Feedback feedforward and concurrent controls

The Controlling Function

Learning Objectives

After completing this chapter, you should be able to:

• Complete the steps involved in the organization’s constant and periodic control systems. • Prescribe specific corrections for problems identified at the functional/departmental level. • Use accounting and financial controls to improve company-wide performance. • Finalize all other aspects of the control process.

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Introduction Chapter 7

7.1 Introduction The modern organization operates in a complex, ever-changing environment. In fact, the exter- nal environment continues to be highly competitive thanks to the ever-increasing expectancies of customers, clients, and key stakeholders. Competitors also constantly vie for market share. Control systems and methods assist managers by providing information about the state of the organization’s production expectancies, financial condition, employee demands, operating sys- tems, marketing activities, governmental influences, and other factors as they arise. Such infor- mation is essential to drive manager course correction decisions (Etzioni, 1964; Merchant, 1982).

Successful organizations use effective and appropriate control systems to obtain organizational goals and objectives. In this chapter, we explore control systems and their importance to overall organizational success. The first section describes the natures of constant and periodic controls. Next, we consider specific departmental and functional area control systems. In the following section, we examine the role played by financial and accounting standards in an organization’s control process. Finally, we look at other forms of control .

M A N A G E M E N T I N P R A C T I C E

At McDonald’s, Organizational Controls Move Fast Food into the New Millennium

McDonald’s has long been known as the industry leader in fast food, specifically in the area of hamburgers, fries, and a soft drink. Numerous business textbooks describe how the company’s stra- tegic model has led to growth domestically and internationally. Everything from the company’s take on where to place stores (location, location, location) to its mantra of quality, service, cleanliness, and value (McDonalds.com, 2013) to the company’s famous Hamburger University management training program suggests that numerous organizational activities and practices have set the stan- dards for success in a crowded marketplace.

The McDonald’s organization has shown the ability to adapt to international circumstances. In India, for example, where consuming beef would violate religious norms, the company created a beefless menu complete with veg- etarian burgers and even vegetarian “cheese.” While critics point out that the children’s menu burger is not exactly a healthy choice (Petrun, 2007), it does appeal to a wide audience within that country.

About a decade ago, however, the tide of public opinion began to turn against the company in some ways. Movies such as Supersize Me began a period in which McDonald’s and many other food companies experienced criticism regarding the health properties present in their menus. McDonald’s first corpo- rate reaction was to change from using

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Larry French/AP Images for McDonald’s

▲▲ McDonald’s has shown the capacity to adapt to changing circumstances, especially in the area of health-conscious menus.

http://www.mcdonalds.com/us/en/home.html
Introduction Chapter 7

Controlling is the process of evaluating performance against established goals and creating methods appropriate to take corrective action to maintain or improve performance in any area of the organization. Control systems allow managers to analyze the state of the organization and its various constituent parts to determine if the plan and structural system are achieving expected results.

The first distinction to be made involves the differences between what may be described as con- stant controls and periodic controls. Constant controls regulate organizational activities on a continual basis. Any time a standard is not met, the management team should immediately react with corrective action. Periodic controls assess organizational activities on a regularly scheduled basis. Then managers are able to undertake corrective action as needed. This section examines these two control processes.

Constant Controls

A great deal of organizational activity is guided by ongoing, continual standards. Such standards regulate the behaviors of individual employees, groups and departments, and the overall organi- zation. Without this form of guidance, companies can quickly drift away from the actions, activi- ties, and behaviors that allow them to succeed.

Individual Constant Controls Each employee in any type of organization will be expected to follow certain standards and behavioral guidelines. The principles constitute the basic necessity of maintaining membership in the company. Two primary forms of individual constant controls include work procedures and the organization’s rule/discipline system.

cooking oil based on beef tallow to a vegetable version. Over time it became clear that, if the com- pany were to succeed in a new era and environment, things would need to change.

The corporate control system led the way. The company’s evolving sense of mission and vision cre- ated new standards for members of the entire organization to follow, from the CEO to individual employees (Git, 2013). Many stores now post the caloric content of each food offering. In 2013 McDonald’s announced plans to sell a greater variety of healthy foods in addition to its traditional menu. In response to concerns about increasing obesity rates among U.S. children, many of these foods were directed at younger consumers.

In this instance, a corporation’s control system began to address two major goals. The first was to continue the organization’s success by maintaining customer patronage. The second, and perhaps loftier outcome, would be to sell more products that enable individuals to enjoy a quick meal out that may help them live longer with fewer health issues. In the future, you can expect McDonald’s and other corporations to continue using control systems as a tool for adapting to a changing world.

Discussion Questions

1. Do you expect fast food to be healthy food? 2. Should McDonald’s continue to alter its mission to address public health concerns, or should it

just give people what they want? 3. How would the most recent changes at McDonald’s affect the marketing department activities,

food production, and individual employees waiting on customers in various stores?

Introduction Chapter 7

Work procedures, or specific task instructions, guide the day-to-day operations of the firm. Often, such procedures are carefully spelled out in an organizational manual or handbook. At other times, they are part of the employee training process. Work procedures include directions regarding methods of operation for various tasks. Table 7.1 indicates work procedures for various vocations within an organization.

Table 7.1 Examples of work procedures

Food preparation Methods of cooking

Methods of cleaning cooking equipment

Methods for disposing of food waste

Methods for maintaining a sanitary work area

Accounting procedures Daily entries into accounting documents

Methods for paying accounts due

Methods for invoicing accounts receivable payments

Manufacturing Methods of operating equipment

Methods for maintaining/repairing equipment

Sales Type of sales pitch to be used

Methods for making suggestive sales

Office management Methods for maintaining employee privacy

Methods for filing information

Store management Methods for handling payments, such as checks

Methods for closing the store properly

Environmental services Methods for disposing of waste

Cleaning methods

A second set of work procedures covers employee safety. Employees are taught how to complete tasks in the safest manner possible. Examples include wearing protective clothing and eyewear, wearing a hard hat, lifting heavy objects properly, using warning signals when appropriate, han- dling dangerous materials properly, and so forth.

The company’s discipline system ties work procedures, safety procedures, and other elements of employee behavior together. As noted in Chapter 4, the human resources department is largely responsible for creating the system and then assessing penalties when employees violate various rules. All of these ingredients serve to ensure that employees take appropriate actions. Whenever a procedure or rule has been violated, the employee’s immediate supervisor is expected to take immediate corrective action. Infractions are normally reported to the human resources office, so that the incident can be recorded and corrective steps taken to make sure the employee does not break the rule or ignore the procedure in the future.

In many organizations, human resources departments prepare policy manuals that spell out com- pany rules, work procedures, and protocols for handling violations of these directives. In addi- tion, various employee manuals spell out procedures across a variety of tasks. These documents,

Introduction Chapter 7

when combined with direct supervision, provide the basis for constant control over the activities of employees across the organization.

Departmental Constant Controls Individual departments have two forms of control that guide the entire unit. Group norms and functional area policies both help ensure the department stays aligned with the overall organiza- tion’s purposes and directives.

Group norms form in both formal and informal settings. Norms, or rules of behavior, dictate how departmental members interact with one another and with managers at higher ranks. Norms tend to operate in the areas of productivity, work behaviors, and social behaviors.

Norms often quickly evolve in the area of productivity. Management’s responsibility will be to ensure that such norms empha- size giving full effort to the greatest extent possible. Those who fail to meet the group standards may be “sanctioned” by cowork- ers to try harder or keep up with the pace set by the group. Sanctions take the forms of praise for positive actions and criticism for negative results.

Work behaviors include the manner of dress the organization and department deem to be acceptable. In some companies, only a suit and tie are appropriate attire for men, and only conservative outfits are acceptable for women. In others, varying degrees of cloth- ing options may be considered admissible, from work casual to blue jeans and T-shirts. Work behav- iors also cover the use of language in daily operations. For some, use of profanity is the norm and takes place constantly. In other departments, such language would quickly meet with disapproval by coworkers and managers. The same holds true for the manner of addressing supervisors and others. In the legal system, a judge is referred to as “Your Honor” in any formal setting, for example.

Social behaviors include views of office romances and relationships between employees and supervisors. Many organizations strongly discourage dating within a specific office, unit, or department. Relationships between employees and their supervisors are also often affected by norms. In some companies, it would be considered very bad form to socialize with someone of a higher rank. In others, such activities would be commonplace.

As is the case with individual constant controls, violations of group norms often meet with quick and consistent corrections. Someone who acts inappropriately will encounter criticism and worse from peers and supervisors.

Functional area policies are the dictates that guide activities of an organizational department or unit. Each department creates specific directives that should be aligned with overall company policies. When a policy is violated, management will step in and make certain the situation is corrected. Examples of functional area policies are provided in Table 7.2.

Brian McEntire/iStock/Thinkstock

▲▲ Wearing the type of dress that an organization considers acceptable is an example of a work behavior.

Introduction Chapter 7

Table 7.2 Examples of functional area policies

Accounting Methods of depreciation of assets

Methods of inventory valuation

Marketing Pricing systems

Preferred promotional activities

Protocols for hiring advertising agencies and public relations agencies

Human resources Methods for recruiting and hiring employees that best match the company

Pay systems

Benefit programs

Production Methods used for quality control

Once again, departmental managers are expected to abide by functional area policies. Any that are not followed should meet with quick and consistent correction protocols.

Company-Wide Constant Controls As noted in Chapter 2, mission statements define the organization’s overall purpose and reason for being. A corporation’s board of directors oversees the application of the company’s mission statement and is largely responsible for any alterations or revisions to that statement. Then, the CEO and other top managers will be expected to carry out the mission and prevent the organiza- tion from drifting off course. Vision statements then outline the direction for the organization as it moves into the future.

At the most basic level, mission and vision statements serve as the ultimate constant controls because they regulate and guide the entire organization. Top-level managers, even in companies without boards of directors, should constantly examine the path the organization takes, making sure the actions remain consist with these statements. Thus any activity that pulls the organi- zation away from its mission should be corrected as quickly as possible. A few years ago, when Toyota experienced problems in the area of product quality, the CEO quickly apologized and promised to get the organization back on course. Over the years, many similar statements have been made by company executives when they recognized the need to remain true to the organi- zation’s mission. In 2013, Chris Franz, CEO of Peak Venture Group, stated the company needed to return to its core mission of reaching out to the community and providing resources to local entrepreneurs (Gillentine, 2013).

In summary, a series of individual, departmental, and company-wide standards and practices create one level of organizational control. Any time one of these guidelines is violated, manag- ers are advised to step in and make immediate corrections. Organizations with high-quality, constant control systems are much more likely to survive and succeed over time. When constant controls are complemented by periodic controls, the company’s odds of success rise to an even higher level.

Periodic Controls

Planning and controlling are inseparable parts of the management system. Standards are set in planning, and the controlling system uses those standards to identify and correct problems. The

Introduction Chapter 7

standard control process consists of four steps (Anthony & Govindarajan, 2007; Steers, Ungston, & Mowday, 1985):

1. Review the standards set in the planning process. 2. Measure performance at the strategic, tactical, and operational levels. 3. Compare performance outcomes with the standards that were set. 4. Make a decision:

• Successful performance should be rewarded. • Unsuccessful performance should be corrected.

Reviewing Performance Standards Control processes are carried out on three levels: company-wide, departmental or functional area, and individual. These are the same three levels at which plans were written. At the company-wide level, the executive team is responsible for evaluation of activities. Departmental managers assess success in their functional areas. Supervisors working in concert with the human resources department conduct individual performance appraisals.

Planning forms the basis for an effective control system. Managers who fail to prepare quality standards have no basis for evaluating performance. The goal-setting literature (Locke, Shaw, Saari, & Latham, 1981) has taught us that quality goals reflect the following characteristics:

• difficult but attainable • measurable • clearly stated • flexible

At all three levels, members of the organization should be challenged to achieve at the highest levels. Difficult but attainable goals establish an environment in which employees are not tempted to slack off when goals are too easy and are readily met, or to give up when goals are too hard. Measurable goals are a necessity. Without tangible performance targets, control systems cannot work. Clearly stated goals eliminate hedging and fudging. Managers and workers at all levels are accountable for results. Accomplishing the objectives that have been set forms the basis for promotion deci- sions and other rewards. Goal setting should remain flexible. When organizational circumstances change, the planning and goal-setting systems should be adjusted to the new circumstances.

Measuring Actual Performance Many individuals and departments gather data to conduct performance analysis. This data can be quantitative, qualitative, or both. Staff members in various positions make reports that mea- sure actual performance across the company.

Top management examines the documents in reports that contain information regarding stra- tegic goals, such as market share, profitability, and well-being of various strategic business units. Judgments are made about the numbers as well as more subjective concepts, such as the strength of the company’s brand name and image.

Departmental leaders report on statistics from each area. Examples include the items shown in Table 7.3. In the performance analysis process, individual measures are developed for the perfor- mance appraisal process: Production workers are assessed with measures of individual output. Salespeople face sales quotas. Each area has goals that have been set for individual employees.

Introduction Chapter 7

Table 7.3 Tactical/functional analyses

Function Examples of factors to analyze

Production Costs, on-time delivery rates, consumer views of quality

Quality control Rates of defects/returns

Marketing Market share, brand loyalty or power

Sales By total volume, product lines, individual products

Accounting Errors noted by auditors

Finance Cost of capital, liquidity, leverage (debt ratio)

Information technology Quality of website, online ordering systems, support of internal operations

Research and development Number of innovations adopted

Human resources Rates of absenteeism, tardiness, turnover

Comparing Performance to Standards Performance data that has been gathered can be compared with the established standards. For example, the budget is compared to the actual department income statement. The variance between the actual performance and the budget allows the manager to assess how he or she per- formed during the period in question. When making comparisons, five outcomes are possible:

1. The person or unit greatly exceeded the standard. 2. The standard was met. 3. The standard was missed slightly. 4. The standard was missed. 5. The standard was badly missed.

As an example, suppose a product has been on the market for six months. A sales goal was established for 100,000 units to be produced and sold in the coming year. If the total sales turn out to be 150,000 units, the standard was greatly exceeded and management must establish a more realistic standard for the following year. If the standard is met—for example, sales total 103,450 units—then those responsible receive awards. If the standard is slightly missed—sales total 99,100 units—managers may consider other factors, such as unreported units in December or other variables that contributed to a variance of less than 1%. When the standard has been missed (91,000 units sold), corrections will be made. When the standard is badly missed (63,000 units sold), then management may consider whether the new product is viable in the marketplace.

Making Decisions Based on the information provided by comparing performance to standards, managers are ready to make decisions. Of the five possible outcomes of this analysis, some lead to relatively straight- forward responses or decisions. A standard that is too low will be raised. A standard that is met should lead to rewards for those involved. A standard that has been slightly missed invites some scrutiny.

Standards that have been missed—or grossly missed—require the greatest amount of investiga- tion and concern. When the standard has been missed, more substantial corrections need to be made. When the standard has been grossly missed, managers will meet to consider whether to stop the activity or create some kind of major overhaul (Maciariello & Kirby, 1994; Weiner, 1948).

Functional Area Controls Chapter 7

The controlling process may be considered as a feedback device for company leaders. Decisions reached in the controlling process lead to new plans for the future. Standards allow for effective management of the organizational system at each level: company-wide, departmental/functional area, and individual. We consider functional area controls next.

7.2 Functional Area Controls Each department sets goals for its own operations. At times these goals apply not only to the department but also to the overall company. For example, if a manufacturing company has only one production department, then the departmental goal becomes the company’s goal. Using the process noted in Figure 7.1, control systems help managers in each functional area (production, marketing, finance, etc.) collect information about operations in their departments. This enables them to make better decisions about how to fix or improve activities in each part of the company. In each department, the fundamentals of the systems approach can be used to make corrections to any problems that have been identified. Figure 7.1 portrays the flow of items in a general con- trol system.

In a departmental system, inputs include whatever items come into the area. For production, this means raw materials; for human resources, it is people. The transformation process is the department’s key function, including the assembly of physical products and the development of intangible services. Outputs are the finished items sent on to the next department or to the out- side environment. An output for the accounting department would be the annual income sum- mary. The feedback mechanism provides correction and adjustment, keeping the department in tune with other departments and the larger environment. Systems concepts help departmental managers identify problems and find solutions.

Production and Quality Control

Production and quality control are closely linked. Production represents a line function, and quality control is more of a staff function. In the area of production, four standard types of goals are set:

1. Quantity 2. Quality

f07.01_MGT330.ai

Inputs Transformation Process

Outputs

Feedback Mechanism

Figure 7.1 A control system

Functional Area Controls Chapter 7

3. Cost 4. Time

Performance figures in these areas are then met with various responses and corrections.

Quantity Goals Quantity goals may be established by unit or by volume. DVD players are counted in units. Beer breweries count liters or gallons. At times, quantity goals are more complex. For instance, man- agers in a construction company that is building a major structure that will take more than one year to complete will still want to know if output levels are sufficient. To access this information, they use benchmarks to note the completion of various tasks. A standard is set for completion of the framing. A second standard applies to finishing the wiring system. In this way, the manager knows more about the level of productivity.

Quality Goals Quality goals are applied in various ways. For some operations, quality will be represented by exceeding a threshold. For example, a building must pass all inspections to be considered of high enough quality to be sold and inhabited. A customized insurance plan sold to a company must be complete before being put into place.

Other standards are set and examined by variation and defect levels. An example of this would be an automated injection molding machine tool that produces golf balls. This particular golf ball specification requires a dimpled cover of thermoplastic with a thickness of 0.30 in. and an overall ball diameter of not less than 1.680 in., as defined by the U.S. Golf Association, but less than 1.685 in., as defined by the manufacturer. Each ball is carefully and automatically measured as it moves through the produc- tion line just before the finishing process to make sure it meets design specifications. Balls outside of the speci- fications are rejected and recycled. If more than 0.5% of the balls are rejected, management intercedes, stops production, and requires process recalibrations. In this way, scrap is limited, costs are managed appropriately, and a high-quality golf ball is produced for the golfer. Quality control tests like these are found in many forms of manufacturing.

A third set of quality goals examines intangible, qualitative issues. Examples include customer satisfaction and loyalty. Consider a restaurant setting, where production of food is only part of the story. For the production system to work, people must enjoy the food they eat. No hard standard can be set, yet managers still want to know whether customers are pleased with their purchasing experiences. Surveys and questionnaires can make available numbers that provide helpful information, such as where the company ranks in the industry in terms of customer satisfaction.

© Ernest Primi/iStock/Thinkstock

▲▲ A building must pass all inspections to be considered of high enough quality to be sold and inhabited; in this case, quality is repre- sented by exceeding a threshold.

Functional Area Controls Chapter 7

Cost Goals The production manager needs information about the efficiencies, or lack thereof, of the depart- ment’s operations. For instance, what costs are incurred by using raw materials, paying labor, storing merchandise, and shipping products to buyers? Quality control adds information by mea- suring the number of defective units that were discarded or required additional funds to repair.

Time Goals Time goals reflect whether items have been produced on schedule. These goals are set in various ways, such as the number of units per day, week, and month, or other means. A large project will have a goal established as a deadline. For example, the publication of a book has a defined produc- tion date and release date. Time goals measure the efficiency of the department.

Measures of Performance: Production and Quality Control Production managers and quality control officers prepare reports for purposes of control. In many cases, these reports are written every day. For example, a newspaper production manager prepares a report for a daily edition. Each day, the newspaper has a different number of pages. In a smaller community, a Monday paper may be as small as 16 pages. Sunday papers normally have four or five times more pages. The production manager notes the page count of the edition, the amount of newsprint and ink used, and the starting and stopping time for the production run. The report also mentions the number of unusable, discarded papers. In this way the manager has reported on quantity, quality, and time.

Quality control managers also report on defects. They may be asked to provide information about the causes of defects or problems. This information can be used to make the needed corrections. The accounting department will generate the final set of statistics and information. Cost infor- mation will be assessed and stored for future use.

These measures can be combined into quarterly, semiannual, and annual reports about the pro- duction department’s level of efficiency (low cost) and effectiveness (high quality).

Making Corrections: Production and Quality Control The systems approach (see Figure 7.1) applies most directly to the production department. Inputs are the materials and labor needed to manufacture products. Inputs can be changed through improved sourcing or by acquiring high-quality raw materials.

The transformation process is the production process. Production transformation processes can be redesigned or streamlined to reduce defects or improve quantity levels.

Outputs are finished goods and services. Outputs reflect changes in the actual products to be sold. Items such as mobile phones continue to evolve as new technologies make it possible to increase their number of uses.

The feedback mechanism measures performance. Feedback mechanisms can be fine-tuned to identify problems more quickly and correctly. Currently, methods to ensure food safety have been restructured due to outbreaks of E. coli and other bacterial foodborne illnesses.

Marketing and Sales

The marketing department manager considers various goals when creating plans. The manager works in conjunction with other departments, most notably production, to make sure that items

Functional Area Controls Chapter 7

are tailored to customer needs. When services are marketed, they must also be of sufficient qual- ity to attract customers and sales. The marketing and sales departments have four common goals (Clow & Baack, 2010):

1. Market share 2. Sales quotas 3. Share of mind (consumer awareness and loyalty) 4. Marketing and sales costs

If there is only one sales department, these standards become company objectives as well.

Market Share Market share measures the company’s percentage of total sales in an industry or a subset of an industry. The executive team and marketing manager examine statistics about the state of the industry, whether the overall marketing is increasing, stable, or declining. Then market share can be assessed in several ways, including total company share, division share, brand or product line share, or individual product share.

Total company share measures how well a company fares in a market. For example, PepsiCo would examine its total in the food and drink industries. Division share would be statistics about sales and market shares of the various major components including snacks (Frito-Lay), breakfast drinks (Tropicana), soft drinks, energy drinks (Gatorade), and breakfast foods (Quaker). Brand or product line would divide Pepsi’s soft drinks into products with the Pepsi name and Mountain Dew products. Market share would be assessed at the product level, such as share of Caffeine Free Diet Pepsi.

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

Share of Mind People will not buy a product or use a service unless they know about it. Share of mind (also known as consumer awareness of the company) indicates that consumers consider a company when they want to buy a product. Share of mind reflects the degree of consumers’ awareness of a company’s existence and thus how inclined they are to visit that company or store. Loyalty means they will go to a company or one of its specific products first when making a purchase decision (Baack, Till, Magnusson, Zdradkovich, & Baack, 2007).

Marketing and Sales Costs Marketing and sales managers spend money to generate money. Marketers create advertise- ments, promotions and sponsorships, contests and sweepstakes, and other activities designed to entice people to come to a store and buy a product. The same is true for sales, where the sales manager pays travel expenses for salespeople, defines commissions, and sets up other rewards for increasing a company’s customer base. These managers want to know if the money has been spent wisely.

Functional Area Controls Chapter 7

Measures of Performance: Marketing and Sales Marketing and sales managers use several devices to measure performance. Market share infor- mation is found in industry and trade publications. Market share statistics also are prepared by local agencies, including governments and educational institutions, for small businesses in a town or city. Sales quotas can be examined using sales reports by individual employees as well as sales summaries prepared by various departments for accounting purposes.

Share of mind and customer loyalty figures are collected in various ways. Share of mind can be measured through ratings of advertisements in various forms. Other measures come from redeemed coupons, entries into contests, and website hits. Customer loyalty normally requires more in-depth market research. The accounting department reports the costs of marketing and sales programs.

Making Corrections: Marketing and Sales Using the systems model, corrections in the area of inputs include attracting and hiring quality marketing experts and salespeople. Most corrections are made in the transformation process, where the marketing manager considers changes in pricing and discounting programs, prod- uct positioning, distribution methods, and methods of promotion including advertising, per- sonal selling, promotions (coupons, contests, rebates, bonus packs), and public relations activities such as sponsoring charities or various events. Marketers may have some control over outputs, although it is limited.

At times, marketers consider changing feedback mechanisms, or how performance is measured. A salesperson may be generating high sales figures but is doing so by spending a great deal of money on travel and offering huge discounts to entice purchases. The marketing and sales man- ager might wish to fine-tune how sales success is measured.

Human Resources

The human resources department often serves the entire company. Departmental goals represent company-wide goals as a result. The standard measures of perfor- mance in human resources, in addition to the cost of running the department, include the rates of absenteeism, tardiness, turn- over, accidents, grievances, and vandalism. Statistics like these reflect the degree of employee satisfaction within the company. Happy, satisfied workers tend to arrive at work on time. They pay attention and are less likely to be accident victims. They see no reason to file grievances or damage company property. They wish to keep their jobs. Conversely, if you have ever held a job you did not like, these factors probably came into play. Human resource managers

© Adam Gregor/iStock/Thinkstock

▲▲ Human resources managers’ performance can be measured based on the degree of employee satisfaction.

Functional Area Controls Chapter 7

are held accountable for these goals, because their primary responsibility is attracting the right people to the company. Matching people with jobs constitutes a key ingredient in success.

The cost of the department reflects the concept that human resource managers spend money on recruiting and selection processes. They should spend the money carefully and efficiently. Human resource managers often are asked to balance the costs of benefit programs. The accounting department provides cost information for the purposes of control.

Measures of Performance: Human Resources Typically, the human resources department is actively involved in evaluation operations. These managers are asked to prepare statistics regarding accidents (lost work time), absenteeism, tardi- ness, turnover, disciplinary actions, grievances, and instances of vandalism.

Making Corrections: Human Resources Human resource managers use the systems model (see Figure 7.1) to create various corrections. Inputs are associated with recruiting and selection methods. The company needs to identify and use the best possible employee sources. The transformation process includes orientation, train- ing, discipline and rules, and workplace safety programs. Each of these areas can be improved to increase worker satisfaction. Outputs are normally not a consideration for human resources. The feedback mechanisms include all methods of assessing performance for individuals and for the department. This includes performance appraisal programs and statistics used to evaluate the effectiveness of employee placements.

Information Technology and Research and Development

Performance in the areas of information technology and research and development is more dif- ficult to assess. The problem is due largely to the inability to create measurable, tangible stan- dards. Company leaders clearly need an effective information technology system; however, what numbers can be assigned to that concept? The same holds true for research and development. Establishing concrete goals is problematic.

A management by objectives system, which is a participative annual goal-setting program, has value in these areas. Individual employees and their managers can establish work-specific goals, such as completing a website update or completing a product’s physical form. At the least, these goals give company leaders an idea of how well the departments are functioning.

Further, a company’s statement of vision and mission can direct the activities of the information technology (IT) and research and development (R&D) departments. These departments should focus on activities that support the overall direction of the organization. When the work moves the company away from its intended direction, corrections can and should be made.

In summary, the four parts of a system can be used to make corrections on a departmental or company-wide basis. Various parts of a systems model are emphasized, depending on the func- tional area corrections required. Production, quality control, marketing, sales, human resource, information technology, and research and development goals all deserve careful attention as part of the controlling system.

Accounting and Financial Controls Chapter 7

7.3 Accounting and Financial Controls Accounting and financial officers are responsible for planning and control in unique ways. Each department manager sets departmental goals. At the same time, planning processes in these areas affect numerous parts of the company. Three common goals are established for these departments: profitability, cost of capital, and increasing efficiencies in company operations. The first two goals pertain to departmental activities; the third applies to the entire organization.

Profitability Goals

Profitability goals are assessed using a variety of instruments. The income summary or P&L (profit and loss) statement is the most common. Figure 7.2 provides an example of an income summary. Other profitability standards are calculated, such as the company’s return on invest- ment (ROI), earnings per share of common stock (EPS), and dividends per share (DPS) paid to shareholders. Profits are required to stay in business, making profitability goals key elements.

M A N A G E M E N T I N P R A C T I C E

Management by Objectives

Beyond the use of the systems approach to understanding the activities of a department and cor- rections to be implemented when performance is lower than expected, other devices are available to link planning and control in meaningful, useful ways.

Over the past half century, a variety of organizations have used management by objectives, due to its ability to link planning and control. In a quality management by objectives program, the follow- ing steps are carried out at every level, from entry-level employee to CEO:

1. Job analysis (states the primary emphasis of the job) 2. Employee preparation of an annual goal list 3. Manager preparation of personal and employee goal lists 4. Supervisor and employee meeting to negotiate a goal list 5. Follow-up

In this type of system, employees begin by outlining their intended goals for the coming year, based on the primary emphasis of the job. By the end of step 3, an employee has a personal goal list as well as the one prepared for him or her by an immediate supervisor. The meeting in step 4 merges the two lists into one. Then, performance evaluation follows after the year has gone by.

The value of using management by objectives as a control system is that individual performance at the lowest level is aligned with goals and performance measures at each level of the organizational hierarchy. Consequently, the control system becomes based on quality standards set by individuals and supervisors. This benefit explains the popularity of the management by objectives system.

Remember, however, that an effective management by objectives program must be sponsored by top management. Companies should be in a position to reward the performances of those who achieve their goals. Effective goals are clearly stated, measurable, and attainable. The system must be designed as part of the annual calendar, so that employees are comfortable with it. When these conditions can be met, the program can contribute to employee morale and organizational perfor- mance through an effective planning/control system program that can be tailored and adapted to each function and department.

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Cost of Capital

The minimum return that investors expect to see from a company they invest in is described as the cost of capital. A balance sheet reports on investing and other business financing activi- ties of the organization (Table 7.4). It lists amounts for assets, liabilities, and equity at a specific time and does so by using the accounting balance sheet equation (Assets = Liabilities + Equity). Accounting for these amounts gives both the organization’s management and other organiza- tional stakeholders a realistic view of the organization’s financial condition.

Table 7.4 Balance sheet information

Assets

=

Liabilities

+

Equity

Cash

Short-term securities

Accounts receivable

Inventory

(short term)

Trade credit

Bank loans

Commercial paper

Common stock

Paid in surplus

Retained earnings(long term)

Bonds payable

Notes payable

Increasing Efficiencies of Company Operations

Accounting and financial managers oversee the operations of the entire company. They are respon- sible for conducting the types of financial analyses and annual financial planning that will lead to the efficient use of company operating funds. The three primary methods for conducting this research and making reports to the executive management team are ratios, budgets, and audits.

f07.02_MGT330.ai

Total Sales

Cost of Goods

Gross Profit

Operating Expenses

Gross Operating Income

Depreciation

Net Operating Income

Other Expenses

Unusual Income

Net Income Before Taxes

Taxes

Net Income After Taxes

100,000.00

(30,000)

70,000.00

(15,000)

45,000.00

(5,000)

40,000.00

(10,000)

5,000

45,000.00

(25,000)

20,000.00

$

$

$

$

$

$

Amount

Income Summary

Figure 7.2 An income summary

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Ratio Analysis

Ratio analysis takes the financial information made available to the accounting and finance departments and helps company leaders understand how well various operations are running. When problems are identified, managers can make the appropriate adjustments and corrections. Four types of ratios are presented in Table 7.5.

Table 7.5 Types of ratios

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

Activity ratios Measure efficiencies in company operations

Leverage ratios Measure company debt and risk

Profitability ratios Assess company profits

Liquidity Ratios To remain solvent, the company must pay bills on time. Liquidity ratios are designed to make sure the company has enough money on hand. Two liquidity ratios are the current ratio and the quick or acid test ratio. A current ratio is calculated as follows:

Current ratio = current assets

= 2:1

current liabilities

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

The quick or acid test ratio is calculated as follows:

Quick ratio = current assets – inventory

= 1:1

current liabilities

The reason for eliminating inventory is that normally it could not be quickly sold at full value. Therefore, the acid test indicates whether a company could make payments without liquidating inventory. A 1:1 ratio suggests that the answer is yes.

Activity Ratios Activity ratios assist managers in understanding how well certain company activities are being carried out. Two common activity ratios are inventory turnover and average collection period. To calculate inventory turnover, the following formula is used:

Inventory ratio = total annual sales

= 7 times average inventory

The manager will see from this outcome that the store or unit sold its entire amount of inventory seven times during the course of the year. It will depend on the industry whether this is a good

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or a bad number. If it were a grocery store, the company would be in trouble. If it were a tractor manufacturer, the retailer would be having a great year.

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

Average collection period = sales per day

= 23 days average accounts receivable

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

Leverage Ratios Leverage ratios measure company debt and company risk. As noted previously, the greater the amount of borrowed money, the greater the risk. Many formulas are available to assess leverage. One simple version, a ratio of debt to equity, is calculated as follows:

Debt-to-equity ratio = total debt

= 45% total assets

In this instance, debt represents 45% of the value of all company assets. The manager would know the company owes 45% and owns 55% of its assets. Top management preferences normally dictate the amount of debt to be assumed by the company. Using more debt will likely increase profit- ability per share of common stock, but at the same time it will increase the risk level.

Profitability Ratios Besides the income summary, company leaders may wish to examine profitability in other ways. Profitability ratios measure company financial success. One common ratio used for that pur- pose is profit margin.

Profit margin = net income after taxes

= 12% total annual sales

This figure tells the manager that after every bill has been paid, including the tax bill, the com- pany earned 12 cents on every dollar of sales.

Analyzing Ratios When analyzing ratios, it helps to remember that they can be either used or misused. Two common ways ratios are misused include manipulating the numbers and overemphasizing a single ratio.

Managers can manipulate numbers through tactics such as miscounting inventory and overstat- ing or understating sales. Doing so may keep a manager from having poor performance exposed in the short term; however, over time the truth will come out. When top managers overempha- size a single ratio, they are not looking at the full picture. One number might be unusual or off, but without seeing how all other figures fit in, the manager fails to see the big picture.

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Effective use of ratios begins with having a frame of reference. Two of the best are industry aver- ages and past year’s ratios. The manager can see how a company’s operations compare to what happens in the industry. For example, if the company’s average collection period is 23 days, but the industry average is 32 days, it may be that other companies are offering more generous repay- ment terms. The company may lose sales to these competitors as a result. Past year’s ratios pro- vide guideposts to current operations. When numbers begin to trend or drift in a certain way, the manager can respond with corrective action when needed (Bedeian, 1986, pp. 561–563; Belverd & Powers, 2010).

The Budgeting Process

As noted in Chapter 1, a budget is an annual financial plan. In most organiza- tions, the budgeting process is complex. In government organizations it can be espe- cially complex as public policy and politics come into play. In a business organization, the distribution of precious resources can enhance interdepartmental conflicts and rivalry, further complicating the budgeting process. Nonetheless, managers are called upon to construct a budget that will allow the organization’s goals to be met by fol- lowing a staged process across the organi- zation. The typical steps in the budgeting process are as follows (Steers et al., 1985):

1. Executive management initiates the bud- get process. The CEO or CFO informs department managers of the periodic organizational goals and advises on estimated resource availability. Normally, this is an annual process.

2. Each operating unit or department prepares a preliminary budget. With the goals and objec- tives as well as the financial resources, each department manager prepares a preliminary bud- get, which defines how those resources will be used to attain their unit’s productive activities.

3. Executive management—the CEO/CFO (or budget committee reporting to the CEO and CFO)—reviews, modifies, and approves the preliminary budget. At this step in the process, critical coordination of organizational activities is achieved.

4. Budget performance is evaluated during the budget period to assess compliance. Variances from the approved budget are reported to the CEO or CFO by each manager (typically on a monthly or quarterly basis), and correction plans and initiatives are designed to bring operat- ing realities into conformance with the approved budget.

The first three steps in this process are planning steps. The final step represents the controlling function.

Forms of Budgets Various types of budgets are part of the planning and control system. A pro forma income sum- mary spells out expected revenues and expenses during the course of the year. Departmental

iStock/Pogonici/Thinkstock

▲▲ The process of budgeting allows managers to plan ahead, allocate resources, and establish priorities.

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budgets are generated at that point. Each department manager knows the amount of funds he or she will be assigned to operate over the next 12 months.

As noted in Chapter 2, three types of budgets are common in business: incremental budgets, zero- based budgets, and rolling budgets. These budgets are used to allocate funds to individual depart- ments. Incremental budgets are easier to prepare; however, they exhibit the greatest tendency to allow managers to build “slack” into the system, where they have excess funds. Zero-based and rolling budgets facilitate coordination of activities and tend to reveal process redundancies, excessive spending, and planning problems. Budgets tend to improve resource allocations by helping managers make decisions about what is important in the organization.

Benefits of Budgeting Budgeting programs offer various benefits to company leaders. First, by putting together an annual financial plan, the manager engages in the planning process. In some organizations, that alone is a major accomplishment. Far too often, managers want to run things by the seat of their pants rather than planning ahead. Budgeting forces managers to plan.

Budgeting allocates resources. The budgeting process designates amounts of money to be spent by various departments. Some of the funds are set aside for pay programs, bonuses and pay raises, and other incentives. Budgeting can become part of the motivational system.

Budgeting establishes priorities. Funded items are clearly more important. Budgets can be used for special projects and assignments as well as for the yearlong normal funding program. A man- ager has a sense that management values his or her project when it receives money. Budgeting is an excellent controlling device. Budgets can be established for departments along with other standards and objectives. In that way, a manager has a clear idea of what needs to be accom- plished in the timeframe involved.

Budgeting Problems As was the case with ratios, budgets can be used or misused. Problems emerge when managers abuse the budgeting process. Issues can arise on both the planning and controlling side of the budgeting program (see Table 7.6).

Table 7.6 Budgeting problems

Planning Control

Poor forecasts

Politics

over-asking

horse trading

Overemphasis on the short term

Manipulating outcomes

Using as a policing device

On the planning side, two major problems that occur are poor forecasts and company politics. Poor forecasts of future sales distort the entire budgeting program. When revenues are badly overestimated or underestimated, departmental allocations no longer work. Managers who do not take the time to obtain quality forecasts hurt the budgeting process.

Company politics take two forms. The first, over-asking, means departmental managers put in budget requests with amounts that far exceed their needs. The goal is to build a “war chest” or “slush fund” to hold for use in emergencies. Funds are not allocated efficiently when this occurs, and the budgeting program becomes essentially a guessing game.

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The second problem, horse trading, involves trading favors in exchange for larger budget alloca- tions. A manager essentially plays politics rather than seeking to achieve organizational goals. The net result will be companies in which distrust of the budgeting process is commonplace.

On the controlling side, budgets create problems when managers overemphasize the short term. For example, suppose a department manager faces a budget in which 100,000 units were to be produced during the year. It is December, and only 88,000 units have been finished. Due to wor- rying about what will happen if the target is not met, the manager authorizes overtime, ignores routine maintenance of equipment, and angrily chastises workers to hit the target. Even if the goal is reached, workers are upset, tired, and the equipment becomes more likely to break down in January (Argyris, 1952).

Some managers simply cut corners in order to manipulate outcomes. They create sales that will be made into returns at the beginning of the next budgeting period. Others count defective items as finished goods in order to reach quotas.

When a budget becomes a policing device, it is used to justify personnel decisions: A manager is informed that she will not receive a pay raise due to failures to meet standards. Another manager is being passed over for promotion because she did not manage her budget adequately. At the extreme, a manager who failed to meet budget requirements is terminated. These tactics turn budgeting into the enemy of workers. Budgets that are used to place blame serve little other pur- pose (Nobles, Mattison, & Matsumura, 2014; Tosi, 1974).

Creating Effective Budgeting Programs To overcome potential problems with budgets, managers must take proactive steps to make sure the process works properly. Doing so involves activities in three areas: planning, control, and both planning and control (see Table 7.7).

Table 7.7 Effective budgeting programs

Planning Control Both

Effective forecasting Correct problems Participation

Reduced politics Long-term view Future oriented

Systematic approach

On the planning side of budgeting, accurate forecasts of sales and revenues are crucial. Only then do the budget allocations work properly. You can never eliminate politics, but you can become aware of them. Employees who try to play games with the system should be admonished.

On the control side, budgets should be viewed as methods for solving problems rather than plac- ing blame. When employees see the budget as a tool rather than a whip, the system works better for both short-term and long-term tasks.

On both sides, employee participation should be encouraged when setting standards and creating budgets as well as when measuring results. Doing so creates a sense of empowerment in the work force. Individual employees are more likely to “buy in” and try to set and achieve quality stan- dards. Budgets that focus attention on the future rather than dwelling on the past are of greater value. And finally, budgets should be built into the calendar. Every employee should know when

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it is time to set standards and when performance will be measured. The budgeting process should feel like a natural part of the yearlong work cycle (Welsch, 1976).

In summary, the budget process offers the potential to establish reliable links between a com- pany’s planning and controlling systems. The standards set for individuals and departments can be used to increase performance and keep the organization on track. Effective managers take the time to make sure a budgeting system works the way it should.

Auditing

Auditing is a crucial component of any control system, but it is especially critical in financial reporting and control activities. Auditing takes many forms, including internal auditing, external auditing, tax auditing, software auditing, risk-based auditing, and fraud auditing. In this section, we discuss auditing as a control function, not as a practice experienced in an accounting course of study. Auditing is an assessment of a person, organization, system, process, operation, project, or product. Auditing is most commonly used to make sure that all financial and accounting state- ments are accurate. However, auditing processes also exist for cost management, project man- agement, quality management, hotel front desk operations, energy conservation, and, of course, tax return auditing conducted by the Internal Revenue Service (IRS), state tax agency, or local government office.

In most organizations, auditing systems (either internal or external) exist to assure that financial statements are reasonably free from material error, accounts reasonably reflect their actual bal- ances, and systems procedures are sufficient to provide accurate and reliable data. External finan- cial audits for publicly traded companies are often conducted by applying standards defined by American Institute of Certified Public Accountants and potentially the International Standards on Auditing.

Quality auditing is conducted to assure conformance with standards defined by the organiza- tion or potentially an externally defined process such as ISO 9001. Quality audits, somewhat like financial audits, require review of objective evidence associated with the defined process, except the quality auditor is an internal agent of the organization with the authority to pass such judgments. Quality audit processes often judge the conformance or nonconformance as well as operational practices that lead to the result evaluated.