Accounting for Management Control - Springer978-1-4899-6952-1/1.pdf · Accounting for Management Control SECOND EDITION Clive Emmanuel University of Glasgow David Otley Uni versi

Accounting for

Management Control

Accounting for

Management Control

SECOND EDITION

Clive Emmanuel University of Glasgow

David Otley Uni versi ty of Lancaster

and Kenneth Merchant

Harvard University

SPRlNGER-SCIENCE+BUSINESS MEDIA, B.V.

First edition 1985 Reprinted twice in 1986, twice in 1987 Second edi tion 1990

© 1985 Clive Emmanuel and David Otley © 1990 Clive Emmanuel, David Otley and Kenneth Merchant

Originally published by Chapman and Hall in 1990

Typeset in 10/11 '/2 Aster by Best-set Typesetter Ltd, Hong Kong

ISBN 978-0-412-37480-7

All rights reserved. No part of this publication may be reproduced or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, or stored in any retrieval system oE any nature, without the written permission of the copyright holder and the publisher, application for which shall be made to the publisher.

British Library Cataloguing in Publication Data

Emmanuel, Clive R. Accounting for management contro!. - 2nd ed. 1. Management accounting I. Title H. Merchant, Kenneth III. Otley, David T. 658.1511

ISBN 978-0-412-37480-7 ISBN 978-1-4899-6952-1 (eBook)

DOI 10.1007/978-1-4899-6952-1

Library of Congress Cataloging-in-Publication Data available

The copyright on each case in this book unless otherwise noted is held by the President and Fellows ofHarvard College and they are published herein by express permission. Permission requests to use individual Harvard copyrighted cases should be directed to the Permissions Manager, Harvard Business School Publishing Division, Boston, MA 02163.

TG GUR WIVES, Gill, Shelagh and Gail

Contents

Preface Xl

Preface to the second edition XlII

Acknowledgements XV

Part One The Context of Management Accounting 1

1 Accounting for organizational contral 3 Summary 3 Introduction 4 Organizations and accounting 5 The concept of control 7 Organizational control 18 The role of accounting information in control 34 Exercises 36

2 The design of organizations 38 Summary 38 Intraduction 39 The historical development of organizational

theory 39 Systems approaches 46 Organizational design as a control device 52 The contingency theory of management accounting 57 Conclusions 66 Exercises 67

3 Individual motivation and incentives 69 Summary 69 Introduction 69 Theories of motivation 70 The use of accounting controls 79 The design of reward systems 81 Conclusions 84 Exercises 85

viii Contents

4 The management of business enterprises 87 Summary 87 The function of management 87 The context of management 91 The rale of accounting information in

management control 96 Conclusions 104 Exercises 106

5 Contrals in business organizations 109 Summary 109 The need for controls 109 Achieving good control 111 Feasibility constraints on the choice of controls 114 Control system design 115 Advantages and disadvantages of different controls 116 Critical success factors 119 Conclusions 122 Exercises 122

Part Two Accounting for Programmed Activities 125

6 Accounting for decision making 127 Summary 127 Introduction 127 Short-term decisions 129 Long-term decisions 134 Financial planning 136 Assumptions of management accounting 138 The role of management accounting in decision

making 148 Exercises 150

7 Budgetary planning and contra I 160 Summary 160 Introduction 160 Multiple functions ofbudgets 162 The basis of budget preparation 165 Managerial use of budgetary information 167 The rale of accounting information in planning

and contral 183 Exercises 187

Part Three Accounting for Non-Programmed Activities 191

8 Planning and contral in a complex and uncertain world 193

Conlenls IX

Summary 193 Introduction 193 A theoretical framework for non-programmed

decision making 194 Accounting in a multidivisional framework 207 Conclusions 217 Exercises 219

9 Performance measurement and evaluation 222 Summary 222 Introduction 222 The contribution of the AIS to management control 223 Potential defects of accounting performance

measures 232 Towards a contingency framework: performance

evaluation 238 Exercises 258

10 Rewarding managerial performance 265 Summary 265 Introduction 265 Forms of reward 266 The link between rewards and results 268 Explicitness of the reward promises 270 Size of results-dependent monetary rewards 271 Conclusions 274 Exercises 275

11 Interdependence and transfer pricing 277 Summary 277 In terdependence 279 The spectrum of accounting treatments 283 Accounting treatments in practice 290 Explanations of practice 293 howards a behaviour-congruent transfer pricing

system 297 Conclusions 304 Appendix 1 Relevant cost concepts far decision

making 306 Appendix 2 International transfer pricing 308 Exercises 311

12 The capital investment decision in the multidivisional company 318 Summary 318

x Contents

Introduction 318 The capital budgeting process 319 ROI, RI and project evaluation 329 Cash flow as a measure of managerial performance 341 Conclusions 346 Exercises 348

Part Four A Framework for Analysis 355

13 Accounting for management control 357 Summary 357 Introduction 357 The contingency approach re-stated 359 The role of financial measures of performance 365 Specific implications for the AIS 369 The design of management control systems 371 The way ahead 377 Exercises 378

Part Five Case Studies 385

14 Management control case studies 387 Permaclean Products pIe 387 Scovill Inc.: NuTone Housing Group 391 BBRpIe 408 Beech Paper Company 412 Altex Aviation 424 HCC Industries 459 ES Inc. 476

References 490

Author index 509

Subject index 515

Preface

The success of a business enterprise depends upon how weIl it adapts to the environment in which it is set. But success is a multiJimen­sional concept and the aspects of success that are considered most important will differ from time to time and from one participant in the organization to another. To attain satisfactory levels of per­formance in each of these dimensions requires the control and co­ordination of a variety of activities carried out by different people. In a large organization this is a substantial task involving the activities of many different specialists to support and inform the line managers most directly involved. A wide definition of the subject matter of this book is that it is concerned with the mechanisms that organizations use to ensure that they remain weIl-adapted to their environments.

Management control may be defined as the processes by which managers attempt to ensure that their organization adapts success­fully to its changing environment. These processess will range from formally specified control devices, such as the allocation of authority and responsibility, to ad hoc enquiries into the state of the environ­ment as, for example, when a manager attempts to discover the price actually paid by a customer for a competing product. Not only do a range of possible controls exist, but the mix and manner of their use will vary from organization to organization and from time to time. However, one set of formal controls appear to be used, albeit in dif­fering ways and to differing extents, in all business organizations (and in many non-business organizations as weIl). These are the formal controls inherent in the use of an internal or management accounting system.

The primary focus of this text is to study how accounting systems should be designed so as to enable effective management control of organizational activities to be achieved. Inevitably the wider context in which the formal accounting controls are set must also be studied, as must the way accounting information is actually used by those to whom it is provided. But the central theme is the provision of ac­counting information for management planning and control. Given this emphasis on management, the concept of behaviour congruence

xii Preface

provides the overarching guideline to the design of accounting in­formation systems. Results, action and personnel controls provide the means of operationalizing the behaviour congruence concept. The distinction which is made between programmed and non­programmed decision-making situations offers a basis for analysing specific situations to ensure that appropriate results, action and personnel controls to achieve behaviour congruence are applied.

Our aim is therefore to complement traditional management ac­counting textbooks which are primarily concerned with the develop­ment of technical competence in performing accounting calculations and which may, in addition, develop relevant economic concepts to ensure that the calculations performed are appropriate to the de­cisions for which they are being used. However, it is increasingly recognized that economic concepts represent only one part of the foundation upon which management accounting rests. The internal functioning of the organization, the ways in which people react to information and the design of control systems to affect human be­haviour are also fundamental to the operation of a complete ac­counting system. The design of an effective management accounting system requires knowledge obtained from the behavioural sciences and from the principles of organization and management as weH as from economics.

The major part of this text concentrates on the applicability of traditional management accounting techniques to business enter­prises and the ways in which they can be developed to serve these purposes more effectively. In Part One, the context in which manage­ment accounting information is used is described and analysed from a control perspective. Part Two considers the foundations of tra­ditional management accounting techniques and the circumstances in which they are most applicable, namely the relatively simple, centralized organization operating in a stable environment. These restrictive conditions are relaxed in Part Three where more flexible uses of accounting information, as aids to control rather than as total control devices, are developed. The threads are drawn together in Part Four and the prospects for the development of management accounting assessed. FinaHy, Part Five consists of some case studies in which the principles outlined earlier can be applied.

CLIVE EMMANUEL, DAVID OTLEY AND

KENNETH MERCHANT

Preface to the second edi ti on

Over the past five years, it has become evident that this text has filled a gap, in that it has been used on accounting degree courses at most universities and many polytechnics in the UK, and in a surprising number of institut ions overseas. It has been used both as a supple­ment to traditional accounting texts by those teaching a broadly based intermediate management accounting course and as a final­year undergraduate text in its own right. It has also played a role in postgraduate courses, both specialist accounting courses and MBA programmes. Indeed, it has attained the ultimate criterion of acceptance into mainstream thought (or the sign that the authors are now over the hill, as one of our unkinder colleagues put it) by appearing as recommended reading for professional accounting examina tions.

During the life of the first edition, we have benefited from the many comments we have received from users, and hope that we have in­corporated many of the suggested improvements in this second edition. We have also invited Ken Merchant to join us as a co-author in order to take advantage of his expertise in the subject area. In this revised second edition, we have kept nearly everything that appeared in the original edition, changed a little, and added a considerable amount of new material. In this way, we hope to have preserved those features which have made the book so popular while increasing its usefulness to even more teachers.

The main changes, apart from general revision and updating, are as follows. Chapter 2 has been extended to include a more detailed discussion of the contingency theory of management accounting, and Chapter 4 now includes discussion of more radical perspectives on the practice of management. But we have tried not merely to review material which may yield useful insights; rather we have tried to assess the utility of alternative approaches to the role of accounting information in the management control process. To that end, a new Chapter 5 has been included which outlines the control tools avail­able to a manager and discusses how an appropriate choice might be made.

xiv Preface to Ihe second edition

In Part Two, Chapter 6 has been extended to elaborate the concepts used in more detail than before, and i t now assumes less familiari ty on the part of the reader with both cost accounting concepts and linear programming techniques. However, for a full understanding of its contents, it should be studied in conjunction with a cost ac­counting text that develops linear programming concepts (e.g. Ryan and Hobson, 1985). Chapter 7 has also been lengthened somewhat to include some more recent empirical material, and also to clarify the transition which takes place here from the programmable to the less programmable situation.

Similarly, Part Three contains additional material, plus a new chapter on rewarding managerial performance. The initial chapter now incorporates a worked example, illustrating the aggregation effect on budget plans, and Chapter 9 likewise provides an appre­ciation of the divisional cost of capital calculation. The present popularity and growing significance of managerial incentive schemes make the inclusion of the new Chapter 10 timely and essential; in many large companies these schemes are an integral part of the management control process. Chapters 11 and 12 concern the com­plexity of operations in the multidivisional company, where recent theoretical and inductive studies relating to divisional autonomy and a 'new' form of performance measure to provide consistency between the short and long term have been added respectively.

The 'Framework for Analysis' in Part Four is extended to address expressly three fundamental aspects in the design of any manage­ment control system, namely what to measure, at what standard of performance and with what associated incentives. Finally, a new chapter in Part Five introduces seven 'tried and tested';' case studies. All are concerned with the management control system in specific organizational settings, although each concentrates on one or more different issues effecting the AIS. Hopefully, these cases will test the relevance, or otherwise, of the concepts introduced earlier in the book.

The intention has been to provide an up-to-date, more broadly based edition which may be used as a 'stand-alone' text. Only the reader can tell us if we have succeeded, and to what degree. Hence, as with the first edition, we welcome comments and criticisms on this the second edition.

,', The Scovill Inc.: Nutone Housing Group, Altex Aviation, HCC and ES Inc. cases are reproduced by kind permission of Harvard Business School and Permaclean Products pie, BBR pie and Beech Paper Company by kind permission of Philip Allan Publishers pie.

Acknow ledgemen ts

This second edition of Accounting ror Management Contral follows and expands the themes contained in the 1985 edition. The colla­boration of Ken Merchant has allowed the introduction of results, action and personnel controls (Chapter 5) to complemcnt and opera­tionalize the behaviour-congrucnce concept. A new chapter on managerial compensation and incentive payments (Chapter 10) has been included, together with seven cases which enable the broad issues of management control systems to be analysed (Chapter 14). All the original chapters have been updated and revised, as have the exercises and questions.

We are indebted to the adoptors of the first edition far their helpful comments and suggestions and trust that this edition goes some way towards satisfying their wishes. In particular, David Cooper, Neil Garrod and Trevor Hopper must be thanked, together with lohn Perrin, our consulting editor, and also the many students who have made helpful comments.

As readers of the first edition will be aware, the preparation period to complcte the manuscript was not without delay. Coordinating the efforts of three co-authors on two continents has stretched the patience of our long-suffering publishers once again. However, the result is an integrated treatment of management contra I embedded in organizational, behavioural and economic theary. Placing manage­ment accounting and accounting information systems in this wider context is, we believe, arewarding exercise, especially when students begin to identify and analyse connections between various issues.

Students at the Universities ofLancaster, Aberystwyth and Glasgow have tested the text and new questions in this edition, and the majority of cases have undergone the strenuous attention of Harvard business graduates. We also thank those who have transformed scribbled thoughts into neat typescript, especially Ruth lohnstone, lacqui Goldthorp and Mareen Cunliffe.

Finally, and by no means last, the continuing effarts and for­bearance of our wives must be acknowledged. Extended release from taxi-driving duties, do-it-yourself repairs and schools liaison has

xvi Acknowledgements

ensured that a certain level of output has been maintained. Again, it seems fitting that we should end by echoing the prayer, attributed to Sir Francis Drake, that 'it is not the beginning, but the continuing thereofuntil it be thoroughly finished, which yieldeth the true glory'.