Third Edition

MANAGEMENT
CONTROL SYSTEMS
Performance Measurement, Evaluation and Incentives

Kenneth A. Merchant
Wim A. Van der Stede


MANAGEMENT CONTROL SYSTEMS


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MANAGEMENT CONTROL SYSTEMS
Performance Measurement, Evaluation and Incentives

Third Edition

Kenneth A. Merchant
University of Southern California

Wim A. Van der Stede
London School of Economics


Pearson Education Limited
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First published 2003
Second edition published 2007
Third edition published 2012
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BRIEF CONTENTS

Preface
Acknowledgements

xii
xv

Section I
THE CONTROL FUNCTION OF MANAGEMENT
1 Management and Control

3

Section II
MANAGEMENT CONTROL ALTERNATIVES AND
THEIR EFFECTS
2
3
4
5
6

29
Results Controls
Action, Personnel, and Cultural Controls 81
Control System Tightness
123
Control System Costs

186
Designing and Evaluating Management
209
Control Systems

Section III
FINANCIAL RESULTS CONTROL SYSTEMS
7 Financial Responsibility Centers
8 Planning and Budgeting
9 Incentive Systems

261
306
367

Section IV
PERFORMANCE MEASUREMENT ISSUES AND
THEIR EFFECTS
10 Financial Performance Measures and
their Effects

413

11 Remedies to the Myopia Problem
12 Using Financial Results Controls in the
Presence of Uncontrollable Factors

445
503


Section V
CORPORATE GOVERNANCE, IMPORTANT
CONTROL-RELATED ROLES, AND ETHICS
13 Corporate Governance and Boards
of Directors
14 Controllers and Auditors
15 Management Control-Related
Ethical Issues

553
617
656

Section VI
SITUATIONAL INFLUENCES ON MANAGEMENT
CONTROL SYSTEMS
16 The Effects of Environmental
Uncertainty, Organizational Strategy,
and Multinationality on Management
Control Systems
17 Management Control in Not-for-profit
Organizations
Index

685
740
801


Supporting resources

Visit www.pearsoned.co.uk/merchant to find valuable online resources:
For instructors
● A complete, downloadable Instructor’s Manual
● PowerPoint slides that can be downloaded and used for presentations
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CONTENTS

Preface
Acknowledgements

xii
xv

Section I
THE CONTROL FUNCTION OF MANAGEMENT
1 Management and Control
Management and control
Causes of management control problems
Characteristics of good management control
Control problem avoidance
Control alternatives
Outline of this book
Notes
Leo’s Four-Plex Theater
Wong’s Pharmacy
Private Fitness, Inc.
Atlanta Home Loan


3
6
10
12
13
16
17
18
19
20
20
22

Section II
MANAGEMENT CONTROL ALTERNATIVES
AND THEIR EFFECTS
2 Results Controls

29

Prevalence of results controls
Results controls and the control problems
Elements of results controls
Conditions determining the effectiveness of
results controls
Conclusion
Notes
Armco, Inc.: Midwestern Steel Division
Loctite Company de México, S.A. de C.V.

Puente Hills Toyota
Houston Fearless 76, Inc.

30
32
33

3 Action, Personnel, and Cultural Controls

81

Action controls
Action controls and the control problems

81
84

36
40
40
41
55
61
74

Prevention versus detection
Conditions determining the effectiveness
of action controls
Personnel controls
Cultural controls

Personnel/cultural controls and the control
problems
Effectiveness of personnel/cultural controls
Conclusion
Notes
The Platinum Pointe Land Deal
Axeon N.V.
Alcon Laboratories, Inc.

85

94
95
95
96
98
105
112

4 Control System Tightness

123

Tight results control
Tight action controls
Tight personnel/cultural controls
Conclusion
Notes
Controls at the Bellagio Casino Resort
The Lincoln Electric Company

PCL: A Breakdown in the Enforcement of
Management Control

123
126
130
131
133
134
160

5 Control System Costs

186

Direct costs
Indirect costs
Conclusion
Notes
Philip Anderson
Sunshine Fashion: Fraud, Theft, and
Misbehavior Among Employees
Fit Food, Inc.

186
186
195
196
197


86
88
90

181

199
203

6 Designing and Evaluating Management
Control Systems

209

What is desired? and What is likely?
Choice of controls
Choice of control tightness

209
209
215
ix


Contents

Adapting to change
Keeping a behavioral focus
Maintaining good control
Notes

Diagnostic Products Corporation
Game Shop, Inc.
Family Care Specialists Medical Group, Inc.
AirTex Aviation

217
217
218
219
220
229
239
246

Section III
FINANCIAL RESULTS CONTROL SYSTEMS

7 Financial Responsibility Centers

261

Advantages of financial results control systems
Types of financial responsibility centers
Choice of financial responsibility centers
The transfer pricing problem
Conclusion
Notes
Kranworth Chair Corporation
Toyota Motor Sales, USA, Inc.
Zumwald, AG

Global Investors, Inc.

261
262
266
269
274
274
275
283
293
295

8 Planning and Budgeting

306

Purposes of planning and budgeting
Planning cycles
Target setting
Planning and budgeting practices, and criticisms
Conclusion
Notes
Citibank Indonesia
HCC Industries
Patagonia, Inc.
VisuSon, Inc.: Business Stress Testing

306
307

309
318
320
321
323
329
341
355

9 Incentive Systems

367

Purposes of incentives
Monetary incentives
Incentive system design
Criteria for evaluating incentive systems
Group rewards
Conclusion
Notes
Harwood Medical Instruments PLC
Superconductor Technologies, Inc.
Tsinghua Tongfang Co. Ltd.
Raven Capital, LLC

368
370
377
379
383

383
384
386
388
397
402

x

Section IV
PERFORMANCE MEASUREMENT ISSUES AND
THEIR EFFECTS
10 Financial Performance Measures and
Their Effects

413

Value creation
Market measures of performance
Accounting measures of performance
Investment and operating myopia
Return-on-investment measures of performance
Residual income measures as a possible
solution to the ROI measurement problems
Conclusion
Notes
Behavioral Implications of Airline
Depreciation Accounting Policy Choices
Las Ferreterías de México, S.A. de C.V.
Industrial Electronics, Inc.

Haengbok Bancorp
Berkshire Industries PLC

414
414
417
420
421

11 Remedies to the Myopia Problem

445

Pressures to act myopically
Reduce pressures for short-term profit
Control investments with preaction reviews
Extend the measurement horizon (use
long-term incentives)
Measure changes in value directly
Improve the accounting measures
Measure a set of value drivers
Conclusion
Notes
Catalytic Solutions, Inc.
First Commonwealth Financial Corporation
Statoil

445
446
447

448
450
451
452
456
456
458
466
487

12 Using Financial Results Controls
in the Presence of Uncontrollable
Factors

503

The controllability principle
Types of uncontrollable factors
Controlling for the distorting effects of
uncontrollables
Other uncontrollable factor issues
Conclusion
Notes
Olympic Car Wash

426
428
429
430
432

435
437
439

504
505
508
515
515
516
517


Contents

Southern California Edison
Beifang Chuang Ye Vehicle Group
Hoffman Discount Drugs, Inc.
Formosa Plastics Group
Bank of the Desert (A)
Bank of the Desert (B)

518
527
529
536
543
546

Section V

CORPORATE GOVERNANCE, IMPORTANT
CONTROL-RELATED ROLES, AND ETHICS
13 Corporate Governance and Boards
of Directors
Laws and regulations
The Sarbanes-Oxley Act of 2002
Boards of directors
Audit committees
Compensation committees
Conclusion
Notes
Vector Aeromotive Corporation
Golden Parachutes?
Pacific Sunwear of California, Inc.
Entropic Communications, Inc.
Financial reporting problems at Molex, Inc.

14 Controllers and Auditors
Controllers
Auditors
Conclusion
Notes
Don Russell: Experiences of a Controller/CFO
Desktop Solutions, Inc. (A): Audit of the
St. Louis Branch
Desktop Solutions, Inc. (B): Audit of
Operations Group Systems
Landale PLC

15 Management Control-Related

Ethical Issues
The importance of good ethical analyses
Why do people behave unethically?
Some common management control-related
ethical issues
Spreading good ethics within an organization
Conclusion

553
554
555
561
563
565
566
566
567
574
578
590
605
617
617
621
626
627
627
634
643
646


656
657
661
662
667
668

Notes
Two Budget Targets
Conservative Accounting in the General
Products Division
Education Food Services at Central Maine
State University
The “Sales Acceleration” Program
The Expiring Software License
Lernout & Hauspie Speech Products

669
670
670
671
673
674
675

Section VI
SITUATIONAL INFLUENCES ON MANAGEMENT
CONTROL SYSTEMS
16 The Effects of Environmental

Uncertainty, Organizational Strategy,
and Multinationality on Management
Control Systems

685

Environmental uncertainty
Organizational strategy
Multinationality
Conclusion
Notes
ConAgra Grocery Products Company
Lincoln Electric: Venturing Abroad
TECO Electric & Machinery Co. Ltd.
Kooistra Autogroep

686
688
690
696
696
698
709
725
732

17 Management Control in Not-for-profit
Organizations

740


Differences between for-profit and
not-for-profit organizations
740
Goal ambiguity and conflict
741
Difficulty in measuring performance
742
Accounting differences
744
External scrutiny
745
Employee characteristics
747
Conclusion
748
Notes
749
City of Yorba Linda, California
750
Waikerie Co-Operative Producers Ltd.
761
Boston Lyric Opera
770
University of Southern California: Responsibility
Center Management System
786

Index


801

xi


PREFACE

This book provides materials for a comprehensive
course on management control systems (MCSs).
MCSs are defined broadly to include everything
managers do to help ensure that their organization’s
strategies and plans are carried out or, if conditions
warrant, that they are modified. Thus, the book could
be used in any course that focuses on topics related
to strategy implementation or execution.
While the treatment of the MCS subject is broad,
the primary focus of the book is on what we call
results controls, which involve motivating employees
to produce the outcomes the organization pursues.
This type of management control, which requires
performance measures and evaluations and the provision of incentives, dominates in importance in the
vast majority of organizations. When we use the word
incentives, we are not referring solely to monetary
incentives, such as bonuses and stock options, we are
also referring to any of a variety of non-monetary
incentives, such as praise, recognition, and autonomy.
Because management control is a core function
of management, all students interested in business or
management can benefit from this book. However,
courses based on the materials in this book should be

particularly useful for those who are, or aspire to be,
managers, management consultants, financial specialists (for example, controllers, financial analysts,
auditors), or human resource specialists (for example,
personnel directors, compensation consultants).
This book includes 71 cases for classroom use. The
cases have been selected because of their interest and
educational value in stimulating useful class discussions. Some of them are also suitable for use in
examinations. We view these cases as an essential
part of the textbook. Case studies that stimulate learning through the analysis of often complex situations
in the “real world” are generally recognized to be the
best pedagogical conduit for teaching a MCSs course.
Because MCSs, the contexts in which they operate,
and the outcomes they produce, are complex and
multi-dimensional, simple problems and exercises
cannot capture the essence of the issues managers
xii

face in designing and using MCSs. Students must
develop the thinking processes that will guide them
successfully through decision tasks with multiple
embedded issues and large amounts of relatively
unstructured information. They must learn to develop
problem-finding skills, as well as problem-solving
skills, and they must learn how to articulate and
defend their ideas. Case analyses, discussions, and
presentations provide the best method available for
simulating these tasks in a classroom.
The discussions in this book assume a basic level
of knowledge of financial accounting (for example,
how financial statements are put together), management accounting (for example, variance analysis),

and core MCS elements (for example, budgeting).
The book was designed primarily for use by graduate
students and practicing professionals. It can also be
used successfully by undergraduate students who
have had a prior management accounting course, but
it should be recognized that some of the cases in
this book might be too challenging for undergraduate
students. Cases for use in an undergraduate course
have to be chosen judiciously.
This book is different from other MCS texts in a
number of important ways. First, the basic organizing
framework is different. The first major module of the
book discusses management controls based on the
object of control: results, actions, or personnel/culture.
The object-of-control framework has considerable
advantages over other possible organizing frameworks. It has clean, clearly distinguishable categories.
It is also relatively all-inclusive in the sense that the
reader can relate many management controls and
other control classifications and theories (for example,
proactive vs. reactive controls, prevention vs. detection controls, and agency theory concepts such as
monitoring vs. incentives) to it. It is also intuitive; that
is, students can easily see that managers must make
choices from among these categories of management
control. Thus, using the object-of-control focus, the
overall structure of the book can be summarized as
being organized around a framework that describes


Preface


the core management control problems that need to
be addressed, the MCSs that can be used to address
those problems, the most important situational factors
that can cause managers to choose one set of management controls over another, and the outcomes that
can be produced, both positive and negative.
Second, the book’s treatment of management
control is broad. Like all MCS textbooks, this book
focuses intensively on the use and effects of financial
performance measures, which dominate in importance at managerial levels in most organizations.
However, this book also provides a broader treatment
of management controls (organized around the
object-of-control framework) to put the financial
results controls in proper perspective. For example,
the book describes many situations where financial
results controls are not effective and discusses the
alternatives that managers can use in those situations (such as nonfinancial performance indicators,
centralization of authority, management audits, or
the creation of a team-oriented culture).
Third, the book provides considerable discussion
on the causes and remedies of the most common
and serious management control-related problems,
including myopia, suboptimization, uncontrollability,
and gameplaying.
Fourth, the book provides a whole chapter of ethics
coverage. This makes it perhaps unique among
accounting and control textbooks. There are many
management control-related ethical issues, and the
recent debacles at, for example, Enron, WorldCom,
Parmalat, Lehman Brothers, and Bear Stearns, clearly
suggest the need to develop managers’ and prospective managers’ ethical reasoning skills more fully.

Related to this is coverage of corporate governance,
to which we devote another whole chapter.
Fifth, the important concepts, theories, and issues
are not discussed just in abstract terms. They are illustrated with a large number of real-world examples,
far more than typically included in any other MCS
textbook. The examples make the textual discussion
more concrete and bring the subject to life.
Finally, the mix of cases included in this book is
different from those included in other MCS textbooks in four important ways:
●

A high proportion of the cases are real and undisguised (that is, they describe the facts of the actual
situations and use the companies’ real names). Reality
and lack of disguise enhance student interest and

“secondary” learning (that is, about named industries,
companies, and individuals).
●

Most of the cases include rich descriptions of the
context within which the MCSs are operating. The
rich descriptions give students opportunities to try
to identify and address management control problems and issues within the same multi-dimensional
situations that practicing managers face.

●

Most of the cases are of relatively recent vintage, and
the set of cases has been chosen to ensure coverage
of the latest MCSs topics and issues, such as how to

stress test budgets; how to minimize management
myopia; how to motivate all employees to create
sustainable value; and whether to use the EVATM or
Balanced Scorecard measurement approaches, just
to name a few.

●

The cases are descriptive of the operations and issues
faced by companies located in many different countries and regions around the world, including Asia,
Europe, Latin America, as well as North America.

The cases in this book permit the exploration of
the management control issues in a broad range of
settings. Included in the book are cases on both large
and small firms, manufacturing and service firms,
domestic-focused and multinational firms, and forprofit and not-for-profit organizations. The cases
present issues faced by personnel in both line and
staff roles at corporate, divisional, and functional
levels of the organization, as well as by members
of boards of directors. Instructors can use this set of
cases to teach a management control course which
is broad in scope or one which is more narrowly
focused (for example, MCSs in service organizations by focusing on the cases from the healthcare,
education, financial, and other service sectors).
The cases provide considerable scheduling flexibility. Most of the cases cut across multiple topic
areas because MCSs are inherently multi-dimensional.
For example, the classroom focus for the new Statoil
case in Chapter 11 might be on performance measurement, as Statoil uses a key-performance-indicator
(KPI) structure that is Balanced Scorecard-like. Or it

could be on Statoil’s planning and budgeting system,
which separates the functions of target setting, forecasting, and resource allocation using the principles
of “Beyond Budgeting”. Students also have to consider the industry characteristics, the organization
structure, the characteristics of the people in key
positions, and the company’s history (for example,
xiii


Preface

a recent merger), so instructors can choose to use
this case when they wish to focus on the effects of
one or more of these factors on the design of MCSs.
As a consequence, the ordering of the cases in the
book is not intended to be rigid. Many alternatives are
possible. A case overview sheet in the accompanying Instructors Manual to this textbook provides a
matrix that helps instructors disentangle the various
relevant topics for which each case could be fruitfully used.
In this third edition of the book, we made a
number of substantive updates, most obviously in
those areas where the world has been moving fast
during the past few years, particularly since the
2008–2009 financial crisis and subsequent economic
recession. This includes changes in incentive systems
(Chapter 9) and corporate governance (Chapter 13).
Throughout the book, we incorporated discussions
of some of the most important recent research findings and updated the survey statistics and examples
provided. We also added some new, exciting cases.
Eleven of the 71 cases included in this edition are
new, and an additional three were revised or brought

up to date. Some of the new cases cover cutting-edge
topics, such as stress testing (scenario budgeting)
(VisuSon, Inc.), enterprise risk management (Entropic
Communications, Inc.), and “Beyond Budgeting”
(Statoil). Others were intended to address the topics
in new and different settings, such as Raven Capital
LLC (a hedge fund), Family Care Specialists Medical
Group, Inc. (a medical group), and Game Shop, Inc.
(a billings system “scorecard”).
In developing the materials for this third edition
of our book, we have benefited from the insightful
comments, helpful suggestions, and cases of many
people. Ken owes special thanks to the two professors who served as his mentors at the Harvard
Business School: William Bruns and Richard Vancil.

Ken also appreciates the valuable research assistance from David Huelsbeck, Sahil Parmar, and
Michelle Spaulding, and useful suggestions from
Jong Hwan Kim, all currently or formerly at USC.
Wim is especially grateful to Renuka Fernando
for her capable assistance with updating the many
examples throughout this book. We also appreciate
the punctual administrative assistance from Ingrid
McClendon and Linda Ramos at USC, and Justin
Adams and Liz Venning at LSE. At Pearson Education, we are indebted to Katie Rowland (Acquisitions
Editor, Accounting) and Gemma Papageorgiou
(Assistant Editor, Higher Education Division).
David Hemsley made helpful suggestions in copyediting the manuscript.
We thank Harvard Business School Publishing
for granting permission to use the Harvard cases that
are included in this text. Tad Dearden, Permissions

Coordinator, was very efficient in helping us through
the permissions process. Requests to reproduce cases
copyrighted by Harvard Business School should be
directed to the Permissions Department, Harvard
Business School Publishing, 60 Harvard Way, Boston,
MA 02163 (). We
also thank the Asia Case Research Center at the
University of Hong Kong for granting permission
to use two of their Poon Kam Kai Series cases, and
especially Neale O’Connor for his help with this.
Finally, we wish to thank the authors of several cases
included in this book, the names of whom are listed
with the cases inside this book.
In closing, we wish to acknowledge that there is
certainly no one best way to convey the rich subjects
related to MCSs. We have presented one useful
framework in the best way we know how, but we
welcome comments about the content or organization of the book, or regarding specific errors or
omissions. Please direct them to us.

Kenneth A. Merchant
Deloitte & Touche LLP Chair of Accountancy
Leventhal School of Accounting
Marshall School of Business
University of Southern California
Los Angeles, CA 90089-0441
USA

Wim A. Van der Stede
CIMA Professor of Accounting and

Financial Management
London School of Economics
Department of Accounting
Houghton Street
London WC2A 2AE
UK
Phone: (020) 7955-6695
Fax: (020) 7955-7420
E-mail:

Phone: (213) 821-5920
Fax: (213) 747-2815
E-mail:
xiv


ACKNOWLEDGEMENTS

We are grateful to the following for permission to
reproduce copyright material:

Figures
Figure 15.6 from Tech firm’s Korean growth raises
eyebrows, The Wall Street Journal, 08/08/2000,
p. C1 (Maremont, Mark, Eisinger, Jesse and Song,
Meeyoung), The Wall Street Journal by News
Corporation. Copyright 2000. Reproduced with
permission of Dow Jones & Company, Inc. in the
format Textbook via Copyright Clearance Center;
Figure 15.6 from Lernout & Hauspie Seeks Bankruptcy

Protection – Company struggles to repay millions
to banks The Wall Street Journal, 30/11/2000, p. A3
(Carreyrou, John, and Maremont, Mark), The Wall
Street Journal by News Corporation. Copyright
2000. Reproduced with permission of Dow Jones &
Company, Inc. in the format Textbook via Copyright
Clearance Center; Figure 15.6 from KPMG, Former
Auditor of L&H, May Draw Investor Ire, The Wall
Street Journal, 18/01/2001, p. C1 (Maremont, Mark),
The Wall Street Journal by News Corporation.
Copyright 2001. Reproduced with permission of
Dow Jones & Company, Inc. in the format Textbook
via Copyright Clearance Center; Figure 17.1 from
USC Financial Report 2010, University of Southern
California, reproduced with permission

Tables
Table 16.4 from BOVAG Autodealers, 2006, reproduced with permission.

Text
Case Study 3.3 from Chris S. Paddison and Associate
Professor Kenneth A. Merchant, Copyright © 1987
by the President and Fellows of Harvard College.
Harvard Business School Case 9-187-197; Case
Study 4.2 from Norman Fast under the direction of
Professor Norman Berg, Copyright © 1975 by the

President and Fellows of Harvard College. Harvard
Business School Case 376-028; Case Study 4.3
from Grace Lao under the supervision of Professor

Neale O’Connor, Copyright © 2010. The University
of Hong Kong. This material is used by permission
of The Asia Case Research Center at The University of Hong Kong (). This
case study is a single piece of work. Reproduction
of the case study does not constitute fair use under
17 USC 107 or equivalent provisions in other laws;
Case Study 5.2 from Grace Lao under the supervision of Professor Neale O’Connor © 2010 The
University of Hong Kong. This material is used by
permission of The Asia Case Research Center at The
University of Hong Kong ().
This case study is a single piece of work. Reproduction of the case study does not constitute fair use
under 17 USC 107 or equivalent provisions in other
laws; Case Study 6.4 from Research Associate
Carleen Madigan under the direction of Professor
Brian Hall, Copyright © 2000 by the President
and Fellows of Harvard College. Harvard Business
School Case 9-800-269; Case Study 8.1 from
Professor Kenneth A. Merchant, Copyright © 1984
by the President and Fellows of Harvard College.
Harvard Business School Case 9-185-061; Case
Study 8.2 from Lourdes Ferreira and Professor
Kenneth A. Merchant, Copyright © 1988 by the
President and Fellows of Harvard College. Harvard
Business School Case 9-189-096; Case Study 11.2
from Professor Robert S. Kaplan with the assistance of Michael Nagel of the Balanced Scorecard
Collaborative Copyright © 2001 President and Fellows
of Harvard College. Harvard Business School Case
9-104-042; Case Study 13.5 from Professor Paul
Healy, Copyright © 2005 President and Fellows of
Harvard College. Harvard Business School Case

9-105-082; Extract 15.6 from Tech firm’s Korean
growth raises eyebrows, The Wall Street Journal,
08/08/2000, p. C1 (Maremont, Mark, Eisinger,
Jesse and Song, Meeyoung), The Wall Street Journal
by News Corporation. Copyright 2000. Reproduced
xv


Acknowledgements

with permission of Dow Jones & Company, Inc.
in the format Textbook via Copyright Clearance
Center; Case Study 16.2 from Jamie O’Connell under
the direction of Professor Christopher A. Bartlett,
Copyright © 1998 by the President and Fellows
of Harvard College. Harvard Business School Case
9-398-095; Case Study 17.3 from Prepared by
Professor Robert S. Kaplan and doctoral student

xvi

Dennis Campbell, Copyright © 2001 President and
Fellows of Harvard College. Harvard Business School
Case 9-101-111
In some instances we have been unable to trace
the owners of copyright material, and we would
appreciate any information that would enable us
to do so.



Section I

THE CONTROL FUNCTION
OF MANAGEMENT


This page is intentionally left blank.


Chapter 1

MANAGEMENT AND CONTROL

M

anagement control is a critical function in organizations. Management control
failures can lead to large financial losses, reputation damage, and possibly even to
organizational failure. Here are some recent examples:

●

In the Autumn of 2010, during the trial of Jérôme Kerviel, a rogue trader who almost
bankrupted Société Générale, France’s second-biggest bank, the French court pondered
the competing descriptions of whether Mr. Kerviel was “a country bumpkin from Brittany,
seduced by a corrupt banking system and the avarice of his bosses, or ‘a crook, a fraud
and a terrorist’?”1 On October 5, 2010, the court ruled that Mr. Kerviel was guilty, sentencing him to five years in jail, thus judging him to be “a fraud.” The court also ordered that
Mr. Kerviel repay the bank a4.9 billion, the amount that it lost due to his fraudulent trades.
Although the court’s sentence essentially implied that Société Générale did not share the
blame for Mr. Kerviel’s fraudulent trading by looking the other way when his positions
were profitable, the bank did not go entirely blameless either. For example, Britain’s

Financial Services Authority (FSA), the regulator, fined the bank for weaknesses in its
record-keeping and reporting because weak oversight allowed a relatively junior employee
to place bets worth more than the bank’s entire capital. Société Générale has since spent
a130 million tightening its controls. Although this may be an extreme case, several other
banks have been fined for similar transgressions. As The Economist reports, Société
Générale’s “experience sounds a loud warning to all investment banks and their regulators
that they need to pay more attention to the boring old back office. The case of Mr Kerviel
– like that of Nick Leeson, whose bets almost two decades ago destroyed Barings Bank
– should not obscure wider questions, [such as] how to remunerate legitimate traders who
stand to earn bucket loads if they make successful bets but lose little if they suffer losses
is prime among them.”2 This is an important question which we will discuss in this book
extensively under the rubric of so-called results controls, of which incentive systems are
an important part. We introduce results controls in Chapter 2 and discuss incentive systems
in Chapter 9, although both results controls and incentive systems are a recurrent theme
across many other chapters throughout the book as well.

●

In October 2009, London stockbroker Seymour Pierce was fined £154,000 by the FSA for
failing to prevent an employee fraud. Weak compliance controls at the broker allowed an
employee to steal approximately £150,000 from the firm’s private client accounts spread,
and then cover up the theft, over 36 separate transactions between 2003 and 2006. The
employee was dismissed before the discovery of the fraud, which only came to light when
his replacement noticed serious accounting discrepancies. Seymour Pierce managers said that
once the fraud was discovered it immediately referred the matter to the authorities. Margaret
Cole, the FSA’s Director of Enforcement and Financial Crime, stated: “This is a serious
3


Chapter 1 · Management and Control


failure on Seymour Pierce’s part. The frauds were not sophisticated and could have been
detected at a much earlier stage if the proper procedures had been in place. Fraud seriously
undermines the integrity of our markets, so this fine is a timely reminder of the consequences
for firms that fail to have in place robust systems and controls to prevent unlawful transactions of this sort.” Simon Morris, a financial services partner at law firm CMS Cameron
McKenna, added: “All firms should heed this latest warning and redouble their efforts to
ensure that their systems and controls are adequate to safeguard against both internal and
external misfeasance.”3 We discuss internal controls as one type of what we call action
controls in Chapter 3, and discuss how tightly they should be applied in Chapter 4.

4

●

In the Autumn of 2010, all 50 US states started a joint investigation into whether mortgage
firms were wrong to repossess hundreds of thousands of homes, following allegations
that the lenders, among them venerable banks, such as Bank of America and JP Morgan
Chase, often mishandled documents when people that had fallen behind on their mortgage
payments had their houses taken from them. At the heart of the issue is the accuracy and
legitimacy of the documents that lenders used to evict people from their properties, suggesting that bank employees signed off on repossession documents without reading them.
Iowa Attorney General Tom Miller said: “This is not simply about a glitch in paperwork;
it’s also about some companies violating the law and many people losing their homes.”4
How can companies, banks in this case, ensure that their employees carry out their jobs
properly? As we will see in this book, what we call action controls, among other control
system elements, are important to consider in respect to this question.

●

In April 2005, employees at the 75-year-old California-based not-for-profit Gemological
Institute of America (GIA), the world’s largest grader of diamonds, were accused of accepting bribes from large diamond dealers to inflate diamond grades. Large diamond dealers

would submit proportionally high bids, often 20 to 30% higher than prevailing bids for
rough stones, knowing that they would be able to sell these stones at a profit because they
bribed GIA staff to get a higher-than-deserved grade. A small difference in grade can mean
a huge difference in price, often hundreds of thousands of dollars on larger diamonds.
The size of the bribes is unknown, but the probe into the allegations mentions cash, theater
tickets, and other gifts. What is known, however, is that the bribes gave the large dealers
enough of a financial edge to control the market and reap excess profits. As such, the
scandal reverberated throughout the $80 billion diamond-jewelry industry around the world,
as many customers overpaid for their diamonds and many diamond dealers, particularly
smaller ones, were forced to leave the industry or were considering it.5 This leads to a
similar question as in the example above, but in reverse: how can companies not only
ensure that employees do not fail to do something they should do, but also guard against
the possibilities that employees will do something the organization does not want them
to do? This is, as we will see in the remainder of this chapter, a key question related to
management control.

●

On that note, more examples abound. In 2002, two clerical workers at the Laguna Niguel,
California-based service center of the US Immigration and Naturalization Service (INS)
were accused of destroying thousands of immigration documents, including visa applications, passports, and other papers. According to the probe, the clerks started shredding
unprocessed paperwork in early 2002 after an inventory revealed a processing backlog of
about 90,000 documents. A month later, in March 2002, the backlog was reported to be
zero. The shredding allegedly went on for about another month to keep the backlog at zero,
until INS officials discovered the shredding spree during an evening shift.6 Although it is not
entirely clear what the clerical workers’ motives were, this example illustrates that money
is not always the motive for wrongdoing. There were no bonuses involved here, and
maybe the employees were just trying to keep their job, but their actions were undesirable
nonetheless, and thus control systems are needed to mitigate undesirable behaviors.



Management and control
●

But not every control problem involves fraud. Control systems must also prevent mistakes.
For example, in July 2009, an employee at Westpac, an Australian bank, accidentally credited
a client’s account with a $10 million overdraft when he had asked for just $100,000.
Westpac had recovered some of the money, but $3.8 million remained outstanding. The
employee who made the mistake had more than 30 years’ banking experience, and he
should have been considered at least somewhat trustworthy. Yet controls should have been
in place to prevent this mistake.7

The examples described above show the importance of having good management control
systems (MCSs) and the types of problems – thefts, frauds, and unintentional errors – they
can address.
However, having more controls in place does not always guarantee better control. As
the next example illustrates, when copious MCSs are stifling, they can exacerbate rather
than mitigate control problems:
In 2003, the European Union’s (EU) anti-fraud office discovered an allegedly “vast enterprise of looting” at Eurostat, the statistical service of the European Commission. The probe
focused on secret bank accounts in which senior managers at Eurostat allegedly funneled
an estimated a900,000 of EU taxpayers’ cash to contractors, including companies that they
themselves had helped set up, by artificially inflating the value of the contracts or by creating
fictitious contracts. Some noted that this was just a confirmation of the popular prejudice that
the “Brussels bureaucracy” is rife with corruption, lax financial controls, complacency, and
cronyism, a reputation that the European Commission had earned in the late-1990s when
several other corruption scandals broke. However, others argued that it was not certain that
the accounts set up by the Eurostat officials were used for the personal enrichment of those
involved, at least not initially. They argued instead that these accounts may originally have been
set up to give Eurostat a way to pay for research quickly without going through the Commission’s
cumbersome procedures. Ironically, while the Commission has elaborate procedures to prevent

financial fraud, these procedures may not only have proved insufficient, they may actually have
made the problem worse. Due to the tortuous form-filling that is required for funding requests,
the number of bureaucratic hoops fund requesters have to jump through to get anything approved,
and the notoriously slow delivery of the funds, commission officials and staff may have got used
to cutting corners and finding “creative” ways to speed up the process. But even though there
might be a strong suspicion that the secret accounts were at first intended to serve legitimate
purposes, they may have been abused as time went on. While the jury was out on the validity
of the conjectures on each side of the argument, some argued that perhaps the most essential
problem at the Commission was its lack of a culture of responsibility.8

It is widely accepted that good MCSs are important. Comparing the books and articles
written on management control is difficult, however, because much of the MCS language
is imprecise. The term “control” as it applies to a management function does not have a
universally accepted definition. An old, narrow view of a MCS is that of a simple cybernetic
or regulating system involving a single feedback loop analogous to a thermostat that
measures the temperature, compares the measurement with the desired standard, and,
if necessary, takes a corrective action (turn on, or off, a furnace or air conditioner). In a
MCS feedback loop, managers measure performance, compare that measurement with
a pre-set performance standard, and, if necessary, take corrective actions.9
In this book, however, we take a broader view. Many management controls in common
use, such as direct supervision, employee selection and retention, and codes of conduct,
do not focus on measured performance. They focus instead on encouraging, enabling
or, sometimes, forcing employees to act in the organization’s best interest. Moreover,
some management controls are proactive rather than reactive. Proactive means that the
controls are designed to prevent problems before the organization suffers any adverse
5


Chapter 1 · Management and Control


effects on performance. Examples of proactive controls include planning processes,
required expenditure approvals, segregation of duties, and restricted access. Management
control, then, includes all the devices or systems managers use to ensure that the behaviors
and decisions of their employees are consistent with the organization’s objectives and
strategies. The systems themselves are commonly referred to as the management control
systems (MCSs).
Designed properly, MCSs influence employees’ behaviors in desirable ways and,
consequently, increase the probability that the organization will achieve its goals. Thus,
the primary function of management control is to influence behaviors in desirable ways.
The benefit of management control is the increased probability that the organization’s
objectives will be achieved.

MANAGEMENT AND CONTROL
Management control is the back end of the management process. This can be seen from
the various ways in which the broad topic of management is disaggregated.

Management
The literature includes many definitions of management. All relate to the processes of
organizing resources and directing activities for the purpose of achieving organizational
objectives.
Inevitably, those who study and teach management have broken the broad subject into
smaller, more discernable elements. Table 1.1 shows the most prominent classification
schemes. The first column identifies the primary management functions of the value chain:
product or service development, operations (manufacturing products or performing services),
marketing/sales (finding buyers and making sure the products and services fulfill customer
needs), and finance (raising money). Virtually every management school offers courses
focused on only one, or only part of one, of these primary management functions.
The second column of Table 1.1 identifies the major types of resources with which
managers must work: people, money, machines, and information. Management schools
also offer courses organized using this classification. These courses are often called

human resource management, accounting and finance, production, and information systems,
respectively. These are sometimes also referred to as the support management functions.10
The term management control appears in the third column of Table 1.1, which separates the management functions along a process involving objective setting, strategy
formulation, and management control. Control, then, is the back end of the management
process. The way we use the term management control in this book has the same meaning
TABLE 1.1 Different ways of breaking down the broad area of management into smaller
elements
Functions

Resources

Processes

Product (or service) development
Operations
Marketing /sales
Finance

People
Money
Machines
Information

Objective setting
Strategy formulation
Management control

Source: K. A. Merchant, Modern Management Control Systems: Text and Cases (Upper Saddle River, NJ: Prentice Hall, 1998), p. 3.

6



Management and control

as the terms execution and strategy implementation. In most organizations, focusing on
improving MCSs will provide higher payoffs than will focusing on improving strategy.
A Fortune study showed that seven out of ten CEOs who fail do so not because of bad
strategy but because of bad execution.11
Many management courses, including business policy, strategic management, and
management control systems, focus on elements of the management process. To focus
on the control function of management, we must distinguish it from objective setting and
strategy formulation.

Objective setting
Knowledge of objectives is a prerequisite for the design of any MCS and, indeed, for
any purposeful activities. Objectives do not have to be quantified and do not have to be
financial, although that is how they are commonly thought of in for-profit organizations.
A not-for-profit organization’s primary objective might be to provide shelter for homeless
people, for example. But many for-profit organizations also have nonfinancial objectives,
such as related to sustainability or personnel development and wellbeing. In any organization, however, employees must have a basic understanding of what the organization is
trying to accomplish. Otherwise no one could claim that any of the employees’ actions are
purposive, and no one could ever support a claim that the organization was successful.
In most organizations, the objectives are known. That is not to say that all employees
always agree unanimously as to how to balance their organizations’ responsibilities to all
of their stakeholders, including owners (equity holders), debtholders, employees, suppliers,
customers, and the society at large). They rarely do.12 That said, organizations develop
explicit or implicit compromise mechanisms to resolve conflicts among stakeholders and
reach some level of agreement about the objectives they will pursue. As Jason Luckhurst,
managing director of Practicus, a UK-based project-management recruitment firm, argues:
[To achieve organizational success], it takes a clear vision around which the entire business

[can] be designed, [and I] think it is something you should be able to communicate simply to
everyone, whether a client or [an employee]. Having a simple and easily understood statement
of intent is vital for setting clear objectives and targets.13

Strategy formulation
Having set the firm’s strategic intentions or objectives, strategies then define how organizations should use their resources to meet these objectives. A well-conceived strategy
guides employees in successfully pursuing their organizations’ objectives; it conveys to
employees what they are supposed to be doing. Or, as Mr. Luckhurst at Practicus states:
“All the planning in areas as diverse as marketing, branding, financing and training, is
designed around [our] objective – as are [our] incentive [systems]. We have a detailed
road map, but it starts with a simple vision that everyone can understand and buy into.
Everything else we do comes on the back of those goals. In effect, we can reverseengineer the business to those objectives.”14
Many organizations develop formal strategies through systematic, often elaborate,
planning processes (which we discuss further in Chapter 8). Put differently, they have
what can be called an intended strategy. However, strategies can sometimes be left
largely unspecified. As such, some organizations do not have formal, written strategies;
instead they try to respond to opportunities that present themselves. Major elements of
these organizations’ strategies emerge from a series of interactions between management,
7


Chapter 1 · Management and Control

employees, and the environment; from decisions made spontaneously; and from local
experimentation designed to learn what activities lead to the greatest success. Nonetheless,
if some decision-making consistency exists, a strategy can be said to have been formed,
regardless of whether managers planned or even intended that particular consistency. In
that sense, strategic visions sometimes come about through dynamic organizational processes rather than through formalized strategizing.15
Not even the most elaborate strategic visions and statements are complete to the
point where they detail every desired action and contemplate every possible contingency.

However, for purposes of designing MCSs, it is useful to have strategies that are as specific
and detailed as possible, if those strategies can be kept current. The formal strategic statements make it easier for management both to identify the feasible management control
alternatives and to implement them effectively. The management controls can be targeted
to the organization’s critical success factors, such as developing new products, keeping
costs down, or growing market share, rather than aiming more generally at improving
profitability in otherwise largely unspecified ways.
Formal strategic statements are not a sufficient condition for success, however. As
Adrian Grace, managing director of Bank of Scotland – Corporate, states:
I have seen businesses with 400-page documents outlining their strategy and it’s clear they
should have spent less time outlining the vision and more time thinking about how they will
deliver on it. You can have the best vision in the world but if you can’t put it into effect, you
are wasting your time.16

It is on the execution side of the management process that MCSs play a critical role.
Jason Luckhurst explained:
The difference between merely having a strategic vision and achieving strategic success is
having a detailed understanding of what that vision means for every level of the business – how
much funding you need, the branding and marketing strategy, which channels you will develop,
how many people you need in which areas and when and what the organizational structure will
be. It is also important to revisit the vision often and be aware of how close you are to achieving
it at any given stage. This helps everyone in the company to stay focused.17

Management control versus strategic control
In the broadest sense, control systems can be viewed as having two basic functions:
strategic control and management control. Strategic control involves managers addressing the question: Is our strategy valid? Or, more appropriately in changing environments,
they ask: Is our strategy still valid, and if not, how should it be changed? All firms must be
concerned with strategic control issues, but the concern that a strategy may have become
obsolete is obviously greater in firms operating in more dynamic environments.18 That
said, strategic options sometimes may be limited. For example, When Archie Norman,
the new executive chairman of ITV, a major television concern, laid out his vision for the

company in March 2010 in a thoroughly businesslike presentation, he told analysts that
he saw a future where ITV was freed from burdensome regulation, made more money from
its online activities and, most importantly, improved the quality of programs. However,
one analyst reacted to it by stating: “It’s true, but it is the same strategy that Michael
[Grade, his predecessor] laid out some years ago. The key is execution.” Another analyst
added: “The headlines are not all that different, but that is because there is not much else
you can do.”19
Management control focuses on execution, and it involves addressing the general question: Are our employees likely to behave appropriately? This question can be decomposed
8