8. MCS in Service Organisation

7/28/2019 8. MCS in Service Organisation

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INDEX

Service Organization in General 02

Professional Service Organization 04

Financial Service Organization 08

Health care Organization 11

Non-profit Organization 13

Conclusion 17

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SERVICE ORGANIZATIONS

In this Assignment, We Describe the management control process in service organizations-

organizations that produce and market intangible services. We first discuss the characteristics

that distinguish service organizations in general from manufacturing organizations. We then

discuss the special problems that arise in professional, financial service, health care, and

nonprofit organizations.

Service Organizations in General

In the 18th and the early part of the 19th century, the workforce in the United States was

predominantly in agriculture. After that, it was predominantly in manufacturing. Early in the

20th century, employment in the service sector overtook employment in the manufacturing

sector. By 2003, service sector employment had grown to more than twice that of

manufacturing. In this chapter we provide insights into management control systems for

service organizations.

Characteristics

For several reasons, management control in service industries is somewhat different from

management control in manufacturing companies. Some factors that have an impact on most

service industries are discussed in this section. (Others, which are characteristics of particular

service industries, are discussed later.) These factors apply also to the management control of

legal, research and development, and other service departments in companies generally.

1. Essence of Inventory Buffer

Goods can be held in inventory, which is a buffer that dampens the impact on production

activity of fluctuations in sales volume. Services cannot be stored. The airplane seat, hotel

room, hospital operating room, or the hours of lawyers, physicians, scientists, and other

professionals that are not used today are gone forever. Thus, although a manufacturing

company can earn revenue in the future from products that are on hand today, a service

company cannot do so. It must try to minimize its unused capacity.

Moreover, the costs of many service organizations are essentially fixed in the short run. In the

short run, a hotel cannot reduce its costs substantially by closing off some of its rooms.

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Accounting firms, law firms, and other professional organizations are reluctant to lay off

professional personnel in times of low sales volume because of the effect on morale and the

costs of rehiring and training.

A key variable in most service organizations, therefore, is the extent to which current

capacity is matched with demand. Service organizations attempt this matching in two ways..

First, they try to stimulate demand in off- peak periods by marketing efforts and price

concessions. Cruise lines and resort hotels offer low rates in off seasons; airlines and hotels

offer low rates on weekends; public utilities offer low rates on slack periods during the day.

Second, if feasible, service organizations adjust the size of the workforce to the anticipated

demand by such measures as scheduling training activities in slack periods and compensating

for long hours in busy periods with time off later. The loss from unsold services is so

important that occupancy rates, sold hours, load factors, student enrollment, hospital

admissions, and similar indications of success in selling available services are normally key

variables in service organizations.

2. Difficulty in Controlling Quality

A manufacturing company can inspect its products before they are shipped to the consumer,

and their quality can be measured visually or with instruments (tolerances, purity, weight,

color, and so on). A service company cannot judge product quality until the moment the

service is rendered, and then the judgments are often subjective. Restaurant management can

examine the food in the kitchen, but customer satisfaction depends to a considerable extent

on the way it is served. The quality of education is so difficult to measure that few

educational organizations have a formal quality control system.

3. Labor Intensive

Manufacturing companies add equipment and automate production lines, thereby replacing

labor and reducing costs. Most service companies are labor intensive and cannot do this.

Hospitals do add expensive equipment, but mostly to provide better treatment, and this

increases costs. A law firm expands by adding partners and new support personnel.

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4. Multi- Unit Organizations

Some service organizations operate many units in various locations, each unit relatively

small. These organizations are fast-food restaurant chains, auto rental companies, gasoline

service stations, and many others. Some of the units are owned; others operate under a

franchise. The similarity of the separate units provides a common basis for analyzing budgets

and evaluating performance not available to the manufacturing company. The information for

each unit can be compared with system wide or regional averages, and high performers and

low performers can be identified. However, because units differ in the Mix of services

provide, in the resources that they use, and in other ways, care must be taken in making such

comparisons.

Historical Development

Cost accounting started in manufacturing companies because of the need to value work-in-

process and finished goods inventories for financial statement Purposes. These systems

provided raw data that were easily adapted for use in setting selling prices and for other

management purposes. Standard cost systems, separation of fixed and variable costs, and

analysis of variances were built on the foundation of cost accounting systems. Until a few

decades ago, most texts on cost accounting dealt only with practices in manufacturing

companies.

Many service organizations (with the notable exception of railroads and other regulated

industries) did not have a similar impetus to develop cost data. Their use of product cost and

other management accounting data is fairly recent mostly since World War II. Nowadays,

their management control systems are rapidly becoming as well developed as those in

manufacturing companies.

PROFESSIONAL SERVICE ORGANIZATIONS

Research and development organizations, law firms, accounting firms, health care

organizations, engineering firms, architectural firms, consulting firms, advertising agencies,

symphony and other arts organizations, and sports organizations (such as baseball teams) are

examples of organizations whose products are professional services.

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Special Characteristics

1. Goals

A dominant goal of a manufacturing company is to earn a satisfactory profit, specifically asatisfactory return on assets employed. A professional organization has relatively few

tangible assets; its principal as set is the skill of its professional staff, which doesnt appear

on its balance sheet. Return on assets employed, therefore, is essentially meaningless in such

organizations. Their financial goal is to provide adequate compensation to the professionals.

In many organizations, a related goal is to increase their size. In part, this reflects the natural

tendency to associate success with large size. In part, it reflects economies of scale in using

the efforts of a central personnel staff and units responsible for keeping the organization up-

to-date. Large public accounting firms need to have enough local offices to enable them to

audit clients who have facilities located throughout the world.

2. Professionals

Professional organizations are labor intensive, and the labor is of a special type. Many

professionals prefer to work independently, rather than as part of a team. Professionals whoare also managers tend. To work only part time on management activities; senior partners in

an accounting firm participate actively in audit engagements; senior partners in law firms

have clients. Education for most professions does not include education in management, but

quite naturally stresses the skills of the profession, rather than management; for this and other

reasons, professionals tend to look down on managers. Professionals tend to give inadequate

weight to the financial implications of their decisions; they want to do the best job they can,

regardless of its cost. This attitude affects the attitude of support staffs and nonprofessionals

in the organization; it leads to inadequate cost control.

3. Output and Input Measurement

The output of a professional organization cannot be measured in physical terms, such as

units, tons, or gallons. We can measure the number of hours a lawyer spends on a case, but

this is a measure of input, not output. Output is the effectiveness of the lawyers work, and

this is not measured by the number of pages in a brief or the number of hours in thecourtroom. We can measure the number of patients a physician treats in a day, and even

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classify these visits by type of complaint; but this is by no means equivalent to measuring the

amount or quality of service the physician has provided. At most, what is measured is the

physicians efficiency in treating patients, which is of some use in identify ing slackers and

hard workers. Revenues earned is one measure of output in some professional organizations,

but these monetary amounts, at most, relate to the quantity of services rendered, not to their

quality (although poor quality is reflected in reduced revenues in the long run).

Example. There are more than 1,300 articles and books dealing with research on student

ratings of teachers. They describe as many as 22 dimensions of teaching performance (e.g.,

explains clearly, uses class time well) and 20 variables that affect the ratings (e.g., size of

course, time of day, gender, level of course).

The best of these rating systems can identify very good teachers and very poor teachers, but

none do a satisfactory job of ranking the 70 or 80 percent of teachers who are not at these

extremes.

Furthermore, the work done by many professionals is non repetitive. No two consulting jobs

or research and development projects are quite the same. This makes it difficult to plan the

time required for a task, to set reasonable standards for task performance, and to judge how

satisfactory the performance was. Some tasks are essentially repetitive: the drafting of simple

wills, deeds, sales contracts, and similar documents; the taking of a physical inventory by an

auditor; and certain medical and surgical procedures. The development of standards for such

tasks may be worthwhile, although in using these standards, unusual circumstances that affect

a specific job must be taken into account.

Some professionals, notably scientists, engineers, and professors, are reluctant to keep track

of how they spend their time, and this complicates the task of measuring performance. This

reluctance seems to have its roots in tradition; usually, it can be overcome if senior

management is willing to put appropriate emphasis on the necessity of accurate time

reporting. Nevertheless, difficult problems arise in deciding how time should be charged to

clients. If the normal Work week is 40 hours, should a job be charged for 1/40th of a weeks

compensation for each hour spent on it? If so, how should work done on evenings and

weekends be counted? (Professionals are exempt employeesthat is, they are not subject

to government requirements for overtime payments.) How to ac count for time spent reading

literature, going to meetings, and otherwise keeping up to date?

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4. Small Size

With a few exceptions, such as some law firms and accounting firms, professional

organizations are relatively small and operate at a single location. Senior management in such

organizations can personally observe what is going on and personally motivate employees.

Thus, there is less need for a sophisticated management control system, with profit centers

and formal performance reports. Nevertheless, even a small organization needs a budget, a

regular comparison of performance against budget, and a way of relating compensation to

performance.

5. Marketing

In a manufacturing company there is a clear dividing line between marketing activities and

production activities; only senior management is concerned with both. Such a clean

separation does not exist in most professional organizations. In some, such as law, medicine,

and accounting, the professions ethical code limits the amount and character of overt

marketing efforts by professionals (al though these restrictions have been relaxed in recent

years). Marketing is an essential activity in almost all organizations, however. If it cant be

conducted openly, it takes the form of personal contacts, speeches, articles, conversations on

the golf course, and so on. These marketing activities are conducted by professionals, usually

by professionals who spend much of their time in production workthat is, working for

clients.

In this situation, it is difficult to assign appropriate credit to the person responsible for

selling a new customer. In a consulting firm, for example, a new engagement may result

from a conversation between a member of the firm and an acquaintance in a company, or

from the reputation of one of the firms professionals as an outgrowth of speeches or articles.Moreover, the professional who is responsible for obtaining the engagement may not be

personally involved in carrying it out. Until fairly recently, these marketing contributions

were rewarded subjectivelythat is, they were taken into account in promotion and

compensation decisions. Some organizations now give explicit credit, perhaps as a

percentage of the projects revenue, if the person who sold the project can be identified.

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MANAGEMENT CONTROL SYSTEMS

1. Pricing

The selling price of work is set in a traditional way in many professional firms. If the

profession is one in which members are accustomed to keeping track of their time, fees

generally are related to professional time spent on the engagement. The hourly billing rate

typically is based on the compensation of the grade of the professional (rather than the

compensation of the specific person), plus a loading for overhead costs and profit. In other

professions, such as investment banking, the fee typically is based on the monetary size of the

security issue. In still others, there is a fixed price for the project. Prices vary widely among

professions; they are relatively low for research scientists and relatively high for accountants

and physicians.

In manufacturing companies, the profit component of the selling price is normally set so as to

obtain, on average, a satisfactory return on assets employed. As noted above, the principal

asset of a professional organization is the skill of its professionals, which is not measurable.

Actually, the total value of the whole organization is greater than the sum of what the value

of the individuals would be if they worked separately. This is because the firm already has

incurred the cost of acquiring and training these individuals, has organized them according to

their personality fit and other considerations, and has developed policies and procedures for

assuring that the work is done efficiently and effectively. In this manner, the firm accepts

responsibility for producing a satisfactory product, including the risk of loss if the work is not

well done, and it absorbs the cost of personnel who are not working on revenue-producing

work. These considerations implicitly affect the size of the profit component that is

included in the fee.

2. Profit Centers and Transfer Pricing

Support units, such as maintenance, information processing, transportation,

telecommunication, printing, and procurement of material and services, charge consuming

units for their services.

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3. Strategic Planning and Budgeting

In general, formal strategic planning systems are not as well developed in professional

organizations as in manufacturing companies of similar size. Part of the explanation is that

professional organizations have no great need for such systems. In manufacturing companies,

many program decisions involve commitments to procure plant and equipment; they have a

predictable effect on both capacity and costs for several future years, and, once made, they

are essentially irreversible. In a professional organization, the principal assets are people;

although the organization tries to avoid short-run fluctuations in personnel levels, changes in

the size and composition of the staff are easier to make and are more easily reversed than

changes in the capacity of a physical plant. The strategic plan of a professional organization

typically consists primarily of a long-range staffing plan, rather than a full-blown plan for all

aspects of the firms operation.

4. Control of Operations

Much attention is, or should be, given to scheduling the time of professionals. The billed time

ratio, which is the ratio of hours billed to total professional hours available, is watched

closely. If, to use otherwise idle time or for marketing or public service reasons, some

engagements are billed at lower than normal rates, the resulting price variance warrants close

attention.

The inability to set standards for task performance, the desirability of Carrying out work by

teams, the consequent problems of managing a matrix organization and the behavioral

characteristics of professionals all complicate the planning and control of the day-to-day

operations in a professional organization. When the work is done by project teams, control is

focused on projects. A written plan for each project is needed, and timely reports should be

prepared that compare actual performance with planned performance in terms of cost,

schedule, and quality.

5. Performance Measurement and Appraisal

As noted above in regard to teachers, at the extremes the performance of professionals is easy

to judge. Appraisal of the large percentage of professionals who are within the extremes is

much more difficult. For some professions, objective measures of performance are sometimes

available: The recommendations of an investment analyst can be compared with actual

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market behavior of the securities; the accuracy of a surgeons diagnosis can be verified by an

examination of the tissue that was removed; and the doctors skill can be measured by the

success ratio of operations. These measures are, of course, subject to appropriate

qualifications, and in most circumstances the assessment of performance is finally a matter of

human judgment by superiors, peers, self, sub ordinates, and clients.

Judgments made by superiors are the most common. For these, professional organizations

increasingly use formal systems to collect performance appraisals as a basis for personnel

decisions and for discussion with the professional. Some systems require numerical ratings of

specified attributes of performance and provide for a weighted average of these ratings.

Compensation may be tied, in part, to these numerical ratings. In a matrix organization, both

the project leader and the head of the functional unit that is the professionals organizational

home judge performance.

Appraisals by a professionals peers, or by subordinates, are sometimes part of a formal

control system. In some organizations, individuals may be asked to make a self-appraisal.

Expressions of satisfaction or dissatisfaction from clients are also an important basis for

judging performance, although such expressions may not always be readily forthcoming.

Example. One firm that sells investment advice to institutional clients keeps a record of

letters of commendation and criticism received from its clients, classifies these according to

the analysts who made the relevant criticisms or recommendations, and uses this information

as part of its performance evaluation System.

The budget can be used as the basis for measuring cost performance, and the actual time

taken can be compared with the planned time. Budgeting and control of discretionary

expenses are as important in a professional firm as in a manufacturing company. Suchfinancial measures are relatively unimportant in assessing a professionals contribution to the

firms profitability, however. The professionals major contribution is related to quantity and

above all quality of work, and its appraisal must be largely subjective. Furthermore, the

appraisal must be made currently; it cannot wait until one learns whether a new building is

well designed, a new control systemactually works well, or a bond indenture has a flaw.

In some professions, internal audit procedures are used to control quality. In many accounting

firms, the report of an audit is reviewed by a partner other than the one who is responsible for

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it, and the work of the whole firm is peer reviewed by another firm. The proposed design of

a building may be reviewed by architects who are not actively involved in the project.

FINANCIAL SERVICE ORGANIZATIONSFinancial service organizations include commercial bank and thrift institutions, insurance

companies, and securities firms. These companies are in business primarily to manage

money. Some act as intermediaries; that is, they obtain money from depositors and lend it to

individuals or companies. Others act as risk shifters; they obtain money in the form of

premiums, invest these premiums, and accept the risk of the occurrence of specific events,

such as death or damages to property. Still others are traders; they buy and sell securities,

either for their own account or for customers.

The Financial Services Sector

Several general observations can be made about the financial services sector.

First, in 2002, financial services firms accounted for over $400 billion, or about 5 percent, of

the gross domestic product, but their importance in the overall performance of the economy is

considerably greater than this percentage indicates. The financial services sector constitutes

an important backbone to the U.S. and world economies.

Second, 30 years ago, commercial banking, investment banking, retail brokerage, and

insurance existed as distinct separate industries; firms specialized in a single industry and

tended to compete in a single country. Nothing could be further from the truth today.

Deregulation (e.g., the weakening of the Glass-Steagall Act) has blurred industry and

geographic boundaries. Financial services firms not only operate in multiple segments

(investment banking, brokerage, etc.) but also are global in scope. In the 1990s several mega

mergers led to the consolidation of the financial services industry (examples: merger of

Citicorp and Travelers; UBSs acquisition of Paine Webber; Morgan Stanleys acquisition of

Dean Witter; Deutsche Banks acquisition of Bankers Trust). Blurring of industry boundaries,

globalization, and consolidation of financial services firms will accelerate in the 21st century.

Third, financial services firms have used the information technology revolution to innovate

new products and discover new methods of trading. For instance, the Charles Schwab

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Corporation introduced TeleBroker (an automated telephone touchpad order entry system),

Voice Broker (an automated voice recognition quote system), and e.Schwab (Internet-based

brokerage service). New entrants such as E*Trade and Ameritrade were able to dramatically

lower brokerage commissions through Web-based trading. In 2002, over 35 percent of all

stock trades by individuals were done via the Internet; yet, six years earlier, this segment did

not exist.

Fourth, the need for controls in the financial services sector has become paramount. The

Asian financial crisis during the second half of the 1990s was, in part, the result of inadequate

controls in banks in Thailand, Indonesia, Japan, and other Asian countries which, in turn,

allowed the banks to make highly risky and bad loans. Most notable failure among financial

services firms was the collapse of Barings, Britains oldest merchant bank, in 1995. Deficient

Control partly contributed to Barings debacle.

Fifth, during the 1990s, new forms of financial instruments (such as derivatives) designed by

financial service firms sometimes resulted in millions of dollars of losses for their clients. In

December 1994 Orange County in California lost $1.7 billion in leveraged interest-rate

products. In April 1994 Procter & Gamble sued Bankers Trust because of its loss of over

$100 million on interest- rate swaps designed by Bankers Trust. In July 1994 Glaxo incurred

losses of $180 million on derivatives and asset-based bonds.

Finally, the corporate scandals during 2002 have created a huge push for in vestment banks

to spin off their research departments. It is argued that under the current system, the interests

of the investment bankers, not those of investors, drive the results of research. Research

analysts are tainted by the potential for a conflict of interest because the companies that they

cover also buy high-fee investment banking services from the analysts employers. The

arguments for spin off are many:

(1) This separation will ensure objective research data.

(2) At present, cost of research is being subsidized by investment banks; if investors

have to pay for it, they will demand higher-quality research.

(3) Investor confidence will improve if they are convinced that research is unbiased.

On the other hand, several arguments are offered against such a spin off:

(1) The cost of research will go up if they are set up as separate firms;

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(2) the best research analysts will join investment banks due to the higher pay scales,

thereby leaving independent research firms with lower caliber employees; and

(3) To keep costs down, research departments may issue short reports instead of a

rich, detailed analysis of stocks as is the current practice.

Example. During 2002, there were investigations into the research work of Salomon Smith

Barney investment bank, a unit of Citigroup. On October 30, 2002, the Citigroup, on a

voluntary basis, spun off its research analysts from investment banking.


While the general principles and concepts of management control systems ap ply, they needto be adapted to the following special characteristics of the financial services industry.

1. Monetary Assets

Most of the assets of financial service firms are monetary. The current value of monetary

assets is much more easily measured than the value of plant and other physical assets, or

patents and other intangible assets. Currency is the extreme example of a fungible

commodity. At any time, dollars held by all companies have the same value; each dollar isworth a dollar, valued at both its face amount and its purchasing power. Its purchasing power

changes with time, but at any given future time, all dollars have equal value. This means that

ones dollar has the same quality at any given moment. In the financial services industry,

quality refers to the quality of services rendered and to the quality financial instruments other

than money; there is no need for quality control safeguards for money.

2. Financial assets

Financial assets also can be transferred from one owner to another easily and quickly. In an

electronic funds transfer, money moves almost instantaneously. In other transactions, it

moves in a few days at most. Its portability is tempting to thieves and forgers. For this reason,

firms that handle financial as sets, especially money, must take strong measures to protect

them. These involve not only physical measures to safeguard currency and documents, but

also measures designed to maintain the integrity of the system for transferring money from

one party to another.

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3. Time Period for Transactions

The ultimate financial success or failure of a bond issue, a mortgage loan to an individual, or

a life insurance policy may not be known for 30 years or more. During this period, thesoundness of the loan or policy may change, and the purchasing power of money will

certainly change. This means that the ultimate performance of those involved in authorizing

and structuring the loan, or in selling and pricing the insurance policy, cannot be measured at

the time the initial decision is made. It also means that control requires that there be a means

of continued surveillance of the soundness of the transaction during its life, including

periodic audits of all outstanding loans. (Failure to identify troubled loans at an early stage

is one important reason for the rash of failures of banks and thrift institutions.)

At the other extreme, some transactions are completed quickly. Many trades are made on the

basis of information that the trader has acquired in the previous few minutes, or even

seconds. F currency transactions and for listed securities, new information may become

available almost instantaneously in markets throughout the world. Traders either buy or sell

securities on the basis of the information they have. If they buy securities, future changes in

prices will change the value of the securities held. Therefore, there is a need for a system to

report held and to assess the risk to the organization if prices move against the traders

securities. This means that the firm must have an accurate, prompt system for obtaining this

information, for summarizing it, for estimating the risk of the securities held (if applicable),

and for making this information available to traders; a computer model (expert system)

evaluates the information and in some cases acts with, human intervention.

4. Risk and Reward

Many financial services firms are in the business of accepting risks in return for rewards.

Most business decisions involve a trade-off between risks and re wards. The greater the risk,

the greater should be the anticipated reward. In financial services firms, this trade-off is more

explicit than in business investments such as those involving the purchase of a machine or the

introduction of a new product. Interest rates on loans and premiums on insurance policies are

based on assumptions about risk that may, or may not, turn out to be accurate.

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5. Technology

Technology has revolutionized the financial services industry. Financial service firms have

used information technology as a way to offer innovative services. Automated teller

machines of banks are just one example. Insurance and mutual fluids have developed

electronic marketplaces. Financial service firms, via their website on the Internet, market

their products electronically to consumers. Investment banks, using concepts from quantum

physics and high- level mathematics formulas, have designed new forms of financial

instruments. Banks have become virtual by offering cyber-payment systems. Online

brokerage services are a fast-growing segment.

HEALTH CARE ORGANIZATIONSHealth care organizations consist of hospitals, clinics, and similar physicians organizations;

health maintenance organizations; retirement and nursing homes; home care organizations;

and medical laboratories, among others. They constitute the largest industry in the United

States: 14 percent of the gross national product, which is about the same percentage as the

total of all durable goods manufacturers. Although they have most of the characteristics of

non profit organizations, which are discussed in the next section, many of them are profit-

oriented companies.


1. Difficult Social Problem

Society is gradually coming to grips with the fact that the present health care delivery system

is unworkable. Although physicians are bound by the Hippocratic oath to provide adequate

health care to their patients, the system can not do this. On the one hand, the cost per

treatment is inevitably increasing with the development of new equipment and new drugs;

hospital expenses in creased from $28 billion in 1970 to over $400 billion by 2003. (Contrast

this trend with the typical experience of manufacturing companies, in which new equipment

usually reduces unit costs). On the other hand, the number of ill persons is increasing because

medical advances prolong the lives of elderly people, who are the most likely to require

treatment. Society cannot pay for the predictable increases if the present rate of increase in

cost continues much longer. Health care providers are aware of this problem, but they dont

know how society, especially the Congiess, will deal with it. It is clear, however, that health

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care delivery will change drastically. Health care organizations must be alert to these

changes.

2. Change in Mix of Providers

Within the overall increase in health care cost, significant changes have occurred in the way

in which health care is delivered and, hence, in the viability of certain types of providers.

Many services that traditionally were provided in hospitals on an inpatient basis are now

provided in outpatient clinics or in patients homes. Entrepreneurs have entered the industry

to provide these new services. There also has been a shift from small local hospitals to larger

regional or medical center hospitals. The number of hospital beds decreased by more than 30

percent from 1970 to 2003. To remain viable, hospitals must have the flexibility to adapt to

these changes, either by providing more outpatient services themselves or by eliminating

inpatient services that are no longer profitable.

3. Third-Party Payers

Of the more than $900 billion total expenditures for health care in 2003, 43 per cent were

financed by the government, 35 percent by insurance companies, and only 22 percent by

individual patients. The largest government program is Medicare, a federal program that

provides support for persons age 65 and up and for younger persons with certain disabilities.

The Medicaid program pays for services provided to low-income people; it is financed by the

states within general guidelines set by the federal government.

Until 1983, Medicare reimbursed on the basis of reasonable costs incurred, which gave

health care providers little incentive to control costs. Currently, Medicare reimburses

hospitals on the basis of Diagnostic Related Groups (DRGs). Medical and surgical

procedures are classified into one of about 500 DRGs, each DRG is priced annually at a set-

dollar amount, and hospitals are reimbursed for these amounts, regardless of the actual length

of stay or the actual costs incurred for individual patients. Other third-party payers have

moved toward a similar system of reimbursement.

The DRG system, and the increase in hospital costs per patient, has motivated hospitals to

install sophisticated cost accounting systems, usually systems that they purchase from an

outside computer software organization and then adapt to their own needs. Some hospitals

provide information processing services to other hospitals on a contract basis. These systems

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provide information on individual patients (similar to job-cost systems in automobile repair

shops), and they report actual costs compared with standard costs for each DRG; costs are

classified by departments and even by attending physicians within departments.

This information is in addition to information traditionally collected in hospitals; it focuses

on outputs (patient care), as well as on inputs (cost per laboratory test).

Increasingly, health maintenance organizations (HMOs) reimburse physicians, hospitals, and

other providers. They contract with companies to provide medical services to employees at a

fixed cost per person covered. In turn, the HMO contracts with hospitals and other providers,

in some cases at a specified amount per DRG. The HMO therefore has the difficult task of

controlling its payments so that they do not exceed the fees earned, but nevertheless seeing to

it that adequate health care is provided.

4. Professionals

In 2003, the health care industry employed over 3 million professionals (physicians, dentists,

registered nurses, and therapists), which was more than any other industry except education.

The management control implications of professionals are the same as those discussed in the

preceding section. Their primary loyalty is to the profession, rather than to the organization.

Departmental managers typically are professionals whose management function is only part-

time; the chief of surgery does surgery. Historically, physicians have tended to give relatively

little emphasis to cost control. In particular, there has been an impression that they prescribe

more than the optimum number of tests, partly because of the danger of malpractice suits if

they dont detect all the patients symptoms.

5. Importance of Quality Control

The health care industry deals with human lives, so the quality of the service it provides is of

paramount importance. There are tissue reviews of surgical procedures, peer review of

individual physicians, and outside review agencies mandated by the federal government.

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Management Control Process

Subject to the characteristics described above, the management control process in the health

care industry is similar to that described in Chapters 8 through 12. Because of the shift in the

product mix and because of the increase in the quantity and cost of new equipment, the

strategic planning process in hospitals is important. The annual budget preparation process is

conventional. Huge quantities of information are available quickly for the control of

operating activities. Financial performance is analyzed by comparing actual revenues and

expenses with budgets, identifying important variances, and taking appropriate actions on

them.

NONPROFIT ORGANIZATIONS

A nonprofit organization, as defined in law, is an organization that cannot distribute assets or

income to, or for the benefit of, its members, officers, or directors. The organization can, of

course, compensate its employees, including officers and members, for services rendered and

for goods supplied. This definition does not prohibit an organization from earning a profit; it

prohibits only the distribution of profits. A nonprofit organization needs to earn a modest

profit, on average, to provide funds for working capital and for possible rainy days.

Nonprofit organizations that meet the criteria of Section 501(c) of the Internal Revenue Code

are exempt from income taxes (except for their unrelated business income); over 1.2

million organizations satisfy these criteria in the United States. If they are religious,

charitable, or educational organizations as defined in Section 501(c)(3) of the code,

contributions made to them are tax deductible by the contributor; they are called 501(c)(3)

organizations. Many such organizations are exempt from property taxes and from certain

types of sales taxes.

In many industry groups, there are both nonprofit and profit-oriented (i.e., business)

organizations. There are nonprofit and for-profit hospitals, nonprofit and for-profit

(proprietary schools and colleges, and even for-profit religious organizations. SRI

International is a nonprofit research organization that corn pete with Arthur D. Little, Inc., a

for-profit research organization.

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1. Absence of the Profit Measure

A dominant goal of most businesses is to earn a satisfactory profit; net income measures

performance toward this goal. No such measure of performance exists in nonprofit

organizations. Many of them have several goals, and an organizations effectiveness in

attaining its goals rarely can be measured by quantitative amounts. The absence of a

satisfactory, quantitative, overall mea sure of performance is the most serious management

control problem in a non profit organization.

The income statement is the most useful financial statement in a nonprofit organization, just

as it is in a business. The net income number is interpreted differently in the two types of

organizations, however. In a business, as a general rule, the larger the income, the better the

performance. In a nonprofit organization, net income should average only a small amount

above zero. A large net income signals that the organization is not providing the services that

those who supplied resources had a right to expect; a string of net losses will lead to

bankruptcy, just as in a business. Although financial performance is not the dominant goal in

a nonprofit organization, it is a necessary goal because the organization cannot survive if its

revenues on average are less than its expenses.

2. Contributed Capital

There is only one major difference between the accounting transactions in a business and

those in a nonprofit organization; it relates to the equity section of the balance sheet. A

business corporation has transactions with its shareholders issuance of stock and the

payment of dividendsthat a nonprofit organization doesnt have. A nonprofit organization

receives contributed capital, which few businesses have. (In both businesses and nonprofit

organizations, equity is in creased by earning income.)

There are two principal categories of contributed capital: plant and endowment. Plant

includes contributions of buildings and equipment, or contributions of funds to acquire these

assets; works of art; and other museum objects. Endowment consists of gifts whose donors

intend that the principal amount will remain intact indefinitely (or at least for many years);

only the income on this principal will be used to finance current operations.

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The receipt (or pledge) of a contributed capital asset is not revenuethat is, neither

contributions of plant nor of endowment are available to finance the operating activities of

the period in which the contribution is received. Endowment assets must be kept separate

from operating assets. This is a legal requirement. for a true endowment, and it is sound

policy for a board-designated endowmentthat is, funds that the trustees have decided to

treat s endowment, even though there is no legal requirement that they do so. It follows that

capital contributions should be reported separately from operating contributions, that is, from

revenues from annual fund drives, grants, and other gifts in tended to finance current

operations.

Thus, a nonprofit organization has two sets of financial statements. One set relates to

operating activities; it includes an operating statement, a balance sheet, and a statement of

cash flows that are the same as those found in business. The second set relates to contributed

capital; it has a statement of inflows and outflows of contributed capital during a period and a

balance sheet that reports contributed capital assets and the related liabilities and equity.

Inflows of contributed capital are capital contributions received in the period and gains on the

endowment portfolio; outflows are the endowment income that is re ported as operating

revenue, losses on the endowment and write-offs of plant.

3. Fund Accounting

Many nonprofit organizations use an accounting system that is called fund ac counting.

Accounts are kept separately for several funds, each of which is self-balancing (i.e., the sum

of the debit balances equals the sum of the credit balances). Most organizations have (1) a

general fund or operating fund, which corresponds closely to the set of operating accounts

mentioned above; (2) a plant fund and an endowment fund, which account for the contributed

capital assets and equities mentioned above; and (3) a variety of other funds for special

purposes. Some of these other funds, such as the pension fund, are also found in business,

although in business they are reported in the notes to the financial statements, rather than in

the financial statements themselves. Others are useful for internal control purposes. For

management control purposes, the primary focus is on the general fund.

4. Governance

Nonprofit organizations are governed by boards of trustees. Trustees usually are not paid, and

many of them are unfamiliar with business management. Therefore, they generally exercise

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less control than the directors of a business corporation. Moreover, because performance is

more difficult to measure in a nonprofit organization than in a business, the board is less able

to identify actual or incipient problems.

The need for a strong governing board in a nonprofit organization is greater than in a business

because the vigilance of the governing board may be the only effective way of detecting

when the nonprofit is in difficulty. In a profit-oriented organization, a decrease in profits

signals this danger automatically.

MANAGEMENT CONTROL SYSTEMS

1. Product Pricing

Many nonprofit organizations give inadequate attention to their pricing policies. Pricing of

services at their full cost is desirable.

A full-cost price is the sum of direct costs, indirect costs, and, perhaps, a small allowance

for increasing the organizations equity. This principle applies to services that are directly

related to the organizations objectives. Pricing for peripheral activities should be market-

based. Thus, a nonprofit hospital should price its health care services at full cost, but prices in

its gift shop should be market-based.

In general, the smaller and more specific the unit of service that is priced, the better the-basis

for decisions about the allocation of resources. For example, a comprehensive daily rate for

hospital ca which was common practice a few decades ago masks the revenues for the mix

of services actually provided. Be yond a certain point, of course, the cost of the paperwork

associated with pricing units of service outweighs the benefits.

As a general rule, management control is facilitated when prices are established prior to the

performance of the service. If an organization is able to re cover its incurred costs,

management is not motivated to worry about cost control.

2. Strategic Planning and Budget Preparation

In nonprofit organizations that must decide how best to allocate limited resources to

worthwhile activities, strategic planning is a more important and more time-consuming

process than in the typical business. The process is similar to that described in Chapter 8,

except that the absence of a profit measure makes program decisions more subjective.

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The budget preparation process is similar to that described in Chapter 9. Colleges and

universities, welfare organizations, and organizations in certain other nonprofit industries

know, before the budget year begins, the approximate amount of their revenues. They do not

have the option of increasing revenues during the year by increasing their marketing efforts.

They budget expenses so the organization will at least break even at the estimated amount of

revenue. They require that managers of responsibility centers limit spending close to the

budget amounts. The budget is, therefore, the most important management control tool, at

least with respect to financial activities.

3. Operation and Evaluation

In most nonprofit organizations, there is no way of knowing what the optimum operating

costs are. Responsibility center managers, therefore, tend to spend whatever is allowed in the

budget, even though the budgeted amount may be higher than is necessary Conversely, they

may refrain from making expenditures that have an excellent payoff simply because the

expenditure was not included in the budget.

Although nonprofit organizations have had a reputation for operating inefficiently, this

perception has been changing for good reasons. Many organizations have had increasing

difficulty in raising funds, especially from government resources. This has led to belt-

tightening and o increased attention to management control. As mentioned above, the most

dramatic change has been in hospital costs, with the introduction of reimbursement on the

basis of standard prices for diagnostic-related groups.

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CONCLUSION

Management control in service organizations is different from that in manufacturing

organizations, primarily because of the absence of an inventory buffer between production

and sales, because of the difficulty of measuring quality, and because service organization are

labor intensive.

Professional Organizations do not have the dominant goal of return on assets employed;

Professionals behavioral characteristics do not include attention to costs, output

measurements are subjective, and there is no clear line between marketing and production

activities. Performance appraisal may be achieved by peer reviews; in any case it tends to be

subjective.

Financial Services Organizations differ in two fundamental respects from industrial

companies. First, their raw material is money. At any given time, the value of each unit of

money in inventory is the same for all organizations, negation any need for control in this

area; however, the cost of using money obtained from various sources varies considerably.

Second the profitability of many transactions cannot be measured until years after the

commitment has been made, necessitating continual periodic audits. In particular, thefinancial services company is profitable only if the future revenues obtained from current

loans, investments and insurance premiums exceed the cost of the funds associated with these

revenues by an amount that is sufficient to cover operating expenses and losses.

Health care organizations have tried to use the DRG system to standardize costs; they and

society, must face the fact that the current control and delivery system is unworkable.

Non profit organizations lack the advantages for control that the profit measure provides;

they must account for contributed capital, a category that rarely occurs in a business.

Expenditure decisions are subjective for non profits; nevertheless, they have succeeded in

becoming more efficient in response t shrinking sources of funds.

8. MCS in Service Organisation

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