Operative Controlling Lecture – Winter term 2012/13

Prof. Dr. Carsten Homburg

Prof. Dr. Carsten Homburg

2 Lecture Operative Controlling - Winter term 2012/13 Prof. Dr. Carsten Homburg

Organizational – Schedule

Lecture: Tuesday, 8:00 - 9:30 a.m. in Lecture hall XXIII Wednesday, 8:00 - 9:30 a.m. in Lecture hall XXIII Start: 09.10.2012 Ending: expected 27.11.2012 Exercise: Thursday 4:00 - 5:30 p.m. in Lecture hall XXV Start: 11.10.2012 Ending: expected 29.11.2012 Exam: Thursday, 20.12.2012, 12:15 – 13:15, in Aula 1

3 Prof. Dr. Carsten Homburg

Outline (I)

1. Fundamentals of Controlling

1.1 Controlling in practice

1.2 Controlling – Theoretical concepts

1.3 Interdependencies as the starting point of Controlling

1.4 Summary

2. Theory, concepts and methods for the foundation of Controlling

2.1 Cost accounting

2.2 Variance analysis and cost control

2.3 Investment analysis

2.4 Linear programming using the example of production planning

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Outline (II)

2.5 Dynamic programming (decision tree analysis)

2.6 The concept of information value

2.7 Agency – Theory

3. Controlling instruments

3.1 Key Performance Indicators

3.2 Budgets and targets

3.3 Transfer pricing

3.4 Overhead cost allocation

3.5 Incentives

4. Conclusion

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1.1 Controlling in practice

The Controller-model (formulated by the International Group of Controlling (IGC))

Controllers design and guide the management process of defining goals, planning and steering and therefore share responsibility with the management for achieving the goals. That means: Controllers ensure the transparency of business results, finance,

processes and strategy and thus contribute to higher economic effectiveness.

Controller co-ordinate sub-targets and the related plans in a holistic way

and organize a reporting-system which is future-oriented and covers the enterprise as a whole.

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Controllers moderate and design the management process of defining goals, planning and steering so that every decision maker can act in accordance with agreed goals. Controllers provide the necessary service of business-oriented data and information support. Controllers develop and maintain controlling systems.

The IGC ( International Group of Controlling ) is a forum for sharing expertise and the coordination and development of controlling concepts and terminology. The IGC developed for example the Basis for the certification of controllers. Source: International Group of Controlling URL :http://www.igc-controlling.org/DE/_leitbild/leitbild.php

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Controllers – Working hand in hand with the management

MANAGER CONTROLLER

Responsible for results as

• Cost Center • Profit Center

and for

Strategic success positions

Responsible for transparency

• Information-, • Decision-making-, • and coordination service

as well as Planning Moderator

C o

n t

r o l

l i n

g

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1.1 Controlling in practice

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1.1 Controlling in practice

Controlling and Controller

The entrepreneur is the responsible captain of the company, who sets the destination. The controller is the navigator, who has to assure that these goals will be certainly reached and that a company is now and in future efficient and profitable.

Source: Focus online (translated from German)

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Command and control

As a first navigator– below the command bridge – the controller is always eager, that all operations within the company can be measured and can be checked. A system of Key Performance Indicators (KPI) supports the Controller to keep in track and make processes more transparent to outsiders. If deviations exist, the Controller has to counteract or present alternatives, how desired results still can be achieved.

Source: o.V. (2000): „Der Controller: Vom Lotsen zum internen Berater“, in WISU 4/00, S.426-427 (translated from German)

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Planning and decision preparation

On the basis of his precise knowledge of internal accounting, the controller makes proposals to the management, e.g. how costs can be reduced or processes can be optimized. Thus, he is also an important guide at upcoming acquisitions of new business units which have to be evaluated. In practice, the controller usually works closely with the management. The more the planning element of his work prevails, the more he will be involved in the functions of the management.

Source: o.V. (2000): „Der Controller: Vom Lotsen zum internen Berater“, in WISU 4/00, S.426-427 (translated from German)

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Planning and decision preparation

Senior controllers often deal with issues such as : • Which key performance indicators should be used in accounting? • Should a full cost or contribution margin analysis be made? • Which portfolio method should be used for strategic planning? • Which objectives should guide the division manager: e.g. operating income, cash flow or shareholder value?

Source: o.V. (2000): „Der Controller: Vom Lotsen zum internen Berater“, in WISU 4/00, S.426-427 (translated from German)

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Profession in transition – from a navigator to an internal consultant

The prophecy is, that the Controller of the future has to orient himself more on soft features of his surroundings than on hard facts. His traditional function, the planning and monitoring of operational processes with the help of indicators, moves more and more into the background and is replaced by a more general control of the enterprise. The Controller of the future has to turn to a greater degree to service and consulting activities, where it matters to impart his existing knowledge. This converts the „Lord of the numbers“ into an internal consultant, who understands the need to satisfy to his customers.

Source: o.V. (2000): „Der Controller: Vom Lotsen zum internen Berater“, in WISU 4/00, S.426-427 (translated from German)

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1.2 Controlling – Conceptions of theory

1.2.1 Definition approaches • Ensuring adequate rationality of the management (Weber, Koblenz) • Result-oriented coordination between planning, control and information provision (Horváth, Stuttgart) • Coordination of the overall management system (Küpper, Munich)

Coordination- oriented approaches

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1.2.2 The approach of Küpper

Management system

HR management

Organi- zation

Information system Planning Control

operational system

Procurement Production Sales

goal-oriented steering securing

Coor- dination

by Con-

trolling

Dis- positive factor

(Guten- berg)

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1.2 Controlling – Conceptions of theory

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1.2 Controlling – Conceptions of theory

The approach of Küpper • Controlling to supply information to single management functions (1) • Controlling has interface function within the management process (2) • Example to (1):

- Target/actual comparison within control - Provision of marginal cost within planning

• Example to (2): - Connection of a target/actual comparison (control) with incentive

payments (HR management) - Connection of a decentralization decision (organization) with transfer

pricing (planning, HR management)

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1.2.3 Perspective in Major / Minor Controlling

• Criticism of Küpper’s view: too comprehensive, almost general business administration character

• Alternative: Providing mainly monetary information for internal coordination of a company with respect to a comprehensive, mostly monetary overall objective

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Perspective in Major / Minor Controlling

• Controlling ≈ (Modern) internal accounting (Ewert/Wagenhofer) ≈ Management accounting (Managerial accounting vs. financial accounting) ⇒ Controlling as the internal financial steering tool of the company

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Perspective in Major / Minor Controlling “....management accounting information ... enhances decision making, guides strategy development and evaluates existing strategies, and focuses efforts related to improving organizational performance and to evaluate the contribution and performance of organizational units and members” (Kaplan/Atkinson (1998), p. 12.)

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Perspective in Major / Minor Controlling

• Controlling ≠ Control

• However: Control is an important part of controlling

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1.3 Interdependencies as the starting point of Controlling

Interdependencies

Hard interdependencies Soft interdependencies

independent from decision maker dependent on decision maker (cannot be analyzed independent of the people who take over tasks)

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1.3.1 Hard interdependencies

1.3.1.1 Composite restriction

• Decision space of an area depends on decisions of other areas Example 1: Purchasing department only buys a certain quantity of a scarce resource Optimal production program of the production area is in general influenced

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Composite restriction Example 1 (formal): x=(x1,...,xJ)T : Production program

d=(d1,...,dJ) : Contribution margins per unit V = ( V1,...,VI )T : Available resources besides raw material

V=(vij) : Matrix of consumption coefficients

RL : Available quantity of raw material in stock (before purchasing)

RE : Purchased quantity of raw material

r=(r1,...,rJ) : Consumption coefficients regarding raw material

x = ( x1,...,xJ )T : Sales limits

_ _ _

_ _ _

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Decision model:

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Composite restriction Example 2: Two production areas have common resources Partly optimal production programs are in general not feasible or not overall optimal

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Area 1 Area 2

Example 2 (formal):

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1 K K+1 Jx = (x ,..., x , x ,..., x ) : P1-PK to area 1P(K+1) - PJ to area 2 (J > K)

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Example 2 (continued): Overall model:

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1.3.1.2 Composite success

The effects of actions of an area on the overall success depend on the actions of another area.

Example 1: Manufacturing process that is to optimize over several areas

Overall success requires successful improvement in all three production areas

MP 1 MP 2 MP 3

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Composite success Example 2: Factor costs, if factor is needed in several areas and cost curve is not linear

⇒ Marginal resource costs of an area can only be given according of factor inputs of other areas

Procure- ment costs

Factor amount

Overhead costs

Direct costs

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Composite success Example 3: Substitutive or complementary relationship between products from two areas xi : Sales volumes pi : Unit prices Ki(xi) = Fi + kixi : Full costs xj = xj(pi,pj) or xj = xj(pj,xi) for i,j = 1,2 and i j Þ P1, P2 substitutive or complementary products

≠

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Composite success Isolated optimization:

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Overall optimization with correct coverage of the composite success

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1.3 Interdependencies as the starting point of Controlling

>2 2 2 2 2i.e. p * K '(x *) covers the (isolated) marginal cost K '(x *)

( )∂ ∂∂= + ∆ = ∆ = − ⋅

∂ ∂ ∂

− >

!1 2

2 2 21 1 1

2 2 2

G xGConsider 0, with p K '(x )p p p

Let p * K '(x *) 0

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Case 1)

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1.3 Interdependencies as the starting point of Controlling

Case 2)

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1.3 Interdependencies as the starting point of Controlling

Simultaneously optimizing:

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M

p2

p1

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Isolated optimization:(Substitution effect was only partly accounted for)

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Extension of the numerical exampleComplete neglection of substitution effects

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Example continued:

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1.3.1.3 Composite Evaluation The actions of areas cannot be evaluated independently, although the results of actions are independent. Example 1: Area A may perform investment (mA, sA) Area B may perform investment (mB, sB) mA, mB: Expected capital values sA, sB: Standard deviations Capital values are statistically independent

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s2

m

2Aσ

AµB

B'2Aσ

Aµ

Source: Laux/ Liermann, 2005, p. 193

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Composite Evalution: Example 2: As above, but other overall utility function

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1.3.1.4 Composite risk Stochastic dependencies between the results of areas, for example: I1, I2, I3 : three investment alternatives in three different areas s1, s2, s3 : three possible equally likely environmental states in t=1

Investment Alternatives Payout in t=0

Cash flows in t=1

s1 (1/3) s2 (1/3) s3 (1/3)

I1 50 100 300 -100

I2 30 50 20 50

I3 14 30 30 0

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• A proportionate implementation of individual projects is possible.

Liquidity constraint: There must be no negative payment in t=1.

• Note, it applies e.g.: Also could I2 in connection with I1 ensure liquidity in case of s3.

2 3 2 31 2 1 2P(I 50 I 0) P(I 50) P(I 0)3 3 3 9

= ∧ = = > = ⋅ = = ⋅ =

Determine the optimal allocation of an investment budget in the amount of 1100 MU, by maximizing the expected payoff in t=1.

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Solution:

• xi = Number of executions of investment alternative i

• Ai = Payout for xi in time t=0

• A risk-neutral decision maker chooses the alternative with the highest expected return

Investment alternative Ii

Expected value (EWi) for the returns of investment alternative Payout for xi=1 in t=0

Expected returns (EVi) per invested MU

I1

I2

I3

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Solution continued: • All investment options are profitable (EVi>1) • Without liquidity restriction, overall investment budget would be invested in I1 (100% expected returns), note in state s3 negative payment for I1

• Because of the liquidity restriction one gets two investment alternatives: Mix of investment 1 and 2 (investment 2 has a positive return on investment and is therefore preferable to cash management) or invest in investment 3 • Optimal mix is achieved, if the investment program in s3 has a backflow of 0, i.e. x2=2x1 or A2/30 = 2·A1/50 Û A2=6/5 · A1

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Solution continued:

• The budget will be fully used in the optimum, thus applies:

• Thus for the (provisional) optimal investment program x1=500/50=10 and x2=600/30=20 • Expected returns through the investment program

EV = 10·EV1 + 20·EV2 = 10·100 + 20·40 = 1,800 per invested MU: EV = 1.800/1.100 = 18/11 = 1.6364

+ =

⇔ + ⋅ =

⇔ ⋅ =

⇔ = ⇒ = ⋅ =

1 2

1 1

1

1 2 1

A A 1,1006A A 1,1005

11 A 1,1005

6A 500 A A 6005

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Solution continued:

• Also check if I3 is not more attractive than the existing investment program of I1 and I2 : EV = 1.6364 > 1.4286 = EV3

thus, the investment program I1 and I2 is preferable compared to the exclusive investment

in I3.

• Solved LP: ⋅ + ⋅ + ⋅

⋅ + ⋅ + ⋅ ≤

≥ ⋅

≥

1 2 3

1 2 3

2 1

1,2,3

max100 x 40 x 20 xsubject to50 x 30 x 14 x 1,100x 2 xx 0

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1.3.2 Soft interdependencies Soft interdependencies: Superposition of hard interdependencies with problems of behavioral control.

Interdependencies

Soft interdependencies Information asymmetry Bounded rationality Opportunistic behavior Discretionary behavior

Hard interdependencies Composite restriction Composite success Composite evalution Composite risk

- - - - - - - -

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1.3.2.1 Information asymmetry Problem: Decision makers have different, possibly conflicting, information. Example 1: In case of a composite evaluation of two divisions (areas) because of substitution effects (see example 3 in 1.3.1.2) the division managers expect different sales functions.

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Information asymmetry Example 2: Different assumptions about the capacity of a shared resource (see example 2: Composite restriction in 1.3.1.1) Example 3: Different (subjective) probabilities with respect to future environmental states (see example 1: Composite risk in 1.3.1.4)

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1.3.2.2 Bounded rationality Problem: Decision makers have only a limited capacity for information acquisition and processing Even in case of cooperative behavior information asymmetry can (in general) not be eliminated without (communication) costs. In general, not all uncertainties can be reduced due to prohibitive costs.

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1.3.2.3 Opportunistic and discretionary behavior Problem: Decision makers pursue (in certain circumstances) selfish goals and use non-controllable decisions (because of information costs) for individual utility maximization. Example 1: Division manager biases (deliberately) his costs Example 2: Unnecessarily high use of indirect areas at the expense of third party Exapmle 3: Biased forecasts in the budgeting process Example 4: Low labor input (effort)

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1.3.3 Intertemporal interdependencies Problem: Both hard as well as soft interdependencies can relate across several points in time. Example: Behavior in t=1,2, ... affects optimal decision in t=0. Decision in t=0 affects possible decisions in t=1,2,...

Selecting and purchasing a manufacturing facility

Utilization of the manufacturing facility by other decision maker

End of useful life: the sale of manufacturing facility

t=0 t=1 t=2 T - - - - -

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Note: information level improves (in general) over time

Information

Time

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1.4 Summary

• Coordination-oriented perspective (broad agreement with the practical point of view) • Usually controlling provides monetary information • Underline overall objective • Interdependencies require coordination

(Types of interdependencies are in general not clear-cut)

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