Management Control Systems, 2nd Edition PDF

 page i SECOND EDITION MANAGEMENT CONTROL SYSTEMS page ii  page iii SECOND EDITION MANAGEMENT CONTROL SYSTEMS FRANK G. H. HARTMANN, KALLE KRAUS AND...

 page i SECOND EDITION MANAGEMENT CONTROL SYSTEMS page ii  page iii SECOND EDITION MANAGEMENT CONTROL SYSTEMS FRANK G. H. HARTMANN, KALLE KRAUS AND GÖRAN NILSSON, ROBERT N. ANTHONY, VIJAY GOVINDARAJAN London Boston Burr Ridge, IL Dubuque, IA Madison, WI New York San Francisco  St. Louis Bangkok Bogotá Caracas Kuala Lumpur Lisbon Madrid Mexico City Milan Montreal New Delhi Santiago Seoul Singapore Sydney Taipei Toronto  page iv Management Control Systems, Second European Edition Frank G.H. Hartmann, Kalle Kraus and Göran Nilsson, Robert N. Anthony, Vijay Govindarajan ISBN-139781526848314 ISBN-10 0077133269 Published by McGraw-Hill Education 338 Euston Road London, NW1 3BH Telephone: +44 (0) 203 429 3400 Website: www.mheducation.co.uk British Library Cataloguing in Publication Data A catalogue record for this book is available from the British Library Library of Congress Cataloguing in Publication Data The Library of Congress data for this book has been applied for from the Library of Congress Portfolio Manager: Sabrina Farrugia Content Developer: Maggie du Randt Content Product Manager: Ali Davis Text Design by Kamae Design Cover design by Adam Renvoize Published by McGraw Hill Education. Copyright © 2021 by McGraw Hill Education. All rights reserved. No part of this publication may be reproduced or distributed in any form or by any means, or stored in a database or retrieval system, without the prior written consent of McGraw-Hill Education, including, but not limited to, in any network or other electronic storage or transmission, or broadcast for distance learning. Fictitious names of companies, products, people, characters and/or data that may be used herein (in case studies or in examples) are not intended to represent any real individual, company, product or event. ISBN-13 9781526848314 ISBN-10 1526848317 eISBN-10 1526848325 © 2021. Exclusive rights by McGraw-Hill Education for manufacture and export. This book cannot be re-exported from the country to which it is sold by McGraw- Hill Education.  page v Brief Table of Contents Case grid ix Preface xiii About the authors xiv Acknowledgements xv Guided tour xvi Road map xviii Part 1: Management control systems: managing organizational performance 1 1 Introduction to management control systems 3 2 Mission, goals and strategies 28 3 Managers, human behaviour and organizations 71 Part 2: Management control systems: applying organizational architecture 113 4 Responsibility centres 115 5 Control with transfer prices and shared service centres 145 6 Organizational structure and cross-functional integration 188 7 Management control systems and inter-organizational relationships 224 Part 3: Management control systems: the performance management process 253  8 Budgeting and forecasting 256 9 Financial and non-financial performance measurement systems 307 10 Monetary incentive systems and motivation 346 11 Risk management systems 393 Part 4: Management control systems: summary and outlook 12 Control and controllership: past, present, future 432430 Additional Cases 462 Appendix: Variance analysis 482 Company Index 497 Subject Index 499  page vi Detailed Table of Contents Case grid ix Preface xiii About the authors xiv Acknowledgements xv Guided tour xvi Road map xviii PART 1: Management control systems: managing organizational performance 1 1 Introduction to management control systems Introduction 4 Top-down and bottom-up roles of management control systems 5 A management control system ‘package’ – input, throughput and output controls 8 Enabling and coercive management control systems 14 Case 1.1: Maybach 16 Case 1.2: Abrams company 17 Case 1.3: Enron 21 Case 1.4: Wal-Mart Stores, Inc. 22 Case 1.5: Southwest Airlines Corporation 25 2 Mission, goals and strategies 28 Introduction 29 The shareholder view 30 The stakeholder view 34 Mission 37  Different types of organizational goal 38 Strategy 39 Contingencies 43 Case 2.1: Gyros: a drama in three acts 50 Case 2.2: Northern Light: growing pains 52 Case 2.3: Scania: a case of differentiation and low cost 53 Case 2.4: BioTool: a biotech company’s innovation journey 55 Case 2.5: Tesla: climate change and the future of the electric vehicle 61 3 Managers, human behaviour and organizations 71 Introduction 72 Models of human behaviour 75 The management control systems model of human behaviour 85 Case 3.1: A matter of ethics? 100 Case 3.2: Do not fool yourself 101 Case 3.3: Decision support systems and ethics 102 Case 3.4: Cultural issues: Netflix culture 105 Case 3.5: ‘In control’ at FBS Executive Education 109 PART 2: Management control systems: applying organizational architecture 113 4 Responsibility centres 115 Introduction 116 Responsibility centres 116 Revenue centres 121 Expense centres 122 Profit and investment centres 125 Case 4.1: BookWorm 132 Case 4.2: MoreSki 133 Case 4.3: BreathEZ 134 Case 4.4: Responsibility structure within the Volvo Group 135 Case 4.5: Grand Jean Company 141 5 Control with transfer prices and shared service centres 145 Introduction 146 Transfer pricing 147  Transfer pricing methods 148 Administration of transfer prices 155 Corporate services 157 Shared service centres 160 Management control system challenges arising from interdependent responsibility centres 164 Case 5.1: SLA contracting: the big three shared services centres (SSCs) 169 Case 5.2: SLA control and reinforcement: Vodafone 171 page vii Case 5.3: Transfer pricing trouble at galeria glassworks 173 Case 5.4: North Country Auto, Inc. 176 Case 5.5: Transfer pricing in international firms: interaction of control and tax 183 6 Organizational structure and cross-functional integration 188 Introduction 189 Organizational structure 191 Lean management 194 Projects 199 Case 6.1: Miracle on ice! 209 Case 6.2: The washer 210 Case 6.3: The Motorway PPP 211 Case 6.4: The cross-functional integration projectc 215 Case 6.5: New product development at Big Fish 217 7 Management control systems and inter-organizational relationships Introduction 225 Increased importance of inter-organizational relationships 226 Types of inter-organizational relationship 227 Inter-organizational management control systems 228 Case 7.1: Ramirent 239 Case 7.2: Working capital management 239  Case 7.3: Outsourcing Unilever 240 Case 7.4: The clothing industry supply chain 241 Case 7.5: J.L. Apparel Limited 247 PART 3: Management control systems: the performance management process 253 8 Budgeting and forecasting 256 Introduction 257 The roles of budgeting 258 The parts of the budget 260 The budgeting process 262 Beyond budgeting 267 Case 8.1: Tight budgetary control 278 Case 8.2: Rolling forecasts or budgets? New wine in old wineskins? 280 Case 8.3: Budgeting at FHP Motors 283 Case 8.4: Beyond budgeting in a medical company 287 Case 8.5: Svenska Handelsbanken 296 9 Financial and non-financial performance measurement systems307 Introduction 308 Pitfalls when using financial measures 310 Pitfalls when using non-financial measures 319 The balanced scorecard: an ‘enabling’ performance measurement system 322 Case 9.1: MedalRain 333 Case 9.2: TurnAround 334 Case 9.3: Setting an appropriate target: continuous improvement or benchmarking? 335 Case 9.4: Performance measurement in a cooperative: context issues and challenges 336 Case 9.5: Frescent: sustainability and the balanced scorecard 343 10 Monetary incentive systems and motivation 346 Introduction 347 Compensation and incentives 348 Agency theory and the design of incentive systems 353 Self-determination theory and incentives 358  Comparing the two theories 366 Case 10.1: Triathlon guy and golf girl 369 Case 10.2: Rome-Work 370 Case 10.3: Eaglet Plc: the phone call 371 Case 10.4: What is CEO talent worth? 380 Case 10.5: The Pitfalls of achieving cost efficiency in the creative organization 387 11 Risk management systems 393 Introduction 395 Behavioural aspects of risk management 397 page viii Risk management 400 Enterprise risk management frameworks 405 Case 11.1: Future gains and future pains 411 Case 11.2: Profit warning 413 Case 11.3: Risk or challenges 415 Case 11.4: Unilever and the risk of being taken over: a case on shareholder value creation... or lack thereof 417 Case 11.5: Risks or challenges? 423 PART 4: Management control systems: summary and outlook 430 12 Control and controllership: past, present, future 432 Controllers 433 Roles and tasks of controllers 436 Developments in controllership and management control systems 438 Case 12.1: Controller involvement 443 Case 12.2: Crisis management: strategic or tactical responses? 444 Case 12.3: Ethical dilemmas in a controller job 446 Case 12.4: Nucor corporation 448 Case 12.5: Aluminum container corporation 458 Additional Cases 462 Appendix: Variance analysis 482 Company Index 497 Subject Index 499  page ix Case Grid C a s e n C u h m a b pt e er r Case title and authors Key concepts covered 1 1 Maybach. Frank strategy, management. Hartmann, Radbound control system design 1 University 1 1 Abrams Company. J. G. responsibility centres,. San Miguel financial performance 2 measurement 1 1 Enron. Frank Hartmann, management control. Radboud University system design, scandals 3 1 1 Wal-Mart Stores, Inc. strategy, cost reduction,. Vijay Govindarajan and management control 4 Julie B. Lang, Tuck system design School of Business at Dartmouth 1 1 Southwest Airlines strategy, HR,. Corporation. Vijay management control 5 Govindarajan, Julie B. system design Lang and Suraj Prabhu, Tuck School of Business at Dartmouth College 2 2 Gyros. Göran Nilsson, corporate governance,. Uppsala University stakeholders, 1 management attention 2 2 Northern Light: Growing contingencies; volatility. Pains. Göran Nilsson and uncertainty, 2 Uppsala University adjusting the MC 2 2 Scania: A case of strategy, differentiation,. differentiation and low low-cost 3 cost. Göran Nilsson, Uppsala University 2 2 Biotool. Torkel corporate governance,. Strömsten, Stockholm performance 4 School of Economics measurement, short- termism 2 2 Tesla: Climate change CSR, greenwashing,. and the future of the implementation 5 electric vehicle. Dr Emma Sjöström, Misum, Stockholm School of Economics 3 3 A matter of ethics?, ethics, types of ethical. Frank Hartmann, reasoning 1 Radboud University 3 3 Do not fool yourself!, people’s cognitive. Frank Hartmann, limitations and the 2 Radboud University potential of data to mislead us 3 3 Decision-support when our quantitative. systems and ethics. Ted analyses suggest 3 Welten, Erasmus decisions that are University against ethical standards 3 3 Cultural issues: Netflix international differences. Culture. Ted Welten, in culture relevant to 4 Erasmus University control 3 3 ‘In Control’ at FBS turn-around. Executive Education. management at 5 Frank Hartmann, Executive Education Radboud University (real life case) 4 4 BookWorm. Ebba responsibility centres,. Sjögren, Stockholm discretionary expense 1 School of Economics centres, profit centres 4 4 MoreSki. Malin Lund, responsibility centres,. Stockholm School of discretionary expense 2 Economics centres, engineered expense centres, revenue centres, decentralization 4 4 BreathEZ. Ebba responsibility centres,. Sjögren, Stockholm discretionary expense 3 School of Economics centres, profit centres page x 4 4 Responsibility centres. responsibility centres,. Johan Åkesson and profit centres, 4 Mikael Cäker, investment centres, Gothenburg University expense centres, non- financial measurement 4 4 Grand Jean Company. responsibility centres,. Joseph G. San Miguel revenue centres, 5 expense centres 5 5 SLA contracting. Ted service level agreement:. Welten, Erasmus how to negotiate 1 University between two partners, role of control 5 5 SLA control and service level agreement:. reinforcement. Ted how to control a running 2 Welten, Erasmus contract, issues that University may arise 5 5 Transfer pricing in multi- transfer pricing and. unit firm, Frank suboptimization 3 Hartmann, Radboud University 5 5 North Country Auto, Inc. transfer pricing. Mark C. Rooney 4 5 5 Transfer pricing in interaction of control. international firm: and tax 5 Interaction of control and tax. Ted Welten, Erasmus University 6 6 Miracles on Ice. Göran differentiation and. Nilsson, Uppsala integration 1 University 6 6 The Washer. Göran cross-functional. Nilsson, Uppsala integration, the silo 2 University problem 6 6 The Motorway-PPE. project control. Salman Ahmad, Aston 3 Business School, Ciaran Connolly, Queen’s University Belfast and Istemi Demirag, Tallinn University of Technology 6 6 The cross-functional cross-functional. management project. integration, product 4 Göran Nilsson, Uppsala development, speed University 6 6 New product product development,. development at Big cross-functional 5 Fish. Angela Liew and integration Julie Harrison, University of Auckland 7 7 Ramirent. Kalle Kraus, inter-organisational. Stockholm School of management control 1 Economics system design 7 7 Working Capital inter-organizational. Management. Kalle management control 2 Kraus, Stockholm systems, working capital School of Economics management 7 7 Outsourcing Unilever. inter-organizational. Frank Hartmann, management control 3 Radboud University systems, outsourcing 7 7 The Supply Chain of the inter-organizational. Clothing Industry. management control 4 Nandita Farhad and systems, strategy, Andrea Fried, Linköping supply chain University management, industry analysis 7 7 J.L Apparel Limited. inter-organizational. Nandita Farhad and management control 5 Andrea Fried, Linköping systems, outsourcing, University supply chain management, supplier evaluation, rank-based rewards 8 8 Tight budgetary control. budgetary control, tight. Frank Hartmann, and loos budgetary 1 Radboud University control page xi 8 8 Rolling forecasts or budgeting, rolling. budgets? New wine in forecasts 2 old wineskins? Paul Thambar, Monash University 8 8 Budgeting at FHP budgeting, micro-. Motors. Göran Nilsson, management 3 Uppsala University 8 8 Beyond beyond budgeting,. Budgeting/Rolling rolling forecasts 4 Forecasts. Knut Fahlén, Ekan Management 8 8 Svenska decentralisation, non-. Handelsbanken: budgetary control 5 Sustaining growth in a decentralized organization. Hamish Scott, Ashridge and North Network Ltd 9 9 MedalRain. Ebba investment centres,. Sjögren, Stockholm return on investment 1 School of Economics (ROI), economic value added (EVA) 9 9 TurnAround. Malin investment centres,. Lund, Stockholm School return on investment 2 of Economics (ROI), residual income (RI), economic value added (EVA) 9 9 Setting an appropriate target setting,. target: continuous benchmarking, 3 improvement or continuous improvement benchmarking? Kalle Kraus, Stockholm School of Economics 9 9 Performance balanced scorecard,. measurement in a non-for-profit, 4 cooperative using a cooperatives BSC. Paul Thambar, Sarah Adams, Matthew Hall, Yolande McNicoll, Yuval Millo and Ms Wen Shi He 9 9 Frescent: sustainability balanced scorecard,. and the balanced sustainability, reward 5 scorecard. Emilia systems Cederberg, Stockholm School of Economics. 1 1 The Triathlon Guy and extrinsic and intrinsic 0 0 the Golf Girl. Göran motivation, motivation. Nilsson, Uppsala crowding 1 University 1 1 Rome-work. George budgeting, bonus 0 0 Kominis and Alvise systems, motivation. Favotto, Adam Smith 2 Business School, University of Glasgow 1 1 Eaglet plc: the phone renumeration, balanced 0 0 call. George Kominis scorecard, motivation. and Alvise Favotto, 3 Adam Smith Business School, University of Glasgow 1 1 What is CEO talent Incentives, dysfunctional 0 0 worth?, David F. effects. Larcker, Usman Liaqat 4 and Brian Tayan 1 1 The pitfalls of achieving intrinsic motivation, 0 0 cost-efficiency in the creativity, company. creative organization. culture 5 Jan Pfister, University of Turku 1 1 Future gains and future behavioral economics, 1 1 pains. Ted Welten, asymmetric utility. Erasmus University page xii 1 1 1 Profit warning. Ted real profit warning, with 1 1 Welten, Erasmus causes and. University consequences 2 1 1 Risks or challenges? differences in risk 1 1 Tiffany’s and Quest appetite between line. Diagnostics Ted Welten, managers and 3 Erasmus University controllers 1 1 Unilever. Professor replacement of CEO 1 1 Frank Hartmann, after disappointing. Radboud University results 4 1 1 Risks or challenges? differences between 1 1 Toshiba Ted Welten, management control. Erasmus University and risk management, 5 including the roles of CEO and CFO 1 1 Controller involvement. fiduciary role of 2 2 Frank Hartmann, controllers, and how it. Radboud University can be put at risk. 1 1 1 Crisis management: companies responses to 2 2 strategic or tactical the COVID crises and. responses? Frank the role of risk 2 Hartmann, Radboud management University 1 1 Ethical dilemmas in a ethical dilemmas, 2 2 controller job. Frank earnings management. Hartmann, Radboud and controller 3 University responsibilities. 1 1 Nucor Corporation (A). responsibility centres, 2 2 Vijay Govindarajan, budgeting, expense. Tuck School of Business centres, profit centres 4 at Dartmouth 1 1 Aluminum Container investment centres, 2 2 Corporation. Vijay strategy, residual. Govindarajan, Tuck income, return on 5 School of Business at investment, non-current Dartmouth asset valuation problems, incentive systems C A Quality Metal service investment centres, a 1 Center. Vijay return on investment s Govindarajan, Tuck (ROI), residual income e School of Business at (RI) e Dartmouth n d o f t h e b o o k C A Pirelli. Paolo Perego, Information overload, a 2 Free University of consistency, judgment s Bolzano-Bozen e e n d o f t h e b o o k C A Johansen’s: The New Balanced scorecard, a 3 Scorecard system. leading and lagging s Luann Lynch, Jennifer indicators, performance e Forman and Graham evaluation e Gillham, Darden case n nr. UV-7131 d o f t h e b o o k A A Case: Variance Analysis Variance analysis p p Problems. John p p Dearden. e e n n d d i i x x  page xiii Preface All types of organization are essentially groups of people interacting with one another. These people typically work at various levels and functions within the organization, perform various tasks and apply their various skills. A central question for all organizations is how to align managers’ and employees’ behaviour with the organization’s mission, goals and strategies. Here management control systems, the focus of this book, play a key role. We define a management control system as comprising a combination of control practices designed and implemented by top managers to increase the probability that lower-level managers and employees will behave in ways consistent with the organization’s mission, goals and strategies. These control practices can take many forms, such as budgets, mission statements, transfer pricing arrangements, codes of conduct, performance measures and reward systems. In the book we systematize the various control practices into three types: input controls, throughput controls and output controls. This follows an intuitive logic that lower-level managers and employees provide important cognitive abilities, skills and personal values to the organization (which top management can try to influence via input controls), which is transformed via the execution of effort, i.e., the actual work and organization of lower-level managers and employees (which top management can try to influence via throughput controls) into some sort of performance, or ‘results’ (which top management can try to influence via output controls). The actual combination of input, throughput and output controls will differ between organizations, depending on the differences in their missions, goals and strategies, which are influenced by, for instance, the markets they serve and the nature of their value creation processes. Our definition of management control systems expresses that we focus our attention on systematic processes in organizations that are deliberately designed to facilitate cooperation and goal achievement. Thus we are primarily interested in systematic and continuous, rather than ad hoc and incidental, control efforts. The distinction between input, throughput and output controls has been proven to ‘stand the test of time’. In the new era we live in, with digitalization and climate change, the need for, and use of, information changes quickly, but the distinction between input, throughput and output controls remains relevant. The three types of control practices also highlight the important message of this book, that management control systems are about so much more than performance measurement and incentives. We intend to send a powerful message about the need to use a broad conception of what a management control system is. We provide a wider presentation of the organizational systems, structures and processes that enable managers and employees to take decisions, perform actions and influence the behaviour of other organizational members. It is this holistic and systematic view on creating organizational performance that distinguishes this book from others. It also helps us highlight that management control systems have an important ‘enabling’ role; top managers need to design control practices that help maintain or enhance the skill set, job motivation and organizational commitment that lower-level managers and employees aim to contribute to the organization. They need to perceive control practices as something that supports them, that they can use to identify problems, prioritize issues and develop ideas for improvements. This supportive and empowering side of management control systems is very important to take into account when deciding on a management control system. Frank G.H. Hartmann, Kalle Kraus, Göran Nilsson  page xiv About the Authors Frank G.H. Hartmann is a Professor of Accounting at the Nijmegen School of Management, Radboud University in the Netherlands. He has a wide experience in researching issues in Management Control and controllership. His teaching spans undergraduate, MBA, executive and professional controller programmes as well as PhD programmes across the globe. Frank holds several editorial board positions, is co-author of a Dutch series on accounting and control, and is widely published in journals such as Accounting, Organizations and Society, Management Accounting Research and Behavioral Research in Accounting. Kalle Kraus is a Professor of Accounting at the Stockholm School of Economics, Sweden. He has broad experience in teaching Management Control to students and management teams in Bachelor, Master, MBA and executive programmes. He has been awarded Best Teacher awards from Masters as well as MBA students. Kalle is involved in a number of research projects, such as inter-organizational management control and control in non-for profit organizations. He holds several editorial board positions and is widely published in journals such as Accounting, Organizations and Society, European Accounting Review and Management Accounting Research. Göran Nilsson is a Senior Lecturer of Management Control at Uppsala University, Sweden. After having worked as a controller in two Electrolux companies for several years, he wrote his doctoral thesis about Lean Management at the Stockhom School of Economics. His main interest is management control under dynamic and uncertain circumstances and he has published a book about the agile company with Lennart Francke, former CFO of Handelsbanken. He is also leading a knowledge sharing group of senior controllers and participates actively in the public debate through debate articles and popular scientific articles, as well as through lectures and seminars for practitioners. Robert N. Anthony was the Ross Graham Walker Professor Emeritus of Management Control at Harvard Business School. Robert has been a director of Carborundum Company and Warnaco, Inc., both Fortune 500 companies. He has consulted for many companies and government agencies. Among Robert’s awards are the Distinguished Accounting Educator of the Year Award from AAA, Comptroller General’s Award of the U.S. General Accounting Office and Distinguished Service Award of the Harvard Business School Association. Robert is widely seen as the founding father of the discipline of management control as a fundamental topic in business education. Vijay Govindarajan is the Earl C. Daum 1924 Professor of International Business at the Amos Tuck School of Business Administration at Dartmouth College. Professional credits include Outstanding Teacher of the Year, voted by MBA students during several academic years, and Outstanding Business School Faculty, named by Business Week. Vijay is widely published in journals such as Harvard Business Review, Academy of Management Review and Strategic Management Journal and books as Strategic Cost Accounting.  page xv Acknowledgements Our thanks go to the following reviewers for their comments at various stages in the text’s development: The selection of cases is always vital to a successful management control systems course. In this context, our sincere appreciation goes to the authors and supervisors who are responsible for case development. Each has been recognized in the citations to the cases. We are particularly indebted to the companies whose cooperation made the cases possible. Requests to reproduce cases should be directed to the copyright holder. Associate Professor Torkel Strömsten, Stockholm School of Economics Visiting Professor KTH Royal Institute of Technology Dr. Emma Sjöström, Research Fellow, Stockholm School of Economics Assistant Professor Ted Welten, Senior lecturer, Erasmus University Rotterdam Associate Professor Paolo Perego, Free University of Bolzano- Bozen Johan Åkesson, Senior Lecturer, School of Business, Economics and Law at the University of Gothenburg Dr. Salman Ahmad, Lecturer in Accounting, Aston University, Birmingham. Dr. Ciaran Connolly, Professor of Accounting, Queen’s University Belfast Professor Istemi Demirag, Professor of Accounting, Tallinn University of Technology Dr. Angela Liew, Senior Lecturer, University of Auckland Dr. Julie Harrison, Associate Professor, University of Auckland Associate Professor Andrea Fried, Linköping University Dr. Paul Thambar, Senior Lecturer, Monash Business School, Monash University Dr. Knut Fahlén, Management Consultant, Ekan Management, Sweden Dr. Emilia Cederberg, Assistant Professor Stockholm School of Economics Dr. Alvise Favotto, Lecturer in Accounting, University of Glasgow Dr. Georgios Kominis, Lecturer in Accounting, University of Glasgow Dr. Jan Pfister, Senior Lecturer, University of Turku Richard Rensen, External Lecturer Nyenrode Business Universiteit. Associate Professor Mikael Cäker, Senior Lecturer, University of Gothenburg Dr. Li-cheng Chang, Senior lecturer, University of Kent Dr. Carl-Johan Petri, Senior Lecturer, Linköping University Lorraine Morris, Senior Lecturer, University of Wolverhampton In writing this text, we hope that you will share our enthusiasm both for the rich subject of management control and for the learning approach that we have taken. As always, we value your recommendations and thoughts about the book. Your comments regarding coverage and content will be most welcome, as will your calling our attention to any specific errors. Frank Hartmann, Professor of Accounting at the Nijmegen School of Management, Radboud University, Postbus 9108, 6500 HK Nijmegen or [email protected] [email protected].  Every effort has been made to trace and acknowledge ownership of copyright and to clear permission for material reproduced in this book. The publishers will be pleased to make suitable arrangements to clear permission with any copyright holders whom it has not been possible to contact.  page xvi Guided Tour Learning Objectives Each chapter opens with a set of learning objectives, summarizing what you will learn from each chapter. Real world vignettes Real world vignettes ensure a strong link to the real world from the outset of each chapter. They provide an insight into real-life situations and companies that embody important management control topics that will be covered in the chapter.  Real world examples Examples are extensively integrated into the chapters. These examples reinforce the relevance of the chapter contents to real life and show how management control affects real companies. Figures and Tables Each chapter provides a number of figures, tables and exhibits to help you to visualize the various models, and to illustrate and summarize important concepts.  page xvii Summaries Summaries provide an opportunity to recap and review the main topics presented in each chapter to ensure you have acquired a solid understanding as you work through the book Suggested additional reading Each chapter features a list of comprehensive readings and references, comprising the latest research and practitioner-oriented literature to broaden your knowledge and understanding of the chapter topics. Cases Each chapter features a selection of cases that emphasize actual practice. The cases not only require you to analyse situations, but also give you a feel for what actually happens in companies  Road map page xviii Part 1 of the book, entitled ‘Management control systems: managing organizational performance’, deals with the meaning and significance of management control systems for organizations. Chapter 1 discusses the nature of management control systems and highlights that if top management fails to implement the appropriate control practices, lower-level managers and employees might not have a clear sense of what decisions to take, what results to achieve, where to lead the people and how to use the resources under their responsibility. The chapter also discusses how, in addition to selecting an appropriate combination of input, throughput and output controls, top managers also need to systematically think through how to achieve an appropriate ‘balance’ between a coercive role of management control systems (i.e., a control device for use by top managers) and an enabling role (premised on a need to enhance the lower-level managers and employees’ capabilities, and to capitalize on their intelligence by giving them the freedom to innovate and engineer solutions to concrete problems). Chapter 2 expands our knowledge of what mission, goals and strategies actually mean and how they relate to management control systems. An organization’s mission concerns the reason why the organization exists. Organizational goals may be of many different kinds, such as financial and strategic goals. When deciding how to design a management control system, top management also needs to consider the contingencies of the organization. The contingencies include, among other things, the environment, strategies and technology. All these factors are shown to influence the selection of an appropriate combination of input, throughput and output controls. An organization facing a stable and certain environment, deploying a low-cost strategy and a manufacturing technology, is likely to benefit from a mechanistic approach, including heavy reliance on throughput controls in a ‘coercive’ manner. On the other hand, an organization facing a dynamic and uncertain environment, deploying a differentiation strategy and a service technology, is more likely to benefit from an organic approach, including heavy reliance on input controls in an ‘enabling’ manner. Chapter 3 discusses human behaviour. It details how the economic model of human behaviour, the psychological model of human behaviour and the sociological model of human behaviour each point to, and focus on, different characteristics of such behaviour. Often a particular management control system design is based on a specific view of what humans are, as laid down in these models. Understanding the similarities and differences between these theoretical models of human behaviour, and the limitations of management control system design and use, is important, since we are not interested in guiding the behaviour of some ideal type of individual, but rather the behaviour of lower-level managers and employees, who are real human beings. Part 2 of the book, entitled ‘Management control systems: applying organizational architecture’, deals primarily with throughput controls – i.e., how top managers direct lower-level manager and employee behaviour through formal delegation of decision-making responsibility and by specifying how behaviours are to be performed or not performed. Chapter 4 expands our knowledge of how top managers can direct the behaviours of lower-level managers and employees by designing appropriate responsibility centres. Should the various organizational units be responsible for only revenues (revenue centres) or only costs (expense centres) or both revenues and costs (profit centres) or also assets employed (investment centres)? As such, the assignment of responsibility to the different organizational units is an important and vital step to ensure the effectiveness of page xix the management control system in large organizations. This tends to be forgotten by many top managers, who want to start directly with budgeting and the design of performance measurement systems and incentives. Chapter 5 notes that the structural design is not intended to create responsibility centres that are free to do what they want. Rather, the challenge is to orchestrate the actions of such centres to achieve the mission, goals and strategies by joint effort. One critical challenge here is how to account for goods and services that are delivered from one unit to another. But such internal transfers cannot happen for free, which is why management control systems should provide practices which ensure that consumers of such goods and services pay the producers appropriately. This chapter deals with three such control practices, namely transfer pricing, corporate service pricing and shared service centres. Chapter 6 reflects on the ‘silo’-based organization created through the responsiblity centre arrangements by highlighting a number of additional structural choices that need to be made. An organization can be organized according to a functional structure, a business unit structure or as a matrix. Or it can primarily rely on a ‘project’ type of organization. This chapter deals with these additional structural choices, and discusses, for instance, lean management, a traditional way to plan projects (the waterfall method) and a more flexible way to manage projects (agile project management). Chapter 7 continues the reflection on the ‘silo’-based organization by highlighting that, so far in the book, there has been a clear hierarchical authority structure between top managers, managers of the various responsibility centres and the rest of the employees in the company. But, considering the significance of inter-organizational relationships, it is necessary for managers to extend the notion of organizational architecture beyond the company’s borders. Inter- organizational management control systems are conceptually different from traditional (internal) management control systems. Compared with coordinating activities within an organization in which hierarchical authority is one important basis for control, inter- organizational coordination takes place between legally independent organizations where there is no clear formal hierarchical authority in place. Part 3 of the book, entitled ‘Management control systems: the performance management process’, deals primarily with output controls – i.e., making managers and employees accountable for certain ‘results’, or output, through planning, measuring and following up on important performance targets. It discusses the most commonly used output controls: budgets, financial and non-financial performance measures, reward systems and risk management systems. Chapter 8 deals with one of the most common output controls, namely budgeting and forecasting. Budgeting is the heart of many management control systems and may fulfill a number of different roles, such as planning, monitoring, creating motivation, as well as reinforcing reflection and communication. We discuss the pros and cons of budgeting and how the budgeting process can be executed in a top-down, bottom-up or iterative manner. The chapter also deals with the beyond budgeting movement, which has suggested that budgeting should be abandoned and replaced with rolling forecasts. Another suggestion is to separate the budgeting process into three different processes, namely target setting, forecasting and resource allocation. Chapter 9 deals with the central question, ‘How well are the organization as a whole and the various responsibility centres performing?’ Performance measurement systems form the basis for such an analysis. By comparing the outcome of the chosen performance measures with appropriate performance targets, managers can assess the performance of the company. The chapter discusses general considerations when designing and using financial and non-financial measures. It also describes one widely adopted performance measurement system, namely the balanced scorecard, which systematizes the performance measures into a number of perspectives: financial, customer, internal business processes, and learning and innovation. page xx Chapter 10 expands our understanding of compensation and incentives, often considered a cornerstone of output controls. The most influential theories on incentives and motivation, namely agency theory and self-determination theory, are reviewed in terms of their implications for designing incentive systems. It is shown that the two theories are fundamentally different in how they view motivation and consequently the proper design of an incentive system. Chapter 11 emphasizes that as all organizations face uncertainty, one key challenge for top managers is to determine how much risk to accept when developing the business. Risk management tools and techniques, such as risk maps and scenario analysis, and the creation of special roles, such as risk officers and risk managers, are designed to help top management to deal effectively with uncertainty and associated risk and opportunity. This chapter deals with this important aspect of management control systems, namely risk management. Part 4 of the book, entitled ‘Management control systems: summary and outlook’, consists, as its name suggests, of a summary and outlook discussion. Chapter 12 summarizes the main messages of the book. It also expands the discussions in Chapter 3 about the role of human behaviour in management control system design and use, by paying attention to the function and role of the controller. We detail the responsibilities of this function, and describe some developments in the role of the controller, in terms of both opportunities and challenges. The chapter ends by discussing some recent trends within the area of management control systems research and practice, and their implications for controller roles.  page xxi Transform learning with Connect® Boost grades, stimulate engagement and deliver an amazing course Connect® is an online platform that integrates the science of learning with award-winning adaptive technology, to offer students and teachers a more effective teaching and learning experience. Connect increases my students’ knowledge and has made my teaching more effective. “ University of Birmingham Business School, UK ” The Three Pillars of Connect® Detailed Ease of set-up Flexible and reporting and and continuous high quality analytics support content tailored to your course Monitor progress McGraw-Hill and improve offers Use a efficiency with comprehensive combination of detailed service, support your content with Connect® and training - McGraw-Hill and reports. 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Develop your study skills Learn how to undertake a research project Enhance your academic writing and avoid plagiarism Learn effective ways to prep for exams Improve time management Increase your grades Get the job you want! Special Offer! As a valued customer, buy online and receive 20% off any of our Study Skills books by entering the above promo code. Learn more https://www.mheducation.co.uk/open-university-press/study-skills Contact the Team [email protected]  page 1 Part 1 Management control systems: managing organizational performance P art 1 of the book, entitled ‘Management control systems: managing organizational performance’, deals with the meaning and significance of management control systems for organizations. Chapter 1 discusses the nature of management control systems and highlights that if top management fails to implement the appropriate control practices, lower-level managers and employees might not have a clear sense of what decisions to take, what results to achieve, where to lead the people and how to use the resources under their responsibility. The chapter also discusses how, in addition to selecting an appropriate combination of input, throughput and output controls, top managers also need to systematically think through how to achieve an appropriate ‘balance’ between a coercive role of management control systems (i.e., a control device for use by top managers) and an enabling role (premised on a need to enhance the lower-level managers and employees’ capabilities, and to capitalize on their intelligence by giving them the freedom to innovate and engineer solutions to concrete problems). Chapter 2 expands our knowledge of what mission, goals and strategies actually mean and how they relate to management control systems. An organization’s mission concerns the reason why the organization exists. Organizational goals may be of many different kinds, such as financial and strategic goals. When deciding how to design a management control system, top management also needs to consider the contingencies of the organization. The contingencies include, among other things, the environment, strategies and technology. All these factors are shown to influence the selection of an appropriate combination of input, throughput and output controls. An organization facing a stable and certain environment, deploying a low-cost strategy and a manufacturing technology, is likely to benefit from a mechanistic approach, including heavy reliance on throughput controls in a ‘coercive’ manner. On the other hand, an organization facing a dynamic and uncertain environment, deploying a differentiation strategy and a service technology, is more likely to benefit from an organic approach, including heavy reliance on input controls in an ‘enabling’ manner. page 2 Chapter 3 discusses human behaviour. It details how the economic model of human behaviour, the psychological model of human behaviour and the sociological model of human behaviour each point to, and focus on, different characteristics of such behaviour. Often a particular management control system design is based on a specific view of what humans are, as laid down in these models. Understanding the similarities and differences between these theoretical models of human behaviour, and the limitations of management control system design and use, is important, since we are not interested in guiding the behaviour of some ideal type of individual, but rather the behaviour of lower-level managers and employees, who are real human beings.  page 3 Chapter 1 Introduction to management control systems Learning objectives After reading this chapter, you should be able to: 1 Explain why organizations have a need for management control system to attain their mission, goals and strategies. 2 Discuss the reasons why lower-level managers and employees do not automatically behave in line with the organizational mission, goals and strategies. 3 Explain the differences between the top-down and bottom-up functions of management control systems. 4 Discuss the various types of control practices – input, throughput and output controls – available to top managers when they design the organization’s management control system. 5 Discuss the enabling and coercive role of a management control system page 4 Real world vignette: The enabling role of management control systems A recent CIMA report took data from 78 UK-based innovation companies and found that they used management control systems to enable their innovative activities. Input controls, such as job-specific  recruitment and orientation programmes for new employees, were widely used and highly effective for innovation. In addition, output controls, such as routine analysis of performance against budget, were associated with better overall performance in innovation companies.1 Therefore, when reading this book you will find strong arguments to ‘kill the myth’ that management control systems are simply a way for top managers to ensure the obedience of lower-level managers and other employees. When designing an appropriate combination of input, throughput and output controls top managers also need to find ways to profit from the skills, motivation and commitment of their lower-level managers and employees. As such, management contro systems have an important ‘enabling’ role – that is, top managers need to design control practices that help maintain or enhance the skil set, job motivation and organizational commitment that lower-leve managers and employees aim to contribute to the organization. The lower-level managers need to perceive control practices as something that supports them, which they can use to identify problems, prioritize issues and develop innovative ideas. This supportive and empowering side of management control systems is very important to take into account when deciding on how to design an appropriate management control system. It has been found that truly groundbreaking innovation companies, such as Netflix and Spotify, realized the benefits of designing enabling management control systems from the start.2 Introduction A central question for all organizations is how to align managers and employees’ behaviour with the organization’s mission, goals and strategies. Take the Red Cross, for example. Its mission is to prevent and alleviate human suffering in the face of emergencies. Or Scania, a world- leading provider of transport solutions, including trucks and buses. One of Scania’s goals is to drive the shift towards a sustainable transport system, creating a world of mobility that is better for business, society and the environment. Or Inditex, one of the world’s largest fashion retailers with, for instance, the Zara brand. Inditex’s strategy is for its brands to work together closely as a single company, globally focused on the key elements of fashion production – design, manufacture, distribution and retail – thereby bringing the customers closer than ever to the products they want at affordable prices. The Red Cross, Scania and Inditex all have numerous managers and employees, and they all need to put considerable efforts into designing appropriate management control systems. Why? Because a well-designed management control system is one of the key factors to help ensure that the behaviour of Red Cross, Scania and Inditex managers and employees is aligned with the organization’s mission, goals and strategies. In this book we define a management control system as comprising a combination of control practices designed and implemented by top managers to increase the probability that lower-level managers and employees will behave in ways consistent with the organization’s mission, goals and strategies. This definition expresses that we focus our attention on formal page 5 control practices that are deliberately designed by top managers. Examples of control practices are budgets, mission statements, transfer pricing arrangements, performance measures and reward systems. When presenting management control systems as an issue of top managers and lower-level managers and employees, we emphasize that understanding management control systems is about understanding organizations of a considerable size. Most small organizations, consisting of only a few people, have little need for the systematic, complex and costly design of management control systems that we present and discuss in this book. Smaller firms, by definition, employ fewer people, such that communication between top managers and the rest of the organization is more direct than in big firms, and will remain more informal. The distinction between top and lower levels of managers within an organization is therefore crucial to our understanding of the organization’s need for management control systems. The essence of such organisations is that not all the power to make decisions that affect the future of the organization resides at the highest levels in the organization. Some of this power is shared with lower-level managers and employees. As, in larger organizations, lower-level managers have the authority to take decisions on their own, such organizations specifically need formal control practices, such as performance measures and value statements, that facilitate motivation and cooperation between the organization’s managers and employees. Without them, organizations may go astray and fail in achieving their mission, goals and strategies. In many cases companies’ failures can be directly attributed to the lack of appropriate management control systems. This means that these failures could have been avoided by the proper design and use of such systems. Understanding the nature of these failures, therefore, helps us to better understand where management control systems fail, and what potential weak spots they have. Recently, companies such as Volkswagen and Wells Fargo have become well known for lapses in control practices to keep managerial and employee behaviour on track. And, some years back, Ahold, a Dutch multinational company operating chains of supermarkets, was near collapse following a strong growth strategy involving many international takeovers in Sweden, the USA and elsewhere.3 The attention these organizations paid to pleasing the stakeholders by achieving pre-set performance targets resulted in behaviour that eventually went against stakeholder interests. Performance pressure may influence people to commit fraud in reporting performance levels that have no economic substance. If it is coupled with an organizational culture of improving reported performance by every means possible, failure is likely to happen some day. Top-down and bottom-up roles of management control systems W emanagement have now established that organizations cannot do without formal control systems. If the top managers fail to implement the appropriate control practices, lower-level managers and employees will often not have a clear sense of what decisions to take, what results to achieve, and where to lead the people and how to use the resources under their responsibility. We call this the top-down role of management control systems. And, without appropriate control practices, top managers will not have a clear sense of what lower-level managers have done (i.e., the decisions they are taking, what results they are achieving, where they are leading the people and using the resources under their responsibility) and what  lower-level managers think (i.e., what local contingencies might attract unsatisfactory attention due to the current strategies and management control system design). We call this the bottom-up role of management control systems. When we define a management control system as comprising ‘a combination of control practices designed and implemented by higher- level managers to increase the probability that lower-level page 6 managers and employees will behave in ways consistent with the organization’s mission, goals and strategies’, we assume that lower managers in the organization do not automatically perform such actions. Indeed, there are a number of reasons why lower-level managers and employees may not automatically perform in line with the organization’s mission, goals and strategies. Hence the need for both top- down and bottom-up roles of management control systems. 1 Lower-level managers and employees may not automatically understand the mission, goals and strategies of the organization, nor how they can contribute to these. An important first reason for the need for management control systems is that lower-level managers and employees need to become aware of how they can contribute to the achievement of the organizational mission, goals and strategies. This is not a trivial issue, because these are typically defined centrally and, therefore, are not immediately meaningful to lower- level managers and employees. For example, common goals for many organizations include to have a certain amount of revenue, to earn a certain amount of profit and to achieve a certain profit margin. But when the organization aims to achieve a certain amount of yearly profit, this does not mean that individual managers and employees automatically understand how this profit should be achieved. Take the example of a sales manager. Should a sales manager increase the selling price and, therefore, try to earn more contribution margin? Or should the selling price be lowered, such that the sales volume goes up, resulting in a higher profit? And should profit only be high this year, or should the sales manager also pay attention to next year’s profit levels? If so, this probably means that the manager should think just as hard about keeping customers as about maximizing profit this year. This relatively simple example shows that even if an organizational goal is relatively easy to measure, as is the case with organizational profit, top managers need to  design control practices that help operationalize the goal and thereby inform lower-level managers and employees about the required direction of their efforts and decisions. In reality, however, many organizations often have goals that are even less easily measurable than profit. For such goals, the need for operationalization is even bigger. Not-for-profit organizations typically have goals defined in terms of delivering maximum quality services to a variety of external stakeholders, subject to the available funding. In such cases, the need to provide lower-level managers with a clear direction for their efforts and decisions is even greater. An important first function of a management control system is therefore its top-down function to provide lower-level managers and employees with a clear sense of direction that helps them take actions, make decisions and achieve results that help the organization to achieve its mission, goals and strategies. Bottom-up, a management control system should inform top managers about the progress of the efforts of lower-level managers. 2 Lower-level managers and employees may not automatically agree with the organizational mission, goals and strategies. A second reason for the need for management control systems is that lower-level managers and employees may not automatically be motivated to achieve the organization’s mission, goals and strategies. This can be the case even if such organizational goals are operationalized and clearly communicated. Such motivation may be lacking because managers and employees have private goals that are incompatible with the goals of the organization. Private goals include goals that managers try to achieve out of self-interest, and that lead to the consumption of organizational resources for private reasons. Examples of such dysfunctional consumption are managers’ inclination to increase holiday and leisure time, or simply the overconsumption of the organization’s internal goods and services. More importantly, however, managers may have private goals that they try to achieve out of a genuine interest in the organization’s well-being. Such managers may even disagree with the ways in which top managers formulate the mission, goals and strategies. Such disagreement is likely to occur because lower-level managers often have better information about the local conditions of the organization. For example, a sales manager is often better informed about local market  conditions than top managers in the organization. Lower-level managers also often have more specialized skills than top managers. Sales managers typically have more commercial skills than higher- page 7 level general management. Note that benefiting from local information and from specialized managerial skills are two important reasons why organizations decide to rely on lower-level managers in the first place. An important second function of a management control system is therefore its top-down function to motivate lower-level managers and employees to take actions, make decisions and achieve results that help the organization achieve its overall mission, goals and strategies. Bottom- up, management control systems should facilitate information sharing and communication so top managers can benefit from the specialized skills and knowledge of lower-level managers and employees. 3 Lower-level managers and employees may not automatically have the resources needed to act according to the organizational mission, goals and strategies. A third reason for the need for a management control system is that lower-level managers and employees are not automatically able to achieve the organization’s mission, goals and strategies. This can be the case even if such organizational goals are operationalized and clearly communicated, and if lower-level managers feel motivated to achieve them. To act in line with the organizational mission, goals and strategies, lower-level managers and employees need both personal skills and monetary and physical organizational resources. While obvious, the lack of personal skills is sometimes hard to detect, as lower-level managers may often find excuses for their poor performance. They may do so by pointing at others or by using external circumstances to explain their failure to make an organizational contribution. Sales managers may, for example, blame the general economic situation for disappointing sales levels, rather than their lack of commercial skills. They may also blame the production managers for a lack of product quality that reflects in dissatisfied customers. The provision of sufficient monetary and physical organizational resources to lower-level managers is also a challenge for most organizations. It is clear that such resources are necessary conditions for the managers to take purposeful actions. However, as resources are costly, it is crucial that the provision of resources results in a sufficient return. This is, of course, not easily established a priori. An important third function of a management control system is therefore its top-down function to ensure that lower-level managers and employees have the skills and the organizational resources they need to perform in line with the organizational mission, goals and strategies. Bottom-up, management control systems should enable lower-level managers and employees to acquire the support to develop their skills as well as the organizational resources to execute their responsibilities. Table 1.1 summarizes the discussion. TABLE 1.1 Top-down and bottom-up roles of management control systems Origin of the need for Top-down role of Bottom-up role of management control management control management control systems systems systems 1. Lower-level Explain mission, Report on goal managers and goals and achievement; employees may strategies in as provide input not automatically operational a way when goals are understand the as possible. unrealistic. mission, goals Support Enable and strategies of coordination coordination and the organization, across business cooperation with nor how they can functions at other contribute to decentralized decentralized them level units  Origin of the need for Top-down role of Bottom-up role of management control management control management control systems systems systems 2. Lower-level Motivate lower- Facilitate top managers and level managers managers to employees may and employees to benefit from the not automatically strive for the specialized skills agree with the organizational and knowledge of organizational mission, goals lower-level mission, goals and strategies managers and and strategies employees 3. Lower-level Resource Enable lower- managers and allocation, level managers to employees may develop personal acquire the not automatically skills of lower- support and have the level managers resources to resources and employees execute their needed to act responsibilities according to the organizational mission, goals and strategies page 8 In order to reap the benefits of the top-down and bottom-up roles of a management control system, its design and use has to be well thought through. Top managers have a variety of control practices to choose from, which is what we turn to next. A management control system ‘package’ – input, throughput and output controls e have now established the need for a management control system and its top-down and bottom-up roles. The question for top managers then W becomes: What are the various types of control practices they can use to form an appropriate management control system for the organization? When we ask top managers this question, the majority of them (too) quickly answer: budgeting, performance measures and incentive schemes. The idea of ‘what gets measured gets done’ is strongly rooted in many managers’ mindsets. These are undoubtedly very important control practices in many organizations (and thoroughly discussed in Part 3), but an important message in this book is that the range of control practices is much wider. In fact, control practices can usefully be divided into three types; we label these input controls, throughput controls and output controls. This division is broadly meant to provide a way in which we can systematically discuss and design control practices. It follows an intuitive logic (see Figure 1.1) that lower-level managers and employees provide important cognitive abilities, skills and personal values to the organization (which top management can try to influence via input controls), which are transformed via the execution of effort – i.e., the actual work and organization of lower-level managers and employees (which top management can try to influence via throughput controls) – into some sort of performance, or ‘results’ (which top management can try to influence via output controls). From this it follows that top managers need to carefully think through how to design and use input, throughput and output controls to help the organization achieve its mission, goals and strategies. FIGURE 1.1 Three types of control practices: input, throughput, output  In most organizations, the way in which lower-level managers and employees are controlled is always through a combination of these three types of control practice. Designing a management control system is therefore about choosing the relative emphasis that is put on ‘cognitive abilities, skills and personal values’, ‘work and organization’, and ‘results’. This ‘conceptual typology’ has proven very useful for making page 9 top managers aware of the broad array of control practices available to them when designing a management control system for their organization. Input controls Input controls have to do with the people in the organization, and the capabilities, characteristics, knowledge and intentions they bring to their function. Top managers can systematically design control practices that help to ensure that these capabilities, characteristics, knowledge and intentions increase the chance that the lower-level managers and employees will engage in such behaviours as can be deemed consistent with the organization’s mission, goals and strategies. The most commonly used input controls are as follows. Employee selection processes: In many organizations, top managers put considerable efforts in designing systematic screening processes for job candidates. The idea is to try to ensure that only people who embrace the organization’s mission, goals and strategies are recruited and promoted. The main idea with systematic employee selection processes is that if an organization simply hires the ‘right’ people, the probability that manager and employee behaviour will be in line with organizational mission, goals and strategies increases. This requires a thorough understanding of how managers will behave, which is considered in more detail in Chapter 3. Real World Example: The consulting company McKinsey is well known for its systematic selection process. On the homepage of its website, it states: ‘While there’s no exact template for success at McKinsey, our people share some qualities that help make us successful-and that make working more fun.’3 These qualities, according to the homepage, are personal impact, entrepreneurial drive, problem-solving skills and leadership abilities. The employee selection process focuses specifically on identifying individuals who score ‘high’ on these qualities. Value statements: Many top managers we talk to emphasize the importance of formally communicating and systematically reinforcing organization-wide values and beliefs through mission statements and credos. The main idea with designing value statements is to inspire lower-level managers and employees, and guide their search for new opportunities. Real World Example: The international company Beiersdorf, with brands such as Nivea and Eucerin, emphasizes in its Annual Report4 that an important key to success is its employees’ united understanding of shared values, and their strong identification with the company and its brands. These values are formally communicated through a value statement comprising four core values: ‘Care, Simplicity, Courage, Trust’. The company describes these in its values statement as follows. Care: we act responsibly towards our colleagues, consumers, brands, our society, and our environment. Simplicity: we strive for clarity and consistency, making decisions quickly and pragmatically, and focusing on what is essential.  Courage: we are committed to bold objectives, take initiative, learn from our mistakes, and see change as an opportunity. Trust: we say what we mean, keep our promises, and treat others with respect. page 10 Real World Example: Another example is Netflix, whose corporate vision is ‘to continue being one of the leading firms of the internet era’.5 One way to formally communicate and reinforce this vision is through a value statement that contains the following key values: Continuing leadership; Internet; Entertainment. Employee socialization processes: In many organizations, employee socialization processes are vital to ensure basic conditions that enable lower-level managers and employees to be informed about organizational mission, goals and strategies. These should not simply be ad hoc activities but systematically designed processes that include introduction programmes for new managers, organizing training programmes to enhance competencies, and influencing collegiality, citizenship and culture. As with value statements, the main idea with designing systematic employee socialization processes is to inspire lower-level managers and employees, and guide their search for new opportunities. Real World Example: The Swedish fashion company H&M, for instance, has well-known trainee programmes with the purpose of enhancing the competencies of its future leaders. H&M describes these programmes as offering a unique, broad introduction to H&M, and deep knowledge about different areas and departments within the company.6 In addition to designing appropriate input controls, it is important for top managers to be aware of the importance of management style. Usually, lower-level managers’ attitudes towards the organization’s mission, goals and strategies reflect what they perceive their superiors’ attitudes to be, and their superiors’ attitudes ultimately stem from the CEO and other members of the organizational highest ranks. Managers come in all shapes and sizes. Some are charismatic and outgoing; others less so. Some spend a lot of time talking to people (‘management by walking around’); others rely more heavily on written reports. When evaluating the effect of top management style on lower-level managerial behaviour we often discuss this in terms of ‘tone at the top’; that is, top managers set the example for lower-level managers in the way they act, the opinions they proclaim and the norms they seem to adhere to. Audit professionals and advisory agencies on corporate governance have traditionally stressed the importance of ‘tone at the top’ as a powerful way to make lower-levels managers behave in line with the organizational mission, goals and strategies. ‘Tone at the top’ often affects behaviour because many lower-level managers, willingly and consciously, as well as unwillingly and unconsciously, often reciprocate the behaviour they see displayed. We want to emphasize, however, that management style is not a control practice. As we have discussed, control practices are designed (by top managers), i.e., they design a process for employee selection, they design value statements and they design processes for employee socialization. More in-depth discussions of input controls are often found in books on human resource management (HRM). It is important to stress, however, that designing appropriate input controls (especially value statements) is ultimately the responsibility of top managers, even if they often delegate some of this responsibility (for instance, regarding employee selection and socialization processes) to the human resource department. In this book, Chapters 3 and 10 provide thorough discussions about ‘people’ and how they are motivated. Such understanding is vital when designing appropriate input controls. page 11 Throughput controls Managerial effort is a generic term that applies to all the observable actions and choices managers make as part of their managerial responsibilities. The actions and choices are made by managers in the context of their managerial role, and because man­agers and employees often do not automatically act and choose in line with organizational mission, goals and strategies, top managers also need to implement throughput controls. These control practices direct lower-level manager and employee behaviour through formal delegation of decision-making responsibility to lower-level managers, and by specifying how behaviours are to be performed or not performed. The most commonly used throughput controls are as follows. The organization’s set of rules: When top managers are asked about throughput controls, the first example they give is always the prescription of certain behaviours of managers in some specific situations through policies, guidelines or codes of conduct – what we label the organization’s set of rules. These throughput control practices describe crucial ‘dos and don’ts’ of lower-level managers and employees concerning, for example, the way they report their accounting performance, the way they do business in foreign countries, and the way they deal with HR-related, ethical or environmental issues. We use the word ‘rules’ as shorthand for all types of formal instructions, including standing instructions, job descriptions, standard operating procedures, manuals and ethical guidelines. Rules range from the most trivial (e.g., paper clips will be issued only on the basis of a signed requisition) to the most important (e.g., the organization is not allowed to expand its operations into country X, or capital expenditures of more than €1 million must be approved by the board of directors). Many rules are in force indefinitely – that is, they exist until they are modified, which happens infrequently. Some rules are guides – that is, organization members are permitted, and, indeed, expected, to depart from them, either under specified circumstances or when their own best judgement indicates that a departure would be in the best interests of the organization. For example, even though a rule specifies the criteria for extending credit to customers, the credit manager may approve credit for a customer who does not currently meet these criteria, but who has been valuable to the company in the past and is likely to become so again. Such departures may require the approval of higher authority, however. Some rules are positive requirements that certain actions must be taken (e.g., fire drills at prescribed intervals). Others are prohibitions against unethical, illegal or other undesirable actions – for instance, requiring signatures and other evidence that a transaction has been authorized and separating duties. One important function of these control practices is to establish limits to the opportunity-seeking behaviour that all organizations try to encourage (for instance, through value statements). These codes of conduct are sometimes explicitly communicated to the outside world, to signal their importance to the organization. Real World Example: The Australian sports equipment producer Quiksilver, for instance, communicates that it is committed to conducting business in an ethical manner and expects its manufacturing partners to share this same commitment. Accordingly, it has established a code of conduct, titled QUEST (Quiksilver Ethical Standards of Trade), to prevent abusive or illegal conditions in the workplace, and prevent human trafficking and slavery. QUEST includes a Supplier Workplace Code of Conduct, and all agents, vendors and factories are required to participate in the QUEST programme as a condition of doing business with Quiksilver.7 The organizational architecture: One important way to control the behaviours of lower-level managers and employees is by systematically designing appropriate structural arrangements for the page 12 organization’s mission, goals and strategies. In this book we use the expression ‘organizational architecture’ to denote these various structural arrangements that are designed by top managers. Should they employ a functional structure for the organization, in which each manager is responsible for a specified function such as production or marketing? Or a business unit structure in which managers are responsible for most of the activities of their particular unit, and the business unit functions as a semi-independent part of the organization? Or a matrix structure in which functional units have dual responsibilities – i.e., a mix between a functional and a business unit structure? Or a project structure, where the responsibilities mostly are related to ongoing projects? Or should the organization engage systematically in formal cooperations with other organizations, and form joint ventures and  outsourcing arrangements? The organizational architecture also concerns designing appropriate responsibility centres. Should the various organizational units be responsible for only revenues (revenue centres) or only costs (expense centres) or both revenues and costs (profit centres) or also investments (investment centres)? It also concerns how transfer pricing and cost allocation systems should be designed if the different organizational units are interdependent. Finally, it encompasses designing job descriptions and roles for employees. Real World Example: Starbucks Coffee works diligently with its organizational architecture to maintain its competitive advantage. As the largest coffee house chain in the world, it continuously ensures that its organizational structure matches current business needs. Starbucks has a matrix organizational structure (see more on this type of structure in Chapter 6),8 which involves intersections among various components of the business. There are four main features of the matrix structure: functional hierarchy, geographical divisions, product- based divisions, and teams. For instance, the company’s product- based divisions intersect with functional groups and geographical divisions, which in turn intersect with other parts of the organization. When we emphasize that the design choices regarding the organizational structure are important throughput controls and therefore a key part of an organization’s management control system, many top managers we talk to admit that they often forget this. They tend to focus on rules, such as policies and codes of conduct. Such throughput control practices are important but a key message in this book is that the organizational architecture is a very powerful (but often forgotten) way to direct lower-level manager and employee behaviour. We therefore devote Part 2 of this book to these throughput control practices. Output controls A third way to direct lower-level manager and employee behaviour is by making managers accountable for certain ‘results’, or output. As previously discussed, these are the control practices commonly emphasized when top managers are asked to describe their management control systems. ‘What gets measured (and rewarded) gets done’ is a quote commonly referred to by top managers when they discuss their control philosophy. Output controls work through planning, measuring and following up on important performance targets. They direct lower-level manager and employee behaviour through expressing expectations of what is a ‘good enough’ performance. The most commonly used output controls are as follows. Budgets: Budget preparation is one of the most important processes in a majority of organizations. An operating budget is the organization’s yearly plan, and is often decided in negotiations between top managers and lower-level managers. The end product of such negotiations is an agreed-upon budget of the anticipated revenues and/or expenses and/or investments for the coming year. In Chapter 8, budgets will be thoroughly discussed. page 13 Real World Example: Danske Bank, for instance, launched ‘Danske Bank’s Budget Guide 2019’, intended as a quick reference guide to help facilitate the 2019 budget planning of companies. The guide sought to answer the following questions with 2019 budgeting in mind: What is the outlook for the global economy and selected countries/regions? What is the outlook for sales to a particular country/region with a focus on consumer spending and investment? What should a company with production or sales in a particular country/region expect in terms of wage and price growth?9 Financial and non-financial performance measures (often combined with reward systems): Most organizations put an enormous effort into selecting performance measures that ‘best’ reflect the organization’s mission, goals and strategies. Often they use a combination of financial measures (for instance, sales, profit, return on capital employed, operating cashflow) and non-financial measures (for instance, customer satisfaction, quality, productivity, employee satisfaction). By comparing the outcome of the chosen performance measures against appropriate standards, top managers can assess the performance of lower-level managers and employees. In addition, making managers accountable for results is often emphasized even further through linking managerial compensation to the achievement of certain performance targets. Performance measurement and incentive systems are discussed in Chapters 9 and 10. Real World Example: Fiat Chrysler Automotive, for instance, stressed in its 2018 Annual Report10 the importance of product quality and customer satisfaction to its ability to produce vehicles to meet product quality standards, gain market acceptance and satisfy customer expectations. It therefore monitors such measures at Group Executive Council and Product Committees meetings. Risk management: All organizations face uncertainty, and thus one key challenge for top managers is to determine how much risk to accept when developing the business. Risk management tools and techniques, such as risk maps and scenario analysis, and the creation of special roles, such as risk officers and risk managers, are designed to help top management to deal effectively with uncertainty and associated risk and opportunity, enhancing the capacity to build value. Real World Example: The Norwegian oil company Equinor (formerly Statoil) works diligently with climate-related business risk. Equinor’s business is subject to strict climate regulations and the company uses internal carbon pricing, scenario analysis and sensitivity analysis to assess and manage climate-related risk. Climate-related risk factors are identified by considering main sources of change, such as market, policy and regulatory, technology, physical and reputation.11 Reflecting the importance of output controls, Part 3 of the book is devoted to the use of budgeting, performance measurement systems, reward systems and risk management.  page 14 Enabling and coercive management control systems S ovariety far, a main message in this chapter is that top managers have a wide of control practices to choose from when they design their organization’s management control system. The distinction between input, throughput and output controls is a powerful way to demonstrate this variety, and it is a distinction that ‘stands the test of time’. In the ‘new era’ we live in, with digitalization and climate change, the need for, and use of, information changes quickly (from ‘small’ data to ‘big’ data, more focus on sustainability measures, etc.), but the distinction between input, throughput and output controls remains relevant. The three types of control practices also highlight the important message of this book, that management control systems are about so much more than performance measurement and incentives. The fact that Part 2 of the book is entirely devoted to throughput controls – which make up the organizational architecture within which output controls are designed – sends a powerful message about the need to use a broad conception of what a management control system is. This also means that this book has a rather comprehensive view of what it