if operating objectives and performance achieved by
a certain unit or the overall units in a business scenario coincide, or it could suggest revising
budgets if there have been some internal or external contingencies that produce misalignments
between operating objectives scheduled in programming phase with actual performance achieved
in measurement phase. The evaluation phase is an important and crucial activity that activates a
certain feedback loop that could also permit to a certain business unit or the overall company tor
arrange strategies if there is a misalignment between goals scheduled in strategic planning,
operating objectives scheduled in programming and performance achieved and measured in
measurement phase and evaluated in evaluation phase.
The technical Management Accounting system
The technical Management Accounting system is the structure that stays at the basis of our activity,
and its very important function is to elaborate information, data and reports that elaborate information
for
1. Budgetary accounts;
2. General accounts;
3. Cost accounting;
4. Variance analysis;
5. Financial statement (or balance sheet) analysis;
6. Balanced Scorecard;
7. …
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There are two components that characterize the Management Control process:
1. Static, activities represented by the Management Accounting technical support, that has to be
stable in order to support the real and effective programing, execution, measurement and
evaluation processes, and the Organization Chart that represents the structure adopted by a firm to
process the overall activities.
2. Dynamic characterized by those activities that are completely an evolutionary trend during the
development of management control systems, that are programming, execution, measurement and
evaluation, strictly related to the dynamics that internally speaking could affect the behavior and
the decision making of the firm as well as the external contingency that could affect the
programming, execution, measurement and evaluation and their systematic rearrangement.
There is also another important distinction between dimensions that characterize Management
Control. It is defined also on the basis of
1. Tangible Dimension, represented by the Management Accounting environment, such as the data
warehouse system, ICT devices adopted and used, the reporting process, the Organization chart
and the Management Control process itself.
2. Intangible Dimension, composed mainly by Management Models adopted and Roles assigned,
and cultural, social and anthropological aspects that characterize that firm community. It refers to
the role assigned to the Management control as well as to several elements that cannot be easily
translated in a formal way (such as documents and/or reports); affects the formal components of
Management Control at the level of functioning and the modalities through which such
Management Control tangible dimension has been structured; is strictly related to the social,
political, cultural and institutional variables characterizing a firm; identifies the relationship
between management control process, the individual behaviors and the firm culture.
The Organization Chart
Thanks to this useful tool we were able to identify how the decision-making powers are distributed in
a firm within different organizational hierarchy levels between the business area. The Organizational
Chart, moreover, is also an helpful way in order to identify Responsibility Centers and the
accountability levels that could characterize the internal environment of a certain company.
In the standard chart we can realize that all divisions, departments, sections, as well as staff units
(such as control, finance, human resources, legal affairs, research and development) could be
considered as Responsibility Centers. At the end we can state that an organization consists of
Responsibility Centers. Therefore, Management Control involves the planning, the control of these
Centers’ activity so that they make the desired contribution towards achieving the organization’s
objectives.
Responsibility Centers (RCs)
In our adopted book, in order to understand the nature of Responsibility Centers, we start with an
analogy with a generating plant.
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The top section depicts an electricity generation plant, which in some important aspects is analogous
to a Responsibility Centers. Like a Responsibility Center, the electricity generating plant uses inputs
such as coal, water and air to do work, which results in outputs. In the case of the generating plant, it
combines these resources to do the work of turning a turbine connected to a generator rotor. The
outputs are kilowatts of electricity.
A Responsibility Center also has inputs to take into account: physical quantities of material, hours of
various types of labour, and a variety of services. Usually both current and non current assets are also
required to activate a specific production process. The Responsibility Center performs work with
these resources. As a result of this work, it produces outputs: tangible outputs, i.e. goods, or intangible
outputs, i.e. services. These products go either to other Responsibility Centers within the organization
or directly to the customers into the market. Of course, inputs, assets and outputs are related to
information that a manager that is responsible for a specific Responsibility Center’s management has
to collect, to elaborate, to measure and also to communicate and to report. This information is related
to the resources used to produce outputs that are mostly non-monetary things, such as pounds of
material and hours of labour. For purposes of management control these things often are measured
with a common monetary denominator, so that physically unlike elements of resources can be
combined.
The monetary measure of resources used in a Responsibility Center is cost. In addition to cost
information, non-accounting information on such matters as the physical quantity of material used, its
quality and the skill level of the workforce.
If the outputs of Responsibility Centers are sold to an outside customer, accounting measures these
outputs in terms of revenue. If, however, goods or services are transferred to other Responsibility
Centers within the organization, the measure of the output may be either a monetary measure, such as
the cost of the goods or services transferred from our Responsibility Center to other Responsibility
Centers within the organization, or a non-monetary measure such as the number of units of output.
Responsibility Accounts
Each manager of a certain Responsibility Center needs information about what has taken place in his
area of responsibility. This information can be classified as:
1. Inputs, used to activate a specific production process. In terms of information these are named
just like the concept of cost;
2. Outputs, that are non monetary data, revenues or transferring costs;
3. Managers could also be taking into account information about future planned inputs and
outputs: historical information about inputs or outputs are also useful.
The Management Accounting construct that deals with both actual and future planned inputs and
outputs of a Responsibility Center is called Responsibility Accounting and involves a continuous
flow of information that corresponds to the continuous flow of inputs into, and outputs from, an
organization’s Responsibility Centers.
In the end have two ways of accounting information as regards costs, revenues or other information of
services that are implemented to activate specific production processes in the activities implemented
by specific Responsibility Centers or business units:
1. An approach that is defined to be more focused on goods and services and this is the so-called
“Product Cost Accounting” procedure, model or system.
2. If we are completely focused on Responsibility Centers involved in the activation and
management of the processes that stay in the background of the production cycles implemented in
certain production lines, then we could adopt the “Responsibility Accounting” system in order to
collect information about costs, revenues and transferring costs within Responsibility Centers or
from Responsibility Centers to customers.
These are two related parts of the Management Accounting system. For a given organization, to
perform work related to several products, in each Responsibility Center different inputs are consumed
in order to produce the Center’s output and these inputs are called cost elements.
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There are three different dimensions of cost information, each of which answers to a different
question:
Where has the cost incurred? And this is the focus on the Responsibility Centers’ dimension.
For which output has the cost incurred? And this is the product dimension.
What type of resources was used? And this is the cost element dimension.
We will focus on a numerical example.
This illustration shows how these three dimensions of cost information typically appear in an
organization’s cost reporting system. For simplicity, it is assumed that this is a manufacturing
company with only two departments: 1 and 2 are the production departments, fabrication and
assembly; department 3 provides all production support functions; and department 4 performs all
selling and administrative activities.
Part A of the illustration shows the full costs of the organization’s two products for a one-month
period, and the details of the cost elements that make up these full costs. Note that it is impossible to
identify from the part A information what costs the managers of Departments 1, 2 and 3 were
individually responsible for. In particular, the costs of Department 3 have been allocated first to the
two production departments and then, through their overhead allocations, to the two products; hence,
Department 3 costs are a portion of the amount shown as each product’s production overhead costs.
By contrast, responsibility accounting identifies the amount of costs that each of the four departmental
managers is responsible for, as shown in part B of the illustration. Note that part B, however, does not
show the costs of the two products. Both types of information are needed.
Note also that the total product costs ($48,120) are equal to the total responsibility costs. The two
parts are different arrangements of the same underlying data.
Full product costs and responsibility costs, then, are two different ways of “slicing the same pie”. This
is depicted in this illustration, which summarizes the cost data in a matrix format to show both
product costs and responsibility costs, without including the cost element details.
If cost information in the cells of the matrix is added across a row, the total is responsibility
accounting data, which is useful for management control purposes. If this information is instead added
down a column, the total is product cost information, which is useful for pricing decisions and product
profitability evaluation.
Responsibility Accounting: Main Performance Evaluation Criteria
The performance of a Responsibility Center manager can be measured in terms of
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1.
Effectiveness, that means how well the Responsibility Center does its job, that is the extent to
which it produces the intended or expected results. Effectiveness means “doing the right thing”.
2. Efficiency is used in its engineering sense: this term refers to the amount of the output per unit of
input. An efficient operation either produces a given quantity of outputs with a minimum
consumption of inputs or, otherwise, an efficient operation could produce the largest possible
output from a given quantity of input. Efficiency means “doing things right”.
In many Responsibility Centers a measure of efficiency can be developed that relates actual costs to a
number that expresses what costs should be for a given amount of output. Such a measure can be a
useful indication, but never a perfect measure, of efficiency for at least two reasons: (1) Recorded
costs are not a precisely accurate measure of resources consumed and (2) standards are, at best, only
approximate measures of what resource consumption ideally should have been in the circumstances
prevailing.
In the end, the Responsibility Center should be both effective and efficient, it is not the case of one or
the other. In some situations both effectiveness and efficiency can be encompassed within a single
measure. When an overall measure does not exist, classifying the various performance measures used
as relating either to effectiveness or to efficiency is useful.
Types of Responsibility Centers
An important business goal is to earn a satisfactory return on investment.
Return on investment ratio is defined as
The three elements of this ratio lead to the definition of three types of Responsibility Centers that are
important in Management Control systems.
Revenue Centers
If a Responsibility Center manager is held accountable for the outputs of the center as measured in
monetary terms, that is revenues, but is not responsible for the costs of the goods or services that the
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center sells, then the Responsibility Center could be defined as a Revenue Center. Many companies
consider their selling departments as Revenue Centers.
Generally, a Revenue Responsibility Center is accountable to sell and retail some goods and
services.
A sales organization treated as a Revenue Center has generally the additional responsibility for
controlling its selling expenses, e.g. travel, advertising and so on. Therefore, Revenue Centers are
often expense centers as well. However, a Revenue Center manager is not responsible for the center’s
major cost item - its cost of goods and services sold. Thus, subtracting just the selling expenses for
which the manager is responsible, the center’s revenues do not result in a very meaningful number
and certainly doesn’t measure the center’s profit.
Expense Centers
If the control system measures the expenses, i.e. the costs, incurred by a Responsibility Center, but
does not measure its outputs in terms of revenues, then the Responsibility Center is called an Expense
Center.
Every Responsibility Center has, of course, outputs, that is “it does something”. In many cases,
however, measuring these outputs in terms of revenues is neither feasible nor necessary. For example,
it would be extremely difficult to measure the monetary value for the accounting or legal department’s
outputs, although measuring the revenue value of the outputs of an individual production department
is generally easy to do. There is no reason for doing so if the responsibility of the department manager
is to produce stated quantity of outputs at the lowest feasible cost. For those reasons, most individual
production departments and most staff units are Expense Centers.
Expense Centers are not the same as Cost Centers. A Cost Center is a device used in Full Cost
Accounting system to collect costs that are subsequently to be charged to cost objects. In a given
company, most but not all Cost Centers are also Expense Centers. However a Cost Center such as
occupancy is not a Responsibility Center at all, and hence it is not an Expense one.
There are two types of Expense Centers and the difference between them is related to the type of cost
involved:
1. Standard Cost Center, in which the standard costs have been set for many of the cost elements.
Actual performance is measured by the variances between its actual costs and the standard costs.
2. Discretionary Expense Center, in which the output cannot be measured properly in monetary
terms: examples are most production support and corporate staff departments, such as human
resources, accounting or research and development. In these responsibility centers the amount of
expenses that should be incurred is a matter of management judgement. Differences between
actual budgeted expenses are not an indicator of efficiency, they merely provide indication as to
whether the Responsibility Center managers have adhered to budget spending guidelines. Since
the value of the output is not measured, it is impossible to say anything about the efficiency of
performance.
A Focus On Cost Variances
To process cost variances we need information about a standard direct material cost of one unit of
products and an actual direct material cost of one unit of product.
The standard direct material cost of one unit of product is equal to the quantity of material input
needed to produce one unit of output omw
times multiplied by the price that should be payed per unit of
material input.
The actual direct material cost of one unit of product is equal to the quantity of material input used
to produce one unit of output Bhangra
times
multiplied by the price payed per unit of material input.
•
To find material quantity usage variance between standard and actual variances, we need to
compare the actual quantity of material used to produce one unit of output Boma
times with the standard
quantity of material input needed to produce one unit of output.
Then we can also process the material price variance that is equal to the comparison between the
actual price of material input used to produce one unit of output M•
times and the standard price of
material input needed to produce one unit of output times.
•w•
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This is another numerical example in order to understand how the hypothesis of standard price and
quantity is compared to the hypothesis of actual price and quantity that, in a real context, is well
figured.
We can realize by using this comparison how to quantify the net variance in terms of the real quantity
used multiplied by the nature of price variance occurred.
We see the variances in price, starting from one euro, that is the standard price that the manager
scheduled before starting budgeting processes, and then five euros, that is the actual price, more
strictly linked to the reality.
At the end of the budgeting processes and of production processes, managers conclude that the
quantity needed to produce one unit of final product has been 825 instead of the 900 scheduled in the
standard manner.
These are numerical examples in which a manager has to implement cost variances and variances
between variables such as price.
Profit Centers
Revenue is a monetary measure of outputs. Expense is a monetary measure of inputs, or resources
consumed. Profit is the difference between revenue and expense.
If the performance in a Responsibility Center is measured in terms of the difference between (1) the
revenues it earns and (2) the expenses it incurs, the Responsibility Center is called a Profit Center.
In Financial Accounting, revenue is recognized only when it is recognized by a sale to an outside
customer. By contrast, in Responsibility Accounting, revenue measures the output of a Responsibility
Center in a given accounting period whether or not the company realizes the revenue in that period.
Thus, a factory is a Profit Center if it sells its outputs to the sales departments and records the revenue
and costs of such sales. Likewise, a service department, such as the corporate information systems or
training department, may sell its services to the Responsibility Centers, that operate within the same
organization, that receive these services and these “sales” generate revenues for the service
department.
Since the difference between sales revenues and cost of these sales is profit, the service department is
a Profit Center if both of these elements are measured.
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A given Responsibility Center is a profit center only if management decides to measure that center’s
outputs in terms of revenues. Revenues for a company as a whole are automatically generated when
the company makes sales to the outside world, to the market. By contrast, revenues for an internal
organization unit are recognized only if management decides that it is a good idea to do so, so it’s just
a discretionary attitude that management could decide to identify and define some Profit Centers
within the organization. No accounting principle requires that revenues be measured for individual
responsibility centers within a company.
In recent years many companies in their total quality management program have been emphasizing
that every department has customers: some have external customers, other have internal customers. To
reinforce this philosophy many departments that formerly were Expense Centers have been converted
to Profit Centers. With some ingenuity, practically, any Expense Center could be turned into a Profit
Center, because some way of putting a selling price on the output of most Responsibility Centers can
usually be found. But in this case the discussion is about whether there are sufficient benefits in doing
so, if top management identifies that the conversion from revenue in Expense Centers to Profit
Centers is a convenient approach to improve the quality of decision making in a certain organization’s
internal environment.
There is some important information we have to take in mind when analyzing the terms of Profit
Responsibility Centers: they could represent the business at a small scale. In particular, as a company
such Responsibility Center has an “income statement” that reports revenues, costs and profit. The
income statement of a Profit Responsibility Center is a basic management control document that
reports the overall information that is elaborated in the management control system. Performance of
managers which are responsible for certain Profit Responsibility Centers are measured on the basis of
profit achievements. Therefore they are motivated to take decisions using information and data about
both inputs and outputs, costs and revenues, which affect the profit level reported for they Profit
Responsibility Center. To this end, the use of Profit Responsibility Centers could be an important
organizational managerial approach also to decentralize the profit responsibility especially in larger
companies.
Advantages
A Profit Center resembles a business in miniature. Like a separate company, it has an income
statement that shows revenues, expenses and profits. Most of the decisions made by the Profit Center
Manager represent the numbers on this income statement. The income statement for a Profit Center is
therefore a basic management control document. Because their performance is measured by profit, the
managers of Profit Centers are motivated to take decisions about inputs and outputs that will increase
the profit reported for their Responsibility Center.
The use of the Profit Center concept is one of the important tools that has made possible the
decentralization of the profit responsibility in large companies and this increases also the quality of
the decision making due to the higher managerial freedom and responsibility that is given to
managers that manage the Profit Centers within the organization.
This kind of Responsibility Centers allow also the rapidity of decision making in taking faster
decisions in autonomy, without any endorsement from the top management.
Due to such managerial decentralization the top management could be more focused on strategic
issues, rather than operative ones.
Managers of Profit Responsibility Centers increase their skills and capabilities in order to have
future advancement in their careers to the top management positions, because the performances of
each Profit Responsibility Center are continuously monitored by managers and these are constantly
incentivized to enhance the efficiency of their units, their decisions, the allocation of resources, the
optimization of the production and the maximization of the output produced.
The logic characterizing the Profit Responsibility Centers increases the corporate awareness
about the income and the cooperation to achieve common goals increasing the final performance of
the firm’s profit.
The managers of these Profit Responsibility Centers are primarily due to the implementation of such
activities which are useful to enhance the corporate income.
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Disadvantages
There are also some criticalities regarding the implementation and the adoption of Profit
Responsibility Centers.
The decentralization of decision making processes through the adoption of Profit Responsibility
Centers could limit the top management performance evaluation, focusing only on each income
statement of every Responsibility Center.
Sometimes a manager of a certain Profit Responsibility Center could have little authority to decide
quantity and quality of the output, so it’s important to understand that there is a limitation in
activating certain decision making processes that could be no useful to rearrange the quantity of input
used and the possibility to optimize the output produced by certain production cycles because of the
little authority in deciding quantity an quality of outputs and this is more important also to understand
how large use of Profit Responsibility Centers could affect also at the end the effectiveness and
efficiency of the production cycles implemented in the firms.
In the case in which a Profit Responsibility Center uses a service, just like needs an auditing process
to analyze some misalignments or quality troubles in business units managed by these centers, this is a
service provided by another Responsibility Center, and this is a strange situation in which the internal
audit unit is not a Responsibility Center so no charges are needed to record having these services
from the side of certain Profit Responsibility Centers provided by a non-profit Responsibility Center.
In case of input and output flows between Profit Responsibility Centers which regard same resources
transfers a non monetary measure may be adequate rather than a monetary one, thus sometimes
there are no reasons to convert outputs in revenues.
Profit Responsibility Centers system could promote a spirit of freedom and competition in
managers that are responsible for this kind of Responsibility centers. The competition usually could
be a driver of good management but it could generate frictions between Profit Responsibility Centers
to the detriment of growth
Profit Centers and Transfer Prices
As regards the implementation of Responsibility Centers, we also have to focus on two definitions.
A Transfer Price is the value of products (goods or services) furnished by a Profit Responsibility
Center to another Responsibility Center within a company. It is to be contrasted with the market
price, which measures exchanges between a company and its outside customers.
Internal exchanges which are measured by transfer prices result in (1) revenue for the Responsibility
Center furnishing the product, and (2) costs for the Responsibility Center receiving the product.
Whenever a company has Profit Centers, transfer prices are usually required.
There are two general types of transfer prices: the market based price and cost based price.
1. If a market price for a product exists, the market based price is usually preferable to a cost based
price. The buying Responsibility Center should ordinarily not be expected to pay more internally than
it would have to pay if it purchased from an outside vendor, nor should the selling center ordinarily be
entitled to more revenue than it would obtain by selling to an outside customer. So, if the market price
is abnormal, as when an outside vendor sets a low “distress” price in order to use temporarily idle
capacity, then such temporarily aberrations are ordinarily disregarded in arriving at transfer prices.
The market price may be adjusted downward to reflect the fact that credit costs and certain selling
costs are not incurred in an internal exchange. This downward adjustment, usually only a few
percentage points, ensures that the buying center is not indifferent between buying within the
company or on the outside.
Market based prices, where available, are frequently used. If a market price exists for goods and
services transferred within a company then formally the market based transfer price is adopted to
regulate the input output exchange of units within a company. Market based transfer prices are widely
used because they are reasonably objective rather than possible values affected by negotiating skills of
the selling and buying Responsibility Centers. Generally, the basic law is that the internal prices
which regulate the transactions between company units should not be higher than market prices. A
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transfer price could be set lower than the corresponding market price because in internal input-output
transaction between the company units credit costs and possible selling costs are not included.
When the market price information is not available for certain goods or services transferred between
Responsibility Centers, to regulate transactions within a company, cost based transfer prices are
used. A cost based transfer price is computed using the Standard Full Cost to produce those goods or
services plus a share of the return on capital invested. In order to avoid disputes and to minimize
possible sub optimization risks a senior management decision or a transfer price policy has to clearly
communicate the method of computing the cost and the amount of the profit to be included in the
transfer price.
Investment Centers
An Investment Center is a Responsibility Center in which the manager is held responsible for the use
of assets as well as for profit. It is therefore the ultimate extension of the responsibility idea. In an
Investment Center the manager is expected to earn a satisfactory return on the asset employed in the
Responsibility Center.
Many companies use a ratio of profit to investment to measure an Investment Center’s return on
investment. Return on assets (profit/total assets) and return on “net assets” or invested capital (profit/
assets net of certain or all current liabilities) are commonly used, in part because these ROI measures
correspond to ratios calculated for companies as a whole by outside security analysts. Other
companies measure an Investment Center’s residual income, also more recently modified and called
economic profit, economic value added or E.V.A. which is defined as profit (before interest expense)
minus a capital charge that is calculated by applying a rate, typically equal to the company weighted
average cost of capital, to the investment in the center’s assets and net assets.
Residual Income is conceptually superior to return on investment ratios as a performance evaluator,.
Despite its conceptual advantage, many companies do not use residual income as an investment center
measure for three reasons. First, ROI measures are scaled. ROI percentages are ratios that can be used
to compare investment centers of differing sizes, whereas residual income is an absolute dollar
amount or euro amount, that is a function of the investment center size. Second, a company’s residual
income is an internal figure that is not reported to shareholders and other outsiders. And third, using
residual income measures often causes confusion. Many people, even experienced managers, do not
understand the meaning of the residual income measure.
Whether ROI or residual income is used, the measurement of assets employed, that is the investment
base, poses many difficult problems. Let’s consider cash: the cash balance of a company is a safety
value, or buffer, protecting the company against short-run fluctuations. Compared with an independent
company, an investment center needs relatively little cash because it can obtain funds from
headquarters on short notice. Part of the headquarters cash balance therefore exists for the financial
protection of Investment Centers and can logically be allocated to them as part of their Capital
Employed. This cash can be allocated to investment centers in several ways.
Similar problems arise with respect to each type of asset that the investment center uses. Valuation of
plant and equipment is extremely controversial: alternatives include gross book values, net book
values, and replacement costs. We need only to state that many problem exist and that there is
disagreement between the best solution to evaluate the performance achieved by Investment
Responsibility Centers. Despise these difficulties, a growing number of companies find it useful to
create Investment Centers.
In the end we could consider that the fact that each Responsibility Center is treated either as a
Revenue, Expense, Profit or Investment Center does not mean that only monetary measures are used
in monitoring its performance. Virtually, all Responsibility Centers have important non financial
objectives to achieve, such as the quality of the goods or services sold or provided. Particularly in
expense centers such as staff units these non monetary factors may be more important than monetary
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measures. Many companies establish formal systems to measure non momentary results. Thus two
systems in common use are Management By Objective system and Balanced Scorecard system.
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Chapter 23
The Management Control Process
Phases of Management Control
Which are the main phases that characterize the functioning of the Management Control system
and the implementation of this process?
Management Control system is characterized by formal and informal activities. It is a system
strictly linked to the planning and produces effects on other operating areas of the organization in
a given accounting period and also in the future ones. It is a continuous dynamic that works along
time.
1. The sequential development of the process of Management Control starts thanks to the inputs
produced in the upstream activity so-called strategic planning.
2. Then, the Management Control system starts implementing the first process named
budgeting (1st phase),
3. followed by measurement and reporting (2nd phase)
4. and at the end we have the evaluation procedure (3rd phase) that, in this case, we analyze in
terms of alternative ways that our Management Control system could take.
This is a brief overview about phases that distinguish the Management Control system and
process, starting from the elaboration of strategies that are formally defined in strategic
planning activities by the top management. These senior executives, CEO and CFO are
supported by market analysts and formulate the strategy (or different strategies) focusing on a
mid-term of time, maximum five years, elaborating qualitative goals presented from a narrative
approach.
This phase gives the input for the activation of programming activities which represent the first
stage of the Management Control process. The main purpose of the programming activity is to
implement the budgeting process, aimed at defining operational budgets for each Responsibility
Center. The information used in this phase is mainly monetary, since in budget definition it is
needed to analyze typical monetary and financial information. At the end of this procedure there is
the need to execute what has been assumed in the budget: operational and supporting activities
are started.
During the execution of each budget predefined in the programming and budgeting process
there’s the second stage of the Management Control process, that is measuring. At the end of
the accounting period adopted by the organization there is the procedure of measuring the actual
performance and reporting in a certain form of virtual or tangible document, the so-called
management control reports, in which the manager could acquire some crucial information
regarding possible alignments between actual costs, investments and profits and what has been
budgeted as regards some items in specific Responsibility Centers. Measuring is carried on
through some metrics, the so-called key performance indicators, and these metrics show how
operational activities developed in terms of performance.
The evaluation activity is mainly characterized by the evaluation of what was previously
scheduled in the budgeting phase for specific Responsibility Centers and what is, in terms of
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→
Budgeting
information, really produced by those Responsibility Centers. The management takes control
reports as the tool to evaluate the situation and possible variances.
If the managers highlight frequent alignments at the end of the evaluation procedure, there is a
restart of the process following the inputs of that same strategy, reconfirming that it is right and
needs to be perpetuated.
There are some possible trick games to play in case of misalignment between what was budgeted
and the actual costs, revenues and investments highlighted at the end of the accounting period in
measuring and reporting activities. In this case managers could realize that there is a need to
adjust some key performance indicators and rearranging some metrics, some measuring
activities; then, thanks to the information acquired through these reports, reconsider to assess the
efficiency in which the activities have been carried out in a certain accounting period. Managers
could also understand that misalignments are generated by a not so rightly defined budget, and in
this case they could produce inputs in order to reconsider the budgets defined to start the new
accounting period. Lastly, managers acquiring information reported in control reports may decide
that the strategy predefined in the upstream activity of strategic planning is not so valid and
efficient, or it needs to be reconsidered in the light of new market trends which affect negatively
the execution of budgets or activities performed by some business units: in this case the middle
or bottom managers could give top management the input to reconsider the strategy, and then
restart with the first activity of strategic planning and rearrange strategic inputs.
Strategic Planning is the set of upstream processes that produce inputs for programming
activities. In particular, it is the process of deciding on the programs that the organization will
undertake; such programs need to be suitable to execute the strategy. Planning is the activity of
formulating a strategy which defines corporate mid or long-term goals to the definition of a plan,
the document useful to share this information within the hierarchy, the structure of the
organization. In this preliminary phase, the top management sets approximate amounts of
resources to be allocated within each business unit. In every profit-oriented company the top
management defines plans or strategies ex-ante to regulate products or product lines. In this
strategy formulation also non operating departments are involved, such as R&D programs, Human
Resources Development programs, or Public relations programs. In some organizations plan
decisions are implemented informally, in others we find some formal documents that characterize
a formalized planning system.
Budgeting or programming process, which represents the first stage of the system we are
studying. The difference between strategic planning and budgeting is that the former looks
towards several years, maybe three, five or ten years, whereas budgeting focuses on the next
accounting period. Most organizations have a budget, which is a program expressed in a
quantitative format, and usually information is monetary, referred to costs, revenues, profits and
investments, and it covers a specific period of time of usually one year. In certain organizations
the budgeting system is focused on semesters, quarters, or months. In preparing the budget,
each plan is translated into the terms that correspond to the responsibility of those managers in
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charge of executing the program or part of it, that is, if plans are originally tailored as individual
programs, these are translated into terms of Responsibility Centers in the budgeting process. The
process of developing a budget is essentially one of negotiation between managers of each
Responsibility Center and their superiors. The result of it is an approved statement of the
revenues expected during the budgeted period and of the resources needed by each
Responsibility Center for achieving the operational objectives and meeting the goals of the
organization.
Measurement activities are focused on the period of the actual operational implementation. We
find records on the resources actually consumed, in terms of costs, and revenues actually earned.
These records are structured so that cost and revenues data are classified by Programs, for
example by products, R&D projects, as a basis for future strategic planning activities, and by
Responsibility Centers, to measure the performance of RC managers and their teams.
Accordingly, data and actual results of performance are reported in the management control
reports in such a way that they can be compared with the budgeted information to support the
evaluation phase in highlighting possible variances between the budgeted costs, profits, revenues
and investments and actual information regarding the same items.
Reporting activities are immediately consequent to the measurement activity; in fact, they are
the output of it. The Management Control system communicates here both accounting and nonaccounting information to managers and to the organization as a whole. Management control
reports can be focused on the external environment or on the internal decision-making process
and performance of the organization in terms of costs, revenues, investment and profit. The
information strictly linked to the external environment keeps managers informed and makes sure
they work in perfect conditions, aligned with what Is expected by the corporate strategy; it is
therefore relevant also for internal decision making. The internal information is useful to carry
out analysis between budgeted and actual performance and also helps explain possible
differences that are called variances. Much of the information about operations is formally
reported in these tangible documents, and shows a summary of the operating information
generated in performing specific tasks. The reporting system used and the information mainly
focused on the internal issues constitute specific management control reports, that are more
detailed with respect to internal contingencies, specific business units activities and specific
tasks, called Task Control.
Evaluation is the activity in which managers of each Responsibility Center, basing on the
information contained in the control reports and on managerial observations, discretionary
approaches and other informally communicated information, process an analysis that involves
comparison between the performance achieved by their Responsibility Center and information
budgeted during their programming activity,. The analysis of the data information collected in the
control reports is processed by the information communication technology, but it needs the
discretionary approach, due to the personal skills experienced by each Responsibility Center
manager, which is the floor useful to identify criticalities and investigate and formulate corrective
actions. These managers may decide to (1) implement some corrections on measurement and
reporting activities, (2) revise some planned data reported in a certain budget, (3) revise or
eliminate some program, (4) start a new strategic planning activity.
Accounting Information in Management Control
In budgeting and measuring processes, the accounting information is structured in Responsibility
Centers and the elaboration of managerial information following that approach is called
Responsibility Accounting, which is necessary because control can be exercised only through
the managers of Responsibility Centers. Full Cost Accounting information is also used in the
Management Control process to support decisional activities as, for example, the setting of the
prices of products.
To better understand the nature and the use of the Responsibility Accounting Information
system we need to know that costs could be classified as
1. Controllable or Non-controllable;
2. Engineered, Discretionary or Committed;
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Controllable and Non-Controllable Costs An item of cost is defined controllable when the
amount of cost assigned to a Responsibility Center is significantly influenced by the actions fo the
managers of that Responsibility Centers. Otherwise, if the decision-making of that manager
doesn’t affect such items of costs, they are non-controllable. There are two aspects of
controllable costs to be considered: (1) they refer to specific Responsibility Centers, to specific
business units managed by managers responsible for objectives, production, and performance
achieved at the end of a specific accounting period; (2) the control activity results from a
significant influence, rather than from a complete influence. When an organization is viewed as a
complete entity, every item of cost is controllable, but in terms of Responsibility Accounting we’re
focusing on the managing of each Responsibility Center, and if they are responsible of managing
specific factors, in that case the managers are responsible to control costs related to the specific
task of the business unit they belong to: for example, a manager could have a limited influence on
its labor costs but he/she usually could have a significant influence on the amount of labour cost
incurred in his/her department despite the wage rates defined by both the human resources and
the union negotiations. The question is what costs are controllable in a specific Responsibility
Center, and this is the main difference between Responsibility Accounting and Financial
Accounting. Generally, direct costs for a Responsibility Center are controllable (with the
exceptions of depreciation and rental charge), while indirect costs are non-controllable.
Setting this information, monitoring if scheduled information is performed and implementing
eventual corrective actions in case of criticalities is the sense of considering controllable costs.
Engineered, Discretionary and Committed Costs is another useful classification for
management control purposes. Both engineered and discretionary costs are generally
controllable, while committed costs are non-controllable in the short run, but they are controllable
in the long run: for example, as regards rental charge, usually there’s an underlying contract and it
is a committed cost because it is defined by the outside of the organization; in the long-run it
becomes a controllable cost when, at the end of the rental period, it could be negotiated by
revising the rental contract. In the latter case, the cost could be classified as controllable, but at
the start oof the contract it is surely non-controllable.
Engineered costs are items of costs for which the right or proper amount that should be incurred
can be estimated through an analytical process. Direct material costs are a clear example of this
category: given the specification for a product, engineers can determine the quantity of raw
materials needed to produce each unit of the product. The total amount of direct material costs
can be estimated by translating these input quantities into monetary terms by means of standard
prices of raw materials needed to provide a service. These standard unit costs can be multiplied
by the number of units needed for production in a specific accounting period to achieve that
information commonly used in budgeting processes, setting the budgeted total amount of direct
material costs for the period , and this is the information related to a specific category of product
produced in a business unit in the accounting period. Since production engineering is not a exact
science and prices or raw materials cannot be perfectly defined or forecasted, the standard
amount per unit of output is not necessarily precise, but the estimates can be usually made with
enough precision, and they usually show a direct relationship between volume and costs related.
Standard Costs Centers by their very nature have an high proportion of engineered costs.
Discretionary costs, also called “programmed costs”, are items of costs which could variate in
line with the judgement of the manager of a Responsibility Center. There’s no analytical way to
establish the right amount of discretionary costs to produce a specific component or to
implement some activities, that are generally supporting activities. In this case it is important the
•
rule
of the skills and the experienced by the managers of Responsibility Centers that collect
information and make decisions. This is the case of R&D activities: they present a high
discretionary nature of forecasts and estimates that need to be later translated into monetary
terms to implement specific activities. In most companies, this category includes R&D, general
administrative and marketing activities, and many items of indirect production costs. Decisions on
how much should be spent on a discretionary cost item could take many forms: spending the
same amount of the previous year as a target amount, or alternatively spending a percentage of
sales as a proxy to implement some activities. It is a decision that can settle in historical spending
patterns or in new patterns given developing contingencies, and it is characterized more on a
forecast or estimation approach. It is a relationship completely different from that of engineered
costs: the latter in fact strictly depend on increases or decreases of production volume, while
discretionary costs depend on the skills and on the reasonings of the experienced manager, and
also on unexpected dynamics, which frequently happen in marketing activities: in fact, marketing
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costs are an independent variable and they do not relate to production volume, but rather on
forecasts generated by attentive market analysis.
Committed costs are those items of costs related to commitments expense previously made,
such as asset depreciation, insurance, rent and taxes. They are also called “sunk costs”. These
costs can be changed only by changing the commitment.
Behavioral Aspects of Management Control
The management control process involves first of all human beings. From those in the lowest
Responsibility Centers, up to the members of senior management units, the management control
process consists in a part of stimulating these human beings in specific categories, and to
manage them in attaining organization goals and refraining them in taking inconsistent decisions
as regards the aforementioned objectives.
Management cannot control a product or the costs of producing it, it can control the influence of
the actions of the people responsible for such costs. The discipline that studies the behavior of
people in an organization is the “Social Philosophy”, a discipline that provides the underlining
principles that are relevant in the control processes. The behavior adopted by each business
participant is affected by the satisfaction of certain human needs that are classified as
1. Extrinsic, for example existence, security, social; self-esteem, reputation, self-control,
independence needs; they can be satisfied by outcomes external to the person.
2. Intrinsic, for example needs for competence, achievement and self realization; they can be
satisfied only by outcomes the person produces on his or her own.
The human behavior drives the people decision-making and actions in society and in a firm
community. Management control processes involve managing also the human behavior, because
of written and unwritten rules that the participants of a community or of a micro community need
to follow. In this sense, control is a driver of the human beings in finding a certain goal
congruence, since there are individual needs each business participant aims to achieve, that
could be detrimental to accomplish the overall goal predefined in a strategic planning activity.
When people become organization participants, they believe that by doing so they can achieve
their personal goals, just as to satisfy their needs to grow in terms of a professional career or in
economic terms; the personal incentive is a driver to lead unemployed people specialized in
specific skills to allocate them in the job market to find the perfect job position for their
competences and experiences and to get a proper salary. The potential employee or future
internal stakeholder of an organization, before starting the engagement with the organization,
feels something as a complete alignment between the cultural corporate values with his or her
own personal values: this is the starting point of any basic employment relationship, of any job
experience. Becoming a new member of an organization, independently of the position one will
cover, it is good to consider that the decision to contribute to the work of the organization is also
based on the perception that it will help achieving the organization’s operational goals and, at the
same time, a part of one’s own individual expectations and goals.
Individual motivations are the starting point: how do people behave in order to satisfy their
needs? Different persons assign different degrees of importance to the various needs, which are
influenced by culture, education, and also by the type of job position that is processed day by
day, Moreover, people’s needs can be different at different times. To sum up, individual
motivations are the key to foster the achievement of organizational goals: it is the attractiveness
that the individual attaches to organizational outcomes that drives this process.
There is a direct relationship between the behavior adopted and the needs people present that
move individual actions. The personal motivations in adopting a given behavior is determined by
1. Individual expectancies about possible outcomes resulting from the adoption of a certain
behavior;
2. The personal belief that such outcomes could enhance the possibility to satisfy other needs
as well as the overall wellbeing.
Management processes manage each corporate participant’s behavior, inducing every people
involved in business activities to take decisions and to implement actions in order to achieve
common firm’s goals, minimizing also possible misalignment (between common firm’s goals and
individual goals) and self-opportunistic attitudes and interests. The Management Control system
encourages the goal congruence between corporate ands individual objectives, focusing on the
following key questions,
1. What action does it motivate people to take in their own perceived self-interest?
2. Is this action in the best interests of the organization?
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Finally, a Management Control system is well-defined if it leads participants to carry out those
actions for the best interest of the firm, which is to accomplish the goal predefined in the strategic
planning activity. At the same time, Management Control leads that participants recognize that
actions carried out are useful to pursuit both their self-interest and corporate goals. The upstream
activity strictly focused on the formulation of corporate strategy is a very important step, since it is
not only the start of the whole Management Control process, but also because it is the way in
which the top management thinks about which are the cultural values that distinguish their
organization from the other organizations, especially from the competitors. That is why the vision
and the mission are so important: in one sentence the top management must have clear in mind
the desired future position of the company.
In the end the top management, in formulating a strategy, must have clear in mind the goals
related to the desired future position and the approach to reach those goals, that is translating in
terms of a mission statement. The strategic planning document internally guides management’s
thinking on strategic issues especially in times of significant and critical changes, like, for
example, the pandemic trends. Vision, mission and strategies might also inspire employees who
work more productively and might influence them in their day-to-day decision-making,
establishing an ethical framework. Such cultural and behavioral principles are therefore
externally driven by specific professionals who are in charge of bringing the organization’s mission
and vision in the world to let stakeholder know what the company is about and where it is
directed, as a public relation tool.
How can the Management Control system motivate corporate participants to take decisions and
to implement actions in order to achieve common firm’s goals despite their individual
expectancies? In this case we have to consider some advances performed in experimental
studies, in which corporate participants have weakest motivations when they perceive a goal
unattainable or too easily attainable. The Management Control needs to find another equilibrium
in order to achieve common goals, and it can use positive or negative “incentives”, that are
mechanisms of rewards and/or punishments, to strongly motivate participants to achieve
common goals or objectives. Rewards are outcomes that result in increased satisfaction, and
punishments are outcomes that result in decreased satisfaction; people join organizations in order
to achieve such rewards they cannot obtain without joining the organizational system.
Examples of positive incentives are bonus and extra compensations which increase the salary;
more autonomy in developing the tasks; the opportunity to participate at the development of an
important corporate project; the opportunity to participate at higher training programs; holidays;
acknowledgements; career advancements; stock options, mostly focused on the extra gains of
the managers of a certain Responsibility Center when achieving higher performance in a given
accounting period. The massive use of these incentives could be also detrimental in the long
term, especially as regards stock options, that change the way to conduct a business in the longterm perspective, since the business could change the objectives to achieve on the basis of those
stock options. Managers may be so focused on performing so well in the sort-term that they
forget about long-term profits and benefits.
Examples of negative incentives are: the participant does not receive any bonus, although it is
assumed by system; the participant receives a benefit lower than the other colleagues; career
relegation; dismissal.
• As regards incentives and personal motivation, it is important to remember that the Senior
Management attitude towards the Management Control system can, by itself, represent a
powerful incentive. If a senior manager signals that an action is important, other managers will
react positively. On the other hand, if the senior manager pays little attention to the system, also
other managers could act along. The example of Senior Management is very important for other
business participants.
• The corporate participants tend to be strongly motivated by the expectancies to earn rewards,
rather than by the fear of punishment.
• The monetary compensation could be a useful option to satisfy certain human needs, but
beyond the substance level, the amount of compensation is not necessarily as important as non
monetary rewards. The amount of a person’s earnings is usually indirectly important, as it is a
signal of the achievements of that person.
• The individual motivation depends on the possibility to receive reports (oral or written) about the
performance achieved. Without such feedbacks, people are unlikely to feel the achievement of
self-realization, and eventual corrective action could not be enacted in a proper time-span.
• The incentives could be monetary and/or formal.
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• Beyond a certain point, adding more incentives to improve performance accomplished nothing,
since the pressure exerted could be detrimental.
Conflicts and cooperation are other important issues in Management Control process.
Conflicts The way in which the organizational goals are attained is the highest level at which the
manager decides and communicates to the organization’s hierarchy. Decisions in a firm go from
the Board of Directors to the different layers until the bottom of the corporate hierarchy. The
subordinates react to the superiors’ instructions in line with how such commands affect their
needs; but the implementation of each corporate plan involves many Responsibility Centers, and
the interactions between the managers and subordinates of such units could produce possible
frictions within the firm.
Cooperation Contextually, the functioning of a dire will not get done unless its participants work
together in a climate of harmony and cooperation.
Summing up, an organization attempts to achieve an appropriate balance in terms of conflicts and
cooperations. Some conflicts are sometimes inevitable, but also participants, since they could be
based on fair competition (e.g. for promotion) between participants, as well as cooperative
attitudes are essential for the correct functioning of firm. This is another crucial point: it is okay to
find goal congruence and implementing some mechanisms that could be translated in the form of
incentives and punishment mechanisms, but there is also a certain perspective to take into
account that is to balance possible conflicts and at the same time fostering cooperation within the
business participants and within the Responsibility Centers involved in some developing
programs.
The Management Control system is based on “formalized” mechanisms of control. This system
produces reports which can be described and observed, fundamental to concretely conclude the
investigation and to take notes of what happens in terms of goals achieved and variances in
performances.
At the same time, in a firm there are other “informal” controls that determine the behavior of the
participants as well, such as,
1. Social Controls, which are based on group norms, in particular informal behavioral rules
observed by a specific subgroup in the firm community. Such norms could be related for
instance to issues which identify an appropriate attire or to a certain level of personal
productivity.
2. Self-controls, which are related to individual motivations or personal values.
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Chapter 24
Strategic Planning and Budgeting
Strategy Formulation
The main purpose of the Management Control system is to implement activities that are useful to execute the
strategy previously defined and elaborated in the planning activity, the starting point of a much more
dynamic process. The process which identifies, evaluates and decides strategies is called Strategy
Formulation: each strategy formulation is a dynamic process due to changing scenarios, such as consumer
preferences, new opportunities to capitalize on new technologies, market competition. The occurrence of
such events is unpredictable, and strategy formulation cannot be a process carried out according to a
predetermined schedule. The strategy formulation should Review Ongoing Programs, those established in
previous accounting periods, and make decisions on Proposed New Programs. Such activities could be
processed informally or formally, depending , for example, on the size of an organization. Small or medium
enterprises, in fact, present this upstream activities as processed more informally than formally. Larger
companies and corporations implement formal planning systems, defining the so-called Long-Range Plan, a
document in which the top management account for projections about the financial (revenues, costs and
profits) and other impacts (benefits) of these programs in a specific future accounting period, sometimes
defined on the short-run, most times on a number of years comprised between 2-25, and these are the most
stable systems.
The systematic part of an organization planning and control activities starts, in particular, with the definition
of a strategic plan.
Strategic Planning is the process of deciding on a new plan that the organization will undertake to
implement its strategies and on the approximate amount of resources to be allocate to each program, or
better, to each plan. The strategic planning process is characterized by the following activities:
1. Review the Ongoing Programs Most activities processed by a firm during the short-term are often
similar to those already in process. However, it is dangerous to be complacent about these ongoing
programs: customer needs and tastes, competition and production methods could change dynamically
over time, due to innovations in technology and in organizational programs. It is therefore important for
companies to recognize the implications of these changes and to adapt accordingly: there must be a
systematic approach to anticipate new conditions and decide on the action to implement. Companies that
do not undertake systematic programming reviews on a regular basis may experience quickly a declining
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profitability. Many companies have to undertake Crash Downsizing or Restructuring Programs to
reduce or eliminate costs, in general, that have been permitted to get out of line in previous years of
prosperity. These programs are obviously less effective and more expensive that is making the needed
adjustment on a regular basis.
One systematic way to provide the analysis of ongoing programs is the Zero-Base Review: this approach
gets the name because, in deciding on the costs that are appropriate for the program, the cost estimates are
built up from zero. Such reviews are useful for major programs to overcome the natural tendency towards
inertia; they are also useful for Expense Centers having a high proportion of discretionary costs. This
involves asking the following basic questions about each significant activity of the Center, such as “Should
this activity continue to be performed at all?” “Is too much being done? Too little?” “Should it be done
internally, or should it be processed in outsourcing?” “Is there a more efficient way of obtaining the desired
results?” “How much should it cost?”
Making a Zero-Base Review of a product line, for example, entails asking questions about the demand for
new products, the nature of competition, the marketing strategy to implement, the production strategy;
among other indicators of performance, a Zero-Base Review evaluates the product lines’ return on assets
employed and market share. It involves truly revising each part of all organization periodically, perhaps
every three or five years. These reviews are appropriate in government agencies and governmental
organizations which tend to present high proportions of discretionary costs.
Another method to review existing programs is the “Activity-Based” programming process. With of the
approaches consider programs as a part of the annual budgeting process. The major difference between these
approaches is that the latter requires the setting of a single budget amount for each activity based on the
recommended service level at the expected volume. Zero-Based budgeting involves the preparation of
multiple decision packages with variable service levels, leaving the choice later in the resource allocation
process. The problem is that Zero-Based budgeting requires more time than it is available during the
preparation fo the annual budget, therefore it is very time-consuming. The Activity Based approach grows up
from the activity based cost movement, which provides the details of activity information that will be used in
the budgeting process. It is therefore a collateral activity.
2. Consider Proposals for New Programs Management analyzes proposals when the need for new
opportunities comes to its attention. In business, such proposals usually involve new capital investments
and appropriate analytical techniques that are needed. Whether or not new capital investment is involved,
special attention needs to be given to whether a new production will increase step function costs in the
departments that will have a role in the implementation of the program. The revenue is a measure of
output of a profit-oriented organization, but also non-profit organizations may be interested in outputs.
Similarly, the outputs of many units in a profit firm can not be expressed in monetary terms. In this
situation, analysis of new programs proposals based on estimated profit or return on investment is not
impossible: sometimes, it is possible to use a similar approach by comparing the cost of programs with
some benefit measures expected as a consequence of incurring these costs. This is the so-called CostBenefit Analysis, widely used for analyzing programs, especially for non-profit organizations or in
public companies. However, profit-oriented companies also use such analysis to analyze such program
proposals as spending mope money to improve specific conditions, such as to improve corporate
reputation or to provide better information to management. The hard part of the analysis is that of
estimating the value of benefits: in many situations, in which no meaningful estimate of quantitative
amount of benefits can be made, the anticipated benefits are carefully described in bones, just as in
quantitative approach.
3. Coordinate Programs defining a formal strategic planning system.
Budgeting
The budget definition is a plan expressed in quantitative, better monetary terms, covering a specified period
of time, usually one year. A budget is a programming short-term plan which reports usually quantitative and
monetary information about objectives and resources referred to a specified period of time (mainly focusing
on one year) to implement a certain business activity.
Many companies refer to their annual budget as a Profit Plan, since this budget shows the planned activities
that companies expect to undertake in their Responsibility Centers in order to deter achieve their profit
objectives; also non-profit organizations prepare budgets. Preparing a budget means not only
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operationalizing a program, but also identifying manages’ responsibilities, namely who has been charged
with executing the program or a part of it.
This represents the first step of Management Control process, which identifies and aligns short-term
objectives to the strategic plans, defining the amount of resources (volumes and values) which need to be
allocated focusing mainly on the next year. The Budget. Execution affects individual and team behaviors,
actions and results for each Responsibility Center.
The definition of budgets serves as an aid in making and coordinating short-term plans. This activity is useful
for
• Making and Coordinating annual (or short-range) programs Major planning decisions are usually
made in strategic planning activities and the process of developing budgets is a refinement of these plans.
Managers must consider how conditions in the future may change and which steps they should take to get
ready for these changed conditions. Each RC affects and is affected by the work of other RCs: the
budgetary process helps coordinate these separate activities in order to ensure that all parts of the
organization are in balance with one another. Most importantly, production plans must be coordinated
with marketing plans, in order to ensure that production processes are able to produce the planned
volume. Similarly, cash management programs must be based on projected inflows from sales and
outflows from operating costs.
• Communicating “annual” programs to the various RCs managers Management plans will not be
carried out unless the organization understands what these plans are: they include specific details about
how production needs to take place and how many resources are needed to activate the production
processes. The organization need to be aware of policies and constraints to which it is expected to adhere,
such as the maximum amounts to be spent for advertising, administrative costs, wage rates and hours of
work. The approved budget, therefore, is the most useful device to communicate quantitative information
concerning these plans and limitations.
• Motivating RCs managers to achieve their goals If the corporate climate is right, the budgeting process
can also be a powerful force in motivating managers to work towards the objectives of their RC and hence
the goals of the overall organization. Motivation will be at its peak when managers will play an active role
in the development of their budgets.
• Benchmarking activities in controlling ongoing programs.
• Evaluating the performance of RCs and their managers A budget is a statement of the results desired
at the time the budget was prepared. A carefully prepared budget is the best possible standard against
which comparing actual performance. The general practice was to compare current results with results
from the same period in a previous lapse of time. This standard comparison is still present in some
organizations; the definition of budgets, in this sense, plays a crucial role. The comparison between actual
performance and budgeted performance directs attention to areas in which there may be a problem, to
underline criticalities to be resolved. Such a variance analysis could also bring to light unpredictable
opportunities that need to be explode, or reveal that the original budget was unrealistic in some way, not
perfectly aligned with the dynamics that certain activities are presenting in internal and external
organizational environments.
• Educating managers Budgets serve to educate managers about the detailed workings of their RC, and
the interrelationships of their Centers with other Centers in the organization.
Since the budget serves multiple purposes, the budget preparation is a very complex process. A problem is
that managers may introduce biases when preparing their proportion of budget. They do this to protect
themselves against uncertainties that may result in unfavorable variances that would look bad in the
evaluation phase of the Management Control Cycle. One important device to eliminate biases in budget
negotiation is the analysis by superiors of misalignments with historical data and opportunistic approaches
adopted by some managers that are introducing such biases.
The functions of the Budget
• The budget plays a key role in leading managers’ actions with the aim of achieving desired results,
identifying objectives to achieve, the resources to sue and the timing needed.
• The budgeting system allows Management Control to coordinate all the organizational resources in the
achievement of specific objectives.
• Budgets ensure an optimal balance between different corporate areas, functions and parts, as well as they
boost the achievement of both specific objectives and firm goals.
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• Budgets set economic-financial parameters useful to compare programs as well as actual results with
•
•
•
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budgeted ones and to carry out variances analysis. The economic dimension of management is defined as
costs - revenues. The financial dimension of management is defined as receipts - disbursements.
The variances analysis allow Management Control to highlight the effective resources use to examine the
actions adopted and to identify possible critical areas that reported gaps between objectives and
performance, thus to implement corrective actions.
Since the budgeting is defined a long progressive and negotiating process in both preparation and
execution phases of budgets, it ensures the ex-ante coordination of all corporate internal areas and
organisms.
The budget preparation and execution fosters managers’ motivation in achieving common corporate
objectives, minimizing competition within the organization . This aspect is more emphasized when the
budgeting is a cooperating (bottom-up) process which involves RCs’ managers.
The use of budgets boosts individual and organizational learning processes.
The Master Budget is the budgeting system composed by all budgets of the individual business functional
areas, that is, the budgets of every RC. It collects and reports data of all the functional areas, organizational
levels, managerial aspects, specific production aspects, business and strategic affair areas. Generally, the
budget could be defined as a “Complete Budget Package”, so-called Master Budget. Such package
includes several items, most of which are themselves budgets. The three principle parts of it are
• The Operating Budget, which shows planned operations for the coming year including Revenues, Costs,
Changes in Inventory and other Working Capital. This part is composed by,
I. Sales Budgets,
II. Production Budgets,
III. Other Budgets.
• The Capital Expenditure Budget, which shows the planned changes in property, plant and equipment.
• The Cash Budget, which shows the anticipated monetary sources and uses of cash in that year.
Most components of the Master Budget are affected by decisions or estimates in constructing other parts.
Every step in the definition of operating budgets starts from the definition of sales budgets; it is the
fundamental activity that affects the production budget, other budgets (in terms of staff units) and, of course,
the capital budget (items of costs in terms of investment programs). The cash budget is primarily affected
by the sales, production and other budgets.
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At the end of this process, the Master Budget is complete with the last document which is the Budgeted
Balance Sheet, indicating the levels of assets, liabilities, and equity based on the budget for the current
accounting period.
The Operating Budget
The Operating Budget is a plan articulated in RCs which reports expected data for the first year pf a longrange plan. The Operating Budget structured in RCs is a statement of expected RCs’ performance and it is an
excellent tool to compare actual and planned costs, revenues and other data. Each manager is responsible for
preparing those parts of Operating Budget that correspond to his or her Responsibility Center. Responsibility
Budgets could be broken down into cost elements to control the spending and to identify in which areas there
are inefficiencies due to higher actual costs respect to the budgeted amounts.
Some firms work on “Defined Projects”: the project manager may use personnel and other resources from
various departments present in the same firm. The Project Budget, thus, contains amounts that are reported
also in the budgets of the functional departments that will be supplying resources to the project. Personnel
from functional departments that are assigned temporarily to projects have two bosses: the manager of their
functional department, and the project manager. Such a practice results in a matrix organization, due to a dual
line of authorities and responsibilities, that is particularly difficult to manage.
If the total costs in a RC are expected to vary with changes in volume, the responsibility budget may be
structured as Flexible Budget showing the planned behavior costs at various volume levels. Also in the case
of the Flexible Budget definition, the manager has to report the level of volume planned for the period
covered by the budget. If the budget covers one year, the the expected volume is considered as the standard
amount for such planned activity. The planned costs reported in a flexible budget related to other volume
levels are used in the evaluation phase, comparing actual costs with the expected ones in line with actual
volumes.
Preparing the Operating Budget The Budget Preparation is a process that can be studied from two different
perspectives: a technical and a managerial dimension. (1) From the technical point of view, the mechanics
of the system, the procedures for assembling data and budget formats are analyzed. These kinds of
procedures are similar for recording actual transactions and the end results of calculation and summaries
regarding mainly the collection of data of financial statements, namely, the Balance Sheet, Income Statement
and Cash Flow Statement. Also, the budget preparation in terms of technical process is identical, in format,
with those resulting from the accounting process that records historical events. The differences between the
financial statements process and the operating budget preparation process is that budget amounts reflect
planned future activities rather than data on what has happened in the past. When we talk about (2) the
managerial process that supports the preparation of the operating budget, and of budgets in general, we
have to follow this scheme to focus our attention on the main steps this procedure is characterized of.
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Before activating such a process, it is needed that an organization defines a specific Budget Committee, that
is composed of several members, senior management groups, that organize the work of preparing the budget.
1. This Committee recommends to the CEO the general guidelines that the organization has to follow in
the operating budget or budgeting processes.
2. After the CEOs approval of these guidelines,
3. the Budget Committee disseminates them to various Responsibility Centers
4. and then this organism coordinates the separate budgets prepared by those centers.
5. The committee resolves any differences among the Centers’ budgets,
6. and then submits the final budget to the CEO and the Board of Directors for approval. Budgeting
instructions go down through the regular chain of command, and the budget comes back up for
successive reviews and approvals through the same channels.
7. The line organization makes decisions about the budget, and the CEO gives final approval subject to
ratification by the Board.
8. The line organization is usually assisted in its budget preparation by a Budget Staff Unit, aided by a
Budget Director, composed by staff persons; the budget directors’ functions are too disseminate
instructions about budget preparation mechanics to provide past performance data useful in preparing the
budget, to make computation also based on decisions reached by the line organization, to assume the
budget numbers and to ensure that all managers submit their portion of the budget on time. The
Accounting Staff at various level assists the Budget Directors and the Budget Staff which is usually a
unit of the Controllers Department, just like a communication technology company. This unit operates
just like a communication system: it is responsible for the speed, accuracy and clarity with which
messages flow through the system, but does not decide in the content of the messages instead.
The Budget Timetable To prepare the budget, an organization has to follow a certain Budget Timetable.
Most organizations prepare the budget once a year, covering the upcoming fiscal year. They usually make
separate budget estimates for each month or quarter within a year. Some organizations initially estimate data
by months, only for the next three months or six months, with the balance of the year being shown by
quarters. Some others adopt the Rolling Budget Procedure: they prepare a new budget every quarter, but for
a fully year ahead. This practice leads Management Control system to drop the budget amounts for the
quarter just completed. The amounts of the succeeding three quarters are revised (if necessary) and the
budget amounts succeeding quarters are added. Generally, in big companies the whole budget preparation
process takes 3 months.
Most components of companies’ operating budget are affected by decisions or estimates made in
constructing other components. Most firms follow the following phases in operating budget definition:
1. Setting Planning Guidelines The budget preparation process involves detailed planning by
Responsibility Centers to implement the broader program plans decided in the Strategic Planning
process. If the organization has a formal Long-Range Plan, this plan provides a starting point in the
budget preparation; in absence of a Long-Range Plan, senior management establishes policies and
guidelines that are to govern budget preparation. These guidelines vary greatly in content among
different organizations: commonly, detailed information and guidance are given on such matters as
projected economic conditions, for example allowances to be made for price and wage increases or
changes in the scale of operations. In addition, detailed instructions are issued are regards the
information required from each RC, and how this information is to be recorded on budget documents.
2. Preparing the Sales Budget1 In budget preparation, the drawing up of Sales Budgets is determinant,
because these specific budgeted decisions affect all other components of operating budgets. The
preparation fo sales budgets is the first phase that starts the Operating Budget process definition: the
amount of sales and the product mix govern the level and general character of a company’s operations.
Therefore, it affects most of other plans, and sales budget plans must be prepared early in the budget
preparation process.
The sales forecast is a passive prediction fo some controllable accounts; on the other hand, a sales
budget carries the commitment of each RC’s managers to implement necessary actions to attain desired
results, that is to say, a commitment to substantial increases in sales, reflecting the management intention
to increase sales personnel, sales advertising and promotion.
1
see Operational Logics of Sales Budget.
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In conjunction with the preparation of the sales budget, the company should prepare the Selling Expense
Budget, that reflects the size and measures of marketing efforts that are intended to generate the budget
sales revenue. In almost all companies, the sales budget is the most difficult plan to make: this is because
a company sales’ revenue depends on customers, which are not subject to the direct control of
management. In contrast, the amount fo costs incurred is determined by the actions of the company itself,
exception made for the prices of certain inputs; therefore, it can be planned with higher confidence.
There are two ways to make estimates as a basis for the sales budget: (1) a manager responsible for the
sales and the staff units that support the decision process could elaborate statistical forecasts of general
market and business conditions; (2) a more judgmental approach, based on the collection of the opinions
of executives and salespersons. Study management analyzed that the majority of large corporations uses
both of these methods, although a minority relies solely on judgement. Many companies have concluded
that the use of sophisticated techniques does not produce accurate forecasts, and these are balanced with
some judgements that are simple to compare the expertise and skills gained from past operations.
3. Initial preparation of other operating budget components The budget guidelines prepared by senior
management, together with the sales budget, are disseminated down through the levels of the
organization. Managers at each level may add more detailed information for the guidance of their
subordinates, and when these guidelines arrive at the lowest RCs, their managers prepare proposed
budgets for the items within their sphere of Responsibility, working within the constraints specified in
the guidelines. The proposed budgets reflect the managers’ judgement on the amount of resources
required to carry out their Centers’ functions effectively. These amounts may have been tentatively
agreed in a previous Zero Based Review; alternatively, the manager may focus on how the coming years’
activities will differ from current years’ activities, and then adjust the current budget amounts on the
basis of these difference. This approach is the so-called Incremental Budget.
4. Negotiations of the budgeted information to agree on final plan for each component The value of
the budget as a motivating device and as a standard against which actual performance will be measured
depends largely on whether and how skillfully this negotiation is conducted. The objective to be
achieved cannot be neither too tight, nor too loose: the aim is to achieve a desirable common ground, in
order to enhance its motivating feature. At the general management organizational level, annual budget
targets are generally designed to be achievable with a high probability, only with the collaboration of an
effective management team. Most companies allow subordinate managers to participate actively in
establishing these targets, but such a participation needs to be meaningful, and not perceived as a sham.
The negotiation process applies principally to revenues and items of discretionary costs; if engineered
costs have been properly analyzed, in fact, there’s little room for differences of opinion about them;
committed costs, by definition, are not subject to negotiation, as long as the commitment remains in
force.
5. Coordination and Reviews of the Operating Budget components This step is repeated at successful
higher levels of the organization hierarchy. Review at the higher levels may result in changes of the
detailed budget agreed in the lower levels; if these changes are significant, the budget is recycled back
down the organizational hierarchy for revision. However, if the budget process was well understood and
conducted, such a recycling is not necessary. In the successive stages of negotiation, the manager who
has the role of superior of one level is logically the subordinate at the next level: managers are wellaware of it, and are strongly motivated to negotiate budgets with their subordinates. On the other hand, if
a superior demonstrates that a proposed budget is too low, this reflects on the subordinate’s ability as a
manager and negotiator. As the individual budgets moves up in the review process, they are also
examined in relation with one another. Therefore, individual Responsibility Centers budgets also may
reveal the need to change amounts, and these changes may disclose that parts of the overall plan may be
out of balance.
6. Final approval Just prior the beginning of the budget year, m the proposed budget is submitted to senior
management for approval. If guidelines have been properly set, and significant issues arisen during the
budgeting process are brought to the senior management for resolution, the proposed budget should
contain no greta surprises. Approval is the official agreement of senior management to proposed
plans for the year. The CEO, therefore, spends considerable time discussing the budget with immediate
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subordinates. After the CEO’s approval, the budget is submitted to the Board of Directors for final
ratification.
7. Distribution of the approved Operating Budget The components of the approved budget are therefore
transmitted down through the organization’s RCs. Each Center’s approved budget constitutes an
authority to implement the plans specified there. The budget incorporates certain assumptions about the
conditions prevailing during the budget year, and after final approval and distribution, there could be the
possibility to process ongoing reviews.
Those who favor budget revision point out that the Budget is supposed to reflect plans in accordance with
what the organization is operating, and when the plan has to be altered because of changing scenarios or
contingencies it should reflect these changes. If the budget is not revised, the information budgeted they
maintain is no longer realistic and loses its potential to motivate managers.
The opposite point of view argues that the revision process not only is time consuming, but may obscure
the objectives that the organization originally intended to achieve and the reasons at the basis of these
objectives. In particular, revision may reflect the manager skills in negotiating, and a change could
undermine the credibility of the budget.
Revisions Many organizations do not revise their budget during the year, but take into account changes in
cognitions when they analyze the difference between actual and budgeted performance. Companies solve
this problem by having two budgets: a Base-Line Budget, set at the beginning of the year, and a current
budget, the so-called Current Outlook or Update Budget, which reflects current variations in estimates
of revenue and expenses. A comparison between actual performance and estimated performance shows
the extent of deviation from the original plan, therefore, how much such a deviation is attributable to
changes in current conditions to those originally assumed.
Variations Instead of having budget estimates generated at the lowest Responsibility Centers, the budget
could be prepared by higher level studs and then transmitted to the lower levels of the organization.
Imposed Budget or Top-Down Budget is generally a less motivating device since its standards are less
likely to be understood and more likely to be seen as difficult or unfair. Variation, in practice, depends on
the negative behavioral approaches adopted by an organization.
The Top-Down Budgeting Process implies that each component of the Master Budget, which is an
imposed budget by the top management, is prepared by the higher layers of the organization, approved
by the senior management and then transmitted to the whole organization. It is highly detailed, but does
not involve subordinate managers in the objectives definition.
Its limitations are that
• the senior top managers often do not know specific aspects and issues as regards lower organizational
levels,
• and the use of imposed master budget may be detrimental for the effective business development:
subordinates, in fact, may be reluctant to accept imposed objectives.
• Contextually, an imposed budget could lead a strong emphasis on negative variances during the evaluation
phase. In such a way, managerial attention could negatively emphasize eventual misalignments, whereas
those variances are not necessarily negative.
To sum up, top-down budget is less effective in motivation, because standards and budget information
are set by the top levels, and these are less likely to be understood and more likely to be viewed as unfair.
The Bottom-Up Process is a cooperating process in which each RC’s manager is involved in the master
budget definition proposing a program. The objectives are defined and agreed by all subordinate
managers involved in budgeting process and then negotiated with the senior management. Moreover, the
emphasis is on the identification and the analysis of the variances causes.
Its limitations are that
• the process could be focused on the individual and areas’ objectives,
• a budgeting cooperating process often could present coordination troubles,
• and the subordinate managers involved in the cooperative budgeting process could use their private
information to distort their budgets in order to set easier targets to achieve chances to negotiate for possible
budget slacks (use of private information to distort prospects hoping to set easy targets to achieve ion the
negotiating phase).
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In bigger firms, steps 4, 5 and 6 usually require, at least, one month. In a typical organization, the time for the
whole budget preparation process takes around 3 months. Very small businesses may go through the whole
process in just one day.
The Cash Budget
The Cash Budget is the translation into terms of cash inflows (receipts) and outflows (disbursements) of
revenues and costs reported in the Operating Budget. The Cash Budget is used for financial planning
purposes. In particular, the Financial Manager uses the Cash Budget to define plans, ensuring that the
organization has sufficient cash for the development of annual activities, better, of the next accounting
period.
There are two approaches for the preparation of the Cash Budget:
1. The first approach starts with the budgeted Balance Sheet and Income Statement, and adjusts the
amounts thereon to derive the planned sources of the uses of cash; this procedure is substantially the
same as the one described for the preparation of the Statement of Cashflows, except for the fact that data
are constituted by estimates of the future, rather than historical.
2. The second approach analyzes those plans having cashflow implications and directly estimates cash
inflows and outflows.
The following is an example of the Cash Budget by a Shipment Company. Note that there is a minimum cash
balance set up at 150,000$ against unforeseen needs.
Collection of accounts receivable is estimated by applying a lag factor to estimated sales. This factor may
be simply based on the assumption that the cash from this month’s sales will be collected next month. Or
there may be a more elaborate assumption — for example, that 10 percent of this month’s sales will be
collected this month, 60 percent next month, 20 percent in the third month, 9 percent in the fourth month and
the remaining 1 percent will be never collected.
The estimated amount and timing of materials purchases are obtained from the materials purchases budget
and are translated into cash outlays by applying a lag factor for the ordinary time interval between receipt of
the material and payment of the invoice.
Most other operating expenses are taken directly from the expense budget, since the timing of cash outlays is
likely to correspond closely to the incurrence of the expense.
Depreciation and other items expense not requiring cash disbursements are excluded. Capital expenditures
also are shown as outlays, with amounts taken from the capital expenditure budget.
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The bottom section shows how cash plans are made. The company desires a minimum cash balance of
about $150,000 as a cushion against unforeseen needs. From the budgeted cash receipts and cash
disbursements, a calculation is made of whether the budgeted cash balance exceeds or falls below this
minimum. In January, the budgeted cash balance exceeds the minimum. In February, the budget indicates a
balance of only $72,000. Consequently, plans are made to borrow $80,000 to bring the balance to the desired
level. The lower portion of the cash budget therefore shows the company’s short-term financing plans.
The Capital Expenditure Budget
The Capital Expenditure Budget is essentially a list of what management believes to be worthwhile
projects for the acquisition of new facilities and equipment. This budget shows the estimated cost of each
project and the timing of the related expenditures.
Individual projects are often classified by purpose, such as
1. Cost Reduction and Replacement;
2. Expansion and Improvement of Existing Production Lines;
3. New Products;
4. Health, Safety and/or Environmental Protection;
5. Other activities.
Proposals in the first two categories are amenable to an economic analysis. Some new-product proposals also
can be substantiated by an economic analysis, although the estimates of sales of the new product is a guess in
many situations; proposals in other categories cannot be sufficiently quantified to make an economic analysis
feasible. In this sense, the Cost-Benefit analysis is another technique that, in this case, top management could
find particularly useful.
The Capital Expenditure Budget is defined separately from the Operating Budget. In many companies, it is
prepared at a different time from the Cash Budget, and cleared through a Capital Appropriation
Committee that is different from the Budget Committee.
As proposals for capital expenditures come up through the organization, they are screened at various levels:
only the sufficiently attractive ones go up to the top management, and then appear in the final capital
expenditure budget estimated cash outlays are shown by years or quarters, so that the cash required in each
time period can be determined. At the final Review Meeting in the Board of Directors, the total amount
requested in the budget is compared with funds available. Some apparently worthwhile projects may not be
approved, simply because not enough funds are available to finance them.
Approval of the capital budget usually means approval of projects, but does not constitute final authority to
proceed with them. For this authority, a specific authorization request is prepared for the project, defining
the proposal in more detail with the firm’s price quotations with the new assets. Some companies use
Postcompletion Audits, to follow up on capital expenditures, which include checks on the spending itself
and also controls on how well the estimates of costs and revenues actually turned out. In few companies
there’s a tight linkage between the costs saving estimated in a capital expenditure request and operating
budget figures for the period of projected savings. Such linkage, like postcompletion audits, is aimed at
motivating managers to make realistic savings estimates in their capital budgeting requests.
Beyond Budgeting Some companies, mostly located in Europe, have abandoned traditional budgeting and
have created a movement called Beyond Budgeting, which is said to combine radical decentralization and
adaptive performance measurement practices. These organizations do not have an annual budget or targetsetting process. Instead, they create as many autonomous profit centers as possible and give managers the
freedom to make fast decisions at the point of contact with he customer. They set stretch performance
targets using high-level key performance indicators by reference to internal and external benchmarks, rather
than negotiating them as part of a formal, rigid budgeting process. They use a rolling strategic review process
that enables managers to continuously adjust strategy. And they assign rewards based on relative
performance evaluation.
Integrating the Accounting System with Nonfinancial Systems The Monetary Accounting
Information is insufficient to program, efficiently the business activities as well as to process an adequate
benchmark for the performance of a Responsibility Center. Organizations considered the need to articulate
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managerial procedures and also defining new advanced systems and tools that could foster such an
integration and to boost goal congruence within an organizations’ employees.
Many firms introduced some suitable systems, such as Management by Objectives (MBO) and Balanced
Scorecard (BSC) to integrate the monetary standpoint of the accounting information with non financial
information about the results of the manager’s actions.
Management by Objectives
The term Management by Objectives relies on the defining objectives for each employee, and to the
performance direction against the objectives set in the budgeting process. It was first defined in 1955 by
Peter Drucker (The Practice of Management), according to whom the manager should avoid the so-called
activity trap, that is to say getting so involved in daily activities to forget the main purpose of objectives and
organizational goals to be achieved.
MBO is a system that aims to improve organizational performance by clearly defining objectives, in line with
all the critical success factors, that are agreed by both management and employees; it allows the objectives
and actions definition through a shared process which encourages participation and commitment among both
managers and employees, as well as aligning objectives across the organization. It also ensures an optimal
matching between firm’s goals and subordinates’ objectives. Ideally, employees receive a strong input to
identify their personal operational objectives, timelines and tasks. Tracking such processes is a fundamental
element of this system.
The five step for Management by Objectives implementation are
1. Determine or revise organizational objectives ( SMART specific, measurable, acceptable, realistic, timebound) for the entire company;
2. Translate the organizational objectives to employees.
3. Stimulating the participation of employees in setting individual objectives. After the negotiation phase in
which objectives are shared from the top layers to the lower layers, employees should be encouraged to
help set their own objectives to achieve these larger organizational objectives;
4. Monitoring the progress of employees;
5. Evaluate and reward employee progress through an honest feedback about what was achieved and what
was not achieved through management’s daily activities.
The Balanced Scorecard
The Balanced Scorecard is a strategic planning and management tool used extensively by businesses and
organizations on a global basis. This system enables entities to sharpen focus, improve strategies, streamline
business activities and increase communication; it is therefore used as a means to better communicate the
goals the organization is striving to achieve. It is useful to assess how RCs and their managerial teams
operate in an integrated manner: how everything worked within thew organization to meet the company’s
goals, so that the senior management can recalibrate workflow priorities as needed. The BSC system is to be
considered as a roadmap that lays out the different components of a company, that is to say, the overall
mission, the long-term vision, performance benchmarks and core values.
The BSC proposes that organizations’ aforementioned components should be viewed from four dimensions,
each with its own metrics, data, collection and analysis,
1. Financial;
2. Customer;
3. Internal Business Processes;
4. Learning and Growth;
In this sense, the BSC empowers companies to think beyond the proximate goals to accomplish, and helps
guiding companies in falling into new areas: scale operations and achieving higher ambitions. This
information is sent to the best positioned parties to take meaningful action. Unlike financial reports that rely
on past financial trends to project future performance, BSC systems use a proactive framework for growth in
the quarters or years at stake.
The first BSC was created in 1987 by an independent consultant. Three years later the same consultant
participated in a related research study led by Kaplan, during which a chance to refer the performance
measurement approach was given to the consultant. In 1993, Norton translated the tool created by
Schimmermann, providing insights on the use and features of this tool. Kaplan and Northon published “The
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Balanced Scorecard”, in which they mainstreamed the concept of BSC as an advanced managerial tool useful
to enhance cooperation and quality of decision-making processes as regards management and management
control.
The Role and Nature of the Budgeting System
An example of Budget Form
1.
•
•
•
•
This is a budget of an Expense Responsibility Center, which the specification of the particular business
units considered by the Management Accounting system. In this format, the main information reported in
terms of codes, descriptions and data are mainly monetary and specifically costs.
Starting from the first row, the Accounting Code is a result of the standardization in the Management
Accounting system, taking a serial number to classify subgroups of items of costs.
The Description indicates qualitative description of the items of costs.
The last section is focused on the expected Budgeted Costs and Actual Costs incurred in the budget
execution, used to perform Variances, that is the difference between them, at the end of each accounting
period.
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In the heading area there’s the indication of the Manager responsible for the Expense Responsibility
Center , and the Department, the macro business area in which the RC operates.
2.
This kind of form is still focused on costs, that is to say, on an Expense Responsibility Center that operates in
a certain department and that is managed by a specific manager, who is responsible for the collection and
recording of data about some cost items or activities described in the first column.
This budget is focused on a one year implementation: month by month, there are quantitative and monetary
information to be reported for each cost item. At the end, we have the total amounts for each month that we
consider as the sum of all cost items that are analyzed and included in the programming activity of this
Responsibility Center.
3. Sales Budget
In the first column we have the different products that the organization produces and markets. The Sales
Budget is the setting of the expected Sales Volume for the year at stake, and the quantity to be sold is
reported raw by raw and product by product.
The Sell Unit Price is predefined for each product included in the product mix portfolio.
The amount of Revenues is the result of the interactions, the multiplication, between sales volume and
selling price.
The Nature of the Budget
The budget preparation is based on the strategic plan. Each budget allows the annual execution of what is
reported in the strategic plan. Each budget is matched with every Responsibility Center, and a budget reports
data which refer to a specific annual and inter annual time horizons.
Most organizations set the budget system on a specific time frame, that could be one year or intervals in the
same year. Interannual time horizons are useful and this is for two main reasons,
• to foster a better identification of deviations and dysfunctions (for example, fluctuations in market
demand)
• and to enhance the capabilities of Management Control in influencing the behavior of managers and
employees as well as the system effectiveness and timeliness to solve criticalities well supporting the
managerial activities.
The setting of budget inter annual time horizon is not a general rule: some organizations could design
budgeting system using long-term budgets.
This is the typical business case in which the organization elaborates a strategic plan and, subsequently, the
budget focused on a yearly time horizon. This matrix helps understand the interactions between the strategic
plan and each accounting period’s definition of the budget.
Planning and programming therefore work together, uniting long and short-term perspectives: the long-lived
planning strategies are executed through the implementation of periodical budgets. At the end of each year,
there’s also the chance for the top management to consider, thanks to this chain, if it is fine to continue
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adopting that strategic plan for the period 2020-2022, or if, at the end of the first year (2020), there is the
preliminary information that might allow a reconsideration of the ongoing program.
This is crucial since the operational execution of each periodical budget allows managers of each RC to
check if the operational objectives, designed aligning the predefined goals in the strategic plan, are achieved,
and if there are some kind of misalignments.
Market dynamics, in this sense, are very relevant. A budgeting system mainly focused on the short-term
works in very dynamic environments: in this case, interim budgets are useful to prevent some corporate
strategy obsolescence.
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Commercial Activities Budgets
Sales Budget This is the first part that the top management and Sales Responsibility Center are going to
define. The budgeting process starts with the elaboration and negotiation of information and data regarding
sales volumes, the product mix and selling prices. These elements govern the level of the general charter of
the company’s operations, from those useful to activate the production cycle. In the Master Budget
preparation process, the Sales Budget must be prepared yearly. It usually shows a commitment to a
substantial increase in sales. At the same time, the company should prepare the
Selling Expense Budget that reflects the principal elements of selling expenses which describe the size and
nature of marketing efforts that are intended to generate the budget and sales revenue. In commercial
activities’ budgeting process, it may be optional to prepare a
CAPEX Selling Activities Budget, just in case proposals for capital investment projects investing
commercial activities areas are made, such as investments in fixed assets or investments in current assets. If a
company, for example, decides to invest in Big Data Technology, then a specific CAPEX selling activity
budget needs to be prepared. It is useful when specific business areas are to be innovated. In order to process
and consider this extra component, it is to be taken into account that a company uses it to foster cost
reduction and replacement.
Operational Logics of the Sales Budget Sales forecasts are passive predictions, whereas the Sales
Budget quantifies the production volume of goods and services which the organization estimates to sell
during the next budget period. The estimation of sales volumes is critical and is biased by internal and
external business data analysis. To minimize possible uncertainties characterizing the Sales Budget
preparation, external data analysis is necessary, such as
• Life Cycle Analysis of both the industry and the products;
• Collection of evaluations produced by the Selling Division;
• Trading Analysis;
• Historical Sales trend analysis;
• Statistical and econometrical analysis.
As regards the Sales Volume definition, to minimize possible uncertainties characterizing the budget
preparation, it is needed to carry out internal constraints analysis regarding the following topics,
• Corporate production capability of firm plants;
• Human and technical resources available;
• Financial resources available;
• Raw material availability.
Possible domino effects may be produced by strongly optimistic or pessimistic volume estimates operated
by other business areas: that’s why the sales budget is one of the most critical steps of the whole budgeting
process.
This table shows the possible effects of such optimistic or pessimistic volume estimates, representing higher
risk probability of incurring in higher losses.
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Key Steps in Sales Budget Preparation
1.
2.
3.
4.
Estimation of Sales Volume;
Break Even Analysis aimed at identifying the break-even point and volume;
Selling Price Set Up based on the information collected in the bears-even analysis and performing price
elasticity of demand/supply analysis;
Production Mix Choice defined on the basis of results obtained through margin contribution analysis
and product life cycle analysis.
Unit Selling Price Definition is a fundamental step which allows managers to analyze the firm’s production
costs by using the production cost accounting. Managers must consider the Unit Contribution Margin (UPuVC), namely the share of selling price of each good or service produced, which should cover fully uVC.
The selling price amount set should recover the share of average unit of fixed costs incurred in the overall
production of those specific goods or services. The unit selling price definition also implies the analysis of
selling price strategies implemented by competitors and the analysis of how the market demand could vary in
line with selling price expected variances.
Product Mix Choice that is the step in which the Sales Manager has to identify how the product portfolio is
going to be composed; it depends by information collected in the prior steps, just like unit variable and fixed
costs, possible forecasts in price elasticity, expected revenues for each product lines.
This step is based on the results produced by the Contribution Margin Analysis: the higher the unit
contribution margin, the higher is the inclusion of such a good or service in the Sales Responsibility Centers
‘product mix. Product mix choice takes into account
• The product market demand trend for each good or service to be sold;
• Production constraints identifying the volume margin safety to produce in the light of the break even
point for each product;
• Fixed costs and their unit allocation for each production lines.
This is a simple business case to better understand how the production mix selection may be developed.
Production mix design is basically determined through a comparison between unit contribution margins and
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break even points of different products that a manager of a Sales Responsibility Center is assuming to
produce and to market, considering also different possible allocations criteria for the fixed costs.
The two hypothesis differ in the fixed costs allocation between different production lines.
In hypothesis 1 there are three products at stake, and such an allocation is balanced: the distribution of the
shares of fixed costs is equal. In hypothesis 2, the sales manager assumes a different allocation of the share of
fixed costs among alpha, beta and gamma: he increases the share in Alpha and decreases the share in
Gamma. In this reconsideration of the allocation of the share of fixed costs, such a variation affects B.E.P.:
the alpha one is higher than that of H1, and this is a negative issue to be considered; on the other hand, in
gamma, the B.E.P. is reduced.
A higher fixed costs share allocated to a specific product determines the increase of the volume margin safety
as regards the same good or service to sell.
The unit contribution margin plays a crucial role: it is a key performance indicator that the Sales Manager
may perform in the production mix definition examining the unit probability for each good and service
assumed to be produced and market.
These two tables correspond to two assumed scenarios in terms of production mixes: these tables report the
principal variables (Revenues, Variable Costs, Fixed Costs, Profits or Losses) articulated for each product.
H1 Alpha is the most profitable product, analyzing its variable costs, fixed costs, with respect to its
contribution margin which is lower than Beta. Gamma has the lowest unit contribution margin.
The manager could consider that Beta leads higher variable costs and foxed costs, even if it allows to achieve
higher expected revenues. On the other hand, producing Gamma could be negative for the organization on
the profit side, because this product is characterized by lower variable and fixed costs. If the manager
assumes to produce only Alpha and Beta,
H2 The fixed costs reallocation implies an increase in terms of shares for Alpha and Beta. By doing so, this
could produce negative effects on Alpha and Beta, and also in the overall profitability of the organization’s
sales. This kind of change could negatively affect the profit and losses achieved at the end. This is due to the
commissioning of gamma production lines. The decommissioning of Gamma in this hypothesis due to its
loss of -300$ highlighted in H1 leads to allocate FCs (1500&) to Bothe remaining production lines (+750$
for both). This decreases the total profit by -1200$ in H2 for an amount equal to the contribution margin of
Gamma reported in H1. The reallocation of the shares of fixed costs between two lines, instead of three,
represents a penalizing issue that managers must take into account,
In Product Mix Design, the Sales Manager should take into account that each product follows a declining S
trend along its Life Cycle due to the following possible factors,
• Market Competition;
• Substitute alternative products;
• Technological advancements;
• Obsolescence.
The Product Life Cycle Analysis highlights the correlation between sales volume and the current life cycle
phase of a product.
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Management Control
Operational Logics of the Selling Expense Budget Usually, the Sales Budget definition could produce
immediate effects. Therefore, the preparation of the Sales Budget preparation leads to the Selling Expense
Budget definition, which quantifies the items of costs incurred to sell products related to the next budget
period, such as
• Salespersons expenses (wages, salaries and commissions);
• Personnel sales staff division expenses (trade analysis, inventories)
• Transport and retail costs;
• Packaging costs;
• Customs fees and insurance costs;
• Customer care assistance costs;
• Other commercial expenses.
The Selling Expenses could be classified in fixed costs (wages of personnel sales staff division), variable
costs (salespersons’ commissions, transport costs) and could also be direct costs, if the cost is objectively
and clearly traceable to a specific item or activity, or indirect costs, when the cost is related to the general
selling activities and therefore is not traceable to a specific product activity.
Example of Sales & Selling Expenses Budget
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Examples of Exercises
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Management Control
2
The Production Budget
The preparation of Production Budget is the second phase of the operating budgeting process which follows
the sales&selling expenses budget definition. Sales volumes setting up, B.E-A- and production mix choice
give inputs to production programs determining each production budget.
The general purposes of the Production Budget are represented by the need to allocate material, human,
technical and financial resources,
• Effectively and efficiently in line with the cost-effectiveness criteria;
• Through coordinate and systematic managerial processes;
• Ensuring the timeliness to meet the market demand.
The Production Budget preparation allows the budgeting process to define
• Programs as regards volumes of goods or services to produce for each production line, considering the
objectives defined for each inter annual period in the sales budget;
• Costs incurred to produce budgeted good or service volumes in the sales budget;
• Programs regarding fixed and current assets investment needed to support the functioning of production
business units in order to ensure the good or service budgeted outputs.
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The Production Budget preparation is characterized by some determinant activities,
1. The definition of Inventories Policy and the analysis of production factors Stocks for each production
line, supporting the Inventories Budget design;
2. Structuring the production program in sub-dimensional budgets, for example direct material, direct
labor, general & administrative expenses budgets, in. Line with the several activities and peculiarities of
the productive functions;
3. The computation in monetary terms of the values elaborated in the budget using the standard costs
approach.
Inventory Budget The production budget preparation needs to know both data reported in sales and
inventories budgets. Possible mismatching between sales and production budget data could be due to stocks
of products for which flows are managed in kine with a well-defined Inventories Policy. Stocks are useful to
meet both possible unexpected market demand changes and delays in procurement processes of production
factors.
To efficiently determine the stocks of products, it is needed to evaluate initial and final inventory
considering the volumes of both goods and semi-finished products produced in that specific period. The
analysis is the result of the following comparison,
The production program is equal to the consideration of the budgeted volumes in terms of sales that are
increased or decreased with respect to the availability of goods or semi-finished products, that is to say, the
dynamic trends that describe the flow of stocks a company has in its inventory to face external or internal
contingencies; this amount, regulated by the inventory policy, is compared by analysts with initial and
historical values of available inventory. Service providers do not generate stocks, in general: therefore the
production program could budget upper, lower or equal volume if goods to produce in comparison with what
was budgeted.
Several factors could affect the inventories policy definition, such as
• Analyzing the perishability of goods and semi-finished products in stock;
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Management Control
• Defining modalities and means of stocking as well as the stocks’ volumes for raw materials and semifinished goods;
• Setting up the amount of security stocks useful to minimize risk in the long-term;
• Analyzing the stocking capability;
• Analyzing the production cycles duration;
• Minimizing costs of stocking;
• Identifying constraints which narrow the raw materials access;
• Analyzing the risks regarding the obsolescence of raw materials and goods in stock;
• Market demand forecasting trends.
The products and semi-finished products stocking management lead to sustain related costs, such as
1. Production costs (wages, indirect costs);
2. Stocking costs of raw materials, goods and products (rent, transport);
3. Insurance costs related to the risks of perishability/damage, or market demand volatility regarding the
stocked items;
4. Financial costs incurred from the moment in which stocks are created to the time when the stocked item
is sold.
Production Budgeting After the definition of production volumes to produce in the budget period, and the
following stocks analysis regarding produced goods and semi-finished products in inventory, the operating
budgeting process starts to define the production budget.
The production budgeting process considers the different categories of resources employed to produce goods,
identifying then costs regarding direct materials, direct labor, general, administrative and technical
expenses.
Standard Costs To overcome the different nature of these costs, the approach used is the standard costs
one. Standard costs are pre-determined ex-ante using a rational and rigorous method in order to translate
in monetary terms the assumptions regarding the future functioning of management based on typical
conditions. As a result, standard costs are designed after the definition of operating standards conditions:
each standard cost represents both a forecast and an objective for managers and the business participants.
Indeed, standard costs have not a long validity period, and are usually set as standard of a specific fiscal
year.
The difference between estimated costs and standard costs is that the estimated cost is based on any cost
configuration that an organization estimates to sustain in processing a future production activity,
considering the internal and external business conditions The standard cost is the result of an estimation
based on internal and external business conditions assumed as typical for that firm, namely “standard”.
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Management Control
sUC = sUV * sUP
sUC = Standard Unit Cost to purchase an amount of a raw material useful to produce a unit volume of a
certain product;
sUV = Standard Unit Volume of a raw material useful to produce a unit of volume of a certain product;
sUP = Standard Unit Price needed to purchase a unit of raw material.
Direct Materials Budget The Direct Materials Budget preparation is based on the program of raw
material volumes to employ activating production processes. The raw material volumes are defined in line
with the budgeted sales volumes in sales budget. In particular, a firm has to analyze the following issues,
1. The production volumes that are programmed to produce in the budget period.
2. The raw materials consumption in production processes of every product. This design considers the
unit standard yield of raw materials to use for producing the budgeted production volumes. To
determine the raw materials consumption program in production processes, it is needed to multiply the
budgeted production volumes per unit standard yield, which is the typical unit yield for each raw
material employed in production processes based on physical standard unit needed reported in products’
technical specifications.
3.
The raw materials stocks in initial inventory, that is, highlighted at the end of the prior budget period,
and the estimated stocks in final inventory, that is, stocks which are expected to have available at the end
of referred budget period. Rw materials stocks are key in the production program definition, because
they must be considered in fine tuning the procurement processes. While the stocks amounts in Final
Inventory are determined by a specific corporate stocks policy, the initial inventory are defined basing on
the situations by business analysts for each staring budget period.
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Direct Labour Budget The Direct Labor Budget preparation is implemented following the phases
below,
• Determining the workforce needed to produce the budgeted production volumes;
• Calculate the number of employees useful to activate the new production processes (number of
personnel to hire, re-allocate or lay off; number of temporary or permanent employees).
• Assigning costs to direct labor in line with different salary levels and hourly costs.
Basing on the production program and to the defined workforce, a company is able to determine the total
hours needed to produce the budgeted product volumes. This definition takes in account technical
estimates and standard hours of workforce employment.
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Management Control
After the determination of direct labor program, it is needed to quantify the operating hours that each
employee can ensure during the budget period. This leads to calculate the average per capita operating
hours of workforce.
The following step is represented by the definition of the workforce needed to produce the budgeted
production volumes. This is computed through the comparison between total hours needed to produce the
budgeted product volumes and the average per capita operating hours of workforce.
The last step is represented by the definition of the total cost of direct labor for contracted employees:
in the hourly cost computation for each employee it needs to take in account several cost items to direct
labor budgeting preparation.
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Management Control
Examples of exercises
%
%
y
.
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General & Administrative Expenses Budget The General & Administrative Expenses concern all
those items of cost not directly attributable to the manufactured products, such as
• Indirect labor;
• Technical fixed assets depreciation;
• Maintenance costs;
• Other operating costs in common between more business units.
Often the General & Administrative Expenses could be fixed costs that are not related to the production
volumes. Differently, they could be variable costs or semi variable costs. Some others could be
discretional costs (personnel training activities).
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Chapter 25
Reporting and Evaluation
Measuring, reporting and evaluation activities are fundamental to identify misalignments between actual and budgeted
performance and favorable or unfavorable variances in budget data. This is the procedure that is going to be activated to
finish the Management Control process, giving inputs in terms of revising strategies or consolidating the
implemented ones and also in terms of budget revision to restart the programming activities for the infra annual
period through adjustments. This is the so-called feedback loop, that is fundamental to understand how MC processes
could be operationalized, and to identify the inputs that are useful to reformulate strategies.
Key Success Factors In all organizations and in most Responsibility Centers within them, a limited number of
factors (usually no more than five or six) must be watched closely because they are crucial to achieving the objectives
of the organization or of the responsibility centers.These are called key or critical success factors, and quantitative
measures related to them are the key indicators or key performance indicators. The key success factors can shift
quickly and unpredictably; when they do, they have a significant effect on performance. The reporting system should be
designed so that particular attention is paid to them.
As a general rule, a key success factor has these characteristics,
• It has an important impact on performance of the RC;
• It is volatile— it can change quickly, often for reasons not controllable by the manager;
• If a change does occur, prompt action should be taken;
• The change can be measured by a related key indicator.
Key success factors affect profit, but profit is not itself a key success factor, rather, it is the accountant’s measure of
overall economic success.
Types of Management Reports The main types are
• Information Reports are designed to tell management what is going on. Each reader studies these reports to detect
whether or not something has happened that requires investigation. If nothing significant is noted, which is often the
case, the report is out aside without action. If something does strike the reader’s attention, an inquiry or an action is
initiated. The information on these reports may come from the accounting system; it also may come from a wide
variety of other sources and include such external information.
• Performance Reports are types of reports about the performance of a RC. Economic Performance Reports are
internal documents prepared dealing with the information of performance achieved by a particular RC that is
considered as an economic entity. For example, a conventional Income Statement prepared for a profit center is one.
Economic Economic performance reports are derived from conventional accounting information, including full cost
accounting. A performance report could focus on whether or not investment in an economic entity should continue,
be increased or decreased. Managerial Performance Reports, usually referred to as Control Reports, are prepared
from responsibility accounting information. Essentially, they report how well managers did compared with some
standards describing what they were expected to do. The difference is that these, if properly designed, exclude non
controllable items from the measures that will be used as a basis for evaluating the managers. The control report may
show that a profit center is doing an excellent job, considering the circumstances. But if the profit center is not
producing a satisfactory profit, action may be required regardless of this fact. There are therefore two different ways
in which the performance of a responsibility center is judged. The control report focuses the manager’s responsibility
for actual performance that corresponds to the commitment made during the budget preparation process. Behavioral
considerations are important in the use of this report.
Period of Control Reports The proper control period, that is the period covered by one report, is the shortest
period of time in which management can intervene and in which significant changes in performance have occurred or
are likely to occur. This period varies for various items. For key success factors, it is more frequent than for other
items. A flash report is issued immediately if a significant change has occurred in a key success factor or if an
unexpected, important event of any type has occurred, such as a malfunction of a crucial machine. Daily reports may
be issued for important and volatile items, such as new orders booked. Monthly reports on overall performance are
common, although in some relatively stable businesses, these reports are issued only quarterly. The report period also
varies with the level fo the organization. The same type of event is reported more frequently at lower levels in the
organization than at higher levels. Managers at lower levels are expected to deal with the problem without waiting
for instructions from their superiors.
The other aspect of report timing is the interval that elapses between the end of the period covered by the report and
the issuance of the report itself. For monthly reports, the interval should be less than a week. To meet such a
deadline, it may be necessary to make approximations of certain “actual” amounts for which exact information is not
available. Such approximations are worthwhile because an approximately accurate report provided promptly is far
preferable to a precisely accurate report that is received so long after the event that no effective action can be taken.
Contents of Control Reports The essential purpose of a control report is to compare actual performance in a
Responsibility Center with what performance should have been under the circumstances prevailing, so that reasons
for the difference between actual and expected performance are identified and, if feasible, quantified. Three kinds of
information are conveyed in such reports (1) information on what performance actually was, (2) information on what
performance should have been and (3) reasons for the difference between actual and expected performance. This
suggests three essential characteristics of good control reports,
1. Reports should be related to personal responsibility. In this sense, we recall responsibility accounting, the type
of management accounting information that classifies costs and revenues according to the centers responsible for
incurring the costs and generating the revenues. Responsibility accounting provided information that meets the
criterion that control reports should be related to. Personal responsibility. Responsibility accounting also
classifies the costs assigned to each responsibility center as controllable or non controllable within it. In many
companies, control reports show only controllable costs; in others, reports also contain non controllable costs for
information purposes.
2. Actual performance should be compared with the best available standard. A report that contains information
just on actual performance is useless for control purposes; it becomes useful only when actual performance is
compared with some standard. Standards used in control reports are of three types
• Negotiated Standards are the most commonly used, also called budgets. The usefulness of these standards
depends on how much care went into their development; it also depends on how clearly the managers can see
the circumstances that will be faced in the forthcoming performance period. If circumstances change
dramatically from those assumed in the budget, the standards will become obsolete unless a planning
assumption variance can be isolated and removed from the budget, the aforementioned feedback loop. If this
variance can be removed, the adjusted standard has the same characteristic as flexible or variable budgets: the
standards adapt to actual conditions faced during the performance period.
• Historical Standards are records of past actual performance. Results for the current month may be compared
with results for last month or with results for the same month a year ago. Some companies base performance
standards on historical performance primarily to avoid the cost of negotiating standards as part of the budgeting
system. Standards that are set as a function of historical performance are commonly referred to as ratcheted
standards. These have two potential weaknesses (1) conditions may have changed between the two periods in a
way that invalidates the comparison and (2) when managers are measured against their own past record, there
may be no way of knowing whether the prior period’s performance was acceptable in the first place.
• External Standards are standards derived from the performance of other responsibility centers. For example,
the performance of the whole company can be compared with that fo others in the same industry. This approach
is called benchmarking, or relative performance evaluation: the standards employed in benchmarking can be
either non monetary standards or financial standards. Despite their theoretical appeal, relative performance
evaluations are not in widespread use. They are useful only if the entities whose performances are being
compared are similar and are facing similar operating conditions.
3. Significant information should be highlighted. The current problem, due to management digitalization, is to
decide on the right type of information that should be given to management so as to avoid information
overload. Individual cost and revenue elements therefore should be reported only when they are likely to be
significant. The significance of an item is not necessarily proportional to its size. Management may be interested
in a cost item of relatively small amount if this item is a discretionary cost that warrants close attention.
Management is similarly interested if costs incurred for a relatively small item may be symptomatic of a larger
problem. A management control system should operate on the exception principle, that is, a control report
should focus management’s attention on the relatively small number of items in which actual performance is
significantly different from the standard. Little or no attention needs to be given to the relatively large number of
situations where performance is satisfactory. No control system makes a perfect distinction between the
situations that warrant management attention and those that do not; for example, although those items for which
there is a significant unfavorable variance are usually flagged for further investigation, such an investigation may
reveal that the variance was entirely justified. Conversely, even though the variance is zero or favorable, an
unsatisfactory situation may exist. Many control reports have three columns (1) actual, (2) standard or budget
and (3) variance. Standard column is often not reported because its values can be determined as actual +
variance.
The Reporting Process The Reporting is a decision-making process based on the analysis of
A. The external socioeconomic context in which the firm operates;
B. The internal organizational environment characterizing that corporate culture.
Control Reports meet the need to monitor and evaluate
• Performance achieved by each RC carrying out its activities in line with some identified KSFs and KPIs (Scorecard
Questions). This fundamental activity completes the definition of the Scorecard with KSF and KPI to better support
the reporting system.
• The current evolution of external/internal context which could affect the KSFs validity (Attention-Directing
Questions).
Finally, Control Reports should identify possible solutions in the light of emerging criticalities in both internal and
external environments that characterize the behavior and functioning of a certain organization (Problem Solving
Questions).
The S.W.O.T. Analysis
KSF Key Succes Factors
KPI Key Performance Indicators
I
I
Such an analysis identifies those
1. Internal corporate strengths and weaknesses elements in line with the organizational management characteristics;
2. Opportunities and threats emerging from the socioeconomic external environment.
The matching between the identified variables of both external socioeconomic environment and the internal corporate
capacities leads the definition of those KSFs which allow the organization to pursuit a competitive advantage.
The S.W.O.T. analysis leads to the identification of those corporate critical areas to monitor and better manage to
achieve a better competitive advantage. For example, in the flight industry, the selling price is one of the most important
KSFs, since customers are always buying according to the lowest price principle.
The reporting should be updated basing on management evolutions, such as a result of both:
• The dynamics of the external context;
• Changes in internal organizational structure and operating process.
In this regard, some reporting processes characteristics (for example the timing orientation, the terms of action, and
the reporting form) are correlated to the different typologies of external/internal context changes.
Forms of Control Report useful to deal with the business dynamics in line with current or forecasted
changes in socioeconomic context change.
Reporting as a Result of a Closed External Context of Change A change is defined closed when possible
opportunities or threats relating to the context in which a firm operates are clearly identified (historical analyses and
actual data are available for such an identification). Such a change happened in the same characteristics of the past and
its possible impacts do not produce significant effects in terms of performance. This typology of context change induces
Management Control systems to design a reporting system focused on past performance in order to produce feedback
information able to support the programming and controlling activities.
Reporting as a Result of a Limited Context Change A change is defined limited when possible opportunities or
threats emerging in the context in which a firm operates are sufficiently identified. Such a change happened requires
analysis of both past performance and those future perspectives regarding the next economic and business
administration scenario. This typology of context change induces MC system to design a reporting system focused on
both past and future performance in order to produce feedback and feed forward information able to project in the future
results achieved in the past. The Management Control system should use a Control Report to ensure the ongoing
controlling, in which are accounted past performance, the results achieved in progress during phases of each activity
and the performance related to future events or actions of which it is possible estimate their effects on the final results.
Control report in this case accounts for past performance, and forecasts for each costs, revenues, profit or investment
items as well as variances “actual vs budgeted” and “actual vs forecast”.
The Reporting as a Result of an Opened Context Change When a firm operates in a strongly variable
socioeconomic environment characterized by hardly forecastable and not repetitive events, the reporting process should
be mainly focused on future based or feed forward mechanisms. Control reports in this case are designed in order to
take into account alternative assumptions or future actions. In particular, that reports show results from simulations
produced by “What If” analysis which estimates the probability of some events happened and their possible negative
effects affecting the management. The what if analysis allows the Management Control system to highlight changes in
KPIs in then light of some variations occurred at one or two identified variables. In the case there are several factors
affecting the KPIs dynamics, it needs to carry out sequential analysis considering two independent variables per time.
Therefore, in this case, the control report should summarize the trends of principal economic and financial
alternative forecasts ( i.e. Gross Margin, Operating Profit, Net Income, Debt Exposure) in line with assumed changes
in one or two critical identified variables (i.e. Sales Growth, Selling and Operating Costs Growth, Investment Growth,
Interest Expenses Growth, Inflation Growth).
Forms of Control Reports that Should be Adopted in Line With the Characteristics of the -internal
Organizational Context
A well-designed reporting system takes into account both
• The evolutions of socioeconomic environment in which a firm operates,
• And those critical aspects that characterize the corporate culture.
Therefore, the reporting system design is determined also basing on
1. How the accountability is allocated at the different levels of a typical organization chart (the Accountability Map);
2. The complexity grade of the internal organizational structure.
Generally, the control reports are much more detailed as higher is the number of decision-makers detaining a share of
accountability and as higher the level of organizational structure complexity is.
A reporting system should be designed according four main configurations in line with the combination between the
accountability map and the internal organizational structure peculiarities,
All control reports generally show controllable costs or production items which are directly under the accountability and
control of each manager. The first level is the most analytical one, since it is prepared for each Responsibility Center in
which each operating area is divided. The example shows the Drill Press Department Report: this document only brings
actual values of operating data and cost items that best express the overall performance in such a Responsibility Center.
The first level shows the direct labour hours and the related costs, the controllable general production costs and related
variances. The second level shows the summary of general production controllable costs for both the Drill Press
Department and for all RCs involved in production activities. Moreover, it shows the overall performance achieved by
the overall firm in June.
The third level summarizes all actual, general and controllable costs, and their related variances implemented in June by
the company.
The Reporting Process could be implemented adopting the following
1. Top-Down Approach, when the control reports are managed and shared directly by the top management without
an involvement of lower levels managers and personnel.
2. Bottom- Up Approach, when the I and II levels of Control Reports show objectives predefined by superiors and
shared with RCs’ managers of the same operating areas.
3. A mixed Top-Down & Bottom-Up Approach.
Conversely, III level control report, which summarize the overall performance reported in I and II levels control reports,
are used to inform the top management.
Principal Reporting Models
Tableau de Bord The application of such a reporting model needs to identify those KSFs useful to explain the main
achieved corporate performance and the factors “controlled” by each head of business areas that affect some critical
variables in developing of certain corporate key activities.
The Tableau de Bird is a dashboard that helps the top management in monitoring those KPIs useful for understanding
whether the development of business activities and the implementation of actions are in line with both strategic goals,
the programmed objectives and the scheduled timing.
The design of such a reporting model is articulated in the following phases,
1. Identifying those KSFs through meetings processed, firstly, at the top management level and, secondly, at the lower
organizational levels.
2. Selecting the appropriate KPIs in line with KSFs to control;
3. Defining a set of KPIs correlated with the budgeting system;
4. Measuring corporate performance at the end and each programmed period and setting of possible actions.
The Balanced Scorecard This Reporting Model aims to deal with both financial and non financial information
needs, regarding some critical management aspects to take into account in measuring, evaluating and controlling in
order to monitor the corporate mission achievement.
The BSC reporting ensures the monitoring of corporate performance in different perspectives of analysis which are
focused on the management aspects related to
1. Economic and financial area;
2. Customers’ engagement;
3. Internal business processes;
4. Organizational learning, innovation and firm growth.
The design of such a reporting model is articulated in the following phases:
1. Analysis of corporate mission;
2. Translating of corporate mission in strategic objectives;
3. Debating about the set of designed strategic objectives aligned to the corporate mission at the level of heads’
business areas;
4. Implementation plan designing in order to execute the agreed strategic objectives set aligned to the corporate
mission.
5. Defining a team that will create the BSC, sharing with all organizational levels of both the methodology used and
the related criterion adopted to define such reporting system.
The corporate mission plays a pivotal role in the BSC control and reporting process based on a system able to monitor
management strategic objectives to pursuit in line with four dimensions. BSC control reports highlight the grade of
achievement of those strategic objectives showing the value of relating KPIs and, in some cases, suggesting initiatives
to implant as to enhance the corporate performance and to minimize unfavorable variances limiting the mission
achievement.
The frequency of BSC reports follow a mid-long term timing, often not corresponding with the budgets of fiscal
periods. Moreover, this reporting model is correlated with the rolling budgeting system, with an opened time-horizon,
which allows forecasts aligned with the mission.
Use of Control Reports Managers’ performance can be measured only after they have performed and no
subsequent action by anyone can change what has been done. Of what value, therefore, are reports on past
performance?
First if people know in advance that their performance is going to be measured, reported and judged, they tend to act
differently than if they had believed that no one was going to check up on them. This is an example of decision
influencing purpose of management accounting information. Second, even though it is impossible to alter an event that
has already happened, an a analysis of how people have performed in the past may indicate ways of obtaining better
performance in the future; such analysis leads to learning, This is an example of the decision facilitating purpose of
management accounting information. Corrective action taken by people themselves is important; the system should help
people to help themselves. But action by the superior is often also necessary; such action ranges in severity from giving
verbal criticism or praise, to suggesting specific means of improving future performance, to the extremes of dismissing
or promoting a person.
Steps in Control Process The control process consists of three steps,
1.
2.
Identification The control report is useful only in the first step in the process. It suggests areas that appear to
need investigation. The manager’s superior interprets the variances in the light of her or his own knowledge about
conditions int he Responsibility Center. The superior may have already learned, from conversations or personal
observations, that there is an adequate explanation for the variance or may have observed the need for corrective
action before the report was issued. Some managers say that an essential characteristic of a good management
control system is that reports should contain no surprises. By this they mean that managers of responsibility centers
should inform their superiors as soon as significant events occur and should institute the necessary action
immediately. If this is done, important information will already have been communicated informally to the superior
prior to receipt of the formal report.
In examining the report, the superior attempts to judge both the efficiency and the effectiveness of the
Responsibility Center. To do this, information on outputs is needed. Control reports for standard cost centers
usually contain reliable output information. In many other responsibility centers, output cannot be expressed in
quantitative terms; this is the case with most staff departments of a company and also generally with nonprofit
organizations. In these cases, the reports show, at best whether the managers of the responsibility center spent the
amount that they planned to spend. It does not show what was accomplished — the center’s effectiveness. The
reader of the report must therefore form a judgement as to the manager’s effectiveness by other means, usually by
conversations with those who are familiar with the work done or by personal observation.
For all types of Responsibility Centers, the evaluating manager also must distinguish between items of engineered
cost and items if discretionary cost, With respect to engineered cost, the general rule is “The lower they are, the
better”, consistent with quality and safety standards. With respect to discretionary costs, however, good
performance often consists of spending the amount agreed on. Spending too little may be as bad as, or worse than,
spending too much. A production manager can easily reduce current costs by skimping on maintenance: this action
may not be in the overall long-run best interest of the company, although it results in lower costs on the current
short-run reports performance.
Superiors also must remember that a variance is meaningful only if it is derived from a valid standard. Even a
standard cost may not be an accurate estimate of what costs should have been for either or both of two reasons: (1)
the standard was not set properly or (2) although set properly in the light of conditions existing at the time, those
conditions have changed so that the standard has become obsolete. An essential first step in the analysis of a
variance, therefore, is an examination of the validity of the standard.
Investigation Usually, an investigation of possible significant areas takes the form of a conversation between the
head of a responsibility center and his or her superior. In this conversation, the superior probes to determine
whether further action is warranted. More often than not, it is agreed that special circumstances not anticipated in
the budget have arisen that account for the variance. If the changed circumstances are non controllable, this may be
the explanation for an unfavorable variance, and the responsibility center manager therefore cannot be justifiably
criticized. Corrective action may nevertheless be required because the unfavorable variance indicates that the
company’s overall profit is going to be less than planned.
Another possible explanation of an unfavorable variance is some unexpected, random occurrence, such as a
machine breakdown. The superior should be less concerned about these random events than about tendencies that
are likely to continue in the future unless corrected. Thus, there is particular interest in variances that priests for
several months, especially if they increase in magnitude from one month to the next. The superior wants to find out
what the underlying causes of these trends are and how they can be corrected.
3. Action Based on investigation, the superior decides whether further action is required. The superior and the
manager should agree on the steps that will be taken to remedy the unsatisfactory conditions. Equally important, if
investigation reveals that performance has been good, a pat on the back is appropriate. Of course, frequently no
action at all is indicated. The superior judges that performance is satisfactory, and that is that. The superior should
be particularly careful not to overly emphasize short-run performance. An inherent characteristic of management
control systems is that they tend to focus on short-run rather than long-run performance. Thus, if too much
emphasis is placed on results as shown in current control reports, long-run profitability may be hurt.
Total Quality Management In recent years, many companies have instituted initiatives called total quality
management that involve attempting to enhance on an ongoing basis the effectiveness and efficiency of every aspect of
the business. Not surprisingly, such continuous improvement efforts have produced better results when there was an
explicit attempt made to measure and report the results being achieved.
Continuous improvement efforts usually are focused on activities at lower levels in the organization and involve non
managerial employees as well as the department manager. Most of the non managerial employees are not accustomed to
working with non monetary control reports, and even the manager may rely more on personal observation and
monitoring activities in terms of physical quantities than on reading control reports. In these circumstances, visual
displays in the form of charts and graphs are often the most effective type of control report. The display should track
progress on the key indicators that relate to the department’s key success factors, and it should be visible to all of the
department’s employees. A few companies have concluded that using standard cost and variance reporting for
performance evaluation in lower-level responsibility centers hampers, rather than enhances, continuous improvement
efforts. Such a decision is based on two observations relating behavioral aspects of variance reporting. First, experience
shows that, in most companies, managers focus their investigation almost exclusively on unfavorable variances and
often ignore favorable ones. Yet analysis of favorable variances may provide as many insights into how to improve
operations as analysis of unfavorable ones. Second, in many instances, people stop trying to improve once they reach
the standard. They feel that if they continue to improve, the standard will just be made tougher the following year, or
they feel that they should “save” any further ideas on how to improve until the next time an unfavorable variance needs
to be addressed.
Incentive Compensation Performance-dependent compensation can be a powerful motivating device. The vast
majority of companies in the United States, and increasingly also those in many other countries, provide profit center
and investment center managers with cash bonuses and other forms of rewards (e.g., restricted stock, promotions) based
on their performance. The bonuses can be lucrative, in many cases exceeding 100 percent of base salary.
Typically, “short-term” bonuses are based on a measure of annual performance, although in some companies they are
based on quarterly or even monthly performance. Some companies also use long-term bonus plans that base rewards on
performance measured over a three- or five-year period, or even longer. Managers at higher levels usually receive a
higher percentage of their compensation in the form of bonuses than do managers at lower levels, and the time horizon
for at least a portion of the performance bonus for higher-level managers is longer.
Most bonus plans have both a quantitative aspect and a judgmental aspect; the bonus is based in part on the control
report, and in part on the superior’s judgment about the manager’s performance. This judgment is applied to
unmeasurable aspects of performance, such as whether the manager took some action that improved this year’s
measured results but that will be harmful to the company in the future.
KEY PERFORMANCE INDICATORS
Chapter 27
Longer-Run Decisions: Capital Budgeting
As regards the nature of the problem that stays at the background of capital budgeting, the typical situation is
that of an organization that budgeted to produce internally or to purchase a long lived asset. This budgeted
operation allows management to allocate financial resources, making real the investment, just like the bank
does when operating a loan.
The similarity consists in the fact that the cash is committed today in the expectation of being recovered plus
an additional amount of cash. In this case, our organization, as an investor, commits cash today with the
expectation of receiving both a return on the investment and a satisfactory profit: the return on investment
and the profit are in the form of cash earnings generated by the sue of that asset. If over the life on the
investment the inflows of cash earning exceed the initial investment outlays, we know the original
investment was recovered. Thus, an investment is the purchase of an expected future stream of cash inflows.
When an organization considers whether to buy a new long lived asset, the question is whether the expected
future cash inflows are likely to be large enough to warrant making the investment. This is the typical
definition that leads to the elaboration of capital budgets, and that characterizes the capital budgeting
problems.
A capital budget is a list of capital investment projects that an organization has decided to carry out.
Examples of capital budgeting issues are
• Replacement, that is to say, shall we replace existing equipment with more efficient equipment?
• Expansion, that is to say, should we acquire a new facility? In this case, the objective of the study is the
future expected cash inflows on the investment that are the cash profits for goods and services produced in
new facilities. The analysis takes into account these typical items.
• Cost reduction, that is to say, should we buy equipment to automate that manual operation? In this case, it
is important to focus on money expenditure to save money: the future cash inflows from such an
investment are represented by savings in operating costs.
• Choice, that is to say, which brand and model of equipment should we buy? The tricky game is that the
choice turn on items expected to give the largest return.
• New product, that is to say, should we add a new product line? In this case, the choice is on whether
expected cash inflows from the sale of new products are large enough to warren equipment, working
capital and required costs investments.
Capital budgeting differs from sales, production another business functions budgeting due to the fact that the
CAPEX Budget reports data regarding,
• Fixed assets acquisition projects to implementing the future period;
• Mid or long-term timeline;
• Investment programs related to all corporate functioning areas or part of them in the overall organization.
An investment evaluation has to take into account the impacts of production notably in financial terms, but
also in economic terms. There is also the need to improve skills, knowledge, and to have trainings, courses,
activities, to give the personnel the possibility to efficiently used the newly purchased long-lived asset.
The strategic planning in a specific section sets up the investment plan to be carried out in a specific timing
period. In that document, some information as regards budgeted investments (approved or to be approved
proposals) can be found; these involve activities related to sales, selling, production and other business
functions areas. At the same time, we have to consider that this relationship is translated in terms of budgets,
and the budgeting process of capital could produce effects in terms of data allocation, information that could
be used in other business functional areas’ budgets.
In the CAPEX budget we find information as regards proposals approved or to be approved on the topic of
investment aimed at the internal production of long-lived assets or at the purchased of new long-lived assets.
Some technical aspects are to be taken into account in the Capital Budgeting preparation process.
From the Financial Point of View Investment projects require monetary outflows defined on specific
disbursement plans agreed with the assets suppliers, or the allocation of certain financial resources to activate
the internal production of new fixed assets. Therefore, the CAPEX has to highlight periodic payments to
process in line with redefined deadlines. This must be aligned with the Cash Flow Budget which allows the
financial covering of those expenses.
From the Economic and Balance Sheet Standpoints the CAPEX reports the value of capital invested to
acquire those assets to be reported in the fixed assets section of the Balance Sheet Budget. The inclusion of a
new long-lived asset needs to identify the depreciation annual shares to be included in the economic budget.
CAPEX budgeting process presents the following main phases,
• Analysis of investment long-term plan;
• Inclusion fo the investment projects in CAPEX Budget;
• CAPEX Budget preparation;
• Economic and financial sustainability analysis of budgeted investment projects that gives the status quo in
terms of approval;
• Technical analysis regarding the budgeted investment project execution;
• Project investment authorization from the top management;
• Ex post control and analysis.
Capital budgeting processes involve a set of critical variables that characterize investment in general,
• Required rate of return. Two alternative ways of computing it are (1) The trial and error approach,
which recalls that the higher the required rate of return, the lower the present value of cash inflows;
therefore, the fewer the investment proposals that will have cash inflows whose present value exceeds the
amount of the investment. Thus, if a given rate results in the rejection of many proposed investments that
management intuitively feels are acceptable, or if not enough proposals are being sent to senior
management for final approval, the indication is that this rate is too high. Conversely, if a given rate results
in senior management receiving a flood of project proposals, the indication is that the rate is too low. As a
starting point in this trial and error process, a company may select a rate that other companies in the same
industry use. (2) The cost of capital approach, which is a theoretical approach that requires the rate of
•
•
•
•
return to be equal to the company’s cost of capital. This is the cost of debt capital plus the cost of equity
capital, wighted by the relative amount of each in the company’s capital structure. The problem with the
cost of capital approach is that, although the cost of debt is usually known within narrow limits, the cost of
equity is difficult to estimate. Conceptually, the cost of equity capital is the rate of return that equity
investors expect to earn on their investment in the company’s stock. These expectations are reflected in the
stock’s market price; but getting from the concept of the cost of equity to a specific number can be a
difficult trip. As regards the selection of a rate, most companies use a judgmental approach in establishing
the required rate of return; either they experiment various rates by the trial and error method, or they
judgmentally settle on a rate because they feel elaborate calculations are likely to be fruitless. In general,
the return demanded for an investment varies directly with the investment’s risk. Thus, the required return
for an individual investment project of greater-than-average risk should be higher that the average rate of
return on all projects. Conversely, a project with below-average risk should have a lower required rate.
Economic life, that is, the number of years for which cash inflows are anticipated, namely, the number of
years over which cash inflows are expected as a consequence of making the investment. Even though they
may be expected for an indefinitely long period, the economic life is usually set at a specified maximum
number of years, such as 10, 15 and 20. The end of the period selected for the economic life is called the
investment horizon, which suggests that beyond this time, cash inflows are not visible. Economic life can
rarely be exactly estimated, but the best possible estimate must be made, for the economic life has a
significant effect on the calculations. For example, when a proposed project involves the purchase of
equipment, the economic life of the investment corresponds to the estimated service life of the equipment
to the user. When thinking about the life of equipment, there is a tendency to consider primarily its
physical life, but in most cases the economic life of the equipment is considerably shorter than its physical
life. The primary reason is that technological progress makes equipment obsolete and the investment in the
equipment will cease to earn a return when it is replaced by even better equipment. The economic life also
ends when the entity ceases to make profitable use of the equipment.
Amount of cash inflows in each year. The earnings from an investment are the additional amounts of cash
expected to flow in as a consequence of making the investment compared with what the cash inflows
would be if the investment was not made. The discount rate already includes an inflation component, so
inflation is calculated in discount processes. The depreciation on the proposed equipments is not an item
of differential cost. In capital investment problems, we analyze cash inflows. The cash flow associated with
the acquisition of equipment is an outflow at time zero. This cash outflow is the amount of the investment
against which the present value of the expected future cash inflows is compared. Because of the matching
concept, accrual accounting capitalizes this initial cost as an asset, and then uses depreciation to charge the
cost systematically to the periods in which the asset is used. The accounting entries tor record depreciation
(Depreciation Expense, Accumulated Depreciation) have no impact on cash. When estimating inflows, we
do not consider depreciation impact on that value.
Amount of investment. The investment is the amount of the funds an entity risks if it accepts an
investment proposal. The relevant investment costs are the differential costs, namely, the cash outlays that
will be made if the project is undertaken but that will not be made if it is not undertaken. The cost of the
asset itself, any shipping and installation costs and costs of training employees in the use of the new asset
are examples of differentia investment costs. These outlays are part of the investment, even though some of
them may not be capitalized (treated as assets) in the accounting records.
Terminal value of each investment project. A project may have a value at the end of its time horizon: this
terminal value is a cash inflow at that time. The discounted amount of the terminal value is added to the
present value of the other cash inflows. There are several types of terminal value: for example, residual
value. In many cases, the estimated residual value is so small and so far in the future that has no significant
effect on the decision. When the estimated residual value is significant, the net residual value is viewed as
a cash inflow at the time of disposal, and is discounted along with the other cash inflows. Often the
terminal value of the investments is reasonably assumed to be approximately the same as the amount of the
initial investment: these assets can be liquidated according to their original costs. The amount of terminal
current assets, net of any related accounts payable settlements, is treated as a cash inflow in the last year of
the project, and its present value is found by discounting that amount at the required rate of return.
The economic and financial sustainability analysis of budgeted investment projects has a great relevance.
Studies in literature identify the following evaluation methods which are commonly used by firms.
Payback Period Approach This method computes the number of years over which the investment outlay
will be recovered, namely, the payback period. It is often used as a quick but crude method for appraising
proposed investments. If the payback period is equal to, or only slightly less than, the economic life of the
project, then the proposal is clearly unacceptable. If the payback period is considerably less than the
economic life of our investment proposal, then the project begins to look attracting. If several investment
proposals have the same general characteristics, then the payback period can be used as a valid way of
screening out the unacceptable proposals.
The danger of using payback as a criterion is that gives no consideration to differences in the length of the
estimated economic lives of various projects. There may be a tendency to conclude that the shorter the
payback period, the better the investment is.
Discounted Payback Approach The present value of each year’s cash inflows is computed, and these are
cumulated year by year until they are equal or exceed the amount of the investment. The year in which this
happens is the discounted payback period. For example, a discounted payback of 5 years means that the total
cash inflows over a 5 years period will be large enough to recover the investment and to provide the required
return on investment. If the decision-maker considers that the economic life of the investment project should
be at least long equal to this period, then that investment proposal is acceptable.
Unadjusted Return on Investment Approach The net income expected to be earned from the project
each year is computed in accordance with the principles of accrual accounting, including a provision for
depreciation expense.
The unadjusted return on investment is found by dividing the annual net income either by the amount of the
investment or by one-half the amount of the investment. This method is also referred to as the accounting
rate of return method. Since depreciation expense in accrual accounting provides for the recovering of the
cost of depress cable assets, one may suppose that the return on the investment could be found by relating the
investment to its accrual accounting income after depreciation; but such is not the case. The calculation,
instead, will be as summarized by the red lines. An investment of $1200 with cash inflows of $400 a year for
four years has a return of 12%. In the unadjusted return method, the calculation would be as it is shown:
dividing net income ($100) by the investment ($1200) gives an indicated return of 8%. But we know this
result is incorrect: the true return is 12%. If we divide the $100 net income by one-half of the investment
($600), the result is 16%, which is also incorrect. This error arises because the unadjusted return method
makes no adjustment for the differences in present values of the inflows of the various years. The unadjusted
method, based on the gross amount of the investment, will always understate the true return.
Net Present Value Approach is the most used approach to identify the investment proposal. It focuses on
the difference between the present value of cash inflows and the present value of cash outflows over a period
of time. NPV is sued in capital budgeting and investment planning to analyze the profitability of a projected
investment project. It identifies the sum or the net of the present value of all cash outflows and inflows
related to an investment
And if NVP is zero or higher than zero, then that investment project is quantitatively acceptable.
This example focuses on the variables that characterize the investment assessment approach NPV. The
investment total cost in of $9000, taking into account installation costs and the sales of the old plants to be
replaced. This sum is the computation of the total investment, investment capital at time zero. Then we have
the cash flow of all cash inflows earnings, capitalized and discounted by the 40% discounting rate, and then
we have the residual value that is computed just like a dismantling cost actualized at the 40% discounting
rate. The economic life of the investment is equal to 5 years, and we have to compute the total inflows that er
cash inflows plus residual value.
The analysis will assess the comparison between total inflows and total investment; in this case, total inflows
are higher, and the investment proposal is financially acceptable.
In order to compare two or more investment projects using NPV method we must relate the size of the
discounted cash inflows to the amount of money risked. This comparison is based considering the
profitability index, which is computed dividing the present value of the cash inflows by the amount of
investment. The higher the profitability index, the better the project.
The quantitative analysis involved in a capital investment proposal does not provide the complete solution to
the problem because it encompasses only those elements that can be reduced to numbers. For many capital
expenditure proposals in the research and development and general administrative areas, no reliable estimate
of increased revenues or decreased costs can be made, so the NPV approach is not feasible.
Possible important non monetary considerations in the NPV method and in investment decision-making
process are
• Necessity, for example safety, pollution control.
• Maintain status quo, for example competitor’s action. The status quo alternative may be incorrectly stated:
it may implicitly be assumed that if a proposal for anew process is rejected, the sales of the products made
with the existing process will continue as is.
• Training or start-up costs associated with some new technology may be included in their entirety in the
first proposal that will benefit from them, when in fact these costs will benefit similar followh-onprojects in
the future. This causes a negative bias in the initial analysis of the project.
• Gain foothold, that is to say, a new product line.
• Human error, that is, the use of overly optimistic estimates or hidden costs.
• Benefits generated for other projects.
• Difficulties in quantifying or high risk.
Summing up, the steps of the NPV method are
1. Select a required rate of return.
2. Estimate the economic life of a proposed project.
3. Estimate differential cash inflows for each year.
4. Determine net investment made at time zero and later periods if needed.
5. Estimate terminal values at end of economic life.
6.
7.
8.
Find present value of all inflows and outflows by discounting.
Determine present vale by subtracting the net investment (outflows) from present value of inflows. If
NPV is zero or positive, accept the project. If NPV is negative, reject the project,
Take into account non monetary factors and reach a decision.
Internal Rate of Return Approach is a complementary approach to the NPV one. When the NPV
method is used, the required rate of return must be selected in advance of making the calculations because
this rate is used to discount cash inflows in each year. The IRR approach avoids this difficulty: it computes
the rate of return that equates the present value of the cash inflows with the present value of the investment
— the rate that makes the NPV equal to zero. The calculated rate is the internal rate of return or
discounted cash flow (DFC) rate of return.
If the opportunity cost of the invested capital to execute a project is lower than the IRR, then that project can
be implemented.
Economic Value Added Approach EVA is a measure of a company’s financial performance based on the
residual wealth calculated by deducting its cost of capital from its operating profit, adjusted for taxes on a
cash basis.
NOPAT Non Operating Profit After Taxes which shows how well a company performed through its core
operations, net of taxes.
Invested Capital = Equity + Financial Debts(+/- Adjustments)
Wighted Average Cost of Invested Capital which takes in account each category of capital (common stock,
preferred stock, bonds, and any other long-term debt) proportionately weighted. A firm’s WACC is the
overall required return for a firm.
Multiple Decision Criteria Most companies use two or more methods to analyze a potential capital
investment. The use of decision criteria that do not involve discounting is explained by several factors. Some
corporate managers tend to be concerned about the short-run impact a proposed project would have on
corporate profitability as reported in the published financial statements. Thus, a project acceptable according
to the NPV criterion may be rejected because it will reduce the company’s reported net income and
accounting return on investment in the first year or two of the project. If management believes that the
accounting ROI is sued by securities analysts in evaluating a company’s securities, management may use the
unadjusted return method as one of its decision criteria.
The manager of a profit center may have similar concerns. If he feels that his carrier advancement is related
to near-term profitability of the profit center, then a proposal that would have an adverse short-run impact
on those profits may never be submitted to corporate headquarters. This is particularly likely to happen if the
manager has incentives compensation tied to the profit center’s short-term profitability.
Another factor explaining why projects that have an acceptable net present value or a positive and acceptable
IRR are sometimes rejected is risk aversion: although a given proposal may constitute an acceptablegamfle, a
manager may fear being penalized if the project doesn’t work out. Risk aversion probably explains the
widespread use, despite its conceptual flaws, of the payback criterion. In sum, factors other than true
economic return of a project greatly influence whether a project is approved and even whether the project is
formally proposed up to top management.
There are two classes of investment problems,
Screening problems, where the question is whether or not to accept the proposed investment. Many
individual proposals come to management’s attention, and those that are worthwhile are screened.
Preference problems question, of a number of proposals, each of which has an adequate return, how are
they ranked in terms of preference. The decision may merely involve a choice between two competing
proposals, or it may require that a series of proposals be ranked in order of their attractiveness. Such a
ranking of projects is necessary when there are more worthwhile proposals than finds available to finance
them, which is often the case. Both the IRR and NPV methods are used for reference problems. If the
internal rate of return method is used, the preference rule is as follows: the higher the IRR, the better the
project, provided that they are of equal risk. If the projects entail different degrees of risk, then judgement
must be used to decide how much higher the IRR of the more risky project should be.
If the net present value method is used, the present value of the cash inflows of one project cannot be directly
compared with the present value of the cash inflows of another unless the investments are of the same size.
In order to compare two proposals under the NPV method, therefore, we must relate the size of the
discounted cash inflows to the amount of money risked. This is done by simply dividing the present value of
the cash inflows by the amount of the investment, to give a ratio that is the profitability index.
The Balanced Scorecard
This is the typical model that needs to continue to survive and grow in time: every organization has to set an integrated
management control system aimed at well operationalizing the strategic plan recalling the purpose, vision, mission, and
strategy the firm aims to implement in a certain period to achieve a business success.
In 2008 Kaplan and Norton followed the idea of Balanced Scorecard, generated in the early 90s, deepened their prior
studied and focused on the six stages of the management system:
1. Develop The Strategy The model starts from the first stage, the description of an integrated process in which the
manager develops strategies using appropriate techniques, such as the S.W.O.T. analysis. The five competitive
forces proposed by Porter in 1990 and the value chain model proposed by the same author in 1985 are the levels
examined by managers in developing the strategy, setting these planning activities taking in mind the number and
power of companies’ rivals, market entrants, suppliers, customers, substitute products influence on the company’s
profitability. The value chan is a complex topic to analyze in order to better elaborate the strategy, since this model
describes the four ranges of activity needed to create a product or service. For companies that produce goods, a
value chain comprises the steps that involve bridging the product form conception to the distribution step. A
company conducts a value chain analysis in formulating new strategies by evaluating the detailed procedures
involved one each step of its business activities. This is to increase production efficiency so that the company can
deliver maximum value for the least possible cost.
2. Translate The Strategy Managers are called to elaborate plans that formalize the strategy to be implemented in a
mid long-term period. For this aim, two main tools are used: the integrated strategy map and the BSC. These
enable the organization to describe and illustrate in clear language its objectives, initiatives and targets; the
managers use them to assess their performance along different dimensions and linkages that are the foundation for
strategic direction.
3. Align The Organization The integrated strategy map and BSC are linked and diffused to all organization units,
their managers and employees. Int his stage, personal objectives and incentives of employees are aligned with
strategic objectives.
4. Plan Operations All the organizational units and employees are already aligned with the strategy and operational
planning, and they use appropriate tools, such as quality and process management, reengineering process activity
based ghosting.
5. Monitor and Learn The organization, in this case, monitors and learns about problems, barriers and challenges in
implementing strategies using the strategy map and the BSC.
6. Test & Adapt In this stage, the organization’s managerial activities test and adapt. Managers use internal operation
data produced by Management Control systems and new external contingencies’ competitive data to adapt the
strategy according to the feedback loop. The evaluation aims at rethinking or confirm strategies.
In these two last stages, according to Kaplan and Norton, it is also possible to launch a new loop around the integrated
strategy planning and operation execution system. In this clear framework, the use of the strategy map and BSC allow
the organization to well execute its purposes, vision and mission.
The Balanced Scorecard The Balanced Scorecard was originally developed by Kaplan and Norton. It is a
management tool that supports the successful implementation of corporate strategies, through the alignment and
management of corporate activities according two their strategic relevance. The Balanced Scorecard translates a
company’s vision and strategy into strategic objectives, performance indicators, targets and measures with respect to
four perspectives: finance, customers, internal business processes, learning and growth.
The Balanced Scorecard is a flexible tool: it allows companies to adapt themselves to the growing complexity ad
mutability of the market environment in which they operate. Its functions are
1. External Perspective The identification of successful strategies that make the company competitive;
2. Internal Perspective The understanding of strategies within the company, as well as their actual execution,
aligning corporate culture, strategy and employees’ motivations.
The Bottom-Up Process of the Balanced Scorecard involves superiors and Responsibility Centers managers in
debating on how to set strategic objectives aligned with corporate purpose, vision or mission, strategy and designing a
BSC implementation plan. Objectives and measures in all BSC perspectives are deduced from the long-term strategic
goals defined in the strategic plan.
The advantage of it is that all business activities are linked to the successful implementation of the business strategy.
Objectives and key performance indicators are linked in a chain of cause-effect relationships able to make visible the
links between the strategic issues of a company and the activities that will lead to the achievement of the predefined
objectives, defined in the
Strategy Map
This is the Strategy Map of a company operating in the mobile industry. The vision is what a company would like to see
in the next future. The purpose os the reason of the existence of such a company. This document identifies the key
success factors reported in terms of strategic priorities, translated in strategic results to achieve.
The Balanced Scorecard team designs strategy map considering all the four dimensions typical of the BSC system. The
difficulty is to try to put together in a cause-effect relationship different strategic objectives that refer to different
dimensions, all evaluated according to difference KPIs. If the firm is aiming to achieve financial strategic objectives,
such as to increase revenue profitability, and on the other hand decreasing operating firms, the firm should attract
customers through improvements in clarity of the offering, market perception and customer satisfaction. The decrease
in operating costs could also be achieved by achieving cost control, highlighted in the internal process dimension
improvement. Moreover, the firm, to enhance customer activity and improve the financial dimension, should pay
attention to other internal processes, such as offering selection, information services and stock reliability. But these
internal processes need to be improved through the identification of determinant objectives related tot he growth of
business areas and organizational capacity (improvements in knowledge and skills, improvements in technology and
improvements in the supply chain). The targets show how the company should perform in order to be successful; they
are expressed as percentages or absolute terms, therefore there are different numbers for different objectives to achieve.
The company is therefore allowed to define strategic projects to execute strategies aimed at pursuing targets aligned
with the KPIs.
Financial Perspective makes explicit the impact of strategies on value creation, by examining the economic and
financial results. It indicates whether the transformation of a strategy leads to improved economic success. The BSC
must continue to emphasize the economic-financial results, to which all the other measures of the scorecard are
ultimately linked.
Examples of objectives and measures of the financial perspective are,
• Objectives Profitability of the company, growth rate, value created for shareholders, increase in sales, cost reduction;
• Measures Operating income, revenue growth, ROI, ROE and cost reduction in specific areas.
Customer Perspective defines the customer/market segments in which the business completes. It allows managers to
articulate a strategy oriented towards customer satisfaction and retention (and, therefore, more profits in the future).
The definition of the customer value proposition is operated by means of appropriate strategic objectives, measure,
targets and initiatives, through which the firm wants to achieve a competitive advantage.
Examples of objectives and measures of the customer perspective are,
• Objective I Increase market share;
Measures New customers (% of increase).
• Objective II Increase customer satisfaction;
Measures Level of customer satisfaction, delivery time, effectiveness of after-sales customer assistance, number of
returned goods, number of maintenance.
Internal Processes Perspective identifies those internal business processes that enable the firm to meet the
expectations of customers in the target market and those of the shareholders.
Examples of objectives and measures of the internal process perspective are,
• Objectives Improve business innovation;
• Measures Number of new products or services developed over a certain period of time, investments in research and
development.
Learning and Growth Dimension describes the infrastructure necessary for the achievement of the objectives of
the other three perspectives. The most important areas are qualification, motivation and goal orientation of
employees, and information systems. It ranks strategic activities focusing on the need and capacity of the firm to learn
from external and internal contingencies as well as dynamics. The behavioral skills of managers and employees are
taken into account to sustain learning process, that are fundamental to avoid the detriment of the success of the firm’s
business areas.
Examples of objectives and measures of the learning and growth perspective are,
• Objective Align the objectives of the company with those of the staff;
• Measures Survey to evaluate company staff satisfaction, % of corporate turnover.
Chapter 28
Management Accounting Design
The design of the management accounting system is complex but it is crucial for the strategy execution because, as we
know, management accounting systems aim to integrate various processes like information collection, elaboration,
measuring, reporting activity, budgeting process, control etc.
As we learned at the beginning of the course, financial accounting information is different from the management
accounting one that helps the organization internally. Financial accounting documents need to be prepared in accordance
with GAAP (General Accepted Accounting Principles); they are primarily useful for interest outside users such as
shareholders, bondholders, banks and other creditors and they are built around the basic equation of: Assets = Liabilities
+ Owners’ Equity. In contrast, management accounting has three primary purposes and each of them requires a different
cost construct. These three purposes are measurement, control and alternative choice problems. Information used for
the first two purposes, is directly taken from the management accounting system: for the measurement purpose the system
collects the full cost of cost object, while for the control purpose it collects costs by responsibility centres. For the third
purpose of solving alternative choice problems, information does not come directly from the management accounting
system but the systems assists in finding the best solutions.
Talking about the measurement purpose, costs it’s self-measured, it expresses in monetary terms the amount of resources
used for something (cost object). To determine the full cost of a cost object, we have to sum the direct cost + a fair share
of indirect cost. The main cost objects in a company are the goods/services that it produces and sells; companies use
accounting systems to collect its product cost and generally they use full costing system (only few companies use variable
costing systems). The full cost principle can be used to measure any activity of interest for example training programs,
not only product cost; full cost are used in financial accounting to measure inventory and cost of sales and in management
accounting to determine prices, analyse economic performance of business segments and the profitability of products.
Regarding the control purpose of management accounting, we can say that it collects costs incurred in responsibility
centers, which are organization units headed by managers which are held accountable for the center’s performance.
Managers compare actual inputs and outputs to planned inputs and outputs, they identify the variance and investigate it,
then corrective actions are taken. Behavioral considerations are at least as important as accounting considerations in this
management control process.
In finding the preferable alternative in the alternative choice purpose, differential costs (amounts that are different
under one set of conditions than they would be under another) are analyzed (they could also be differential revenues or
differential assets). Relevant data to address alternative choice problems varies according to the specific issue, so
managers should utilize their judgement and knowledge. In short-run problems, contribution analysis is appropriate, in
longer run or capital budgeting problems the present value analysis of cash inflows and outflows is used.
There are a number of categories of costs that management accounting collects, analyzes and reports and uses them to
revise budgeting, strategies or management activities. Management accounting systems depends on the measure of the
cost items and the use of its information. There are eight ways of categorizing costs:
1. Accounting treatment: when a cost happens, it is treated either as a reduction of retained earnings (expensed)
or as an increase in assets (capitalized). Costs that are expensed as they are incurred are called period costs.
Capitalized costs include plant, equipment, material, supplies but also the cost of working progress and goods
inventory. Product costs are expensed when the product is sold while plant, equipment… are depreciated
(amortized) over their useful life.
2. Traceability to a cost object: direct costs are costs that can be traced to a single cost object, indirect costs
are associated with two or more cost objects jointly; at the end the full cost of a cost object is the sum of the
direct costs + the indirect costs. The terms direct and indirect costs are meaningful only when related to a specific
cost object (e.g. a plant manager’s salary is a direct cost of the plant but indirect of each product produced in the
plant). Indirect production costs are also known as production overhead, factory overhead, overhead.
3. Cost element: it indicated where cost occurred, for example materials costs, direct labor costs, selling costs.
4. Behavior with respect to volume:
- Variable cost: item of cost where the total cost varies proportionately with volume, an example is the
materials cost in a production setting;
- Fixed (non-variable) cost: cost that vary less that proportionally with volume, they can be decomposed
into their fixed and variable cost components;
- Semi-variable (mixed) cost: is in part variable and in part fixed cost;
- Step-function cost: costs that increase in chunks as volume increases.
In describing cost behavior with respect to volume, a relevant range and time period must be stated.
5. Time perspective: actual costs are costs at the time of the transaction, standard costs are estimated future
cost on per unit amounts, budgeted costs are estimated future costs in total per time period.
6. Degree of managerial influence: controllable cost are costs that the responsibility center managers can
significantly influence, non-controllable costs are the ones that responsibility center managers cannot
significantly influence (they are presumably controlled by someone else in the organization).
7.
Ability to budget right amounts:
-
8.
Engineered cost: the right or proper amount to spend for some activity is predetermined (e.g. direct material
production costs);
- Discretionary (programmed, managed) cost: the proper amount to spend is a matter of judgement;
- Committed cost: a cost that is an inevitable consequence of a past decisions and can be budgeted with
certainty (e.g. annual rent expense signed last year for 5 years);
- Sunk cost: depreciation of fixed assets, for example on equipment; it is a type of committed cost.
Changeability with respect to specified conditions: differential (incremental, avoidable) cost are costs
that are different under one set of circumstances than under another (alternative choice problem) and they are
always estimated future costs.
As previously stated, accounting information must be captured from valuable sources and documents that are management
by ICTs, thanks to the digitalization of the management accounting system; this is very useful for managers to collect
data and to make the decision-making process faster. The accounting database include for example vendor invoices,
billing documents, payment records etc; these data is recorded using the double-entry accounting system and collected in
the chart of accounts that determines the structure of the accounting database. A major design issue in management
accounting is the level of detail that the chart of accounts needs to have: it must satisfy the requirements of multiple users
and purposes (management accounting, financial accounting, tax accounting). Many organizations prefer a detailed
system that means to design a complex accounting system; a benefit/costs analysis must be performed because of the cost
of rewriting all the computer programs to be more detailed.
An organization faces many choices when designing its cost accounting system: those choices include job costing vs.
process costing; actual cost vs. standard cost; choices of volume measures. Cost accounting systems are unique for every
organization, they could depend on the specific industry, on the dynamics of the firm, on the strategy…, however there
should be one integrated accounting database underlying the several systems, because each system simply organizes the
accounts in different ways useful for its purpose. The availability of accounting information is crucial to support full cost
and differential analyses and behavioural considerations are of equal importance to responsibility accounting
information in the management control process. Every practice of management control should held up to the goal
congruence between individual business participants (managers, employees); goal congruence needs to be tested to see
what actions motivate managers to take in their own perceived self-interest and which action could be in the best interest
for the organization. Organizations frequently ignore the important aspect of behavioural considerations and goal
congruence is often not used. Other common mistakes in management control consist of assuming favourable or
unfavourable variances between actual and standard cost information in variance analysis (poor management
performance) and not commending managers for favourable performance.