MGT 601 The Functions of Modern Management / week 6 discussion 1 and responce and week 6 discussion 2 and responce.

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15 Management Control Systems Chapter Outline

• Introduction • Control and the Control Process • Forms of Organizational Control • Operational Control

• Nonfinancial Controls • Challenges in Managing Control

Systems • Managing the Control Process

Learning Outcomes

After reading this chapter, you should be able to

• Describe management control and the control process.

• Distinguish among the various forms of organizational control.

• Explain how to implement effective operational controls.

• Describe nonfinancial controls.

• Describe challenges to managing control systems.

• Summarize the elements involved in managing the control process.

• Assess an organization’s control program.

Inside Management: Coca-Cola Changes Controls to Adapt to Mexican Soda Tax

Mexico is the biggest per capita consumer of Coca-Cola in the world. The company sells about $2.5 billion in products in the country each year. Mexican purchases constitute about 5% of the company’s global sales, a significant percentage for an organization of Coca-Cola’s global scope and magnitude.

On the surface, Mexico appears to be an ideal market for Coca-Cola, but its people have suffered significant health consequences as a result of their preference for sweeter beverages. Mexico has one of the highest death rates from type 2 diabetes of any of the 31 members of OECD—152 deaths per 100,000 people, versus an average of 19 per 100,000 in the other 30 countries. Also, according to Mexican government statistics, about 70% of adults in the country are overweight or obese, which puts the country first in the world for that problem. The issue is partly complicated by the fact that many Mexican consumers do not trust the water supply in their areas, and as a result drinking a Coke may seem to be a “safer” choice.

To deal with the problem, the Mexican government introduced a special 8% tax on sugary soft drinks and various sweetened packaged foods. Whether such taxes will affect Mexican consumption behaviors remains to be seen; however, this change definitely affected the planning and controlling mechanisms in the Coca-Cola Company. Coca-Cola has established itself in the country with ubiquitous billboards and signage in the streets and at sporting events. FEMSA, Coca-Cola’s largest bottling facility, is located in Mexico. A significant disruption in the price to consumers could therefore seriously impact Coca-Cola’s presence in the country, along with its bottom line. Coca-Cola has also faced criticism that selling its drinks promotes unhealthy behavior. To respond to these issues, the company began to advertise with slogans such as “Movement=Happiness.” Another tactic was to disassociate the company from lobbyists who tried to do away with the tax. While this move might seem counterintuitive, the company’s management team believed that not opposing the tax would be perceived as the more responsible move.

Unfortunately, to control its market share and absorb the effects from the tax on its soft drinks, Coca-Cola FEMSA managers were forced to make some hard decisions. It is expected that prices for its drinks—and for sugary drinks across the board—will increase by 12% to 15%. Coca-Cola FEMSA also had to reduce its workforce by 3% to 4% and cut back on distribution routes. These internal controls will ideally help the firm cope with changing environmental conditions without significantly impacting its bottom line (Flannery, 2013; Walker, 2013; Comlay, 2013).

Ton Koene/age footstock/Superstock As an international company, Coca-Cola has to adapt its internal controls to a number of global issues.

Section 15.1Control and the Control Process

Introduction Businesses around the world constantly adapt their organizational controls to address a wide range of issues. As we will discuss, control is vital for efficient and effective organizational operations. Managers need to understand both the purpose and importance of control to use it wisely.

In this chapter, we explore management control systems. Control is closely associated with the other managerial functions. We begin by examining the nature of management control, including its purpose, importance, areas, responsibilities, and how it relates to planning. Next, we distinguish among the various forms of organizational control and discuss ways to imple- ment effective operational controls. We also look at the utilization of nonfinancial controls to cope with additional issues that confront organizations. We also explore challenges that arise to managing control systems and some of the approaches used to overcome them. Finally, we look at ways to manage and assess an organization’s control system.

15.1 Control and the Control Process Management control includes every activity an organization undertakes to ensure that its actions help it achieve its stated objectives. A management control system is a planned, ordered scheme of detecting deviations from goals and standards and making the appropri- ate corrections. It enables managers to readily assess where the firm actually is at a point in time relative to where it wants or expects to be. Without effective control, a company has no way of knowing how well it is doing.

Internal controls refer to processes managers develop to provide assurance that an orga- nization has reached its objectives, specifically those that relate to operational efficiency, accuracy of financial reporting, and regulatory compliance (Committee of Sponsoring Orga- nizations of the Treadway Commission, n.d.). Internal controls cover a wide range of issues. Some are designed to limit risk and prevent mistakes before they occur. For instance, a bank may allow any officer of the rank of vice president or above to approve a loan up to $10,000, but loans above this amount must be approved by multiple bank officers. Such an approach represents a proactive form of control that prevents a problem (giving a loan to someone who cannot repay it) before it happens. Company budgets are also an important tool for internal control.

The control process consists of four basic steps: establishing performance standards, mea- suring performance, comparing performance against standards, and deciding whether cor- rective action is required or if performance should be rewarded (see Figure 15.1). This, in turn, sets the stage for the next round of planning and control. Based on problems that have been identified and solved, managers are better able to set standards for the future.

Section 15.1Control and the Control Process

Figure 15.1: The control process

The control process contains four basic steps.

2. Measuring performance

3. Comparing performance against standards

4. Evaluation and corrective action

Correct deviation Change standard Maintain status quo

1. Establishing performance standards

Establishing Performance Standards in the Control Process Establishing performance standards constitutes the first step of control. Managers set these targets during the planning function. They make it possible to accurately gauge the effec- tiveness of the company’s efforts. As part of the planning function, standards are set at the company-wide or strategic level, at the functional area or departmental level, and for indi- vidual workers. Typically, individual controls are part of the performance evaluation process as directed by the human resource department. We will briefly restate and analyze the per- formance standards at the strategic and departmental levels.

Strategic Goals and Standards Many years ago, Peter Drucker outlined a series of goal areas that indicate organizational health. Market share is the percentage of overall sales (in an industry or a specific geographic region) a company holds. Managers seek to either increase a company’s share in a stagnant marketplace or hold share when total industry sales continue to rise. For example, a company that sells solar panels might be content to hold share in this rapidly growing field. In contrast, as sugary soft drink sales have flattened in the United States, a company’s management team

Section 15.1Control and the Control Process

might be more interested in expanding share. Market share demonstrates consumer accep- tance, brand loyalty, and a strong competitive position.

Innovation includes finding new and different ways to achieve objectives. This does not nec- essarily mean inventing new products. Innovation takes place in a variety of ways, including increasing efficiencies in production, delivery, and other areas. Innovative companies stay ahead of the competition.

Productivity is reflected by output-per-worker statistics. Many company leaders currently think improved or increased productivity are key to other aspects of organizational success.

Physical and financial resources include a company’s plant and equipment combined with the means to obtain those items. Access to loans and the ability to raise money by selling stock indicate a strong position relative to physical and financial resources.

Profitability remains important. Companies need to make a profit to stay in business. At the same time, there is a difference between short-term and long-term profits, and top manage- ment should consider both.

Manager performance and development is indicated by successful recruiting and manager training programs. A successful company maintains a pipeline of people ready to move into top-level assignments.

Employee performance and attitudes are found in statistics regarding absenteeism, tardi- ness, turnover, and grievances. Satisfied employees tend to remain with a company. Company morale should be routinely assessed as part of the strategic control process.

Social responsibility is linked to an organization’s long-term well-being. It includes two activi- ties. First, responsible companies and their managers eliminate negative company activities such as discrimination, harassment of various individuals and groups, pollution, tax evasion, and selling defective or dangerous products. That is only half of the battle, however. The other aspect of social responsibility is the company’s obligation to engage in positive activities such as becoming more environmentally friendly, assisting employees with personal problems and challenges, and serving the local community.

Although it may be difficult to create precise measures for each of these standards, Drucker argues they should always be a part of managerial thinking in order to achieve long-term success.

Strategic performance standards should be stated in clear, measurable terms. Table 15.1 offers some potential examples. They should be realistic, given both the internal and com- petitive environment in which the organization operates. Performance standards are set for various products and markets. A well-established market leader such as Procter & Gamble might set performance standards related to maintaining its market share in each of the many product categories in which it competes, while a smaller, less well-known company might set standards related to gaining initial entry and acceptance in a limited number of geographi- cal markets. In international markets where Procter & Gamble is not the market leader, per- formance standards are likely to reflect different strategic considerations. For instance, the company might set a performance standard for a brand of shampoo introduced in Peru to

Section 15.1Control and the Control Process

attain a 4% market share in the first 6 months, even though the same shampoo has long led the domestic market—where the standards reflect the company’s objective to maintain its relative competitive position.

Table 15.1: Examples of strategic objectives

Profitability Growth of assets Growth in number of employees Levels of employee satisfaction Levels of customer satisfaction System improvement (efficiency) Survival in hostile circumstances

Departmental or Functional Area Standards Individual department managers are responsible for functional area controls. Table 6.1 indi- cates common standards in these areas. Performance targets in each of these areas should be set in the planning process.

Measuring Performance in the Control Process The second step in the control process is to measure performance. In most organizations, this occurs continuously. For example, if a company establishes as a performance standard a cer- tain maximum acceptable product defect rate, managers must continually measure the rate to ensure that all products fall below it.

It is sometimes difficult to accurately measure performance. Consider a pharmaceutical com- pany such as Amgen, which concentrates its efforts on relatively “high-risk” drugs in many developing fields of medicine that some of its competitors often avoid. Amgen may spend years developing and testing a potential product that may never actually make it to market. Although it can be difficult to measure performance in such a case, a valid method must be developed to facilitate effective control. Company analysts might measure performance by looking at reviews and testing that was conducted as part of ongoing projects by other scien- tists or medical associations. Or the company could consider performance in terms of whether the drug successfully combatted individual disease symptoms in the laboratory, regardless of whether the drug gets to market. The upcoming sections examine functional area standards and ways to measure performance in some basic areas.

Production Measures Production and quality control are closely linked. Production is a line function, and quality control assesses the outputs of the production department. Managers typically set four types of goals for the production department, including the following:

Section 15.1Control and the Control Process

• Quantity • Quality • Time • Cost

Production departments file reports regarding these standards. Production measures can be taken on a daily, weekly, monthly, quarterly, or annual basis, depending on the nature of the department and its operations.

Quantity goals may be stated in units or by volume. Shirts and pants are counted in units. Wineries count their product in liters or gallons. Managers in other situations enact more complicated controls. For instance, a construction foreperson on a building site will want to know whether output levels are sufficient. Consequently, the foreperson will use various benchmarks to note the completion of tasks (dates and/or times). One standard applies to framing and another to the wiring system.

Quality goals take several forms. Quality is sometimes measured by exceeding a threshold, such as the construction of a house that must pass all inspections before it can be put up for sale. Other quality standards include variation and defect levels. Quality-control tests such as these are found in many forms of manufacturing. A third set of quality goals examines intangible, qualitative items, such as customer satisfaction. Automobile manufacturers know people must enjoy something that will be hard to measure, such as the quality of the car’s interior. No hard standard can be set, yet managers still want to know whether customers are pleased with their purchase. Surveys and questionnaires can make available numbers that provide helpful information, such as where the company ranks in the industry in terms of customer satisfaction.

Time goals reflect whether items have been produced on schedule, by the number of units per day, week, and month, or other means. A large project will establish a goal as a deadline. For example, the publication of a book has a defined production and release date. Cost and time goals combine to measure the efficiency of the department.

Cost controls are vital. Costs associated with raw materials, labor, storing, and shipping should be examined. Discarded products or those that need to be repaired drive up costs. The accounting department measures and reports costs.

Marketing and Sales The marketing manager works with other departments, most notably production, to make sure that items for sale will satisfy customer needs. When services are marketed, they must also be of sufficient quality to attract customers and sales. The marketing and sales depart- ments share four common goals:

• Market share • Sales quotas • Share of mind (consumer awareness and loyalty) • Marketing and sales costs

Section 15.1Control and the Control Process

When a firm only has one marketing and/or sales department, these standards become com- pany-wide objectives as well.

Market share can be assessed in several ways, including total company share, division share, brand or product line share, or individual product share. Total company share measures how well a company fares in a market. For example, PepsiCo would examine its total in the food and drink industries. Division share would be indicated by statistics about sales and mar- ket shares of the company’s various major components, including snacks (Frito–Lay), break- fast drinks (Tropicana), soft drinks, energy drinks (Gatorade), and breakfast foods (Quaker). Brand or product line would divide PepsiCo’s soft drinks into products with the Pepsi name and Mountain Dew products. Market share is assessed at the product level, such as share of Diet Caffeine-Free Pepsi. Market share information is available in industry and trade publica- tions. Market share statistics also are prepared by local agencies, including governments and educational institutions, for small businesses in a town or city.

Sales quotas are examined at all three levels: company-wide, departmental, and individual. Additional sales quotas can be assigned to divisions, product lines, and individual products. Sales can be examined in summaries prepared by the accounting department. Marketing and sales managers take both an overall view of sales and more specific sales activities.

People won’t buy a product or use a service unless they know about it. Share of mind indicates that consumers consider a specific brand when they go to buy a product. Loyalty means they will find a company first when making purchase decisions. Share of mind can be measured by using market research to rate advertisements. Other measures come from redeemed cou- pons, entries into contests, and website hits. Customer loyalty normally requires more in- depth market research.

Marketing and sales managers spend money to generate money. Marketers create adver- tisements, promotions and sponsorships, contests and sweepstakes, and other activities designed to entice people to come to a store and buy a product. The same is true for sales, where the sales manager pays salespeople’s travel expenses, pays commissions, and estab- lishes rewards for increasing the number of customers. Marketing managers want to know if the money has been spent wisely. The accounting department reports the costs of marketing and sales programs.

Human Resources The HR department serves the entire company. Departmental goals represent company-wide goals as a result. The standard measures of performance in human resources include rates of:

• absenteeism, • tardiness, • turnover, • accidents, • grievances, and • vandalism.

Section 15.1Control and the Control Process

The HR department prepares reports regarding all of these statistics at regularly scheduled intervals.

The cost of a department reflects the con- cept that HR managers spend money on recruiting and selection. They should spend the money carefully and efficiently. HR man- agers are also often asked to balance the costs of benefit packages. The accounting department calculates cost information for the purposes of control.

Information Technology and Research and Development Performance in the areas of IT and R&D is more difficult to assess. The problem is largely due to the inability to create measurable, tangible standards. Company leaders clearly need an effective IT system; however, it may be difficult to identify numbers that can be assigned to the concept. The same holds true for R&D; it can be difficult to establish concrete goals.

A company’s vision and mission statements can provide some guidance. IT and R&D depart- ments should focus on activities that support the organization’s overall direction. When the work moves the company away from its intended direction, corrections can and should be made.

Financial Control: Budgeting Organizations typically use a number of financial control techniques, many of which are beyond the scope of this book. Here, we focus on the most commonly used and basic methods: budgetary control, analyzing financial statements, and financial audits.

The principal means of controlling annual company operations in financial terms is bud- geting. A budget is an annual, formal, written plan that directs future operations in finan- cial terms. Budgeting allows companies to anticipate and control financial resource needs. In a manufacturing company, for example, a cash-flow budget tracks and controls financial resource needs as the firm purchases materials, produces and inventories finished goods, sells the goods, and receives cash for them. Budgets are established for the overall company, and then individual departments are allocated funds for the next operating cycle.

There are two main forms of budgeting. Operating budgets establish relatively short-term financial control concerns, including having sufficient cash on hand to cover daily financial obligations such as routine purchases and payroll. Cash-flow budgeting is a form of operating budgeting. In contrast, capital budgeting is concerned with the intermediate and long-term control of capital acquisitions such as plants and equipment.

Shironsov/iStock/Thinkstock HR managers are tasked with measuring and reporting turnover, accidents, grievances, and more to assess the company as a whole.

Section 15.1Control and the Control Process

Control Budget Approaches Companies develop control budgets in one of three ways. With top-down budgeting, top managers establish budgets and hand them down to middle-level and lower level managers. Top-down budgeting has the advantage of being able to take a broad, corporate perspective and is relatively quick and inexpensive to prepare. Unfortunately, it may fail to consider the inputs of employees closest to and most knowledgeable of actual work activities.

Bottom-up budgeting flows upward from the lower levels of an organization to top manage- ment. Bottom-up budgeting involves those directly engaged in the actual tasks covered by the budget; however, its disadvantage is the possibility that those people may have somewhat narrow views of specific tasks, leading them to ignore the effects of their proposed actions on the overall organization.

In practice, a form of negotiated budgeting is usually called for. As the name implies, negoti- ated budgeting involves a degree of give and take between upper and lower levels of man- agement to develop the most appropriate form of budgetary control for a given situation.

Regardless of the type or process, budgeting in general has both advantages and disadvan- tages as a form of financial control. Its advantages include the fact that it can lead to better coordination of organizational activities. This is because the budgeting process often involves employees from various organizational areas, allowing conflicts to be discovered and dis- cussed before they become actual problems. When properly carried out, budgetary control also serves as a way to bring together diverse organization members to determine overall objectives as well as a way to communicate these plans to the organization as a whole. Finally, budgeting emphasizes the need for the organization to continually adapt to environmental changes.

Disadvantages of using traditional budgeting for control include the unavoidable fact that it is difficult to do. Managers must successfully allocate scarce organizational financial resources among many departments and subunits, all for projects that they feel are worthy of full orga- nizational backing.

Types of Annual Budgets Budgeting often involves the extensive use of incremental budgeting, which is one that stays the same from year to year. It typically involves adjusting the previous period’s budget to arrive at the new plan. Two types of changes can be part of the process:

• Across the board, in which every department receives a percentage increase (or decrease) in operating funds for the next year

• Relative amount, in which some departments receive larger increases due to addi- tional or special needs in a given year

Incremental budgeting enjoys the advantage of being easy to prepare. It often contributes to morale, as employees and managers know what they have to “work with” each year.

Overreliance on incremental budgeting can create problems. For one, some managers are able to build up “slack” in their departmental budgets, which is essentially unneeded funding.

Section 15.1Control and the Control Process

Also, this approach increases the probability that managers will fail to consider current—and likely changed—environmental conditions. Incremental budgeting suffers when it is used as a way to legitimize current power structures, such as when upper level managers slash or redistribute financial resources in order to reinforce their power—possibly “paying back” or “rewarding” a subordinate manager—rather than basing their decisions on matters more directly related to overall operational performance.

A second method, zero-based budgeting, requires top management to annually evaluate organizational activities to determine their true level of importance. The key elements in this approach include identifying objectives, evaluating alternative ways to accomplish each activity, evaluating alternative funding levels (whether to maintain the current level or raise or lower levels), evaluating work load and performance levels, and establishing priorities (Sweeny & Rachlin, 1987). A primary phrase associated with zero-based budgeting is cost– benefit analysis. Departments receive annual funding when the benefits of their activities most greatly exceed the costs.

As form of financial control, zero-based budgeting forces managers to view it as a true man- agement process rather than just simply recycle and adjust the budget from the previous planning period. It requires managers to reevaluate all activities to determine their true level of importance and determine how much funding each should receive. In essence, it is a pro- gram that can be used to “trim the fat” out of a company’s incremental budget.

The disadvantages of zero-based budgeting start with the problem that it can cause manag- ers to overemphasize the short range. In order to receive funds, they must make the case that their department’s activities should have the highest priority. This in turn can cause unneces- sary conflict and morale problems in departments that do not receive full funding.

A third form of annual budgeting has several names, and includes budgets that are:

• rolling, • moving, • adjusted, • variable, and • flexible.

In each case, managers adjust departmental budgets as revenue figures become known. For example, if a company projects $1 million in first-quarter sales, but the number comes in at $1.3 million, that means additional raw materials were used, higher shipping costs were incurred, salespeople received higher commissions, and so forth. Management can adjust all appropriate budgets at that time, rather than waiting until the end of the year. If sales total only $800,000, budgets are adjusted downward. Budgets can be rolled on a monthly, quar- terly, or semiannual basis, depending on the company.

The most efficient budget is one that is both zero-based and variable. Managers have the ulti- mate level of control over financial disbursements to departments. This approach will likely be reserved for a financial crisis.

Section 15.1Control and the Control Process

Financial Statements and Analysis Financial statements allow a firm to classify the effects of the many varied transactions that occur while conducting business. The two principal financial statements used in management control are balance sheets and income statements.

A balance sheet provides a snapshot of the organization’s financial position at a given moment. It indicates what the firm owns and the portion of its assets that are financed with its own or borrowed money.

An income statement summarizes the organization’s profitability over a period of time, such as a month, quarter, or year. Income statements summarize the organization’s overall revenues (from sales and investments) and the costs incurred to generate those. A detailed analysis of such statements helps management determine the adequacy of the organization’s earning power and its ability to meet current and long-term obligations.

Analyzing balance sheets and income statements as a form of financial control answers two basic questions: (a) How much money did the organization make or lose? and (b) What is a measure of the organization’s worth based on historical values found on the balance sheet?

Ratio Analysis Managers (often from the accounting department) take information from the two financial statements and calculate various ratios, a process known as ratio analysis. Table 15.2 identi- fies four basic types or categories of ratios.

Table 15.2: Types of ratios

Type Description

Liquidity ratios Measure the company’s ability to meet its short-term obligations by pay- ing its debts on time

Activity ratios Measure efficiencies in company operations

Leverage ratios Measure company debt and risk

Profitability ratios Assess company profits

Source: The Five Functions of Effective Management, by D. Baack, M. Reilly, and C. Minnick, 2014, San Diego, CA: Bridgepoint Education.

Liquidity Ratios A company needs to pay its bills on time. Liquidity ratios help management make sure it has enough money to do so. Two liquidity ratios are the current ratio and the quick or acid test ratio. A current ratio is calculated as follows:

Current ratio = Current assets = 2:1 Current liabilities

Section 15.1Control and the Control Process

Current assets are all items that convert to cash in the coming year, including cash on hand, accounts receivable, inventory, and any other payments due. Current liabilities are all bills that must be paid in the next year. These are normally accounts payable, bond/loan payments, and any other credit accounts. The 2:1 figure suggests that the company has twice as many cur- rent assets on hand as current liabilities—a fairly typical number.

The quick or acid test ratio is calculated as follows:

Quick ratio = Current assets – Inventory = 1:1 Current liabilities

The reason for eliminating inventory is that it normally could not be quickly sold at full price. Therefore, the acid test indicates whether a company could make payments without selling and/or deeply discounting inventory. A 1:1 ratio indicates the company can pay its bills with- out resorting to more desperate measures.

Activity Ratios Activity ratios help managers understand how well certain company activities are being car- ried out. Two of the more common activity ratios are inventory turnover and average collec- tion period. To calculate inventory turnover, the following formula is used:

Inventory turnover = Total annual sales = 7 times Average inventory

The manager will see from this outcome that the store or unit sold its entire amount of inven- tory 7 times during the course of the year. It will depend on the industry whether this is a good or bad number. If it were a grocery store, the company would be in trouble. If it were a heavy equipment manufacturer, the company would be having a great year.

Average collection period measures the time it takes to collect on debts. It is calculated as follows:

Average collection period = Sales per day = 23 days Average accounts receivable

Sales per day results from dividing total annual sales by 360. The resulting figure tells the manager that 23 days passed from the time an item was sold until it was paid for. Some accountants prefer to use a credit sales per day figure rather than total sales per day, thereby eliminating the effects of cash sales from the calculation.

Leverage Ratios Leverage ratios measure company debt and company risk. The greater the amount of debt, the higher the degree of risk. Many formulas assess leverage. One simple version, a debt-to- equity ratio, is calculated as follows:

Debt-to-equity ratio = Total debt = 45% Total assets

Section 15.1Control and the Control Process

The result indicates that debt represents 45% of the value of all company assets. The com- pany owes 45% and owns 55% of its assets. Top management preferences normally dictate the amount of debt a company assumes. Greater debt will likely increase profitability per share of common stock but increase risk. A bad year and the failure to pay interest and prin- ciple payments creates a major financial hazard.

Profitability Ratios Besides the income summary, company leaders may wish to examine profitability in other ways. Profitability ratios measure company financial success. One common ratio used for that purpose is profit margin, which is calculated as follows:

Profit margin = Net income after taxes = 12% Total annual sales

This figure tells the manager that after every bill has been paid, including taxes, the company earned 12 cents on every dollar of sales.

Analyzing Ratios Ratio analysis can be misused by either manipulating the numbers or overemphasizing a sin- gle ratio. Managers can manipulate numbers through tactics such as miscounting inventory and over- or understating sales. This may keep a manager from having poor performance exposed in the short term; however, over time the real story will be revealed. When managers overemphasize a single ratio, they fail to see the big picture. One number might be unusual or off, but without studying the other figures, the manager might “fail to see the forest for the trees.”

Effective use of ratios begins with having a frame of reference. Two of the best are industry averages and past year’s ratios. The manager can assess a company’s operations compared to other firms in the industry. For example, if the company’s average collection period is 23 days, but the industry average is 32 days, it may be that other companies are offering more generous repayment terms. The company may lose sales to these competitors as a result. Past year’s ratios provide guideposts for current operations. When numbers begin to trend or drift in a certain way, the manager can respond with corrective action as needed.

Financial Audits A financial audit is a periodic and comprehensive examination of a firm’s financial records. As a control technique, auditors can tell managers whether the information on which they have been basing decisions has been accurate. Audits may be internal, performed by the orga- nization’s own accounting staff, or external, conducted by qualified independent agencies. External auditing carries the advantage of objectivity; an outsider is unlikely to be so accus- tomed to the way that things are routinely done within an organization as to overlook com- mon errors. Also, an external agency may be in better touch with new or innovative accounting methods and thus be better able to suggest alternative ways to enact more effective financial control. Additionally, an outside auditor is less likely to encounter a conflict of interest.

Section 15.1Control and the Control Process

Comparing Performance Against Standards in the Control Process The third step in the control process involves comparing measured actual performance against the established standards. When making comparisons, five outcomes are possible:

• The unit greatly exceeded the standard. • The standard was met. • The standard was missed slightly. • The standard was missed. • The standard was badly missed.

Consider a new product launch. Assume managers set a sales goal of $200,000 in gross revenues for the coming year. If sales actually totaled $300,000, the standard was greatly exceeded, and management would create a more realistic projection for the next year. If the standard was met, such as if sales figures were $208,000, then rewards should be given to those responsible. If the standard was slightly missed, say, $198,100, managers may consider other factors, such as unreported sales in December or something else that led to a variance of less than 1%. When the standard has not been achieved—say, $168,000 in sales—correc- tions will be made. When the standard is badly missed ($125,000), management may con- sider whether the new product was viable in the first place.

Management must decide how much deviation will be tolerated before considering corrective action. In some cases, this decision is quite straightforward. If Procter & Gamble sets a stan- dard to be the market share leader in each product category in which it competes, it is easy to determine whether the standard was met. In other situations, the decision may not be so simple. If Amgen sets standards for a drug that are related to combating specified symptoms of a disease, and the drug fails to meet those standards but receives a number of unexpected positive reviews from scientific experts, Amgen may decide it has made acceptable progress anyway. Or a sales manager might find that while an annual sales increase of 10% falls short of the 12.5% performance standard, no action is warranted because of unexpected environ- mental circumstances—such as the surprise introduction of a strong competitive product or new government regulation or taxes—during the measurement period. Managers should be constantly aware that unforeseen conditions may influence performance levels.

Making a Decision: Rewarding Success or Taking Corrective Action in the Control Process In the final step of the control process, managers evaluate actual performance relative to stan- dards and then take appropriate action. Ideally, the fourth step is a pleasant task, as managers recognize successful performance. Examples of rewards granted for meeting or exceeding preestablished goals include the following:

• Favorable performance appraisal ratings • Public recognition (individual and group) • Bonuses (individual and collective) • Pay raises • Being admitted to manager training programs • Promotions • Being assigned exciting and challenging new tasks

Section 15.1Control and the Control Process

At times, individuals, groups, or departments may not reach their assigned objectives. Before deciding how to respond to deviations between performance standards and actual perfor- mance, managers must determine the reason(s) for the deviation. Specifically, they must determine whether the plan previously laid out was properly implemented and failed to work or if it was not implemented properly. As was illustrated in Figure 15.1, once managers have evaluated the firm’s performance, they must decide which of three basic options constitutes the appropriate response: correct the observed deviation, change the performance standards, or simply maintain the status quo.

Corrective Action: Maintain the Status Quo When performance standards are either met or nearly met, maintaining the status quo—the current course of action—may be the best response. If production managers set an optimistic performance standard of a 50% decrease in product defects, and actual performance indi- cates a 48% reduction, the company has obviously made significant progress. Maintaining current production control policies and procedures is generally the proper course of action in such a case. Moreover, managers should reward employees for a job well done and otherwise encourage them to continue on their current course.

Corrective Action: Change Standards A second option for when there is a discrepancy between actual performance and the perfor- mance standard is to change the initial performance standards. This is the likely choice when observation of actual performance leads managers to conclude that the original standards were unrealistic given environmental conditions. Standards may have been set too low or too high, requiring modification if future control activities are to be effective.

For example, Nintendo’s introduction of its Wii console in 2006 was so popular that it sold out with each new shipment. The consoles were popular throughout the world, but Nintendo particularly did not realize how popular the Wii consoles would be in the United Kingdom. In 2007 Nintendo estimated that it would sell 14 million units. Toward the end of the year, it adjusted the figure to 17.5 million units. Even these new standards were not sufficient to keep up with demand. European customers—particularly those who had preordered the Wii con- sole in advance for Christmas—were frustrated after Nintendo was not able to ship enough to stores in the area (BBC News, 2006, 2007). Years later Nintendo’s next Wii console, the Wii U, had similar shortage problems (Bedigian, 2012). Such unexpected success requires that managers increase future performance standards to more realistic and challenging levels for effective control; otherwise, the passive standards may encourage suboptimal performance when objectives are achieved far too easily. On the other hand, if the Wii had not fared so well, Nintendo managers might have had to decrease future performance standards.

Corrective Action: Fix the Deviation When actual performance deviates significantly from the performance standard, managers usually take steps to correct the discrepancy. For example, faced with a higher-than-acceptable

Section 15.1Control and the Control Process

number of customer complaints, managers at a service firm such as McDonald’s may decide, after careful investigation, that certain employees or groups of employees need additional customer service training. Corrective action may be called for when performance standards have been exceeded as well. For example, a restaurant that easily surpasses its profit or tar- get customer number standards may decide to expand physical facilities, increase hours of operation, or even raise menu prices to try and bring actual performance more in line with standards.

Corrective Action: A Systems Approach In each department, the fundamentals of the systems approach can be used to make correc- tions to any problems that have been identified. Figure 15.2 portrays a general system.

Figure 15.2: A system

Every department—as well as the overall organization—can be viewed as a system to help managers decide where and how corrective action should be taken.

Inputs Transformation

process Outputs

Feedback mechanism

Source: The Five Functions of Effective Management, by D. Baack, M. Reilly, and C. Minnick, 2014, San Diego, CA: Bridgepoint Education, Inc.

Systems concepts help departmental managers identify problems and find solutions. Inputs are the items that come into the department. For production it is raw materials; for human resources, it is people. The transformation process is what the department does; for example, assembling physical products in the production department or creating an advertisement in the marketing department. Outputs are the finished items sent to another area or the out- side world. An output for the accounting department is the annual income summary state- ment. The feedback mechanism provides correction and adjustment, keeping the department in tune with other departments and the larger environment. Every department as well as the overall organization can be viewed as a system in order to help managers decide where and how corrective action should be taken.

Section 15.2Forms of Organizational Control

15.2 Forms of Organizational Control Organizational control oversees the firm’s overall functioning. It is a broad-based form that guides all organizational activities. Two dominant forms of organizational control are bureau- cratic and clan control. Some companies adopt one form to the complete exclusion of the other; however, most exhibit characteristics of both, with one exerting noticeably more influ- ence. Figure 15.3 illustrates the characteristics of and differences between the two forms of organizational control.

Figure 15.3: Forms of organizational control

Organizational control oversees the whole firm’s overall functioning.

Bureaucratic Control Organizational Control Clan Control

Rigid hierarchical structure Strict rules Formal controls Reward system focused on individual employee compliance Limited employee input Example: IBM

Informal and organic structure Self-control Informal group norms Reward system focused on group performance Extensive employee input Example: Google

InI st S I

Bureaucratic Control Bureaucratic control, sometimes called hierarchical control, regulates the firm’s overall functioning through formal, mechanistic structural arrangements. It seeks to gain employee conformance by strictly administrating rigid, straightforward policies and procedures. It fea- tures a reward system that focuses on individual employee compliance with either an implied or formal written code of behavioral standards. As such, bureaucratic control allows for lim- ited employee input into organizational activities.

Although its corporate culture has become much less bureaucratic in recent years, IBM Cor- poration was for many years known for exhibiting strong bureaucratic control tendencies. As stated by one former IBM sales representative, the long-standing traditional dress for male managers at IBM was “a dark blue pinstriped suit with a freshly starched white shirt; a con- servative, striped tie—with the stripes pointing to the heart; and heavy, polished, black wing- tip shoes” (L. Bierman, personal interview, April 6, 1994). Using its formal control system, IBM developed a distinctive, respected, and effective way of conducting business that count- less organizations copied, with varying degrees of success.

Section 15.3Operational Control

Clan Control Clan control (also referred to as decentralized control) regulates overall organizational functioning by relying on informal, organic structural arrangements. It fosters employee com- mitment by vigorously encouraging input and group participation. Rather than setting strict behavioral standards, clan control relies on self-control and informal group norms to create a relaxed yet sharply focused work environment. Google has been recognized for its relatively informal, easygoing, clan-controlled atmosphere. Google’s rapid rise to the top of its industry and its long stay there can be attributed to clan control.

Bureaucratic or Clan Control? Although one form of organizational control is not necessarily “better” than the other, manag- ers should keep several issues in mind when deciding on which to use. First, companies rarely use one form of organizational control to the exclusion of the other. For example, the formerly highly bureaucratic IBM always permitted some employee participation, and Google, the clas- sic example of a company that exhibits clan control, also has formal rules that employees must follow. Second, control that is too bureaucratic may alienate employees and fail to high- light and use potentially good ideas that are often better generated in a more informal setting. Third, control that is too clan oriented might result in an organization that has no idea where it is going or one headed in so many different directions that it fails to accomplish anything. Finally, it is vital that control orientation be consistent. Not only will employees resist drastic change—especially to extreme bureaucratic control—but after working under one form of organizational control, they may have a hard time adjusting to a new one. If Google were to suddenly decide to move to a more radically bureaucratic form of control, managers and sub- ordinates used to the more informal atmosphere would likely have a lot of trouble adapting.

15.3 Operational Control Operational control regulates one or more individual operating systems within an organiza- tion. Most companies practice three basic forms of operational control—preliminary, screen- ing, and feedback—which are differentiated primarily by the focus of the control itself.

Preliminary Control Preliminary control (sometimes referred to as feed-forward or steering control) moni- tors deviations in the quality and quantity of the firm’s resources to try to prevent devia- tions before they enter the system; it focuses on inputs to the goods or service production process. In the area of human resources, for example, preliminary control techniques include employee selection and placement and, where it occurs before formal employment, training newly hired personnel. Such activities help management find job candidates who suit the company’s needs. Another preliminary control technique is to inspect incoming materials for the production process.

Section 15.3Operational Control

Nowhere is the importance of preliminary control more important than in the total qual- ity management (TQM) movement. Although TQM focuses on achieving superior levels of quality and customer value at all levels of the operation, high-quality inputs are essential for overall organizational quality because they reduce the need for costly inspections (that is, feedback control) and allow managers to pay more attention to quality problems that occur within internal firm operations (Davy, White, Merritt, & Gritzmacher, 1992). This helps explain why so many organizations have consistently reduced the number of suppliers of parts and materials while at the same time built deeper and more permanent relationships with those vendors they retain (Magnet, 1994; Davy et al., 1992; Cavinato, 1992; Tenner & DeToro, 1992).

Screening Control Screening control (also called yes/no or concurrent control) regulates operations to ensure they are consistent with objectives; it focuses on the transformation process that converts inputs into outputs. Managers who supervise the work of their subordinates, for example, exert screening control to ensure that employees’ activities achieve their objectives. Delegating authority gives managers the power to use both financial (pay raises and promo- tions or demotions) and nonfinancial (praise or verbal reprimand) incentives to carry out screening control.

Screening control includes quality and production control measures such as ongoing train- ing programs designed to continually update the skills and knowledge of both managers and nonmanagers. These programs serve as controls in that well-trained employees consistently require less formal supervision compared to their less trained counterparts. The rapid pace of change due to technological advances and an increasingly global business environment has made training-based control programs more popular. Some corporations run such pro- grams on an in-house basis, while others contract with universities and other entities for such training.

Another form of screening control is statistical process control (SPC), which employs con- trol charts such as the one depicted in Figure 15.4 to continuously track performance varia- tions over time. The variations indicate that a standard has not been met in some way, either due to defective outputs or because resources have been wasted in creating the outputs. The charts provide employees with readily accessible information with which to monitor their work and predict when they are about to exceed control limits and possibly waste organizational resources. Developed by Walter Shewhart at Bell Labs in the 1930s and later refined by W. Edwards Deming, SPC is a key TQM tool with which to explain the variation that inevitably occurs in every production process (Tenner & DeToro, 1992; March & Garvin, 1986). In short, SPC serves to determine whether work processes can effectively be brought under control or if they should be left alone, as well as when it is necessary for a manager to intervene.

Section 15.3Operational Control

Figure 15.4: Hypothetical SPC chart for steel casing manufacturing

An example of statistical process control.

Upper Control Limit

Average All Readings

In te

ri or

D ia

m et

er Va

ri an

ce fr

om S

pe ci

fic at

io ns

(M ili

m et

er s)

Readings of Finished Castings (Over Time)

Lower Control Limit

2 3 4 5 6 7 8 9 . . .

= readings within limits (random variation) = readings outside limits (indicate the need for management intervention)

According to Shewhart, management intervention is called for only when the limits of random variation that occur strictly by chance have been exceeded. Otherwise, the level of variance does not significantly affect the performance of the production process and should be left alone, at least for the time being. It should also be contingent on ongoing SPC efforts (Tenner & DeToro, 1992). Faced with the production process depicted in the SPC control chart in Figure 15.4, managers in charge of screening control should be concerned with the specific causes of the intermittent, nonrandom variation. They may need to take immediate action to bring the system back into control. As with all other forms of management control, SPC works best when the individuals involved in the system understand the nature and purpose of the control process, which is to help them perform at higher levels and increase the company’s overall performance.

Feedback Control Feedback control (also known as postaction control) monitors the firm’s outputs, the results of the transformation process. Feedback control techniques include (a) analyzing financial statements to evaluate the actual costs relative to expected (standard) costs using standard cost accounting systems, as noted earlier; (b) using quality-control efforts to deter- mine whether the manufacturing process is producing output of an acceptable quality level; and (c) evaluating employees’ performance to determine whether their actual performance, in terms of productivity or number of errors, is acceptable. The results of these analyses are fed back into the operating system, where they then affect future output. If, for example, after

Section 15.4Nonfinancial Controls

completing a production run, a company’s analysis of cost-accounting data indicates that its manufacturing output cost more than anticipated, management will be alerted to the situa- tion and can take corrective action to prevent the costly deviation from recurring on future production runs.

Multiple Control Systems In practice, most companies do not employ the three forms of operational control in isolation. Instead, most use a multiple control system, often using all three forms simultaneously to effectively achieve control. For example, computer firms employ multiple control systems in assembling personal computers: Integrated circuits must conform to prescribed quality stan- dards before being installed (preliminary control); various circuit configurations are tested during assembly (screening control); and the completed units are stringently tested before being packed for shipment, pinpointing or correcting operational errors in the system if nec- essary (feedback control).

In general, operational control methods employed earlier in the production process are less costly than those performed at later stages. For example, while concerned with minimizing deviations from quality standards at all stages in the production process, TQM focuses pri- marily on controlling the quality of various inputs to the system—that is, “doing things right the first time” (Tenner & DeToro, 1992; Wood, 1988; Crosby, 1979). Many company leaders know that the costs associated with correcting mistakes already made far outweigh the costs of controlling initial product quality (Juran, 1993; Reichheld, 1993; Shapiro, Rangan, & Svio- kla, 1992; Tenner & DeToro, 1992). Errors first detected by feedback control not only cost the company in terms of product repair or replacement, but also often result in high long-term costs associated with losing customers who experience poor product quality. When prelimi- nary control detects errors early on in the production process, both the short-term and long- term costs associated with poor product quality can be avoided.

15.4 Nonfinancial Controls Nonfinancial controls provide a company with a way to measure nonfinancial performance, such as ethics, compliance, and sustainability activities. It is a way for a company to balance its behaviors and their resulting impact on the communities that are served. Companies that focus solely on financial measures tend to be more consistently short-sighted because they make decisions based on immediate fluctuations in the bottom line. Those that give equal weight to financial and nonfinancial measures alike have a long-term perspective of how their actions will impact others. Since the implementation of the Sarbanes–Oxley Act, regulators are increasingly asking for information other than financial measures to judge the character of a company’s operations. Those who have instituted some form of nonfinancial account- ing are looked upon favorably even when they violate financial or ethical standards. Two of the more popular nonfinancial control methods are the balanced scorecard and the triple bottom line.

Section 15.4Nonfinancial Controls

Balanced Scorecard The balanced scorecard is a management control system customized for a company’s indus- try, technology, mission, and strategy. The scorecard scores four categories: financial, cus- tomers, internal processes, and innovation and improvement activities. These features are chosen by the manager and reflect a direct relationship with the company’s overall strategy. The “balance” in the scorecard comes from measuring both financial and nonfinancial aspects of the company’s operations such that one complements the other. In this way, the balanced scorecard reveals the tradeoffs that result from the company’s decisions, which allows man- agers to evaluate the future course of the company. Financial measures offer a picture of the company’s past. The balanced scorecard presents a picture of the company’s current state and future performance, with indications regarding how to improve (Kaplan & Norton, 1993).

Nike uses the balanced scorecard to assess its social and environmental sustainability initia- tives. The company’s main focus in this area is in manufacturing. As such, the scorecard is divided into three sections. The first measures lean manufacturing objectives such as physi- cal changes to the production process, leadership capabilities, and employee empowerment. The second measures health, safety, and the environment by ensuring the company’s code of conduct is being practiced so that factories are safe and operating at the highest levels of energy efficiency. The third section relates to HRM, or the treatment of employees. The card is scored by a team from Nike as well as a team from a third party. This reduces bias, increases transparency, and provides balanced information for the company to evaluate (Nike, 2012).

Triple Bottom Line The triple bottom line approach (also known as people, planet, profit) focuses equally and simultaneously on the social, environmental, and economic impact of a company’s operations. Usually, all of these aspects are integrated into each other and can be measured in different ways. Because measuring social and environmental initiatives is difficult, it is important for companies to standardize measurements validly and consistently (Environmental Leader, 2013).

For example, actress Jessica Alba founded the Honest Com- pany after discovering there were very few nontoxic baby products such as diapers and lotions on the market. She established the company with a mission to view social and environmental goals just as important as profits. The com- pany measures its contribution to each goal in five ways. First, a portion of product sales is donated to charities that work to improve the health and social situations of chil- dren and families. Second, products are made from natu- ral, organic, sustainably harvested, renewable, and pure raw materials. Third, materials are tracked so the company knows where they end up. Fourth, the company uses renewable sources of electricity. Finally, it abides by a code of conduct for its supply chain, which encourages humanitarian treatment of workers and environmental and transparency standards (Field, 2012).

Carlo Allegri/Associated Press An organization like the Hon- est Company focuses on the triple bottom line—people, planet, and profit.

Section 15.4Nonfinancial Controls

Many public companies do not post their balanced scorecard results because they directly correspond to the company’s strategic road map. This is not the case for the triple bottom line, however. One indication that a company is employing the triple bottom line approach is that it applies to become a benefit corporation, or B corp. This certification from the nonprofit B Lab signifies that the company is acting responsibly when it comes to social, environmental, and economic concerns (B Corporation, n.d.).

Business Dilemma

What Would You Do?

Suppose you are a business consultant. In your role, you work with clients to help them develop strategies, define plans, and solve problems. Consider the following client’s case. Use your knowledge of this chapter’s core concepts to address the questions presented at the end of the case. Possible answers to these questions are included at the end of the chapter.

THE CLIENT: Tracy Reynolds, vice president of ethics at Aerodyne Corporation

THE PLACE: Bethesda, Maryland

Aerodyne Corporation is the fourth largest aircraft manufacturer in the United States. Nearly 50% of Aerodyne’s sales come from government contracts and the remainder from commercial airlines.

Over the past 10 years, airlines have experienced intense scrutiny as a result of labor problems, bankruptcies, consolidation, and plane crashes. Aerodyne has been the subject of two investigations that examined the use of defective parts and lack of quality control in certain aspects of the production process. In addition, Aerodyne has come under scrutiny for padding expenses on government contracts. These incidents probably occurred because the company failed to take proper advantage of ethics training and control systems.

It was in this context that Tracy Reynolds was hired 2 years ago to head Aerodyne’s first ethics department; her goal was to establish training systems for the entire company. Reynolds’s first step was to develop a comprehensive code of ethics, a formal statement of what the company expects in terms of ethical behavior from its employees. Once the code of ethics was developed, employees were trained on the code’s requirements. Employees were also encouraged to report violations without any fear of retribution. A special 24-hour toll-free ethics hotline was established to allow employees to ask anonymous questions about any issue or policy.

Reynolds also helped establish systems to monitor Aerodyne’s compliance with federal procurement laws; she also installed procedures for voluntarily disclosing violations to the appropriate authorities. Once these systems were in place, training was conducted on a region-by-region basis, with Reynolds and her four assistants conducting 3-hour seminars. Part of each seminar involved discussing ethical issues in the industry, situations that have plagued the company in the past, and ways to avoid making unethical decisions. Many who reviewed the content of the seminars felt the frank group discussions of issues and dilemmas were perhaps the strongest part of the training. The interactions

(continued)

Section 15.5Challenges in Managing Control Systems

Business Dilemma (continued)

helped employees recognize ethical issues and gave them tools for obtaining additional information, both of which helped them make more ethical decisions.

Questions

1. How does the ethical program offer Aerodyne control? 2. What investment in training and development is required by an ethics program? 3. What are the potential benefits of this program?

15.5 Challenges in Managing Control Systems As is the case with any management function, things can go well or poorly. Control systems should increase efficiency and effectiveness while at the same time improve employee morale and motivation. Unfortunately, this may not always be the case. Two areas of concern regard- ing control are resistance to it and the presence of inadequate systems.

Resistance to Control Employees often regard control as a force that restrains individual or group action, and thus are more likely to resist it. Managers charged with developing or maintaining a control system should recognize that employees may regard the process negatively. Furthermore, implementing a new control system often requires managers to modify their management philosophies and institute new responsibilities for workers. As with other forms of change, such alterations are likely to be met with resistance. Fortunately, some employees may be less likely to resist change because of personal factors, such as what might be called a “zone of indifference,” or differences in the degree to which they accept authority.

Employees may also resist control when it is not properly implemented; this includes instances of overcontrol, inappropriately focused control, control that rewards inefficiency, and control that enhances accountability. Table 15.3 describes these in more detail.

Table 15.3: Reasons for resistance to control

Type of Control Examples

Overcontrol The manager of an engineering department insists on being part of every project, including small ones.

Inappropriately focused control

An accountant is rewarded for getting a major business account finished by the deadline, although he had to skip sections of the audit to do so.

Control that awards inefficiency

A consultant must fill out an hour of paperwork just to file a short report.

Control that enhances accountability

Employees are angry when they learn their computers are being monitored.

Section 15.5Challenges in Managing Control Systems

Overcontrol How much control to apply depends on the situation. Control that seems overly aggressive or restrictive for managing a team of administrative office workers may be essential to con- trolling a military unit. A fine line exists between the proper level of control and overcontrol, which occurs when managers try to control employee activities more than they should. For example, an organization that explicitly tells its employees what to wear, when to eat, what social media they can use, and what they can and cannot do during their time away from the workplace is likely to generate major employee resistance.

Most employees recognize that control is necessary for regulating activities that directly relate to job performance. Management should make sure that this understanding exists (Zangwill, 1994). When control creeps into the realm of non-job-related behavioral matters, many employees may feel that the organization is overstepping. However, a general problem today is that the lines between on-duty work requirements and some off-duty activities can be blurry.

Rather than improve organizational performance, overcontrol is likely to lower employee morale and commitment, generate mistrust, and even spark legal hassles with labor-related regulatory agencies. Managers should carefully balance the level of control against both situ- ational demands and employee rights. Control must be firmly founded in actual and relevant job performance in ways that employees find reasonable.

Inappropriate Focus A production control system that places an extremely high priority on number of units pro- duced may cause workers to feel that they must sacrifice quality to meet the system’s quantity standards; this is a prime example of inappropriate focus. This wastes company resources, especially when it results in defective units and lost customers. It is increasingly more profit- able for companies to retain customers by providing consistently high product quality than to recruit new customers through promotional efforts (Heskett, Jones, Loveman, Sasser, & Schlesinger, 1994).

Thus, it is important to properly focus management control efforts. A company’s operations and financial control efforts might be supported by extensive training programs in which all employees learn to read financial statements and understand the impact of their work on the company’s profit structure. Employees might also be given broad access to financial informa- tion. Control systems must be focused on relevant issues in terms that make clear sense to those being controlled if they are expected to function optimally.

Rewards for Inefficiency Many reward systems can unintentionally reward inefficiency. This occurs when funds are directed to a department that supposedly needs them, without considering why the need arose. Misappropriating budget to inefficient departments and individuals dampens morale, creates resistance to control systems, and lowers performance levels company-wide.

Section 15.6Managing the Control Process

Accountability Even a properly designed control may be resisted if it creates additional levels of account- ability. Effective control allows managers to pinpoint departmental or individual deficien- cies. A worker who has been performing inefficiently is likely to resist a control system that shows that he or she is not performing up to standards. For example, consider recent tech- nological advances that allow companies to monitor employees’ computer activities. Doing so may increase individual accountability, but at the same time may cause workers to dis- trust the system, or some supervisors to abuse it. Managers must carefully consider the pos- sible ethical implications of attempting to secure additional levels of accountability through increased control.

Inadequate Control Systems In addition to knowing how to overcome resistance to control, managers also need to be aware of the basic signs that a control system is not operating effectively. Indicators of con- trol-related difficulties include the following:

1. A high incidence of employee resistance to control. A control system that employees continually resist may simply not be right for the specific situation. This is likely to be the case after repeated attempts to either improve the control system or explain or justify it to employees.

2. A unit meets control standards but fails to achieve its overall objectives. In this case, it is likely that the link between planning and control is poor. Also, the control may be unable to measure what it is supposed to measure or perhaps is not being enforced stringently enough.

3. Increased control does not lead to increased or adequate performance. The extra control may simply not be needed, or it may be inappropriate for the situation. Add- ing control where it is not needed risks alienating those controlled and should be avoided.

4. The existence of control standards that have been in place for an extended period of time. An organization cannot remain competitive if it becomes stagnant. As the envi- ronment inevitably changes, so should the organization and its system of manage- ment control.

5. Organizational losses in terms of sales, profits, or market share. Declining perfor- mance is a clear indicator of trouble. Anytime an organization appears to be los- ing ground from a competitive or financial standpoint, it is wise to examine its control system.

15.6 Managing the Control Process To facilitate effective control, managers must understand how to develop the process as well as how to overcome resistance to it. To ensure that control systems continue to operate smoothly, managers must be able to identity signs of inadequate control. Effective control systems overcome resistance and are typically well integrated with planning; this means that they must be being flexible, accurate, timely, and objective.

Section 15.6Managing the Control Process

Overcoming Resistance to Control Although employees may resist control because of, among other factors, management misuse, control remains a necessary managerial function. The challenge to managers is to exercise control so that employees understand the need for it but are not unduly inconvenienced. In general, there are four ways managers can overcome resistance to control: create effective control, encourage employee participation, use management by objectives, and emphasize a system of checks and balances.

Create Effective Control Probably the best way to avoid resistance is to establish effective control in the first place. This requires both careful planning before implementation and continually monitor the con- trol system’s effectiveness. Only with thorough planning and maintenance can a control sys- tem be properly integrated into overall organizational planning and be as flexible, accurate, timely, and objectively meaningful to those most directly affected by it.

Encourage Employee Participation Many companies recognize the benefits of encouraging nonmanagerial employees to be involved in the establishment of organizational policies and procedures. Empowerment applies to planning for and implementing a system of control. Employees are less likely to resist a system that they helped create.

Empowered employees know their jobs better, accept more responsibility, and exhibit higher levels of commitment. Resistance can be reduced by carefully educating employees about how the process works and how their work activities affect overall organizational performance.

Use Management by Objectives Another way to overcome resistance to control may be by using management by objectives (MBO). This management philosophy is based on converting organizational objectives into individual ones. The steps to MBO are as follows:

Step 1: Job analysis: Each employee considers the most important aspects of his or her job. Step 2: Employees prepare a list of annual goals. Step 3: Supervisors prepare a goal list for their employees. Step 4: Employee and supervisor meet to negotiate one goal list. Step 5: Employee and supervisor follow up to make sure goals are being achieved. They

reward success and correct deficiencies.

Notice that while working in concert with management, workers are asked to set their own goals, which in turn serve as standards against which to evaluate their performance. As Fig- ure 15.5 shows, individual goals are linked with goals that have been established at every level in the organization. This facilitates a more unified effort for all employees and managers.

Section 15.6Managing the Control Process

Figure 15.5: Linking individual goals to company goals

Management by objectives involves participative goal setting.

Company Mission

Top Management Goals

Middle Management Goals

Supervisor Goals

Employee Goals

MBO assumes that allowing employees to set personal objectives will make them more com- mitted to achieving those objectives, which will lead to increased performance. Also, employ- ees know before starting work that they will be rewarded on the basis of how well they satisfy and maintain these personal goals and standards. Moreover, MBO closely links planning and control, which reduces the likelihood that there will be resistance to control.

Some business experts refer to MBO as a “participative goal-setting process.” Employees at every level are invited to set personal and organizational goals that build toward the goals and objectives established at higher levels. Such a program creates organizational consis- tency, closely links planning and control systems (by setting standards and then later mea- suring performance), and is likely to improve employee morale, so long as managers use the program to help employees succeed rather than punish them when their efforts fall short.

Use Checks and Balances A system of checks and balances helps document managerial control decisions. For example, if a production worker is reprimanded for poor-quality work, a properly designed quality- control system can provide information that explains why. Resistance to control decreases when a system of checks and balances is available to protect both employees and managers. A reprimanded production worker, for example, should be able to refer to information provided by the control system to see if the cause of the poor-quality work is truly something under his or her control; the worker can use the system of checks and balances to prove his or her case and hopefully help correct the deviation should he or she not be directly at fault.

Section 15.6Managing the Control Process

Integration With Planning For a control system to be effective, it must be closely linked with the planning process. Man- agers should set objectives that can be readily converted into performance standards. This close link with planning ensures that efforts to increase control can be easily and accurately evaluated for whether they help meet organizational objectives.

Flexibility Flexibility enables the company to respond to changes in the business environment. The more turbulent or complex the environment, the more flexible the control system should be. Con- trol must be flexible enough to readily accommodate modifications while remaining effective.

Accuracy Control systems are useful only to the extent that the information on which they rely is accu- rate. System outputs can be only as good as system inputs. If a quality-control system some- how permits workers an opportunity to hide product defects, the control system is useless because it cannot accurately measure or report outcomes.

Timeliness An effective management control system gives information on performance when it is needed. In general, the more uncertain and unstable the situation, the more often information will be required. Marketing managers require control-related information that pertains to the sales performance of a new product much more often than they need such information about a mature, stable product that has been on the market for several years. For example, consider that Microsoft wanted to develop a tablet to compete against the iPad. To compete, marketing managers at Microsoft required more information at shorter intervals than they would have for more established products. The firm needed to find out how it could improve the iPad and provide customers with the features they most desired.

Objectivity To be effective, the control system must provide unbiased information. The manager who plays favorites with certain subordinates and “lets them off the hook” if they submit informa- tion that does not reflect actual performance deficiencies has failed the organization. If pro- duction workers allow defective products to slip through the system, bypassing control, the company’s image will suffer; consumers will complain, but the production unit held respon- sible for the errors may be unfairly blamed for the flaws. Moreover, objective, control-related information requires managers to qualitatively assess the information they receive. Rather than simply report unusually high sales figures for a region or individual salesperson, a sales manager should look beyond the numbers into how the sales were made. It could be that drastic and unauthorized price concessions or unrealistic guarantees were provided to buy- ers to promote sales. Information about such deviations must be uncovered and reported in detail to facilitate effective management control.

Section 15.6Managing the Control Process

Although it is an essential managerial function, controlling the complex activities of organiza- tion members is rarely a simple undertaking. The challenge to managers is to understand the purpose and importance of control and to use it to enhance individual and organizational per- formance outcomes. As part of this process, it is management’s responsibility to convey the need for control to employees in a way that facilitates active and voluntary participation in the process. For this ideal situation to occur, managers must communicate the objectives of the process throughout the organization so those being controlled understand the need to conform to clearly defined guidelines. Responsibility for control does not end after the system is imple- mented, nor does it involve simply inspecting the output of the production process. Through control, managers must constantly look for sometimes hidden signs of inadequate performance at all stages and levels of organizational activity and enact corrective action when warranted.

Management Insights: Renewal by Objectives

MBO programs can be applied to every type of organization. In profit-seeking firms, employees set goals in traditional functional areas and occupations. For example, a salesperson might set a goal to contact five new potential buyers each month. An accountant might set a goal of finalizing all statements and paying all invoices 1 week ahead of schedule throughout the year. An HR manager might set a goal of reducing “first- day quits” by 50% annually by using an improved placement and orientation system. The same types of goals may be set in governmental organizations. In both instances, each level of employee works closely with a manager at the next level in the hierarchy to agree on objectives for the coming year and then revisits them to see if they have been reached. Effective programs offer meaningful rewards for achieving one’s standards; these can include prizes, pay raises, bonuses, and other perks.

What about nonprofits? Can MBO apply to those settings? The answer is yes. In fact, a new congregation engaged in a system called “renewal by objectives” that was based on MBO. The program’s ultimate purpose was to create a participatory system in which members of the congregation would help the church build its first worship center. Instead of directly asking parishioners for money, the church council asked them to set different types of goals. The objectives were set in three areas: (a) attendance, (b) personal Bible study, and (c) contributing time to the building program. Church statistics indicate a strong connection between attendance and the amount a person donates. Therefore, asking people to commit to attending more frequently made sense.

Personal Bible study goals were just that: personal. Each member of the congregation could commit to the amount of time spent on that activity. The idea was that such an effort might strengthen the person’s loyalty to the congregation while helping the individual personally at the same time.

Asking members to contribute their time was designed to reduce the cost of constructing the building. Member skills ranged from electrical, to dry wall preparation, to painting, and beyond. With an 18-month time frame as a guide, members had the opportunity to gift their skills and talent when needed.

The program’s net result was that the cost of building the new facility was reduced by more than 20%. In addition, surveys of those who engaged in the program revealed a strong sense of satisfaction with participants’ personal involvement and with the approach itself. It seems clear that when carefully applied, MBO principles offer value to any type of organization.

Summary and Review

Summary and Review • Define management control and the control process. Management control includes

the activities an organization undertakes to ensure that its actions help it achieve its objectives. A management control system is a planned, ordered scheme of manage- ment control. Internal controls are processes developed to provide assurance that an organization reaches its objectives that relate to operational efficiency, accuracy of financial reporting, and regulatory compliance. The control process consists of four steps: establishing performance standards (targets set by management against which to compare actual performance at a future date); measuring performance; comparing performance against standards; and rewarding performance or taking corrective action. Should discrepancies occur between desired and actual perfor- mance, a firm can decide to correct the deviations, change the performance stan- dards, or maintain the status quo.

• Distinguish among the various forms of organizational control. Forms of control are organizational and operational. Organizational control regulates the organization’s overall functioning. It includes bureaucratic control (control through formal, mecha- nistic structural arrangements) and clan control (control through more informal, organic structural arrangements). These can be regarded as opposite levels of orga- nizational control, though most firms make use of both to varying degrees.

• Explain how to implement effective operational controls. Operational control regu- lates one or more individual operating systems within an organization and can be subdivided into preliminary, screening, and feedback control. Preliminary control monitors deviations in the quality and quantity of the organization’s inputs; its goal is to prevent deviations before they enter the system. Screening control regulates the transformation process to ensure it is consistent with objectives. Feedback control monitors the firm’s outputs.

• Describe nonfinancial controls. Nonfinancial controls offer a company a way to measure nonfinancial performance such as ethics, compliance, and sustainability activities. A balanced scorecard is a management control system customized for a company’s industry, technology, mission, and strategy. The scorecard judges four categories: financial, customers, internal processes, and innovation and improve- ment activities. The triple bottom line approach (also known as people, planet, profit) focuses equally and simultaneously on the social, environmental, and eco- nomic impact of a company’s operations.

• Describe challenges to managing control systems. Common reasons to resist control include overcontrol, inappropriately focused control, control that rewards ineffi- ciency, or control that enhances accountability.

• Summarize the elements involved in managing the control process. To overcome resistance to control, managers should create effective control from the outset. They should also encourage employee participation and employ both MBO and a system of checks and balances. Effective control systems are well integrated with planning and are flexible, accurate, timely, and objective. Most important, control systems should make sense to those who are being controlled.

• Assess an organization’s control program. Based on the material presented in the Business Dilemma box and throughout this chapter, evaluate the vice president’s efforts to control Aerodyne’s ethical decision making. You should be able to describe the forms of control being used and address how these efforts will help improve the organization’s performance.

Summary and Review

Key Terms activity ratios Ratios that help manag- ers understand how well certain company activities are being carried out; they include inventory turnover and average collection period.

balanced scorecard A management control system customized for a company’s industry, technology, mission, and strategy.

balance sheet A snapshot of the organiza- tion’s financial position at a given moment; indicates what the firm owns and what proportion of its assets are financed with its own or borrowed money.

bottom-up budgeting Budgeting that flows up from lower levels of an organization for review by top management and involves those more directly engaged in the actual tasks covered by the budget.

budgeting The principal means of control- ling the availability and cost of financial resources.

budgets Formal, written plans for future operations in financial terms.

bureaucratic control A form of control that attempts to regulate the firm’s overall functioning through formal, mechanistic structural arrangements; sometimes called hierarchical control.

capital budgeting Budgeting that is con- cerned with the intermediate and long-term control of capital acquisitions such as plants and equipment.

clan control (decentralized control) A form of control that seeks to regulate over- all organizational functioning by relying on informal, organic structural arrangements; also referred to as decentralized control.

feedback (or postaction) control A form of control that monitors the firm’s outputs, the results of the transformation process.

financial audit A periodic and compre- hensive examination of a firm’s financial records.

income statement Shows the profitability of an organization over a period of time—a month, quarter, or year—and helps man- agers focus on the organization’s overall revenues (from sales and investments) and the costs incurred to generate them.

internal controls Processes that are devel- oped to provide assurance that an organi- zation reaches its objectives that relate to operational efficiency, accuracy of financial reporting, and regulatory compliance.

leverage ratios Ratios that measure com- pany debt and company risk.

liquidity ratios Ratios that help manage- ment make sure the company has enough money; two liquidity ratios are the current ratio and the quick or acid test ratio.

management control A form of control that includes all activities an organization undertakes to ensure its actions help it achieve its objectives.

management control system A planned, ordered scheme of management control that allows managers to readily assess where the firm actually is at a point in time relative to where it wants or expects to be.

negotiated budgeting Budgeting that involves a degree of give and take between upper and lower levels of management to develop the most appropriate form of bud- getary control for a given situation.

Summary and Review

nonfinancial controls Controls that offer a company a way to measure nonfinancial performance such as ethics, compliance, and sustainability activities.

operating budgets Budgets that deal with relatively short-term financial control concerns, including having sufficient cash on hand to cover daily financial obligations such as routine purchases and payroll.

operational control A form of control that regulates one or more individual operating systems within an organization.

organizational control A broad-based form of control that guides all organizational activities and oversees the whole firm’s overall functioning.

performance standards The first step in the control process; management sets targets against which actual performance is compared at a future date.

preliminary (or feed-forward or steering) control A form of control that monitors deviations in the quality and quantity of the firm’s resources to try to prevent deviations before they enter the system; focuses on inputs to the product or service production process.

profitability ratios Ratios that measure the company’s financial success.

ratio analysis An analysis in which managers take information from the two financial statements (balance sheets and

income statements) so they can measure the company’s efficiency, profitability, and sources of finances relative to those of other organizations.

screening (or yes/no or concurrent) con- trol A form of control that regulates opera- tions to ensure that they are consistent with objectives; focuses on the transformation process that converts inputs into outputs.

statistical process control (SPC) Another form of screening control that uses control charts to continuously track performance variation over time.

top-down budgeting A budgeting approach in which top managers establish budgets and hand them down to middle- and lower level managers to review and implement.

total quality management (TQM) A man- agement view that strives to create a cus- tomer-centered culture; it defines quality for the organization and lays the foundation for activities aimed at attaining quality-related goals.

triple bottom line approach A nonfinan- cial control method that focuses equally and simultaneously on the social, environmental, and economic impact of a company’s opera- tions; also known as people, planet, profit.

zero-based budgeting A method of bud- geting in which managers thoroughly reeval- uate organizational activities to determine their true level of importance.

Ready Recall 1. Why is control important? What do you think would happen without it? 2. Why must control be closely integrated into organizational planning? 3. List the four steps in the control process. 4. List and define the types of control. How do they differ from one another? How do

they relate?

Summary and Review

5. Differentiate between bureaucratic and clan control. Which do you think is the better form of control, and why?

6. How does operating budgeting differ from capital budgeting? 7. How is a financial audit used for control? 8. What are some common reasons people resist control? 9. How can managers combat resistance to control? What is the most important factor

in this process? 10. How can managers recognize inadequate control systems?

Expand Your Experience 1. Take a look at your place of employment (if you are not employed, apply the ques-

tion to your college or university). Who is responsible for the control function? Cite specific examples of the four forms of control used in your workplace.

2. How effective are control systems that are based on meeting objectives stated in the same terms for both the finance and production departments? Why might control of this nature prove less than optimal? How would you alter the system to be more meaningful for each functional department?

3. Analyze the control system of a local small business (you may have to interview some managers and employees to get enough information). Identify examples of each form of control as practiced within the company. Is the control system adequate? Why or why not? If you judge the control to be inadequate, recommend some ways to improve it.

Possible Answers to Business Dilemma Questions 1. Aerodyne has control because it is basically telling the employees how to conduct

themselves at work. The code of ethics imparts the ethical behavior expected. The employees have no choice regarding how to behave.

2. Training would be very beneficial because it would eliminate any questions that would arise. Because past ethical questions were discussed in the seminars, it was made clear how such situations should be handled.

3. There would be fewer suits filed for unethical behavior. The new training on ethi- cal and unethical behavior could also help the employees become better people in general.

Strengthen Your Skills Controlling Read the following scenario and apply the concepts of the triple bottom line approach to Tam- boran’s control systems, which are designed to direct a company’s actions toward achieving its goals. Tamboran is an innovative explorer for hydrocarbon shale gas in onshore basins that tries to be ethical in its practices. You may refer to the end of chapter case, Hydraulic “Frack- ing” and Corporate Environmental Control, to inform your work.

Summary and Review

Scenario Companies often refer to the state of their bottom line, which means they are concerned about their profits. In fact, the decisions companies make are often based on the extent to which their profits will be affected. The triple bottom line, on the other hand, measures the impact a company’s decisions have on social and environmental concerns, in addition to prof- its. Companies that emphasize the triple bottom line in their operations focus on social, envi- ronmental, and financial issues. These additional factors are a form of nonfinancial auditing, and this approach is especially useful for companies whose activities might be regarded as controversial.

Tamboran specializes in alternative energy resources such as hydraulic fracturing, or frack- ing, and it applies a triple bottom line approach to its operations. Fracking involves using a high-powered mixture of water and rocks or chemicals to split, or fracture, the areas where natural gas is abundant in order to release and capture the gas. Many regard the process as harmful both to the environment and those who live in the areas where drilling occurs because it uses millions of gallons of water and certain chemicals that pose a health risk. Oth- ers claim that fracking is a better alternative to traditional oil drilling and that natural gas use is better for the environment than oil.

Tamboran is sensitive to these issues, as evidenced by its corporate values—which include wealth creation, providing for a “low-carbon” energy future, environmental responsibility, health and safety, and community engagement and partnership. The company has issued a commitment statement to each region in which it operates (Ireland, the United Kingdom, Botswana, and Australia) that outlines what these communities can expect from it in terms of monitoring groundwater and air quality, noise pollution, and seismic activity before, dur- ing, and after operations. It also says companies can expect it to publicly display information regarding operations; use steel surface and intermediate casings lined with advanced, engi- neered cement from the base of the well to the surface to ensure groundwater safety; use a Cement Bond Log across the entire surface casing to ensure stability, which will be inspected by the appropriate regulatory agency before drilling begins; abstain from the use of chemi- cals; and recycle as much water as possible. The company claims its actions in all of these areas will exceed mandatory regulations.

1. Evaluate Tamboran’s concern for social issues. 2. Evaluate Tamboran’s concern for environmental issues. 3. What information can you find that gives you some indication of Tamboran’s

profitability?

Case 15: Hydraulic “Fracking” and Corporate Environmental Control The United States has long depended on imports from foreign countries to meet its energy needs. Americans spend approximately $632 billion a year on oil alone, requiring the United States to import 10.6 million barrels of petroleum products per day. This dependence has caused concern among U.S. stakeholders.

However, discoveries of shale gas reserves in the United States have begun to change the country’s energy outlook. Hydraulic fracturing, also known as fracking, has played an impor- tant role in America’s oil and natural gas production for the past 60 years. Fracking involves

Summary and Review

creating high-pressure fractures in rock formations by injecting the rock with a mixture of water, sand/proppant, and chemicals. Fracturing the rock allows oil and gas to flow more freely into the drilled well. Advances in technology have enabled companies to pursue hydraulic fracturing on a commercial level, and roughly 35,000 wells are now processed via this method.

Although proponents of fracking claim the process is more environmentally friendly than other forms of energy generation, critics disagree. They believe fracking is dangerous to the environment and inefficiently uses vast amounts of natural resources. On average, it takes between 1 and 8 million gallons of water to complete a single fracking job, and there is con- cern about whether the U.S. water supply can support such robust ongoing fracturing activ- ity. Moreover, the water is transformed into fluid that contains approximately 600 chemicals, including carcinogens and toxins.

Fracking also releases methane gas into the atmosphere. Methane dissipates more quickly than carbon dioxide in the atmosphere, but its ability to trap radiation is 20 times greater. This could contribute to global warming by trapping heat close to the surface of the earth. Furthermore, methane has implications for human health. In addition to respiratory prob- lems, methane gas exposure has been linked to cardiovascular problems and increases the likelihood of heart attacks.

The EPA has established various procedures and practices companies must follow when fracking—and companies incorporate these into their regular control procedures. Managers of fracking organizations must also prepare for additional controls that could impose limits on fracking activities. For instance, the EPA requires fracking wells to have mandatory pollu- tion control equipment in place to catch methane and volatile organic compounds. Rules also limit the amount of methane emissions that can be released from fracking. It is estimated that tighter controls reduced methane emissions by 850 million metric tons between 1990 and 2010.

On the other hand, given the considerable impact fracking has on the environment, some argue that companies should do more than what the EPA and other government regulations require. Critics of fracking claim that people and animals have gotten sick from groundwater that became polluted as a result of fracking operations. Fracking is also known to contribute to seismic activity.

The oil and gas industry could implement a triple bottom line approach to placate concerns and create industry best practices. Doing so would allow organizations to create benchmarks by which to measure the effectiveness of their operations. Some energy companies are com- mitted to researching less harmful fracking processes to establish best practices. For example, the CEO of Tamboran announced that it would attempt to fracture without using chemicals in Ireland. If fracking can be performed without chemicals, it would go a long way toward reduc- ing concerns that the process pollutes water sources.

Other ways companies can become more socially responsible is by attempting to recycle the water used in fracking, safely disposing of water that cannot be reused, training employees on proper safety procedures, and maintaining roads and providing support for communities in which fracking takes place. Additional controls—such as carefully monitoring fracking’s environmental impact—can eliminate possible errors. Planning for worst case scenarios will

Summary and Review

also help an organization develop systems for handling a crisis situation, should one arise. Businesses that adopt best practices and make safety a top priority can help guard against health and environmental risks (Hassett & Mathur, 2013; Kernsher, 2013; Dong, 2015; Green Car Congress, 2013; Dangers of Fracking, n.d.; Catskill Mountainkeeper, 2012a, 2012b; State Impact Pennsylvania, n.d.; Food & Water Watch, n.d.; Connelly, Barer, & Skorobogatov, n.d.; Duke University, 2011; Denning, 2013).

1. Do you think organizations involved in fracking should adopt a triple bottom line approach? Why or why not?

2. What are the costs and benefits of a fracking company spending additional financial resources on environmental controls?

3. Describe some control systems that fracking firms can use to create best industry practices and minimize fracking’s negative impact.