Management Accounting Practice and Research Related to

Vertical Hierarchies

within Organizations

Kenneth A. Merchant University of Southern California EIASM, December 2006 1

What is a vertical hierarchy?

– Organization built on series of superior/subordinate relationships – Headquarters/divisions/departments • Functional • Divisionalized • Geographical 2

Critical problems in vertical hierarchies • The organizational coordination problem • The management control/agency/motivation problem 3

Primary control alternatives in vertical hierarchies • Direct supervision (monitoring) • Bureaucracy (rules and procedures) • Meritocracy (autonomy plus accountability 4

Creating a meritocracy generally the preferred alternative is • Encourage coordinated actions.

• Energize the workforce.

• Stimulate learning, creativity/innovation and continuous improvement.

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Management accounting in meritocracies • Long history – E.g., DuPont, General Motors, GE • “Centralized control with decentralized authority” • Responsibility accounting – E.g., Solomons (1965) 6

Virtually all corporations of at least minimal size … • Create financial plans/budgets • Measure financial and operational performance monthly • Use responsibility accounting • Provide rewards based on financial performance (typically annually) 7

So is “best practice” well established?

Not exactly 8

Among the things we don’t know 1. Why so heavy an emphasis on summary financial measures of performance when it is known that these measures provide poor indications of value creation?

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What we want (in for-profit organiations) Measures that go up when value is created and down when value is destroyed.

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What we’ve got Correlation between annual accounting earnings and annual value creation ≈ .20

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Lots of financial measurement alternatives

Profit measures

operating income, EBITDA, OIBDA) (e.g., PAT, PBT,

Return measures

ROC, ROI, RONA, RAROC, CFROI) (e.g., ROE,

Residual measures

(e.g., residual income, EVA  , economic profit) 12

Summary financial measures: unsolved questions • Which measures work best in which settings?

• Can the measures be improved?

• Are there roles for financial measures even if they do not reflect value changes well?

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Correlations between accounting earnings and value creation One year Two years Five years Ten years .22

.39

.57

.79

Source: Easton et al, JAR, 1992.

Should firms just extend the measurement horizon?

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Among the things we don’t know (cont.) 2. How best to link market, financial and non financial measures of performance?

– Lots of frameworks for “Integrated Performance Measurement Systems” • Balanced Scorecard • Tableau de Bord • Performance Prism • Intellectual Capital Navigator • SMART (Strategic Measurement and Reporting Technique) • EFQM (European Foundation for Quality Management’s Excellence Model) (Or more generally, MBO/CSF) 15

Measurement issues when using a combination of measures • How to test the

assumed

causal linkages?

• How many measures is enough?

• How should the measures be weighted in importance? (What is “balance”?) • What to do when measures have interactive or non-linear effects on overall performance?

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An example of a non-linear relationship Relationship between Satisfaction and Forthcoming Year's Profit 400000 5-Month Survey 300000 200000 100000 .6

.7

.8

Satisfaction with Customer Service .9

1.0

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We must understand better …

The different purposes of performance measurement systems.

Does some combination of the major categories say it all?

attention directing, problem solving, decision facilitating

and/or

decision influencing

– Difference between a

dashboard

and an

objective function

?

– Difference between a

complete objective function optimally designed incentive system

?

and an 18

Among the things we don’t know (cont.) 3. Why do so many organizations base performance-dependent rewards on

corporate

performance even though few employees can have a material effect on overall corporate performance?

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Among the things we don’t know (cont.) 4. Can budgeting be improved, or is it really passé?

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Among the things we don’t know (cont.) 5. Why is the typical bonus formula so complex?

For example: – Organizational level of performance – Objective function – Performance contingencies – Shape of the reward function 21

Shape of a typical short-term bonus function Rewards Results 22

Among the things we don’t know (cont.) 6. Why don’t firms use truth inducing incentive systems?

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Among the things we don’t know (cont.) 7. Why are systems sometimes dramatically different across settings – Individual “contingencies” and combinations of them – Management style 24

Among the variances in practice that are difficult to explain • Differences in use of “punishments” • Differences in tolerance for use of subjectivity in performance evaluations • Differences in implementation of the “controllability principle” 25

Differences in application of the “controllability principle” 1. One company’s philosophy: No tolerance for any “excuses.” – President: “We don’t pay for effort. We pay for results.” 2. Most(?) companies protect managers from some “bad luck” but reward them for virtually all “good luck.” 26

An important, poorly understood contingency—national setting Performance-dependent incentives for department managers in automobile retailers: U.S.

(n = 433) % earning formula bonus Formula bonus floor and cap 64.3% Size of formula bonus (% salary) 54.6% Primary performance measure=profit 94.0% 1.6% 27

Cross-national differences in reward systems (cont.) Performance-dependent incentives for department managers in automobile retailers, U.S. vs. Netherlands: U.S.

Netherlands (n = 433) (n = 145) % earning formula bonus Size of formula bonus (% salary) 54.6% 8.6% Primary perf. measure=profit 64.3% 10.3% 94.0% 15.4% Formula bonus floor and cap 1.6% 23.1% 28

Among the things we don’t know (cont.) 8. More generally, what are the motivations of people in the hierarchy?

We know that it’s often not: a. Value maximization; e.g., superiors encourage subordinates to create slack.

b. Pure self-interest; e.g., many people try to do the “right” things even at personal cost.

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Conclusion

There is a lot yet to be learned, even in this “very mature” area of management accounting.

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