Management Control System Structure

1. Management Control System Structure April 3, 2007

2. The Structure of the MCS Defining the MCS structure means: • defining the elementary units of the MCS, i.e. the company sub-systems of which the performance must be evaluated in autonomy respect to the overall performance • defining the specific information that must be measured relating to each elementary unit  each elementary unit can be considered a “Responsibility Centre” with a dedicated manager which is responsible for the activities of the unit  a “Responsibility Centre Accounting System” is so defined

3. What is a Responsibility Centre • A Responsibility Centre is a business segment of the company, where the manager is responsible for a specific set of activities and the related economic-financial variables (costs, revenues, investments) and non- financial measures • In a responsibility centre: • inputs are used (resources as materials, labour, overheads, commercial and administrative resources); • service or production activities are carried out (Research and Development, Production, Logistic, Sales and Administration); • outputs are achieved (tangible products or services)

4. Definition of the responsibility centres • The responsibility centres can be defined in different ways by the organisations. In general a company can divide the responsibilities according to: 1. company functions (line functions, such as production or sales, or staff units such as finance, administration, research and development, etc..) 2. products and services (Business Units or Divisions) 3. geographic areas (Business Units or Divisions) • The sub-division of responsibilities reflects normally the Organisational Structure of the company

5. The responsibility levels • the responsibility centres belong to different levels of the Organisation Structure of the company (also within the functions, sub-units can exist - departments and offices - ex. within the function “Logistic”, can be defined the sub-unit “Transport” assigned to a specific manager) • consequently, three basic MCS dimensions can be identified: • A VERTICAL dimension • A HORIZONTAL dimension • A TRANSVERSAL dimension (PROCESS/PROJECT dimension); different units belonging to different levels and to different functions can carry out an activity (ex. new product development process)

6. 1. Vertical dimension • It includes the set of organisation levels for which a specific evaluation is required: • Corporate level (overall company) • Business Unit level (product/market segment) • Operation level (function, department, office)

7. 1. Vertical dimension Understanding the vertical dimension means: • asking which MCS requirements are relevant at different organisational levels; • consequently, asking which indicators and specific measures (economic, financial, non-financial) are relevant at different levels

8. 1. Vertical dimension: the relative importance of the requirements Corporate Business Unit Operation Completeness Long term orientation Timeliness Measurability Identif. Spec responsibility

9. A review of the requirement satisfaction by different measures

10. 1. Vertical dimension: the techniques used at different organisational level

11. Ferrari Case: Vertical structure • If you want, consider also “vertical dimension” in your benchmarking project: • taking into account which are the most important requirements at each level (corporate, business unit, operation) and which are the advantages and limits of each techniques (economic, financial, non financial) with respect to different requirements •  illustrate how different techniques and specific indicators are used at different organizational levels

12. 2. Horizontal dimension • It identifies the specific responsibilities associated to each unit belonging to a certain level • Different types of responsibility centres can be distinguished: • Cost Centres at the operation level • Expense Centres (discretion cost centres) at the operation level • Revenue Centres at the operation level • Profit Centres usually at business level • Investment Centres at corporate level

13. The responsibility levels: vertical and horizontal dimension Headquarter Investment Centres Division Europe Division USA - - - Profit Centres Product A Product B - - - Production Marketing Cost Centres, Revenue Centres Expense Centres ………... Dep.2 Dep.3 Department 1 (ex. Packaging)

14. 2. Horizontal structure at the operation level Cost centres • output level not defined in autonomy • responsibility on the input employed to achieve the output, that is a responsibility on costs (price and employment of the input) • production department is the classic example of cost centre • traditionally this responsibility is evaluated through the variance between standard costs and actual costs • the traditional approach, however, doesn’t allow to take into consideration the performances that the production cost centres are able to control. On one hand, the employment of the input is only partially controllable by the cost centres due to the fact it depends also on the “quality” of the input (Purchase offices) and on the product design (Design offices). On the other hand, the production decisions have an impact on other variables such as the production quality, the delivery time, the post-sales service requirement, variables linked to the company revenues • a first solution is to enlarge the set of performance dimensions for which the cost centre is responsible, considering also non-financial measures (delivery time, quality of products, etc.) • a second solution is the definition of task forces composed by different units (Production, Purchases, Design, etc.) which responsibilities are interdependent in order to improve the collaboration between the units

15. 2. Horizontal structure at the operation level Expense centres • output that is difficult to be measured in monetary terms • no strong and clear relation exists between resources used (inputs) and results achieved (outputs) • examples of discretionary expense centres are general and administrative (G&A) departments (controller, industrial relations, human resources, accounting, legal), research and development (R&D) departments, and some marketing activities such as advertising, promotion and warehousing. All these activities are defined as “supporting activities” • traditionally, the unique type of control for these units has been the definition of a maximum year level of expenses • non financial measures (ex. quality, time, productivity, flexibility) and also economic measures (costs) can be introduced according to the type of activity (ex. productivity indicators can be introduced for the more repetitive activities, such as the administrative activities), in order to evaluate the quantity/quality of output of the centre

16. 2. Horizontal structure at the operation level Revenue centres • responsibility on the sales of goods/services (price and volume of good sold) • traditionally the performances are measured through the variance between the expected revenues and the actual revenues • commercial units are the classic examples of revenue centres • the traditional approach, however, doesn’t allow to take into consideration the set of performance that the revenue centres are able to control. On one hand, the prices can be defined by central offices and the volume can be linked to product features and not only to the sale enforce. On the other hand, the commercial units doesn’t have the responsibility on other controllable activities, such as the customer assistance, which have an relevant impact on sales volume • a first solution is to enlarge the set of performance dimensions for which the revenue centre is responsible, considering also non-financial measures (ex. customer assistance) • a second solution is the definition of task forces composed by different units (Sales, Production, Purchases, etc.) which responsibilities are interdependent in order to improve the collaboration between the units

17. 2. Horizontal structure at the business level Profit centres • responsibility both on the costs and revenues • traditionally, the performance is evaluated through the variances between the standard and the actual costs, the expected revenues and the actual revenues (the expected profit and the actual profit) building partial profit/loss statements for each centre • A profit centre is free to: • Select the source for procurement • Choose the acquisition prices • Select the customer • Decide the selling price • business units and divisions are the classic examples, but sometimes also departments can be defined as profit centres (i.e. maintenance department that sells its services to other units)

18. 2. Horizontal dimension at the corporate level Investment centre • responsibility on costs, revenues and investments • this responsibility is evaluated considering the assets (invested capital) through the return on investments measures (ROI, ROS, etc.) • usually, it is applied to the corporate level or to the business units with a strong autonomy

19. 2. Horizontal dimension at business level • Business units are independent units which have the responsibility on one product/market • To evaluate the economic performance of BU it is necessary to evaluate: • The partial Profit/Loss statements for Business Unit: •  Advanced Direct Costing schema to take into evidence the contribution of each unit (i.e. product line) to the overall company net operating income; only fixed “specific” costs are assigned to each business unit in order to avoid any arbitrary allocation of common costs •  “Controllable” costs to evaluate business unit manager (II Controllable Contribution Margin) • The possible internal trade (goods/services) between business units •  it is necessary to analyse and to evaluate the internal trade among units (i.e. transfer pricing)

20. The advanced direct costing schema to evaluate business unit contribution

21. The advanced direct costing schema to evaluate business unit contribution Examples • Superpizza • Officina Veneta

22. SUPERPIZZA • In 20X0, Mr. Gennaro Esposito, decided to start up his own activity. He started, at first, with the production and sale of pizzas “take away” and then he added the delivery of pizzas at home in the evening hours. By the way, he realized that a combination pizza + drink was very appreciated by customers. He decided to apply a unique price for each combination: 6 euro for the combination “take away”; 7 euro for the delivery at home. In the following year, Mr. Esposito decided to rent a place to offer all the activities, included the service on the table. The combination was the same but offered with a price equal to 7,5 euro. For this specific activity, it was also necessary to engage a waiter. The “take away” cashier could be dedicated also to the new activity for a 20% of time. Another person (named “pony”) was specifically dedicated to the delivery at home and he personally managed the takings. For the deliveries, he used a small van, available for the overall activities (purchases of materials, etc.). Besides, 5 producers of pizza (“pizzaioli”) were engaged. • In table 1, data concerning the first semester 20X1 are reported. • Elaborate the Profit/Loss Statement for the first semester 20X1 in order to point into evidence the contribution provided by different selling combinations to the net operating income for the overall company.

23. OFFICINA VENETA Officina Veneta (O.Ve.) is a small company that produces components for kitchen production, in particular structural elements for ovens: ELEMENT 1; ELEMENT 2; ELEMENT 3. Production is carried out by means of three production lines: • Line 1 is devoted to ELEMENT 1; • Line 2 is devoted to ELEMENT 2; • Line 3 is devoted to ELEMENT 3. Due to the particular nature of some activities, it has been possible to calculate a direct labor cost per unit (see Annex 1). Indirect Workers (for activities supporting production) are the following: • 2 workers for warehouse management; • 2 workers for maintenance and repairing; • 2 administrative employees. On the basis of other information in Annex 1: • Elaborate Profit/Loss Statement to take into evidence the contribution of each product line to the overall company net operating income.

24. ANNEX 1: • Production/sales in units and selling price per unit: 90.000 units ELEMENT 1; 11 euro per unit; daily production: 360 units 90.000 units ELEMENT 2; 5,5 euro per unit; daily production: 630 units 90.000 units ELEMENT 3; 7,5 per unit; daily production: 840 units • Annual average indirect worker cost: 35.000 euro • Annual average administrative employee cost: 40.000 euro • Direct material per unit: 3,15 euro per ELEMENT 1; 1,62 euro per ELEMENT 2; 2,25 euro per ELEMENT 3. • Direct labor cost per unit: 1,16 euro per ELEMENT 1; 0,44 euro per ELEMENT 2; 0,16 euro per ELEMENT 3. • Annual energy cost: 80.500 euro (the energy consumption is considered a variable cost depending on number of operating days per line) • Annual amortization: 560.000 euro, in part specific for each line (250.000 for ELEMENT 1; 150.000 for ELEMENT 2; 100.000 for ELEMENT 3) • Other general expenses: 35.000 euro

25. The advanced direct costing schema to evaluate business unit manager

26. The advanced direct costing schema to evaluate business unit manager Example • JB Trucking

27. JB TRUCKING • Jb Trucking is a transport company which is operating in the North California and in Nevada. In order to evaluate performances, the company Profit/Loss has been divided for geographic areas. An area, the Truckee Meadows, is dedicated to sub-areas Reno and Lake Tahoe, in California. The information relating to the deliveries of January are the following: • Direct variable costs include oil and fuel costs and the costs for the car loading. • The specific fixed costs includes the amortisation, the maintenance (provided by Jb Trucking central shop), the licence costs for the trucks. In particular, the maintenance costs (400$ for Reno; 800$ for Lake Tahoe) are not controllable by the sub-area managers because maintenance is carried out monthly on the basis of government rules. • The geographic areas, and the sub-areas of delivery, are considered profit centres. • Truckee Meadows’ costs of administration and marketing (“common” to sub-areas) are equal to 4.000 euro. Questions: 1) Elaborate a partial profit/loss statement to evaluate a) the profitability of the sub-areas; b) the performance of the sub-areas managers. 2) If common costs are allocated on the basis of sub-areas revenues, which is the impact on sub-areas’ profitability? Discuss this type of solution.

28. Common Corporate Costs allocation to Business Units • The allocation of common corporate costs to Business Units has an impact on their profitability and therefore on their performance evaluation (examples of corporate costs are general costs, legal costs, research and development costs) • In the practice it is possible to have the following alternatives: • to allocate to the BU all the corporate costs using arbitrary allocation basis • to allocate only a share of corporate costs, in particular those costs which are specific for each business unit (see the Advanced Direct Costing schema). For example, between the research costs only the costs of applied research specifically “used” by business units. In this case the corporate level “sells” its services to the business units

29. Corporate Costs allocation : advantages and disadvantages • Complete allocation: • the business unit performance decreases with the increase of corporate costs; • common is the proportional allocation (based on revenues) which is not consistent with the specific responsibility principle (a BU which increases its revenues receives a higher share of corporate costs even if the activity increase does not cause a higher use of the corporate resources!). • corporate inefficiency can be unfairly assigned to the business units • Partial allocation: • more consistent with the specific responsibility principle; • the BU can require a lower corporate service level with disadvantaged in term of long-period company competitiveness, in order to avoid the allocation of corporate costs