Designing an effective management control
•
Planning action programmes (programming);•
Preparing the budget;•
Executing the plan;•
Measuring performance, following up the budget and reporting; and•
Evaluating and rewarding.Important design parameters of the control process
When used in an appropriate way, the budgeting process may motivate managers to improve performance. The motivating impact of the budget is influenced by the following parameters.
The level of management commitment to budget targets First of all, companies may use the budget to assess the financial impact of their strategic action plans. In this case, budgeting is primarily used as a feed forward control mechanism and its primary function is to support the planning process (‘budgeting for planning’). Budget targets are an indication and show the direction in which the company wants to go, but managers do not feel a strong pressure to realize the targets. Budget targets can also be seen as commitments for the managers. In this case, the budget is used for control.
Top-down versus bottom-up budgeting Budget targets may be imposed top- down by executive management (in consultation with the division managers, or not). Besides this, there is also a bottom-upprocess, in which each division sets up its own budget, yet within the general goals and directions of the company. The global company budget is then formed by combining the various sub-budgets.
The level of participation during the budgeting process When setting up a budgeting process, an important parameter is the level of participation managers may have in the target-setting process. We can talk about participative budgeting when subordinate managers participate in the budgeting process and in defining the budget objectives. Participative budgeting involves back-and-forth communication between superiors and subordinates – they share information and converge on a mutually acceptable budget. It is generally agreed that involvement in setting up the budget leads to higher acceptance than when the budget is imposed fully from the top. Moreover, it is assumed that participative budgeting has a positive effect on the commitment of the division managers who have to realize the budget later on.
The difficulty of budget targets It is necessary to think about guidelines regarding the degree of difficulty in realizing the budgets (‘goal difficulty’).
Certain companies have a policy of realistic budgets, where the budget objective will be accepted if it most probably can be reached. Other
companies prefer challenging budgets, where top management expects the division managers to work very hard. The basic assumption behind challenging budgets is that managers can always achieve more with their team than they think they can. The task of top management is to stimulate managers to try to excel themselves over and over again. In this situation, managers who submit realistic budgets are evaluated poorly beforehand and a more challenging budget is imposed on them from the top. Whatever the budget philosophy, a budget can be accepted if it holds sufficient task content, i.e., if the team in the department will have to exert a lot of effort to realize the budget. As a general rule, the set targets ought to be realistic but challenging. This means that they may not be set unattainably high, which results in frustration and manipulation of data, but they may also not be too easily achievable, because then most of the performance stimulus disappears.
Tolerance for budget slack It should also be verified whether or not the budget is too pessimistic. Some managers may be inclined to build a certain ‘slack’ into their budget. The phenomenon of budget slack occurs when a manager submits a budget in which a certain ‘buffer’ is built in so that the budget objectives are relatively easy to reach. Indeed, in a participative budgeting process the tendency might exist to ask more than one strictly needs to cover oneself against unforeseen circumstances or out of fear that top management will reduce the budget by a certain amount.
For example, if the purchasing department fears that it will no longer be able to buy raw materials at the prices that were budgeted in the past, it can ask for extra means for this part of the budget. It can also be that managers prefer not to set the budget standards too high in companies where their bonuses are calculated on the degree to which they have reached their budget objectives. In all these cases, the general interests of the company are not respected because, by building in budget slack, the company funds are not optimally allocated.
Fairness in budget target setting When assessing the budget, one should verify whether the task content of the budgets of the various departments are of equal value. The budget negotiation process is not only a vertical negotiation process in the organization, it is also a process of comparing the planned efforts of the various departments. Dynamic managers, who always work with challenging budget objectives, may become demotivated when they discover that other departments are tolerated when they exert less effort (i.e., make less profit or be less productive).
However, equally balancing the task content of the budgets of the various departments presents difficulties because the management problems may differ widely per department (e.g., different management functions, product groups, markets, etc.) and the concept ‘task content’ is difficult to measure objectively. The task content of a budget depends on the experience of the manager and his or her team. There is also a certain
psychological insight involved here. Some managers, along with their teams, feel more quickly swamped with work than others. In any case, clear imbalances in the performances of the various departments need to be eliminated as quickly as possible. For instance, in a profit centre structure, where all divisions are making profits and a certain division is constantly in the red, a thorough restructuring plan must be set up in the short run to make the department profit-making as fast as possible.
Tightness of budget control With regard to following up the budget, a choice can be made between tight and loose control. The tightness of the control is determined by the degree to which restrictions are imposed on the freedom of subordinates and emphasis is placed on reaching the predefined objectives. In most cases, it is assumed that tight control provides more certainty that the people in the organization will act as is expected of them.
This can be done by determining the activities in detail, by following up very accurately the results of the departments, and by exerting pressure on the responsible managers to adjust quickly potentially unfavourable anomalies. With tight budget control, it is frequently (e.g., monthly) verified whether the real costs and revenues are in accordance with the planned short-term objectives. Undesired anomalies in the budget are not tolerated and must be eliminated quickly. The advantage of tight control is that managers become more aware of the importance of costs and profitability, and they actively seek ways to eliminate inefficiencies.
However, tight control may also have undesired dysfunctional effects.
Focusing on short-term results too intently may encourage managers to organize actions that optimize profitability in the short term, but that are disadvantageous in the long term. For example, in order to reach its budget figures, the purchasing department may decide to buy cheaper, but qualitatively inferior, raw materials. However, this may lead to significant quality problems in production and possibly to lower quality end products, which result in losing the goodwill of the customers. When the emphasis is primarily on reaching budget objectives in the short term, managers may also not be motivated to make the strategic investments that are necessary for the long-term survival of the company. Moreover, excessively tight budget control may lead to building in ‘slack’ when setting up the budget objectives or to playing accounting tricks to artificially boost the short-term results.
On the contrary, with loose budget controldeviations from the budget that arise in between are overlooked by top management, and there is a trust that potentially unfavourable anomalies will be eliminated by the divisional managers at the end of the budget period. The budget is used more for communication and planning, and there is less pressure to undertake immediate short-term actions to adjust the results.
The use of budget performance in rewarding managers When setting up the budget, for managers of responsibility centres it is required that the
proposed objectives be realized (although we know some companies that start paying bonuses when only 80 per cent – and even 60 per cent – of the budget target is realized). At the end of the year, the actual results are compared to the planned objectives and are further analysed by means of variance analysis. In this way, the budget is an ideal basis for evaluating the performances of the responsible managers. Managers who succeed in realizing the proposed objectives must be rewarded for their good performance. This reward may be of a financial nature (e.g., bonus, salary increase or other financial advantages), but the reward may also be more focused on non-financial motivators, such as promotion, extension of responsibilities and recognition. A bonus for performance relative to the budget can be determined subjectively or by formula. To be effective, the reward system must be designed in such a way that it optimally motivates the managers to act in accordance with the corporate goals and strategies.
Optimizing management control process policies
A management control process (and more specifically, the budgeting process) is effective when it motivates managers on the various levels of the organization to perform actions in line with the organizational goals and strategies. From contingency research on management control, evidence suggests links between strategy and the characteristics of the management control process.
Defenders, and companies with conservative, cost leadership strategies, find cost control and specific operating goals and budgets more appropriate than entrepreneurs, prospectors and companies with product differentiation strategies (Simons, 1987; Dent, 1990; Chenhall and Morris, 1995). Chenhall and Morris (1995) have found that tight control is suitable for conservative strategies; they also found tight control in entrepreneurial situations but, importantly, operating together with organic decision styles and communications.
Some research has been focused on the relationship between the chosen competitive strategy and the management control process.
Differentiation strategies are associated with a de-emphasis on budgetary goals for performance evaluation (Govindarajan, 1988).
Govindarajan and Fisher (1990) found that product differentiation with high sharing of resources (between functional departments) and a reliance on behavioural control was associated with enhanced effectiveness. Bruggeman and Van der Stede (1993) found that business units implementing differentiation strategies based on a make-to-order strategy preferred loose control in budgeting, while business units with a cost leader strategy or a differentiation strategy based on standard products found tight budget control more suitable. They also found that bottom-up budgeting and a commitment to budget targets was considered optimal for all competitive strategies. Overall, Van der Stede
(2000) has shown that product differentiation strategies are associated with less rigid budgetary control, but this is also associated with increased budgetary slack.
It has also been suggested that bonus systems must be suited to the strategy. Anthony and Govindarajan (1995) suggest that formula-based bonus determination approaches should be used with a harvest strategy and that subjective bonus determination is optimal for build strategies.
Contingency research has also found relationships between characteristics of the management control process and the level of uncertainty in the environment. Companies operating in an environment of unpredictable change require an appropriate set of control process characteristics. Uncertainty has been related to performance evaluation characterized by a more subjective evaluation style (Govindarajan, 1984;
Moores and Sharma, 1998), less reliance on incentive-based pay (Bloom, 1998), non-accounting style of performance evaluation (Ross, 1995), and participative budgeting (Govindarajan, 1986). As environmental uncertainty increases, using more participative budgeting increases performance. In contrast, when environmental uncertainty is low, participative budgeting decreases performance. In situations where environments are stable and predictable, there is little informational benefit from participation because superiors have sufficient information to develop budgets.
Companies may also operate in a hostile, difficult environment. This is an environment that is stressful, dominating and restrictive.
Environmental hostility has been associated with a strong emphasis on meeting budgets (Otley, 1978). Hostility from intense competition has been related to a reliance on formal control and sophisticated accounting, production and statistical control (Khandwalla, 1972;
Imoisili, 1985).
The optimization of target-setting approaches seems to be related to task complexity. Locke and Latham (1990) found that difficult goals lead to higher performance, but this effect is moderated by task complexity.
The result leads us to expect that performance will be higher when managers are invited to work towards challenging targets, except when the performance task is too complex.
The appropriateness of bottom-up budgeting has been associated with information asymmetry between superiors and subordinate managers (Shields and Young, 1993). When subordinates have much better information about their business than their superiors do, bottom-up budgeting leads to more accurate budgets, arising from the use of the subordinates’ better information. When top-down budgeting is used in the case of high information asymmetry, subordinates may reject the budget because it is not consistent with their information. Top-down budgeting is beneficial in situations where superiors have sufficient knowledge about the subordinate’s activities being budgeted.