Prin of Mgmt Control Sys

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Chapter 1

Introduction to Management

Control Systems

In this chapter we will discuss:

• Importance of Control Systems

• Nature of Management Control Systems

• Types of Management Control Systems

• Subsystems and Components of Management Control Systems

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Principles of Management Control Systems

In 2001, Enron Corp., the global energy giant, collapsed in one of the largestcases of bankruptcy filing in U.S. corporate history. Tyco International, adiversified manufacturing and service company, had to abandon plans to splitinto four parts, because of doubts about its accounting practices. The stunningnews that WorldCom, the telecom giant, had artificially inflated its earnings

by $3.8 billion rocked the corporate world and shook investors’ confidence instock markets. WorldCom's accounting irregularities involved the deliberatemis-recording of expenses as capital expenditures, in order to inflate its cashflows. The accounting irregularities included transfers between internalaccounts of $3.06 billion in 2001 and $797 million in the first quarter of 2002.

As these examples illustrate, the absence or malfunctioning of control systemscan lead to huge losses, and even to corporate bankruptcy. Defective productsand poor coordination between departments also arise due to weak controlsystems.

This chapter focuses on the importance of control systems, the nature of management control systems, types of management control systems, and thesubsystems and components of management control systems.

IMPORTANCE OF CONTROL SYSTEMS

A control system is a set of formal and informal systems to assist themanagement in steering the organization towards its goals. Controls help inguiding employees effectively towards the accomplishment of theorganization’s goals. Establishing a control system in an environment of

distributed accountability, reengineered processes, and local autonomy andempowerment is a challenging task.

The control process in any organization can be undertaken at three levels.These are: the strategic level, the management level, and the operational level.Each type of control occurs primarily at one of the three distinct levels of theorganizational hierarchy.

• Strategic control deals primarily with the broad questions of domaindefinition, direction setting, expression of the organization’s purpose, andother issues that impact the organization's long-term survival. Strategiccontrol overlaps to some extent with the process of strategy formulation.Strategic control also deals with issues relating to general company

objectives and the implementation and monitoring of progress.• Management control deals with effective resource utilization, the state of

competitiveness of the unit, and the translation of corporate goals into business unit objectives.

• Operational control is primarily concerned with efficiency issues.Occurring at very specific functional or sub-departmental levels of theorganizational hierarchy, this mode of control generally conforms totraditional control models. The time horizon of control is very short, the

benchmarks are known and well defined, and the outcomes are tangibleand easily measurable.

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Introduction to Management Control Systems

It is important to recognize that the three levels of control are not mutuallyexclusive. They represent a nested arrangement. If the control process doesnot identify and deal appropriately with a problem occurring at a lower level,the problem worsens. The problem then gets kicked up to a higher level of control. This can be illustrated through the example of Kimberly-Clark inExhibit 1.1. In extreme cases, when the issue gets more complicated,threatening the organization’s survival, the problem needs to be handled fromthe highest levels, in terms of strategic control.

Increased control in an organization will result in reduced creativity and

entrepreneurship. Hence it is important for organizations to establish the trade-off between the amount of control and the level of freedom for employees, andto choose the right mix of controls.

Elements of a Control System

Any control system has four important elements. They are a detector or sensor, an assessor, an effector and a communications network, as can be seenin Figure 1.1. The detector analyzes the situation that is being controlled. Anassessor helps in comparing the actual results with the standard or expectedresults. An effector is used to reduce the gap between the actual and the

Exhibit 1.1

Management Control at Kimberly-Clark

Kimberly-Clark, the manufacturer of household and health products, is an exampleof a company that mixed up operational and management control issues. Thecompany has a good reputation as a manufacturer of household and health

products. Since 1950s, it also started selling cigarette paper and sheets of pressed,reconstituted tobacco-to-tobacco companies for use in cigarettes. The tobaccoreconstitution process used by Kimberly-Clark enabled tobacco companies tomanipulate nicotine levels in cigarettes.

The state of West Virginia in the US alleged that Kimberly-Clark conspired withcigarette companies to deceive the public about the hazards of smoking. When thecompany realized that its tobacco business was becoming a legal and financialliability, it spun off the tobacco unit.

At the operational control level, the company did not ascertain whether theadvertisements claiming that the tobacco reconstitution process allows nicotinelevels to be adjusted to a smoker’s individual requirement was indeed misleading.At the management control level, the company did not act immediately oncesmoking related illness became common. The strategic control failure was notmaking a conscious determination whether the tobacco business was consistentwith the company's mission and values. If the tobacco business was consistentwith the mission and values, the company then needed to follow up by instituting

proper operational and management control systems that protected theorganization against legal liability.

Adapted from Veliyath, Raj; Hermanson, Heather M. “Organizational control systems:

Matching controls with Organizational levels” Review of Business, Winter97, Vol. 18 Issue 2, p2.

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standard result. The communication network transmits information betweenthe detector, the assessor and the effector.

The process of control usually involves four important steps. They are:

• Identifying the goals or objectives,

• Implementing the programs or policies,

• Measuring and comparing outcomes against targets, and

• Analyzing whether the achieved targets are in accordance with the goalsor objectives.

NATURE OF MANAGEMENT CONTROL SYSTEMS

The role of the management is to organize, plan, integrate and interrelate

organizational activities to achieve organizational objectives. The achievement

of these activities is facilitated by management control systems. A

management control system is designed to assist managers in planning and

controlling the activities of the organization. A management control system is

the means by which senior managers ensure that subordinate managers,

efficiently and effectively, strive to attain the company's objectives. According

to Anthony, Dearden and Govindarajan1 (1992), management control is “the

process by which managers ensure that resources are used effectively and

efficiently in the accomplishment of the organization's objectives”.

If the management monitors the activities of the business units frequently,then it is exercising tight control. Limited monitoring of the business units’activities can be termed as loose control. The difference between tight andloose control thus relates to the degree to which the management monitors the

1 Robert N Anthony and Vijay Govindarajan, Management Control Systems, Eight EditionIrwin Publications.

Figure 1.1 Elements of the Control Process

Controldevice

2. Assessor. Comparisonwith standard

1. Detector. Observedinformation about what is

happening

Entity being

controlled

3. Effector. Behavior altering communication,

if needed

Source: Robert N.Anthony, Govindarajan, Management Control Systems , (USA: Irwin, 1995) 5.

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activities of a unit. When there is tight control by the management, there isextensive involvement of the management in the day-to-day operations of the

business unit. The budget is considered a binding constraint with a strong

emphasis on meeting the budgeted targets. Deviations from the budget aregenerally not considered acceptable. Loose control is characterized by limitedinvolvement by the management in day-to-day operations. Under loosecontrol, the budget is regarded more as a tool for planning and communicationthan as a binding commitment.

Management control systems involve a number of activities in anorganization, including:

• Planning the future course of action

• Coordinating and communicating the various activities of the organizationto different departments

• Evaluating information and deciding the various activities; and finally,

• Influencing people to work in accordance with the goals of theorganization.

Important Features of Management Control Systems

Nature of decisions

Management control decisions are based on the framework established by theorganization's strategies. Management control decisions also take into accountthe quantity and quality of resources available. Within the constraints of theavailable resources and the policies of the organization, a manager should be

able to implement activities that are best suited for a particular business unit.Decisions are made at the highest level, but their actual implementation mayrequire some time. For instance, employees need time to adapt to a newtechnology.

Decisions are systematic and rhythmic

Decisions in management control process are systematic and rhythmic i.e.they are in accordance with the strategies and procedures laid down by the topmanagement. Plans developed for a unit must encompass the wholeorganization, and the plans for each of the organization’s units must becoordinated with one another, so that there is a balance between differentactivities. For example, operations and distribution should be balanced with

the sales program.Strategy implementation tool

Management control helps an organization to move towards its strategicobjectives. It is an important vehicle for the execution of strategy. Figure 1.2explains how strategies are implemented through management controls,organizational structures, human resource management, and culture. Effectiveexecution can take place with the help of an efficient organizational structure,human resource management and culture. All these are influenced by thesystem of management control, and hence it is an important aspect of strategyimplementation.

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Behavioral considerations

People are important assets for an organization. Without the cooperation of theemployees, managers cannot implement their decisions. To manage peopleeffectively, control systems are required for the following three reasons- lack

of direction, motivational problems and personal limitations.Poor performance in organizations can be attributed to lack of directionamong employees. Giving employees the required support and direction toaccomplish organizational goals is one of the important functions of management control systems.

Motivation is important to help employees perform to their full potential.Most of the organization’s problems occur because individual goals andorganizational goals do not match. This results in demotivated performance bythe employees. At the managerial level too, lack of motivation will result inemployees taking decisions that are harmful to the organization. The decisionsmay be made in order to advance the personal interests of the employeesinvolved. In extreme cases, this could lead to employee fraud and theft. In IT

companies, computer-related crime can result in huge losses for theorganization. Hence, there is a need to control such behavior in anorganization.

Another behavioral problem that can have serious consequences for anorganization is personal limitations. In spite of high motivation to perform,certain employees may be unable to perform because of their personallimitations. These limitations are specific to individuals, and could also be

because of inadequate training, lack of knowledge or information, andinexperience. Job design also plays an important role in performance. Some

jobs are designed in a manner that creates stress. This can lead to accidentsand errors in decision-making. Training plays an important role in reducing

Figure 1.2Framework for Strategy Implementation

Implementation mechanisms

ManagementControls

OrganizationStructure

Culture

Human ResourceManagementStrategy

Performance

Source: Robert N Anthony and Vijay Govindrajan, Management Control Systems (USA:

Irwin, 1995) 11.

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the severity of limitations at the individual level. Finding effective tools for control of such limitations is an important part of control systems.

Management Control Process

The management control process involves three interrelated activities –

communication, motivation and evaluation. First, it involves communication

between the superior and the subordinates. Communication helps the

subordinates understand the goals of the organization. The superior should

make sure that the subordinates understand what the organization expects of

them. Second, for the subordinates to put in their best efforts to achieve

organizational goals, they have to be motivated. It is the responsibility of the

superior to motivate the subordinates. Finally, for effective performance,

superiors should evaluate the work of the subordinates and give them

feedback periodically. It is essential for the superior to evaluate the performance of subordinates without any bias.

Characteristics of a Good Management Control System

A good management control system ensures success for an organization. Good

management control here implies that the goals of the organization are clearly

communicated to the employees, and that the employee is confident about

performing his tasks well. For example, good inventory control means that

employees have information about the quantity of inventory present and its

availability at different locations. An organization does not usually have

perfect control. For perfect control all the employees should be working in the

best possible way. But this is not always possible as employee behavior is notstable. Good control can be achieved in the following ways:

Future-oriented

Planning is always oriented to the future. The organization should be focused

on the future. Employees should be encouraged to be flexible so as to respond

effectively to change.

Clear Objective

Good control cannot be established unless the multiple objectives of a

particular task are considered separately. For example, to assess the control

system relating to production, all major performance parameters likeefficiency, quality and asset management, have to be measured.

Minimum control losses

Control devices are costly and not always economically feasible. So, control

devices should be put in place only when the economic benefits exceed the

costs. The difference between the performance that is theoretically possible

and one that can be reasonably expected is called “control loss.” An

organization achieves optimal performance when control losses are

minimized.

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Distinction between Strategy Formulation, Management Control and Task Control

It is important to analyze the differences between management control andother types of control. Management control needs to be distinguished clearlyfrom strategy formulation and from task control. While strategy formulationtakes place at the highest level in an organization, task control takes place atthe individual level. Management control lies at the middle level betweenstrategy formulation and task control. Figure 1.3 explains the distinction

between strategy formulation, management control and task control.

Distinction between strategy formulation and management control

Strategy formulation takes place at the highest level of the management andinvolves formulation of new strategies, whereas management control involvesimplementation of these policies. Strategy formulation takes place in

accordance with situations, both internal and external to the organization.Hence, strategy formulation may not always follow a clearly defined system.The management control process takes place in a systematic manner, andinvolves managers and staff at all levels in the organization. Strategyformulation usually involves only those at the highest level of theorganization. There may be changes in one or a few strategies, while othersremain unaffected. In contrast, the management control process involves thewhole organization, and changes affect all the parts since they are linked withone another. Therefore, a high level of coordination is required.

Task control vs. management control

Task control involves the control of individual tasks. These tasks are carried

out according to the rules and regulations laid down by the management

Figure 1.3 General Relationship among Planning and Control Functions

Activity Nature of

End product

Strategy formulationGoals, strategies and

policies

Management controlImplementation of

Strategies

Task control

Efficient and effective performance of

individual tasks

Source: Robert N.Anthony, Govindarajan, Management Control Systems, (USA: Irwin,

1995) 9.

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control process. Usually the techniques in operations research andmanagement science focus on task control. The information important for task control in an organization is usually quantitative in nature e.g. the number of

items ordered by the customers, the components used in manufacturing the products, the number of man-hours used in a particular process, etc. Thedevices used for task control include programmable machine tools, processcontrol computers and robots. In task control, each task requires a differenttask control system (a production control system is different from a cashmanagement system).

Thus, it can be concluded that task control is quantitative in nature whereasmanagement control is oriented towards behavior. In task control, in somecases, such as automated processes, employees may not be involved; in other cases, there may be interaction between a manager and a worker. Managementcontrol involves interaction between two managers or between a superior andsubordinate.

TYPES OF MANAGEMENT CONTROL SYSTEMS

Control systems in an organization fall under two broad areas: formal andinformal. Formal controls are laid out in writing by the management, whereasinformal controls arise as a result of employees’ behavior. Examples of formalcontrols are plans, budgets, regulations and quotas. Informal controls includegroup norms and organizational culture. Formal controls are framed by themanagers, whereas informal controls often originate with employees and areaffected by general socio-cultural factors.

Formal Control System

Formal control systems are written, management-initiated mechanisms thatinfluence the behavior of employees in achieving the organization’s goals.Formal controls can be classified into three types, based on the nature of management intervention. They are:

Input controls

These are the actions taken by the company before a planned activity isimplemented. These measures help the company to select the right way toundertake the activity. Input controls include selection criteria, recruitmentand training programs, manpower allotments, strategic plans and resource

allocations.Process controls

Process controls involve tracking certain variables and taking corrective actionwhenever there is any deviation from specified parameters in the variables.The control action takes place before the process of transformation iscompleted and the output is produced. Process control is exercised when thefirm attempts to influence the ongoing activity to achieve the desired ends.The control is applied to the behavior or activities rather than the end results.

For example, under a feed-forward system of inventory control, the factorsthat affect inventory levels of finished goods, such as the rate of sales or

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dispatch delays, are tracked. When the sales begin to decline or there is adispatch bottleneck, this information is fed forward, and the level of thefinished goods inventory is controlled by reducing production. Thus, the

inventory levels are prevented from exceeding required levels. Alternatively,the managers may realize that the original standards for sales or dispatchdelays are no longer appropriate and must be revised. This again feeds into aloop, which leads to the inventory objectives or plans being updated. Processcontrol can also be illustrated using the example of a salesperson’s job. Themanagement may direct the salesperson to follow certain procedures for newmarket development, but may not hold the salesperson responsible for theextent of new business generated i.e. the end result. In such a case, processcontrol has been exercised.

Output controls

Output control is exercised when performance standards are set and

monitored, and the results are evaluated. Output control takes place when thecontrol activity is based on the comparison of actual and planned outcomes.Such controls are applicable when it is easy and inexpensive to measure theoutput and when there are few elements of uncertainty. In this type of control,the management expects the employee to perform in a result-oriented way, asit believes that the employee has the requisite knowledge to undertake theactivities required, in a suitable manner, and to complete the assigned task without management intervention.

Informal Control System

These are unwritten, typically worker-initiated mechanisms that influence the

behavior of individuals or groups in business units. There are three types of informal controls. They are:

Self-control

It deals with the establishment of the personal objectives by the individual,monitoring their attainment and adjusting the behavior in the organization toattain the goals. Self-control can be beneficial to an organization if theorganization’s goals are in congruence with the individual’s goals. But if thegoals do not match then the performance of the employee can suffer.

Social controls

Social control refers to the prevailing social perspectives and patterns of

interpersonal interactions within subgroups in the firm. In this type of control,an organization establishes certain standards, monitors conformity with thestandard and takes action when deviations occur. Social control arises out of the internalization of values and mutual commitment towards some commongoals.

Cultural controls

According to William G Ouchi, culture is “the broader values and normative patterns that guide worker behavior within the entire organization.” Culturalcontrol can be realized by norms of social interaction, and stories, rituals andlegends relating to the organization.

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SUBSYSTEMS AND COMPONENTS OF MANAGEMENT CONTROLSYSTEMS

The subsystems and components of control systems can be discussed on the basis of formal and informal processes.

Formal Control Process

The formal control process has two dimensions- formal planning and formalreporting.

Formal planning process

The formal planning process has two dimensions: strategic planning andoperations planning. In most organizations there are two budgets- one for operations and one for strategy; and, there are two sets of reports - one for strategic projects and one for operating activities. The formal planning andcontrol process should support the style and culture of the organization, andshould be supported by the infrastructure, the rewards, and the communicationsystems in the organization.

A strategic planning system is necessary to assist the organization in the planning and control of projects. It helps the organization to decide its goalsand objectives, and key strategies. An operational planning system undertakesactivities that are short term in nature.

Formal reporting process

Detailed reports help the organization to assess the progress of its strategic and

operational planning. Monthly, quarterly or yearly reports help theorganization to analyze its performance periodically, and to decide on the nextset of programs to be undertaken.

Although planning and reporting appear to be two distinct processes, thereshould be a certain degree of integration. Strategic programs are funded out of current operations and grow out of current activities. Further, strategic plansand programs have a great impact on current operations and so, these strategic

plans should be adjusted from time to time in line with their effect onoperations.

Informal Control Process

Management decisions are based upon experience, intuition and feeling.Informal control processes are formed as a result of interaction between people. The informal control process helps in the development of new goalsand objectives. There are a number of mechanisms for control throughinformal systems. One mechanism is the use of ad hoc teams to solve

problems, improve productivity and achieve organizational change. Informalteams usually consist of cross-organizational groups which work incoordination to solve problems related to a particular client, product or market. Informal communication systems evolve as people develop work relationships. Informal communication is helpful in supporting the key valuesof the organization. Fostering informal communication is critical to thedevelopment and maintenance of effective informal controls.

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Informal rewards and recognition are conferred upon the key team memberswithin the informal system. The respect an individual is shown is an informalreward for performance. Communication systems are not highly guarded in

informal systems.

SUMMARY

The purpose of control is to ensure that an organization meets desiredobjectives and that individual members behave in a manner consistent withorganizational objectives. In recent times, several companies have lost billionsof dollars because the necessary controls were absent. Management controlsystems are considered essential for the successful attainment of corporateobjectives. It is the means by which senior managers effectively andefficiently strive to attain company's objectives. Any control system in an

organization has four important elements that help in synchronizing theorganization’s various activities. They are – the detector (which providesinformation about the situation), the assessor (for comparison with

benchmarked standards), the effector (which tries to bridge the gap betweenthe actual situation and the standard required), and finally, the communicationsystems (that help in passing the information between the other threeelements). Control systems can be divided into formal and informal controls.Formal control systems can be classified as input controls, process controlsand output controls. Informal control systems can be classified into self-control, social control and cultural control. A clear corporate strategy,corporate structure, well-defined centers of responsibility, and reliableinformation centers are essential for management control systems to be

successful. A good management control system is oriented towards the future,has clear objectives, and minimizes control losses. It is important to analyzethe distinction between strategy formulation, task control and managementcontrol. Strategy formulation takes place at the higher level of themanagement, and task control involves the control of individual tasks.Management control lies at the intermediate level between the levels of strategy formulation and task control. It helps in the implementation of thedesired strategies.

The subsystems and components of control systems can also be divided on the basis of their use in formal and informal systems. Managerial style andorganizational culture play an important role in determining whichcomponents are used, and whether the formal or informal processes are

dominant.

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Prin of Mgmt Control Sys

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