The Problem of Management Control - Coursework Example

? Finance and Accounting: Management Accounting Question 4: Critically evaluate the contribution of contingency theory in helping us to understand how accounting and budgets can and should be utilized to address the problem of management control. In accounting, there are several theories which give guidance in understanding certain aspects. In management accounting, there are specific theories; among them is the contingency theory. In management accounting, contingency theory is basically concerned with the situational factors. The theory aims at reflecting management accounting system as dependent on factors that crop up from time to time. This theory brings details of the factors which rise up and affect a management accounting system. According to this contingency theory, the contingent factors affecting a management accounting system are unique to each organisation. Organisations vary from one another in terms of operations thus the difference in the form of adoption, functioning and sophistication of a system. This means that each company will have a management accounting system which is specific to its form. This explains why we do not have a globally adopted accounting system. Contingency theory has made bold steps in helping us understand how accounting and budgets can and should be used to deal with the issue of management control. The theory basically supports the handling of accounting and budgets in a way which recognizes related changes which might occur in the company (Sharma, 2009). The contingency theory is usually very important in ensuring that the management accounting system in a company is in sync with the prevailing factors at a given time. The efforts by this theory have been successful through the manipulation of the factors that affect a management accounting system among other factors. External factors are one of the areas of situational factors which affect a management accounting system (Sharma, 2009). According to the contingency theory, these factors can be stable or unstable, simple or complex, dynamic or static among others. For example, the theory shows how an organisation with a stable surrounding externally depends on things such as its performance financially or conformance to budgets. With this, the organisation does not need to have management control based on a sophisticated management accounting system. Under such a situation, the management will control the organisation on the basis of the set out budgets. The contingency theory also shows how accounting and budgets can be used to handle matters of management control through the consideration of strategies and mission as situational factors. Basically, the type of strategies and mission applied by a company determines the kind of system for management accounting to be put in use. For example a firm may decide to apply a strategy of low cost and defense. Under such a strategy, a company will work towards standard products, few lines of products, low cost operations as well as policies promoting economies of scale. with  this, there will be need to have plans capable of making employees uphold low cost mentalities, incentives to workers depending on the results of evaluation of financial performance and adherence to budgets among others. This means that there is need for a management accounting system which is a bit sophisticated. Contingency theory shows that accounting can be utilized to handle the issue of management control through the determination of the accounting information need and use (Emmanuel et al,1990). According to this theory, the kind of accounting information needed by an organisation is very key in determining the management accounting system required. In a situation where the accounting information required is complex, then a highly sophisticated management accounting system is required. If a firm requires just simple information, then a less sophisticated management accounting system is required by an organisation. There is also the intended use of the accounting information of an organisation. If the information is intended to be used by many stake holders, then there is need to use a management accounting system which creates a comfortable interface needed for such use. With contingency theory advocating for companies to adapt o changes in the accounting environment, the changes in accounting forecasts and budgets should be appreciated (Emmanuel et al. 1990). Basically, accounting forecasts and budgets are one in anticipation that a company's performance will be as per the budget. However, due to situational factors, the expectation may not be met. Therefore with reference to contingency theory, the company may adapt the factors and variables in the present form and adjust all appropriately. The contingency theory also gives the management support to set the management accounting systems in a way which gives the company optimal results at a given time with specific situational factors. This will also translate into the best way of management control thus driving the company positively. There is also the factor of technology in management control. Basically technology is nowadays the key t efficiency in the world. When company needs to create n efficient management control system, there is need to adapt the latest upgraded technology. This will ensure that the company has the best management accounting system which is capable of giving ll the required options. The accounting function of the company will be able to operate in the highest standards possible. The budgeting exercise will also be performed with the ease thus giving the company the desired results. With this, updated reports will be available all the time thus giving the management no reason to make the best decisions for a company. With timely and informed decisions, the management control in the company will be able to give the desired optimal results. The contingency theory can also shows that accounting and budgets can play a big part in management control through looking at things such as creating divisions in a company. Basically, when these divisions are being done, there is usually a very big focus o the accounting information and budgets. These two are affected by the effect of the created divisions on performance experienced in the company. With divisionalisation, there are controls which have to be reviewed. These controls are related to sales, assets, gross national product as well as the entire industry performance. In this scenario of divisionalisation, the contingency theory will be able to guide on what to be adapted so that management control is in place. The theory will guide in the process of making adjustments to adopt the situational variables as they are at a given time period. Question 5 Lowe and Shaw were able to note three main sources of bias in companies. The discovery of the three sources of bias in companies was made during a seminar on budgeting in organisation s. One of the sources of bias in companies which was noted by the two is the reward system. Lowe and Shaw discovered that the way the company's reward system was shaped meant a lot regarding relations.  Many a times, companies fail to have a streamlined and harmonized reward system for the employees. This creates a very bad base for basing judgments in relation to each individual working in the organisation. Many times, the group of employees in the side of higher rewards often gets better treatment than their colleagues in the side of lower rewards. This is usually a very negative thing for the company. With bias in the side of rewards, project managers under the correct side of the bias will always get preference in terms of project funding. This means that the status-quo will always remain since possibility of an overturn is impossible. According to Lowe and Shaw, organisation s should always give rewards on the basis of people's performance and skill. The rewards should not be structured in consideration of other factors such as employee’s physical attributes, connections or network among other retrogressive factors in relation to a rewards system. Appraisals and evaluation should be performed continuously to ensure that every reward is updated appropriately to avoid disturbances in the organisation. According to Donaldson (2001), companies should always give rewards to employees who exhibit exemplary performance even if they do not get good results due to certain known factors. On the other hand, the employees who give a poor performance should be reprimanded even if they get the desired results under mysterious cases. The factor of luck as a base for giving rewards should be done away with. The second source of bias in companies is the influence of recent practice and norms. Lowe and Shaw discovered the effects of practice and norms try to take the shape of a habit. It is common belief that old habits are hard to die and in this is why the management and employees tend to do things just the way they have been doing it before. This means that with bias based on recent practice, there will be high levels of resistance by employees and other related stakeholders. The practices which were in existence earlier n the allocation of resources will affect the company in the present. This is because the people in the company will always lean towards what is familiar to them and they have been used to. You will find that most companies will always try to refer to previous budgets when the system has changed much. The reference is usually aimed at getting ideas on how to go about it which is an outright effect of practices and norms which is very bad for a company. Norms on the other hand are referred to as certain behaviors which are familiar to a gen group. You will find that a given society, community or group of people have their specific set of norms which are useful in the day to day activities. This means that there will be uniformity in the group’s operations. The norms have a great effect in the way things are done thus ending up being a source of bias in companies. People will always be doing things in a way which tend to respect their well known norms. Anything which requires response which does not respect the companies known norms will end up failing or getting poor response and results. This ends up affecting the company’s performance which is quite unfair. The third source of bias which Lowe and Shaw noted was insecurity of managers. Generally managers have a big task of ensuring that their departments or projects end up succeeding. This puts them under high levels of pressure. Due to the pressure and need to succeed, the managers end up doing all things possible to have their efforts recognized. This leads sometimes to doing things just to please their superiors so that they may recognize them and their efforts while on the other hand bias is taking shape (Cardy &Leonard, 2011). The two researchers discovered that this is very common thing in companies thus the need t have proper mitigation methods. This common behavior of pleasing superiors by managers is sometimes brought about the need to be on top especially in places where there is high level of competition in the management hierarchy. This ends up creating a situation where the managers will always do things in the way which pleases their superiors (Bryman, 2007). This means that when the employees do things just to please them, the results obtained may not be the best for the company. at the end of the projects, the companies will have lost a lot of opportunities just because people did the wrong things just to be on the side of their bosses. This bias brings about a conflict of what best should be done with what places a manager in a better position with his or her seniors. To do away with this, companies should be able to hire people with independent minds (Bryman, 2007). This will lead to a trend where only the best option f doing things is taken. With this, the company will be able to explore the many available options in the quest for optimal results. The employees will always act with the question of what best suits the company rather than what pleases my boss. Budgets usually form a very big part of company’s priorities. This is why the company's senior managers should be able to remove biasing in budgeting. One of the things that the senior managers should do is select the right people into the budgeting teams. Secondly independent people such as external experts should be engaged to carry out certain budgeting functions for a company. The managers should do this through the keenness in overcoming fabrication of budgets and the management accounting systems in the companies they are serving (Cardy & Leonard, 2011). The language in budgeting should be clear an up to the required standards to avoid loopholes instituted through biasing. Question 6: Assess the contribution of management accounting measures to the control of divisionalized organisation s. Generally speaking, structure of an organisation is influenced by a number of factors. The most common of these factors being organisation’s strategy, size of the organisation, technology employed and the environmental context within which the entity is operating. In order to be effective, large organisations are divided into divisions based on products and services. Managers are appointed to oversee operations in each division relating to the product or service they produce or offer. Divisionalisation is enables functional areas to share work. As organisations become larger and complex, the decision making processed and management can become bogged down hence easily getting out-of-touch. Divisionalisation is a concept of delegated profit and investment responsibility (Drury, 2005). Profit centers and investment centers As indicated in the preceding paragraph, creation of different divisions based on products and services results to the delegation of certain duties or degree of authority to divisional managers of each division. For instance, other than having authority to make decisions on important things such as sources of supply and appropriate markets for products, divisional managers can also engage in capital investment decisions. This situation occurs only in divisionalized organisation s. Divisions where managers make capital investment decisions are commonly known as investment center. In the event that a divisional manager has no control on capital investment, they assume responsibility of profits associated with operating fixed assets within his/her segment. This segment is called a profit centre. Investment centre and profit center are some of the sensitive areas whose performances have far-reaching effect on the success of the entire organisation. The performance of each division is often determined using various management accounting measures in order to facilitate their control. Management Accounting Measures Commonly used to monitor and control performances in divisionalized organisation s Return on Investment (ROI) This accounting measure has been used commonly to determine the performance of each division in a corporation. It is crucial because it helps an organisation identify undesirable behavior among the divisional general managers. ROI expresses profit made by each division as a percentage of the fixed assets delegated to the division. In this regard, fixed assets employed are defined as total assets that are controllable by the divisional manager. ROI is a relative measure that can be adopted when determining the performance of a division in regard to certain investment compared with other investments on similar investments in other divisions. Each division reports its profit at specific period of time i.e. quarterly, semi-annually or annually. If an organisation has two divisions, let us say Division A and B. Division A reports a profit of $1million whereas Division B reports a profit of $2million. Does it mean that Division B is more profitable than Division A? The answer for this question can also be arrived at after ascertaining the returns of each division on capital invested. Using the same example, we can assume that Division A has a capital investment of $4 whereas Division B has $20. Therefore, return on investment for each division can be determined as follows. ROI=Profit/Investment Therefore, the ROI for Division A is $1m/$4m=25% and Division B will be $2m/$20m=10%. From this accounting measure, it is explicit that Division A is more profitable than Division B. However, it is important to understand the fact that capital invested has different uses in each division. Therefore, corporate management has the responsibility of ascertaining whether the returns being earned in each division is more than the division’s opportunity is cost of capital i.e. the returns that could be earned if the capital had been invested in alternative options. In the above example, if it is discovered that the returns available on the same investments to that of Division B is 15%, then the corporate management ought to question economic viability and performance of Division B so as to ensure that profitability is improved (Camillus, 1986). According to Camillus (1986), return on investment (ROI) is also useful in understanding how dissimilar businesses are performing. It is a common denominator for making comparisons between different divisions within a group so as to know whether the products or a service offered by a particular division is of considerable importance. In the event that it emerges that the product or service in a specific division does not contribute positively to the success of the entire organisation, then the corporate management can go back to the drawing board and review its business strategies. Even though ROI has been used to monitor and control performance of divisionalized organisation s, the management accounting measure has certain demerits (Camillus, 1986). Residual income This is an accounting measure used in divisionalized organisation s to overcome the functionality problems associated with ROI. Residual income refers to controllable contribution minus cost of capital charge on an investment under the control of divisional manager. The following table is an illustration showing investment decisions for two divisions i.e. X and Y and the residual income calculations are shown. Division X Division Y Proposed Investment 10 million 10 million Controllable Contribution 2 million 1.3 million Cost of Capital Charge(15% of the Investment cost) 1.5million 1.5 million Residual income 0.5 million -0.2 million From these calculations, it is explicit that division X will have higher residual income than residual Y if each invest in proposed project. Therefore, this means that corporate management should consider allowing division X to invest in the proposed project and advising the general manager not to invest in the proposed project. The divisional managers should also be involved in these decisions. The most important thing with the use of residual income as a management accounting measure for monitoring and controlling performance of divisionalized organisation s is that it motivates divisional managers. This means that these individuals will act at the best interests of the entire company (Camillus, 1986). Profit Margins This is defined as a measure of return, commonly net operating earnings after deducting tax, then divided by revenue from sales. A division whose profit margin is below average means that they are not performing well. This accounting measure enables corporate management to identify products that ought and ought not to be invested in. It is also provides a benchmark for assessing efficacy of each division in their business undertakings. It can also be used to identify accounting malpractices in each division (Drury, 2005). Question 7: Does capital budgeting theory over-emphasize on ‘techniques’ of evaluation at the expense of organisation al context? Discuss using examples Business firms and organisation s use developed cash flows to make decisions about capital expenditures. In most cases, these decisions lead rejection or acceptance of a specific project. There are number of techniques used by organisation s when making these decisions and the applicability of each depends entirely on the nature of the organisation s. This process is referred to as capital budgeting. Note mentioning, capital budgeting process is the backbone of modern economics. In the recent past, many organisation s especially in developed countries such as the United States, UK and Canada have invested a great deal of resources in systems designed to identify risks in different lines of business. The main purpose of these systems is to provide an organisation with a more reliable way of ascertaining the amount of capital required to support identified project or activity. Most accounting managers around the world have embraced capital budgeting theory as an integral aspect of their undertakings. Surprisingly, these managers have relied solely on the theory during their undertakings, something which Bower (1972) believes is unhealthy for any business entity. Allocating funds among the most competitive projects is a crucial duty of top management of an organisation. It is an appropriate way of implementing organisation’s strategy. Notably, top management of most organisation s has devoted considerable attention to techniques and methods of evaluating investment projects as suggested in capital budgeting theory. However, little attention has been given to other factors that would otherwise influence their choices. Capital budgeting theory is essential in dealing with uncertainty. The theory supports discounted cash flow as one of the most appropriate techniques of evaluating investment projects. As indicated by Brennan and Schwartz (1992), discounted cash flow technique has serious shortcomings in appraisal or analysis of viable investment projects especially when the information about future investment decisions is insufficient. The author further suggests that it is important to adopt other principles as analysis tools to evaluate projects in the quest of supporting investment strategy of an organisation. Net present value is another technique commonly used by managers to evaluate investment projects. It is now over five decades since explicit attention is being paid to net present value as proposed in capital budgeting theory. This technique has been used by both large and small business firms and organisation s. In respect to this, it is important to point out the fact that capital budgeting process in large organisation s and corporations has little to do with identification of the most viable project or similar class of decisions. Rather, a set of issues ought to be considered. The theoretical characterization of a project, by determining net present value, as a financial security in identifying choice of project to invest in is inaccurate conceptual framework. As argued by Bower (1972), investment managers should focus on the impact their organisation al structure i.e. effect of vertical integration on the investment projects and processes. In integrated firms, the factors that influence investment decisions should focus on various issues emerging at various levels as opposed to using net present value as the a measure of the viability of the project in question. Capital budgeting theory emphasizes so much on the use of net present value as a measure for identifying projects that an organisation should invest in. However, this is not sufficient. Therefore, an investment manager must take into account organisation’s ability to pursue diversification. In integrated and diversified firms, investment decision process is influenced by numerous factors other than financial framework as postulated in capital budgeting theory. In such firms, allocation of resources is done in three distinct stages namely authorization, definition and impetus. Most integrated firms have centralized definition and impetus and authorization is a function of corporate management. As such, investment decision process is influenced by factors other than financial framework as supported by capital budgeting theory through net present value (Miller & O’Leary, 2000). Capital budgeting is an idealization which leads to making choices without having neither sufficient nor right information. Therefore, this process is partial as opposed to being comprehensive. There is need to expend effort in an attempt to follow the capital budgeting theory worthwhile. The theory has paid too much attention of techniques for financial evaluation as opposed to the process of decision making in an organisation. To make it clear, different organisations have adopted different styles of decision-making depending on their size and organisation al structure. Based on case studies of large capital firms in Britain, Miller and O’Leary (2000) called for greater attention to decision making process as opposed to emphasizing so much on financial techniques of evaluation. Most financial techniques articulated by capital budgeting theory address only small proportion of investment decision making process in an organisation. Evaluation is a process of endorsement without judging. Therefore, capital budgeting theory offers no assistance to investment managers who strive to articulate projects based on available information about the past performance of the organisation in such projects. Most techniques of capital budgeting theory such as discounted cash flow and net present value make no contribution to how an organisation can pursue screening of the projects and search process. Capital budgeting theory assumes that capital budgeting decision is a single act that ought to be deliberated by top management alone. Therefore, the theory fails does not take into account the fact the process of investment decision making is not a function of top management alone. In some organisation, this act is deliberated by several individuals from different levels of management (Brennan 7 Schwartz, 1992). It is important to consider and understand the relationship existing between decision-making process and organisation al structure. A good capital investment decisions can only be achieved through complex social process where top management allows other parties in different level of organisation to be involved. This means that exclusively financial phenomenon proposed by capital budgeting theory should focus on organisation al dimensions that have far-reaching effect on investment appraisals. No doubt, this call was prompted by Japanese manufacturers in 1990s owing to a competitive threat from British companies (Miller & O’Leary, 2000). Question 8: Management accounting theory highlights the role of transfer pricing systems for the objectives of goal congruence, rational decision making and divisional autonomy. Owners and top level management of business organisation s wish to maximize profits for economic growth. In order to this, they set achievable goals, plan and strategize how to achieve them. Large organisations have embraced different organisation al strategies in a bid to realized predetermined goals and objectives (Horngren et al., 2005). Transfer pricing is an approach that has been adopted by most decentralized firms as a primary way of motivating managers of various functional units or divisions. By definition, transfer pricing refers internal price charged by a division of corporation for a raw material or finished goods, which is supplied to another division of the same organisation. This concept has been necessitated by the need to stimulate conditions in the external markets within the entity so that divisional managers are motivated to perform well. Note mentioning, this approach does not have direct effect on entity’s profit as a whole since its influence on the revenue of one division is matched by its effects on cost incurred by the buying division. . However, the impact occurs when different rates of taxes are applied on each division. As highlighted by management accounting theory, transfer pricing is assumed by an organisation for three main reasons namely goal congruence, rational decision making and divisional autonomy (Horngren et al., 2005) i. Goal congruence The goal of each division in a large organisation should be aligned with the goals of the entire organisation. If one division pursue goals which are quite different from those of the whole corporation, then failure is likely to occur. In a goal congruence objective, the actions of employees should be controlled and led in order to ensure that they are in accordance with the perceived interest of the entire organisation. This means that divisional managers should select actions that guarantee maximization of firm’s profits. The division managers must engage in decision making that will optimize the organisation’s performance in a bid to realize maximization of profits (Hansen et al., 2009). ii. Rational Decision making The success of an organisation is influenced largely by the decision made by the top level management. Transfer pricing is pursued in an organisation to support reliable and objective assessment of operations or business undertakings of each profit centers. Therefore, this approach should provide relevant and accurate information that would guide divisional managers throughout the process of decision making. The information should also be useful. In assessing performance of managers, value added by each profit center thus enabling corporate management to make rational decision (Horngren et al., 2005) iii. Divisional autonomy As elaborated in management accounting theory, transfer pricing system is important in providing divisional autonomy, which is crucial because it allows the benefits of decentralization to be retained by each division. In pursuing this objective, each divisional manager has a responsibility and freedom of ensuring that the requirements of the profit center are met from either internal or external sources. The general manager at the buying center should not interfere with functions of the profit center in an attempt to minimize costs (Horngren et al., 2005) Objectives of transfer pricing system in multinational organisation s Running of large business firms and corporations is sometime engaging. There is need for managers of these companies to embrace appropriate strategies that would guarantee success in the competitive global markets. In order to achieve goal congruence objective through transfer pricing, large organisation s are divided into various business units and each business unit is responsible for all activities involved in production and marketing a specific product or product line. A business manager is appointed to head each business unit in a manner that is like distinct from the entire company. Business units have departments which work towards common goals of the business unit. The transfer pricing system activities aimed at enhancing profits of a division will also have positive impact on overall company profitability (Hansen et al., 2009). To achieve the transfer pricing objectives in multinational companies requires management to take into considerations several factors when formulating their transfer pricing policy that is applicable or acceptable between legal entities in different states or regions. These factors include: Ability of a corporation to handle competitive pressure Existence of free movement of resources between countries Ability of an organisation to properly manage exchange rate fluctuation Organisation’s capacity to reduce effect of taxes and tariffs. Ability of a multinational corporation to manage exchange rate fluctuation Transfer pricing provides a multinational organisation an opportunity to reduce risks associated with exchange rate. The purchasing power of the currency declines when it depreciates. As such, a corporation based in that region is obliged to pay more of imports. On the other hand, organisations earn less from revenues when currency depreciates. However, multinational corporations have advantage in overcoming this since they can rely on their subsidiaries for imports and exports. They can also utilize transfer prices to properly monitor and manage fluctuations of exchange rate (Hansen et al., 2009). Multinational Corporations can handle competitive pressures Multinational corporations can use transfer pricing to reduce prices of goods to a level similar to that of local competition. Reduce the potential effect of taxes and tariffs Multinational organisation s can employ transfer pricing to reduce liability arising tax. Such organisation s can enhance their profitability in regions where taxes are lower hence eliminating huge tax liability of tariffs that occurs from imports through transfer pricing. This is useful particularly when purchasing goods or services from the business units of the multinational corporations located overseas (Hansen et al., 2009). Movement of funds between countries In most cases, multinational organisations prefer investing its resources in one country rather than another. These entities utilize transfer pricing system which provides a way of shifting resources from one country to another (Hansen et al., 2009). References Bower, J. 1972. Managing the resource allocation process. Homewood, IL: Irwin. Brennan, M. & Schwartz, E.1992. A new approach to evaluating natural resource investments. In: Stern, J.M., Chew, D.H. (Eds.), The Revolution in Corporate Finance, second ed. Blackwell Publishers, Oxford, UK, pp. 107–117. Bryman, A. 2007. Business Research Methods. Oxford University Press Cardy, R. & Leonard, B. 2011. Performance Management: Concepts, Skills and Exercises: M.E Sharpe Camillus, J. 1986. Strategic Planning and Management Control: Systems for survival and Success. New York: Lexington Books.Donaldson, L. 2001. The Contingency Theory of Organisation s: Sage. Drury, C. 2005. 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