Fundamentals of Cost Accounting 3rd Edition by William N. Lanen, Shannon W. Anderson, Michael Maher

Exercise 24

Divisional Performance Measurement: Behavioral Issues

Paulista Corporation’s division managers have been expressing growing dissatisfaction with the methods the organization uses to measure division performance. Division operations are evaluated every quarter by comparing them with a budget prepared during the prior year. Division managers claim that many factors that are completely out of their control are included in this comparison, resulting in an unfair and misleading performance evaluation.

The managers have been particularly critical of the process used to establish budgets. The annual budget, stated by quarters, is prepared six months prior to the beginning of the operating year. Pressure by top management to reflect increased earnings has often caused divisional managers to overstate revenues and/or understate expenses. In addition, after the budget is established, divisions must “live with it.” Frequently, the budgets that top management has supplied to the divisions have not recognized external factors such as the state of the economy, changes in consumer preferences, and actions of competitors. The credibility of the performance review is damaged when the budget cannot be adjusted to incorporate these changes.

Recognizing these problems, top management has agreed to establish a committee to review the situation and to make recommendations for a new performance evaluation system. The committee consists of each division manager, the corporate controller, and the executive vice president. At the first meeting, one division manager outlined an achievement of objectives system (AOS). This performance evaluation system evaluates division managers according to three criteria:

•         Doing better than last year. Various measures are compared to the same measures for the prior year.

•         Planning realistically. Actual performance for the current year is compared to realistic plans and/or goals.

•         Managing current assets. Various measures are used to evaluate division management’s achievements and reactions to changing business and economic conditions.

One division manager believes that this system would overcome many of the inconsistencies of the current system because divisions could be evaluated from three different viewpoints. In addition, managers would have the opportunity to show how they would react and account for changes in uncontrollable external factors.

Another manager cautions that the success of a new performance evaluation system will be limited unless it has top management’s complete support.

Required

a. Explain whether the proposed AOS would be an improvement over the evaluation system of division performance currently used by Paulista Corporation.

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b. Develop specific performance measures for each of the three criteria in the proposed AOS that could be used to evaluate division managers.

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c. Discuss the motivational and behavioral aspects of the proposed performance system. Also recommend specific programs that could be instituted to promote morale and give incentives to divisional management.

Step 1 of 4

Management control system

Management control system is needed to manage the complications arising out of decentralization like dysfunctional decision making. Owners of the organization use structure and procedures of management control system to influence the actions of its managers and other employees to ensure smooth implementation of organizational strategies. Management controls system comprises of three elements such as delegation fo decision making authorities, evaluation of performance and measurement systems and finally awarding compensation and rewards for performance.

Compensation system

Compensation system are made effective and attractive for managers in order to motivate for them for the best performance and achieve organizational objectives. Contingent compensation is part of compensation system where part of remuneration is based on performance. Paying commission to sales person based on sales revenue is part of compensation system that motivates sales teams to deliver their best, which eventually helps to achieve organizational objectives.

Contingent compensation may result in dysfunctional results also. Sales managers may take some decisions to meet their individual goals, that are not in the interest of organization. For example, sale managers may make false commitments or mislead customers about the benefits of sales schemes so that they can meet their sales targets.