The Controllability Issue

Question 1

What is the controllability principle?

Answer 1

• Managers of responsibility centres should only be held accountable and be rewarded for financial performance metrics which they can control (or at least influence).
• The controllability principle is closely associated with the notion of responsibility accounting, but also applies to any performance evaluation and incentive scheme.
• Assumes perfect matching of financial responsibilities and decentralization.
• Numerous studies show that many organizations do not apply the controllability principle (by design or default).

Question 2

Why do organizations fail to implement the controllability principle?

Answer 2

• Group based reward systems (profit sharing schemes) in order to avoid means end inversion and silo thinking. Beneficial in order to ensure overall goal congruence deliberate breach.
• Deformed reasons?

Question 3

How can the controllability principle be applied?

Answer 3

• Ex ante methods (before the event)(protect managers from uncontrollable events):

1. Buy insurance – protecting against uncontrollable events such as floods, fires and damages. (Acts of nature/ Natural disasters). Problem is that some risks cannot insure or high insurance premiums cost benefit trade off.
2. Ensuring responsibility centres and financial targets mainly include controllable items are matched with adequate decentralization.

• Ex post methods (after the event) (results with targets)

1. Variance analysis
2. Flexible performance standards, revised after set during accounting period if they are uncontrollable variances.
3. Relative performance evaluation (rankings and league tables): assumes similar responsibility centres face the same types of risk, in built controllability factors as comparison leaders to residual. Automatically neutralised due to level playing field. Magnitude is assumed to be the same, is it?
4. Subjective adjustments in performance evaluation. Major one off events, hurricane in one area! One off very subjective adjustments to avoid penalties for something which managers cannot control.

Question 4

How is variance analysis to filter out uncontrollable?

Answer 4

• Compare actual and planned results for the focal variance.
• Multiply by the planned results
• Gradually replace the planned with the actual results in multiplier as variances are isolated
• Determine which variance is controllable/uncontrollable and filter out the uncontrollable ones (judgement).
• Industry volume variance, size of company 0.5% market share, not something the company has total control over (uncontrollable).
• Market share, you want the manager to try and influence through sales, keep an eye on competitors, (controllable, partly)
• Price variance, price taker/price setter? Monopoly – perfect competition, raw materials. Some influence on price (controllable, partly)
• Exchange rate, exchange rate exposure uncontrollable but could be hedged?

Question 5

Explain the ideology behind completeness?

Answer 5

• Level of aggregation. Complete measures used at a high level such as SBU’s.
• Middle level, profit is used. Lower level, revenues costs and variances.

Question 6

What is the controllability/completeness trade off?

Answer 6

• Measures are complete if they capture all relevant financial consequences to a responsibility centre.
• There is a generally negative relationship between completeness and controllability.
• Incomplete measures may be controllable but imply a risk of sub-optimization (employee behaviour not aligned to maximising financial performance and shareholder wealth). Managers focus on something good for their unit but not for the organisation as a whole.
• For example – maximizing sales vs maximising sales calls in a revenue centre. Which is most complete? What type of behaviours does each of these measures stimulate? Sub optimal?
• (Simons 1995) decision tree

Question 7

Benefits of openly disregarding the controllability principle?

Answer 7

• The principle is sometimes deliberately ignored. Merchant and Van der Stede discuss 3.

1. Attention (external) direction to critical, but only controllable performance aspects. Sales might not be completely controllable, but we don’t want managers to forget about what they can do in order to influence sales in the longer term. Try to at least have knowledge of competitors. Engage in some environmental scanning.
2. Improved communications and coordination across responsibility centres (internal). Draw manager’s attention to whole companies’ profits. The disregarding of the controllability principle allows people to talk, to overcome shared problems TEAMS. Gets rid of the false sense of security and Silo thinking.
3. Risk sharing argument, through linking of rewards to uncontrollable performance. Breaching controllability is able to share the pain with lower levels not just senior managers. Risk adverse may increase and slack may increase. Double edged sword.

Question 8

What are the drawbacks of disregarding the controllability principle?

Answer 8

• If we assume that most managers and employees are risk adverse, flouting the controllability principle may enhance:
• The cost of additional compensation/rewards to make managers accept risk. “Out of pocket costs” if you hold people accountable for controllable you can pay them for what they did, no windfall gains.
• Cost of reduced motivation and staff turnover
• Avoidance of risky, but potentially valuable investments, Myopia!
• Gaming (e.g. creation of slack as protection of uncontrollable)
• Excuse culture: time consuming discussions of uncontrollable variances in performance evaluation. No excuses for those metrics which can be influenced.

Question 9

Reasons for a lack of controllability: Economics based view

Answer 9

• Economic and Competitive Factors: e.g. macro-economic fluctuations, not even CEO can do anything about it, exchange rate exposure. Competitor’s actions positioning in external markets less controllable further down.
• Acts of nature: natural disasters, riots, wars etc. political risks, country risks.
• Horizontal Interdependencies: between responsibility centres, especially when couples with transfer pricing systems that give little discretion to buying and selling units (e.g. administered transfer prices)
• Hierarchical interdependencies: how can someone control something when they have little decision making power? Ad-hoc interventions roll out cost cutting programme. Treating adults like children, taking power away.

Question 10

Reasons for lack of controllability. Psychology view

Answer 10

• Risk appetite: the lesser managers risk adversity, the lesser the need for controllability. (uncontrollable = risk)
• Ambiguity: higher tolerance to ambiguity /uncertainty people are better able to cope, the lesser the need for controllability.
• Fairness: the greater need for fairness (justice), the greater need for controllability. Underlying sources of uncertainty, internal sources - Horizontal and hierarchical interdependence, greater need for controllability more feelings of unfairness. People accept to be held accountable for uncontrollable factors which are external, affects everyone. (Giraud et al 2008)

Question 11

Should we care about psychology when we design a performance contract?

Answer 11

• Hard to do for individuals, rarely done if at all.
• Is this part of personnel controls? Select people able to deal with risk. Homogenous? Training?
• The financial crisis saw many people employed who gambled and the incentive contracts enforced this through annual bonuses with no penalties. RBS! If you don’t make individual adjustments we still need to think about psychological issues to match right type of people with contracts. You don’t want either extreme, risky or risk adverse. Let’s not forget about them!

Question 12

Should we care about sociology when we design a performance contract?

Answer 12

• In some industries and societal sectors, controllability of financial results is reduced by political and institutional factors.
• Political regulation e.g. labours regulations, regulated salary structures, health and safety regulations. Uncontrollable because apply to whole sector.
• Institutional mind-sets e.g. professional values that is alien to financial controls. Doctors / Nurse – adverse to financial controllability, medical professionals. Resistance and pushback.
• Professional power struggles e.g. conflicts between professional groups in charge of independent tasks. Each hospital two budgets, 1 budget nursing head nurse complete budgetary for whole wards head physician. Cost of overtime
• Decentralisation weakly related to application of the controllability principle and main affecting reliance on ex post, subjective adjustments.
• Senior management making deliberate efforts to implement the controllability principle in internal cost allocations but not for external reporting purposes.
• What explains this? Possibilities of decentralisation constrained by external regulation and power struggles. Subjective adjustments to protect departmental managers from very arbitrary cost allocations undertaken to justify budgetary over-spending to external bodies.

Question 13

Concluding thoughts about controllability?

Answer 13

• Decisions about whether to adhere to or flout the controllability principle involve making important cost benefit trade-offs while factoring in contextual constraints
• Many contextual constraints are beyond the control of even top management
• Perfect controllability is hardly ever possible
• After all, the job of a manager is to try at least to influence financial results.

Question 14

Giraud et al 2008

Answer 14

Controllability principle
Findings show a lot of managers would rather adhere to the influencability principle - think about span of control vs span of influence
Managers want the principle applied for internal factors but not external factors - supported by merchant 1898
Internal factors are other employees decisions - relates to fairness