Control System Costs

Management control systems (MCSs) provide one primary benefit: a higher probability that
employees will pursue organizational objectives. Managers are willing to incur sometimes
significant direct, out-of-pocket costs to try to obtain this benefit.
But managers must also consider some other, indirect costs that can be many times greater
than the direct costs:
 Some of these indirect costs arise from negative side effects that are inherent in the
use of specific types of controls.
 Others are caused either by a poor MCS design or by implementation of the
wrong type of control in a given situation.
 To make informed cost-benefit judgments, managers must understand these side
effects, their causes, and their consequences (costs).
Costs may also arise from the need to adapt MCSs to the context in which they
operate, which is particularly pertinent in multinational operations.
 Adaptations to local circumstances can be costly, but not adapting may render the
MCSs less effective and give rise to indirect costs.

1- Direct costs
The direct costs of a MCS include all the out-of-pocket, monetary costs required to design
and implement the MCS. Some direct costs are relatively easy to identify:
 the costs of paying cash bonuses (incentive compensation for results control) or
 the costs of maintaining an internal audit staff (ensure compliance with action-control
prescriptions)
Other costs, however, such as those related to the time employees spend in planning and
budgeting activities or preaction reviews, can only be estimated.
 Even of the time spent, it is hard to estimate how much of it is “value-added.”
For example, a recent survey of practice suggests that of all the time spent on
financial analysis and planning, “only 28% is spent on the analysis that drives
insightful business decisions,” with the rest being spent on validating data and
administering processes.
Many organizations often are unaware of, or do not bother to calculate accurately the size of,
all of these direct costs. But all that is required for our purposes is to acknowledge that these
costs are not trivial and, thus, should be put against the benefits that MCSs have or are
expected to have.
 With the process costs of internal audit for the Fortune 500 representing between
0.026% and 0.126% of revenue (variable based on company size, industry, and
adoption of leading practices), extracting greater value from such an investment is
paramount.
 Moreover, since many Chief Audit Executives (CAEs) still report administratively
to the CFO, it behooves Finance to equip the function with capabilities to deliver
more-informed audit reports.

Adapted for Students using English as a Second Language Page 1 of 16

What is more, there is an intricate link between direct costs and indirect costs. For example,
the costs for banks to comply with US regulations on financial transactions with countries on
the US sanctions list:
BNP Paribas’s guilty plea to violations of sanctions against Sudan, Iran and
Cuba was accompanied by a gigantic fine of nearly $9bn plus a one-year ban
on conducting certain transactions in dollars.

This is a huge indirect cost of the failure of compliance, which has led to more direct costs
incurred on internal controls to enhance compliance:
 BNP Paribas, for example, took a £200m charge related to an overhaul of compliance
procedures as it responded to its fine by setting up a special unit in New York, aimed
at ensuring that it stays on the right side of US rules.
 Macquarie, the Australian investment bank, announced in May that its direct
compliance costs had tripled in three years, to A$320m.
 HSBC took on 1,500 extra compliance staff in the first half of the year, lifting its
compliance spend by about $150m.

2- Indirect costs
Challenging as estimating the direct costs of control may be, they can be largely surpassed
by indirect costs of control caused by any of a number of harmful side effects, including:
- behavioral displacement,
- gamesmanship,
- operating delays, and
- negative attitudes.
Some of the harmful side effects that commonly arise from the use of financial results
controls, are especially
- management short-termism or myopia.

1. Behavioral displacement

Behavioral displacement is a common MCS-related side effect that can expose organizations
to significant indirect costs; it occurs when the MCS produces, and actually encourages,
behaviors that are not consistent with the organization’s objectives.
Behavioral displacement is most common with accountability-type controls (either results
or action accountability), where the specification of the results or actions desired is
incongruent. But some forms of personnel/cultural control can also produce the problem.

Behavioral Displacement and Results Controls

In a results-control system, behavioral displacement occurs when an organization defines
sets of results measures that are incongruent with the organization’s “true” objectives. For
example:
 When companies give their salespeople monthly sales quotas, the salespeople tend
to work on the easiest sales, which are not necessarily the most profitable sales or
sales with the highest priority.

Adapted for Students using English as a Second Language Page 2 of 16

  When brokerage firms reward their brokers through commissions on client trades,
some brokers respond by engaging in more transactions than are in the customers’
best interests and that run the risk of client dissatisfaction and turnover.
 When companies reward their computer programmers for output measured in lines of
code per day, the programmers tend to generate programs with lengthy code even
when the company’s problems can be better addressed by simpler programs or by
off-the-shelf applications.
 When software testers are evaluated in terms of the number of “bugs” they find, the
bug count goes up. But more of the bugs found will be minor. Bug counts also create
incentives for superficial testing, penalizing testers to take the time either to look for
the harder-to-find but more important bugs or to document their findings thoroughly.
Bug counts also penalize testers who support other testers through coaching,
helping, and auditing.
 When companies reward their research scientists for the number of patents filed, they
are likely to see an increase in the number of patents filed. However, this incentive
may lead to patent proliferation only and may not enhance, and may even erode,
researchers’ concerns for the eventual commercial success of their discoveries.
Why do organizations, then, use measures that are not congruent with their true objectives?
Most commonly, incongruence arises because organizations focus on easily quantifiable
results that lead them to incompletely capture all of the desired results. When that is the
case, employees are induced to concentrate on the results that are rewarded by the control
system and to snub other desired but unmeasured result areas.
 For example, when a major personal computer (PC) maker started paying its sales
reps higher commissions for selling add-on services than for selling PCs, the sales
reps became lax about selling no-frills PCs. Sometimes they would even hang up on
customers who did not want add-ons. As a result, customer satisfaction went down as
did the referral business on which the company had relied for its growth in a highly
competitive market.
 Similarly, when city officials wanted to tackle overtime in their garbage collection
service, they offered the garbage collectors an incentive scheme where they would
be paid full time even if they reported back early. It worked. Garbage collectors came
back consistently early and received full pay for the shift. Despite this good effect on
overtime reduction, however, there was an increase in preventable traffic accidents,
missed pickups of garbage, and trucks filled over the legal weight limit. Because the
incentive scheme emphasized time, employees nearly exclusively focused on time at
the expense of safety, service and obeying work rules.
Garbage collection is not exactly what comes to mind when thinking of multitasking, yet
even this job is presumably complex enough to be subject to the effects of distorted
incentives (a form of behavior displacement). Consider, then, the complexity involved in
determining appropriate weights on the multiple dimensions of, say, managerial jobs, and
one can see how easily incentives can have potentially displacing effects.
All told, there are very few jobs, even presumably simple jobs, where what is counted is all
that counts – in other words, results controls are almost invariably incomplete. If the relative
importance of the various aspects of the job is not captured correctly, employees are unlikely
to allocate their efforts properly, and outcomes will be distorted.
Later chapters offer various possible remedies to this displacement problem, such as by
using baskets of measures and/or relying on subjective performance evaluations to try to
Adapted for Students using English as a Second Language Page 3 of 16
cover more completely all the important drivers of performance.
 Compensation should reflect the performance of the firm as a whole, and include
productivity, teamwork, citizenship, communication and compliance. That was
true until 2005, when the company determined workers’ annual awards “not just
on how much business you’d brought in, but also on how good you were for the
organization,” alleges Greg Smith, a former Vice President, in Goldman Sachs:
“From 2005 until the present day, the system has become largely mathematical:
you were paid a percentage of the amount of revenue next to your name,” a
figure that could vary from 5 to 7 percent, wrote Smith. “The problem with the new
system was that people would now do anything they could – anything – to pump
up the number next to their name.”

Behavioral Displacement and Action Controls

Behavioral displacement can also occur with action controls. One form of action control-
related displacement is often referred to as means-ends inversion, meaning that
employees pay attention to what they do (the means) while losing sight of what they are to
accomplish (the ends).
 For example, managers who are given an approval limit for capital expenditures have
been known to invest in a series of small projects, each of which fall just within their
authorization limits. Although the action-accountability controls may not be
breached, the resulting pattern of small, incremental investments may be suboptimal.
Sometimes action control-related displacement occurs simply because the defined actions
are incongruent. As with results controls, this problem arises in an action-accountability
context.
 For example, the PC maker mentioned above also implemented a policy to put a time
limit on customer service calls. Specifically, customer service reps who spent more
than 13 minutes talking to a customer would not earn their commission. Not
surprisingly, service reps began doing just about anything possible to get customers
off the phone, such as pretending that the line was not working or just hanging up. As
a result, the company’s customer satisfaction ratings, once the best in the industry,
dropped dramatically and fell below the industry average.
Some action controls cause behavioral displacement because they promote compliant yet
rigid, non-adaptive behaviors, a pathology commonly associated with bureaucratic
organizations.
 For example, US automobile manufacturers focused on elaborate action prescriptions
for their assembly workers to try to optimize assembly-line operations. On Japanese
assembly lines, in contrast, the control systems in use for assembly workers were
much more flexible. Workers were encouraged to experiment with different ways of
doing their jobs – for example, by putting the doors on the car before the locks were
installed, and then alternating the order to see which was more efficient. By giving
their workers more flexibility, the Japanese gained a competitive advantage.
 Similarly, at Continental Airlines, there used to be a rule for just about everything
conceivable in the nine-inch-thick procedures manual known as the “Thou Shalt Not”
book. As one company observer noted, “No one could possibly know everything in
the book, so most employees played it safe by doing nothing at all.” To overcome the
undesired rigidity fostered over time by the rule book, the new management team
ceremoniously burned the “Thou Shalt Not” book in the company parking lot to

Adapted for Students using English as a Second Language Page 4 of 16

 provide a clear signal that, from then onward, employees had “permission to think for
themselves.”
Action controls and bureaucratization can be good in stable environments with
considerable centralized knowledge about what actions are desired because they help
establish compliant, reliable, and efficient work routines. In changing environments, however,
they may hinder the change that is required to stay competitive.
A recent study in Australia suggested that the direct costs of red tape also can be
significant. Global accounting firm Deloitte says internal red tape and self-imposed rules
are costing businesses twice as much as government regulations: the average worker
spends essentially a day a week jumping through the hoops of this self-imposed red
tape.
 Much of it is a good thing: over the past decade, miners and the construction
sector have become safer. Industrial accidents have gone down.
 But not all of it is a good thing because businesses never look back: they don’t do
the audit, and they don’t ask “Why are we doing this, do the rules make sense
anymore? Our existing rules are costing us a fortune; they’re not necessarily
making us that much better off, or that much less risky.”

Behavioral Displacement and Personnel/Cultural Controls

Behavioral displacement can also occur with personnel/cultural controls.
 It can arise from recruiting the wrong type of employees or providing insufficient training.
 And when personnel/ cultural controls are implemented in the wrong setting, they will be
rendered ineffective and encourage unintended behaviors.
 For example, when Levi Strauss wanted to raise productivity and reduce costs,
particularly those incurred by injured workers pushing to make piecework goals, it
turned to teamwork, which Levi’s felt would be more humane, safe, and exemplary of
workplace standards in an industry notorious for poor working conditions.
The old piecework system – under which a worker repeatedly performs a specialized
task (such as attaching pockets or belt loops) and gets paid by the amount of work
completed – was abandoned and replaced by teams consisting of 10–35 workers who
shared the tasks and were paid according to the total amount of trousers the group
completes.
Despite these praiseworthy intentions, however, the nature of the work at Levi’s may not
be well suited for teamwork.
o Garment manufacturing consists of a series of specific tasks (pocket setting,
belt looping). The speed of these tasks relates directly to a worker’s skill for the
grueling, repetitive motions involved in stitching fabric. Some workers are
much faster than others.
o Although team-work was expected to reduce monotony, enable workers to
perform different tasks, and reduce repetitive injuries, it failed. When skilled
workers were pitted against slower co-workers, the wages of top performers
fell while those of lower-skilled workers went up. This not only eliminated
savings for Levi’s but also caused infighting among co-workers. Longtime
friendships were dissolved, and faster workers tried to banish slower ones.
Morale was damaged, efficiency dropped, and labor and overhead costs
surged. The teamwork concept did not fit the context.
Adapted for Students using English as a Second Language Page 5 of 16
2. Gamesmanship

We use the term gamesmanship to refer generally to the actions that employees take to
improve their performance indicators without producing any positive effects for the
organization.
Gamesmanship is a common harmful side effect faced in situations where accountability
forms of control, either results or actions accountability, are used. We discuss two major
forms of gamesmanship: slack creation and data manipulation.

Creation of Slack Resources

Slack involves the consumption of organizational resources by employees in excess of what
is required to meet organizational objectives.
The propensity to create slack often takes place when tight results controls are in use;
that is, when employees, mostly at management levels, are evaluated primarily on whether
or not they achieve their budget targets.
Managers who miss their target face the prospect of
- interventions in their jobs,
- the loss of organizational resources,
- the loss of annual bonuses and pay raises, and
- sometimes even the loss of their job.
Under these circumstances, managers may look for ways to protect themselves from the
downside risk of missing budget targets and the stigma attached to underachievers.
One way in which managers keep tight results control from hurting them is by negotiating
more easily achievable targets; that is, targets that are deliberately lower than their best-
guess forecast of the future. This is called budget slack; it protects the managers against
unforeseen contingencies and improves the probability that the budget target will be met,
thus increasing the likelihood of receiving a favorable evaluation and associated rewards
(such as a raise, a bonus, recognition, or a promotion).
 On the negative side, the slack obscures true underlying performance and, hence,
distorts the decisions based on the obscured information, such as performance
evaluations and resource-allocation decisions.
 That said, slack should not be seen as producing only negative effects. On the
positive side, slack can reduce manager tension and stress, increase organizational
resilience to change, and make available some resources that can be used for
innovation.
In most situations, slack is nearly impossible to prevent.

Theoretically, slack is feasible only where there is information asymmetry, where superiors
have less-than-complete knowledge about what can be accomplished in a given area, and
where subordinates are allowed to participate in setting the performance targets for that
area.
Thus, where performance can be accurately forecast or be set in a top-down manner, it
should be possible to prevent, or at least mitigate, slack. But these conditions exist only in
rare situations – highly stable environments. If accountability controls are used in other
situations, slack must be considered almost inevitable. We will discuss various ethical
considerations related to slack creation.

Adapted for Students using English as a Second Language Page 6 of 16

Data Manipulation
Data manipulation involves fudging the control indicators. It comes in two basic forms:
falsification and data management.
 Falsification involves reporting erroneous data, meaning that the data are changed.
 Data management involves any action undertaken to change the reported results
(such as sales numbers or profits) while providing no real economic advantage to the
organization and, sometimes, even causing harm.

Data management actions are typically undertaken to make performance look better, such as
to achieve a budget target or to increase stock price.
However, data management actions can also be undertaken to make performance look
worse.
- Sometimes managers “save sales” for a future period when the current-year bonus
has reached its cap.
- Sometimes they “take a bath” – that is, they make results look worse in bad times
(while there are no bonus payouts, anyway) to get a head start on recording an
improvement in the subsequent period.
- Sometimes they report abnormally poor results to try to lower the stock price to
coincide with, say, a stock option grant.

Data management can be accomplished through either:

- accounting or
- operating means.
 Accounting methods of data management involve an intervention in the
measurement process. Individuals engaging in accounting methods of data
management sometimes violate accounting rules; more frequently, they use the
flexibility available in either the selection of accounting methods or the application of
those methods, or both, to “manage earnings,” as it is often called.
To boost earnings, for example, managers might shift from accelerated to straight-
line depreciation or change their judgments about accounting estimates (such as
about reserves, allowances, and write-offs). A Fortune article called accounting
treatments like these, which are consistent with generally accepted accounting
principles, “legal, but lousy.”
 Operating methods of data management involve the altering of operating decisions.
To boost earnings in the current period, managers can, say, try to delay the timing of
discretionary expenditures (such as maintenance) and/or try to accelerate sales.
These methods affect the size and/or timing of cash flows, as well as reported
earnings. Several companies have been charged with booking revenues on sales to
distributors (as opposed to waiting until the products have been sold by the
distributor), thus taking advantage of the ambiguity in accounting rules on revenue
recognition. This rules ambiguity makes “channel stuffing” tempting by persuading
distributors to take more product than they really need or want, particularly toward
the end of a poor quarter, to help earnings look better than they really are. A recent
example occurred at Tesco, a large UK grocer, the analysis of which appears to allow
for the possibility of operating as well as manipulating causes of the problems:

Adapted for Students using English as a Second Language Page 7 of 16

Suppliers make payments to supermarkets that meet certain sales targets for their
products, run promotions or place the goods in eye-catching places, such as at the
end of aisles. Tesco managers appear to have been too ambitious in forecasting these
“rebates.” They may also have underreported the costs of stolen and out-of-date
produce. The complexity of Tesco’s promotional deals with suppliers may have left too
much room for discretion, and honest mistakes, as well as deliberate distortions. But the
risks around accounting for such payments are hardly new. The auditors of several big
retailers have amplified their warnings in recent years as rebates have taken up more
space on balance-sheets. In its most recent report, in May, Tesco’s auditor, PwC,
warned of the “risk of manipulation.”

Because altering decisions can have adverse effects on real economic value, even when
they improve reported accounting income, operating methods of data management can be
harmful to the firm in the long term. The actions can harm customer satisfaction (arising from
the aggressive sales tactics), employee productivity (arising from the unneeded overtime at
quarter’s end), and/or quality (arising from postponed maintenance or reduced quality
inspections).

Manipulation is a serious problem because it can render an entire control system ineffective.
If the data are being manipulated, it is no longer possible to determine whether a company,
entity, or employee has performed well. The effects of manipulation can also go far beyond
the MCS because they affect the accuracy of an organization’s information system. If that is
the case, management’s ability to make good, facts-based decisions will be curtailed. Thus,
even though various data manipulation methods are not illegal, they can be costly to the
firm in the long term.
Some data manipulation schemes involve outright fraud, however.
At Sunrise Medical, four employees at one of the firm’s major divisions, including its
general manager, engaged in falsifying financial reports. The scheme was intended to
disguise a deteriorating financial situation. The company’s bonus plan was seen as a
major cause of the fraud. The plan paid annual cash bonuses worth up to 50% of salary,
but it paid no bonuses in divisions that failed to record a year-on-year earnings increase. It
shocked many observers that such a fraud could occur at Sunrise, which “has long
presented itself as a values-conscious health-care firm whose employees carry lofty
corporate precepts about customers, shareholders and social responsibility on wallet
cards.” When such frauds come to light, their financial impact can be huge. Reputations
are ruined and billions of dollars of shareholder value can be destroyed.

Despite these costs, data manipulation schemes are often fostered by excessive short-term
performance pressures and inadequate controls to prevent the dysfunctional side effects.

In other situations, the blame is laid on the failure of auditors to perform their functions well.
Auditors do not always understand the company’s business or its accounting methods well
enough, or they do not pursue some of the observed improprieties far enough, perhaps in
part because of a lack of independence from their clients.

The 2008 financial crisis has nudged regulators further toward enacting regulatory and
legislative reforms focused on the roles and responsibilities of management and boards of
directors in financial reporting as well as the roles and responsibilities of independent
auditors in performing their audits of the financial reports. This falls broadly under the realm
of corporate governance.

Adapted for Students using English as a Second Language Page 8 of 16

4. Operating Delays

Operating delays often are an unavoidable consequence of the preaction review types of
action controls and some of the forms of behavioral constraints.
Delays such as those caused by limiting access to a stockroom or requiring the typing of a
password before using a computer system are usually minor and are inevitable (although
they can be made more effective and less time- wasting or cumbersome through the use of
technology, such as touch IDs or retina-recognition systems).
However, other control-caused delays can be major, such as those arising from approvals
requiring multiple signatures from managers at various levels in the hierarchy, or from
endless memos through layers of higher-ups before anything gets cleared. In these
circumstances, required approvals sometimes straitjacket operations and, hence, curtail
market and customer responsiveness.
Obviously, where fast action is important, as it is in many competitive markets, decision
delays can be quite costly. Delays are a major reason for the negative connotation
associated with the word bureaucracy. In organizations that tend to place greater emphasis
on action controls and suffer these bureaucratic operating delays as a consequence, many
MCS changes are motivated by a desire to reduce the burdens caused by these types of
controls, which are often seen as killing entrepreneurship.
Control-caused operating delays are not an independent problem. They can cause other
managerial reactions that are potentially harmful, such as game-playing, or that are
undermining the behaviors the controls were designed to keep in check, such as when
managers or employees seek the required approvals after they spend the money in order to
speed up the process; that is, they are said to act first, apologize later.

5. Negative attitudes

Management controls can also cause negative attitudes, including

- job tension,
- conflict,
- frustration and
- resistance.

Such attitudes are important not only because they are indicators of employee welfare, but
also because they are often coincident with other behaviors that can be harmful, such as
- gameplaying,
- lack of effort,
- absenteeism and
- turnover.

The causes of negative attitudes are complex. They may be precipitated by a large number
of factors such as
-
economic conditions,
-
personal difficulties, or
-
administrative procedures,
o
which can be cumulative

Adapted for Students using English as a Second Language Page 9 of 16

Negative Attitudes Produced by Results Controls

Results controls can produce negative attitudes.

One cause of negative attitudes arises from a lack of employee commitment to the
performance targets defined in the results-control system. Most employees are not
committed to targets they consider:
- too difficult,
- not meaningful,
- not controllable,
- or imprudent (and, of course,
- illegal or unethical).

Negative attitudes may also stem from problems in the measurement system. It is
common for managers to complain that their performance evaluations are not fair because
they are being held accountable for things over which they have little or no control.
Other potential causes of negative attitudes may be associated with the rewards (or
punishments) associated with the MCS. Rewards that are perceived as inequitable, and
perhaps most forms of punishment, tend to produce negative attitudes.
The collection of factors affecting attitudes is complex.
- Some evidence suggests that poor performers may react more negatively to better
control systems because the limitations in their abilities are easier to discover.
- More critical, however, are system flaws that could cause negative attitudes in good
performers.
Attitudes are important MCS outcomes to monitor:
- because they have their own value as indicators of employee welfare, but also
- because the presence of these negative attitudes may indicate the propensity to
engage in any of a number of harmful behaviors, such as:
o data manipulation or other forms of gamesmanship,
o withdrawal, or
o even sabotage.

Negative Attitudes Produced by Action Controls

Most people, particularly professionals, react negatively to the use of action controls.
Preaction reviews can be particularly frustrating if the employees being reviewed do not
perceive the reviews as serving a useful purpose.
At 7-Eleven, the global convenience store chain, some managers described the action
controls in use in the Japanese locations as “draconian.” The company’s point-of-sale
computer system, which registers every sale at each store location, is used to monitor
how much time each manager uses the analytical tools built into the cash register system.
Stores are ranked by how often their operators use the system, and if they are not using it
“enough,” the store managers are told to “shape up.”
One manager complained: “Sometimes I don’t know who’s really running the store. It’s like
being under 24-hour surveillance; it’s like being enslaved.” Even though 7-Eleven Japan has
been called “the world’s best-run convenience store chain,” efforts to import the computer-

Adapted for Students using English as a Second Language Page 10 of 16

focused action control system to stores in the United States met with stiff resistance
because it “goes against American workers’ desire for independence.” Moreover, although
employee-monitoring software (some call it “spyware”) may provide what seems useful
information, it may undermine employee morale and mutual trust.

3- Adaptation costs
In addition to direct and indirect costs, further costs related to running effective MCSs
may arise from the need to adapt MCSs to the context in which they operate, which is
particularly pertinent when operating multinationally, and which we will use as the case
in point here.

But adaptation costs are also incurred when firms adapt their MCSs across different strategic
business units (SBUs) or across different business or product/service lines because these
have adopted different business unit or competitive strategies.

Regardless, adaptations to local circumstances can be costly, and firms may prefer to
standardize their systems rather than to adapt them. However, not adapting them may
render the MCSs less effective and trigger indirect costs like those we discussed above,
for a number of reasons that we discuss in this section.

Adapting MCSs is particularly challenging in multinational environments. Managers of

multinational organizations (MNOs) almost invariably face high information asymmetry
between themselves and personnel in the foreign locations.
- The foreign personnel have specialized knowledge about their environments (such as
about local norms, tastes, regulations, and business risks).
- The information asymmetry limits the corporate managers’ abilities to use action
controls, such as preaction reviews, because the corporate managers have limited
knowledge to make the needed judgments.

MNO managers also face the barriers of distance, time zones, and language, which limit the
use of direct monitoring. They cannot easily visit their foreign-based subordinates, although
advances in technology have made virtual communications easier.

On top of that, they must deal with the significant problem of measuring performance in
multiple currencies. All this carries extra costs – costs of operating and adapting the control
systems in a multinational environment.

MNOs 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 similarities with large domestic organizations in that they are usually
characterized by a high degree of decentralized decision-making and by management
control through financial results controls.

That said, controlling MNOs is often more difficult than controlling domestic organizations
because MNOs face a multidimensional organizational problem: they are organized not only
by function and/or product line, but also by geography. Geographic spread requires
managers to be sensitive to each of the national cultures in which they operate and to
appreciate different institutional settings and local business environments.

Adapted for Students using English as a Second Language Page 11 of 16

National culture

Some of the effects, benefits, and costs of management controls are universal because, at a
certain basic level, people in all countries have similar physiological needs and desires, say,
for achievement and financial security.
Despite such 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.” As such, the
national culture concept essentially recognizes that people’s
o tastes,
o norms,
o values,
o social attitudes,
o personal priorities, and
o responses to interpersonal stimuli
vary across nations.

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.
When groups of employees perceive things differently, or react to things differently, different
control choices may have to be made.
Several taxonomies of national culture have been proposed. The most widely 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. This affects people’s comfort levels with self-interests,
their preferences for conflict resolution, and their attitudes toward interpersonal
relationships.
- The power distance dimension refers to the extent to which people accept that
institutional or organizational power is distributed unequally.
- Individuals who score high on uncertainty avoidance feel uncomfortable when the
situation they face is ambiguous.
- The masculinity dimension relates to the preference for achievement, assertive- ness,
and material success (traits labeled masculine), as opposed to an emphasis on
relation- ships, modesty, and the quality of life (traits labeled feminine).

Hofstede showed that people from different countries vary considerably on these cultural
dimensions. For example, 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. To
name just one implication, employees high in individualism are possibly more likely to prefer
individual rather than group-oriented work arrangements, performance evaluations, and pay.

Adapted for Students using English as a Second Language Page 12 of 16

But these four dimensions 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.
To illustrate, Jack Ma of China’s Alibaba emphatically noted that he had said on numerous
occasions that he will put “customers first, employees second, and shareholders third” even
though he “can see that investors who hear this for the first time may find it a bit hard to
understand.”
Managers running a business for the benefit of many stakeholders, and not primarily its
shareholders, will make different decisions. With regards to MCS design, they are likely to
choose, or respond better to, different performance measures (e.g. employee safety) and
use different ways of rewarding employees (e.g. job security and employee benefits).

Local institutions

Corporate governance regulations, employment law, and contract law, as well as banking
systems and governance interventions, also vary significantly across nations.
Just as with national culture, such institutional factors can influence both the design and
effects of an organization’s MCS.
 For example, organizations in countries with strong labor unions may find it difficult to
provide incentive pay as unions often prefer seniority-based pay systems.

One set of institutional factors with potentially important MCS implications consists of those
descriptive of:
- The financial markets in various countries,
- their importance in raising capital, and
- the extent of disclosures and types of information they demand.

The strength of:

- regulation,
- auditing, and
- enforcement also
may affect managers’ abilities and propensities to engage in earnings management.
Not all countries require the reporting of quarterly financial performance, which may
affect managers’ focus on short-term financial performance and, hence, their propensity to
engage in myopic decision-making.

Differences in local business environments

Business environments also differ significantly across countries. Elements of these

environments can affect:
- environmental uncertainty,
- inflation, and the
- availability of qualified personnel.
Each of these factors, and many others in this realm, has MCS implications.

Adapted for Students using English as a Second Language Page 13 of 16

Uncertainty
Country-specific environmental uncertainty can be caused by many things. Some countries
are inherently riskier places in which to do business. Military conflicts, kidnappings, terrorism,
and extortion threats can create major security problems. Some countries are also prone to
corporate espionage and theft of corporate secrets by local competitors, perhaps even with
the tacit consent of the host government.
Risk also differs across countries because of the stage of economic development. As
discussed, developing countries tend to have limited access to capital, relatively poor
accounting regulation and oversight, weaker legal enforcement of contract violations, and
other obstacles to doing business.
Government interventions also affect business risk. Governments have, to a greater or lesser
extent, powers that enable them to serve certain objectives. These powers can have major
effects on the value of companies’ assets and the expected returns on those assets. For
example, governments can exercise bureaucratic control in issuing business permits,
controlling prices, and restricting currency flows. They can implement laws that restrict
foreign firms’ activities and/or favor domestic firms. They can design tax laws that
redistribute income or affect the value of monetary compensation and other reward
arrangements. They can apply constraints through labor policies designed to reduce
unemployment such as by rigid labor laws to restrict layoffs.
Inflation
Inflation and fluctuations in inflation, which affect the relative values of currencies, create
financial risk. Valued in terms of a fixed currency, high inflation can cause a company’s
assets or an individual’s compensation to deteriorate significantly in value in a short period
of time.
Inflation, especially when severe, may require the adoption of some form of inflation
accounting, which involves either the expressing of accounts and financial statements in
terms of real (rather than nominal) amounts or expressing all assets and liabilities at cur-
rent (or replacement) values. Or, when less severe, it may require the use of some form
of flexible budgeting, to shield managers from uncontrollable inflation risk, or the partial
abandonment of accounting measures of performance in favor of some nonfinancial
measures.
Talent
Organizations operating in developing countries often face limited availability of skilled and
educated personnel. When employees are not highly educated, decision-making structures
are usually more centralized, and MCSs tend to be more focused on action controls rather
than results controls.
Small offices may contain only a few educated people. This makes it difficult to implement
one of the basic internal control principles: separation of duties.
All told, when talent is in short supply, both the firm’s ability to do business and its capacity to
affect good control are more likely to be compromised.
Personnel mobility and retention also differ across countries, which the following quote
nicely illustrates:
 Japanese workers introduce themselves by their company name first and their
own name second, and are far more likely to define themselves by whom they
work for than by what they do. This is true even in Japan’s most global
companies.
Adapted for Students using English as a Second Language Page 14 of 16
When personnel mobility is low, there is less need for implementing long-term incentive plans
that motivate managers both to think long term and to stay with the firm to earn their
rewards.

Foreign currency translation

MNOs also face currency exchange and translation problems. At first glance, it is not
obvious that results controls in MNOs should be complicated by the fact that the firms’ profits
are earned in multiple currencies. Results controls over foreign entities can be implemented
using the same practices employed in most domestic firms, by comparing performance
measured in terms of the local currency with a pre-set plan also expressed in the local
currency.
However, MNOs bear economic risk caused by fluctuating currency values. The values of
foreign investments appreciate or depreciate based on the relative values of 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. These issues involve uncontrollable
factors. The extra measurement noise caused by uncontrollable foreign exchange risk, and
various methods of measuring the gains and losses, can affect judgments about the entity
managers’ performances.

Conclusion
The implementation of virtually all controls, as well as their adaptation to local or situational
circumstances, requires companies to incur some direct, out-of-pocket costs.
But sometimes those direct costs are largely surpassed by the indirect costs caused by any
of a number of harmful side effects. We can make four general observations about the
occurrence of these side effects.
- First, as the table below summarizes, the harmful side effects are not unique to one
form of control. However, the risk of side effects seems to be smaller with personnel
controls.
- Second, some of the control types have negative side effects that are largely
unavoidable. It is difficult, or even impossible, for people to enjoy following a strict
set of procedures (action accountability) for a long period of time, although the
negative attitudes can probably be minimized if the reasons for them are well
communicated and if the list is kept to a minimum.
- Third, the likelihood of severe harmful side effects is greatest when there is either a
failure to satisfy one or more of the desirable design criteria or a misfit between the
choice of type(s) of control and the situation.
- Fourth, when controls have design imperfections or when they are inappropriately
used, the tighter the controls are applied, the greater are both the likelihood and the
severity of harmful side effects.
What makes dealing with these potential side effects difficult is that there is not always a
simple one-to-one relationship between the control type and the effect. The need to adapt
MCSs to different situations across various business units, with different strategies or
operating in different regions of the world, adds to the complexity.

Adapted for Students using English as a Second Language Page 15 of 16

Moreover, the existence of the side effects is often difficult to detect. For example, a failure to
make the measurement processes more robust in a results-accountability control system or
action-accountability control system only offers the opportunity for data manipulation.
Actual manipulation may not occur until an employee has a personal need for more money;
poor performance creates additional pressure to perform; there is a lower chance of being
detected or caught; and/or leadership creates a motivation to manipulate.
That said, the better organizations can alleviate both the opportunity and motivation for
undesired behaviors, the more likely their control systems will have predominantly desired
effects and, hence, lower costs.
Even costs can have hidden or indirect benefits. For example, managers in diversified or
multi- national corporations are able to learn from potentially desirable practices used in their
various businesses or foreign countries. Those practices are known by employees in their
entities, and some of those practices can be readily adapted across other entities. Firms that
grow by acquisition learn from the management systems, including MCSs, being used in the
organizations they acquire. When firms grow by acquisition, they are likely to have to use, at
least for a period of time, several variations of MCSs. The MCS variations may persist if they
are superior for controlling the acquired businesses, even though it can be costly to maintain
multiple sets of MCSs.

Control types and possible harmful side effects

Behavioral Games- Operating Negative

Type of control displacement manship delays attitudes
Results controls
Results accountability x x x
Action controls
Behavioral constraints x x
Preaction reviews x x
Action accountability x x x
Redundancy x
Personnel/cultural controls
Selection and placement x
Training x
Provision of necessary resources
Creation of a strong organizational culture x
Group-based rewards x

Source: K. A. Merchant, Modern Management Control Systems: Text and Cases

(Upper Saddle River, NJ: Prentice Hall, 1998), p. 224.

Management Control Systems - Performance Measurement, Evaluation and Incentives -

Kenneth A. Merchant, Wim A. Van der Stede, - Fourth Edition - Pearson Education Limited,
2012, 2017.

Adapted for Students using English as a Second Language Page 16 of 16