Management control systems complete summary with insights from papers!
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Course
Managing And Motivating For Value (320121M6)
Institution
Tilburg University (UVT)
This is a summary which incorporates the lecture notes, lecture slides and insights from papers that are necessary to understand the material. The following papers are discussed in this course:
1. Moers, F. 2006. Performance Measure Properties and Delegation. The Accounting Review 81(4): 897-924....
Lecture 1:
2 key problems are discussed in this course:
- Decision influencing: There is an incentive issue, as the agent does not want to put in a lot of
effort, while the principal wants him to do so. Therefore, there is an incentive misalignment.
We need to devise incentives. For example, Google provides variable bonusses for their
employees and employees can get free meals and snacks in the office. Google also reduces
the agency problem through identity: employees call themselves “Googlers”.
- Decision facilitating: There is no misalignment between incentives (= not a principal-agent
problem!), but there is an informational issue. If the right information were to be provided,
the agent can work optimally. For example, Google wants their employees to always back
their opinion with data, so that everyone always has the right information to make informed
decisions.
Accounting systems can help to overcome the agency problems. Mechanisms could be devised to
align employees’ incentives with maximizing the organization’s value. All these mechanisms
constitute the firm’s control system. The principal-agent problem becomes larger in larger
organizations, as it is more difficult to control and monitor employees here (more layers, more
different places, and offices).
Adverse selection
- Adverse selection is a principal-agent problem in which an agent has private information
already before a contract is written.
- For example, students might get 1000 euro when they achieve a GPA of 7.5. If they don’t
achieve this, they must pay 400 euros. Only students that know beforehand that they are likely
to achieve this goal, are going to self-select into the contract. Therefore, a selection effect
with only good students exists (while you wanted to attract students that are not achieving this
target to get 400 euros of charity from them).
- For example, Google uses a lot of peer and collective bonuses because Google wants to
attract people that like to work in a team.
- Different contracts might attract different people:
o Incentive contracts with employees that stipulate performance levels can attract
able people (ability).
o Relative performance systems: compare performance against peers can attract
competitive types.
o Bonus contracts, variable pay (more risk) vs. fixed pay (less risk) can attract risk-
taking people.
o Set targets for financial and non-financial performance can attract long-term
oriented people.
o Deferred compensation plans can attract people that do not want to go for
immediate results.
, - General Electric: this is a system where people are ranked according to their performance
against peers. Employees are fired when they end up as a low performer (C-players) 10%
forced employee turnover.
Moral hazard
- Moral hazard is a principal-agent problem where there is often symmetric information at the
time of contracting. The agent, however, can become privately informed after the contract or
has information that the principal is not aware of at the time that the contract is concluded.
- Hidden information: the agent has information that the principal is unaware of. For example,
a taxi driver knows the location better and can drive longer routes without you noticing.
- Hidden action: the entrepreneur cannot perfectly monitor the agents’ efforts. The entrepreneur
would get more profits when more effort is exerted, but the agent only receives a fixed wage,
which makes him put in minimal effort as putting in effort is costly. Monitoring is costly for
the principal and the principal does not have enough knowledge to judge. An example of
hidden action is time theft. A potential solution could be to also pay a variable wage based on
performance, next to the fixed salary. An assumption for this to be valid is that output is a
noisy measure of effort.
- Because of moral hazard, it is always good to think about decentralization/centralization. An
advantage of decentralization is that those local managers have local knowledge. A
disadvantage of decentralization is that the principal cannot check whether the targets
proposed by the managers are too easy to reach. The risk exists that the manager makes
inaccurate forecasts to make life easier to himself. If people have a lot of private information,
it might be dangerous to put a lot of decision rights at local level because they might misuse
the private information. When you can delegate depends on which types of performance
measures you use.
- Moral hazard can be reduced by monitoring. For example:
o Monitoring systems by peers to prevent theft.
o Internal control procedures.
o Video surveillance, etc.
o Increased documentation, supervision authority.
o Where to put the decision rights: local or central?
Decision facilitating
- Principal and agent incentives are aligned but the information is not there. Accounting could
help to facilitate this information. What information should we provide our employees with to
ensure that they make the right decisions that add value to the organization? The provision of
information should reduce pre-decision uncertainty. We want to improve employees’
knowledge to ensure that they make organizationally desirable judgements.
- Google nudges people into saying “the data suggest” instead of “I think” such that all
employees back their claims with data so that the information is there.
Management control: ways to reduce the gap & mitigate the agency problem
- A management control system is everything that a company can use to induce their
employees to act in the best interest of the firm.
- Management control systems that we focus on in this course can range from
-
, - Sometimes, hard controls might backfire, and in that case, you want to use more soft controls.
-
- strategy is very important, but if employees do not execute/implement the strategies well,
the firm is not going to perform well. Therefore, a management control system can help to
make sure that the strategy is implemented well! Management control systems help to
innovate/motivate employees.
- Some management control systems might not work in some companies: “Red tape and
command-and-control cultures can frustrate creative types who see a million ways to
improve things. They want to be able to voice and implement ideas. If they face chronic
barriers, they leave. If this trend is pervasive, you end up with a creative void in your
enterprise. Who will envision and implement your next great products and services (the ones
you need for long-term organizational health)?” it really depends on the type of company
as to what control system you would implement.
Management control and the type of agent
- Economists think of people as the Homo economicus: this agent is fully rational, without any
biases. Typically, economists think of agents as lazy, self-interested, and fully rational.
- However, recent evidence shows that people are more like a Homo Simpson: this agent is not
fully rational. Instead, these agents care about social norms, compare themselves to others,
reciprocate indirectly, care about their reputation, are subject to biases, act on preferences and
have cognitive limitations.
o Employees are not self-interested, but they have social motives. Many people reveal
information honestly, they send money to receivers in dictator games and people care
about fairness.
o Employees are boundedly rational, as biases do exist. For example, people anchor on
certain numbers. As performance measures are clearly numbers, they might anchor on
the cut-off points for their bonus.
o Employees are not lazy; they can be intrinsically motivated. A lot of people do their
job because it makes them feel competent and they feel autonomy. A lot of people are
intrinsically motivated to put in effort to advance the firm’s goals. Often we see that
people are not creative anymore when they become constrained.
- If we know what people care about in their utility or the mistakes they possibly make, we
can try to make accounting relevant again (by putting the right performance management
systems in place).
- Management control systems need to be based on the most accurate characterization of the
agent, otherwise management control systems can increase the gap!
o For example, the principal can stipulate a fine to increase effort levels (= optimal
assuming self-interested agents). However, people who reciprocate high wage offers
are less likely to do so in case of a (negative) economic incentive.
o Another example: Shown how to better manage maternity leave resulting in a fifty
percent reduction in defections
o Example: Created on-boarding agenda for an employee’s first four days of work that
boosted productivity by up to 15 percent
o Example: Great manager award allows managers to share ideas with senior
management “Googlers prize opportunities to exchange ideas with senior leaders”
have more impact on career satisfaction than the pace of their promotions
In general, 3 types of agents can occur:
- Competitive agents: they care about maximizing the difference between them and others.
- Pro-social agents: they care about equality between different groups of people/individuals.
, - Individualistic agents: they maximize their own profits.
Lecture 2: Performance measures
Firms use a variety of performance measures to evaluate their employees. They can range from more
detailed measures to more aggregate (often financial) measures:
Goal congruence
- The higher in the hierarchy, the more likely that companies will use more aggregated
measures of performance. Aggregated measures are more goal congruent. Goal congruent
means that something does create value for the firm.
- at lower levels of hierarchy, people are more likely
to identify with measures they know. However, these measures are often less goal congruent.
- The higher in the hierarchy the more likely one uses more aggregated measures; the
advantage is that they are more comprehensive leading to higher thinking in trade-offs and
less dysfunctional behaviour.
Characteristics of good quality performance measures
- Controllability: how much influence does the manager have on performance?
o Sensitivity (informative): does the action of the manager lead to higher (or lower)
performance? It is the influence of effort of the manager on the outcome (measured
performance).
o Precision (noise/ random variation): difference between measured and achieved
performance. What is the effect of random variation, uncontrollable factors, noise?
- Verifiability: is the measurement process done objectively or not? To what extend is it ex ante
clear how the performance measure is calculated.
o Audited = e.g., profit before or after tax
o Unaudited = pro-forma earnings, CSR emission rights
Measures that are not sensitive, not precise, and difficult to verify, are less likely to be used in the
performance contract and lack sufficient quality for contracting.
The quality of performance measures is important. Typically, non-financial performance measures are
not very congruent as they mainly measure a subset of the actions a manager can take. Financial
performance measures are typically quite congruent but sometimes lacked sensitivity, precision, and
verifiability. Finding the right performance measure is very context specific and largely depends on
the actions that an agent is allowed to do.
Performance measures should be SMART:
- Specific: understandable and recognition
- Measurable: easy to measure
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