Effective Management Control Systems for Business Success

Posted on Jan 19, 2025 in Modern Languages and Management

1. Introduction to Management Control

Management Control is the process by which managers ensure that resources are obtained and used in the most efficient way to achieve the organization’s goals. Therefore, it is a tool for assessment defined within an established timetable.

• It involves:
  • Strategy definition: mission, external analysis, internal analysis, company goals, strategic plan.
  • Organization: hierarchy and responsibility.
  • Management Control System: Identify Key Performance Indicators (KPI), measure according to KPI, evaluate performance, and implement corrective actions for deviations.
• Management historical evolution:
  • Pre-Industrial Age: The guild-ruled economy was based on financial accounting.
  • The early years of the industrial age (XVIII and XIX): The workforce was hired and the first tools of management control appeared.
  • 1895: Taylor, initiator of the MC, introduced cost accounting, the timing of direct labor, standards, allocation of indirect costs, pay for performance, and other concepts that are still used today (they didn’t care about the people, but about the objective).
  • 1st half XX: Standard production (Ford, DuPont, etc.), Brown (1907), the formula for return on capital. Work division. Departments. H. Fayol (1916): verify if everything occurs in conformity with the plan adopted, the instructions issued, and the principles established. Objective: point out weaknesses and errors to rectify them and prevent a recurrence.
  • 1950: From stable fixed rules to turbulent and highly competitive. Business success requires continuous adaptation to its competitive environment.
  • 1960: Direct Costing, ‘Push economy model’, all the production sold and the main goal is the highest production rates.
  • 1970: New criteria in Cost Accounting, Robert J. Mockler: a systematic effort by business management to compare performance to predetermined standards, plans, or objectives. ‘Pull economy model’, only what was required was produced, Just In Time introduction.
  • 1980: The computer era, manage the increasing complexity reducing efforts (higher rivalry, globalization, shorter life cycles, etc.), ERP.
  • 1990: Kaplan and Norton, a research study about a system of mixed financial and non-financial measures = Balanced Scorecard.
• Steps: Setting goals, planning and budgeting, measuring actual performance and comparing, and taking corrective actions.

2. Setting Goals

Strategy is a set of plans to achieve the goals of an organization: strategic goals (long term, 5 years), business strategies (from 1 to 4 years), operative strategies (days, months, one year maximum). Setting goals, tools:

• SWOT Analysis: Strengths, Weaknesses (internal factors, over which you have some measure of control), Opportunities and Threats (external factor, over which you have essentially no control). The most renowned tool for analysis of the overall strategic position of the business and its environment, the foundation for evaluating the internal potential and limitations, and the opportunities and threats from the external environment, it views all positive and negative factors inside and outside the firm that affect success.
  • Strengths: The qualities that enable us to accomplish the organization’s mission, the basis on which continued success can be made and sustained, what you have expertise in, the traits and qualities your employees possess (individually and as a team), and the distinct features that give your organization its consistency.
  • Weaknesses: The qualities that prevent us from accomplishing our mission and achieving our full potential, they deteriorate influences on the organizational success and growth, they’re the factors that do not meet the standards we feel they should meet.
  • Opportunities: Presented by the environment within which our organization operates, when an organization can take benefit of conditions in its environment to plan and execute strategies that enable it to become more profitable, organizations can gain competitive advantage by making use of them.
  • Threats: When conditions in the external environment jeopardize the reliability and profitability of the organization’s business, compound the vulnerability when they relate to the weaknesses.
• BCG Matrix: Created by the Boston Consulting Group, aims to identify high growth prospects by categorizing the company’s products according to growth rate and market share. By optimizing positive cash flows in high potential products, a company can capitalize on market-share growth opportunities.
  • Stars: Business units having a large market share in a fast-growing industry.
  • Cash Cows: Having a large market share in a mature, slow-growing industry.
  • Question Marks: Having a low relative market share and located in a high growth industry.
  • Dogs: Having weak market shares in low-growth markets.
• GE/McKinsey Multifactor Portfolio matrix: Developed as a more sophisticated version of the BCG Growth-Share Matrix, it plots “Market Attractiveness” against “Business Strength” (i.e. the competitiveness of the business unit or product in the market).
• Porter’s Five Forces: Created by Michael Porter, determines industry structure. The nature of competition in any industry is personified in the following forces:
  • Threat of entry by new potential competitors: Potential competitors are firms that are not currently competing in the industry but have the potential to do so if given a choice. It increases the industry capacity, begins competition for market share, and lowers the current costs. It’s partially a function of the extent of barriers to entry: economies of scale, brand loyalty, government regulation, customer switching costs, absolute cost advantage, ease in distribution, strong capital base.
  • Threat of substitute product/services: Substitute products are products having the ability to satisfy customers’ needs effectively, they pose a ceiling (upper limit) on the potential returns of an industry by setting a limit on the price that firms can charge for their product in an industry. The lesser the number of close substitutes a product has, the greater is the opportunity for the firms in the industry to raise their product prices and earn greater profits.
  • Bargaining power of customers: Buyers are the customers who finally consume the product or the firms who distribute the industry’s product to the final consumers, it’s the potential of buyers to bargain down the prices charged by the firms in the industry or to increase the firm’s cost in the industry by demanding better quality and service of the product. Strong buyers can extract profits out of an industry by lowering the prices and increasing the costs, they purchase in large quantities, they have full information about the product and the market, they emphasize upon quality products, they pose a credible threat of backward integration. They are regarded as a threat.
  • Bargaining power of suppliers: Suppliers are the firms that provide inputs to the industry, it’s the potential of the suppliers to increase the prices of inputs (labor, raw materials, services, etc) or the costs of industry in other ways. Strong suppliers can extract profits out of an industry by increasing the costs of firms in the industry, suppliers’ products have a few substitutes, strong suppliers’ products are unique, they have a high switching cost, their product is an important input to the buyer’s product, they pose a credible threat of forward integration, buyers are not significant to strong suppliers, they are regarded as a threat.
  • Rivalry among current competitors: Rivalry is the competitive struggle for market share between firms in an industry, extreme rivalry among established firms poses a strong threat to profitability, it’s a function of the following factors: economies of scale, the extent of exit barriers, amount of fixed cost, competitive structure of the industry, presence of global customers, absence of switching costs, growth rate of industry, demand conditions.
• Goals: The measurable objectives of the business (if we are not able to measure, we will not be able to control or check if we are correct), they must be specific (precise, concise, clearly defined), measurable (comparable with previous situations), achievable (realistic), time-bounded, coherent with the strategy of the business.

3. Planning

Planning is one of the most critical processes in the company; it’s deciding in advance what to do, when to do it, and how to do it; it’s a future course of actions, it’s an exercise in problem-solving and decision-making, it’s a determination of courses of action to achieve desired goals, it’s a systematic thinking about ways and means for the accomplishment of pre-determined goals.

• Business Plan: A formal statement of business goals, reasons they are attainable, and plans for reaching them. Strategic planning/Business plan: period: long term > 3 years (3 to 5 years), people involved: top management, information: mainly external, area of control: influence of environment changes in the company. 1. Executive Summary, 2. Business Goals, 3. Marketing plan, 4. Operations plan, 5. Financial plan, 6. Budget.
• Budgetary planning: Period: short term < 1 year (yearly/monthly), people involved: top management and dept. management, information: mainly internal (financial), area of control: budgetary variance. Budget: management’s quantitative expression. Budgeting is concerned primarily with the PLANNING and CONTROLLING steps of management. It involves forecasts of the income and expenditure of a business or a part of a business over a time period, it is used extensively in planning, it helps to establish efficient use of resources, it helps to control cash flow and identify deviations from plans, and it maintains a focus and discipline for those involved. Types:
  • Flexible Budget: Takes account of changing business conditions.
  • Static Budget: Prepared for only one level of a given type of activity.
  • Zero-Based Budget (ZBB): Requires to be re-evaluated thoroughly, starting from the zero-base, without taking into account previous budgets, independently of whether the total budget or specific line items are increasing or decreasing. It was first used by Pete Phyrr in the late ’60s in Texas Instruments and became popular in the 1970s, particularly when US President Jimmy Carter supported it for state and federal governmental units. It has received less attention since then. Under zero-base budgeting, managers in a company start each year with zero budget levels and must justify every dollar that appears in the budget. Managers do not assume any costs incurred in previous years should be incurred this year. Each manager prepares decision packages that describe the nature and cost of tasks that can be performed by that unit and the consequences of not performing each task. Top organization officials rank the decision packages and approve those that they believe are most worthy.
• Operative planning: Period: weekly/daily, people involved: dept. management and operative staff, information: only internal (technical), area of control: Operative Performance VS. Standard.

4. Check and Control

Management Control System: A set of formal and informal procedures to assist the management in steering the organization towards its goals, controls help in guiding employees effectively towards the accomplishment of the organization’s goals, it consists of structure, process, and Information System.

• Structure: The organization of a company is the integration of different activities and responsibilities for the realization of a product or service, the different activities and responsibilities of the organization in terms of control are organized in Responsibility Centers. A responsibility center is an organizational unit headed by a manager responsible for its activities.

The organization structure and responsibilities component includes the way the organization is structured and responsibilities are assigned to achieve the entity’s mission. Responsibility centers fall into one of four categories, each category is defined by the nature of the manager’s responsibility for the center’s monetary inputs and/or outputs that are measured:

• Revenue center: An organizational unit whose manager is held primarily responsible for its revenues (outputs). Sales units are typically managed as revenue centers. It can be recognized in a responsibility accounting system through the process of selling to outside customers or by transfers of products or services to other responsibility centers and putting a monetary value (transfer price) on these transfers.
• Cost center: A responsibility center where the manager is responsible for its costs (inputs). Manufacturing and R&D are typically managed as cost centers.
• Profit center: A responsibility center whose performance is measured as the difference between its revenues and costs (output minus input). A business unit is typically managed as a profit center.
• Investment center: A responsibility center where the manager is held responsible for the use of its assets as well as its profit. In this situation, the manager is held responsible for earning a specified return on the center’s net investment.
• Process: Once the goals have been set and the structure and responsibilities are defined, then the control process deals with: define the key variables that will inform about the performance, define how are these variables going to be measured, measure and record results, report, and analysis.
• Information System. ERP: The set of methods and criteria of measurement and evaluation of the critical variables, that enables the organization to compare actual performance and planned goals. In 1990 Gartner Group first employed the acronym ERP as an evolution of material requirements planning (MRP), later manufacturing resource planning, and computer-integrated manufacturing (CIM). Initially, companies began with accounting, maintenance, and human resources. By the mid-1990s, ERP systems addressed all core functions of an enterprise. Enterprise resource planning (ERP) systems integrate internal and external management information across an entire organization, with a centralized database, embracing finance/accounting, manufacturing, sales and service, customer relationship management, etc. ERP systems automate this activity with an integrated software application. Their purpose is to facilitate the flow of information between all business functions inside the boundaries of the organization and manage the connections to outside shareholders. Controllable and uncontrollable costs of each responsibility center should be separately shown. Cost and financial accounts may be integrated in order to avoid duplication of accounts. Well-trained and educated staff should be employed to operate the system. It should prepare accurate reports and promptly submit the same to the appropriate level of management so that action may be taken without delay. Resources should not be wasted on collecting and compiling cost data not required. Only useful cost information should be compiled and used whenever required.

• Indicators: A measurement tool, they are usually focused on relevant aspects of the company (KPI or Key Performance Indicators), they show us if we are achieving the goals or if there’s a relevant deviation. Characteristics: Relevance, Stability, Objectivity, Unique interpretation, Sensible, Precise, Accessible, Comparable. Types: By nature (efficacy, efficiency, excellence, etc.), By object (result, process, structure, etc,), By scope (external, internal), By function (Economic indicators, Commercial indicators, Productive indicators, Human resources indicators).
• Scorecard: It derives from the concept called “tableau de bord” in France, which means instrument panel, like those found on the dashboard of a car. It’s a system that informs us of the evolution of business fundamentals and shows the main indicators and presents a clear and useful way.
• Balanced Scorecard: Presents a mixture of financial and non-financial measures, connected to business strategy. Kaplan and David P. Norton included details of the balanced scorecard design in a 1992 article, it wasn’t the only article on the topic published but it was a popular success, and in 1996, the two authors published the book ‘The Balanced Scorecard’. These articles and the first book spread knowledge of the concept of a balanced scorecard widely and have led to both of them being seen as the creators of the concept. The four “perspectives”: Financial (“How do we look to shareholders?”. Examples: cash flow, sales growth, operating income, return on equity.), Customer (“How do customers see us?” Examples: percent of sales from new products, on-time delivery, etc.), Internal business processes (“What must we excel at?” Examples: cycle time, unit cost, yield, new product introductions.), Learning and growth (“How can we continue to improve, create value and innovate?”. Examples: time to develop a new generation of products, life cycle to product maturity, time to market versus competition.)

5. Cost System

Cost: A monetary valuation of consumed resources, in order to achieve a goal.

Cost types:

• Direct cost: Can be specifically and exclusively identified with the particular object (product/service) → salary of a production worker.
• Indirect cost (overheads): Cannot be specifically and exclusively identified with the particular object (product/service) → salary of a financial manager.
• Fixed cost: Remains constant relative to activity level changes → rent cost of a building.
• Variable cost: Fluctuates in direct proportion to the level of activity or volume → cost of raw material.
• Period cost: Period costs are those costs that are not included in the inventory valuation and as a result are treated as an expense in the period in which they are incurred → machinery amortization. It is a cost of a period (1 year).
• Product cost: Identified with goods purchased or produced for resale → individual packaging material. The cost associated with a product.

Cost system: A tool used to measure the consumption of resources.

Cost system types: The method of costing adopted should be suitable to the industry. It should be tailor-made according to the requirements of the business, a ready-made system cannot be suitable. It must be fully supported by executives of various departments and everyone should participate in it. In order to derive maximum benefits from a costing system, well-defined cost centers and responsibility centers should be built within the organization.

• Types:
  • Direct costing/variable costing/marginal costing: Includes in-unit product cost: direct costs and variable manufacturing costs (direct materials, direct labor, and variable manufacturing overhead). Ex.: inventorial, or products, costs (direct materials, direct labor, variable manufacturing overhead). Advantages: It allows to know the contribution margin of each product, it allows to calculate the break-even point, it helps to decide whether to produce or not. Disadvantages: It’s difficult to decide selling price, even more when fixed costs are high, it’s difficult to allocate overheads, labor costs are considered as variable, it’s possible to make mistakes assigning costs to responsibility centers, inventory value is under real value.
  • Full costing/absorption costing: Treats costs of ALL manufacturing components as inventorial, or product costs (direct materials, direct labor, variable factory overhead, fixed factory overhead). Presents expenses on income statements according to functional classifications (cost of goods sold, selling expenses, and administrative expenses). Advantages: You may have finished goods in inventory. Because you assign a per-unit amount for fixed expenses, each product in inventory has a value that includes part of the fixed overhead. You do not show the expense until you actually sell the items in inventory. This can improve your profits for the period. Disadvantages: Profit figures can be artificially inflated as fixed overhead is added to finished products in stock, increasing the total income of the period.
  • Activity-based costing (ABC costing): Treats costs of all manufacturing components as inventorial or product costs (direct materials, direct labor, variable factory overhead, fixed factory overhead). Presents expenses on income statements according to functional classifications (cost of goods sold, selling expenses, administrative expenses).
  • Standard costing: The expected level of costs associated with the production of goods/services (Actual costs – Standard costs = Variance). Monitoring variances can help the business to identify where inefficiencies or efficiencies might lie. Standard cost refers to expected costs under anticipated conditions. Standard cost systems allow for the comparison of standard versus actual costs. Differences are referred to as standard cost variances. Variances should be investigated if significant.
• Make decisions on: To do or subcontract, To do or commercialize, Transfer price, Selling price, Sales mix, Inventory value.
• Uses: Helps in deciding the selling prices, Helps in inventory control, Helps in the introduction of a cost reduction program and finding out new and improved ways to reduce costs, Helps in preventing manipulation and frauds and thus reliable cost can be furnished to management, It reveals profitable and unprofitable activities, It helps in controlling costs with special techniques like standard costing and budgetary control, It supplies suitable cost data and other related information for managerial decision-making such as the introduction of a new product, replacement of machinery with an automatic plant, etc.

Cost allocation/cost assignment: The process of distributing overhead costs to costs objects. Cost object may be a product, a department or a project. Unlike direct costs, overheads cannot be traced directly to specific cost objects. Indirect costs are assigned to cost objects using an allocation base called cost driver. (Ex. floor area, direct labor hours, machine hours, etc.). Allocation of individual costs centers. Allocation of service department costs. Allocation of costs to individual products.

Break-even point: The level of activity at which REVENUES = COSTS, the point which profits are zero because total revenues equal total costs (Total revenues = Total variable costs + Total fixed costs). Total revenue fluctuates in direct proportion to the level of activity or volume. On a per-unit basis, the selling price remains constant. Total variable costs fluctuate in direct proportion to the level of activity or volume. On a per-unit basis, variable costs remain constant. Total fixed costs remain constant relative to activity level changes. Per-unit fixed costs decrease as volume increases and increase as volume decreases. Total costs result in an addition of both fixed and variable costs. Total costs equal sales so there’s neither profit nor loss.

Contribution Margin (CM): Per unit equals selling price per unit less variable cost per unit, SP (selling price) – VC (variable cost) = CM. Total Sales (TS) – Variable Costs (VC) = Fixed costs (FC). In units = Total fixed costs / CM per unit. In sales [€] = Total fixed costs / CM ratio.

Contribution Margin Ratio (CM%): The unitary Contribution Margin (CM) divided by Selling Price (SP), or total contribution margin divided by total sales dollars, CM/SP = CM%.

Sales mix: The proportion in which two or more products are sold. For the calculation of the break-even point for the sales mix, the proportion of the sales mix must be predetermined and the sales mix must not change within the relevant period. The calculation method for the break-even point of sales mix is based on the contribution approach method. Since we have multiple products in the sales mix, therefore, it is most likely that we will be dealing with products with different contribution margin per unit and contribution margin ratios. This problem is overcome by calculating the weighted average contribution margin per unit and contribution margin ratio. These are then used to calculate break-even points for the sales mix.

Transfer price: One of the main difficulties of operating in a decentralized system is to create a satisfactory system to value goods and services transfers from one responsibility to another. Transfer price is the value of the transfer of services or products between two or more profit centers. The transfer pricing system enables the management to enjoy the benefits of centralization and decentralization.

Transfer prices are not set by the corporate staff; they are negotiated by the divisions among themselves. The process of determining transfer prices is governed by two criteria: goal congruence and fairness. The main objective of transfer pricing is the proper distribution of revenue between profit centers. If two or more profit centers are jointly responsible for product development and marketing, then the resulting profit has to be shared between the profit centers. Objectives: Providing relevant information to the profit centers regarding the trade-off between costs and revenues of the company; inducing goal-congruent decisions, i.e., decisions that improve the profits of business units and also improve the profits of the company; helping to measure the economic performance of profit centers; and minimizing tax liability. Methods of calculating transfer price: Market-based pricing method, Cost-based pricing method, and Negotiated pricing method.

6. Variances

Variance: The difference between planned values and actual values.

Variance analysis: A process to understand the reasons for variances. Those differences may come from either revenues or expenses. Comparing the budget to actual results accomplishes an important performance evaluation purpose. Variance analysis is an important part of an organization’s information system. Variance analysis is an analytical tool that managers can use to compare actual operations to budgeted estimates. Actual results may differ from the master budget because sales were not the same as originally forecasted, or variable costs per unit of activity and fixed costs per period were not as expected. The comparison of actual costs with standard costs is called variance analysis and it is vital for controlling costs and identifying ways for improving efficiency and profitability. If the actual cost exceeds the standard costs, it is an unfavorable variance. On the other hand, if the actual cost is less than the standard cost, it is a favorable variance. Variance analysis is usually conducted for Direct material costs (price and quantity variances), Direct labor costs (wage rate and efficiency variances), and Overhead costs. Analysis of variance in planned and actual sales and sales margin is also vital to ensure profitability.