kenneth merchant

8/7/2019 Kenneth Merchant

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Management AccountingPractice and ResearchRelated to VerticalHierarchieswithinOrganizations

Kenneth A. Merchant

University of Southern California

EIASM, December 2006


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What is a vertical hierarchy?

Organization built on series ofsuperior/subordinate relationships

Headquarters/divisions/departments

Functional Divisionalized

Geographical


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Critical problems in vertical

hierarchies

The organizational coordination problem

The management control/agency/motivation

problem


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Primary control alternatives in

vertical hierarchies

Direct supervision(monitoring)

Bureaucracy (rules andprocedures)

Meritocracy (autonomy plusaccountability


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Creating a meritocracy is

generally the preferredalternative

Encourage coordinated actions.

Energize the workforce.

Stimulate learning, creativity/innovationand continuous improvement.


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Management accounting in

meritocracies Long history

E.g., DuPont, General Motors, GE

Centralized control withdecentralized authority

Responsibility accounting

E.g., Solomons (1965)


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Virtually all corporations of at

least minimal size Create financial plans/budgets

Measure financial andoperational performancemonthly

Use responsibility accounting

Provide rewards based onfinancial performance

(typically annually)


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So is best practice well

established?

Not exactly


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Among the things we dont know

1. Why so heavy an emphasison summary financialmeasures of performance

when it is known that thesemeasures provide poorindications of value creation?


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What we want (in for-profit

organiations)

Measures that go up when value is createdand down when value is destroyed.


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What weve got

Correlation between annual accountingearnings and annual value creation .20


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Lots of financial measurement

alternatives

Profit measures (e.g., PAT, PBT,operating income, EBITDA,

OIBDA)Return measures (e.g., ROE,

ROC, ROI, RONA, RAROC,CFROI)

Residual measures (e.g.,residual income, EVA,economic profit)


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Summary financial measures:

unsolved questions

Which measures work best in which settings?

Can the measures be improved?

Are there roles for financial measures even ifthey do not reflect value changes well?


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Correlations between accounting

earnings and value creationOne year

Two years

Five years

Ten years

Source: Easton et al, JAR, 1992.

Should firms just extend themeasurement horizon?

.22

.39

.57

.79


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(cont.)2. How best to link market, financial and non-financial measures of performance?

Lots of frameworks for IntegratedPerformance Measurement Systems

Balanced Scorecard Tableau de Bord

Performance Prism

Intellectual Capital Navigator

SMART (Strategic Measurement and

Reporting Technique) EFQM (European Foundation for Quality

Managements Excellence Model)

(Or more generally, MBO/CSF)


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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? (Whatis balance?)

What to do when measureshave interactive or non-lineareffects on overall performance?


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An example of

a non-linear relationship

Relationship between Satisfaction

and Forthcoming Year's Profit

5-Month Survey

Satisfaction with Customer Service

1.0.9.8.7.6

Profitb

yCommunity

400000

300000

200000

100000


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We must understand better

The different purposes of performancemeasurement systems.

Does some combination of the major categories say

it all? attention directing, problem solving,decision facilitating and/or decisioninfluencing

Difference between a dashboardand an objective function?

Difference between a completeobjective function and anoptimally designed incentivesystem?


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(cont.)3. Why do so many organizations

base performance-dependentrewards on corporate

performance even though fewemployees can have a materialeffect on overall corporateperformance?


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(cont.)4. Can budgeting be improved,

or is it really pass?


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(cont.)5. Why is the typical bonus

formula so complex?

For example:

Organizational level ofperformance

Objective function

Performance contingencies

Shape of the reward function


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Shape of a typical short-term

bonus function

Rewards

Results


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(cont.)6. Why dont firms use truth-

inducing incentive systems?


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(cont.)7. Why are systems sometimes

dramatically different acrosssettings

Individual contingenciesand combinations of them

Management style


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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


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Differences in application of the

controllability principle

1. One companys philosophy:No tolerance for any

excuses.

President: We dont pay foreffort. We pay for results.

2. Most(?) companies protectmanagers from some bad

luck but reward them forvirtually all good luck.


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An important, poorly understood

contingencynational setting

Performance-dependent incentives for departmentmanagers in automobile retailers:

U.S.(n = 433)

% earning formula bonus 64.3%Size of formula bonus (% salary) 54.6%Primary performance measure=profit 94.0%

Formula bonus floor and cap 1.6%


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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 64.3% 10.3%Size of formula bonus (% salary) 54.6% 8.6%Primary perf. measure=profit 94.0% 15.4%

Formula bonus floor and cap 1.6% 23.1%


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(cont.)8. More generally, what are the

motivations of people in thehierarchy?

We know that its often not:a. Value maximization; e.g.,

superiors encouragesubordinates to create slack.

b. Pure self-interest; e.g.,many people try to do theright things even atpersonal cost.


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Conclusion

There is a lot yet to be learned,even in this very maturearea of managementaccounting.

kenneth merchant

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