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 is
generally the preferred
alternative
• Encourage coordinated actions.
• Energize the workforce.
• Stimulate learning, creativity/innovation
and continuous improvement.

5
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?

9
What we want (in for-profit
organiations)

Measures that go up when value is created

and down when value is destroyed.

10
What we’ve got

Correlation between annual accounting

earnings and annual value creation ≈ .20

11
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 if
they do not reflect value changes well?

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Correlations between accounting
earnings and value creation
One year .22
Two years .39
Five years .57
Ten years .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
5-Month Survey
400000
P r o fit b y C o m m u n ity

300000

200000

100000
.6 .7 .8 .9 1.0

Satisfaction with Customer Service

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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 and an
optimally designed incentive
system?

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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?

20
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

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Shape of a typical short-term
bonus function

Rewards

Results

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

23
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

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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 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.”

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An important, poorly understood
contingency—national setting

Performance-dependent incentives for department

managers 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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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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