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Profit

$1,000,000

$1,000,000

$1,000,000

FIGURE 16.4
Profit model for a service business.

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S E R V I C E B U S I N E S S E S

Service Line

Standard

Basic

Premier

Sales price

$90.00

$67.50

$135.00

Revenue-driven expenses

$7.65

$2.70

$10.12

Unit-driven expenses

$6.50

$5.00

$8.75

Unit margin

$75.85

$59.80

$116.13

Contribution margin target

$8,500,000

$10,050,000

$6,500,000

Required sales volume

112,063

168,060

55,974

Present sales volume

100,000

150,000

50,000

Sales volume increase needed

12,063

18,060

5,974

FIGURE 16.5
Sales volumes needed at 10 percent lower sales prices.

decrease, basic = 14,555 units decrease, and premier = 4,822

units decrease.) Whether a service business would willingly sacrifice sales volume and market share in order to increase its sales prices is another matter.

s

END POINT

In most ways, the financial statements of service businesses are not all that different from those of product companies (though there are some differences, of course). In a service business income statement, there is no cost-of-goods-sold expense or gross margin. In a service business balance sheet, there are no inventories or accounts payable for inventories.

Having said this, a service business may sell incidental products with its services (popcorn and candy at a movie theater, for example) and therefore report a relatively small amount of inventories. Some service businesses are very capital-intensive (e.g., transportation companies, telephone companies, and gas and electricity utilities). Other service companies need relatively little in the way of long-term operating assets (e.g., CPAs and law firms).

The tools of financial analysis are essentially the same for both product and service businesses. Naturally the models and tools of analysis have to be adapted to fit the characteristics of each business. The chapter demonstrates techniques of profit analysis for service businesses. The profit consequences
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for a change in sales volume versus a change in sales price for service businesses are not nearly as divergent as those of product businesses. Sales price improvements have an edge over sales volume improvements for both types of businesses, but the advantage is not nearly so pronounced for service businesses.

I should mention in closing that the ratios used for interpreting profit performance and financial condition (Chapter 4) and the techniques for analyzing capital investments (Chapters 14 and 15) apply with equal force to service businesses and product businesses.

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C H A P T E R 17

1

Management Control

MManagement decisions constitute a plan of action for accomplishing a business’s objectives. Establishing the objectives for the period may be done through a formal budgeting process or without a budget. In either case, actually achieving the objectives for the period requires management control. In the broadest sense,
management control
refers to everything managers do in moving the business toward its objectives. Decisions start things in motion; control brings things to a successful conclusion. Good decisions with bad control can turn out as disastrously as making bad decisions in the first place. Good tools for making management decisions should be complemented by good tools for management control.

Previous chapters concentrate on models of profit, cash flow, and capital investment that are useful in decision-making analysis. This chapter shifts attention to management control and explores how managers keep a steady hand on the helm during the business’s financial voyage, often across troubled waters. This chapter also presents a brief overview of business budgeting. This short summary on budgeting is not an exhaustive treatise on the topic, of course.

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FOLLOW-THROUGH ON DECISIONS

Management control is both preventive and positive in nature.

Managers have to prevent, or at least minimize, wrong things from happening. Murphy’s Law is all too true; if something can go wrong, it will. Equally important, managers have to make sure right things are happening and happening on time.

Managers shouldn’t simply react to problems; they should be proactive and push things along in the right direction. Man-

agement control is characterized not just by the absence of problems, but also by the presence of actions to achieve the goals and objectives of the business.

One of the best definitions of the management control process that I’ve heard was by a former student. I challenged the students in the class to give me a very good but very con-

cise description of management control—one that captured the essence of management control in very few words. One student answered in two words: “Watching everything.” This pithy comment captures a great deal of what management control is all about.

Management theorists include control in their

conceptual scheme of the functions of managers,

although there’s no consensus regarding the exact meaning of
control.
Most definitions of
management control
emphasize the need for
feedback information
on actual performance that TEAMFLY

is compared against goals and objectives for the purpose of detecting deviations and variances. Based on the feedback information, managers take corrective action to bring per-

formance back on course.

Management control is an information-dependent process, that’s for sure. Managers need actual performance informa-

tion reported to them on a timely basis. In short, feedback information is the main ingredient for management control.

And managers need this information quickly. Information received too late can result in costly delays before problems are corrected.

MANAGEMENT CONTROL INFORMATION

In general, management control information can be classified as one of three types:

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Team-Fly®

M A N A G E M E N T C O N T R O L

1.
Regular periodic comprehensive coverage reports
(e.g., financial statements to managers on the profit performance, cash flows, financial condition of the business as a whole and major segments of the business)

2.
Regular periodic limited-scope reports
that focus on critical factors (e.g., bad-debt write-offs, inventory write-downs, sales returns, employee absenteeism, quality inspection reports, productivity reports, new customers) 3.
Ad hoc reports
triggered by specific problems that have arisen unexpectedly, which are needed in addition to regular control reports

Feedback information divides naturally into either good news or bad news. Good news is when actual performance is going according to plan or better than plan. Management’s job is to keep things moving in this direction. Management control information usually reveals bad news as well—problems that have come up and unsatisfactory performance areas that need attention.

Managers draw on a very broad range of information sources to keep on top of things and to exercise control. Managers monitor customer satisfaction, employee absenteeism and morale, production schedules, quality control inspection results, and so on. Managers listen to customers’ complaints, shop the competition, and may even decide that industrial intelligence and espionage are necessary to get information about competitors. The accounting system of a business is one of the most important sources of control information.

Managers are concerned with problems that directly impact the financial performance of the business, of course—such as sales quotas not being met, sales prices discounted lower than predicted, product costs higher than expected, expenses running over budget, and cash flow running slower than planned. Or perhaps sales are over quota, sales prices are higher than predicted, and product costs are lower than expected. Even when things are moving along very close to plan, managers need control reports to inform them of conformity with the plan.

Control reports should be designed to fit the specific areas of authority and responsibility of individual managers. The purchasing (procurement) manager gets control
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reports on inventory and suppliers; the credit manager gets control reports on accounts receivable and customers’ payment histories; the sales manager gets control reports on sales by product categories and salespersons, and so on.

Periodic control reports are rich in detail. For example, the monthly sales report for a territory may include breakdowns on hundreds and perhaps more than a thousand different products and customers. Moving up in the organization to a brand manager or a division manager, for example, the span of management authority and responsibility becomes broader and broader. At the top level (president or chief executive officer), the span of authority and responsibility encompasses the whole business. At the higher rungs on the organizational lad-der, managers need control information in the form of comprehensive financial and other reports.

Financial statements for management control are much more detailed and are supplemented by many supporting schedules and analyses compared with the profit and cash flow models explained in earlier chapters, which are used primarily for decision-making analysis. For instance, management control financial reports include detailed schedules of customers’ receivables that are past due, products that have been held in inventory too long, lists of products that have unusually high rates of return from customers (probably indicating product defects), particular expenses that are out of control relative to the previous period or the goals for the current period, and so on. The profit and cash flow models illustrated in earlier chapters are like executive summaries compared with the enormous amount of detail in management control reports.

In addition to comprehensive control reports, a manager may select one or several specific factors, or key items, for special attention. I read about an example of this approach a couple of years ago. During a cost-cutting drive, the chief executive of a business asked for a daily count on the number of company employees. He was told he couldn’t get it. Some data kept by divisions were difficult to gather together in one place. Some were in a payroll database accessible only to programmers.

But the CEO persisted, and now the data are at his fingertips whenever he wants them: A specially designed executive
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M A N A G E M E N T C O N T R O L

information system links personnel data directly to a personal computer in his office. “Management knows I’m watching the count very closely,” he said. “Believe me, they don’t add staff carelessly.”

It’s a good idea to identify a few relatively critical success factors and keep a close watch on them. Knowing what these factors are is one secret of good management. Product quality is almost always one such key success factor. Customer loyalty is another.

By their very nature, management control reports are confidential and are not discussed outside the company. Management control reports contain very sensitive information; these reports disclose the “mistakes” of decisions that went wrong.

Often, unexpected and unpredictable developments upset the apple cart of good decisions. Some degree of inherent uncertainty surrounds all business decisions, of course. Nevertheless, management control reports do have a strong element of passing judgment on managers’ decisions and their ability to make good predictions.

INTERNAL ACCOUNTING CONTROLS

A business relies heavily on its accounting system to supply essential information for management control. The reliability of accounting information depends heavily on specially designed procedures called
internal accounting
controls
and how well these controls are working in actual practice.

Forms and Procedures

Specific forms are required to carry out the activities of the business, and certain established procedures must be followed. One fundamental purpose of these forms and procedures is to eliminate (or at least minimize) data processing errors in capturing, processing, storing, retrieving, and reporting the large amount of information needed to operate a business.

Forms and procedures are not too popular, but without them an organization couldn’t function. Without well-designed forms and clear-cut procedures for doing things, an organization
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couldn’t function very well, if at all. On the other side of the coin, there’s a danger that filling out the forms becomes per-functory and careless, and some employees may bypass them or take shortcuts instead of faithfully following official procedures.

Internal accounting controls also are instituted for another DANGER!

extremely important reason—to protect against theft and fraud by employees, suppliers, customers, and managers themselves. Unfortunately, my father-in-law was right. He told me many years ago that, based on his experience,

“There’s a little bit of larceny in everyone’s heart.” He could have added that there’s a lot of larceny in the hearts of a few.

It’s an unpleasant fact of business life that some customers will shoplift, some vendors and suppliers will overcharge or short-count on deliveries, some employees will embezzle or steal assets, and some managers will commit fraud against the business or take personal advantage of their position of authority. Newspapers and the financial press report stories of employee and management fraud with alarming frequency.