C16: The Effects of Environmental Uncertainty, Organizational Strategy, and Multinationality of Management Control Systems

A basic premise that pervades this book is that there is no universally best management control system (MCS) that applies to all situations in any organization, much less all organizations. Managers involved in designing, implementing, and using MCSs must consider a large number of situational factors that, individually and collectively, affect either the costs or the effectiveness of the various management controls. Figure 16.1 depicts the general contingency framework within which MCS design should be considered. This figure shows that the effects of the various elements and characteristics of MCSs on the various MCS outcomes are contingent upon any of a number of situational factors.

Because the range of organizational settings is large, many relevant situational factors exist. Examples of factors that affect one or more MCS choices include differences in aspects of national culture; differences in the structure, stability, size, growth, competition, and regulation of the industry or market; differences in aspects of the ownership, size, strategy, and culture of the organization; differences in production or service process complexity, technology, interdependence, or routineness; and differences in management and employee experience, skills, and training. Although this list is necessarily incomplete, failure to consider even one of these situational factors can make the difference between an excellent and a suboptimal MCS choice.

Determining the relevant aspects of the situational context and their effects on MCS elements is difficult because (1) many of the factors are related (e.g. technological change may affect production process complexity, or organization size may affect organizational culture); and (2) many of the factors interact with each other to produce MCS-related effects (e.g. technological change may not have the same impact on the MCSs in large and small organizations).

Research has only begun to sort out the many complex MCS-related relationships. But even if all of the effects of each of these, and other, factors on MCS elements and MCS-related outcomes were well understood, space constraints would not permit their detailed discussion in a general-purpose book. A few of these factors that have not been discussed in prior chapters but that are important in a broad range of settings deserve extra highlighting. That is the purpose of this chapter. The chapter focuses on the effects of three important situational factors: (1) environmental uncertainty, (2) organizational strategy, and (3) multinationality.

Environmental UncertaintyEnvironmental uncertainty refers to the broad set of factors that, individually and collectively, make it difficult or impossible to predict the future in a given area. Uncertainty can stem from changes (or potential changes) in natural conditions (e.g. weather), the political and economic climate, or the actions of competitors, customers, suppliers (including labor), and regulators. Uncertainty is higher where the pace of technological change is higher. Uncertainty is also generally higher the farther one tries to look into the future. Thus, uncertainty is higher in organizations where the natural business cycle – the lag between investment and the payoff from that investment – is longer.

Uncertainty has some powerful effects on MCSs. Uncertainty makes action controls difficult to use. Action controls are effective only if there is knowledge as to which actions are desirable and if those actions are consistently desirable. If managers want to use action controls in uncertain situations, they have to develop knowledge about the desirable actions, which usually implies that they must become personally involved in the activities being controlled. They must use more intensive preaction reviews, get involved in more face-to-face meetings with the employees being controlled, and/or use more direct observation and supervision.

When action controls are deemed to be infeasible or impractical, managers generally place a high reliance on result controls. Result controls can be used even in highly uncertain settings, as employees can be rewarded for generating more of what is known to be desirable (e.g. sales or profits). However, uncertainty often makes the use of result controls more difficult too, for a number of reasons.

First, result controls are not effective when employees do not understand how to generate the desired results. Uncertainty often hinders their abilities to know. Second, even when employees know how to do

better, result controls will not be optimally effective unless properly challenging performance targets are set. In uncertain situations, it is difficult to calibrate performance targets. It is almost inevitable that fixed targets (i.e. those that do not adjust to changing conditions and are not relative to the performance of peers facing like business conditions) will be too easy or too challenging to meet. Because information asymmetry between superiors and subordinates is likely to be relatively high, subordinates can add slack to their budgets relatively easily. In addition, the targets will include many uncontrollables caused by forecasting errors regarding, for example, the state of the economy, competitors’ actions, and sources and prices of supplies. These uncontrollables will adversely affect the reliability of the performance evaluations.

Third, uncertainty combined with the use of result controls causes employees to bear business risk, which brings into play all the conditions discussed in Chapter 12: The organization will either have to compensate employees for bearing the greater risk or take steps to limit the risk. To limit the risk, organizations facing an uncertain environment might choose not to regard managers’ budget targets as firm commitments to the organization and, thus, might not interpret unfavorable budget variances as clear indicators of poor performance. If they do so, organizations will give up some short-term performance pressure, which is generally motivational. Alternatively, if organizations decide to treat budget targets as performance commitments from their managers, they will likely find it desirable to implement systems using contingency (scenario) planning, flexible performance targets, or subjective performance evaluations; to use shorter planning and measurement periods; or to increase their reliance on environmental scanning mechanisms and forecasting procedures to reduce the uncertainty (as discussed in Chapter 12).

Fourth, high uncertainty tends to have some broad effects on organization structures and decision-making and communication patterns, and these effects increase the complexity of the management task. Organizations facing relatively high uncertainty will tend to decentralize their operations, have more participative, relatively bottom-up planning and budgeting processes, and make important decisions only after relatively intensive consultations among larger groups of managers.

The broad effects of uncertainty are well illustrated with a production example. In the old mass production system invented by Henry Ford, the production function of the organization was buffered from the environment so the uncertainty faced by managers in that area of the company was, in the short run, effectively zero. This buffering was possible because customer demand was relatively predictable, competition low, and product variety limited (e.g. all Ford T-models were black). Thus, production managers could standardize behaviors and processes and produce in large runs or batches. Tasks were divided into many separate parts; labor was specialized; employees’ actions were dictated by rules; decision-making was centralized; and many vertical levels of management were used to provide coordination.

However, most organizations today operate in vastly more uncertain (less programmable) environments, ones that require agility to respond to rapidly changing customer-driven demands. Customer-driven organizational processes also require multi-functional, cross-departmental problem solving and coordination characterized by greater interdependencies across tasks and entities within organizations. Many firms have responded to these challenges by implementing so-called “new” manufacturing processes, including flexible manufacturing systems (FMS), just-in-time production (JIT), total quality management (TQM), and elimination of non-value-added activities. While these new processes are designed to streamline production processes and eliminate buffers (inventories), they have also shifted the control focus. In order to be responsive, line personnel must exercise more control. As a result, firms that use the new manufacturing processes tend to have flat organization structures and use few formal work rules and less hierarchical control. Jobs lose much of their formal definition; duties are continuously redefined; the number of middle managers is reduced; and the workforce is asked to be adaptive. There is less top-down monitoring; more teamwork; more coordination through personal, lateral channels rather than by standard operating procedures; less rewards based on individual performance; and greater use of control through socialization mechanisms. The result is that the production environment is more adaptive as the workforce is encouraged to solve problems and implement solutions. But the MCS must be implemented more loosely, particularly with respect to behavior-constraining action controls, because actions are less programmable.

Uncertainty is not only prevalent in many contemporaneous manufacturing environments; it also is a significant situational factor that affects MCS design in many other organizations, particularly service organizations, such as professional service firms that provide legal, accounting, business consulting, or financial services, where coordination and knowledge integration is critical for effective service delivery). Early research findings in this area indicate that effective controls in such organizations evolve around carefully chosen combinations of controls, including extensive planning and budgeting processes (to perform preaction reviews and to ensure coordination), individual and team measures of performance and associated incentives (to ensure individual and team accountability commensurate with decision autonomy), personnel controls (such as selective recruiting and staffing of teams to ensure the presence

of the requisite knowledge as well as knowledge sharing), and cultural controls (to provide reinforcements of the core organizational values, such as teamwork, customer focus, and knowledge sharing).

Organizational StrategyLarger, more complex organizations often specify two levels of strategy: a corporate strategy (often called diversification strategy) and a business strategy within each of their so-called strategic business units (often called competitive strategy). Strategies at both levels constrain organizations to focus on what they do best and constitute important situational factors for the design of effective MCSs.

Corporate StrategyAn organization’s corporate strategy determines what businesses it wants to be in and how resources should be allocated among those businesses. One way of viewing corporate strategies is to array them along a continuum from related to unrelated diversification. Firms pursuing related diversification do not stray far from their core business activity. They diversify in order to exploit economies of scope stemming from relationships among their divisions (business units). Firms pursuing unrelated diversification are not concerned with restricting their focus to their core business. They pursue a portfolio of unrelated businesses to exploit internal capital market benefits that stem from internal decision makers’ relative information advantages for resource allocations compared to external capital markets. However, to fully realize the benefits of either the related or unrelated forms of diversification, firms must adopt appropriate and effective administrative systems, including MCSs.

An important distinguishing characteristic of firms that are diversified into related businesses is high interdependence among their business units. Related-diversified firms should design their MCSs to take advantage of this interdependence to exploit synergies and reap economies of scope. Hence, related-diversified firms often have relatively elaborate planning and budgeting systems; that is, those requiring large amounts of interpersonal communication. These systems force the business unit managers to communicate with each other and make it more likely that the managers can keep their interrelated activities coordinated to exploit synergies. Further, to signal that cooperation among entities is important, related-diversified firms are more likely to use incentive compensation systems that base some portion of business unit managers’ bonuses on the performance of the next higher-level entity in the organization, which may be a division, region, business group, or the entire corporation. Related-diversified firms are also likely to spend considerable resources addressing transfer pricing problems, as we discussed in Chapter 7. Transfer pricing problems become particularly acute if some business units supply others and no competitive price is observable from outside markets.

An important distinguishing characteristic of firms that are diversified into unrelated businesses is relatively high information asymmetry between corporate and business unit management as corporate managers are unable to remain well-informed about all the developments in all of their diverse business units’ operating areas. Decentralization and heavy reliance on financial result controls are common responses to information asymmetry. Corporate managers can reduce their information processing requirements by pushing the locus of decision making lower in the organization. And they can obtain good management control by relying on financial result controls built around profit and investment center responsibility structures. The financial measures help the corporate managers in comparing diverse businesses.

These choices will, however, cause many performance discussions among corporate and business unit managers to be largely in financial terms. Because they do not have the detailed knowledge about the activities and idiosyncrasies of the business units, the corporate managers will also tend to judge the performances of the diverse business units objectively and award formula bonuses based on what they monitor – financial performance. They will tend to use relatively little subjectivity in their performance evaluations. With such a system, the business unit managers usually have considerable pressure for financial performance, but they also have relatively high autonomy. They tend to participate heavily in the setting of their performance targets, and they have considerable discretion as to how to achieve their financial targets. But if the autonomy is combined with the use of less-than-perfect financial measures, the business unit managers are likely to engage in some dysfunctional behaviors, such as slack creation, thereby undoing some of the benefits of internal capital markets that unrelated diversification strategies purport to generate.

Finally, because business units of unrelated diversified corporations have few operational synergies and are essentially autonomous, corporate performance is a noisy measure that provides relatively little information about any individual business unit manager’s actions. Therefore, business unit managers in these firms more commonly receive bonuses that are strictly based on the financial performance of their own units, rather than those based on corporate performance.

Business Strategy

Business strategy, also sometimes called competitive strategy, defines how a firm or entity within the firm (often called a strategic business unit) chooses to compete in its industry and tries to achieve a competitive advantage relative to its competitors. The strategy literature distinguishes two primary competitive strategies: cost leadership and differentiation. A cost leadership strategy involves offerings of relatively standardized, undifferentiated products; vigorous pursuit of cost reductions; generation of volume to exploit economies of scale and to move down the learning curve; acquisition of process engineering skills; and, as much as possible, establishment of a routinized task environment. A differentiation strategy involves the creation of a product or service that customers perceive as uniquely differentiated from competitors’ offerings. Such differentiation can focus on one or more dimensions, including product innovation, product functionality, quality, brand image, customization, or customer service. Regardless of the chosen focus, a likely requirement is intensive coordination and collaboration across a broad array of employees and organizational entities. For example, success in improving customer service is likely to depend on the free flow of information and coordinated efforts among marketing, product design, production, and delivery. Such interdependency increases uncertainty, as decision-making processes become more unprogrammable due to the decision context in one functional area being affected by the decisions made in other areas. Another feature of differentiation initiatives is that they often require substantial time to translate into financial results, as they involve prospecting new markets and/or developing new product or services.

An extensive strategy literature discusses the conditions that lead a business to adopt a particular competitive strategy, but these are outside the scope of this book. What is important here is the impact of whatever strategy that has been selected on one more MCS characteristics. So-called contingency theory maintains not only that competitive strategy (as well as other contingency factors) should drive the design of MCSs, but more importantly, that organizational effectiveness depends on the extent to which both are aligned; that is, on the extent to which the MCSs “fit” the competitive strategy.

Competitive strategy, then, should be directly related to the results measures included in a results control system. Businesses endeavoring to be cost leaders, and those defending existing businesses, should control their employees’ behaviors through relatively tight, formal financial controls and standardized operating procedures designed to maximize efficiency. For motivating managers, results measures should emphasize cost reductions (process innovation) and budget achievement. Conversely, businesses competing on the basis of differentiation, and those prospecting for new markets, should have a more informal control system, a participative decision-making environment, and they should reward employees and managers based on any of a number of forward-looking, nonfinancial performance indicators, such as product innovation, market development, customer service, and growth, in addition to financial indicators such as budget achievement. Moreover, some of the key dimensions of differentiation strategies, such as those focused on knowledge sharing and cooperativeness, are difficult to quantify, and thus may need to be evaluated subjectively.

In summary, organizational strategies are important to MCS designers because they define what is critical to success. An organization’s critical success factors should drive the various MCS design choices. Organizations that align their choice of MCSs with their strategy are more likely to affect better control, and thus, are more likely to exhibit superior performance.

MultinationalityMultinational organizations (MNOs), those that operate in more than one country, must understand how they must adapt their management practices, including management control practices, to make them work in each of their international locations. MNOs have many similarities with large domestic organizations in that they are usually characterized by a high degree of separation of ownership and control. Authority is decentralized to a relatively large number of decision makers, and management control is exercised to a considerable extent through financial results controls. Generally, though, controlling MNOs is more difficult than is controlling domestic organizations. MNOs face a multidimensional organizational problem: they are organized not only by function and product line, but also by geography. The geography dimension requires managers to be sensitive to each of the national (and perhaps even regional) cultures in which they operate. Adapting management (control) practices across borders is complicated, and research on the topic is in its early stages. However, if the MCS adaptation is done improperly, the organization may suffer because it induces employee behaviors that are contrary to its interests or because it increases the costs of attracting and retaining good employees. This section provides a discussion of, primarily, three sets of factors that have been shown to affect MCS choices or outcomes across countries in a systematic manner: national culture, institutions, and local business environments. We also discuss the additional problem of evaluating the performance of managers whose results are measured in different currencies and currencies that are different from that in the firm’s home country.

National Cultures: Behavioral Similarities and Differences Across Countries

Clearly some of the effects, benefits, and costs of management controls are universal because, at a certain basic level, people in all countries, and all regions of all countries, are alike. They have the same basic physiological needs and similar desires for safety, comfort, and accomplishment. People around the world also tend to respond to the sets of incentives with which they are faced. It is well accepted that people in capitalistic economies like the United States react to monetary incentives, such as bonus pay. But so, too, do people in socialistic economies. China, in fact, passed a labor law in early 1995 that provided for a transition away from secure, permanent employment and towards performance-based employment. Nearly 90% of Chinese workers signed new labor contracts with their employers. Guangdong Kelon Electrical holdings, a southern China-based refrigerator manufacturer, is one company which now bases part of its managers’ pay on both company profitability and the managers’ individual performances. The company’s chairman, Pan Ning, claims that, “this gave directors a greater incentive to work harder to increase [the refrigerator maker’s] profitability.” Examples like these from China, a country with a socialistic economy for many years, provide evidence that people around the world respond to results controls and that money is a powerful motivator. Despite the basic similarities in people around the world, there are also many differences.

One important set of factors with potentially important influences on MCSs can be explained under the rubric of national culture. National culture has been defined as “. . . the collective programming of the mind that distinguishes the members of one group or society from another . . .” The national culture concept recognizes that people’s tastes, norms, values, social attitudes, religions, personal priorities, and responses to interpersonal stimuli differ across nations. Of particular importance here is the fact that people of different national origins have different preferences for, and reactions to, management controls. National culture has a direct effect on MCSs because control problems are behavioral problems. When groups of employees perceive things differently or react to things differently, different control choices may have to be made. Thus, an important factor that contributes to the effectiveness of MCSs is whether the employees perceive them as culturally appropriate; that is, whether they suit the shared values maintained by the society in which they operate.

Several taxonomies of national culture have been proposed. The most commonly cited taxonomy consists of the four cultural dimensions identified in a study by Geert Hofstede: individualism, power distance, uncertainty avoidance, and masculinity. The individualism (vs. collectivism) dimension of national culture relates to individuals’ self-concept; that is, whether individuals see themselves primarily as an individual or as part of a group. Individuals from an individualistic culture tend to place their self-interests ahead of those of the group and prefer interpersonal conflict resolution over conflict suppression. Individuals in a collectivist culture are motivated by group interests and emphasize maintenance of interpersonal harmony. The power distance dimension relates to the extent to which members of a society accept that institutional or organizational power is distributed unequally. Individuals who score high in uncertainty avoidance feel uncomfortable when the situation they face is ambiguous. The masculinity dimension relates to the preference for achievement, assertiveness, and material success (traits labeled masculine), as opposed to an emphasis on relationships, modesty, and the quality of life (traits labeled feminine).

Hofstede showed that people from different countries vary significantly on these cultural dimensions. For example, Hofstede showed that, as compared to the Taiwanese culture, the US culture is much more individualistic and more masculine, while the Taiwanese culture is higher in both power distance and uncertainty avoidance. If that is true, then each of the cultural dimensions can be said to have MCS implications. For example, employees high in individualism are possibly more likely to prefer individual rather than group-oriented work arrangements, performance evaluations, and pay. Similarly, given the high value placed on individualism in the US, it should perhaps not be surprising to observe that organizations in the United States make relatively high use of individual performance-based incentives as compared to organizations in other countries.

People who are high in power distance are likely to prefer, or at least more likely to accept, greater centralization of decision authority and less participation in decision processes. Thus, when power distance is high, employees may be more willing, say, to accept greater discretionary power or subjectivity exercised by their superiors in performance evaluations and incentive determinations.

People high in uncertainty avoidance are likely to want to avoid or reduce risk and ambiguity. When designing MCSs in high uncertainty-avoidance settings, organizations might therefore consider using less subjectivity in performance evaluations.

Finally, and merely providing more examples, employees’ desire for achievement and competition in masculine cultures may be conducive to an effective use of relative performance evaluations where employees’ performances are directly compared, and hence, are competing with one another. But whereas employees high in masculinity may prefer rewards based on “hard” performance, those low in masculinity may prefer more “equitable” allocations based on need. And so on.

These four dimensions, however, do not explain all aspects of national culture and their differences across countries. For example, one aspect of cross-cultural differences not directly picked up by any of the four Hofstede dimensions relates to corporate goals. Managers in some countries, particularly those in Asia, are often more concerned with the interests of non-owner groups than are US managers. For example, when the presidents and middle managers of large Japanese firms were asked what their company’s objectives were, the presidents ranked pursuit of shareholders’ profit only a distant fourth, with only 3.6% of the responses. Both groups ranked employees first among those entitled to the organization’s profits. Managers running a business for the benefit of many stakeholders (including employees, the communities in which they operate, and the society at large), and not primarily the owners or shareholders, will make different decisions. With regards to MCS design, they are likely to choose different performance measures (e.g. employee safety) and use different ways of rewarding employees (e.g. employee benefits).

Local InstitutionsSocial, government, and legal institutions vary significantly across nations. These include government agencies, corporate ownership structures, banking systems, and labor unions. Also important are the legal systems, including rights given to property holdersand the enforceability of contracts. Each of these factors can influence organizations’abilities to influence employee behaviors. For example, organizations in countries withstrong labor unions often find it difficult to provide incentive pay as most unions preferseniority-based pay systems.One set of institutional factors with potentially important MCS implications are thosedescriptive of the financial markets in various countries, their importance in raising capital,and the extent of disclosures and types of information they demand.28 The quality ofthe required disclosures of (financial) information by publicly traded firms also variesacross countries, in part because of differences in the capabilities, organization, and regulationof firms in the auditing profession.29 In some countries, equity capital markets arenot particularly important for raising money; in their place, firms raise money from banksand other financial institutions or, as is the case in some developing countries, from thestate. But even in countries where financial markets are important, many managers do notbelieve that short-term accounting profits are reflected to a significant degree into stockprices.30 In developing countries, these beliefs may be correct because trading is oftenthin.31 If managers do not believe that stock market valuations accurately reflect firmvalue on a timely basis, they may place less emphasis on accounting profits for incentivepurposes and, perhaps, may be less likely to engage in the short-sighted actions designedto manage earnings that were described in Chapter 10. The state of the capital marketsin various countries may also affect the extent to which organizations can provide stockbasedincentives, such as restricted stock or stock options.Accounting regulations also differ dramatically across countries. Even the basicpurpose of accounting differs across countries. In the US, accounting standard-settingbodies, such as the Financial Accounting Standards Board, use decision usefulness(which is related to the extent and transparency of disclosure) as its paramount guidingprinciple.32 In some other countries, accounting standard setters or lawmakers use prudenceas their paramount principle. Prudent accounting rules are ultra-conservative. Theyemphasize creditor and employee protection, so they make it critically important that thewealth and earnings of a company never be overstated. As we have discussed in priorchapters, accounting rules and regulations affect managers’ abilities and propensitiesto engage in earnings management. For example, not all countries require the reportingof quarterly financial performance, which may affect managers’ focus on short-termfinancial performance, and hence, their propensity to engage in myopic decision-makingto meet or beat expected performance targets on a quarterly basis to affect stock pricevaluations.

Differences in Local Business EnvironmentsBusiness environments also differ significantly across countries. Elements of these environmentscan affect environmental uncertainty, inflation, and the availability of qualifiedpersonnel. Each of these factors has MCS implications.

Risk and uncertaintyCountry-specific environmental uncertainty can be caused by many things. Some countriesare inherently more risky places in which to do business. Military conflicts,kidnappings, terrorism, and extortion threats can create major security problems. Somecountries are also prone to corporate espionage and theft of corporate secrets by localcompetitors, perhaps even with the tacit consent of the host government. Risk alsodiffers across countries because of the stage of economic development. As discussed, regulation and oversight, and other obstacles to doing business.Government activities also affect business risk. Governments have, to a greater or

lesser extent, powers that enable them to serve certain objectives. These powers can havemajor effects on the value of companies’ assets and the expected returns on those assets.For example, governments can exercise bureaucratic and quixotic control in issuing businesspermits, controlling prices, and restricting currency flows. They can enforce antitrustlaws. They can design tax laws that dramatically redistribute income or affect thevalue of monetary compensation and other reward arrangements. They can apply constraintsthrough labor policies designed to reduce unemployment (forced production orprohibition of layoffs).In general, in nations where the governments have greater powers and tend to usethem more frequently, business risk is higher. However, governments can also act tolower business risk. Tariff barriers can protect corporations from competitive marketforces. Governments can buy some of the companies’ products to stabilize prices. Theycan provide direct subsidies in case of calamities. They can provide support for researchand investment activities through grants or tax provisions. They can also make availableeconomic data (economic growth, monetary policy) and demographic data (populationgrowth and composition, migration patterns) that can be used for planning purposes(market size) as well as competitive data that can be used for benchmarking (industryproductivity data) and comparative performance evaluation purposes (employee compensationdata).Company growth patterns also can affect risk through their influence on organizationallearning. Managers of MNOs have one important MCS-related advantage overtheir domestic counterparts: they are able to learn more quickly and more thoroughlyabout potentially desirable practices used in foreign countries. Those practices are knownby employees in their foreign entities, and some of those practices can be readily adaptedacross countries. Firms that grow by acquisition learn from the management systems,including MCSs, being used in the organizations they acquire. When firms grow byacquisition, they are likely to have to use, at least for a period of time, several variationsof MCSs. The MCS variations may persist if they are superior for controlling theacquired businesses, even though it can be costly to maintain multiple sets of MCSs. Butwhat is important is that the acquisitions enhance organizational learning. The companiesare exposed to multiple MCSs, and they can adapt the features that suit them best.This enhanced learning can improve management control and lower uncertainty. In theabsence of acquisitions, it is possible to derive much of the same benefits by entering intojoint ventures with companies in other countries.33InflationInflation is another environmental factor that differs significantly across countries.Inflation and fluctuations in inflation, which affect the relative values of currencies, createfinancial risk. Valued in terms of a fixed currency, high inflation can cause a company’sassets or an individual’s compensation to deteriorate significantly in value in a shortperiod of time.High inflation – at the extreme, hyperinflation – affects the congruence of financialmeasurement systems. It can lead to the adoption of some form of inflation accountingwhich involves either the expressing of accounts and financial statements in terms of real(rather than nominal) amounts or expressing all assets and liabilities at current (orreplacement) values. It can also lead to the use of some form of flexible budgeting,to shield managers from uncontrollable inflation risks, or the partial abandonment of accounting measures of performance in favor of some non-financial measures, such asschedule achievement, production quality, commitment to R&D, and/or training oflocal staff.Personnel availability, quality, and mobilityOrganizations operating in developing countries often face limited availability of skilledand educated personnel. When employees are not highly educated, decision-makingstructures are usually more centralized, and MCSs tend to be more focused on actioncontrols, rather than results controls. Small offices may contain only a few educatedpeople. This makes it difficult to implement one of the basic internal control principles:separation of duties. But personnel availability and quality (such as measured by thequality of education in various countries) also varies across developed countries.Personnel mobility also differs across countries. In the US, managers tend to changecompanies often over the course of their career. In many other countries, including Japan,most managers in the larger companies, particularly, spend their entire career with onecompany. When personnel mobility is low, there is less need for implementing long-termincentive plans that motivate managers both to think long-term and to stay with the firmto earn their rewards.34

Foreign Currency TranslationMNOs also face currency translation problems. At first glance, it is not obvious that

result controls in MNOs should be complicated by the fact that the firms’ profits areearned in multiple currencies. Result controls over foreign entities can be implementedusing the same practices employed in most domestic firms, by comparing performancemeasured in terms of the local currency with a preset plan also expressed in the local currency.However, MNOs bear a real economic risk caused by fluctuating currency values.The values of foreign investments appreciate or depreciate based on the relative valuesof the home and foreign currencies. Through their performance evaluation practices,MNOs can make their entity managers bear this risk or can shield them from it.Some MNOs evaluate the managers of their foreign entities in terms of resultsmeasured in home-country currency. The home-country currency is the unit of measurein which the corporate financial objectives are stated; it is usually the currency thatmost of the shareholders will be spending; and it is the unit of measure used to evaluatetop management. As such, it is natural for corporate management to want to encourageentity managers to take actions to increase home-currency-denominated profits.Use of home-country currencies, however, causes problems when comparing performancevs. an industry profit or rate-of-return norm. If the foreign currency is appreciatingrelative to the home currency, overseas entities can comfortably earn the target rate ofreturn or show impressive sales gains while still not performing anywhere near the potentialthat is offered by foreign market opportunity. The converse is also true.In other words, evaluating managers of foreign entities in terms of the amount ofhome-country currency they earn subjects those managers to risk: foreign currencytranslation risk. The risk arises because the managers earn their cash returns (profits)in the foreign currency that fluctuates in value in comparison to home currency. Whenmeasured in home-country currency, the foreign entities’ reported profits are subjectedto an extra uncontrollable factor: the relative change in the two monetary units overthe measurement period. If the home currency appreciates in value relative to the localcurrency, then foreign entity profits expressed in home currency will be lower thanthey otherwise would have been; that is, the foreign entity incurs a foreign currency then the converse is true: a foreign currency translation gain will be incurred.The amount of translation gain or loss can vary significantly depending on the accountingconvention used. The current US convention, described in Financial AccountingStatement (FAS) No. 52, requires translation of assets and liabilities at the exchangerate at the time of the financial statement.35 FAS No. 52 was effective on January 1, 1983.From 1976 to 1982, the US accounting rule for translation was expressed in FAS No. 8,which required translation of “real” assets, such as inventories and plant and equipment,at the rates in effect when the assets were booked.The most important control decision in this area, however, is whether to hold managersaccountable for foreign exchange gains and losses, thus subjecting them to foreigncurrency translation risk. The issues involved here are identical to those discussed in controllabilitychapter (Chapter 12). The extra measurement noise caused by uncontrollableforeign exchange risk, and various methods of measuring the gains and losses, can affectjudgments about the entity managers’ performances.One could argue that entity managers who can influence the amount of the foreignexchange gains or losses should bear the foreign exchange risk. Most entity managerscan take actions that have foreign currency implications. Most have the authority to makesignificant cross-border investments, product sourcing, or marketing decisions. Mosthave the authority to write purchasing or sales contracts denominated in one currency oranother. Some even have the authority to enter into foreign exchange transactions, suchas hedging, currency swaps, or arbitrage. But most of these specialized hedging transactionsrequire special skills most operating managers do not have, and thus, authority inthis area commonly resides with an international finance department, usually at corporatelevel.36However, if corporate managers decide that the managers of their foreign entitiesshould not bear the foreign exchange risk, they can use any of four essentially identicalmethods:1. Evaluate the manager in terms of local currency profits as compared to a local currencyplan or budget.2. Treat the foreign exchange gain or loss as “below” the income-statement line for whichthe manager is held accountable.3. Evaluate the manager in terms of profits measured in home currency, but calculate a “foreignexchange variance” and treat it as uncontrollable.4. Reexpress the home currency budget for the entity in local currency using the end-of-year,not beginning-of-year, exchange rate. This procedure creates a budget that “flexes” withexchange rates.

Conclusion

This chapter has identified some of the situational factors that can influence MCS choicesand the effects of those choices. Clearly, the appropriateness of each MCS choicedepends on the situation. The chapter also described some of the most salient MCSrelatedeffects of three important situational factors: environmental uncertainty, organizationstrategy, and multinationality. Similar discussions could be presented with respectto other factors, such as the impacts of technology and organizational structure and size.37Some of these factors can create MCS design conflicts. For example, a business unitin an uncertain environment but with a cost leadership strategy faces conflicts between the desire to stay inward focused and efficient and the need to scan the environment togather information that might indicate a structural change in the industry.Similar conflicts can arise with respect to national culture. For example, employees incultures characterized by high uncertainty avoidance may not react favorably to theambiguity associated with subjective performance evaluations used to award discretionarybonuses. The amount of dissatisfaction with subjective performance evaluations,however, will depend in part on the amount of trust and respect for the evaluator, whichis an element of power distance. Hence, uncertainty avoidance and power distance mayinteract and cause mutually reinforcing or opposing effects on the preference for MCSs.Furthermore, employees with a high aversion for uncertainty may prefer group, asopposed to individual, performance-based incentives because they facilitate the sharingof risk. But the reaction to group rewards, however, also depends on the degree of individualism.In short, multiple cultural dimensions may affect an employee’s preferencesfor, and reactions to, MCSs in interactive ways.Adapting MCSs is particularly challenging in multinational environments. MNOmanagers almost invariably face high information asymmetry between themselves andpersonnel in the foreign locations. The foreign personnel have specialized knowledgeabout their environments (such as about local norms, tastes, regulations, and businessrisks). The high information asymmetry limits the corporate managers’ abilities to useaction controls, such as preaction reviews, because the corporate managers have limitedknowledge to make the needed judgments. MNO managers also face the barriers of distance,time zones, and language, which limit the use of direct supervision. They cannoteasily visit their foreign-based subordinates, although advancing information technologieshave made communications easier. On top of that, they must deal with the significantproblem of measuring performance in terms of multiple currencies.Despite the incomplete state of knowledge about the effects of various forms of MCSsin various situations, managers must cope. The main message in the chapter is thatmanagers must be sensitive to these situational factors. They must be aware of the keydimensions of the situations in which they are managing and either adapt their MCS tothe situational contingencies they face or find ways to alter the situation.