Management Control System

Unit 5:

Management Control System

5.1 Introduction

Every organization needs basic systems for allocating financial resources, approving and developing human resources, analyzing financial performance, and evaluating operational productivity. In long established organizations the challenge for managers is to know how to use these control systems and improve them. In new, entrepreneurial firms – specially those that have grown rapidly – managers must design and implement new control systems.

We will begin by explaining how multiple control systems fit together to provide overall control for top managers and then examine control systems used by middle managers.


5.2 Core Management Control System

Research into the design of control systems across organizations has revealed the existence of a core management control system. The core control system consists of strategic plans, financial forecasts, budgets, management by objectives, operations management techniques and MIS reports that together provide an integrated system for directing and monitoring organizational activities. The elements of the core control system and their relationship to one another are indicated in the figure below.

The strategic plan consists of the organization's strategic goals and is based on in-depth analysis of the organization's industry position, internal strengths and weaknesses, and environmental opportunities and threats. The financial forecast is based on a one-to five-year project of company sales and revenues and is used to project income statements, balance sheet, and departmental expenditures. The operating budget is an annual projection of estimated expenses, revenues assets and related financial figures for each operating department for the coming year. Budget reports typically are issued monthly and include comparisons of expenditures with budget targets. Budget reports are developed for all divisions and departments.

Many companies also use management by objectives to direct employee activities toward corporate goals. MBO is integrated into the performance appraisal system and enhances management control. Operations management systems and reports pertain to inventory (economic order quantity, just in time), purchasing and distribution systems, and project management (PERT charts). Management Information Systems (MIS) reports are composed of statistical data, such as personnel complements, volume of orders received, delinquent account ratios, percentage sales returns, and other statistical data relevant to the performance of a department or division.

Each control system component is separate and distinct from the others. However, a successful core control system combines them into an integrated package of controls. In recent years, many companies have adopted new approaches to simultaneously control costs and improve organizational performance. The manager's shoptalk box describes how technology driven, "paperless" management systems are helping companies meet new needs.


5.3 Top Management Financial Control

Based on the overall strategic plan, top management must define a financial forecast for the organization, perform financial analysis of selected ratios to reveal business performance, and use financial audits to evaluate internal operations. Each of these controls is based on financial statements – the building blocks of financial control.

   5.3.1 Financial Statements: The Basic Numbers

Financial statements provide the basic information used for financial control of a company. Two major financial statements – the balance sheet and the income statement – are the starting points for financial control.

The balance sheet shows the firm's financial position with respect to assets and liabilities at a specific point in time. An example of a balance sheet is presented in the table below. The balance sheet provides three types of information; assets, liabilities and owner's equity. Assets are what the company owns and include current assets (assets that can be converted into cash in a short time period) and fixed assets (assets such as buildings and equipment that are long term in nature). Liabilities are the firm's debts and include both current debt (obligations that will be paid by the company in the near future) and long-term debt (obligations payable over a long period). Owner's equity is the difference between assets and liabilities and is the company's net worth in stock and retained earnings.

The income statement, sometimes called a profit-and-loss statement, summarizes the firm's financial performance for a given time interval usually one year. A sample income statement is given in the table below. Some firms calculate the income statement at three-months intervals during the year to see if they are on target for sales and profits. The income statement shows revenues coming into the organization from all sources and subtract all expenses, including cost of goods sold, interest, taxes, and depreciation. The bottom line indicates the net income – profit or loss – for the given time period.

For example, some organizations used the income statement to detect that sales and profits were dropping during certain periods. And they immediately evaluate company activities and take action on some losing stores. This use of the income statement follow the control cycle, beginning with the measurement of actual performance and then taking corrective action to improve performance to meet targets.


   5.3.2 Financial Analysis: Interpreting the Numbers

The most important numbers typically are not actually dollars spent or earned but ratios. Any business is a set of hundreds of relationship among people, things, and events. Key relationships are typically revenue in ratios that provide insight into some aspect of company behavior. These insights make manager decision making possible. A financial ratio is the comparison of two financial numbers. To understand their business, managers have to understand financial ratios.

Several financial ratios can be studied to interpret company performance. Managers must decide which ratios reveal the most important relationships for their business. Frequently calculated ratios typically pertain to liquidity, activity, and profitability. Many companies compare their performance with those of other firms in the same industry as well as with their own budget targets.

Liquidity Ratio: it indicates the organization's ability to meet its current debt obligations. For example, the current ratio tells whether there are sufficient assets to convert into cash to pay off debts if needed. If a hypothetical company had current asset of $600,000 and current liabilities of $ 250,000, the current ratio is 2.4, meaning it has sufficient funds to pay off immediate debts 2.4 times. This is normally considered a satisfactory margin of safety.

Activity Ratio: it measures internal performance with respect to key activities defined by management. For example, inventory turnover is calculated by dividing total sales by average inventory. This ratio tells how many times the inventory is turned over to meet the total sales figure. If inventory sits too long, money is wasted. 

Profitability Ratio: it describes the organization's profits. One important profitability ratio is the profit margin on sales, which is calculated as net income divided by sales. Another profitability measure is return on total assets (ROA), which is the percentage return on investors on assets. It is a valuable yardstick of the return on investment compared with their investment opportunities.

Analyzing these various financial ratios can help managers of different companies understand their business more clearly, especially with the increase in global competition.


   5.3.3 Financial Audits: Verifying the Numbers

Financial audits are independent appraisals of the organizations financial records. Audits are of two types – External and Internal.  An external audit is conducted by experts, from outside the organization, typically certified public accountants (CPAs) or CPA firms. An internal audit is handled by experts within the organization. Large companies have an accounting staff assigned to the internal audit function. The internal auditors evaluate departments and divisions throughout the corporation to ensure that operations are efficient and conducted according to prescribed company practices.

Both external and internal audits should be thorough. Their purpose is to examine every nook and cranny to verify that the financial statement represents actual company operations. The following are some of the areas examined by auditors:

  • Cash: go to banks and confirm bank balance, review cash management procedures.
  • Receivables: obtain guarantees from customers concerning amounts owed and anticipated payments; confirm balances.

  • Inventory: conduct physical count of inventory and compare with financial statement; review for obsolescence.

  • Fixed assets: make physical observation, evaluate depreciation determine whether insurance is adequate

  • .

    Loans: review loan agreements; summarize obligations.

  • Revenues and expenses: evaluating timing, propriety and amount.

Using Financial Controls

Remember that the point of financial numbers is to gain insight into company relationships to identify areas out of control and take corrective action. Managers must use numbers wisely and see beneath the surface to decide exactly what is causing the problem and devise a solution. A financial performance short fall often has several causes, and managers must be familiar with company operations and activities in order to make an accurate diagnosis. Managers can use numbers creatively and dig beneath the figures to find the causes of problems. After defining the causes, they can initiate programs that will rectify the problem and bring the financial figures back into line.


5.4 Middle Management budge Control

Budgets are a primary control device for middle management. Of course, top managers too are involved with budgets for the company as a whole, but middle managers are responsible for the budget performance of their departments or divisions. Budgets identify both planned and actual expenditures for cash, assets, raw materials, salaries, and other resource departments need. Budgets are the most widely used control system, because they plan and control resources and revenues essential to the firm's health and survival.

A budget is created for every division or department with in the organization, no matter how small, so long as it performs a distinct project, program or function. In order for budgets to be used, the organization must define each department as a responsibility center.


   5.4.1 Responsibility Centers

A responsibility center is the fundamental unit of analysis of budget control system. A responsibility center is defined as any organizational department under the supervision of a single person who is responsible for its activity. There are four major types of responsibility centers – cost centers, revenue centers, profit centers, and investment centers.

Cost Center: a cost center is a responsibility center in which the manager is held responsible for controlling cost inputs. The manager is responsible for salaries, supplies and other costs relevant to the department's operation. Staff departments such as human resource, legal and research typically are organized as cost centers and budgets reflect the cost to run the department.

Revenue Center: a revenue center, the budget is based on generated revenue or income. Sales and marketing departments frequently are revenue centers. The department has a revenue goal, such as $3,500,000. Assuming that each sales person can generate $250,000 of revenue per year the department can be allocated 14 sales people. Revenue budgets can also be calculated as the number of items to be sold rather than as total revenues.

Profit Center: in a profit center, the budget measures the difference between revenues and costs. For budget purposes, the profit center is defined as a self-contained unit to enable a profit to be calculated. Control is based on profit targets rather than on cost or revenue targets.

Investment Center:  an investment center is based on the value of assets employed to produce a given level of profit. Profits are calculated in the same way as in a profit center, but for control purposes, managers are concerned with return on the investment in assets for the division. For example, XYZ Co. may acquire a garment factory for a price of $40 million. If XYZ managers target a 10 percent return on investment, the garment factory will be expected to generate profits of $4 million a year. XYZ managers are not concerned with the absolute dollar value of costs, revenues or profits so long as the budgeted return on assets reaches 10 percent.

Relationship to Structure: responsibility centers are closely related to the types of organizations structure. Cost centers and revenue centers typically exist in a functional structure. The production, assembly, finance, accounting and human resource departments control expenditures through cost budgets. Marketing or sales departments, however, often are controlled as revenue centers. Profit centers typically exist in a divisional structure. Each self-contained division can be evaluated on the basis of total revenues minus total costs, which equals profits. Finally, very large companies in which each division is an autonomous business use investment centers.


   5.4.2 Operating Budgets

An operating budget is the financial plan for each organizational responsibility center for the budget period. The operating budget outlines the financial resources allocated to each responsibility center in dollar terms, typically calculated for a year in advance. The most common types of operating budgets are expense, revenue and profit budgets.

Expense Budgets: an expense budget outlines the anticipated expenses for each responsibility center and for the total organization. Expense budgets apply to cost centers, as described previously. The department of management at the Unity University College may have a travel budget of $ 24,000; thus, the department head knows that the expense budget can be spent at approximately $ 2000 per month. Three different kinds of expenses normally are evaluated in the expense budget – fixed, variable and discretionary.

Fixed Costs: are based on a commitment from a prior budget period and cannot be changed. The price of expensive machinery purchased 3 years ago that is paid over a period of 10 years is a fixed cost.

Variable Costs: often called engineered costs, are based on an explicit physical relationship with the volume of departmental activity. Variable costs are calculated in manufacturing departments when a separate cost can be assigned for each product produced. The greater the volume of production, the greater the expense budget the department will have.

Discretionary Costs: are based on management decisions. They are not based on a fixed, long term commitment or on the volume of items produced, because discretionary costs cannot be calculated with precision. In the judgment of top management, an expense budget of $ 120,000 might be assigned to the inspection department to pay the salaries of four inspectors, one assistant and one secretary. This budget could be increased or decreased the following year, depending on whether management feels more inspectors are needed.

Revenue Budget: a revenue budget identifies the revenues required by the organization. The revenue budget is the responsibility of a revenue center, such as marketing or sales. The revenue budget for a small manufacturing firm could be $ 3 million, based on sales of 600,000 items at $ 5 each. The revenue budget of $ 6 million for a local school district would be calculated not on sales to customers but on the community's current tax rate and property values.

Profit Budget: a profit budget combines both expense and revenue budgets into one statement to show gross and net profits. Profit budgets apply to profit and investment centers. If a bank has budgeted income of $ 2 million and budgeted expenses of $ 1,800,000, the estimated profit will be $ 200,000. If the budget profit is unacceptable, managers must develop a plan for increasing revenues or decreasing costs to achieve an acceptable profit return.


   5.4.3 Financial Budgets

Financial budgets define where the organization will receive its cash and how it intends to spend it. Three important financial budgets are the cash, capital expenditure, and balance sheet budgets.

Cash Budget: the cash budget estimates cash flows on a daily or weekly basis to ensure that the organization has sufficient cash to meet its obligations. The cash budget shows the level of funds flowing through the organization and the nature of cash to meet its obligations. The cash budget shows the level of funds flowing through the organization and the nature of cash disbursements. If the cash budget shows that the firm has more cash than necessary, the company can arrange to invest the excess cash in treasury bills to earn interest income. If the cash budget shows a payroll expenditure of $20,000 coming at the end of the week but only  $10,000 in the bank, the controller must borrow cash to meet the payroll.

Capital Expenditure Budget: the capital expenditure budget plans future investments in major assets such as buildings, trucks and heavy machinery. Capital expenditures are major purchases that will be depreciated over several years. Capital expenditures must be budgeted to determine their impact on cash flow and whether revenues are sufficient to cover capital expenditures and cash management, revenues and operating expenses will mesh into the financial results desired by senior management. The balance sheet budget shows where future financial problems may exist. Financial ratio analysis can be performed on the balance sheet and profit budgets to see whether important ratio targets, such as debt total assets or ROA will be met.


5.5 The Budgeting process

The budgeting process is an integral part of the planning process and is concerned with how budgets are actually formulated and implemented in an organization. Budgets are allocated during the strategic planning process commensurate with agreed-upon goals. In this section, we will briefly describe the procedure many companies use to develop the budget for the coming year.


   5.5.1 Top Down or Bottom-Up Budgeting

Many traditional companies use top-down budgeting, which is consistent with the bureaucratic control approach. The budgeted amounts for the coming year are literally imposed on middle and lower-level managers. The top down process has certain advantages: Top managers have information on overall economic projections; they know the financial goals and forecasts; and they have reliable information about the amount of resources available in the coming year. Thus, the top-down process enables managers to set budget targets for each department to meet the needs of overall company revenues and expenditures.

The problem with the top-down budgeting process is that lower managers often are not committed to achieving budget targets. They are excluded from the budgeting process and resent their lack of involvement in deciding the resources available to their departments in the coming year.

In response to these negative outcomes, many organizations adopt bottom-up budgeting, which is in line with the decentralized approach to control. Lower managers anticipate their departments' resource needs, which are passed up the hierarchy and approved by top management. The advantage of the bottom-up process is that lower managers are able to identify resource requirements about which top managers are uninformed, have information on efficiencies and opportunities in their specialized areas, and are motivated to meet the budget because the budget plan is their responsibility.

However the bottom up approach also has problems. Because managers are evaluated on their performance against the budget, they may not be motivated to make their budget submissions very challenging, striving instead for the most conservative budget that can get approval. Another problem is that managers' estimates of future expenditures may be inconsistent with realistic economic projections for the industry or with company financial forecasts and goals.

The result of these advantages and disadvantages is that many companies use a joint process. Top managers are the controller define economic projections and financial goals and forecasts and then inform lower managers of the anticipated resources available to them. Once these overall targets are made available, department managers can develop their budgets within them. Each department can take advantage of special information, resource requirements, and opportunities. The budget is then passed up to the next management level, where inconsistencies across departments can be removed.

The combined top-down and bottom up process is illustrated in the figure below. Top managers begin the cycle. They also end it by giving final approval to all departmental budgets. Departmental budgets fall with in the guidelines approved by top management, and the overall company budget reflects the specific knowledge, needs and opportunities with in each departments.



5.5.2 Zero-Based Budgeting

In most organizations, the budgeting process begins with the previous year's expenditures; that is, managers plan future expenditures as an increase or decrease over the previous year. This procedure tends to lock departments into a stable spending pattern that lacks flexibility to meet environmental changes. Zero base budgeting was designed to overcome this rigidity by having each department start from zero in calculating resource needs for the new budget period. Zero base budgeting assumes that the previous year's budget is not a valid base from which to work. Rather, based on next year's strategic plans, each responsibility center justifies its work activities and needed personnel, supplies, and facilities for the next budget period. Responsibility centers that cannot justify expenditures for the coming year will receive fewer resources or be disbanded altogether. In zero base budgeting, each year is viewed as bringing a new set of goals. In forces department managers to thoroughly examine their operations and justify their departments' activities based on their direct contribution to the achievement of organizational goals.

The zero-base budgeting technique was originally developed for use in government organizations as a way to justify cost requests for the succeeding year. The specific steps used in zero-based budgeting are as follows:

  1. Managers develop a decision package for their responsibility centers. The decision package includes written statements of the department's goals, activities, costs and benefits; alternative ways of achieving goals, consequences of not performing each activity and personnel, equipment, and resources required during the coming year. Managers then assign a rank order to the activities in their department for the coming year.
  2. The decision package is then forwarded to top management for review. Senior managers rank the decision packages from the responsibility centers according to their degree of benefit to the organization. These rankings involve widespread management discussions and may culminate in a voting process in which managers rate activities from "essential" to "would be nice to have" to "not needed".

  3. Top management allocates organizational resources based on activity rankings. Budge resources are distributed according to the activities rated as essential to meeting organizational goals. Some departments may receive large budgets and others nothing at all.

Zero-based budgeting demands more time and energy than conventional budgeting. Because it forces management to abandon traditional budget practices, top management should develop a consensus among participants that zero-based budgeting will have a positive influence on both the company and its employees.


5.6 Trends in Financial Control

Today companies are responding to changing economic realities and global competition by reassessing organizational management and processes – including the way they control their finances. Some of the major trends in financial control include open-book management, economic value added systems and activity based costing.

These trends have emerged from changing organizational structures and the resulting management methods that stress information sharing, employee participation, and teamwork. The realities of higher quality demands from consumers, together with the need to cut costs while improving product and service, also require new approaches to financial control.


   5.6.1 Open-Book Management

In the changing organizational environment that touts information sharing, teamwork and managers as facilitators rather than bosses, top executives do not hoard financial data. Employees throughout the organization are admitted into the loop of financial control and responsibility to encourage active participation and commitment to organizational goals.

Open book management provides employees with the "why" to reorganization, cost cutting, customer service and other organizational strategies.

  • First, open book management allows employees to see for themselves – through charts, computer printouts, meetings and so forth – the financial condition of the company.
  • Second, open book management shows the individual employee how his or her job fits into the picture and affects the financial future of the organization.

  • Finally, open book management ties employee rewards to the company's overall success. As employee see the interdependence and importance of each function, cross functional communication and cooperation are enhanced.

The goal of open book management is to get every employee thinking and acting like a business owner rather than like a hired hand. To get employees to think like owners, they are provided with the same information as owners and given responsibility and authority to act on what they know. Top management support and regular communication with employees throughout the company are essential to the success of open-book management.


   5.6.2 Economic Value-added System

 Economic value added system can be defined as a company net operating profit after taxes and after deducting the cost of capital. Economic value added measurement captures all the things a company can be to add value from its activities, such as run the business more efficiently, satisfy customers, and reward shareholders. Each job department or process in the organization is measured by the value added.

To be successful, economic value added be central to the financial management system and integrated throughout company policies and procedures. In addition, employees throughout the organization should be trained, because even the smallest jobs can help create value for the company. When implemented properly, economic value added systems can effectively measure and help control a company's financial performance.


   5.6.3 Activity Based Costing (ABC)

In recent years, the dramatic rise in production concepts such as just-in-time manufacturing and total quality management (TQM) created a financial dilemma for corporate accountants. Often a product would cost for more to manufacture that it could be sold for, but costing systems hid this fact, losing the company a lot of money.

The relationship between labor and overhead has changed. Increased automation has resulted in less employee labor. Total product costs are driven to a degree by higher overhead costs for setup, distribution, and maintenance of sophisticated machinery. In addition, small-batch production to meet changing consumers desires drivers up costs.

Activity based costing assumes that true costs are reflected by a formula under which products consume activities and activities consume resources. The crucial step is identifying various activities needed to produce a product and determining the costs of those activities. Costs are then allocated to products accordingly. For example, a manufacturing division may develop three cost pools:

Procurement overhead: including incoming documentation, storage, inspection and logistics.

Production overhead: including various steps in the production process, such as start-up- stations, soldering and testing and defect analysis.

Support overhead: including production and process engineering and data processing.

For each pool, overhead costs are measured and allocated according to the true cost of specific products. 

The activity based costing process can provide an accurate reflection of product costs by measuring specific cost factors. The key is the selection of appropriate activities and selection of an allocation base that best reflects each activity. Activity-based costing is appealing because implementation does not interfere with the financial accounting system, and it can be tailored to specific company needs.


5.7 Signs of Inadequate Budget Control Systems

Financial statements, financial analysis, and budgets are designed to provide adequate control for the organization. Often, however, management control systems are not working properly. Then they must be examined for possible clarification, revision or overhaul. Indicators of the need for a more effective control approach or revised management control systems are as follows:

  • deadlines missed frequently

  • poor quality of goods and services

  • declining or stagnant sales or profits

  • loss of leadership position or market share within the industry.

  • Inability to obtain data necessary to evaluate employee or departmental performance

  • Low employee morale and high absenteeism

  • Insufficient employee involvement and management employee communications

  • Excessive company debts, uncertain cash flow, or unpredictable borrowing requirements

  • Inefficient use of human and material resources, equipment and facilities.

Management control systems help achieve overall company goals. They help ensure that operations progress satisfactorily by identifying deviations and correcting problems. Properly used, controls help management respond to unforeseen developments and achieve strategic plans. Improperly designed and used, management control systems can lead a company into bankruptcy.


5.8 Summary

This unit introduces a number of important concepts about management control systems and techniques. Organizations have a core management control system consisting of the strategic plan, financial forecast, operating budget, management by objectives, operations management system and management information system. Top management financial control uses the balance sheet, income statement, and financial analysis of these documents.

At the middle levels of the organization, budgets are an important control system. Departments are responsibility centers, each with a specific type of operating budget – expense, revenue or profit. Financial budgets are also used for organizational control and include the cash, capital expenditure, and the balance sheet budget. The budget process can be either top down or bottom up, but a budget system that incorporates both seems most effective – zero-based budgeting is a variation of the budget process and requires that managers start from zero to justify budget needs for the coming year. Recent trends in financial control include open-book management, economic value-added measurement systems, and activity based costing. Finally, indicators of inadequate budget control systems were discussed.


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