Course overview
Planning
- Setting the stage
o Lecture 1: The kick off
o Lecture 2: The three-legged stool
- The basics: core building blocks to develop your three-legged stool
o Lecture 3: Designing your organization
o Lecture 4: performance measures
o Lecture 5: Subjectivity
o Lecture 6: Target setting
o Lecture 7: Measure management
o Lecture 8: Selecting the right employee
- Capita selecta: concepts to finetune your three-legged stool
o Lecture 9: Leadership
o Lecture 10: Honesty of managerial reporting
o Lecture 11: Feedback and reporting systems
o Lecture 12: Updating management control systems
,Lecture 1: The kick-off
Course
- Goal of the course (strategy implementation): how should we design our managerial
reporting system (MRS) to optimize the three functions of MRS to implement our strategy in
a better way, to achieve organizational objectives in a timely, efficient and effective manner
- Relation of the course to practice
o Reflection: The MRS is the only way through which organizations can observe ‘the
real world’. A good controller does not only work with data but also have to know
the business.
o Diagnostic use of MRS: MRS facilitate the implementation of the current strategy (bv
design a cost system to better understand the drivers of the cost and to see the
negative effects of outsourcing)
o Interactive use of MRS: MRS allows to develop a better understanding of the
strategic uncertainties that could instigate a change in current strategy (bv based on
new cost system you advise management on revising outsourcing)
Introduction
- MRS very important: you cannot see it in a firm but if it does not work well than everyone
will complain and only at that point you will start to appreciate it (same with human brain:
you cannot see it in your body but if it does not work well (bv concussion cancel out a lot of
things in your body) you start to appreciate it
- Human brain in body = MRS in firm (methaphor)
1. Remembering, instructing, 1. Decision-facilitating, decision-
coordinating influencing, coordination-facilitating
2. Not visible from the outside 2. Not visible for outsiders
3. Motivation to train human brain is low 3. Motivation to invest in MRS is low
4. Malfunctions in human brain strongly 4. Weak MRS limits the creation of
decrease quality of life value
5. Without human brain other body parts 5. Without MRS other function in the
do not function properly firm do not function properly
6. Surgery on human brain is difficult 6. Improvement on MRs is difficult
- Human brain functions
o Remembering
o Instructing body parts: moving parts in certain direction
o Coordinating between body parts: moving parts in specific direction, walking
- MRS functions
o Decision-facilitating function: enabling employees to take value-generating strategic
and operational decisions. Based on data kept in MRS we remember things and firm
can make decisions (bonus or not) → EC10, 11, 12
o Decision-influencing function: Aligning individual behavior with organizational
objectives. Based on data in MRS we influence employees to move in a certain
direction making decisions in interest of company → EC3, 4, 5, 6, 7, 8, 9, 10
o Coordination-facilitating function: facilitating cooperation between entities. Based
on data kept in MRS we can find out the problem and coordinate between
departments to solve the problem → EC 4, 5, 6, 10, 11
,Macro level problem
- Main question of the course: how should we deign the management control system (MCS) in
general and the management reporting system (MRS) in particular to reduce the impact of
internal and external risks on the strategy implementation
o Step 1: strategies are implemented to reach expected outcomes
o Step 2: with strategy implementation you first try to reach control objectives
o Step 3: these control objectives in turn leads to expected outcomes
o Step 4: whether these actions lead to expected outcomes depends on the risks
o Step 5: with a MCS you try to mitigate those risks
o Control objectives: desired outcome for a specific action or set of actions
o External risks: competition, regulation, geographical issues, COVID
o Internal employee-related risks: risks related to emp behavior (actions and decisions)
o Management control system (MCS): helps the firm remember what happened in past
▪ Control system that embodies the elements of an organization that support
people in the achievement of the organizations objectives
▪ Control system that reduces the probability of a risk happening, the impact
when a risk occurs or both. For example based on COVID data you can
anticipate on upcoming regulations, based on employee data you can fire
employees that do not work hard
- Example
o Strategic focus point: fast delivery
o Activity: stock and order picking
o Expected outcome: customer satisfaction
o External risk: traffic affects transportation
o Internal employee-related risk: employee does not understand the business
Micro level problem
- How should we design the MCS so that employees know what is expected from them, we
attract the right employee, and that they provide effort level that approximates the effort
level of the manager?
- Internal employee-related risks
o Lack of direction: employees do not know what is expected from the because they
do not know the strategy and control objectives
o Lack of ability: employees do not have the right ability to do what is expected from
them because they do not have the right ability to implement strategy and reach
control objectives
o Lack of effort: employees do not work hard enough both quantity and intensity
because they do not deliver the same level of effort that the manager delivers
,Agency problem (AP)
- Agency relationship: situation in which one individual (agent) acts on behalf of another
individual (principal) and is supposed to advance the principals goals through effort
- Relationship
o a → Y (positive relationship)
o a: action of agent (not observable for principal because continuous monitoring is
costly and principal has not enough knowledge to judge agents effort)
o Y: benefits for the principal
o x: KPI for the action of the agent (observable for principal, bv worked hours)
o C(a): private and convex cost for the agent to executes its action a
▪ Convex: increasing positive line, cost of providing effort increase with time
o W(x): payment to the agent based on perceived action x
o Payouts
▪ Agent: W(x) – C(a)
▪ Principal: y – w(x)
- Solution = KPI
o MRS provides information about the signals x (performance measures) that carry
information about the ability and effort of managers and employees and the
direction in which firm wants to go
- Problem with KPI
o However, the observed accuracy of information contained in MRS is the outcome of
a cost-benefit tradeoff and thus nearly always imperfect
o Reasons of imperfection
▪ Financial constrains: setting up an MRS is costly
▪ Contextual factors: in case of more competition more investing in system
▪ Bounded rationality: employees do not understand the KPIs
o Imperfect KPIs
▪ Agents unhappy with KPI: x not always accurate reflection of a, customer
satisfaction does not only depend on your effort but also external factors
▪ Principals unhappy with KPI: x not always good predictor of y, x can be
increased by agent without increasing y (manipulation)
▪ Example: y is profit, a is the given service to customers, and x is customer
satisfaction. Customer satisfaction is not a good reflection of work of
employee ( a – x not ok), customer satisfaction is a good predictor of profit
( x – y ok), but employee can be manipulated by asking clients to be positive
on survey (x – y weakened)
Employees
- In economic models vs real life
o Only extrinsically motivated (lazy) vs intrinsically and extrinsically motivated
o Selfish vs selfish and social preferences
o Rational vs rational but sometimes decisions are subject to behavioral biases
,Lecture 2: The three-legged stool (important!)
Case carrefour
- Decentralized purchasing: purchasing decentralized to the country level
o Advantage: easier to adapt the product range to the local taste
o Disadvantage: local stores negotiate with big retail firms like Pepsi implying that
Carrefour does not exploit the cost benefits of its size
o Purchasing costs are depended on the country manager, manager is evaluated on
sales – costs (excluding depreciation of buildings)
o Cost component is a big part of sales thus managers focus on reducing costs which is
in line with strategy of company
- Centralized purchasing: purchasing centralized at HQ level
o Purchasing costs are depended on the HQ, manager is evaluated on sales – costs
(excluding depreciation of buildings and purchasing costs)
▪ Formula = sales – cost component
▪ Formula = (p x q) – (costs – depreciation – purchasing costs)
o Cost component is a smaller part of sales thus manager focus on increasing sales by
increasing price or quantity which is not in line with strategy of company
- Change in organizational design: decentralized purchasing → centralized purchasing
- Change in reporting system: manager reports purchasing cost → HQ reports purchasing cost
(need more developed vertical reporting lines as HQ should know what to purchase)
- Change in performance evaluation: sales – (costs – dep) → sales – (costs – dep – pc)
- Change in soft controls: control system → stricter control system/new type of employee
Case forest gump
Allocate the overhead cost to the most popular movie to reach the target of profit and get the bonus
→ Cost allocation (reporting system) has an impact on profit (performance evaluation
The three-legged stool
- MCS = three legged stool: MCS consists of four components which are complementary, if you
change on of the four component you also have to check the other three components and
maybe change that one(s) to make sure the whole MRS keeps working.
o Organizational design: how is the organization of your firm designed
o Reporting system: which data do you need to collect, who can report this data, how
should you design your reporting system to get data (and honest)
o Performance evaluation: how can you evaluate people in your firm, which PM/KPI
o Soft controls: do the changes fit with the current organizational culture, social
norms, and leadership in your firm, or do you need another type of employee
- And then question whether all changes that are needs to establish fit between he elements
of the stool are possible at a reasonable cost. What means the complementarity approach
instead of ‘one size fits all’ for MCS consultants?
o Positive: higher prices for the extra work thus more generating sales (increase in p)
o Negative: higher salary for the extra work thus more costs (increase in q)
o Tradeoff between: sales (p) x costs (q)
Wrap up
,Lecture 3: Designing your organization
Organizational design
- Decision 1: what is the structure of my organization? → However in most cases the structure
of a firm is given and is not something that a controller can easily change for the type of
problems controllers have to solve
- Decision 2: how will I allocate decision rights within this structure?
Decision 1: structure
- Market structure
o Organizing by
▪ Customer (industrial, BTC, BTB clients)
▪ Geography
▪ Product
o Advantage: high responsive to changes in market condition and customer preference
o Disadvantages: duplication of functions and costs + information flow across markets
- Function structure
o Advantage: efficiency in executing the functions
o Disadvantages: slow recognize new opportunities + information flow across functions
- Matrix structure: structure along multiple dimensions (bv market, function, and business)
o Advantage: interactions across dimensions (big companies)
o Disadvantages: slow decision making + blurred accountability (who is accountable)
Decision 2: decision right allocation
- Decision right allocation: who decides what and who is accountable for what (bv separation
of duties (segregation) or decentralizing)
- Decision right allocation from who: the allocation of decision rights (and organizational
design in general) is not the outcome of a mechanical process but of a human decision-
making process. Delegation is not decided by a machine but by a human. In the same
structure, organization, industry, a different manager can lead to different delegation. The
question is whether humans can come to the right delegation or distracted by human biases.
- Decision right allocation to who (for efficient and effective functioning of the organization)
o Decision rights to person who has or can obtain the relevant information
(county CEO has soft information that is valuable)
o Decision right to person who has incentives to take best decisions for organization
(global CEO will take also costs into account that are not in the performance
evaluation but important for organizational perspective)
o No match: change one element of the three-legged stool (for example change
performance evaluation or soft control to trust your employee)
- Decision right allocation when
o Controlling (no decision right allocation)
▪ Info needs to be communicated upwards (effort costs and info problem)
▪ You can chose the alternative you want (no incentive problem)
▪ You have intrinsic value of decision rights thus CE is low
o Delegation (decision right allocation):
▪ Less info need to be communicated upward (no effort costs or info problem)
▪ Chosen alternative can be another one than you prefer (incentive problem)
▪ You do not have intrinsic value of decision rights thus CE is high
- Decision rights allocation determined by
o CEO characteristics: tenure, degrees
o Firm characteristics: size, complexity, listed status
,Explanation certain equivalent (CE)
- We find it hard to delegate our decision rights, we like to keep decision rights ourselves, thus
having the decision rights is intrinsically rewarding. This intrinsic value of decision rights leads
to a lower CE for controlling than delegation. CE delegation > CE control
- When you have control and kept the decision rights yourself you require a lower amount of
money to be equivalent between lottery (choosing alternatives) or fixed amount (lower CE).
- When you delegated your decision rights you do not have the intrinsic value of decision
rights so you compensate for this by requiring a higher amount of money to be equivalent
(higher CE). CE delegation = CE control + intrinsic value of decision rights
Implications intrinsic value of decision rights
- Intrinsic value of decision rights can vary
o Intrinsic value of decision rights increases with the amount of money that is at stake:
in general, we prefer to keep decision rights but this effect is even stronger when the
stakes of the decision are high
o Intrinsic value of decision rights decreases with the size of the conflict of interest
between the principal and the agent: Making decisions that are also in the best
interest of someone else are comfortable. Making decisions that harm someone else
are considered as less valuable. Or, we like to shift the blame!
- Intrinsic value of decision rights can explain
o Why people accept lower-paid jobs with more autonomy
▪ Salary job with less autonomy > Salary job with more autonomy
▪ Salary job with less autonomy = Salary job with more autonomy + intrinsic
value of keeping decision rights
o Why firms promise autonomy in job advertisements
o Why we have on average aversion against being the agent
o Why principals are biased towards keeping the decision rights (even when it can be
detrimental to other parties within the organization or organization as a whole)
o Why we decide to centralize (= keeping decision rights)
Summary
- Organizational design consists of: structure of organization and allocation of decision rights
- Decision rights should be allocated to the person who has or can receive the best
information and has the strongest incentives to act in the best interest of the firm
- However we do not always do so because of intrinsic value of decision rights: we prefer to
keep decision rights ourselves rather than delegating them to someone else (information
problem but no incentive problem)
- Intrinsic value of decision rights are higher when the stakes are higher
- Intrinsic value of decision rights are lower when the decision could lead to a conflict
- Intrinsic value of decision rights can explain several phenomena in organizations and markets
- Delegation of decision rights driven by: economic factors, the intrinsic value of decision rights
and personality
, Lecture 4 (videos)
Introduction
Performance measures
- Performance measures (PM) / key performance indicators (KPI): quantifiable indicator used
to assess how well an organization is achieving its desired objectives
- Type from aggregate to specific
o Market based measures: stock price
o Accounting return measures: return on investment (ROI)
o Aggregate financial measures: net profit
o Disaggregate financial measures: sales vs last year
o External nonfinancial measures: customer satisfaction
o Internal nonfinancial measures: employee satisfaction, machine downtime
Performance measure properties
- Important factors for agent (employee)
o Precision: extent to which expected value of pm is influenced by factors outside of
the control of the agent
▪ Purple: positive influenced
▪ Green: precise
▪ Red: negative influenced
o Sensitivity: extent to which expectd value of pm changes with changes in agent effort
▪ Purple: overly sensitive pm
▪ Green: sensitive pm
▪ Red: less sensitive pm
o Verifiability: extent to which it is ex ante clear how the pm is calculated
- Important factors for principal (CEO)
o Congruence: extent to which the pm reflects contributions to overall firm value
▪ Difference between firm and business unit performance big: bad congruence
▪ Difference between firm and business unit performance small: good con.
Performance measure tradeoff
- BU effort leads to a certain BU pm and then firm value (a – x – y)
- Agent (BU manager): interested in link between BU effort and BU pm (a – x)
- Principal (CEO): interested in link between BU pm and firm value (x – y)
- Perfect pm does not exist: make a tradeoff between aggregate, congruent pm (for CEO) and
specific, sensitive, and precise pm (for BU manager). Moving from aggregate to specific pm,
moving from congruence to sensitivity and precision
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