MANAGEMENT

CONTROL SYSTEMS
Performance Measurement, Evaluation and Incentives
Kenneth A. Merchant & Wim A. Van der Stede

Fourth Edition
MANAGEMENT
CONTROL SYSTEMS
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MANAGEMENT
CONTROL SYSTEMS
Performance Measurement, Evaluation, and Incentives
Kenneth A. Merchant
University of Southern California
Wim A. Van der Stede
London School of Economics
Fourth edition

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A catalogue record for the print edition is available from the British Library

Library of Congress Cataloging-in-Publication Data

Names: Merchant, Kenneth A., author. | Van der Stede, Wim A., author.
Title: Management control systems: performance measurement, evaluation and incentives / Kenneth A. Merchant,
University of Southern California, Wim A. Van der Stede, London School of Economics.
Description: Fourth Edition. | New York: Pearson, [2017] | Revised edition of the authors’ Management control
systems, 2012.
Identifiers: LCCN 2016053625| ISBN 9781292110554 (print) | ISBN 9781292110585 (pdf) |
ISBN 9781292181875 (epub)
Subjects: LCSH: Industrial management. | Cost control. | Managerial accounting. | Performance—Measurement. |
Industrial management—Case studies. | Cost control—Case studies. | Managerial accounting—Case studies.
Classification: LCC HD31 .M3972 2017 | DDC 658—dc23
LC record available at https://lccn.loc.gov/2016053625

10 9 8 7 6 5 4 3 2 1
21 20 19 18 17

Print edition typeset in 9/12, Charter ITC Std Regular by iEnergizer Aptara® Ltd.
Printed by Ashford Colour Press Ltd, Gosport

NOTE THAT ANY PAGE CROSS REFERENCES REFER TO THE PRINT EDITION
 To our families

Gail, Abbidee, Madelyn (KM)

Ashley, Emma, Erin (WVDS)

This page intentionally left blank
 BRIEF CONTENTS

Preface xiii 11 Remedies to the Myopia Problem 448

Acknowledgements xvi 12 Using Financial Results Controls in
the Presence of Uncontrollable Factors 517

SECTION I
The Control Function of Management SECTION V
Corporate Governance, Important
1 Management and Control 3 Control-Related Roles, and Ethics

13 Corporate Governance and Boards

SECTION II of Directors 573
Management Control Alternatives
14 Controllers and Auditors 629
and Their Effects
15 Management Control-Related
Ethical Issues 677
2 Results Controls 33
3 Action, Personnel, and Cultural Controls 86
4 Control System Tightness 128
SECTION VI
Management Control When
5 Control System Costs 173
Financial Results Are Not the Primary
6 Designing and Evaluating Management
Control Systems 221
Consideration

16 Management Control in Not-for-profit

SECTION III Organizations 721
Financial Results Control Systems
Index 761
7 Financial Responsibility Centers 261
8 Planning and Budgeting 297
9 Incentive Systems 353

SECTION IV
Performance Measurement Issues
and Their Effects

10 Financial Performance Measures and

Their Effects 397

vii
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 CONTENTS

Preface xiii Prevention vs. Detection 92

Acknowledgements xvi Conditions determining
the effectiveness of action
controls 93
SECTION I
Personnel controls 95
The Control Function of Management Cultural controls 97
Personnel/cultural controls and
1 Management and Control 3
the control problems 101
Management and control 8 Effectiveness of personnel/cultural
Causes of management control problems 12 controls 101
Characteristics of good management control 15 Conclusion 103
Control problem avoidance 15 Notes 103
Control alternatives 19 Witsky and Associates, Inc. 105
Outline of this text 19 The Platinum Pointe Land Deal 106
Notes 20 EyeOn Pharmaceuticals, Inc. 114
Leo’s Four-Plex Theater 22 Axeon N.V. 121
Wong’s Pharmacy 23
Private Fitness, Inc. 23 4 Control System Tightness 128
Atlanta Home Loan 25
Tight results control 128
Tight action controls 131
SECTION II Tight personnel/cultural controls 137
Management Control Alternatives Conclusion 139
and their Effects Notes 140
Controls at the Bellagio
2 Results Controls 33 Casino Resort 142
Prevalence of results controls 34 PCL: A Breakdown in the Enforcement
Results controls and the control problems 37 of Management Control 168
Elements of results controls 38
Conditions determining the effectiveness 5 Control System Costs 173
of results controls 42
Direct costs 173
Conclusion 46
Indirect costs 174
Notes 46
Adaptation costs 182
Office Solutions, Inc. 48
Conclusion 186
Puente Hills Toyota 58
Notes 187
Kooistra Autogroep 71
Philip Anderson 189
Houston Fearless 76, Inc. 78
Sunshine Fashion: Fraud, Theft,
and Misbehavior among
3 Action, Personnel, and Cultural Employees 190
Controls 86
Better Beauty, Inc. 194
Action controls 86 Fit Food, Inc. 206
Action controls and the control problems 91 Atlantis Chemical Industries 212

ix
Contents

6 Designing and Evaluating Incentive system design 364

Management Control Systems 221 Criteria for evaluating incentive systems 365
Group rewards 370
What is desired and what is likely 221
Conclusion370
Choice of controls 222
Notes371
Choice of control tightness 229
Harwood Medical Instruments PLC 374
Adapting to change 230
Superconductor Technologies, Inc. 375
Keeping a behavioral focus 231
Raven Capital, LLC 384
Maintaining good control 231
Notes 232
Diagnostic Products Corporation 233
Game Shop, Inc. 242 SECTION IV
Family Care Specialists Medical Performance Measurement
Group, Inc. 252 Issues and Their Effects

SECTION III 10 Financial Performance Measures

Financial Results Control Systems and Their Effects 397
Value creation 398
7 Financial Responsibility Centers 261 Market measures of performance 399
Advantages of financial results Accounting measures of performance 401
control systems 261 Investment and operating myopia 404
Types of financial responsibility Return-on-investment measures
centers 262 of performance 406
Choice of financial responsibility centers 267 Residual income measures as a possible
The transfer pricing problem 269 solution to the ROI measurement
Conclusion 274 problems411
Notes 275 Conclusion413
Kranworth Chair Corporation 275 Notes414
Zumwald AG 283 Behavioral Implications of Airline Depreciation
Global Investors, Inc. 285 Accounting Policy Choices 415
Las Ferreterías de México, S.A. de C.V. 417
8 Planning and Budgeting 297 Industrial Electronics, Inc. 421
Haengbok Bancorp 422
Purposes of planning and budgeting 297
Corbridge Industries, Inc. 424
Planning cycles 299
King Engineering Group, Inc. 433
Target setting 301
Berkshire Industries PLC 442
Planning and budgeting practices,
and criticisms 310
Conclusion 312 11 Remedies to the Myopia
Notes 313 Problem 448
Royal Wessanen NV 315
Pressures to act myopically 448
The Stimson Company 323
Reduce pressures for short-term profit 450
Multiple Versions of the Plan 332
Control investments with preaction reviews 451
Vitesse Semiconductor Corporation 333
Extend the measurement horizon
VisuSon, Inc.: Business Stress Testing 342
(use long-term incentives) 453
Measure changes in value directly 455
9 Incentive Systems 353
Improve the accounting measures 455
Purposes of incentives 355 Measure a set of value drivers 456
Monetary incentives 357 Conclusion460

x
 Contents

Notes461 14 Controllers and Auditors 629

Catalytic Solutions, Inc. 462
Controllers 629
Dortmunder-Koppel GmbH 470
Auditors 633
Johansen’s: The New Scorecard
Conclusion639
System 478
Notes640
Mainfreight 488
Don Russell: Experiences of a Controller/CFO 641
Statoil 501
Desktop Solutions, Inc. (A): Audit
of the St. Louis Branch648
12 Using Financial Results Desktop Solutions, Inc. (B): Audit
Controls in the Presence of Operations Group Systems657
of Uncontrollable Factors 517 Andrew G. Scavell, Chief Risk Officer 660
The controllability principle 519
Types of uncontrollable factors 520 15 Management Control-Related
Controlling for the distorting effects Ethical Issues 677
of uncontrollables 522 Good ethical analyses and
Other uncontrollable factor issues 529 their importance 678
Conclusion529 Why do people behave unethically? 682
Notes530 Some common management
Olympic Car Wash 531 control-related ethical issues 684
Beifang Chuang Ye Vehicle Group 532 Spreading good ethics within
Hoffman Discount Drugs, Inc. 534 an organization 689
Howard Building Corporation, Inc. 541 Conclusion691
Bank of the Desert (A)554 Notes692
Bank of the Desert (B)556 Two Budget Targets 694
Fine Harvest Restaurant Group (A)561 Conservative Accounting in the General
Fine Harvest Restaurant Group (B)565 Products Division 694
Education Food Services at Central
Maine State University 695
SECTION V The “Sales Acceleration Program” 697
Corporate Governance, The Expiring Software License 698
Important Control-Related Wired, PLC 699
Roles, and Ethics Mean Screens USA, Inc. 700
Lernout & Hauspie Speech Products 701
Ethics@Cisco 708
13 Corporate Governance
and Boards of Directors 573
Laws and regulations 574 SECTION VI
The Sarbanes-Oxley Act 575 Management Control When Financial
Boards of directors 580 Results Are Not the Primary
Audit committees 583 Consideration
Compensation committees 585
Conclusion 586
16 Management Control in
Notes586
Not-for-profit Organizations 721
Arrow Motorcar Corporation 588
Golden Parachutes? 594 Corporations, B corporations, and
Pacific Sunwear of California, Inc. 598 not-for-profits722
Entropic Communications, Inc. 610 Key differences between for-profit
Bio/Precise Medical Devices, Inc. 625 and not-for-profit organizations 723

xi
Contents

Goal ambiguity and conflict 724 Notes 733

Difficulty in measuring and SCI Ontario: Achieving, Measuring, and
rewarding performance 725 Communicating Strategic Success 735
Accounting differences 727 University of Southern California:
External scrutiny 728 Responsibility Center Management System 746
Employee characteristics 731
Conclusion 731 Index 761

xii
 PREFACE

This text provides materials for a comprehensive course using this material with pre-work experience students
on management control systems (MCSs). MCSs are is that some of the cases might be too challenging. That
defined broadly to include everything managers do to said, there are several suitable candidates to select
help ensure that their organization’s strategies and from among the set of cases at the end of each chapter
plans are carried out or, if conditions warrant, are mod- to tailor to various audiences and/or to achieve various
ified. Thus, the text could also be used in any course course objectives (see also below).
that focuses on topics related to the back end of the This text is different from other MCS texts in a num-
management process, such as strategy implementation ber of important ways. First, the basic organizing
or execution. framework is different. The first major module dis-
Because management control is a core function of cusses management controls based on the object of
management, all students interested in business or control: results, actions, or personnel/culture. The
management can benefit from this text. However, object-of-control framework has considerable advan-
courses based on the materials presented here should tages over other possible organizing frameworks. It has
be particularly useful for those who are, or aspire to be, clean, clearly distinguishable categories. It is also rela-
managers, management consultants, financial special- tively all-inclusive in the sense that the reader can
ists (e.g. controllers, budget analysts, auditors), or relate many management controls and other control
human resource specialists (e.g. personnel directors, classifications and theories (for example, proactive vs.
compensation consultants). reactive controls, prevention vs. detection controls,
This edition includes 70 cases for classroom use. and agency theory concepts such as adverse selection
Case studies that stimulate learning through the analy- and monitoring vs. incentives) to it. It is also intuitive;
sis of complex situations such as those often faced in that is, students can easily see that managers must
the “real world” are generally recognized to be perhaps make choices from among these categories of manage-
the best pedagogical conduit for teaching a MCSs ment control. Thus, using the object-of-control focus,
course. Because MCSs, the contexts in which they oper- the text is structured around a framework that
ate, and the outcomes they produce, are complex and describes the core management control problems that
multidimensional, simple problems and exercises can- need to be addressed, the MCSs that can be used to
not capture the essence of the issues managers face in address those problems, and the outcomes that can be
designing and using MCSs. Students must develop the produced, both positive (intended) and negative (unin-
thinking processes that will guide them successfully tended).
through decision tasks with multiple embedded issues, Second, the treatment of management control is
incomplete information, and large amounts of rela- broad. Like all MCS textbooks, this text focuses inten-
tively unstructured information. They must learn to sively on the use and effects of financial performance
develop problem-finding skills as well as critical think- measures and associated results controls, which are in
ing and problem-solving skills, and they must learn common use at managerial levels in many organizations.
how to articulate and defend their ideas. Case analyses, However, it also provides a broader treatment of manage-
discussions, and presentations provide an effective ment controls (organized around the object-of-control
method for simulating these tasks in a classroom. framework) to put the financial results controls in proper
Although the text was designed primarily for use perspective. For example, the text describes many situa-
with graduate students and practicing professionals, it tions where financial results controls are not effective
can be, and has been, used successfully with under- and discusses the alternatives that managers can use in
graduate students who have had a prior management those situations (such as nonfinancial performance indi-
accounting course. All that should be recognized when cators or greater reliance on stronger cultures).

xiii
Preface

Third, the text provides considerable discussion on coverage of the latest MCS topics and issues, such as
the causes and remedies of the most common and seri- related to stress testing of budgets; mitigating man-
ous management control-related problems, including agement myopia; balancing sustainable value crea-
the implications of issues of uncontrollability on man- tion; motivating ethical behaviors; and using the
ager’s behaviors; the tendency of managers to adopt a EVATM or Balanced Scorecard measurement systems
short-term horizon in their decision-making; and man- or alternative budgeting approaches, just to name a
agers’ and employees’ propensities to engage in distor- few.
tive “gameplaying” evidencing misalignment with ● The cases are descriptive of the operations and
organizational objectives. issues faced by companies located in many different
Fourth, the text provides a whole chapter of ethics countries and regions around the world, including
coverage. There are many management control-related Asia, Europe, Latin America, Oceania, as well as
ethical issues, and both erstwhile and recent scandals North America.
across industries, including the automobile and bank-
ing sectors, but also the public and not-for-profit sec- The cases permit the exploration of the manage-
tors, clearly suggest the need to develop managers’ and ment control issues in a broad range of settings.
prospective managers’ ethical reasoning skills more Included are cases on both large and small firms, man-
fully. Related to this is coverage of corporate govern- ufacturing and service firms, domestic-focused and
ance, to which we also devote a chapter. multinational firms, and for-profit and not-for-profit
Fifth, the important concepts, theories, and issues organizations. The cases present issues faced by per-
are not discussed just in abstract terms. They are illus- sonnel in both line and staff roles at corporate, divi-
trated with a large number of real-world examples, far sional, and functional levels of the organization, as
more than typically included in any other MCS text- well as by members of boards of directors. Instructors
book. The examples make the textual discussion more can use this set of cases to teach a management control
concrete and bring the subject to life. course that is broad in scope or one that is more nar-
Finally, the mix of cases provided here is different rowly focused (for example, MCSs in service organiza-
from those included in other MCS textbooks in four tions by focusing on the cases from the retail, financial,
important ways: healthcare, education and other service sectors).
The cases provide considerable scheduling flexibility.
● Nearly all of the cases are real (that is, they describe
Most of the cases cut across multiple topic areas because
the facts of an actual situation) although some of them
MCSs are inherently multidimensional. For example,
are disguised (that is, they do not use the company’s
the classroom focus for the Statoil case in Chapter 11
real name and/or use scaled figures/data to avoid iden-
might be on performance measurement, as Statoil uses
tification or to protect data confidentiality). The rela-
a key-performance-indicator (KPI) structure that is
tively small number of cases that do not describe the
“balanced scorecard”-like. Or it could be on Statoil’s
(disguised) facts of an actual situation are “vignettes”
planning and budgeting system, which separates the
that are, even so, almost always based on an observed
functions of target setting, forecasting and resource
situation but do not describe all of it. Instead, they
allocation using the principles of “Beyond Budgeting.”
focus on a particular (narrower) issue. Reality (and
To illustrate the latter further or in more depth, Statoil
lack of disguise where possible) enhance student inter-
could be followed (or preceded) by the Mainfreight
est and learning about, for example, types of indus-
case, which offers ample opportunity for students to dis-
tries, companies, and organizational roles.
cuss and critically challenge the idea of beyond budget-
● Most of the cases (except the vignettes) include rich ing. In that context, both cases could be taught related
descriptions of the context within which the MCSs to the subject matter in Chapter 8 on planning and budg-
are operating. The descriptions give students oppor- eting instead of with Chapter 11. Yet, there are still suf-
tunities to try to identify and address management ficient cases listed with Chapter 11 to focus on remedies
control problems and issues within the multidimen- to the myopia problem, such as the new Johansen’s case
sional situations within which practicing managers that describes a retail company that has adopted a bal-
cope with them. anced scorecard-based performance evaluation system.
● Most of the cases are of relatively recent vintage, Students also have to consider the industry characteris-
and the set of cases has been chosen to ensure tics, the organization structure, the characteristics of

xiv
 Preface

the people in key positions, and the company’s history Engineering Group (an ESOP, or “employee stock own-
(e.g. a recent merger), so instructors can choose to use ership plan,” company), or in relevant control-related
the Statoil case, say, when they wish to focus on the roles, such as corporate risk officers (Andrew G. Scav-
effects of one or more of these factors on the design of ell, CRO).
MCSs. As a consequence, the ordering of the cases is not In developing the materials for this fourth edition,
intended to be rigid. Many alternatives are possible. A we have benefited from the insightful comments, help-
case overview sheet in the accompanying Instructors ful suggestions, and cases of many people. Ken owes
Manual to this text provides a matrix that helps instruc- special thanks to the two professors who served as his
tors disentangle the various relevant topics for which mentors at the Harvard Business School: William
each case could be fruitfully used. Bruns and Richard Vancil. Ken also appreciates the
In this fourth edition, we made various updates, valuable research assistance from Michelle Spaulding.
most obviously in those areas where the world has been And Wim is especially grateful to Olivia Hanyue Luo
moving fast during the past few years, particularly for her capable research assistance. At Pearson Educa-
since the 2008–2009 financial crisis and subsequent tion, we are indebted to Commissioning Editors Caitlin
economic recession. This includes changes in incentive Lisle and Rebecca Pedley for their support of this revi-
systems (Chapter 9), cor porate gover nance sion project from start to finish. Finally, Abhishek
(Chapter 13), and also ethics-related concerns Agarwal of Aptara and Matthew Van Atta made very
(Chapter 15). Throughout the text, we incorporated detailed and helpful suggestions in copyediting the
recent research findings and updated the survey statis- manuscript.
tics and examples provided. We also added some new, We thank the Asia Case Research Center at the Uni-
exciting cases. Twenty-one of the 70 cases included in versity of Hong Kong for granting permission to use two
this edition are new, and an additional 12 were revised of their Poon Kam Kai Series cases (PCL and Sunshine
or brought up to date. Some of the new cases cover rela- Fashion). We appreciate Darden Business Publishing’s
tively recent and/or perennially pivotal topics, such as help with their permission for use of the Johansen’s case,
“mobile monitoring” of employees (Witsky and Associ- and we also thank Winnie O’Grady for letting us use the
ates, Inc.); planning and budgeting f lexibility Mainfreight case. Finally, we thank our co-authors on
(Wessanen N.V.); alternatives to traditional budgeting several cases included in this text, the names of whom
(Mainfreight); project management (The Stimson are listed with the cases.
Company); comprehensive multi-criteria performance In closing, we wish to acknowledge that there is cer-
evaluations (Johansen’s); “hands-on” relative perfor- tainly no one best way to convey the rich subjects related
mance evaluations using real-world data (Fine Harvest to MCSs. We have presented one useful framework in
Restaurant Group); as well as crucial ethical considera- the best way we know how, but we welcome comments
tions (Ethics@Cisco). Others were intended to address about the content or organization of the text, or regard-
the topics in new and different settings, such as King ing any errors or omissions. Please direct them to us.

Kenneth A. Merchant Wim A. Van der Stede

Deloitte & Touche LLP Chair of Accountancy CIMA Professor of Accounting and Financial
Leventhal School of Accounting Management
Marshall School of Business London School of Economics
University of Southern California Department of Accounting
Los Angeles, CA 90089-0441 Houghton Street
U.S.A. London WC2A 2AE
U.K.

Phone: (213) 821-5920 Phone: (020) 7955-6695

Fax: (213) 747-2815 Fax: (020) 7955-7420
E-mail: kmerchant@marshall.usc.edu E-mail: w.van-der-stede@lse.ac.uk

xv
 ACKNOWLEDGEMENTS

We are grateful to the following for permission to repro- Times (January 31, 2003), p. B5 (Morin, M.). Extract
duce copyright material: on page 16 from ‘German Regulator Warns Deutsche
Bank on Commodity Trading’, The Financial Times
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Figures 7.1, 7.2, 8.1, 8.2, 8.3, 14.1, and 14.2: from Rights Reserved. Extract on page 17: from ‘Rio Tinto
Modern Management Control Systems: Text and Cases, Shifts to Driverless Trucks in Australia’, The Financial
Prentice Hall (Merchant, K. A. 1998), pp. 308, 309, Times (October 19, 2015), © The Financial Times Lim-
388, 390, 391, 640, and 642, respectively; MER- ited, All Rights Reserved. Extract on page 87: from
CHANT, KENNETH A., MODERN MANAGEMENT ‘Manage Like a Spymaster’, The Economist (August 29,
CONTROL SYSTEMS: TEXT & CASES, 1st Ed., © 1998. 2015), online at econ.st/1U8j8KK, The Economist by
Reprinted and electronically reproduced by permission ECONOMIST NEWSPAPER LTD.; reproduced with per-
of Pearson Education, Inc., New York, NY. mission of ECONOMIST NEWSPAPER LTD. in the for-
mat Educational/Instructional Program via Copyright
Tables Clearance Center. Extract on page 88: from Association
Tables 3.1, 3.2, 3.3, 4.1, 5.1, 6.1, 7.1, 7.2, 9.1, 10.1, 10.2, of Certified Fraud Examiners, 2014, online at www.
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1998), pp. 30, 31, 130, 166, 224, 253, 303, 306, 427, ECONOMIST NEWSPAPER LTD.; reproduced with per-
545, 546, 547, p. 547, and 548, respectively; MER- mission of ECONOMIST NEWSPAPER LTD. in the for-
CHANT, KENNETH A., MODERN MANAGEMENT mat Educational/Instructional Program via Copyright
CONTROL SYSTEMS: TEXT & CASES, 1st Ed., © 1998. Clearance Center. Extract on page 100: from ‘Method
Reprinted and electronically reproduced by permission in the Madness of the Alibaba Cult’, The Financial Times
of Pearson Education, Inc., New York, NY. (September 7, 2014). Extract on page 131: from ‘Tesco
Monitors Employees with Motorola Armbands’,
Text Business Week (February 13, 2013), online at www.
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All Rights Reserved. Extracts on pages 5 and 6: from Fraud and Abuse 2014 Global Fraud Study, Association
‘Atlanta’s Schools – the Reckoning’, The Economist of Certified Fraud Examiners, 2014, online at www.
(April 6, 2013), online at www.economist.com. Extract acfe.com/rttn/docs/2014 -report-to-nations.pdf.
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on page 6: from ‘Scathing Report Says Toshiba CEOs futurethink, author of Why Simple Wins. Case Study on
Had Role in Accounting Scandal‘, The Financial Times page 183: This case was prepared by Grace Loo (Lao)
(July 20, 2015), © The Financial Times Limited, All under the supervision of Professor Neale O’Connor,
Rights Reserved. Extract on page 6: from ‘Deutsche Copyright © by The Asia Case Research Centre, The
Bank in $6bn “Fat Finger” Slip-Up’, The Financial Times University of Hong Kong. Extract on page 188: from
(October 19, 2015), © The Financial Times Limited, ‘CFO Insights: Can Internal Audit Be a Command
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Accused of INS Shredding Spree’, The Los Angeles tt/1OidCMB. Extract on page 189: from ‘Banks Increase

xvi
 Acknowledgements

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ing Problems Not So Funny’, The Economist (October 27, on page 439 and 497: from ‘Top Managers’ Pay Reveals
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mat Educational/Instructional Program via Copyright Limited, All Rights Reserved. Extract on page 489:
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Grace Loo under the supervision of Professor Neale Financial Times (January 27, 2015), online at on.ft.
O’Connor, Copyright © by The Asia Case Research com/1FmAXiS, © The Financial Times Limited, All
Centre, The University of Hong Kong. Extract on page Rights Reserved. Extract on page 489: from ‘HSBC Suf-
238: from ‘How Corporate Culture Affects the Bottom fers 20% Fall in Profits’, The Financial Times (May 7,
Line’, Duke’s Fuqua School of Business News Release 2014), online at on.ft.com/1FmAXiS, © The Financial
(November 12, 2015), online at www.fuqua.duke.edu/ Times Limited, All Rights Reserved. Extracts on page
news_events/news-releases/corporate-culture; and 491 and 712: from ‘Christine Lagarde Calls for Shake-
Corporate Culture: Evidence from the Field, online at up of Bankers’ Pay’, The Financial Times (May 6, 2015),
https://papers.ssrn.com/sol3/papers.cfm?abstract_ online at on.ft.com/1FmAXiS, © The Financial Times
id=2805602. Extract on page 238: from ‘VW Needs Limited, All Rights Reserved. Extract on page 491:
More Therapy to Change Its Flawed Mindset’, The from ‘Fidelity Challenges Companies on Long-term
Financial Times (December 14, 2015), online Incentives’, The Financial Times (September 22, 2013),
at on.ft.com/1FmAXiS, © The Financial Times Lim- online on.ft.com/1FmAXiS, © The Financial Times
ited, All Rights Reserved. Extract on page 240: from Limited, All Rights Reserved. Case Study on page 516:
‘Will the Affordable Care Act Affect Doctors? Yes’, The Copyright 2016 by the University of Virginia Darden
Heritage Foundation (June 26, 2013), online at www. School Foundation, Charlottesville, VA; All Rights
heritage.org (Moffit, R. E., PhD). Extract on page 326: Reserved. Case Study on page 526: Copyright © Win-
from ‘The Quantified Serf’, The Economist (March 7, nie O’Grady; All Rights Reserved. Extract on page 669:
2015), The Economist by ECONOMIST NEWSPAPER from ‘New Code of Conduct for Internal Auditors’, The
LTD., reproduced with permission of ECONOMIST Financial Times (September 9, 2012), online at on.ft.
NEWSPAPER LTD. in the format Educational/Instruc- com/1FmAXiS, © The Financial Times Limited, All
tional Program via Copyright Clearance Center. Extract Rights Reserved. Extract on page 712: from ‘A Bigger
on page 340: from ‘Integrated Performance Manage- Stick’, The Economist (June 13, 2015), online at econ.
ment: Plan. Budget. Forecast’, Deloitte (2014), online at st/1MsDNRB, The Economist by ECONOMIST NEWS-
www.planbudgetforecast.com. Extract on page 392: PAPER LTD., reproduced with permission of ECONO-
from ‘Executives Ask: How and Why Should Firms and MIST NEWSPAPER LTD. in the format Educational/
Their Employees Set Goals’, Academy of Management Instructional Program via Copyright Clearance Center.
Executive, 18, no. 4 (November 2004), pp. 122–3 (Kerr, Extract on page 722: from ‘Credit Suisse Spooked by
S. 2004). Extract on page 406: from ‘Bonuses and the What Lurks Within’, The Financial Times (March 25,
Illusion of Banking Performance’, The Financial Times 2016), online at on.ft.com/1FmAXiS, © The Financial
(November 25, 2015), online at on.ft.com/1FmAXiS, Times Limited, All Rights Reserved. Extract on page
© The Financial Times Limited, All Rights Reserved. 738: adapted from ‘Tech Firm’s Korean Growth Raises
Extract on page 408: from ‘Small Chinese Cities Steer Eyebrows’, The Wall Street Journal (August 8, 2000), p.
Away from GDP as Measure of Success’, The Financial C1 (Maremont, M., Eisinger, J. and Song, M.), reprinted
Times (August 13, 2014), online at on.ft.com/1FmAXiS. with permission of The Wall Street Journal, Copyright
Extract on page 408: from ‘Bonuses Are Bad for Bankers © 2000 Dow Jones & Company, Inc., All Rights

xvii
Acknowledgements

Reserved Worldwide, License numbers 4032150712139 Street Journal, Copyright © 2015 Dow Jones & Com-
and 4032150524598. Extract on page 755: from ‘Sus- pany, Inc., All Rights Reserved Worldwide, License num-
tainability Matters, but What Does It Mean for Your bers 4032140775190 and 4032140995347. Case Study on
Company?’ NACD Directorship (July 30, 2015), online at page 769: from Bendle, N., copyright 2014, Richard Ivey
w w w . n a c d o n l i n e . o r g / M a g a z i n e /A r t i c l e . School of Business Foundation; Ivey Publishing, Ivey
cfm?ItemNumber=17504. Extract on page 760: from Business School, Western University, London, Ontario,
‘Debate Heightens over Measuring Health Care Quality’, Canada, N6G 0N1, cases@ivey.ca, www.iveycases.com;
The Wall Street Journal (January 30, 2015), online at on. one-time permission to reproduce granted by Richard
wsj.com/1EvciGo, reprinted with permission of The Wall Ivey School of Business Foundation on January 11, 2017.

xviii
SECTION I
The Control Function
of Management

1
This page intentionally left blank
CHAPTER 1
Management and Control

Management control is a critical function in organizations. Management control failures can

lead to large financial losses, reputation damage, and possibly even organizational failure. To
illustrate this, let us start with some examples in the fi nancial services sector that, since the
fi nancial crisis have been beset by a raft of control failures related to rusty information sys-
tems;1 misconduct related to misselling fi nancial services such as pay-protection insurance
stemming from aggressive sales-based tactics;2 allegations that fi nancial services companies
helped their clients evade taxes;3 manipulation of interest rates, such as the venerable LIBOR
(the benchmark inter-bank rate that is used to calculate interest rates on major financial trans-
actions throughout the world);4 faults in internal controls surrounding the reporting of com-
modity prices by banks’ trading desks; more isolated but crippling unauthorized “rogue
trades”;5 and anti-money-laundering violations,6 just to name the most striking ones.
To provide some more detail about one particular case to demonstrate its relevance to man-
agement control systems (MCSs) and the significant risks when they fail, the Financial Services
Authority (FSA) fined UBS, a Swiss-based global bank, £29.7 million (discounted from
£42.4 million for early settlement) for systems and controls failings that allowed an employee
(Kweku Adoboli) to cause substantial losses totaling US$2.3 billion as a result of unauthorized
trading. In particular, UBS’ failings included the following:7

● The computerized system operated by UBS to assist in risk management was not effective in
controlling the risk of unauthorized trading.
● The trade capture and processing system had significant deficiencies, which Adoboli
exploited in order to conceal his unauthorized trading. The system allowed trades to be
booked to an internal counterparty without sufficient details, there were no effective meth-
ods in place to detect trades at material off-market prices, and there was a lack of integration
between systems.
● There was an understanding amongst personnel supporting the trading desk that the opera-
tions division’s main role was that of facilitation. They focused mainly on efficiency as
opposed to risk control, and they did not adequately challenge the front office.
● There was inadequate front office supervision. The supervision arrangements were poorly
executed and ineffective.
● The trading desk breached the risk limits set for their desk without being disciplined for
doing so. These limits represented a key control and defined the maximum level of risk that
the desk could enter into at a given time. This created a situation in which risk taking was not
actively discouraged or penalized by those with supervisory responsibility.
Chapter 1 • Management and Control

● Failing to investigate the underlying reasons for the substantial increase in profitability of
the desk despite the fact that this could not be explained by reference to the end-of-day risk
positions.
● Profit and loss suspensions to the value of $1.6 billion were requested by Adoboli, and these
were accepted without challenge or escalation. The combined factors of unexplained profit-
ability and loss suspensions should have indicated the need for greater scrutiny.

The FSA report concluded that these failings were particularly serious because:8

● Market confidence was put at risk, given the sudden announcement to the market and size of
the losses announced. Negative announcements, such as this, put at risk the confidence
which investors have in financial markets.
● The systems and controls failings revealed serious weaknesses in the firm’s procedures,
management systems and internal controls.
● The failings enabled Adoboli to commit financial crime.

Global regulators have similarly exposed flaws in banks’ internal control systems that
allowed traders to manipulate interest rates, such as LIBOR, around the world.9 To add, Stuart
Gulliver, the chief executive of HSBC, the largest financial institution in Europe, admitted that
“our anti-money-laundering controls should have been stronger and more effective, and we
failed to spot and deal with unacceptable behavior.”10
The press headlines to which these examples are selectively referenced speak for themselves.
Of course, not all banks have been entangled in each and every issue. However, that the list of
those being caught in these nets has been so long, sparing few, is surprising for organizations
whose reputations are among their most valuable assets. Failures of this type and magnitude
also damage the integrity of the wider market and financial system on a global scale. But these
failures have also been costly money-wise, where the wave of fines and lawsuits that has swept
through the financial sector since the financial crisis has cost big banks a whopping $260 bil-
lion, according to research from Morgan Stanley. The report also suggests that “actions taken
by banks to prevent future litigation issues include everything from changing remuneration
[compensation] policies [which we discuss under the rubric of results controls in Chapter 2 and
incentive systems in Chapter 9] to a greater focus on ‘non-financial metrics’ [Chapter 11], adding
compliance staff [Chapters 3 and 14], to elevating chief risk officers to boards [Chapter 13] and
using ‘robo-surveillance’ in trading rooms [a form of action controls which we discuss in Chap-
ter 3]” (brackets added).11 Clearly, the issues illustrated here touch on, and cut across, many of
the issues we discuss in this text.
To add, though, here is a quote from a Financial Times columnist that builds nicely on the
above but extends it to other sectors:

It turns out that bankers may not be alone. The traders who rigged Libor and foreign
exchange rates cheated clients out of money. Volkswagen, we now know, deliberately
polluted our air. The carmaker had a choice: install additional emissions cleaning equip-
ment; admit that its diesel cars were not very fuel efficient; or spew out illegal amounts of
nitrogen oxide. It chose the last of these options, and covered it up by designing soft-
ware to deceive the US regulators. […] This round-the-world tour of fraud also takes in
Toshiba. The nuclear-to-semiconductor conglomerate was hit by a record fine from
Japan’s stock exchange and ordered to improve its governance and internal controls, in
the wake of a $2bn accounting scandal. […] Not even the tech industry has proved
immune. European researchers revealed this week that Google has been charging adver-
tisers for having their ads seen on YouTube, even when fraud-detection systems discover
that the ‘viewer’ is a robot. That practice is clearly not in the same league as rate-rigging,

4
 Management and Control

years of accounting fraud or emission test deceit. But the disclosure reinforces a grow-
ing sense that companies around the world are pushing ethical boundaries [which we
discuss in Chapter 15].12

Another article commented that the issues at VW were predictable because of VW’s lax board-
room controls (which we discuss in Chapter 13) and its peculiar corporate culture (Chapter 3):
“The scandal clearly also has to do with structural issues at VW … There have been warnings
about VW’s corporate governance for years, but they didn’t take it to heart and now you see the
result,” says Alexander Juschus, director at IVOX, the German proxy adviser.13
Effective cultures, structures, and controls are quintessential as the above examples suggest,
but not only in the for-profit sector, as the next example illustrates (we discuss non-profit organ-
izations in Chapter 16). Consider the case of an award-winning teacher who at the time headed
Atlanta’s public schools, and who had been praised by the American Association of School
Administrators for the significant gains in student achievement she had overseen, where Atlan-
ta’s schoolchildren made sizable gains on the standardized tests used to determine yearly pro-
gress. At one school, for instance, the share of 13-year-olds who passed the test’s maths section
rose from 24% to 86%, and the share of those who “exceeded expectations” rose from 1% to
46% – both in a single year. However,

[…] the state of Georgia alleges that those remarkable leaps rested on neither pedagogy
nor determined study, but something far more invidious: cheating. A report by a special
investigative team […] found widespread evidence of cheating […]. Sometimes teachers
gave pupils the correct answers. Sometimes they erased pupils’ answers after the test and
filled in the correct ones themselves. The investigative team ferreted out cheating by ana-
lyzing erasure marks on test sheets. They flagged classrooms with an average number of
wrong-to-right erasures more than three standard deviations above the state average. The
chance of that occurring randomly is one in 370. More than half of Atlanta’s elementary and
middle schools had such classrooms, and many had erasures more than 20 to 50 standard
deviations above the norm. Of the 178 teachers accused of having taken part in the cheat-
ing, 82 confessed. [The head], said the report, either knew or should have known what was
going on. […] Prosecutors did not charge [the head] with taking part in the cheating, but
with putting “unreasonable pressure” on principals and teachers to do well, and for creat-
ing “an environment where achieving the desired end result was more important than the
students’ education.”14

This is an example of results controls (Chapter 2) and, clearly, not only the functional but also the
behavioral displacements that they can create (Chapters 5 and 11), in part due to target pressure
(Chapter 8), but also employees’ and organizations’ moral failures (Chapters 3 and 15).
Excessive target pressure was also identified as a culprit in the accounting scandal at Toshiba
that was mentioned in passing earlier:

In April 2015, an improper accounting scandal came to light that inflated profits by well
over $1bn at Toshiba, the Japanese industrial conglomerate, which makes laptops, mem-
ory chips and nuclear reactors. A panel of external lawyers and accountants that was
appointed to investigate was said to have uncovered emails showing that Hisao Tanaka,
chief executive, and Norio Sasaki, former chief executive and then vice-chairman,
“instructed employees to delay the booking of costs to make the financial figures look bet-
ter” […] and that “the problems were worsened by reporting procedures for projects that
were time-consuming and old-fashioned. Some of the paperwork was being done by junior
employees in their first few years at the company.” Experts further commented that “the
accounting issues at Toshiba also exposed concerns around Japanese corporate govern-
ance practices [which we discuss in Chapter 13], including the weak role of external

5
Chapter 1 • Management and Control

directors and the extensive power that many former chief executives continue to exer-
cise.”15 The scathing panel report also detailed what it said “were ‘institutional’ accounting
malpractices [Chapter 5] and a corporate culture [Chapter 3] in which employees were
afraid to speak out against bosses’ push for increasingly unachievable profits [Chapter 8].
[…] Pressures to meet aggressive, short-term profit targets [Chapter 11] – known as ‘the
challenge’ – existed from the presidency of Atsutoshi Nishida, who headed the company
from 2005 to 2009 and remained an adviser. Those pressures escalated as the company’s
earnings deteriorated in the wake of the global financial crisis and […] the Fukushima
nuclear accident. The panel declared that Mr. Tanaka and Mr. Sasaki were aware that prof-
its were being inflated and did not take any action to end the improper accounting. In some
instances, the report added, top executives pressured employees to achieve their targets
with suggestions that the company may withdraw from underperforming businesses if they
were not met. But the panel found no evidence any of the three current and former chief
executives had given specific instructions to division chiefs to inflate profit figures.”16 They
described a corporate culture – one of exerting pressure on employees to meet aggres-
sive, short-term profit targets spanning three generations of chief executives – in which
employees were afraid to speak out against bosses when they pushed for unrealistic earn-
ings targets.17

The consequences of failures of organizational control (which we define more precisely in

the later sections of this chapter) can reach far and wide beyond the organizations in which
they take place. As mentioned above, the banking failures have undermined the integrity of the
wider market and financial system on a global scale. But there are other major impacts:

Shareholders and customers are obvious victims of the current flood of bad news. They
are seeing their investments shrink, having their cars recalled and paying too much for
goods and services. But there is another set of losers: the employees and shareholders of
the companies that try to play fair. Back in the early 2000s, a company called WorldCom
upended the telecommunications industry by repeatedly posting profit margins that its
rivals simply could not match. Five big groups, including AT&T, responded by slashing
about 5 per cent of their combined workforces – more than 20,000 jobs. In 2002, WorldCom
was exposed as the US’s largest accounting fraud and its chief executive sentenced to jail.
However, the employees who were laid off at rival companies did not get their jobs back.18

And in the case of Atlanta’s schools:

[…] the scandal’s real casualties are Atlanta’s schoolchildren. Schools that cheated their
way to false improvements lost federal funds which could have been used to make actual
improvements. Because of their apparently high test scores, struggling pupils were denied
the help they needed and deserved. A generation of Atlanta’s students have, in fact, been
left behind.19

We discuss these impacts in the light of organizations’ corporate social responsibility and their
concerns about sustainability and the wider stakeholder communities in Chapter 16.
Not all control failures are as consequential, or of similar magnitude, as the examples listed
above; yet they can, and do, inflict costs and/or embarrassment. For example,

[…] this happened when Deutsche Bank paid $6 billion to a hedge fund client by mistake in
a ‘fat finger’ trade, where a junior member of the bank’s forex sales team, while his boss
was on holiday, processed a gross value instead of a net value, meaning that the trade had
‘too many zeroes’. Whereas the bank recovered the money from the U.S. hedge fund the
next day, the incident was “an embarrassing blow to the bank” and it also “raised fresh
questions about Deutsche’s operational controls and risk management.” The $6bn error

6
 Management and Control

also raised questions about why it was not spotted under the bank’s ‘four eyes principle’
[an action control discussed in Chapter 3], requiring every trade to be reviewed by another
person before being processed.20

Other examples of this type also occur in the public sector and do not always involve money
being inadvertently wired. This happened at the Bank of England (BoE), where its head of press
mistakenly sent an email to the media revealing that officials were quietly researching the
impact of Britain’s exit from the European Union, a major blunder given the secrecy of this
study. What had caused this mistake? The “auto-complete” tool in BoE’s internal email service.
The BoE confirmed that following this incident, it had switched off auto-complete from its email
system – that is, staff now have to write the full name of the recipient of their email messages
rather than being automatically proposed through the Outlook auto-complete functionality –
“to preserve the security of its data.”21
Employees do not always have to steal or engage in fraudulent activities to cause harm.
Sometimes it suffices to just “fall asleep.” This happened when a bank teller was making a pay-
ment of €64.20, but as he fell asleep, he left his finger on the number 2 key, accidentally putting
through a payment of €22,222,222.22. The payment almost went through when the supervisor
who was supposed to be looking out for such mistakes allegedly failed to notice and approved
the transaction. The mistake was spotted only by another colleague who managed to correct it
before it was too late.22 As we will see, this is an example of a rather simple internal control
procedure. We discuss internal controls as one type of what we call action controls in Chapter 3,
and we discuss how tightly they should be applied in Chapter 4. The example further illustrates
that not every control problem involves fraud, yet adequate control systems must also be able to
prevent mistakes. Furthermore, when there are irregularities or control breaches, money or
incentives like bonuses are not always the motive for the wrongdoing. For example,

[…] two clerical workers at the Laguna Niguel, California-based service center of the U.S.
Immigration and Naturalization Service (INS) were accused of destroying thousands of
immigration documents, including visa applications, passports, and other papers. Accord-
ing to the probe, the clerks started shredding unprocessed paperwork after an inventory
revealed a processing backlog of about 90,000 documents. A month later, the backlog was
reported to be zero. The shredding allegedly went on for about another month to keep the
backlog at zero, until INS officials discovered the shredding spree during an evening
shift.23

Although it is not entirely clear what the clerks’ motives were, there were no bonuses
involved here, and maybe they were concerned about keeping their job and/or also not doing
their job well or being lazy and cutting corners. Nonetheless, their actions were completely
inappropriate, and thus proper control systems are needed to mitigate such undesirable
behaviors.
However, more controls should not always be equated with better controls. When copious
MCSs are stifling, they can exacerbate rather than mitigate control problems. We discuss this
further in Chapters 4 and 5, where we consider not only direct, explicit, more easily quantifia-
ble, out-of-pocket costs, but also various types of indirect, implicit costs of tightening the con-
trols. For example, when financial irregularities were discovered at Eurostat, the European
Commission’s statistical service, it was not immediately clear whether these had occurred for
the personal enrichment of those involved; instead, some argued that the “secret accounts” may
at least initially have been set up to give Eurostat a way to pay for research quickly without
going through the Commission’s cumbersome procedures. Ironically, then, while the Commis-
sion had elaborate procedures to prevent financial fraud, these procedures may not only have
proved insufficient (because they clearly could be circumvented), they may actually have made

7
Chapter 1 • Management and Control

the problem worse. Because tortuous form-filling was required to request funds, requesters had
to jump through a number of bureaucratic hoops to get anything approved, and funds delivery
was notoriously slow, commission officials and staff may have taken to cutting corners and find-
ing “creative” ways to expedite the process. Of course, these “work-arounds” should be a red
flag for possible exploitation and potential improprieties, too.24
By this point, it should be no surprise that we are claiming, but also that it is widely accepted,
that good MCSs are important. Comparing the books and articles written on management con-
trol is difficult, however, because much of the MCS language is imprecise. The term “control” as
it applies to a management function does not have a universally accepted definition. An old, nar-
row view of a MCS is that of a simple cybernetic or regulating system involving a single feedback
loop analogous to a thermostat that measures the temperature, compares the measurement with
the desired standard, and, if necessary, takes a corrective action (turn on, or off, a furnace or air
conditioner). In a MCS feedback loop, managers measure performance, compare that measure-
ment with a pre-set performance standard, and, if necessary, take corrective actions.25
In this text, however, we take a broader view. Many management controls in common use,
such as direct supervision, employee selection and retention, and codes of conduct, do not
focus on measured performance. They focus instead on encouraging, enabling, or sometimes
forcing employees to act in the organization’s best interest. This is consistent with the observa-
tion that all the above examples have one key question in common: how can organizations of
all types ensure that their employees up and down the hierarchy carry out their jobs and
responsibilities properly? Moreover, some management controls are proactive rather than
reactive. Proactive means that the controls are designed to prevent problems before the organi-
zation suffers any adverse effects on performance. Examples of proactive controls include
planning processes, required expenditure approvals, segregation of duties, and restricted
access. Management control, then, includes all the devices or systems that managers use to
ensure the behaviors and decisions of their employees are consistent with the organization’s
objectives and strategies. The systems themselves are commonly referred to as management
control systems (MCSs).
Designed properly, MCSs influence employees’ behaviors in desirable ways and, conse-
quently, increase the probability that the organization will achieve its goals. Thus, the primary
function of management control is to influence behaviors in desirable ways. The benefit of man-
agement control is the increased probability that the organization’s objectives will be achieved.

Management and control

Management control is the back end of the management process. This can be seen from the
various ways in which the broad topic of management is disaggregated.

Management
The literature includes many definitions of management. All relate to the processes of organiz-
ing resources and directing activities for the purpose of achieving organizational objectives.
Inevitably, those who study and teach management have broken the broad subject into smaller,
more discernable elements. Table 1.1 shows the most prominent classification schemes. The
first column identifies the primary management functions of the value chain: product or service
development, operations (manufacturing products or performing/delivering services), market-
ing/sales (finding buyers and making sure the products and services fulfill customer needs),
and finance (raising money). Virtually every management school offers courses focused on only
one, or only part of one, of these primary management functions.

8
 Management and control

Table 1.1 Different ways of categorizing the broad area of management

Functions Resources Processes

Product (or service) development People Objective setting

Operations Money Strategy formulation

Marketing/sales Machines Management control

Finance Information

Source: K. A. Merchant, Modern Management Control Systems: Text and Cases (Upper Saddle River, NJ: Prentice Hall, 1998), p. 3.

The second column of Table 1.1 identifies the major types of resources with which managers
must work: people, money, machines, and information. Management schools also offer courses
organized using this classification. These courses are often called human resource manage-
ment, accounting and finance, production and operations management, and information sys-
tems, respectively. These are sometimes also referred to as the support management functions. 26
The term management control appears in the third column of Table 1.1, which separates the man-
agement functions along a process involving objective setting, strategy formulation, and manage-
ment control. Control, then, is the back end of the management process. The way we use the term
management control in this text has the same meaning as the terms execution and strategy imple-
mentation. In most organizations, focusing on improving MCSs will provide higher payoffs than
will focusing on improving strategy. A Fortune study showed that 7 out of 10 CEOs who fail do so not
because of bad strategy, but because of bad execution.27 The above examples reinforce this, too.
Many management courses, including business policy, strategic management, and manage-
ment control systems, focus on elements of the management process. To focus on the control
function of management, we must distinguish it from objective setting and strategy formulation.

Objective setting
Knowledge of objectives is a prerequisite for the design of any MCS and, indeed, for any pur-
poseful activities. Objectives do not have to be quantified and do not have to be financial,
although that is how they are commonly thought of in for-profit organizations. A not-for-
profit organization’s primary objective might be to provide shelter for homeless people, for
example; but even in these organizations, there have been calls to express the achievement
of these objectives in financial or quasi-financial terms, such as social return on invest-
ment. 28 However, many for-profit organizations also have nonfinancial objectives, such as
related to sustainability or personnel development and well-being (see Chapter 16). In any
organization, however, employees must have a basic understanding of what the organiza-
tion is trying to accomplish. Otherwise, no one could claim that any of the employees’ actions
are purposive, and no one could ever support a claim that the organization was successful.
In most organizations, the objectives are known. That is not to say that all employees always
agree unanimously as to how to balance their organizations’ responsibilities to all of their
stakeholders, including owners (equity holders), debtholders, employees, suppliers, customers,
and the society at large. They rarely do.29 That said, organizations develop explicit or implicit
compromise mechanisms to resolve conflicts among stakeholders and reach some level of
agreement about the objectives they will pursue. As Jason Luckhurst, managing director of
Practicus, a UK-based project-management recruitment firm, argues:

[To achieve organizational success], it takes a clear vision around which the entire busi-
ness [can] be designed, [and I] think it is something you should be able to communicate

9
Chapter 1 • Management and Control

simply to everyone, whether a client or [an employee]. Having a simple and easily under-
stood statement of intent is vital for setting clear objectives and targets.30

Strategy formulation
Having set the firm’s strategic intentions or objectives, strategies then define how organizations
should use their resources to meet these objectives. A well-conceived strategy guides employees
in successfully pursuing their organization’s objectives; it conveys to employees what they are
supposed to be doing. Or, as Mr. Luckhurst at Practicus states:

All the planning in areas as diverse as marketing, branding, financing and training, is
designed around [our] objective – as are [our] incentive [systems]. We have a detailed road
map, but it starts with a simple vision that everyone can understand and buy into. Every-
thing else we do comes on the back of those goals. In effect, we can reverse-engineer the
business to those objectives.31

Many organizations develop formal strategies through systematic, often elaborate, planning
processes (which we discuss further in Chapter 8). Put differently, they have what can be called
an intended strategy. However, strategies can sometimes be left largely unspecified. As such,
some organizations do not have formal, written strategies; instead they try to respond to oppor-
tunities that present themselves. Major elements of these organizations’ strategies emerge from
a series of interactions between management, employees, and the environment; from decisions
made spontaneously; and from local experimentation designed to learn what works well. None-
theless, if some decision-making consistency exists, a strategy can be said to have been formed,
regardless of whether managers planned or even intended that particular consistency. In that
sense, strategic visions sometimes come about through dynamic organizational processes
rather than through formalized strategic planning.32
Not even the most elaborate strategic visions and statements are complete to the point where
they detail every desired action and contemplate every possible contingency. However, for pur-
poses of designing MCSs, it is useful to have strategies that are as specific and detailed as pos-
sible, if those strategies can be kept current. The formal strategic statements make it easier for
management both to identify the feasible management control alternatives and to implement
them effectively. The management controls can be targeted to the organization’s critical success
factors, such as developing new products, keeping costs down, or growing market share, rather
than aiming more generally at improving profitability in otherwise largely unspecified ways.
Formal strategic statements are not a sufficient condition for success, however. As Adrian
Grace, managing director of Bank of Scotland – Corporate, states:

I have seen businesses with 400-page documents outlining their strategy and it’s clear
they should have spent less time outlining the vision and more time thinking about how
they will deliver on it. You can have the best vision in the world but if you can’t put it into
effect, you are wasting your time.33

It is on the execution side of the management process that MCSs play a critical role. Jason
Luckhurst explained:

The difference between merely having a strategic vision and achieving strategic success is
having a detailed understanding of what that vision means for every level of the business –
how much funding you need, the branding and marketing strategy, which channels you will
develop, how many people you need in which areas and when and what the organizational
structure will be. It is also important to revisit the vision often and be aware of how close
you are to achieving it at any given stage. This helps everyone in the company to stay
focused.34

10
 Management and control

Management control
Management control focuses on execution, and it involves addressing the general question: Are
our employees likely to behave appropriately? This question can be decomposed into several
parts:

● First, do our employees understand what we expect of them?

● Second, will they work consistently hard and try to do what is expected of them – that is, will
they pursue the organization’s objectives in line with the strategy?
● Third, are they capable of doing a good job?

Finally, if the answer to any of these questions is negative, what can be done to solve the man-
agement control problems? All organizations who must rely on their employees to accomplish
organizational objectives must deal with these basic management control issues. Addressing
management control issues, therefore, involves reflecting on how to influence, direct, or align
employees’ behaviors toward the achievement of organizational objectives consistent with the
espoused strategy.
From a management control perspective, strategies should be viewed as useful but not
absolutely necessary to the proper design of MCSs. When strategies are formulated more
clearly, more control alternatives become feasible, and it becomes easier to implement each
form of management control effectively. Managers can, however, design and operate some
types of MCSs without having a clear strategy in mind. As Adrian Grace, managing director
of Bank of Scotland – Corporate, proffers: “If you don’t have [a strategy] but you know how to
deliver, you might still make it. Success in business is 25% strategy but 75% execution.” 35
Or, the other way around, to devise a strategy and write it down is one thing; it is another
thing entirely to make the plan work in practice. That said, there is some evidence that
organizations with formal systems for managing the execution of strategy outperform those
that do not. 36

Behavioral emphasis
Management control involves managers taking steps to help ensure that the employees do what
is best for the organization. This is an important purpose because it is people in the organiza-
tion who make things happen. Management controls are necessary to guard against the possi-
bilities that people will do something the organization does not want them to do, or fail to do
something they should do. For example, aiming to achieve greater cost control is open to ques-
tion without reference to people because costs do not control themselves; people control them.
As many examples throughout the text will illustrate, employees can work against or around
systems, thereby leaving many objectives unmet or producing unintended consequences.
This behavioral orientation has long been recognized by practitioners. For example, Roman
Stanek, chief executive of GoodData in San Francisco, a business analytics company, acknowl-
edged that:

Having a vision and having confidence doesn’t mean anything unless you’re able to com-
municate it to your team […]. The ability to communicate well didn’t come easily for me. I
always assumed that everybody would see things the same way I see them, and now I
understand it takes a lot of time to get people aligned.37

If all employees could always be relied on to do what is best for the organization, there would be
no need for a MCS. But employees are sometimes unable or unwilling to act in the organization’s
best interest, so managers must take steps to guard against the occurrence of undesirable
behaviors and encourage desirable behaviors.

11
Chapter 1 • Management and Control

Causes of management control problems

Given the behavioral focus of controls, the next logical question to ask is: What is it about the
employees on whom the organization must rely that creates the need to implement MCSs? The
causes of the needs for control can be classified into three main categories: lack of direction,
motivational problems, and personal limitations.

Lack of direction
Some employees perform inadequately simply because they do not know what the organiza-
tion wants from them. When this lack of direction occurs, the likelihood of the desired behav-
iors occurring will be haphazard or random. Thus, one function of management control
involves informing employees as to how they can direct their contributions to the fulfillment
of organizational objectives. Indeed, this is also the key point that came through in the quote
from Stanek above.
Lack of direction is not a trivial issue in many organizations, although it is often taken for
granted (as the quote from Stanek also suggests). For example, survey evidence collected by
KPMG, a big-four professional services company providing audit, tax, and advisory services,
from approximately 4,000 US employees spanning all levels of job responsibility across a wide
range of industries and organizational sizes revealed that 55% of the sample respondents had a
lack of understanding of the standards that apply to their jobs. 38 Moreover, a study of 414
World-at-Work members in mostly managerial positions at large North-American companies
suggested that 81% of the respondents believe that senior managers in their organizations
understand the value drivers of their business strategy; 46% say that middle management
understands these drivers; but just 13% believe non-management employees understand them.
This indicates that organizational goals are not cascading down to all levels in the organization.
And while 79% of the respondents in this study believed that their employees’ goals are aligned
with organizational goals, 44% also stated that employees set goals based on their own views
rather than direction from leadership.39
Another survey from KPMG asked what factors might cause managers and employees to
engage in misconduct, which, as we will see across several chapters in this text, is an impor-
tant management control problem. The answer, in fifth place and mentioned by 59% of the
respondents, was “a lack of understanding of the standards that apply to their jobs.”40 Another
survey of 5,000 respondents, including “techies” (e.g. software developers or engineers), indi-
cated that only 28% of the techies said they understood their companies’ vision compared with
(also only) 43% of non-techies.41 And, in a university one of the authors of this text is familiar
with, a staff survey revealed that only half of the employees responded affirmatively to the
question whether “they had a clear understanding of the purpose and objectives of [the univer-
sity],” whereas (also only) 68% said this to be the case for the objectives of their department.42
All told, then, it should not be taken for granted that employees have a clear understanding of
direction. To the contrary, the survey evidence suggests that a lack of direction may be quite a
common occurrence.

Motivational problems
Even if employees understand what is expected of them, some do not perform as the organi­
zation expects because of motivational problems. Motivational problems are common
because individual and organizational objectives do not naturally coincide – individuals are
self-interested.

12
 Causes of management control problems

Employees sometimes act in their own personal interest at the expense of their organiza-
tion’s interest. Frederick Taylor, one of the major figures in the scientific management movement
that took place in the early twentieth century, wrote: “Hardly a competent worker can be found
who does not devote a considerable amount of time to studying just how slowly he can work and
still convince his employer that he is going at a good pace.”43 Such effort aversion and other self-
interested behaviors are still a problem today. Gary Gill, the author of KPMG’s Fraud Barometer
for Australia, believes that broad economic conditions have a significant effect on fraud levels:
“It goes up following a boom period. People want to maintain their standard of living, even if it
means criminal activity.”44 Another survey suggests that fraud is on the increase in the United
Kingdom’s public sector as austerity programs imply personnel reductions and fewer resources
being spent on internal controls, according to a report from PwC, a big-four competitor of
KPMG.45
Overall, survey evidence suggests that wasting, mismanaging, and misappropriating organi-
zational resources, among other types of employee misconduct, are prevalent in most organiza-
tions.46 Even ostensibly inconsequential forms of wasting time on the job can have high costs.
Surfing the Internet while on the job, for example, has been estimated to have cost US employ-
ers in the billions of dollars per year.47 All told, survey participants in the most recent report by
the Association of Certified Fraud Examiners estimated that the typical organization loses 5%
of its annual revenue to fraud. Applied to the estimated 2014 Gross World Product, this figure
translates to a potential global fraud loss of more than $3.7 trillion.48 Staggering as these statis-
tics may be, they suggest that it should not be taken for granted that employees will always reli-
ably act with the best interest of their organizations in mind. Because of this, the costs to
organizations are nontrivial, to say the least.
Indeed, the most serious forms of employees’ misdirected behaviors, such as fraud, can have
severe impacts, including deteriorated employee morale, impaired business relations, lost rev-
enues from damaged reputations, investments in improving control procedures, legal fees and
settlements of litigation, fines and penalties to regulatory agencies, and losses from plummet-
ing stock prices. Many of the examples that we included at the start of this chapter illustrate
this,49 and various fraud or integrity surveys, some of which have been conducted over many
years by major organizations, reinforce this with statistics.50
These huge fraud costs can be traced back to human weaknesses but also, and importantly,
as we will see later in this text, to the lack of effective MCSs. Anecdotal assertions abound. For
example, one manager claimed, rather brashly, that “every single person in your [business] is
trying to steal from you.”51 Another manager’s estimate, while more measured, still suggests
that:
Between 10 and 20% of a company’s employees will steal anything that isn’t nailed down.
Another 20% will never steal; they would say it is morally wrong. The vast majority of peo-
ple are situationally honest; they won’t steal if there are proper controls.52

Regardless of these opinions, one might argue that “stealing” is a rather literal, peculiar, and
perhaps too extreme or negative type of behavior to illustrate self-interest. Taking “stealing”
less literally, many other forms of misaligned behaviors occur when employees, for example,
manipulate their performance reports, either by falsifying the data or by taking decisions that
artificially boost performance, with the intention of earning higher, but undeserved, incentive
pay (see also Chapter 15). The most common cause of this is reported to be pressure to do
“whatever it takes” to meet business targets.53 This goes to the heart of results controls (which
we discuss in Chapter 2) and related performance targets (Chapter 8) and incentives (Chapter 9).
Well-designed MCSs are needed to protect organizations against these behaviors.
However, in addition to focusing on how MCSs can be used to prevent or mitigate these
negative or dysfunctional behaviors, this text’s emphasis is also, even primarily, on how MCSs

13
Chapter 1 • Management and Control

can be employed to motivate positive or productive behaviors; that is, how they encourage
employees to work consistently hard to accomplish organizational objectives. As we will dis-
cuss further below, whenever feasible, motivation should be the primary focus of effective
MCSs, most commonly brought about through results controls (Chapter 2) while also providing
any necessary behavioral constraints and/or mitigating any behavioral displacements through
a well-designed combination or “configuration” of action and personnel/cultural controls
(Chapter 3).54

Personal limitations
The final behavioral problem that MCSs must address occurs when employees who know
what is expected of them, and may be highly motivated to perform well, are simply unable to
perform well because of any number of other limitations. Some of these limitations are per-
son-specific. They may be caused by a lack of aptitude, training, experience, stamina, or
knowledge for the tasks at hand. An example is the too-common situation where employees
are promoted above their level of competence; that is, when employees are “over their
heads.” Sometimes jobs are just not designed properly, causing even the most physically fit
and apt employees to become tired or stressed, leading to on-the-job accidents and decision
errors.
Regarding lack of training, for example, Illinois-based Ace Hardware was forced to restate
its earnings for four fiscal years because of a $152 million accounting error made by a poorly
trained employee, who incorrectly entered accounts in ledgers in the Finance department at
the company’s headquarters. Ace CEO Ray Griffith stated: “We are embarrassed by it. We did
not provide the training, oversight or checks and balances to help that person do (the) job.”55
Errors such as these are not uncommon. For example, when Bank of America, a global US-
based bank, disclosed that it had made a significant error in the way it calculates a crucial
measure of its financial health, which led the bank to report that it had $4 billion more capital
than it actually had, the error raised serious questions about the “quality of its accounting
employees.”56 Similarly, at Tesco, the largest UK supermarket chain, when it announced to
have overstated its expected profits by £250 million, one commentator observed that “even if
there was no fraudulent intent and the problems stem from a misunderstanding of the rules
[…], the apparent scale of the error suggests that, at the very least, Tesco’s internal controls
need a thorough overhaul.”57
Moreover, research in psychology and behavioral economics suggests that all individuals,
even intelligent, well-trained, and experienced ones, face limitations in their abilities to per-
ceive new problems, to remember important facts, and to process information properly (or
rationally). In looking at the future, it has been shown, for example, that people tend to overes-
timate the likelihood of common events and events that have occurred relatively recently (both
of which are easier to remember) as compared with relatively rare events and those that have
not occurred recently. Such biases may, for example, affect employees’ propensities to assess
risks by biasing their estimates of either the likelihood or impact, or both, of certain risk events.
Sometimes training can be used to reduce the severity of these limitations. Nonetheless, these
limitations are a problem because they reduce the probability that employees will make
the correct decisions or that they will correctly assess the problems about which decisions
should be made.58
These three management control problems – lack of direction, motivational problems, and
personal limitations – can obviously occur simultaneously and in any combination. However,
all that is required to call for the necessity of effective MCSs is that at least one of these prob-
lems occurs, which will almost inevitably be the case in complex organizations as the above
arguments and examples have suggested.

14
 Control problem avoidance

Characteristics of good management control

To have a high probability of success, organizations must therefore maintain good management
control. Good control means that management can be reasonably confident that no major
unpleasant surprises will occur. The label out of control is used to describe a situation where
there is a high probability of poor performance, either overall or in a specific performance area,
despite having a sound strategy in place.
However, even good management control still allows for some probability of failure because
perfect control does not exist except perhaps in very unusual circumstances. Perfect control
would require complete assurance that all control systems are foolproof and all individuals on
whom the organization must rely always act in the best way possible. Perfect control is obvi-
ously not a realistic expectation because it is virtually impossible to install MCSs so well
designed that they guarantee good behaviors. Furthermore, because MCSs are costly, it is
rarely, if ever, cost effective to try and implement enough controls even to approach the ideal-
ized perfect control.
The cost of not having a perfect control system can be called a control loss. It is the difference
between the performance that is theoretically possible given the strategy selected and the per-
formance that can be reasonably expected with the MCSs in place. More or better MCSs should
be implemented only if the benefits by which they would reduce the control loss exceed the
costs. Except in cases where the consequences of failure are incalculable, optimal control can be
said to have been achieved if the control losses are expected to be smaller than the cost of imple-
menting more controls. Because of control costs, perfect control is rarely the optimal outcome
(or even conceivable). The benchmark, therefore, is adequate control rather than perfect con-
trol, except again in cases where failure is not an option and where control must be uncompro-
misingly focused on avoiding failure at any cost (such as in nuclear plants).
Assessing whether good control has been achieved must be future-oriented and objectives-
driven. It must be future-oriented because the goal is to have no unpleasant surprises in the
future; the past is not relevant except as a guide to the future, such as in terms of experiences or
lessons learned from control failures. It must be objectives-driven because the objectives repre-
sent what the organization seeks to attain. Nonetheless, assessing whether good control has
been achieved is difficult and subjective. It is difficult because the adequacy of management
control must be measured against a future that is inevitably difficult to predict, as are predic-
tions of possible unintended consequences of the controls. Good control also is not established
over an activity or entity with multiple objectives unless performance on all significant dimen-
sions has been considered. As difficult as this assessment of management control is, however, it
should be done because organizational success depends on good MCSs.
As the examples at the beginning of this chapter illustrate, organizations that fail to imple-
ment adequate MCSs can suffer loss or impairment of assets, deficient revenues, excessive costs,
inaccurate records, or reports that can lead to poor decisions, legal sanctions, or business dis-
ruptions. At the extreme, organizations that do not control performance on one or more critical
dimensions can fail.

Control problem avoidance

Implementing some combination of the behavior-influencing devices commonly known as

MCSs is not always the best way to achieve good control; sometimes the problems can be
avoided. Avoidance means eliminating the possibility that the control problems will occur.

15
Chapter 1 • Management and Control

Organizations can never avoid all their control problems, but they can often avoid some of them
by limiting exposure to certain types of problems and problem sources, or by reducing the max-
imum potential loss if the problems occur. Four prominent avoidance strategies are activity
elimination, automation, centralization, and risk sharing.

Activity elimination
Managers can sometimes avoid the control problems associated with a particular entity or
activity by turning over the potential risks, and the associated profits, to a third party through
such mechanisms as subcontracting, licensing agreements, or divestment. This form of avoid-
ance is called activity elimination.
Managers who are not able to control certain activities, perhaps because they do not have the
required resources, because they do not have a good understanding of the required processes,
or because they face legal or structural limitations, are those most likely to eliminate activities.
Here is an example:

When the German financial regulator ordered Deutsche Bank “to do more to ensure that
commodity prices cannot be manipulated by its traders,” the bank responded that it “has
since shut trading desks dedicated to energy, agriculture, dry bulk and freight and base
metals. Other commodity businesses have been transferred to Deutsche’s non-core bank
where they will be wound down or sold, while some parts remain active,” adding that “we
significantly scaled back our commodities business and exited entirely non-precious met-
als trading. As we have previously said, we continue to cooperate with authorities in their
industrywide review of certain benchmarks and are investing to further improve our control
environment.”59

When managers do not wish to avoid completely an area that they cannot control well, they are
wise at least to limit their investments, and hence (some of) their risks, in that area. An example is
cloud computing, which means that companies obtain computing resources (processing, storage,
messaging, databases, and so on) from outside, and pay only for what they use, rather than
develop their own computing infrastructure and run their own systems. With the increase in
demand for servers to store and process data, many companies would need to multiply their
server capacity manyfold, for which they sometimes have neither the money nor the skills, nor the
interest, because doing so falls outside of most companies’ core competencies. By using cloud
computing services, firms can leave all that to be managed by those who have the competencies
and, hence, can provide essential control over the process. Whereas this does not eliminate all
risks, it partially avoids some control problems related to data management and all that it entails.
Indeed, many companies have been expanding their use of cloud services, with growing
numbers running systems such as email services, human resources, and administrative pro-
cesses via the cloud, as well as data storage and backup. James Petter, UK managing director of
EMC, the data storage and software group, said: “Organizations move to the cloud for a number
of reasons, but they most often relate to agility, control and efficiency” (italics added). “More
than just hosting services, the cloud is ensuring availability and performance, protecting data
and helping businesses with change management by deploying functions and lessening disrup-
tion,” Joe King, senior vice-president at JDA, the supply chain software group, added.60
The economics-based literature that focuses on whether specific activities (transactions) can
be controlled more effectively through markets (external) or through organizational hierarchies
(internal) is known as transaction cost economics. A detailed examination of the theories and
evidence in this field of study is outside the scope of this text.61 We just note that the cost/benefit
tradeoffs of dealing with management control issues internally do not always favor arms-length,
market-based transactions or inter-organizational arrangements, and thus a careful balance has

16
 Control problem avoidance

to be struck.62 Referring back to the cloud services, for example, one issue that sometimes holds
companies back is a concern about security. As such, organizations will always have to rely on
MCSs internally, which have been found to be effective in a broad range of settings. The preva-
lence of large diversified organizations has depended to a large extent on good MCSs.

Automation
Automation is a second avoidance possibility. Managers can sometimes use computers, robots,
expert systems, and other means of automation to reduce their organization’s exposure to some
control problems. These automated devices can be set to behave as required, and when they are
operating properly, they perform more consistently than do humans. Computers eliminate the
human problems of inaccuracy, inconsistency, and lack of motivation. Once programmed, com-
puters are consistent in their treatments of transactions, and they never have dishonest or dis-
loyal motivations. Here is a representative quote from the mining industry:

Rio Tinto has rolled out fully automated driverless truck fleets at two of its iron ore mines in
the Pilbara in Western Australia. […] “Our autonomous fleet outperforms the named fleet by
an average of 12 per cent, primarily by eliminating required breaks, absenteeism and shift
changes,” said Andrew Harding, Rio’s iron ore chief executive. “Innovation and technology
is critical in our efforts to improve safety.” […] The world’s biggest miners are turning to
technology to cut costs. […] This follows a similar trend across a wide range of industries,
from car manufacturing to computing, whereby robots or artificial intelligence are increas-
ingly taking roles traditionally performed by humans. […] “Removing people from the mine
environment is safer,” said Dr. Carla Boehl, a lecturer at Curtin University – “It has cost
advantages too. It can be very costly for companies if employees are hurt onsite.” […] “We
have also seen a 13 per cent reduction in load and haul costs due to the greater efficiency,”
Mr. Harding said. Dr. Boehl said embracing technology could create more interesting jobs
while making lower skilled positions obsolete. “You will tend to lose the boring, repetitive
jobs performed in the 50 degrees centigrade heat in the Pilbara but you can also create new
innovative roles in analyzing data and developing technology,” she said.63

As technology has advanced, organizations have substituted machines and expert systems for
people who have been performing quite complex actions and making sophisticated judgments
and decisions. In hospitals, for example, artificial intelligence systems are able to perform many
of the tasks doctors and nurses used to perform. These systems monitor the patients’ conditions
and trends and alert the medical staff of possible problems; they assist in making diagnoses; they
order the needed drugs; and they check for potential drug interactions and allergic reactions.
Computer-aided insertions of central venous catheters are more accurate and reduce complica-
tions (such as punctured arteries that can lead to infections).64 And so on. Importantly, these
systems allow hospitals to avoid one of the behavioral problems – the personal limitations of the
medical staff. In the vast majority of situations, these systems are more likely than are medical
personnel to recall all the details of every condition, medication, and possible complications to
initiate the proper response. Needle injection robots use tracking algorithms to keep the blood
vessel aligned, and thus, are more accurate. Hence, these systems make it more likely that no
major, unpleasant surprises will occur; in this case, avoidable medical errors and complications.
Similarly, many legal tasks, although sometimes quite complex, are variations on a theme,
where the production of certain types of legal documents does not differ vastly from one
instance to another. Legal firms are therefore increasingly using what is called document
assembly software, allowing them to reduce the time needed to put together a certain type of
legal document (such as a trademark registration or a real estate lease) to a fraction of the time
it takes an employee to do the same and, possibly, more consistently and accurately with fewer

17
Chapter 1 • Management and Control

errors. Moreover, automating these onerous processes reduces costs and allows lawyers to
spend more time dealing with their clients.65
Another example is where banks (when they have not exited parts of the trading business as
Deutsche Bank did in the example above) have sped up digital trading to settle trades via auto-
mated processes to minimize human intervention because traditional trading over the phone
has come under intense regulatory scrutiny due to alleged manipulation of benchmarks such as
currency fixes and interbank lending rates. Automation leads to a better client experience at
lower cost with stronger control, thereby reshaping a once opaque but lucrative business to
become less risky.66
In most managerial situations, however, automation can provide only a partial control solu-
tion at best. One limitation is feasibility. Humans have many talents – particularly those involv-
ing complex, intuitive judgments – that no machines or decision models have been able to
duplicate. There are often also regulatory constraints, where the regulators may be understand-
ably wary of fully autonomous systems in some settings, such as in health care. In other set-
tings, such as automated trading in banks, they may welcome them. Regulators may find fully
autonomous or “self-driving” cars not yet feasible, but they are likely to welcome semi-autono-
mous systems that help “take the human error out of driving”.67
A further limitation is cost. Automation often requires major investments that may be justifi-
able only if improvements in productivity, as well as in control, are forthcoming. Finally, auto-
mation may just replace some control problems with others, or introduce different control
issues. The elimination of source documents can obscure the audit trail; the concentration of
information in one location can increase security risks; and placing greater reliance on com-
puter programs can expose the company to the risks of programmer errors or fraud.

Centralization
Centralization of decision-making is a third avoidance possibility, which is a key element of
almost all organizations’ MCSs. High degrees of centralization, where all the key decisions are
made at top management levels, are common in small businesses, particularly when they are
run by the founder or owner. High degrees of centralization also exist in some large businesses
whose top managers sometimes have reputations for being “detail oriented” or “control freaks.”
When that is the case, top management reserves the important, and sometimes the not-so-
important, decisions for themselves, and in so doing, they avoid having the lower-level employ-
ees make poor judgments.
Centralization inevitably exists to some extent in all organizations, as well as at all levels of
management within organizations, as managers tend to reserve for themselves many of the
most crucial decisions that fall within their authority. Common candidates for centralization
are decisions regarding major acquisitions and divestments, major capital expenditures, nego-
tiation of pivotal sales contracts, organization changes, and hiring and firing of key personnel.
However, in most organizations of even minimal size, it is not possible to centralize all critical
decisions, and other control solutions are necessary. As we will see in Chapters 2 and 7, results
controls play a critical role when decisions are decentralized. When decisions are decentral-
ized, results controls need to be in place to hold the managers who enjoy the decision authority
accountable for the results of their decisions. Accountability for results is what makes delegated
authority legitimate.

Risk sharing
A final, partial avoidance possibility is risk sharing. Sharing risks with outside entities can bound
the losses that could be incurred by inappropriate employee behaviors. Risk sharing can involve
buying insurance to protect against certain types of potentially large losses the organization

18
 Outline of this text

might not be able to afford. Many companies purchase fidelity bonds on employees in sensitive
positions (such as bank tellers) to reduce the firm’s exposure. These insurance contracts pass at
least a portion of the risk of large losses and errors to the insurance providers. Another way to
share risks with an outside party is to enter into a joint venture agreement. This shares the risk
with the joint venture partner.
These avoidance alternatives are often an effective partial solution to, or bounding of, many
of the control problems managers face. It is rarely possible to avoid all risks because firms are
rewarded for bearing risk, but most firms use some forms of elimination, automation, centrali-
zation, and risk sharing in order to limit their exposure to the management control problems.

Control alternatives

For the control problems that cannot be avoided, and those for which decisions have been made
not to avoid, managers must implement one or more control mechanisms that are generally
called management controls. The collection of control mechanisms that are used is generally
referred to as a management control system (MCS).
MCSs vary considerably among organizations and among entities or decision areas of any
single organization. That said, they commonly include a combination of action, results, and
personnel/cultural controls, which we discuss in depth in the next two chapters. The MCSs of
some organizations consist primarily of trying to hire people who can be relied upon to serve
the organization well. Other organizations provide modest performance-based incentives, and
still others offer incentives that are highly leveraged. Some organizations base incentives on the
accomplishment of targets defined in terms of accounting numbers, others use nonfinancial
measures of performance, and still others evaluate performance subjectively. Some organiza-
tions have elaborate sets of policies and procedures that they expect employees to follow,
whereas others have no such procedures, or they allow the procedures that were once in place
to get out of date. Some organizations make extensive use of a large professional internal audit
staff, while others only ensure to be in minimal compliance with regulatory requirements in
this regard. These are just examples. The distinctions that can be made among the MCSs in use
are numerous.
Management control choices are not random, however. They are based on many factors.
Some controls are not effective, or are not cost-effective, in certain situations. Some types of
controls are better at addressing particular types of problems, and different organizations and
different areas within each organization often face quite different mixes of control problems.
Some types of controls have some undesirable side effects that can be particularly damaging in
some settings. And some controls merely suit particular management styles better than others.
A major purpose of this text is to describe the factors affecting management control choice deci-
sions and the effects on the employees and the organization when different choices are made.

Outline of this text

The text discusses MCSs from several different angles, each the focus of one major section.
Section II distinguishes controls based on the object of control, which can focus on the results
produced (results control), the actions taken (action control), or the types of people employed
and their shared norms and values (personnel and cultural control). Chapters 2–6 in Section II
discuss each of these forms of control, the outcomes they produce (which can be both positive
and negative), and the factors that lead managers to choose one object of control over another.

19
Chapter 1 • Management and Control

Section III focuses on the major elements of financial results-control systems, an important
type of results control in which results are defined in financial terms. This section includes dis-
cussions of financial responsibility structures (Chapter 7), planning and budgeting systems
(Chapter 8), and incentive systems (Chapter 9).
Section IV discusses some major problems managers face when they use financial results-
control systems and, particularly, the performance measurements that drive them. These prob-
lems include the tendency of accounting measures to cause managers to be excessively
short-term oriented (myopic), the tendency for return-on-investment measures of performance
to cause poor investment and performance evaluation decisions, and the likelihood of negative
behavioral reactions from managers who are held accountable for factors over which they have
less than complete control. Throughout Chapters 10–12, we also discuss several approaches
organizations can rely on to mitigate these problems.
Section V discusses some key organizational control roles, including those of controllers,
auditors, and audit committees of the board of directors. It also discusses recent developments
in corporate governance (Chapters 13 and 14) as well as common control-related ethical issues
and how to analyze them (Chapter 15).
Given the focus on financial results controls in primarily Sections III and IV, in the final sec-
tion (Chapter 16), we come back to broaden this focus by discussing the pertinence of MCSs
even when financial results are not the primary raison d’être of the organization, such as in non-
profit organizations, or where there are broader missions or concerns beyond the financial
realm, such as regarding sustainability and corporate social responsibility.

Notes
1 See, for example, and selectively only, “Royal Bank of 8 Ibid.
Scotland Fined £56m for IT Meltdown,” Financial Times 9 “Libor Probe Said to Expose Collusion, Lack of Internal
(November 20, 2014), online at on.ft.com/14PBtV9. Controls,” Bloomberg (February 15, 2012), online at
2 See, for example, and selectively only, “Banks Braced for www.bloomberg.com.
Additional £22bn in PPI Claim Payout,” Financial Times 10 “HSBC Reveals Problems with Internal Controls,” The
(April 4, 2016), online at on.ft.com/1VoDSwj. New York Times (July 12, 2012), online at nyti.ms/NO7PkC.
3 See, for example, and selectively only, “BNP Paribas Made 11 “Bank Litigation Costs Hit $260bn – with $65bn More to
Ethical and Legal Mistakes, Says Chairman,” Financial Come,” Financial Times (August 23, 2015), online at on.
Times (February 15, 2015), online at on.ft.com/1ITIql4. ft.com/1JHtT1P.
4 Too many articles on the LIBOR scandal have appeared in 12 “Bankers Not Only Ones Pushing Ethical Boundaries,”
the press to make a sensible selection. For a taste, and Financial Times (September 25, 2015), online at on.ft.
indicatively only, type “Libor Investigation” in the search com/1FmAXiS.
box on next.ft.com. 13 “Boardroom Politics at Heart of VW Scandal,” Financial
5 See, for example, and selectively only, “Hong Kong Mar- Times (October 4, 2015), online at on.ft.com/1hiU1CQ.
ket Regulator Fines RBS for Trading Control Failure,” 14 “Atlanta’s Schools – the Reckoning,” The Economist (April
Bloomberg (April 22, 2014), online at bloom.bg/1VKR9l2; 6, 2013), online at www.economist.com.
“London Whale Complains of Unfair Blame for $6.2bn 15 “Accounting Scandal Set to Shake Up Toshiba,” Financial
JPMorgan Losses,” Financial Times (February 23, 2016), Times (July 16, 2015), online at on.ft.com/1fMNz7h.
online at on.ft.com/1SR98Ek. 16 “Scathing Report Says Toshiba CEOs Had Role in Account-
6 See, for example, and selectively, “BNP Paribas Made Eth- ing Scandal,” Financial Times (July 20, 2015), online at
ical and Legal Mistakes, Says Chairman,” op. cit.; “HSBC on.ft.com/1KgFnZB.
Monitor Says Bank’s Compliance Progress Too Slow – 17 “Toshiba Chief Hisao Tanaka Resigns over $1.2bn Account-
Bank Needs to Do More to Fix Corporate Culture, Update ing Scandal,” Financial Times (July 21, 2015), online at on.
Technology, Compliance Monitor Says,” The Wall Street ft.com/1edzVbE.
Journal (April 1, 2015), online at on.wsj.com/1ajxzqz. 18 “Bankers Not Only Ones Pushing Ethical Boundaries,” op. cit.
7 “FSA Fines UBS £29.7 Million for Significant Failings in 19 “Atlanta’s Schools – the Reckoning,” op. cit.
Not Preventing Large Scale Unauthorized Trading,” 20 “Deutsche Bank in $6bn ‘Fat Finger’ Slip-Up,” Financial
Financial Services Authority (November 26, 2012), online Times (October 19, 2015), online at on.ft.com/1QMFz2q.
at www.fsa.gov.uk/library/communication/pr/2012/105. 21 “Bank of England Moves to Stamp Out ‘Fat Finger’ Errors,”
shtml or at www.fsa.gov.uk. Financial Times (June 14, 2015), online at on.ft.com/1JNEF5M.

20
 Notes

22 “Bank Clerk Nods Off with Finger on Keyboard and Gives 37 “A Good Manager Must Be More Than a Messenger,” The
Away £189m,” Evening Standard (June 11, 2013), p. 3. New York Times (May 30, 2013), online at nyti.ms/12Skw5l.
23 “Two Accused of INS Shredding Spree,” The Los Angeles 38 KPMG 2005/2006 Integrity Survey (KPMG LLP, 2005).
Times (January 31, 2003), p. B5. 39 World-at-Work, Sibson, and Synygy, The State of Perfor-
24 “The Road to Perdition: Are the EU’s Financial Controls so mance Management (Survey Report, August 2004); and J.
Exasperating that They Force Its Own Staff to Evade Kochanski and A. Sorensen, “Managing Performance
Them?,” The Economist (July 24, 2003), p. 39. Management,” Workspan (September 2005), pp. 21–6.
25 For an academic article on the various concepts of man- 40 KPMG 2013 Integrity Survey (KPMG LLP, 2013), p. 16,
agement control, see T. Malmi and D. A. Brown, “Manage- online at www.kpmg.com/CN/en/IssuesAndInsights/
ment Control Systems as a Package – Opportunities, A rticlesPublications/Documents/Integrit y-Sur vey-
Challenges and Research Directions,” Management 2013-O-201307.pdf.
Accounting Research, 19, no. 4 (December 2008), pp. 287– 41 “The Other Side of Paradise,” The Economist (January 16,
300. For a lighter reading, see also “How Not to Lose Con- 2016), online at econ.st/1URPB3P.
trol,” Finance & Management, 242 (April 2016), pp. 14–15, 42 A [university] staff survey (2016); source withheld for
online at www.icaew.com. confidentiality reasons.
26 For a classic text, see, for example, M. E. Porter, Competi- 43 F. Taylor, The Principles of Scientific Management (New
tive Advantage: Creating and Sustaining Superior Perfor- York: Harper, 1929).
mance (New York: The Free Press, 1985), Chapter 2. 44 “Employee Fraud Is a Growing Problem, Survey Shows,”
27 “Why CEOs Fail,” Fortune (June 21, 1999), online at The Australian (June 25, 2010), online at www.adelaide-
www.businessbuilders.bz/why-ceos-fail.pdf. See also now.com.au.
“How to Execute a New Business Strategy Successfully,” 45 “PWC Survey Shows Rise in Fraud by Public-Sector Staff,”
Financial Post (August 8, 2013), online at natpo.st/21Klsrs. The Independent (July 4, 2010), online at www.independ-
28 M. Hall, Y. Millo, and E. Barman, “Who and What Really ent.co.uk.
Counts? Stakeholder Prioritization and Accounting for 46 KPMG 2013 Integrity Survey, op. cit.
Social Value,” Journal of Management Studies, 52, no. 7 47 “Are Employees Wasting Time Online?” PCWorld.com
(November 2015), pp. 907–34. (August 2, 2001); see also “These Charts Show What We’re
29 See R. E. Freeman, Strategic Management: A Stakeholder Not Doing because We’re Online All the Time,” Business
Approach (Cambridge: Cambridge University Press, Insider (October 21, 2013), online at read.bi/16qZVGz.
2010). See also “Shareholders vs. Stakeholders: A New 48 Association of Certified Fraud Examiners – 2016 Report to
Idolatry,” The Economist (April 24, 2010), online at econ. the Nations (ACFE, 2016), online at www.acfe.com/
st/KA1p7h; “Analyse This,” The Economist (April 2, 2016), rttn2016.aspx (hereafter ACFE 2016 Report).
online at econ.st/1V9hSFB. 49 See, for example, “Bank Litigation Costs Hit $260bn –
30 “Keep Sight of Your Vision,” The Sunday Times (March 23, with $65bn More to Come,” op. cit.
2008), online at www.business.timesonline.co.uk. 50 KPMG 2013 Integrity Survey, op. cit.; ACFE 2016 Report,
31 Ibid. op. cit.
32 A seminal framework for “strategy analysis” is that by M. E. 51 “Thou Better Not Steal,” Forbes (November 7, 1994), p. 170.
Porter, Competitive Strategy: Techniques for Analyzing Indus- 52 “Crime Is Headed Up – and So Is Business,” Boston Globe
tries and Competitors (New York: The Free Press, 1980). A (February 15, 1983), p. 47.
seminal contributor to the “emergent strategy” view is H. 53 KPMG 2013 Integrity Survey, op. cit.
Mintzberg, “Crafting Strategy,” Harvard Business Review, 54 For a recent study of “configurations” of the various types
65, no. 4 (July–August 1987), pp. 66–75. For a recent edi- of MCSs that organizations employ, see, for example, D. S.
tion of a textbook on strategic management, see R. M. Grant, Bedford and T. Malmi, “Configurations of Control: An
Contemporary Strategy Analysis, 9th ed. (Chichester, UK: Exploratory Analysis,” Management Accounting Research,
Wiley, 2016). For a recent empirical study on the “ongoing 27, no. 2 (June 2015), pp. 2–26. For another recent study
riddle” of formal and/or emergent planning practices, see in a non-profit setting that pertinently illustrates the
R. B. Bouncken, V. Fredrich, and R. Pesch, “Configurational “inter-relatedness” of pay-for-performance, autonomy
Answer to the Ongoing Riddle of Formal and/or Emergent (related to incentives or results controls), and mission con-
Planning Practices,” Journal of Business Research, 69, no. 9 gruence (related to personnel/cultural control), see M. A.
(September 2016), pp. 3609–3615. Barrenechea-Méndez and A. Ben-Ner, “Mission Congru-
33 “Keep Sight of Your Vision,” op. cit. ence, Incentives and Autonomy: An Empirical Analysis of
34 Ibid. Child-Care Facilities in Minnesota, the U.S.,” Working
35 Ibid. Paper (2016), online at papers.sioe.org/paper/848.html.
36 R. S. Kaplan and D. P. Norton, Execution Premium (Bos- 55 “Poorly Trained Finance Worker Makes $152m Flub,”
ton, MA: Harvard Business School Press, 2008); see also CFO.com (January 14, 2008), online at ww2.cfo.com.
D. C. Hambrick and J. W. Frederickson, “Are You Sure You 56 “Bank of America Finds a Mistake: $4 Billion Less
Have a Strategy?,” Academy of Management Executive, 15, Capital,” The New York Times (January 14, 2008), online
no. 4 (November 2001), pp. 48–59. at nyti.ms/1mR3FLb.

21
Chapter 1 • Management and Control

57 “Not So Funny: Booking Revenues, Like Comedy, Is All 62 For a more detailed discussion and overview of the issues
about Timing,” The Economist (September 27, 2014), related to inter-organizational controls, see S. W. Ander-
online at econ.st/1qxwvPw. son and H. C. Dekker, “The Role of Management Controls
58 For a flavor of research in this area of behavioral econom- in Transforming Firm Boundaries and Sustaining Hybrid
ics, see, for example, R. Thaler, Misbehaving: The Making Organizational Forms,” Foundations and Trends in
of Behavioral Economics (London: Allen Lane, 2015). Accounting, 8, no. 2 (November 2014), pp. 75–141.
59 “German Regulator Warns Deutsche Bank on Commodity 63 “Rio Tinto Shifts to Driverless Trucks in Australia,” Finan-
Trading,” Financial Times (June 19, 2014), online at cial Times (October 19, 2015), online at on.ft.com/
on.ft.com/T9Xacd. 1W1IJGh.
60 “Companies Take to The Cloud for Flexible Solutions,” 64 See, for example, “Medical Robotics: To the Point,” The
Financial Times (January 28, 2014), online at on.ft. Economist (April 11, 2015), online at econ.st/1JpkkjU.
com/1evKHmS. 65 “Curbing Those Long, Lucrative Hours,” The Economist
61 Oliver Williamson is generally recognized as the most (July 22, 2010), p. 66.
prominent theoretical contributor in the area of transac- 66 “Banks Speed Up Shift to Forex Automation,” Financial
tion cost economics, and went on to win the Nobel Prize in Times (June 22, 2014), online at on.ft.com/1lhky2N.
Economics for it in 2009. For a layman’s overview of some 67 “Google’s Self-Driving Cars Get Boost from U.S. Agency,”
of the key ideas behind his seminal contributions, see Bloomberg (May 30, 2013), online at www.bloomberg.
“Reality Bites,” The Economist (October 15, 2009), p. 92. com.

CASE STUDY
Leo’s Four-Plex Theater

Leo’s Four-Plex Theater was a single-location, four- number of the first ticket sold from the ending
screen theater located in a small town in west Texas. number.
Leo Antonelli bought the theater a year ago and hired 2. The amounts of cash collected were counted daily
Bill Reilly, his nephew, to manage it. Leo was concerned, and compared with the total value of tickets sold. The
however, because the theater was not as profitable as he cash counts revealed, almost invariably, less cash
had thought it would be. He suspected the theater had than the amounts that should have been collected.
some control problems and asked Park Cockerill, an The discrepancies were usually small, less than $10
accounting professor at a college in the adjacent town, per cashier. However, on one day two weeks before
to study the situation and provide suggestions. Park’s study, one cashier was short by almost $100.
Park found the following:
3. Just inside the theater’s front doors was a lobby with a
1. Customers purchased their tickets at one of two refreshment stand. Park observed the refreshment
ticket booths located at the front of the theater. The stand’s operations for a while. He noted that most of the
theater used general admission (not assigned) seat- stand’s attendants were young, probably of high school
ing. The tickets were color coded to indicate which or college age. They seemed to know many of the cus-
movie the customer wanted to see. The tickets were tomers, a majority of whom were of similar ages, which
also dated and stamped “good on day of sale only.” was not surprising given the theater’s small-town loca-
The tickets at each price (adult, child, matinee, tion. But the familiarity concerned Park because he had
evening) were prenumbered serially, so that the also observed several occasions where the stand’s
number of tickets sold each day at each price for attendants either failed to collect cash from the custom-
each movie could be determined by subtracting the ers or failed to ring up the sale on the cash register.

22
 Private Fitness, Inc.

4. Customers entered the screening rooms by passing passes with Bill Reilly’s signature on them. These
through a turnstile manned by an attendant who problems did not account for all of the customer test
separated the ticket and placed part of it in a locked count discrepancies, however. Park suspected that the
‘stub box.’ Test counts of customers entering and ticket collectors might also be admitting friends who
leaving the theater did not reconcile either with the had not purchased tickets, although his observations
number of ticket sales or the stub counts. provided no direct evidence of this.
Park found evidence of two specific problems. First, When his study was complete, Park sat down and
he found a few tickets of the wrong color or with the wondered whether he could give Leo suggestions that
wrong dates in the ticket stub boxes. And second, he would address all the actual and potential problems,
found a sometimes significant number of free theater yet not be too costly.

This case was prepared by Professor Kenneth A. Merchant.

Copyright © by Kenneth A. Merchant.

CASE STUDY
Wong’s Pharmacy

Thomas Wong was the owner/manager of Wong’s Phar- Although the store thrived in its early years, perfor-
macy, a small, single-location drugstore. The store was mance in the last few years had not been good. Sales
founded by Thomas’s father, and it had operated in the and profits were declining, and the problem was get-
same location for 30 years. All of the employees who ting worse. The performance problems seemed to have
worked in the store were family members. All were hard begun approximately at the time when a large drug-
workers, and Thomas had the utmost trust in all of them. store chain opened a branch two blocks away.

This case was prepared by Professor Kenneth A. Merchant.

Copyright © by Kenneth A. Merchant.

CASE STUDY
Private Fitness, Inc.

“I don’t know how much money I might have lost because figure out a way to make my business work effectively
of Kate. She is a long-time friend whom I thought I could without my having to step in and do everything myself.”
trust, but I guess that trust was misplaced. Now I’ve got Rosemary Worth was talking about the conse-
to decide whether or not to fire her. And then I’ve got to quences of a theft that had recently occurred at the

23
Chapter 1 • Management and Control

business she owned, Private Fitness, Inc. Private Fitness upkeep, scheduling of appointments, and record keep-
was a small health club located in Rancho Palos Verdes, ing. Kate was paid a salary plus a commission based on
California, an upscale community located in the Los gross revenues. During normal business hours when
Angeles area. The club offered personal fitness training Kate was teaching a class, one of the other instructors,
and fitness classes of various types, including aerobics, or sometimes a part-time clerical employee, was asked
spinning, body sculpting, air boxing, kickboxing, hip to staff the front desk in return for an hourly wage. Pri-
hop, step and pump, dynamic stretch, Pilates, and yoga. vate Fitness was open from 5:30 a.m. to 9:00 p.m., Mon-
Personal training clients paid $50 per hour for their day through Friday. It was also open from 6:00 a.m. to
instructor and use of the club during prime time. Dur- noon on Saturday and noon to 3:00 p.m. on Sunday.
ing slower times (between 9:00 a.m. and 4:00 p.m.) the Rosemary was still in the process of building the vol-
price was $35 per hour. The price per student for each ume necessary to operate at a profit. Typically, one or
hour-long fitness class was $12. Some quantity dis- two private fitness clients were in the facility during
counts were offered to clients who prepaid. Unlike the the prime early morning and early evening hours. A
large health clubs, Private Fitness did not offer member- few clients came in at other times. Classes were sched-
ships for open access to fitness equipment and classes. uled throughout the times the club was open. Some of
Prior to starting Private Fitness, Rosemary had been these classes were quite popular, but many of them had
working as an aerobics instructor and fitness model. only one or two students, and some classes were can-
She had won many local fitness competitions and was a celled for lack of any clients. However, Kate’s market-
former finalist in the Ms. Fitness USA competition. She ing efforts were proving effective. The number of
wanted to go into business for herself to increase her clients was growing, and Rosemary hoped that by the
standard of living by capitalizing on her reputation and end of the year the business would be earning a profit.
knowledge in the growing fitness field and to have As the quote cited above indicates, however, Rose-
more time to spend with her two young children. Pri- mary gradually realized that Kate Hoffman was stealing
vate Fitness had been operating for six months. from the club. On one occasion when Rosemary came to
To open the club, Rosemary had to use almost all of the club she noticed $60 in the cash drawer, but she
her personal savings, plus she had to take out a bank noticed when she was leaving that the drawer contained
loan. The building Rosemary rented, located in a con- only $20. She asked Kate about it, and Kate denied that
venient strip mall with ample parking, had formerly there had been $60 in the drawer. Rosemary wondered
been operated as a fresh food market. Rosemary spent if other cash amounts had disappeared before they had
about $150,000 to renovate the facility and to buy the been deposited at the bank. While some clients paid by
necessary fitness equipment. The club was comprised credit card or check, others, particularly those attend-
of five areas: an exercise room, a room containing aero- ing fitness classes, often paid cash.
bic equipment (e.g. treadmills, stair climbers, station- Rosemary became very alarmed when, during a cas-
ary bicycles, cross-country ski machines), a room ual conversation with one of the other instructors, the
containing weight machines and free weights, men’s instructor happened to mention to Rosemary some sur-
and ladies’ locker rooms, and an office. prising “good news.” The good news was that Kate had
Rosemary contracted with five instructors she knew brought in a new private fitness client who was working
to run the classes and training sessions. The instructors out in the 1:00–2:00 p.m. time period on Monday,
were all capable of running personal training sessions, Wednesday, and Friday. Kate was doing the training
but they each tended to specialize in teaching one or herself. However, Rosemary checked the records and
two types of fitness classes. Rosemary herself ran most found no new revenues recorded because of this new
of the spinning classes and some of the aerobics classes. client. She decided to come to the club during the
The instructors were paid on commission. The commis- period to see if this client was indeed working out.
sion, which ranged between 20% and 50% of revenue, Since the client was there and no revenue entry had
varied depending on the instructor’s experience and on been made, she confronted Kate. After first explaining
whether the instructor brought the particular client to that she had not yet gotten around to making the book-
Private Fitness. keeping entry, Kate finally admitted that this client had
As manager of the business, Rosemary hired Kate been writing her checks out to Kate directly, in
Hoffman, one of the instructors and a long-time friend. exchange for a discount. Kate said that she was very
Kate’s primary tasks included marketing, facility sorry and that she would never be dishonest again.

24
 Atlanta Home Loan

Rosemary realized she had two major problems. But how could she ensure that her business received
First, she had to decide what to do with Kate. Kate all the revenues to which it was entitled without
was a valuable instructor and a longtime friend, but being on site at all times herself? Should she leave
her honesty was now in question. Should she forgive Kate, who promised not to steal again, in the man-
Kate or fi re her? Second, Rosemary also realized that ager position? Or should she hire one of the other
she had an operating problem. She did not want to instructors, or perhaps a non-instructor, to become
step in and assume the managerial role herself the manager? And in either case, were there some
because she had significant family responsibilities to procedures or controls that she could use to protect
which she wanted to be able to continue to attend. her business’s assets?

This case was prepared by Professor Kenneth A. Merchant.

Copyright © by Kenneth A. Merchant.

CASE STUDY
Atlanta Home Loan

In late 2002, Albert (Al) Fiorini was becoming more and the Orange County Chapter of the California Associa-
more frustrated and depressed. In September 2002, he tion of Mortgage Brokers. Under his direction, AHL’s
had taken a leave of absence to return to school to earn business grew rapidly in its fi rst quarter of operation.
his MBA, and he had trusted some employees to run the By the summer of 2002, the company consisted of four
mortgage lending business he had founded. Now it was telemarketers and eight loan officers, all of whom
clear to Al that those employees had schemed to wrest worked from their homes. “Telecommuting” was con-
control of the business away from him. And amazingly, venient for the employees because Atlanta was a large
they seemed to have been successful. Al lamented, city with heavy traffic.
“They didn’t just steal some of my assets. They stole my Al established banking relationships that allowed
whole business!” Being 2,500 miles away and busy with AHL clients to borrow money at wholesale rates. The
his studies, Al felt nearly powerless to stop them. He had actual loan terms varied depending on the clients’ FICO
spent many sleepless nights wondering what he could scores.1 In summer 2003, banks might offer an AHL cli-
and should do to get his business back. He also thought ent with a very high FICO score (over 620) a rate of
about where he went wrong – what he should have done 6.25–6.75% on a fi xed 30-year mortgage. This rate pro-
to prevent this problem from happening in the first place. vided the bank with an operating margin of 1.5% to
2.0%. AHL earned a fee of 1.50% of the loan amount
for every loan funded. This provided AHL with an aver-
The company age revenue per loan of $3,200.
Atlanta Home Loan (hereafter AHL) was a mortgage
lending and financing company based in Atlanta, Geor-
1
gia. Al Fiorini founded the company in April 2002, with FICO® scores provide a numeric representation of an individual’s
fi nancial responsibility, based on his or her credit history. FICO
an initial investment of about $40,000. He started scores are based on a scale from 300 to 900. Most individuals actu-
operating the company from his home. ally have three FICO scores, one from each national credit bureau
Al had many years of experience in the mortgage (Equifax, Experian, TransUnion). These three FICO scores are the
measure that most lenders look at when evaluating credit or loan
banking industry. He had worked for several different applications. FICO is an acronym for Fair Isaac Credit Organization,
companies and had also served a year as president of the developer of the credit-rating analytics.

25
Chapter 1 • Management and Control

AHL bought leads from list brokers for $0.20 per company and the fees due to the loan officer involved.
name. These lists provided information as to whether AHL paid the loan officers 40% of this total loan reve-
the individuals owned their homes; if so, when they nue on loans that AHL originated, and 60% on loans
bought their homes; and when, if ever, they had refi- they originated (by generating their own leads). At
nanced their mortgages. closing, AHL received its funds directly from the pro-
The telemarketers called people on the lead lists to ceeds. A broker’s check would be overnight mailed to
assess their interest in refinancing. Al knew from AHL’s office, or the money would be wired directly into
industry experience that telemarketers should gener- AHL’s general account.
ate a minimum of one lead per hour. They were paid a
combination of an hourly wage plus a performance
bonus ($10.00) for each lead produced. Since most of
Back to school
them worked part-time, AHL’s telemarketers gener- For years Al had been thinking about earning an MBA
ated, on average, about four new leads per person per degree. In June 2002, he was admitted to the executive
day.2 They gave the leads, the potential clients’ names, MBA (EMBA) program at the University of Southern
to Al Fiorini. Al distributed the names to AHL’s loan California in Los Angeles, and he decided to enroll.
officers.3 While in California, he planned to start another mort-
The loan officers helped the prospective clients to fill gage lending company.
out their loan applications and to assemble the needed Al had several options for AHL. He could find some-
backup documents, such as W-2s, pay stubs, and bank one to run it; he could try to sell it; or he could shut it
statements. After the clients’ information had been col- down. If he chose to shut it down, he would turn the
lected, office support personnel, called “loan proces- unfunded applications over to a contract processing
sors,” would order an appraisal and a credit report, firm. The contract processing firm would be responsi-
open escrow, and independently verify the financial ble for ordering credit reports and appraisals and for
information. After all the information was collected interfacing with the escrow companies and attorneys
and verified, the completed file would then be submit- until the loans were funded. For its services, this firm
ted to the prospective lenders either electronically or in would charge AHL $300–$400 per contract.
paper form. But Al decided that he did not want to close AHL. It
AHL did not yet have electronic links to the proces- was a profitable business with considerable growth
sors’ files that would allow monitoring of the progress potential. In September 2002 alone, AHL loan officers
of the applications before they were submitted. Capa- were preparing to submit 30–40 new applications to
bilities for those links were being put into place. How- banks for funding, and the volume of business was con-
ever, each application required a credit inquiry, so Al tinuing to grow. Al enlisted the services of a business
monitored the activities of his loan officers by tracking broker who placed a value of $600,000 on the company.
the number of credit inquiries each requested. This However, Al doubted that he had enough time to find a
provided him with an early indication of how many buyer before he left for California. He decided to find
applications were being submitted. The loan applica- someone to operate the company in his absence.
tion/lead ratios varied from 5% to 20% depending on
the skill of the loan officer. Al also closely monitored
these ratios and their trends.
A partner
In the mortgage lending industry, a 30% “fallout
ratio” (the proportion of loans submitted to processing Joe Anastasia4 was one of AHL’s loan officers. He had
that were not funded) was typical. AHL’s fallout ratio 20 years’ experience in the mortgage lending business.
was slightly less than 30%. Although Al had known him for only about two months,
Once approved, the legal loan documents were pre- his initial judgments about Joe were quite favorable.
pared. At that time, Al knew the revenue due to his Joe seemed to have excellent sales ability; he was peo-
ple-oriented; and he was knowledgeable about all areas
of mortgage lending and financing. On his resume, he
2
AHL also developed leads from the Internet, as it operated the
described himself as “dependable and honest.” Before
website www.lowerrate.com. joining AHL, Joe had worked for 10 years as vice presi-
3
In Georgia, unlike in some other states, loan officers are not licensed. dent of operations for a sizable financial corporation

26
 Atlanta Home Loan

and had previously operated his own mortgage service Wilbur would be quite good at sales. He had the requi-
company for three years. Since Joe joined AHL, he had site knowledge, and “he was smooth.” On the basis of
closed a higher loan volume than any of the other loan these quick judgments, on September 1, 2002, Al
officers. signed a written partnership and licensing agreement
Impressed by Joe’s background and performance, Al with Wilbur. This agreement stated that Al would offer
decided to make Joe a deal to be his partner. In July Wilbur the use and privileges of AHL as an ongoing
2002, Al and Joe reached a verbal partnership agree- business until he returned, and Wilbur would provide
ment. Joe would invest $8,400, which was used to rent AHL with his management services. AHL would make
an office and to purchase some office equipment, and commission payments to Wilbur at 100% on all loans
Joe and Al would share AHL’s profits equally. closed less a monthly licensing fee of $5,000 or 10% of
Curiously, however, on the day when the two part- all revenue, whichever was greater. Wilbur would also
ners were to meet their new landlord, Joe did not show be responsible for interviewing and hiring all new loan
up for the meeting. Al could not find him for two days.5 officers, paying the expenses of running the office, and
In the first 10 working days after becoming Al’s part- managing the entire staff.
ner, Joe showed up in the office only three times. Wilbur asked for authority to sign checks written
Al did not feel comfortable letting Joe continue to against AHL’s main bank account, but Al refused.
run the company. Two weeks after their partnership Instead, as a gesture of good faith, Al left with Letitia
agreement had been struck, he made Joe a deal. In Johnson (the office manager) four signed, blank checks
exchange for terminating their agreement, Al agreed to written against the main account. Al’s instructions to
pay Joe 100% of the fees earned on loans that Joe Letitia were that the checks were not to be used with-
closed. Al then brought in an acquaintance, one with out Al’s permission.
banking experience, to run AHL in his absence, but this Letitia had been with Al since May 2002. She had
manager lasted only three days before quitting. Faced effectively managed the telemarketers and had dem-
with limited options and desperate to find someone to onstrated her loyalty to Al. In August 2002, because
run the company before he left for Los Angeles the next of slow funding loans, Al was unable to pay Letitia
day, Al turned again to his first option – Joe. Joe apolo- her full salary. He asked her whether she would like
gized for his absences with the admittedly weak excuse to find employment elsewhere or go through the
that “he had been partying, but it wouldn’t happen hardship with AHL. Letitia responded that she would
again.” So Al and Joe reinstated the previous agree- like to stay with AHL. Al promised to pay Letitia the
ment. When Al left for Los Angeles in August 2002, deferred part of her salary as soon as some loans got
AHL had 90 loan applications in the pipeline, constitut- funded, which they did in September. Al trusted
ing nearly $300,000 in potential revenue. Letitia.
Al started monitoring AHL from afar. He learned Later that month, when Joe found out what was hap-
that in the following two weeks, Joe went to the office pening, he became quite upset. Not only was he no
only four times. One day he took a large batch of loan longer the managing partner of AHL, he thought Al
files home and did not return to the office for three days. owed him a lot of money. He wanted his $8,400 invest-
ment back. But Al refused to pay him until he returned
all of AHL’s leads and loan files in his possession. Not
A new partner and licensing only had his dereliction of duty caused AHL great harm,
agreement but none of Joe’s loans had closed since August, which
In September 2002, Al made a final decision that he Al found suspicious.6 In response, Joe filed a civil law-
could not trust Joe. He turned to Wilbur Washington, suit demanding payment.7
to whom Al had been introduced by Joe several months
earlier. Like Al and Joe, Wilbur had considerable expe-
rience in mortgage banking. Al judged quickly that
6
Al later also found out that Joe had used a friend to close his loans,
which violated legal regulations for the mortgage business. Another
reason for Al’s suspicion was that one of AHL’s loan officers had orig-
inated a loan and asked Joe to bring it to the office, but Joe never
4
All names, with the exception of Al Fiorini’s, are disguised. brought it in.
5 7
Al found out later that Joe had a problem with alcoholism. The court dismissed this lawsuit on December 5, 2002.

27
Chapter 1 • Management and Control

Monitoring from California Al had been monitoring the activity in the BofA
account on the Internet from Los Angeles. He noticed
While he was no longer managing the day-to-day oper- that the four checks had been written without his
ations of the company, Al continued to monitor AHL’s knowledge and that they had all bounced. He immedi-
operations closely. Daily, or as soon as the information ately called Wilbur for an explanation. Wilbur told Al
was available, he tracked the employee head count, the that he had withdrawn money from the account to pay
number of leads produced, credit inquiries requested, the employees. Al did not believe this explanation, in
loan applications funded, office expenses, and bank part because the checks were made out to Wilbur and
activity. Al was also on the phone three to four hours not run through the payroll account where payroll
per day talking with employees and, particularly, loan taxes would be withheld if the checks were meant for
officers. He thought that this would allow him to moni- employees. On October 7, 2002, Al sent a fax and certi-
tor the employees’ emotional states, an important lead- fied letter to Wilbur and Letitia and also spoke directly
ing indicator of forthcoming company performance. Al to them, ordering them not to write any more checks
also had all of AHL’s corporate mail forwarded to his without his permission and to make sure that there
California address. Al was particularly concerned were sufficient funds in the account to cover the checks
about Wilbur keeping overhead expenses in line with they wrote. With the returned check charges, the main
production levels so that he would be able to pay the AHL account was already $1,533.09 overdrawn.
employees, to whom Al continued to feel a responsibil- Al also called BofA to stop payments on the four
ity, as well as Al himself. checks and asked the bank to transfer the funds from
In late September, Wilbur hired a new loan proces- the general checking account to a side payroll account
sor. Al knew from experience that every loan officer to which Wilbur would not have access. However,
believes that there is never enough processor time Wilbur managed to release the stop payments on the
available to get “his” particular loan documents com- checks. He transferred the money from the payroll
pleted on a timely basis. But Al’s experience also told account back into the general account and cashed the
him that each processor should be able to fund 20 loans checks. Bank personnel apparently assumed that
per month, so the company needed only one processor Wilbur had authority over the account since he had
for every four loan officers. Al thought that Wilbur was deposited the funds in the first place.
now employing one, or maybe even two, too many pro- Angry and frustrated, Al decided that he could no
cessors and/or salaried, overhead personnel. He sent longer trust Wilbur and could not do business with him.
Wilbur a note telling him that his processor-to-loan- On October 9, 2002, Al asked a friend of his who used to
officer ratio was too high. But Wilbur reacted angrily. be a sales manager in the mortgage company that Al
He told Al “not to tell him what to do,” that he was man- had worked for previously to act as his agent. The friend
aging the company in the best way he saw fit. was to go to AHL’s office and fire all the employees.
Among other things, Al was particularly concerned that
AHL had over 100 client files with sensitive personal
Subsequent events information that might be misused. However, when Al’s
At the time Wilbur took over the operation of AHL, four agent went to the AHL premises to fire the employees,
loans, which would generate total revenues of $11,700, they all refused to go. Al called in the police to support
were about to be funded. This amount was supposed to the firing action, but when they arrived, Wilbur told the
be wired into AHL’s main corporate checking account police that he was the owner, not Al. Not knowing who
at Bank of America (BofA). When the loans funded, was telling the truth, the police just left.
however, on October 1, 2002, without Al’s permission, On October 14, 2002, Al sent a letter to all 100+
Wilbur personally collected the four checks himself AHL clients whose loans were in process that the com-
from the closing attorneys, pooled them together, and pany had to drop their applications. The key phrase in
deposited them into BofA. After depositing the checks, the letter was, “We are no longer going to be able to ser-
Wilbur immediately wrote checks to himself and Leti- vice your application.”
tia for the entire amount of $11,700 using the four pre-
signed checks Al had left.8 However, since Wilbur
wrote the checks against uncleared funds, the checks
bounced. 8
Al found out later that Wilbur and Letitia were actively dating.

28
 Atlanta Home Loan

On October 15, Wilbur opened a new account at Citi- over $7,500 in legal fees and travel costs, and he wasted
zens Bank & Trust (CBT) in Atlanta, a bank where he substantial time and energy dealing with these frivo-
did his personal business and where he knew the man- lous lawsuits.
ager personally. Wilbur wired the funds being held in During all this time, the AHL personnel were main-
AHL’s corporate name at the offices of the closing attor- taining their daily routines. Wilbur renegotiated a lease
neys into this new bank account. He now had signing with the landlord and established AHL as his own com-
authority over the checks. pany. Al suspected that Wilbur had used all of his
Al discovered the second bank account when a “Wel- means of persuasion to mislead the employees in order
come” letter from CBT arrived to his California address. to break their bonds with Al. Al received his $5,000
Al was outraged that personnel at CBT did not ask licensing fee in September, but that was the last money
Wilbur for any corporate documents: he received. By December, Al realized that he had
already lost at least $15,000 in licensing fees, and pos-
Wilbur showed no documentation whatsoever . . . You
sibly more that might have been realized from the
would expect highly regulated institutions like banks
funding of the loans in the pipeline. Moreover, he had
to provide better protection for the public, but . . .
lost his company. Al said, sadly, “I have no idea how
Al immediately called bank personnel and informed much revenue ended up being taken in my name.”
the manager that Wilbur had opened a fraudulent Sensing defeat, Al finally asked the Georgia Depart-
account with CBT. But CBT refused to freeze the ment of Banking and Finance to withdraw AHL’s mort-
account or return the money. As a last resort, Al gage banking license. Not only had he lost his business
informed the Atlanta police and the FBI, thinking that and his income, he had also lost his credit rating since
they might be interested in this identity theft case. he had incurred bills that he was unable to pay. And in
However, possibly due to the relatively small amount of February 2003, Al was forced to sell his home.
money involved, neither the police nor the FBI gave the In the summer of 2003, Al had still not decided what
case any attention. he should do. Should he fight to regain control over
To make things worse, the day Wilbur opened the AHL? But what was left of it? Perhaps only about
fraudulent bank account at CBT, he also filed two appli- $25,000 worth of equipment. Or should he give up, let
cations for warrants for Al’s arrest. Wilbur claimed that these crooks get away with it, and try to rebuild some-
Al was the one who had taken the proceeds received where else?
from the closing attorneys out of the company’s Al also pondered how he had gotten into this mess.
accounts. Al had to return twice to Atlanta to defend What might he have done to prevent this disaster from
himself. Both cases were dismissed, but Al incurred happening?

This case was prepared by Professors Kenneth A. Merchant and Wim A. Van der Stede, and research assistant Clara (Xiaoling) Chen.
Copyright © by Kenneth A. Merchant and Wim A. Van der Stede.

29
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SECTION II
Management Control Alternatives
and Their Effects

31
This page intentionally left blank
CHAPTER 2
Results Controls

If asked to think about powerful ways to influence behavior in organizations, most people
would probably think first about pay-for-performance, which is no doubt an effective motivator.
For example, at Thor Industries, a large recreational vehicle manufacturer, CEO Wade Thomp-
son attributes much of the company’s success to its incentive compensation system. Among
other things, the company shares 15% of each division’s pretax profits with the division manag-
ers, because, Mr. Thompson explained, “I want every one of our company heads to feel like it is
their business, in their control. If they don’t perform, they don’t get paid very much. If they do,
there is no cap to what they can make.”1 Indeed, Vicky Wright, managing director at Hay Group,
a compensation consultancy firm, argues:

[Many] companies on the Most Admired list [a list of companies produced annually by
Fortune] have chief executives who understand what performance measurement is all
about. It’s about learning how to motivate people – how to link those performance meas-
ures to rewards.2

Pay-for-performance is a prominent example of a type of control that can be called results

control because it involves rewarding employees for generating good results. Identifying what
are good results, as we will see, is crucial. Indeed, following the financial crisis through to today,
pay-for-performance systems, especially in banks, have received a hard look, in part because,
rather than producing “good” results, they have been bashed for having bred “bonus cultures”
of greed and short-termism. Even the chief executives of such major banks as Barclays admitted
that their bonus systems were overly “geared,” created temptations for employees to “cut cor-
ners,” and may have backfired through “ethical lapses,” while the chief executive of Deutsche
Bank touched on the basic underlying motivational effect of bonuses by contemplating that
“[he] ha[d] no idea why [he] was offered a contract with a bonus in it because [he couldn’t
imagine he would] work any harder or any less hard in any year, in any day because someone is
going to pay [him] more or less.”3
Nonetheless, even in the aftermath of the financial crisis, investors, regulators, and politi-
cians did not indiscriminately call to do away with pay-for-performance; rather, their calls for
reform were typically directed at making compensation more closely tied to sound performance,
particularly long-term value creation.4
Setting aside possible idiosyncrasies of the financial sector, where one could argue that good
employees work hard every day in other organizations without monster bonuses, results con-
trols of the pay-for-performance variety are widely used, even increasingly so in the non-profit
sector. For example, the National Health and Hospitals Reform Commission in Australia argued
that the fee-for-service system of healthcare rebates often fails to promote the most effective

33
Chapter 2 • Results Controls

treatments because doctors get paid for each consultation or clinical activity regardless of
whether the patient recovers well or not. In considering how to reform this system, the Commis-
sion recommended to link the pay of doctors and nurses to measures of how well they treat their
patients or how quickly they are seen.5 Similar initiatives to create “accountable care organiza-
tions” by providing extra rewards for efficiency and quality performance have also been consid-
ered elsewhere, particularly in the United States.6 “The idea is to see whether shifting financial
incentives for hospitals can make people healthier and save the U.S. money before Medicare’s
hospital trust fund becomes depleted, which could happen by 2024.”7
Clearly, designers of results controls of the pay-for-performance variety have “good” results
(e.g. long-term value creation) – even perhaps lofty results (e.g. making people healthier and
saving a country’s healthcare system from ruin) – in mind when implementing them, brought
about through the motivational, results-driven effects such systems purportedly can have.
Anecdotal as well as research evidence, however, have repeatedly thrown the potency of these
systems into sharp relief by suggesting that either they have weak or no effects or, where they
do, they can produce the wrong results or have severe unintended consequences.
Even so, and despite, perhaps, a prevalent emphasis on pay-for-performance in many con-
texts, the rewards that can be linked to results go far beyond monetary compensation. Other
rewards that can be usefully tied to measured performance include job security, promotions,
autonomy, plum assignments, and recognition. (We discuss the vast array of rewards that can
be given more fully in Chapter 9.)
Furthermore, results controls create meritocracies. In meritocracies, the rewards are given to the
most talented and hardest-working employees, rather than to those with the longest tenure or the
right social connections. At Koch Industries, a conglomerate, results controls are seen as the “secret
sauce” with two main ingredients – meritocracy and operational efficiency. Charles Koch, its boss,
is proud to proclaim that “workers can earn more than their bosses [and] high-school-educated
farm boys from Kansas can rise faster than Ivy League MBAs” based on their performance.8
The combinations of rewards linked to results inform or remind employees as to what result
areas are important and motivate them to produce the results the organization rewards. Results
controls influence actions or decisions because they cause employees to be concerned about the
consequences of their actions or decisions. The organization does not dictate to employees what
actions or decisions they should take; instead, employees are empowered to take those actions or
decisions they believe will best produce the desired results. Results controls also encourage
employees to discover and develop their talents and to get placed into jobs in which they can
perform well.
For all these reasons, well-designed results control systems can help produce the results
desired. A review of studies on the use of incentives to motivate performance found an average
gain in performance of about 22% stemming from the use of incentive programs.9 Like all other
forms of controls, however, results controls do not operate in isolation10 and, equally, cannot be
used in every situation. They are effective only where the desired results can be clearly defined
and adequately measured by the organization, and where the measured results can be suffi-
ciently controlled by the employee.11 We discuss the conditions for the effective use of results
controls in greater depth in this chapter.

Prevalence of results controls

Results controls are commonly used for controlling the behaviors of employees at many organi-
zational levels. They are a necessary element in the employee empowerment approach to man-
agement, which became a major management trend starting in the 1990s.12 Results controls

34
 Prevalence of results controls

are particularly dominant as a means of controlling the behaviors of professional employees;

those with decision authority, like managers. Reengineering guru Michael Hammer even
defines a professional as “someone who is responsible for achieving a result rather than [for]
performing a task.”13
Results controls are consistent with, and even necessary for, the implementation of decen-
tralized forms of organization with largely autonomous entities or responsibility centers (which
we discuss in more detail in Chapter 7). For example, business pioneer Alfred Sloan observed
that he sought a way to exercise effective control over the whole corporation yet maintain a
philosophy of decentralization.14 At General Motors (and numerous other companies that fol-
lowed), the results controls under Sloan’s leadership were built on a return-on-investment
(ROI) performance measure (which we discuss in more detail in Chapter 10). By using this type
of control system, corporate management could review and judge the effectiveness of the vari-
ous organizational entities while leaving the actual execution of operations to those responsible
for the performance of the decentralized entities – the entity managers.
Many large corporations have gone through the process of instituting decentralized forms of
organization with a concurrent increased emphasis on results control. For example, DuPont
replaced a complex management hierarchy by splitting the company into 21 strategic business
units (SBUs), each of which operates as a free-standing unit. The SBU managers were given
greater responsibility and asked to be more entrepreneurial and more customer-focused. They
were also asked to bear more risk, because a large portion of SBU managers’ compensation was
based on SBU performance (sales and profitability). The managers noticed the change. One
SBU manager said, “When I joined DuPont [21 years ago], if you kept your nose clean and
worked hard, you could work as long as you wanted. [But today] job security depends on
results.”15 The change was perceived as being successful: A Business Week article noted that,
“The image of DuPont has morphed from giant sloth to gazelle.”16
In 2010, Sanofi-Aventis, a large pharmaceutical company, divided its vast resources into
decentralized disease-based units, each with its own departments for research and develop-
ment, regulatory affairs, marketing, and sales – a plan designed to identify promising drugs
more quickly and weed out failures before spending large amounts of money on unsuccessful
drugs. One industry expert noted that “the [model of] fully independent units, operating under
the parent company’s umbrella, [constitutes] a break from the traditional big pharma business
model, and represents companies’ interest in duplicating the flexibility and cost-efficiencies of
small biotech and biotech-like companies.”17 By establishing accountability for a fully inte-
grated entity’s results, where the entity manager closest to the business makes the tradeoffs and
takes responsibility over the entity’s budget, the company aims to instill a “performance cul-
ture” that encourages both operating discipline (efficiency) and greater responsiveness to local
business needs (flexibility).
In other words, decentralization attempts to replicate an “entrepreneurial model” within
typically large corporations, where entity managers are given decision authority but then held
responsible for the results that their decisions produce. Accountability for results was exactly
the driving motive behind a recent reorganization into “reporting segments” at Air Products
Chemicals Inc., a large industrial gases producer, which Seifi Ghasemi, Air Products’ chief exec-
utive, claimed would retain Air Products’ leadership position through “a decentralized, simpler,
and more efficient structure which creates true profit and loss (P&L) accountability at many
levels of the organization.”18
Similarly, when Nick Reilly became CEO in late 2009 of troubled Opel, the German car man-
ufacturer owned by General Motors, he announced that he wanted to encourage an entrepre-
neurial spirit at Opel by delegating most decisions to country heads and dismantling GM’s
bureaucratic style of centralized management that fostered a “debilitating culture of passing
the buck.” “It might seem obvious, but it isn’t the way GM was managed and there was definitely

35
Chapter 2 • Results Controls

some confusion about who was accountable,” he said. “From the top line of revenue to the bot-
tom line of profit, this is now the responsibility of the managing directors of the major entities,”
Reilly added.19
However, managers will act in an entrepreneurial manner necessary to thrive in competitive
environments not only if they are subjected to the same market forces and pressures that drive
independent entrepreneurs, but also if they are promised commensurate rewards for the risks
they bear from doing so. As such, Richard Chandler, founder of Sunrise Medical, a medical
products company, defended his company’s decentralized organization and lucrative incentives
by stating that “people want to be rewarded based on their own efforts. [Without divisional
accountability] you end up with a system like the U.S. Post Office. There’s no incentive [for
workers to excel].”20
Results controls need not be limited to management levels only; they can also be driven
down to lower levels in the organization, as many companies have done with good effects. Lin-
coln Electric, a worldwide leader in the production of welding products, serves as the poster
child of companies that use results controls down to the lowest organizational level. Lincoln
Electric provides wages based solely on piecework for most factory jobs and lucrative perfor-
mance-based bonuses that can more than double an employee’s pay.21 This incentive system
has created such high productivity that some of the industry giants (General Electric, Westing-
house) found it difficult to compete in Lincoln Electric’s line of business (arc welding) and exited
the market. A Business Week article observed that “in its reclusive, iconoclastic way, Lincoln
Electric remains one of the best-managed companies in the United States and is probably as
good as anything across the Pacific.”22 And even though Lincoln’s legendary Incentive Perfor-
mance System has essentially remained the same since it was installed in 1934, the company is
still acclaimed for its systems and performance today, such as in the book The Modern Firm.23
Whereas decentralization is an effective way to empower employees in a results-control con-
text, there can, and even should, be limits to empowerment in certain circumstances. One prob-
lem is infighting, as exemplified at Sears, a struggling US retailer. Edward Lampert, the investor
who had tried for eight years to turn around the company, “divided Sears into more than 30
units, each with their own presidents, chief marketing officers, boards of directors and profit-
and-loss statements, which former executives say has caused infighting.”24
Other issues stem from loss of economies of scale or increased costs and inefficiencies, or
even inconsistencies, and complexity. This is reflected in the situation that Alex Gorsky, a
21-year Johnson & Johnson veteran who was named CEO in April 2012, inherited:
The J&J that Gorsky inherited was superficially easy to understand: 40% of sales came
from drugs, another 40% from medical devices, and the rest from consumer products. Dig
deeper and it was unimaginably complex: 275 operating companies, 450 distribution cent-
ers, more than 120 manufacturing sites, 500 outside manufacturers, and 60 enterprise
resource-planning systems. It was more a flotilla of speedboats than a single ship. In the
past, that famous decentralization inspired entrepreneurial thinking. Lately, it caused qual-
ity-control problems that bedeviled the company.25

Gorsky said: “We have to be more decisive and disciplined, and more efficient. Otherwise, it
is too complex, and it costs too much.” Part of that was addressing decentralization: Gorsky
introduced a program to centralize procurement, which would enhance J&J’s buying power. He
also ordered up new quality and compliance controls to ensure consistent standards.26
Decentralization may also increase overlap, and curiously, it “may also create more oppor-
tunities for corruption by increasing the number of decision makers with the power to exploit
the decision-making process for personal gain.” 27 For example, when pursuing rapid growth
in China, French hypermarket Carrefour faced systemic corruption among its management
ranks at the local levels. Unlike the centralized approach to management that Wal-Mart

36
 Results controls and the control problems

employed in China, Carrefour empowered local managers to take charge of virtually all
aspects of running their stores, including product pricing and promotions, supplier selection,
and store design. Whereas this high degree of flexibility gave ample leeway for managers to
expand fast in the early stages of building the chain, it also encouraged widespread bribe-
taking at the local level and, over time, led to higher operating costs and reputation risk than
would a centralized system.28
But decentralization puts decision making closest to where the detailed knowledge and
understanding of the business resides, allowing greater responsiveness. “A decentralized struc-
ture provides better information over time, which helps decision-making and accountability,”
said Lambert of Sears,29 and echoed by Airbus chief Fabrice Bregier:

Now is the time to give a little bit more power to local teams in our countries, in our pro-
grams, in our plants [as] we need to take decisions faster. This is a weakness of Airbus. It
takes much too long to make decisions, I want to speed it up and simplify it.30

The chief executive at China’s Huawei, Ren Zhengfei, put it as follows:

The future model is to give the biggest say to our local teams who are closest to our cus-
tomers and empower them so they have flexibility in interaction with customers. The head-
quarters or corporate functions will change into a more supporting and service function.31

And at Samsonite, the luggage maker, chief executive Tim Parker said:

I think we were trying to run a very centralized business in a marketplace where our con-
sumers differed enormously. We had to decentralize our decision-making. So we created
an Asian business, a Europe business and an American business, and that allowed each
management team to concentrate on local customers.32

The multitude of examples above also illustrate that firms can decentralize by geographical
regions, business groups or segments, product lines, or a variety of other lines of delegation in
their organization structure. One critical point, however, is that decentralization or “delegation
of decision rights” to managers, and the design of incentive systems to motivate these managers
to generate the desired results, are two critical organizational design choices in a results-con-
trol context; they are part of what organizational theorists call the organizational architecture.
This literature maintains that organizational choices about decentralization and incentive sys-
tems should be made jointly, and that concentrating on one element to the exclusion of the other
will lead to poorly designed organizations.33

Results controls and the control problems

Results controls provide several preventive-type benefits. Well-defined results inform employ-
ees as to what is expected of them and encourage them to do what they can to produce the
desired results. In this way, the results controls alleviate a potential lack of direction. Results
controls also can be particularly effective in addressing motivational problems. Even without
direct supervision or interference from higher up, the results controls induce employees to
behave so as to maximize their chances of producing the results the organization desires. This
motivational effect arises particularly when incentives for producing the desired results also
further the employees’ own personal rewards. Finally, results controls also can mitigate per-
sonal limitations. Because results controls typically promise rewards for good performers, they
can help organizations to attract and retain employees who are confident about their abilities.

37
Chapter 2 • Results Controls

Results controls also encourage employees to develop their talents to position themselves to
earn the results-dependent rewards.34
The performance measures that are a part of the results controls also provide some non-
motivational, detection-type control benefits of a cybernetic (feedback) nature, as was men-
tioned in Chapter 1. The results measures help managers answer questions about how various
strategies, organizational entities, and/or employees are performing. If performance fails to
meet expectations, managers can consider changing the strategies, the processes, or the man-
agers.35 Investigating and intervening when performance deviates from expectations is the
essence of a management-by-exception approach to management, which large organizations
commonly use.

Elements of results controls

The implementation of results controls involves four steps: (1) defining the dimension(s) on
which results are desired; (2) measuring performance in the chosen dimensions; (3) setting
performance targets for employees to attain for each of the measures; and (4) providing rewards
for target attainment to encourage the behaviors that will lead to the desired results. While
these steps are easy to list, executing them effectively can be challenging.

Defining performance dimensions

Defining the right performance dimensions involves balancing an organizations’ responsi-
bilities to all of their stakeholders, including owners (equity holders), debtholders, employ-
ees, suppliers, customers, and the society at large. Should a firm’s sole aim be to maximize
shareholder returns, or should it also, or even primarily, be customer- or employee-focused?
Are these performance foci mutually exclusive, or are they rather mutually reinforcing?36
Where do performance dimensions such as innovation and sustainability belong? And so on.
As challenging as defining the desired performance dimensions may be, it is equally critical
to choose performance measures that are congruent or aligned with the chosen performance
dimensions because the goals that are set and the measurements that are made will shape
employees’ views of what is important. Phrased differently, what you measure is what you get.
For example, firms may define one of their desired performance dimensions to be shareholder
value creation, and yet measure performance in terms of accounting profits. This implies that
employees are likely to try to improve the measured performance (in this example, accounting
profits) regardless of whether or not it contributes to the desired performance (in this example,
shareholder value). We discuss this problem, and the difficulties related to this particular exam-
ple, further in Chapters 5, 10, and 11.
Similarly, firms may aim to pursue innovation, yet they end up measuring patents filed.
Anxious to promote innovation, many companies offer incentives to their employees to
develop patentable ideas, and such incentives are likely to produce results in the form of an
increase in the number of patents filed. But as Tony Chen, a patent attorney with Jones Day
in Shanghai, notes, “patents are easy to file, but gems [can be] hard to find in a mountain
of junk.” 37
Citibank’s chief executive, Michael Corbat, slightly rephrased this adage by proclaiming
that “you are what you measure.”38 He felt he needed to measure performance in five catego-
ries to try to alleviate the singular focus of managers on one measure, exactly because you get
what your measure. His plan was welcomed by an analyst who commented that “the most
important job of a CEO is to make sure that the right incentives are in place [because]
improper measures lead to improper behavior.” 39 We discuss the use of multiple measures of

38
 Elements of results controls

performance, such as by way of so-called scorecards, which Mr. Corbat advocated at Citibank,
in Chapter 11.
The problem of misalignment has also been at the heart of some of the work by Jean Tirole,
the 2014 Nobel Prize winner in economics. Tirole examines the undesirable consequences that
performance-dependent incentives in the measured areas can have, either by skewing how
employees approach their jobs, shifting effort away from less-easily measured (and hence unre-
warded) tasks such as long-term investments, employee development, and within-firm cooper-
ation; or by undermining work ethic by encouraging excessive risk-taking, inducing “managed”
performance or producing “fudged” performance metrics.40 The first part of this problem – the
skewing part – is known in the literature as the multitasking problem, and we discuss it in more
detail in Chapter 5.
Even though Bloomberg concluded that “there’s a role for Tirole to advise on how to struc-
ture compensation without inciting the kind of disastrous risk-chasing that sparked the finan-
cial crisis,”41 this important congruence problem also surfaces in many other sectors,
including the non-profit sector. For example, a study by the Home Office in the United King-
dom found that organized trafficking was a “thriving industry” that “makes a killing,” amass-
ing healthy profits with little risk of detection. The study suggested that one of the reasons for
this was the ill-defined performance targets that the police had to meet. Solving high volumes
of simple crimes such as petty thefts and home burglaries is easier and cheaper than the long-
drawn-out and expensive police work that is needed to crack down on trafficking rings. Even
though the goal was to reduce crime, the result may have been that hardened criminals were
let off.42
Hence, not only do firms need to decide what is desired, but they also must ensure that their
measurements of the desired performance dimensions are aligned with what is desired. If they
are not, the results controls are likely to encourage employees to produce undesired results. The
results controls can then be said to have unintended consequences.

Measuring performance
As per the above, then, measurement is a critical element of a results-control system. The object
of the measurement is typically the performance of an organizational entity or an employee
during a specific time period. Many objective financial measures, such as net income, earnings
per share, and return on assets, are in common use. So, too, are many objective nonfinancial
measures, such as market share, customer satisfaction, and the timely accomplishment of cer-
tain tasks. Some other measurements involve subjective judgments involving assessments of
qualities; for example, “being a team player” or “developing employees effectively.”
Performance measures typically vary across organizational levels. At higher organizational
levels, most of the key results are defined in either stock market terms (such as share price)
and/or financial or accounting terms (such as a return on equity). Lower-level managers, on
the other hand, are typically evaluated in terms of operational measures that are more control-
lable at the local level. The key result areas for a manager in charge of a manufacturing site, for
example, might be a combination of measures focused on production efficiency, inventory con-
trol, product quality, and delivery time. The variation in the use of financial and operational
performance measures between higher- and lower-level management creates a hinge in the
management hierarchy. That is, at some critical middle organizational level, often a profit
center level (see Chapter 7), managers must translate financial goals into operational goals.
These managers’ goals are defined primarily by financial measures, so their communications
with their superiors are primarily in financial terms. But because their subordinates’ measures
are primarily operational, their downward communications are primarily in operational
terms.

39
Chapter 2 • Results Controls

If managers identify more than one result measure for a given employee, they must attach
weightings to each measure so that the judgments about performance in each result area can be
aggregated into an overall evaluation. The weightings can be additive. For example, 60% of the
overall evaluation is based on return on assets and 40% is based on sales growth. The weight-
ings can also be multiplicative. For example, achievement of profit and revenue goals might be
multiplied by a score assessed on the basis of environmental responsibility. If the environmen-
tal responsibility score is less than 70%, say, the multiplier is zero, yielding no bonus. Sometimes,
organizations make the weightings of performance measures explicit to the employees, as in the
example just presented. Often, however, the weightings are partially or totally implicit, such as
when the performance evaluations are done subjectively. Leaving the weighting implicit blurs
the communication to employees about what results are important. Employees are left to infer
what results will most affect their overall evaluations. That said, evidence suggests that implicit
weights can generate improvements in performance and, thus, can be effective as an alterna-
tive, or at least complement, to the explicit weighting of performance measures in incentive
contracts.43

Setting performance targets

Performance targets are another important results-control element because they affect behav-
ior in two ways. First, they improve motivation by providing clear goals for employees to strive
for. Most people prefer to be given a specific target to shoot for, rather than merely being given
vague statements like “do your best” or “work at a reasonable pace.”44 Second, performance
targets allow employees to assess their performance. People do not respond to feedback unless
they are able to interpret it, and a key part of interpretation involves comparing actual perfor-
mance relative to target. The targets distinguish strong from poor performance. Failure to
achieve the target signals a need for improvement. (We discuss performance targets and target
setting processes in more detail in Chapter 8.)
The following example illustrates both points. Maria Giraldo, a nurse in the intensive care
unit at Long Island Jewish Medical Center, used to be evaluated on such criteria as leadership,
respectfulness, and how well she worked with others. A few years ago, her hospital imple-
mented a new computer-based performance system that broke down her job description into
quantifiable goals, such as to keep infection rates for her unit low and patient satisfaction
scores high, all relative to specific target levels. Ever since this new system was implemented,
at review time, the discussion does not linger on about how Ms. Giraldo had performed. Either
she hit the targets, or she did not. The clarity about measures and goals, and the reviews “by
the numbers” that they allow, changed Ms. Giraldo’s views about success and what she needs
to do to get ahead in her career – all for the better, she believed.45 (In Chapter 9, we discuss the
drawbacks of relying exclusively on objective, formulaic performance evaluations in more
detail.)

Providing rewards
Rewards or incentives are the final element of a results-control system. The rewards included in
incentive contracts can come in the form of anything employees value, such as salary increases,
bonuses, promotions,46 job security, job assignments, training opportunities, freedom, recogni-
tion, and power. Punishments are the opposite of rewards. They are things employees dislike,
such as demotions, supervisor disapproval, failure to earn rewards that colleagues earn, or, at
worst, dismissal.

40
 Elements of results controls

Organizations can elicit motivational effects from linking the prospect of rewards (or
punishment) to results that employees can influence. For example, organizations can use
any of a number of extrinsic rewards. They can grant additional monetary rewards, such as
in the form of cash or stock. They can use non-monetary rewards, such as by granting high-
performing employees public recognition and more decision authority. Alternatively, in
entities where performance is mediocre or poor, they can threaten to reduce the decision
authority and power that managers derive from managing their entities or decline to fund
proposed projects.
Results measures can provide a positive motivational impact even if no rewards are explic-
itly linked to results measures. People often derive their own internally generated intrinsic
rewards through a sense of accomplishment for achieving the desired results. For example,
when William J. Bratton became the New York City police commissioner, he gave his police
force one clear, simple goal: cut crime.47 (Previously the thinking had been that crime was due
to societal factors beyond the department’s control, so the police were measured largely by how
quickly they responded to emergency calls.) He also implemented a results-control system. He
decentralized the department by giving the 76 precinct commanders the authority to make
most of the key decisions in their police units, including the right to set personnel schedules,
and he started collecting and reporting crime data daily. Even though Commissioner Bratton
legally could not award good performers with pay raises or merit bonuses, the system was
deemed effective. In the subsequent two years, major felonies in New York fell first by 12% and
then a further 18%, respectively. This clearly could not have been attributable to pay-for-perfor-
mance in the strictest sense; it was instead due, at least in part, to providing officers with clear
goals and empowering them to go about fighting crime. Seeing the results of their initiatives
may have given police officers a sense of accomplishment and a greater intrinsic motivation to
perform well.
The motivational strength of any of the extrinsic or intrinsic rewards can be understood in
terms of several motivation theories that have been developed and studied for over 50 years,
such as expectancy theory. Expectancy theory postulates that individuals’ motivational force, or
effort, is a function of (1) their expectancies, or their belief that certain outcomes will result from
their behavior (e.g. a bonus for increased effort); and (2) their valences, or the strength of their
preference for those outcomes. The valence of a bonus, however, is not always restricted to its
monetary value; it also may have valence in securing other valued items, such as status and
prestige.48
Organizations should promise their employees the rewards that provide the most powerful
motivational effects in the most cost-effective way possible. But the motivational effects of the
various forms of reward can vary widely depending on an individual’s personal tastes and cir-
cumstances. Some people are greatly interested in immediate cash awards, whereas others are
more interested in increasing their retirement benefits, increasing their autonomy, or improv-
ing their promotion prospects. Reward tastes also vary across countries for a number of rea-
sons, including differences in cultures and income tax laws.49 However, if organizations can
tailor their reward packages to their employees’ individual preferences, they can provide mean-
ingful rewards in a cost-efficient manner. But tailoring rewards to individuals or small groups
within a large organization is not easy to accomplish and is sometimes even seen as possibly, or
even legally, inequitable. A tailored system will likely be complex and costly to administer.
When poorly implemented, it can easily lead to employee perceptions of unfairness and poten-
tially have the opposite effects of those intended: demotivation and poor employee morale. We
discuss the choice of different forms of incentives and incentive system design in more detail in
Chapter 9.

41
Chapter 2 • Results Controls

Conditions determining the effectiveness of results controls

Although they are an important form of control in many organizations, results controls cannot
always be used effectively. They work best only when all of the following conditions are present:

1. Organizations can determine what results are desired in the areas being controlled;
2. The employees whose behaviors are being controlled have significant influence on the
results for which they are being held accountable; and,
3. Organizations can measure the results effectively.

Knowledge of desired results

For results controls to work, organizations must know what results are desired in the areas they
wish to control, and they must communicate the desired results effectively to the employees
working in those areas. Results desirability means that more of the quality represented by the
results measure is preferred to less, everything else being equal.
As we alluded to earlier, even if one might agree that (one of) the primary objective(s) of for-
profit firms or corporates is to maximize shareholder value, this does not imply that the desired
results, even if the overall objective is understood, will be unequivocally known or have unam-
biguous meaning at all intermediate and lower levels in the organization. The disaggregation of
overall organizational objectives into specific expectations for all employees lower in the hier-
archy is often difficult. Different parts of the organization face different tradeoffs.
For example, purchasing managers create value by procuring good-quality, low-cost materi-
als on time. These three result areas (quality, cost, and schedule) can often be traded off against
each other, and the overall organizational objective to maximize profit provides little guidance
in making these tradeoffs. The importance of each of these results areas may vary over time and
among parts of the organization depending on differing needs and strategies. For example, a
company (or entity) short of cash may want to minimize the amount of inventory on hand,
which may make scheduling the dominant consideration. A company (or entity) with a cost
leadership strategy may want to emphasize the cost considerations. A company (or entity) pur-
suing a unique product quality image or differentiation strategy may emphasize meeting or
exceeding the specifications of the materials being purchased. Thus, to ensure proper purchas-
ing manager behaviors, the importance orderings or weightings of these three results areas
must be made clear and aligned with the strategy.
If the wrong results areas are chosen, or if the right areas are chosen but given the wrong
weightings, the combination of results measures will not be congruent with the organization’s
intended objectives. Using an incongruent set of results measures may then result in motivating
employees to take the wrong actions. In the above setting, for example, ill-guided cost consid-
erations may damage the company’s pursued product-quality reputation.

Ability to influence desired results (controllability)

A second condition that is necessary for results controls to be effective is that the employees
whose behaviors are being controlled must be able to affect the results in a material way in a
given time period. This controllability principle is one of the central tenets of responsibility
accounting (which we discuss in more detail in Chapters 7 and 12). Here are some representa-
tive expressions that have stood the test of time of this perennial principle:

It is almost a self-evident proposition that, in appraising the performance of divisional

management, no account should be taken of matters outside the division’s control.50

42
 Conditions determining the effectiveness of results controls

A manager is not normally held accountable for unfavorable outcomes or credited with
favorable ones if they are clearly due to causes not under his control.51

The main rationale behind the controllability principle is that results measures are useful
only to the extent that they provide information about the desirability of the actions or deci-
sions that were taken. If a results area is totally uncontrollable, the results measures reveal
nothing about what actions or decisions were taken. Partial controllability makes it difficult to
infer from the results measures whether or not good actions or decisions were taken.
In most organizational situations, of course, numerous uncontrollable or partially uncontrol-
lable factors inevitably affect the measures used to evaluate performance. These uncontrollable
influences hinder efforts to use results measures for control purposes. As a consequence, it
becomes difficult to determine whether the results achieved are due to the actions or decisions
taken or, rather, to uncontrollable factors or noise. Good actions and decisions will not necessar-
ily produce good results. Bad actions or decisions may similarly be obscured.
In situations where many significant, uncontrollable influences affect the available results
measures, results control is not effective. Managers cannot be relieved of their responsibility
to respond to some uncontrollable factors or be exempted from dealing with reasonable or
normal uncertainty in their environment; but if these factors, or the uncertainty, are difficult
to separate from the results measures, results controls do not provide good information for
either evaluating performance or motivating good behaviors. We discuss the methods that
organizations use to cope with uncontrollable factors in results-control systems in more detail
in Chapter 12.

Ability to measure controllable results effectively

Ability to measure the controllable results effectively is the final constraint limiting the feasi-
bility of results controls. Often the controllable results that the organization desires, and that
the employees involved can affect, cannot be measured effectively. In virtually all situations,
something can be measured; but often, however, the key results areas cannot be measured
effectively.
The key criterion that should be used to judge the effectiveness of results measures is the
ability to evoke the desired behaviors. If a measure evokes the right behaviors in a given situ-
ation – that is, if the measure can be said to be congruent with the desired results area – then
it is a good control measure. If it does not, it is a bad one, even if the measure accurately
reflects the quantity it purports to represent; that is, even if the measurement has little meas-
urement error.
To evoke the right behaviors, in addition to being congruent and controllable, results meas-
ures should be precise, objective, timely, and understandable. Even when a measure has all of the
above qualities, it should also be cost efficient; that is, the costs of developing and using the
measure should be considered.

Precision
Measurements inevitably contain error, some random, some systematic. Error makes the meas-
urement inaccurate. Measurement accuracy refers to the degree of closeness of measurements
of a quantity to its actual (true) value. Precision is the degree to which repeated measurements
under similar conditions show the same result; if they do, the measurements can be said to be
reliable. Using a bull’s-eye analogy, accuracy describes the closeness of arrows (measurement)
to the target (true value). When all arrows are grouped tightly together, the cluster of arrows
(measurement) is considered precise since they all struck close to the same spot, even if not nec-
essarily near the bull’s-eye.

43
Chapter 2 • Results Controls

Reducing systematic error (or bias) improves accuracy but does not change precision. How-
ever, it is not possible to achieve accuracy in measurement without precision; that is, when the
measures contain mostly random error or, thus, when they are unreliable. In other words, and
in the bull’s-eye analogy, if the arrows are not grouped close to one another, they cannot all be
close to the bull’s-eye. Therefore, lack of precision is an undesirable quality for a results meas-
ure to have. But even precise measures that are biased (i.e. that contain systematic error) may
not be of great use for control purposes. If the degree of the systematic error is not known; then
the measurement will be systematically biased by either showing greater or lesser values than
the actual value (see the next section on objectivity).
It is obvious that some aspects of performance (such as social responsibility, leadership acu-
men, and personnel development) are difficult, or even impossible, to measure precisely, either
because the measurements contain random error or are systematically biased (such as may be
the case when subjective performance evaluations are used). Precision, therefore, is important
because without it, the measure loses much of its information value. Imprecise measures
increase the risk of misevaluating performance. Employees will react negatively to the inequi-
ties that inevitably arise when equally good performances are rated differently.

Objectivity
An objective measure here means that it is not influenced by personal feelings, mental states,
emotions, tastes, or interpretations – hence, that it is unbiased. Measurement objectivity will be
inevitably suspect where either the choice of measurement rules or the actual measuring is
done by the persons whose performances are being evaluated. Low objectivity is likely, for
example, where performance is self-reported or where evaluatees are allowed considerable dis-
cretion in the choice of measurement methods. Indeed, and referring to the earlier definition
related to measurement precision, low objectivity is likely to introduce systematic error due to,
for example, selectivity, leniency, or lack of self-criticalness. If that is the case, the measure-
ment may be precise, but it will not be accurate. Good measures for control purposes therefore
should be both precise (reliable) and objective (unbiased).
There are two main ways to increase measurement objectivity. The first is to have the meas-
uring done by people independent of the processes that generate the results, such as by person-
nel in the controller’s department. The second is to have the measurements verified by
independent parties, such as auditors.

Timeliness
Timeliness refers to the lag between the employee’s performance and the measurement of
results (and the provision of rewards based on these results). Timeliness is an important meas-
urement quality for two reasons. The first is motivational. Employees need repeated perfor-
mance pressure to perform at their best. The pressure helps ensure that the employees do not
become complacent, inattentive, sloppy, or wasteful. Measures, and thus rewards, that are
delayed for significant periods of time lose most of their motivational impact. The sustained
pressure can also encourage creativity by increasing the likelihood that employees will be stim-
ulated to repeatedly search for new and better ways to improve results.
As The Financial Times noted about deferred bonuses in banks, “beloved by the regulators
because they allow the payout to be adjusted if conditions change, [they do, however,] reduce
the motivational value of bonuses – by the time the employees receive the money they may not
remember what was being rewarded,”52 making it also unlikely that the rewards will affect or
adjust the behaviors that led to those results.
A second advantage is that timeliness increases the value of interventions that might be nec-
essary. If significant problems exist but the performance measures are not timely, it might not
be possible to intervene to fix the problems before they cause (more) harm.

44
 Conditions determining the effectiveness of results controls

Understandability
Two aspects of understandability are important. First, the employees whose behaviors are being
controlled must understand what they are being held accountable for. This requires communi-
cation. Training, which is a form of communication, may also be necessary if, for example,
employees are to be held accountable for achieving goals expressed in new and different terms,
such as when an organization shifts its measurement focus from accounting income to, say,
economic value added (more on this in Chapter 11).
Second, employees must understand what they must do to influence the measure, at least in
broad terms. For example, purchasing managers who are held accountable for lowering the
costs of purchased materials will not be successful until they develop strategies for accomplish-
ing this goal, such as improving negotiations with vendors, increasing competition among ven-
dors, or working with engineering personnel to redesign certain parts. Similarly, employees
who are held accountable for customer satisfaction must understand what their customers
value and what they can do to affect it. The same holds for teachers in universities who often do
not understand what specific teaching skills or approaches result in better (or worse) teaching
evaluations by their students at the end of the term.
When employees understand what a measure represents, they are empowered to work out
what they can do to influence it. In fact, this is one of the advantages of results controls: good
control can be achieved without knowing exactly how employees will produce the results.

Cost efficiency
Finally, measures should be cost efficient. A measure might have all of the above qualities and
yet be too expensive to develop or use (e.g. when it involves third-party surveys of customers,
say, to collect the data), meaning that the costs exceed the benefits. When that is the case, the
firm may need to settle for an alternative, more cost-efficient measure. Advances in technology
and data analysis, such as related to “big data,” have made data that had hitherto been hard to
obtain or analyze more readily available. But data are not information, and these data do not
uniformly have good properties, where much of it is unstructured. For example, understanda-
bility in terms of the claimed relationships with specific actions and decisions often is particu-
larly problematic. And even objectivity can be an issue, perhaps surprisingly, because, as it has
been said, “torture the data long enough and they will confess to anything.”53
For example, California’s MemorialCare Health System is part of a movement by hospitals
around the United States to change how doctors practice by monitoring their progress toward
goals. What is different this time, some hospital executives argue, is that “new technology ena-
bles closer, faster tracking of individual doctors,” where MemorialCare is keeping detailed data
on how the doctors perform on many measures, including adolescent immunizations, mammo-
grams, and keeping down the blood-sugar levels of diabetes patients. The results are compiled,
number-crunched, and eventually used to help determine how much money doctors will earn,
where the new insurance payments also factor in quality goals. An assessment of this “doctor-
data” system indicates that it has helped reduce the average stay for adult patients, trimmed the
average cost per admitted adult patient, and led to improvements in indicators of quality,
including patient re-admissions, mortality, and complications. This has not been unconten-
tious, however. Cardiologist Venkat Warren said that he worried that “some bean-counter will
decide what performance is” and wondered whether doctors would be pushed to avoid older
and sicker patients who might drag down their numbers.54
Overall, many measures cannot be classified as either clearly good (effective) or poor (inef-
fective). Different tradeoffs among the measurement qualities create some advantages and dis-
advantages. For example, measures can often be made more congruent, controllable, precise
and objective if timeliness is compromised. Thus, in assessing the effectiveness of results

45
Chapter 2 • Results Controls

measures, many difficult judgments are often necessary. These judgments are discussed in
more detail throughout several chapters of this text.

Conclusion

This chapter described an important form of control, results control, which is used at many lev-
els in most organizations. Results controls are an indirect form of control because they do not
focus explicitly on the employees’ actions or decisions. However, this indirectness provides
some important advantages. Results controls can often be effective when it is not clear what
behaviors are most desirable. In addition, results controls can yield good control while allowing
the employees whose behaviors are being controlled high autonomy. Many people, particularly
those higher in the organizational hierarchy but also so-called knowledge workers, value high
autonomy and respond well to it, although they may not always respond well to the measures
used, particularly when these suffer from significant weaknesses in terms of the various meas-
urement properties we discussed.
Results controls are therefore clearly not effective in every situation. Failure to satisfy all
three effectiveness conditions – knowledge of the desired results, ability to affect the desired
results, and ability to measure controllable results effectively – will impair the results controls’
effectiveness, if not render them impotent. Worse, it could produce dysfunctional side effects,
various forms of which we discuss in later chapters.
That said, results controls usually are the major element of the management control system
(MCS) used in all but the smallest organizations. However, results controls often are supple-
mented by action and personnel/cultural controls, which we discuss in the next chapter.

Notes
1 “Lord of the Rigs,” Forbes (March 29, 2004), p. 68. a Manufacturing Firm,” European Accounting Review, 24,
2 “Measuring People Power,” Fortune (October 2, 2000), p. no. 2 (2015), pp. 241–76.
186. 11 As an example of several results-control issues that can
3 “Bank Bonuses: Bashing Ignores the Benefits for Inves- arise when these conditions are not met, see S. Kerr, “The
tors,” Financial Times (November 27, 2015), online at on. Best-Laid Incentive Plans,” Harvard Business Review, 81,
ft.com/1kXpBJ9. no. 1 (January 2003), pp. 27–40.
4 Ibid. See also “Geithner: Link Executive Pay to Perfor- 12 See, for example, K. H. Blanchard, J. P. Carlos, and W. A.
mance,” The Washington Times (June 10, 2009), online at Randolph, The Three Keys to Empowerment (San Fran-
washingtontimes.com. cisco, CA: Berrett-Koehler Publishers, 1999). Also see “C.
5 “Performance Pay Likely for Doctors,” The Australian Oswick, “Engaging with Employee Engagement in HRD
(May 6, 2009), online at www.theaustralian.com.au. Theory and Practice,” Human Resource Development
6 “Hospitals Prescribe Big Data to Track Doctors at Work,” Review (2015), pp. 1–9, particularly Figure 1, p. 2.
The Wall Street Journal (July 11, 2013), online at www. 13 M. Hammer, Beyond Reengineering: How the Process-Cen-
wsj.com. tered Organization is Changing Our Work and Our Lives
7 “Medicare’s $963 Million Experiment,” Business Week (New York: Harper Business, 1996).
(September 6, 2012), online at www.bloomberg.com. 14 A. P. Sloan, My Years with General Motors (New York: Dou-
8 “From Alpha to Omega,” The Economist (August 15, bleday, 1964).
2015), online at econ.st/1J5S3AE. 15 “For DuPont, Christmas in April,” Business Week (April
9 S. J. Condly, R. E. Clark, and H. D. Stolovitch, “The Effects 24, 1995), p. 130.
of Incentives on Workplace Performance: A Meta-Analytic 16 Ibid., p. 129.
Review of Research Studies,” Performance Improvement 17 “Sanofi Seeks Efficiencies with New Model,” The Boston
Quarterly, 16, no. 3 (2003), pp. 46–63. Globe (August 16, 2010), online at www.boston.com.
10 I. Friis, A. Hansen, and T Vamosi, “On the Effectiveness of 18 “Air Products Unveils Widespread Reorganization,” The
Incentive Pay: Exploring Complementarities and Substi- Wall Street Journal (September 18, 2014), online at on.
tution between Management Control System Elements in wsj.com/1w5yrGy.

46
 Notes

19 “In Break with Past, No More Passing the Buck at Opel,” 35 See, for example, D. Campbell, S. Datar, S. L. Kulp, and V.
Reuters (December 6, 2009), online at www.reuters.com. G. Narayanan, “Testing Strategy with Multiple Perfor-
20 R. H. Chandler, quoted in “Sunrise Scam Throws Light on mance Measures: Evidence from a Balanced Scorecard at
Incentive Pay Programs,” The Los Angeles Times (January Store 24,” Journal of Management Accounting Research,
15, 1996), p. D3. 27, no. 2 (Fall 2015), pp. 39–65.
21 The details of Lincoln Electric’s legendary Incentive Perfor- 36 “Shareholders vs. Stakeholders: A New Idolatry,” The
mance System are described in the case bearing the compa- Economist (April 24, 2010), pp. 65–6.
ny’s name at the end of Chapter 4. See also “Ohio Firm 37 “Patents, Yes; Ideas, Maybe,” The Economist (October 14,
Relies on Incentive-Pay System to Motivate Workers and 2010), pp. 78–9.
Maintain Products,” The Wall Street Journal (August 12, 38 “Citi’s CEO Is Keeping Score,” The Wall Street Journal
1983), p. 23; and “Lincoln Electric: Where People Are Never (March 4, 2013), online at www.wsj.com.
Let Go,” Time (June 18, 2001), p. 40. Today, the company’s 39 Ibid.
website states that “Every year since 1934, eligible employ- 40 See, for example, R. Benabou and J. Tirole, “Bonus Cul-
ees have received a profit sharing bonus in December. ture: Competitive Pay, Screening and Multitasking,”
Lincoln’s pay-for-performance culture, rewards employees Working Paper 18963 (Cambridge, MA: National Bureau
for their contributions to the success and profitability of the of Economic Research, 2013).
Company. The average bonus award over the last 10 years 41 “Banker Bonuses Get a Nobel Dis,” Bloomberg View (Octo-
is 40% of an employee’s year to date, base earnings” ber 13, 2014), online at bv.ms/1toxQQN.
(www.lincolnelectric.com/en-us/company/careers/Pages/ 42 “Making a Killing,” The Economist (July 16, 2009), p. 36.
lincoln-tradition.aspx; accessed December 2015). 43 D. Campbell, “Nonfinancial Performance Measures and
22 “This Is the Answer,” Business Week (July 5, 1982), pp. 50–2. Promotion-Based Incentives,” Journal of Accounting
23 J. Roberts, The Modern Firm: Organizational Design for Research, 46, no. 2 (2008), 297–332.
Performance and Growth (New York: Oxford University 44 G. P. Latham, “The Motivational Benefits of Goal-Setting,”
Press, 2004). Academy of Management Executive, 18, no. 4 (November
24 “Lampert Cuts Sears Below 50% to Meet Redemptions,” 2004), pp. 126–9.
Bloomberg (December 4, 2013), online at bloom. 45 “Performance Reviews by the Numbers,” The Wall Street
bg/1RodSO2. Journal (June 29, 2010), online at online.wsj.com.
25 “Embracing the J&J Credo,” Barron’s (December 14, 2013), 46 See, for example, D. Campbell, “Nonfinancial Perfor-
online at www.barrons.com. mance Measures and Promotion-Based Incentives,” Jour-
26 Ibid. nal of Accounting Research, 46, no. 2 (2008), 297–332.
27 “OECD Casts Doubt on Indonesia Growth View,” The Wall 47 “A Safer New York City,” Business Week (December 11,
Street Journal (September 27, 2012), online at on.wsj. 1995), p. 81.
com/1Oao9zG. 48 V. H. Vroom, Work and Motivation (New York: Wiley,
28 “Carrefour Contends with Bribes in China,” Forbes 1964).
(August 27, 2007), online at www.forbes.com. 49 E. P. Jansen, K. A. Merchant, and W. A. Van der Stede,
29 “Lampert Cuts Sears Below 50% to Meet Redemptions,” “National Differences in Incentive Compensation Prac-
op. cit. tices: The Differing Roles of Financial Performance Meas-
30 “Airbus Chief Bregier to Empower Local Sites in Company urement in the United States and the Netherlands,
Overhaul,” Bloomberg (September 10, 2012), online at Accounting, Organizations and Society, 34, no. 1 (January
www.bloomberg.com. 2009), pp. 58–84.
31 “Huawei’s Chief Breaks His Silence,” Business Week (May 50 D. Solomons, Divisional Performance: Measurement and
9, 2013), online at www.bloomberg.com. Control (Homewood, IL: Richard D. Irwin, 1965), p. 83.
32 “Samsonite Sees Rapid Growth in Asia,” The Wall Street 51 K. J. Arrow, “Control in Large Organizations,” in M. Schiff
Journal (December 29, 2013), online at on.wsj. and A. Y. Lewin (eds.), Behavioral Aspects of Accounting
com/1zDPRcr. (Englewood Cliffs, NJ: Prentice Hall, 1974), p. 284.
33 See, for example, J. Brickley, C. Smith, and J. Zimmer- 52 “Bank Bonuses: Bashing Ignores the Benefits for Inves-
man, Managerial Economics and Organizational Architec- tors,” op. cit.
ture (Boston, MA: McGraw-Hill Irwin, 2001). 53 “A Different Game: Information Is Transforming Tradi-
34 For the so-called “selection effect” benefits of (results) tional Businesses,” The Economist (February 25, 2010),
controls, see, for example, D. Campbell, “Employee Selec- online at http://econ.st/KA1qb8.
tion as a Control System,” Journal of Accounting Research, 54 “Hospitals Prescribe Big Data to Track Doctors at Work,”
50, no. 4 (September 2012), pp. 931–66. op. cit.

47
Chapter 2 • Results Controls

CASE STUDY
Office Solutions, Inc.

In December 2014, Bob Mairena, president of Office Both Bob and Cindy had an entrepreneurial spirit and
Solutions, Inc., an office supply distributor based in were looking for an opportunity to start their own busi-
Southern California, was considering making a signifi- ness. They saw an opportunity in the early 1980s. Per-
cant change in the compensation plan for his sales per- sonal computers were just coming into prominence,
sonnel. The company’s current compensation plan for creating a new need for computer supplies. Traditional
all sales personnel was based on sales commissions, office supply companies did not have the technical
plus the potential for an incentive of 2–4% for achieve- expertise to sell computer supplies effectively. Bob and
ment of some specific sales goals. Cindy prepared themselves by taking computer classes
However, Bob had come to believe that a commis- at night. By 1984, they had gained enough expertise to
sion-based compensation system was appropriate start a company called Data Extras, the predecessor to
only for the few individuals bringing in signifi cant Office Solutions.
amounts of new business, those whom he called For several years, Data Extras successfully pro-
“hunters.” Most of the company’s salespeople were vided supplies to companies with computers. Eventu-
not hunters; they were not generating significant ally, however, computer supplies became a commodity,
amounts of new business. They were more like account and the expertise and consulting services that Data
managers who, Bob thought, should be compensated Extras offered were no longer as valuable and the
with a lower-risk plan based on a relatively high pro- business was not scalable. Bob and Cindy made a stra-
portion of guaranteed salary, supplemented with a tegic decision to expand the business to carry a full
performance-dependent bonus. Because of lower job line of office supplies. In 1989, the Data Extras name
pressure and more stable compensation, the account was changed to Office Solutions to reflect the change
managers should be paid less than sales reps. Office in service scope.
Solutions could use the cost savings to funnel more Over the years, Office Solutions grew both organi-
money to the relatively few salespeople who were cally and by acquisition. In 2014, it was generating
generating growth opportunities for the company. approximately $36 million in annual revenue. The
But Bob was not yet totally sure how the new system company had 110 employees, including 40 salespeople
should be designed and what kind of transition would who sold four product lines: office supplies, office furni-
be required to get the salespeople comfortable with ture, facility supplies, and print services. ( Exhibit 1
the change. shows an organization chart.) Office Solutions used
23 company-owned trucks to deliver its products to
customers.
The company Offi ce Solutions used sophisticated management
Office Solutions, Inc., headquartered in Yorba Linda, techniques. Its distribution system was very efficient.
California, sold and distributed a full range of office The company carried only the most basic supplies in
supplies to customers in Southern California, from San its own warehouse. Most of the products sold were
Diego in the south to Santa Barbara in the north. The delivered to them on the following morning and
company was founded in 1984 by a husband-and-wife delivered to the customer with a 98.5% fi ll ratio. The
team, Bob and Cindy Mairena. company was also metrics-driven. A vital-factor
Prior to starting Office Solutions, Bob worked for spreadsheet, which tracked sales, sales leads, and
UPS and Cindy worked for an office supply company. multiple other measures, was produced regularly. An

48
 Office Solutions, Inc.

electronic ticker on the wall tracked call-service sta- Adding to the management challenges in the indus-
tistics in real time. try, sales of office supplies were shrinking. As customers
Office Solutions had many long-tenured employees moved toward digital information sharing, they needed
and a fun working atmosphere. For example, Bob was a fewer supplies such as paper, toner, files, and binders.
proponent of fitness. He encouraged employees to wear Some privately owned distributors posted small posi-
exercise gear at work, and most of them participated in tive, single-digit sales growth in 2013,1 but the big-box
a company exercise break twice a day. companies in the industry were reporting continuing
Office Solutions offered every employee, excluding sales declines. Sales at Office Depot fell 4% in 2013,
those included in any other incentive plan, a quarterly excluding effects of the merger with Office Max. Staples’
incentive of 1% of salary if the company made its sales declined 5% in 2013, and the company announced
quarterly profit numbers. This incentive was designed plans to close more than 225 of 2,000 stores.2
both to enhance unity of purpose and to share profits
and risks with the employees. The Office Solutions strategy
Office Solutions managers’ understanding of the com-
Industry environment petitive landscape allowed it to carve out a successful
Until the mid-1980s, the office supply industry was competitive niche. They categorized industry custom-
dominated by small, independently owned dealers, ers using a pyramid paradigm (see Figure 1). At the
some owned by the same families for generations. Then bottom of the pyramid were small customers, defined
three large big-box retailers – Staples, Office Max, and as businesses with 1–15 employees. These customers
Office Depot – as well as consolidators – such as Corpo- typically bought office supplies directly from retail out-
rate Express, USOP, and BT, who were more focused in lets or online.
the commercial contract space – entered the market. Figure 1 Customer pyramid
These office supply giants built nationwide distribution
networks and retail presence. They enjoyed economies Enterprise customers:
250+ employees
of scale, and they shaved margins. Among other things,
they offered “loss leaders,” selling some popular prod- Commercial customers:
ucts at or below cost to attract new customers. In 2013, 15–250 employees

Staples, the largest office supply retailer, had annual

Retail customers:
revenues of $23 billion. Office Depot and Office Max 1–15 employees
merged in November 2013 and had combined 2013 rev-
enue of $17 billion. The success of the big-box stores
drove thousands of independent dealers out of busi- At the top of the pyramid were enterprise custom-
ness. But in 2014, the office supply industry still ers, defined as businesses with 250+ employees. These
included the two remaining big-box companies, thou- businesses typically had multiple employees purchas-
sands of independent retailers, and, increasingly, ing office supplies, but prices and product choices were
online retailers such as Amazon that had moved into controlled with a contract between the company and
the office supply space. By early 2015, an additional the dealer that was negotiated at the corporate level.
merger between Staples and Office Depot had been Staples and Office Depot served most of the enterprise
negotiated and was awaiting FTC approval. customers. Pricing strategy was the key to winning
The independent dealers that survived consolida- enterprise business. Dealers in this market segment
tion and the onslaught of the retailers were strong deal- offered popular products at low prices to win contracts;
ers that were competitive. Independents still owned margins for some products could be as low as 5%.
about 35–45% of the market, and they were especially These dealers had to bid carefully and have an excel-
strong in the small and medium business space. Two lent understanding of product mix so that they could
major wholesalers served this market. They both pro- win contracts and still earn a reasonable profit.
vided depth and breadth of product offerings and pub-
lished the two major marketing catalogs that were 1
M. E. Biery (2014). Office Supply Stores Seeing Profit Margins Erased,
customized by the individual dealers to provide brand- Forbes.com, April 13.
ing consistency in their specific markets. 2
SEC filings.

49
Chapter 2 • Results Controls

Office Solutions’ primary market included those increase product penetration by introducing, mar-
companies in the middle of the pyramid, commercial keting, and selling additional products and services
customers with 15–250 employees. These businesses to existing customers.
typically worked with dealers and had a single decision 3. Acquisition: Sales reps were expected to open
maker responsible for all of the office supply purchases. doors for the acquisition of new customer accounts.
Commercial customers were the most likely to value After the door was opened, Office Solutions sup-
strong relationships and excellent customer service. ported the reps as needed with specialists in the
Office Solutions had recently started moving up the areas of furniture, printing, and janitorial sup-
customer pyramid, competing for enterprise-level con- plies. At the enterprise level, sales reps were
tracts. Bob recognized the mergers of the big-box sup- expected to identif y when current contracts
pliers as an opportunity. Enterprise customers usually expired and to register Office Solutions for the con-
considered three bids. With only two, or maybe only tract bid process. Once in the bid process, Office
one, big box distributors remaining, Bob reasoned that Solutions management became involved with the
Office Solutions could be a viable second or third option. contract negotiations (e.g. pricing) and responded
The role of the sales representatives was different at directly to customer queries without the input of
the enterprise level. They were responsible for initially the sales rep.
requesting participation in the RFP and for building
enough of a relationship to understand the expectations Sales personnel were also charged with maintaining
and priorities of the customer. The formal bid response the accuracy of the information in Office Solutions’
and margin management was wholly provided by cor- sales-related systems.
porate. Once the contract was established, the role of The reps were not responsible for pricing because
the representative became less important as customer they did not understand the business well enough to
service provided more direct and immediate contact consider all the relevant factors and all of the dynamics
and problem resolution. affecting pricing.
Bob also recognized the move towards e-commerce. The office supply market in Southern California was
He committed a growing share of company resources huge, estimated at $1.2 billion per year, so plenty of
towards the company website and online marketing. opportunities existed for Office Solutions sales person-
A major growth engine for Office Solutions was the nel. The sales people were free to develop new busi-
acquisition of other office supply dealers. Over the ness wherever they thought their potentials were
years, Office Solutions had acquired quite a few smaller highest; they were not assigned to sales territories.
companies. The purchase of an office supply company They could use Office Solutions’ customer-relation-
was, in essence, the purchase of the target’s salespeo- ship-management (CRM) system and identify poten-
ple and their customer relationships. Every effort was tial customers that were not already buying from
made to retain the target’s salespeople for at least a Office Solutions. The salespeople lived all over South-
year, at which point their customer relationships were ern California, and they tended to call on customers
transferred to Office Solutions. near where they lived.

The sales role The existing sales compensation

program
The role of the sales personnel at Office Solutions was
threefold: Sales personnel were included in a commission-plus-
bonus program.3 They earned a commission of 25% of
1. Retention: Sales reps were responsible for keeping the gross profit generated by sales to their customers. A
their current customers happy. Customer service commission-based compensation structure had the
responsibilities included consultative services, obvious benefit of making the sales compensation costs
ensuring that customer orders were handled cor-
rectly and on time, handling rush orders and other
special requests, and general relationship building. 3
In 2014, a few sales personnel were in different compensation
programs. They had joined Office Solutions as part of an acquisition,
2. Penetration: Sales reps were responsible for increas- and they remained on the compensation structure provided by their
ing sales to their existing customers. They could former employer.

50
 Office Solutions, Inc.

Table 1 Calculation of base bonus was vital for management to correct slumps before they
materialized into low sales numbers.
Achievement Bonus earned Managers and sales reps met together as a group
of gross profit goal (% gross profit) every month to discuss their performance against
100.00–104.99% 0.4% their official goals and the other measures on the
VFSS. The meetings could be unpleasant for those
105.00–109.99% 0.5
who did not meet their goals. Performance against
110.00–114.99% 0.6 goals was also discussed during annual performance
reviews.
115.00–119.99% 0.7
Finally, Office Solutions held annual sales meetings
> 120% 0.8 where the top sales reps were recognized. Bob found
that the recognitions were surprisingly motivating. He
variable. If sales declined, costs declined with them, explained:
thus reducing profit risk. I can think of some sales reps who were perfectly
Bonuses were paid only if the sales personnel met or content with their compensation, but became very
exceeded their gross profit goal. The goal was set by top unhappy when they were no longer recognized as
management based on a targeted growth rate. Sales one of the top sales reps at the sales meeting.
managers met with their sales reps to explain the goal
and to secure commitment to the goal. They spent time
breaking down the goal by month, category, and cus-
Concerns
tomer and discussing how it could realistically be Bob recognized some shortcomings in the current com-
achieved. pensation structure. First, it did not seem to provide
The base bonuses ranged in value from 0.4% to 0.8% adequate motivation to generate new business. Bob
of the gross profit earned by the sales rep’s accounts noted that while there were some exceptions,
according to the step function shown in Table 1. The
Most people don’t enjoy hunting. Hunting only hap-
sales reps could earn an additional bonus of 0.15% of
pens when you have to and that happens when you
gross profit for each of three smaller product categories
are building your book of business.
(furniture, facility supplies, printing) if they exceeded
a category revenue goal. These sales categories were Bob wanted the sales reps to generate more new busi-
smaller and more volatile than the office supply cate- ness. He had ambitious growth goals for the company.
gory, but they were also more profitable. But many, perhaps even most, of the sales personnel
Under this system, bonuses amounted to a rela- could seemingly earn enough money to satisfy their
tively small part of the overall compensation package, lifestyle needs just by retaining the customers that they
maxing out at less than 4.8% 4 of a sales rep’s total were already serving.
compensation. Second, the compensation structure was perhaps
too lucrative. Office Solutions was competing with the
Additional accountability big-box stores that had lower costs of sales. Bob wanted
to reduce his company’s overall cost of sales so that
Office Solutions tracked several measures in addition they were more in line with the competition.
to the official gross profit goal in a report called the Finally, the commission structure attempted to moti-
vital factor spreadsheet (VFSS). (Exhibit 2 shows an vate the reps with “carrots.” The reps acted too much
excerpt from a VFSS.) This report tracked sales leads like independent contractors. Bob thought that he
all the way from initial contact to a yes-or-no decision, needed a better way to express dissatisfaction with job
as reported by the sales reps. The sales reps did not like performance, and he needed objective criteria for ter-
reporting their leads in such detail, but the information minating underperforming employees. He explained:

In addition to setting the pay structure, you need to

4
manage the activity. You have to monitor what they
Maximum bonus is 1.25% of GP. Maximum total compensation is 25%
of GP (commission) + 1.25% of GP (bonus). Max percent of incentive are doing and motivate them to sell more. People
compensation in the form of bonus is 1.25%/26.25% =4.76%. slack off when they have met their own needs. For

51
Chapter 2 • Results Controls

example, one of our reps—I’ll call him Tom—seems William is a good example of someone who
perfectly happy earning $40,000 a year. I suspect should be an account manager. He has been with us
that he spends as much time as a tennis instructor for many years and is our #2 salesperson, responsi-
as he does as a sales rep. We reprimand Tom ble for $2.5 million in sales. He works 24/7. He is up
privately after every monthly sales meeting, but all the time checking backorder reports. The cus-
that seems to be of no consequence to him. tomers love him. He micro-manages their accounts
By age 50, most of the reps are cruising. They to make sure that nothing goes wrong. He does a
are not out generating new accounts. I need to great job of customer retention and selling more cat-
grow the business. Should I fire all of my estab- egories of products to his accounts. But he hasn’t
lished reps who are not willing to hunt? generated even two new accounts each year. I have
had a sales manager go with him to help him develop
new leads, but that is just not what he is good at.
A proposal for change
Bob’s instinct was to leave the compensation plan for
In determining what changes to make, Bob decided
those in the sales rep category just as it was. The com-
that he should divide the sales personnel into two
pensation mix for the account managers would change
groups – sales reps and account managers – and differ-
dramatically to a targeted 70% base salary and 30%
entiate their compensation programs. Those desig-
variable compensation, which included both commis-
nated as sales reps would be just those personnel who
sion and bonus. The expected total compensation of
were bringing in significant amounts of new business.
the account managers would be set to be slightly lower
The sales reps’ compensation structure would continue
than the current compensation levels, reflecting the
to be based almost exclusively on commission.
reduced compensation risk.
To illustrate the characteristics of a near-ideal sales
rep, Bob thought immediately of Marsha:
Transition
Marsha is in her late 40s. She will do about $3 mil-
lion in sales this year. She is a pure hunter, and she Through some early, casual discussions, Bob had got-
loves competing. She lost a $600,000 account last ten some indications that the transition to a new com-
year because her client was acquired, but she has pensation structure for the account managers would
replaced it already. Her weakness is that she deals not be easy. Bob raised the subject first with William,
with too much minutiae. When she is ready, I will someone who was important to the company but also
give her an assistant to do computer set-ups and the perfect candidate for the switch to account man-
the like. I want her focused on new business. ager. Bob offered William what he thought was a gener-
ous package: a base salary that was 90% of William’s
The non-hunter sales reps would be placed into the
current commission level, with the potential to earn an
account manager category. Many of these personnel
additional 10–15% as a bonus. (Exhibit 3 shows Wil-
were excellent at customer relations and retention of
liam’s compensation calculations.) But William
accounts, but, for whatever reason, they did not bring
resisted. He insisted that he wanted to continue as a
in significant amounts of new clients. Bob explained:
sales rep despite Bob’s warnings that there would be a
If a sales rep is only retaining existing customers, lot more pressure to win new accounts should he
his or her job description should be changed to an choose to remain in that role.
account manager with a pay structure that makes Bob suspected that the conversations would be
sense for those job responsibilities. Theoretically I even more difficult if the change in structure was
would love to have a company full of sales reps who combined with the reduction in expected compensa-
are aggressively pursuing new business, but I don’t tion, as Bob thought it should. For the reps who wished
want to use a sales rep compensation model to pay to stay on the commission structure, should he add a
someone who is actually functioning as an account negative consequence if they failed to acquire new
manager or really working as an outside customer accounts?
service representative. Bob knew that he still had some details to work out.

52
 Office Solutions, Inc.

Exhibit 1 Office Solutions Organization Chart, December 2014

CEO
Bob
Mairena

Director, SVP,
Manager, VP, Manager,
HR Operations
Marketing Sales Accounting
Michelle Marsh John Acampora

Manager,
Manager, Manager, Sales Sales Sales
Customer
Purchasing Distribution Manager Manager Manager
Service

Sales Rep Sales Rep Sales Rep

Sales Rep Sales Rep Sales Rep

Sales Rep Sales Rep Sales Rep

Sales Rep Sales Rep Sales Rep

Sales Rep Sales Rep Sales Rep

Sales Rep Sales Rep Sales Rep

53
54
Exhibit 2 Excerpt from the VFSS

New Accounts Jan-14 Feb-14 Mar-14 Apr-14 May-14 Jun-14 Jul-14 Aug-14 Sep-14 Oct-14 Nov-14 Dec-14 Total

Manager 1 8 9 14 13 7 6 8 16 6 10 4 8 109

Manager 2 10 4 12 9 4 5 3 9 9 6 2 7 80

Manager 3 9 7 10 12 20 10 9 8 6 17 6 5 119

Manager 4 1 1 7 1 3 2 2 4 0 4 1 4 30

Manager 5 3 1 0 2 1 3 0 0 1 2 2 0 15

Total 31 22 43 37 35 26 22 37 22 39 15 24 353

Cumulative Revenue for New Customers in 2013

Manager 1 13,448 21,730 23,271 18,861 52,671 26,750 28,146 59,864 67,255 67,957 45,639 47,417 473,008

Manager 2 9,559 9,278 13,053 18,043 20,620 22,450 21,629 27,317 32,833 41,019 31,279 32,591 279,672

Manager 3 3,949 3,542 13,771 17,779 29,084 40,260 43,052 42,337 82,297 84,185 54,250 70,911 485,418

Manager 4 - 19,583 37,788 18,107 1,125 16,267 5,159 5,779 8,290 1,747 64,215 106,122 284,182

Manager 5 - - - - - 847 8,479 301 1,266 5,874 7,974 17,879 42,620

Total 26,956 54,133 87,882 72,790 103,500 106,574 106,465 135,598 191,941 200,782 203,358 274,921 1,564,899

Total Goal 37,750 69,000 100,750 132,400 169,750 206,500 238,750 264,500 296,250 333,250 353,000 364,500 2,566,400

Variance (10,794) (14,867) (12,868) (59,610) (66,250) (99,926) (132,285) (128,902) (104,309) (132,468) (149,642) (89,579) (1,001,501)

Var % −28.6% −21.5% −12.8% −45.0% −39.0% −48.4% −55.4% −48.7% −35.2% −39.8% −42.4% −24.6% −39.0%

Bids: Jan-14 Feb-14 Mar-14 Apr-14 May-14 Jun-14 Jul-14 Aug-14 Sep-14 Oct-14 Nov-14 Dec-14 Total

Manager 1 5 27 35 21 17 18 19 14 11 10 11 4 192

Manager 2 16 13 17 12 11 9 17 6 11 6 3 10 131

Manager 3 5 12 13 13 10 9 14 7 12 8 4 4 111

Other 2 4 5 4 5 4 4 6 5 2 2 2 45

Total 28 56 70 50 43 40 54 33 39 26 20 20 479
 Exhibit 2 Continued

Opportunities Jan-14 Feb-14 Mar-14 Apr-14 May-14 Jun-14 Jul-14 Aug-14 Sep-14 Oct-14 Nov-14 Dec-14 Total

Stage 1 - 430 484 507 544 545 541 520 577 552 566 576 394
Qualifying

Stage 2 - Initial 351 379 426 425 440 416 340 366 368 357 367 289
Meeting

Stage 3 163 167 193 216 219 200 174 166 164 155 157 134
- Developing
Proposal

Stage 4 118 114 113 114 121 108 146 149 157 169 162 127
- Presentation

Stage 5 51 70 98 58 57 51 45 47 51 53 56 50
- Commitment
to Buy

Total Current 1,113 1,214 1,337 1,357 1,382 1,316 1,225 1,305 1,292 1,300 1,318 994
Opportunities

Stage 6 - Won 255 272 284 293 304 318 319 348 387 418 436 321

Stage 7 - Lost 180 192 226 244 270 268 299 318 413 440 468 333

Total All 1,548 1,678 1,847 1,894 1,956 1,902 1,843 1,971 2,092 2,158 2,222 1,648
Opportunities

(Continued)

55
56

Exhibit 2 Continued

2013 Web
Analytics Jan-14 Feb-14 Mar-14 Apr-14 May-14 Jun-14 Jul-14 Aug-14 Sep-14 Oct-14 Nov-14 Dec-14

Sessions 20,812 17,825 18,806 18,780 18,182 34,969 37,566 35,964 37,869 39,959 31,827 28,523

Users 8,851 7,813 8,297 8,045 7,974 14,681 15,957 15,895 16,603 16,805 14,381 13,634

Pageviews 35,903 30,877 33,137 33,426 34,216 304,010 325,674 309,291 318,452 345,600 275,187 238,281

Pages/Visit 1.73 1.73 1.76 1.84 1.88 8.69 8.67 8.6 8.41 8.65 8.65 8.35

Visit Time 2:46 2:48 2:41 2:42 2:44 7:33 7:25 7:05 6:56 7:14 7:06 6:52

Bounce Rate 66.02% 66.55% 67.09% 66.57% 67.10% 42.62% 43.87% 44.11% 44.29% 43.22% 43.76% 45.86%

% New Visits 31.16% 30.63% 31.61% 30.11% 31.44% 35.92% 30.98% 31.52% 31.13% 29.45% 30.77% 31.69%

Session: A session is a period time where the user is actively engaged with your website.
User: Users have had at least one session within the selected date range. Includes both new and returning users.
Pageviews: The total number of pages viewed. Repeated views of a single page are counted.
 Office Solutions, Inc.

Exhibit 3 William’s Compensation Calculator

William’s 2014 performance

2014 Goal 2014 Actual Variance Variance %

Total Revenue $ 2,104,350 $ 2,254,393 $ 150,043 7.1%

Office Supply Rev. $ 1,411,512 $ 1,403,717 $ (7,795) −0.6%

Furniture Rev. $ 313,899 $505,495 $ 191,596 61.0%

Facility Supply Rev. $ 228,071 $239,152 $ 11,081 4.9%

Printing Rev. $ 150,868 $106,029 $ (44,839) −29.7%

Gross Profit $ 502,939 $538,799 $ 35,860 7.1%

Revenue from New Accounts $ 39,000 $1,200 $ (37,800) −96.9%

William’s 2014 compensation under commission structure

Percentage Gross Profit Base Compensation

Commission 25.00% $538,799 $134,700

Base Bonus .50% $538,799 $2,694

Furniture Bonus .15% $538,799 $808

Facility Bonus .15% $538,799 $808

Printing Bonus 0 0

Total Compensation $139,010

William’s compensation under new proposal

AS OFFERED TO WILLIAM

90% base/10% bonus If 70% base/30% bonus

Base Salary $121,230 $94,290

Bonus Potential $ 13,470 $40,410

Total Compensation $134,700 $134,700

This case was prepared by Professor Kenneth A. Merchant and Research Assistants Michelle Spaulding and Seung Hwan
(Peter) Oh.
Copyright © by Kenneth A. Merchant.

57
Chapter 2 • Results Controls

CASE STUDY
Puente Hills Toyota

In December 2003, Howard Hakes, vice president of It was important for the dealerships to keep two
Hitchcock Automotive Services, reflected on some of the important constituencies – manufacturers and custom-
challenges his team faced in managing his company’s ers – happy. The manufacturers allocated larger
stable of automobile dealerships. He illustrated his points numbers of their best-selling models to their better
by discussing the challenges faced at Puente Hills Toyota, performing dealers. The manufacturers evaluated
Hitchcock’s largest dealership, although all of the Hitch- their dealers in terms of their abilities to fulfi ll their
cock dealerships faced essentially the same problems. market potential: to meet sales targets the manufactur-
This is very much a people business. It’s people
ers set for each geographical trading area, known as
who give us our biggest successes as well as our
the primary market area. The dealerships also had to
biggest challenges. At our Toyota store, in sales, I
satisfy the manufacturers’ licensing and certification
would say that about 20% of our people are loyal
standards. The manufacturers regularly performed
to the company and really want to do a good job.
compliance audits to evaluate dealership practices in
The other 80% are just in this for the money . . . and
comparison with the established standards. However,
they can make more money here than anywhere
Howard Hakes believed that short of flagrant violations
else. Our compensation attracts some very tal-
of standards (e.g. selling competing brands under the
ented people. But some of these people are
same roof), fulfi lling market potentials was the pri-
sharks who try to get away with whatever they
mary factor affecting the dealers’ relationships with
can. Others have personal problems. They live
the manufacturers.
from paycheck to paycheck; that is their mentality.
Customer satisfaction was obviously important in
Still others are cancers whose bad habits can
obtaining repeat sales and, hence, future profits. Cus-
spread. We coach and counsel; we give written
tomer satisfaction surveys were given to every cus-
notices; and for most of the employees, once they
tomer who bought or leased a vehicle or had one
get the message that is the end of the problems.
serviced at a dealership. A copy of the survey given to
But for some others . . .
all Toyota customers who purchased or leased a vehicle
I think the key to management in this business is
is shown in Exhibit 1.1 The responses to these survey
all about managing attitude. How can we keep the
questions were mailed directly to the manufacturer
team moving in the same direction, to get every-
and aggregated into a customer satisfaction index (CSI),
body to be part of the team, and prevent the can-
to which considerable attention was paid by both the
cers from spreading?
manufacturer and dealership managers. Manufactur-
ers sometimes changed dealership vehicle allocations
when CSI ratings fell below acceptable levels in three
The company and industry consecutive years.
Hitchcock Automotive Services was a privately held cor-
poration comprised of seven automobile dealerships – Puente Hills Toyota
three Toyota dealerships and one each for Volkswagen,
Ford, Hyundai, and BMW – and a large body shop. All of Puente Hills Toyota (PHT) was a large Toyota dealer-
the entities were located in southern California. Four of ship. Annual sales were about $85 million, including
the dealerships, including Puente Hills Toyota, were sit-
1
uated adjacent to each other in City of Industry, Califor- Toyota also required the use of a service survey, which asked service
customers a comparable set of questions focused on satisfaction with
nia, about 25 miles east of Los Angeles. The others were (1) making the service appointment, (2) writing up the service order,
located in Anaheim, Hermosa Beach, and Northridge. (3) work quality, (4) work timeliness, (5) price, and (6) the facilities.

58
 Puente Hills Toyota

approximately $10 million from the body shop, which only marginally profitable. Used vehicles provided a
provided services to all of the Hitchcock dealerships in better profit source, as Howard Hakes explained:
City of Industry. PHT had a total of 145 employees, and
This is one of the last barter businesses left. For
annual profits totaled about $1.8 million.
some new vehicles, there is only an $800 difference
PHT had won many awards for excellent perfor-
between the window sticker price and dealer cost,
mance. For example, the dealership had been awarded
so there is not much margin and not much room for
Toyota’s President’s Award for overall excellence in
bargaining. In used vehicles, we have a little more
each of the prior 13 years.
profit opportunity. We can sometimes take a trade-
In 2003, PHT moved into a new, state-of-the-art, $13
in for $2,000, put $1,500 worth of work in it, and sell
million facility with 119,000 square feet of space. The
it for $6,000.
new building provided the latest in customer ameni-
ties, including a children’s play area, a movie theatre, The ser vice department was consistently PHT’s
efficient work layout areas, and room for growth. most profitable department, with margins typically
PHT’s organization structure was fairly typical in in the range of 15–20%. (See comparison statis­t ics
the industry. Reporting to the dealership general man- f rom an industr y consulting report show n in
ager were a general sales manager whose organization Appendix A.)
included both new and used vehicle sales, a service As required by Toyota, PHT managers kept separate
manager, a body shop manager, a parts manager, and records for new and used vehicle sales, as if they were sep-
a director of finance and insurance (F&I) (see arate departments, even though all PHT salespeople could
Exhibit 2). The one unique feature of the organization sell both new and used vehicles. The separation of new
was the combined new and used vehicle sales depart- and used vehicle profits required some allocations of
ment. Only about one in five auto dealerships, typi- expenses. With rare exceptions, all items of expense were
cally the smaller ones, had such a combined vehicle split 70% to new vehicles and 30% to used vehicles, an
sales department. More typically, the managers of the allocation formula that was typical in the industry. How-
new and used vehicle sales departments reported ard Hakes knew that this formula was somewhat arbitrary.
directly to the dealership general manager. But PHT For example, he knew that some forms of advertising, such
managers liked the flexibility of having their sales per- as half-hour television shows or “infomercials” on Spanish
sonnel sell whatever vehicle customers wanted, new or language television stations, were solely aimed at selling
used, and some customers wanted to look at both new used vehicles. But, he explained, “I’ll bet we aren’t off by
and used vehicles. more than 5% with the 70 –30 split. Maybe it’s 65 –35, one
Each of PHT’s departments was managed as a profit way or the other, but we won’t be further off than that.”2
center. Many indirect or overhead expenses, such as All interdepartmental transfers were done at market
dealership administrative salaries and dealership prices. Thus, for example, when PHT’s used vehicles were
advertising expenditures, were assigned or allocated to serviced in the PHT shop, the sales department paid full
the departments. Only some infrastructure-related retail price for parts and labor. This policy gave the used
expenditures (e.g. rent and equivalent) and some other vehicle manager some negotiating power in the service
expenditures over which the department managers area. Paying full retail price ensured that internal used
had little or no control (e.g. insurance, taxes, legal, and vehicle service jobs would not be given lower priority.
auditing) were not allocated to them. Valuations of used vehicle trade-ins sometimes cre-
Exhibit 3 shows one page of the financial statement ated disagreements. These valuations were important
report that PHT was required to submit monthly to primarily because the sales personnel earned commis-
Toyota Sales Corporation. The other pages in this report sions based on the profits of the “deals” they closed.
called for an extensive array of information, including Such disagreements were common in dealerships
the profitability of the other departments, balance sheet
data, unit sales by model, personnel counts by depart- 2
The industry consulting report showed that for FY 2002, the average
ment and category, and a variety of performance ratios overhead expenses (equivalent to line 57 in Exhibit 3) in the industry
(e.g. total bonuses as a percentage of sales, gross profit were $2.6 million for new vehicle departments, or 7.22% of sales
average per unit of each model sold). (equivalent to line 1 in Exhibit 3) or 94.48% of new vehicle depart-
ment profit (equivalent to line 33 in Exhibit 3). For used vehicle depart-
The profitability of PHT’s departments varied widely. ments, average overhead expenses in the industry amounted to $1.4
As in most dealerships, new vehicle sales at PHT were million, or 8.12% of sales or 85.78% of used vehicle department profit.

59
Chapter 2 • Results Controls

because new car salesmen were often motivated to over The bonuses, which were typically 250 –300% of the
pay the customer for trade-ins to secure the new car sales employees’ base salaries, provided a significant
sale. And at PHT, and indeed all dealerships, needed proportion of total compensation. The salaries were
repairs on trade-ins were sometimes not spotted at the paid semi-monthly, and commissions and bonuses
time of the sales deal. This could happen anytime, but were paid monthly.
at PHT it was most likely to happen on Sundays when Howard Hakes explained that one side benefit of
the service department was closed and no service having a combined new and used vehicle sales depart-
advisor could be called in for a second opinion on esti- ment was that, combined, the department was
mated trade-in repair costs. As Howard explained: generally profitable, whereas new vehicle sales depart-
ments alone often were not.3 Howard wondered how
On Mondays, we often have animated discussions managers provided “profit-based” incentives in sales
between sales and service about the repairs that the departments that were losing money.
service department claims are required on trade-ins. All of the sales managers’ bonus plan contracts also
But we stick to the market price rule! If the costs of included the following wording:
repair are higher than what the salesmen had antici-
Adjustments. “Any cancelled sales or subsequent
pated on Sunday, it eats into their deal profit. If they
changes to the account as a result of a returned
don’t agree with the service repair cost estimate,
product will be calculated into the commissionable
they are free to sell the trade-in “as-is” on the whole-
gross profit and will be used to calculate your com-
sale market. Sometimes they even get lucky when
missions earned for each month. Adjustments may
the repair problem isn’t spotted there either. That’s
also be made to correct errors, or for rewrites to
why some used vehicles come to be called “lemons.”
the deal; unwinds, null and voided deals; customer
receivables not collected (including, but not limited
Performance measures and incentives to down payments, drive-off fees, insurance
Compensation of line personnel at PHT was high, par- coverage, or penalties on trade-in), or policy
ticularly given the employees’ generally relatively adjustments.”
modest education levels. Even young salespeople, those
Other Factors. “Other factors such as the Customer
still in their early 20s, could earn $6,000–$7,000 per
Satisfaction Index (CSI)4 and Employee Satisfac-
month if they hustled and followed up effectively with
tion Index (ESI)5 score may be taken into account in
customers. Top sales personnel could earn $20,000 per
determining bonuses.”
month, or even more. Some service technicians earned
over $10,000 per month. Performance-based incen- How these nonfinancial performance indices were
tives were a significant part of the compensation of all taken into account for bonus determination was left
line personnel. vague. They could be used in a positive sense, to pro-
vide “discretionary” bonus awards, or they could be
A. Incentives in the sales department used to limit the formula bonuses. However, no one at
All personnel in the sales department were paid a rela- PHT could remember any situations where they had
tively modest base salary plus incentive pay. The sales- made a substantive difference in the bonuses awarded,
men and assistant sales managers earned commissions perhaps because at PHT, the indices had never fallen
on the deals they closed. The average commission rate below acceptable levels.
was 20% and 7% of deal gross profit for salesmen and For comparison purposes, Appendix B provides
assistant sales managers, respectively. The general sales
manager, used vehicle sales manager, and sales desk man- 3
The consulting report showed that about one in three new vehicle
agers’ bonuses were based on a proportion of depart- sales departments incurred a loss (see note (2) in Appendix A).
4
mental profit after overhead expenses but before taxes CSI was explained earlier in the case. The sales customer survey
form is shown in Exhibit 1.
(line 59 in Exhibit 3). The general sales manager and 5
ESI was calculated from the results of a survey designed by a
desk sales managers were paid 2.25% and 1.2–1.5% of consulting firm given annually to all PHT employees. Each employee
this amount for the total sales department, respectively. was asked to indicate the level of agreement, on a scale from 1
(strongly disagree) to 5 (strongly agree), with 26 statements, such
The used vehicle sales manager was paid 5% of this as “I feel my work is valued by the dealership” and “Overall the
amount for the used vehicle department only. managers are honest and fair in their treatment of employees.”

60
 Puente Hills Toyota

excerpts from a consulting report showing vehicle replace the defective electronic module, hook up a test
dealership department manager compensation data. In recorder, and test-drive the vehicle. The flag rate for
this appendix, Schedule 1 shows data about the amounts this job might be 48 minutes. A technician who wanted
and forms of monetary compensation given to depart- to cut corners might skip the test drive. Knowing that a
ment managers. Schedule 2 shows the measures used in supervisor would check the vehicle’s mileage-in and
allocating formula bonuses. Schedule 3 shows the inci- mileage-out, he would have to put the vehicle up on a
dence and size of discretionary (nonformula) bonuses. hoist and run it for, perhaps, three minutes to increase
the odometer mileage. But by cutting corners, he might
B. Incentives in the service department be able to complete the entire job in less than
15 minutes.
The service technicians were paid from $10 to $23 per
PHT managers had two types of controls over these
“flag hour” of work completed. The actual hourly rate
gaming behaviors. First, if the time spent on a job was
depended on each individual’s technical specialty and
very low, service managers asked the technician for an
their certifications (e.g. master technician). Flag hours
explanation of the anomaly. Second, management mon-
were standards set by the manufacturer for the
itored the number of “re-checks,” instances where the
accomplishment of specific tasks. The standards were
problem was “not fixed right the first time.” In the indus-
set so that an average qualified technician could
try, a 1% re-check rate was considered good. The re-
achieve them. However, it took technicians at PHT,
check rate usually could not go to zero because some of
who were generally very experienced, about 45 min-
the re-checks were not the technician’s fault. The cause
utes on average to do one flag hour of work. For some
might be simply that a needed part was unavailable.
technicians the disparity between flag and actual
Technicians who cut corners were “written up,” that
hours was much higher. Jesus Barragan, PHT’s service
is, given notice, and their ticket was deducted. “Bad
manager, said “Our top guy, who is a ‘natural,’ beats
habits can be corrected; bad mechanics can’t,” Jesus
the flag time by 600%.” The disparity also varied by
Barragan observed.
area.
Howard Hakes had some confidence that this gam-
The service advisors earned a base salary of approxi-
ing problem was under control because the service area
mately $2,000 per month. They also earned bonuses as
at PHT was averaging only about four re-checks per
follows:
month for approximately 700 completed service jobs. If
8% commission on customer-paid labor and parts; service technicians were cutting corners in a signifi-
6% commission on manufacturer-paid labor under cant way, he estimated that the re-check rate would be
warranty; significantly higher.
6% commission on labor and parts paid for internally The service technicians at PHT were very loyal to
at PHT. the company, because “we treat them as people, not
mechanics,” Jesus said. “We also train and pay them
The PHT service manager was paid a base salary of well.” Turnover was virtually zero.6 But the mechanics
$3,000 per month plus a bonus based on a percentage had to buy their own tools. Jesus Barragan noted that
of the service department gross profit (before overhead “one of our guys has bought well over $535,000 worth
expenses). The percentage was 3.75% if the gross profit of tools during his 36-year career with us, but then, he
figure was $195,000 or less in any given month; the makes $130,000 per year too.”
percentage rose to 4% if gross profit exceeded
$195,000. The $195,000 was the total annual budgeted
amount divided by 12. Management Issues
Howard Hakes knew that his PHT management team
had not solved all their problems. He lamented about the
C. Gameplaying temptations in the service
fact that, in general, sales personnel were not effective
area
at following up with customers. Follow-up means that
Because they were paid by the job, service technicians
had temptations to cut corners. For instance, for a 6
This is in stark contrast with turnover in the sales department, which
typical Electronic Engine Control (EEC) repair, the Howard described as “horrid” (about 60% per year, as opposed to
technician might be required to diagnose the problem, only about 5% in service).

61