Management Accounting
Chapter 5
Management Control
Systems
Types of Control
Responsibility Accounting
Variance Analysis
Performance Indicators
Management Control Systems
Types of Control
Types of Controls
Theoretical Background
“The private corporation or firm is simply one form of legal fiction which serves as
a nexus for contracting relationships and which is also characterized by the
existence of divisible residual claims on the assets and cash flows of the
organization which can generally be sold without permission of the other
contracting individuals.“
Jensen and Meckling (1976, p. 311)
© Prof. André Hoppe Management Accounting 4
Types of Controls
Theoretical Background
Shareholder
Management of the company
+ Manager
Quality of management
decision
Firm Value
© Prof. André Hoppe Management Accounting 5
Types of Controls
Theoretical Background
The existence of management control systems can be explained from an
agency theory perspective.
Agency conflicts arise in case of separation of ownership and control
= In decentralized companies owners/shareholders
(“principals”) have only a passive role in the direction
of the corporation. They delegate decision authority to
managers (employees) (“agents”). Very often, agents
have more local, specialized information to take sound
decisions.
BUT agents do not always act in line with the interests of the principles.
There is a divergence of interests.
→Need for the implementation of a management control system
(“monitoring cost”)
© Prof. André Hoppe Management Accounting 6
Types of Controls
Theoretical Background
© Prof. André Hoppe Management Accounting 7
Types of Controls
Causes of the need for control
Assumptions
▪ Individual utility maximization
▪ Bounded rationality
▪ Information asymmetry
▪ Opportunistic behavior
▪ Working burden
© Prof. André Hoppe Management Accounting 8
Types of Controls
Heese & Pérez-Cavazos (2020)
New York Chicago Chicago San Francisco
New York San Francisco
Travel-time reductions decrease the number of violations by 2 percent and penalties
by 23.4 percent
Treatment https://doi.org/10.2308/tar-2019-0068
Indicator variable that is set to 1 in the five years following the introduction of a new airline route that
reduces travel time by at least two hours, and 0 in the five years prior to its introduction.
© Prof. André Hoppe Management Accounting 9
Types of Controls
Heese, Pérez-Cavazos, and Peter (2022)
After a local newspaper closure, local facilities increase violations
by 1.1% and penalties by 15.2%
Treatment https://doi.org/10.1016/j.jfineco.2021.08.015
Indicator variable that is set to 1 in the three years following the closure of a local newspaper, and 0
in the three years prior to the closure-
© Prof. André Hoppe Management Accounting 10
Types of Controls
Management Control Systems
Management Control is defined as “… the process by which managers
ensure that resources are obtained and used effectively and efficiently in the
accomplishment of the organization’s objectives.” Anthony (1965)
© Prof. André Hoppe Management Accounting 11
Types of Controls
Controls & Incentives
© Prof. André Hoppe Management Accounting 12
Types of Controls New / Changed
Management Control Systems – Definition
Social / Cultural Control
▪ Recruitment:
select staff with the appropriate qualifications and fitting
the organizational culture and the personalities already present.
▪ Training & job design
▪ Social control, control by peers
▪ Promotion of shared norms/values (value congruence):
the commitment of organizational members is often facilitated
through a shared belief in the purpose of the organization (and not
merely through financial control and rewarding). Intrinsic motivation.
© Prof. André Hoppe Management Accounting 13
Types of Controls New / Changed
Management Control Systems – Definition
Behavioral / Action Control
▪ Direct supervision
▪ Codes of conduct, work rules & procedures, job descriptions
▪ Behavioral contraints:
▪ Physical constraints: computer passwords, keys
▪ Administrative constraints:
▪ Caps on the amounts of capital expenditure that managers may authorize
▪ Required approval of action plans/expenditures before a course of action can be
undertaken
▪ Segregation of duties (the concept of using two or more employees to complete a
task)
© Prof. André Hoppe Management Accounting 14
Types of Controls New / Changed
Management Control Systems – Definition
Output / Result Control
▪ Assigning responsibilities to subordinates
▪ Communicating their objectives and targets, and their rewards if they achieve the
targets
▪ Measuring their performance and comparing that measurement with the pre-set
targets
▪ Rewarding them if they reached the targets vs. ‘punishing’ them if not
▪ Providing feedback and, if necessary, taking corrective actions
© Prof. André Hoppe Management Accounting 15
Types of Controls
(Dis)advantages of types of control
Social/cultural control
▪ Quite loose
▪ No harmful side effects
▪ May be entirely effective in small firms without complementing them with
other controls
Action control
▪ Most effective type of control: happens during task execution
▪ Limitation: only effective if
▪ one knows which actions are desirable and which not
▪ one can assure that desirable behavior takes place (and undesirable behavior does not):
‘action tracking’
© Prof. André Hoppe Management Accounting 16
Types of Controls
(Dis)advantages of types of control
Result control
Advantages:
▪ can be applied where knowledge of what actions are desirable is lacking
(no immediate control of actions, but the final results provide a
mechanism to indicate whether actions benefited the organization)
▪ does not restrict individual autonomy. Managers are free to decide how
they reach the target.
Disadvantages:
▪ Lack of goal congruence
▪ not all results can be measured effectively (e.g., social responsibility)
▪ difficulties in separating controllable and uncontrollable factors
▪ feedback control: errors are allowed to occur
© Prof. André Hoppe Management Accounting 17
Management Control Systems
Responsibility Accounting
Responsibility Accounting
Introduction
Standard costs analyzed by operations and products
Operation no. Total
Resp. and standard standard Actual
Center costs Products costs costs
No. (£) 100 101 102 103 104 105 106 (£)
A 1 20 120
B 2 30 90
C 3 40 120
D 4 50 200
Standard £ 110 £ 100 £ 90 £ 50 £ 60 £ 60 £ 80 530
product
costs
Drury (2012, p. 424)
© Prof. André Hoppe Management Accounting 19
Responsibility Accounting
Functional organizational structure
Chief Executive
Officer (IC)
Financial and
Production Marketing Purchasing R&D
adminstration
manager manager Manager Manager
manager
(CC) (RC) (CC) (CC)
(CC)
Other
funcional
manager
(CC)
IC = Investment center, CC = Cost center, RC = Revenue center
© Prof. André Hoppe Management Accounting 20
Responsibility Accounting
Divisionalized organizational structure
Chief Executive
Officer (IC)
Product X Product Y Product Z
divisional divisional divisional
manager (IC) manager (IC) manager (IC)
Other Other Other
funcional funcional funcional
manager manager manager
(CCs) (CCs) (CCs)
IC = Investment center, CC = Cost center, RC = Revenue center
© Prof. André Hoppe Management Accounting 21
Responsibility Accounting
Result control: Controllability principle
▪ Managers are only responsible and must only be evaluated on
the basis of the results that they effectively control.
▪ Factors that hinder controllability:
▪ internally: high levels of interdepartmental dependence,
transfer pricing
▪ externally: environmental volatility
© Prof. André Hoppe Management Accounting 22
Responsibility Accounting
Overview
Cost Revenue Profit Investment
center center center center
Manager has Costs Costs Costs
control over Revenues Revenues Revenues
Investments
Manager has Revenues Costs
NO control Investments Investments Investments
over
Performance Cost Sales Profit RoI
measures variances variances RI
EVA
© Prof. André Hoppe Management Accounting 23
Management Control Systems
Variance Analysis
Variance Analysis
Definition
“A variance is the difference between actual results and expected performance.”
Datar and Rajan (2018, p. 270)
“Standard costs are predetermined costs; they are target costs that should
be incurred under efficient operating conditions.”
Drury (2012, p. 423)
“Standard cost is the expected cost that is reasonably required to achieve a
given objective under specified conditions”
Zimmermann (2016, p. 555)
“The goal of variance analysis is for managers to understand why variances
arise, to learn, and to improve their firm’s future performance.”
Datar and Rajan (2018, p. 287)
© Prof. André Hoppe Management Accounting 25
Variance Analysis
Basics
Cost variances:
▪ discrepancies between actual and standard costs
▪ unfavorable (or negative) cost variance
▪ responsible manager spent more than allowed
▪ favorable (or positive) cost variance
▪ responsible manager spent less than allowed
▪ assigned to the responsible cost center (= cost object)
▪ serve as an evaluation measure
© Prof. André Hoppe Management Accounting 26
Variance Analysis
Determination of standard values
▪ Actual values of the past (time comparison)
▪ Average values (normalized values)
▪ Actual values of comparable companies
▪ Forecasted values
▪ Plan figures → Engineering Studies
(excludes past inefficiencies)
© Prof. André Hoppe Management Accounting 27
Variance Analysis
Interpreting Cost Variances
GOAL: evaluate the production manager who is responsible for keeping
production costs (DL, DM, and production OH) under control
VARIANCE
difference compared to what is should have
been, eg. +2000- it 2000 more than it should
have been
+ 2000
+1500
- 200
+3300
© Prof. André Hoppe Management Accounting 28
Variance Analysis
Interpreting Cost Variances
The relevant question is . . .
“Which part of the favorable deviation is due to the
lower activity level, and which part is the
consequence of good cost control?”
TO DO: eliminating the impact of the changed activity
level and isolating the impact of good/bad cost control.
HOW? Preparing a flexible budget at actual activity level
→ This budget takes budgeted or standard efficiencies
into account, but at actual activity level
© Prof. André Hoppe Management Accounting 29
Variance Analysis
Interpreting Cost Variances
© Prof. André Hoppe Management Accounting 30
Variance Analysis
Interpreting Cost Variances
© Prof. André Hoppe Management Accounting 31
Variance Analysis
Overview
Total Variance
Sales Variance Cost Variance
Sales Price Sales Quantity Variable Cost Fixed Cost
Variance Variance Variance Variance
Sales Mix Sales Volume Quantity Unused
Variance Variance Variance Capacity
Input Price
…
Variance
© Prof. André Hoppe Management Accounting 32
Variance Analysis
Cost Variances
Total Variance
Sales Variance Cost Variance
Sales Price Sales Quantity Variable Cost Fixed Cost
Variance Variance Variance Variance
Sales Mix Sales Volume Quantity Unused
Variance Variance Variance Capacity
Input Price
…
Variance
© Prof. André Hoppe Management Accounting 33
Variance Analysis
Cost Variances
Total Cost Variance
Material Cost Labour Cost Variable Overhead Fixed Cost
Variance Variance Cost Variance Variance
Material Price Wage Rate Wage Rate Input Price
Variance Variance Variance variances
Quantity (or usage
Material Usage Labour Efficiecy Labour Efficiecy
Variance Variance Variance or efficiency)
variances
© Prof. André Hoppe Management Accounting 34
Variance Analysis
Cost Variances
Total Production Cost Variance
Total direct material Total direct labor Total variable
Total fixed overhead
cost variance cost variance overhead varaince
expenditure variance
= budg. – act. DM C = budg. – act. DL C = budg. – act. OH C
= budgeted f. overhead
= (SQxSP)-(AQxAP) = (SQxSP)-(AQxAP) = (SQxSP)-(AQxAP)
– actual fixed overhead
= P var + Q var = P var + Q var = P var + Q var
Price variance Price variance Price variance
(SP - AP) * AQ (SP - AP) * AQ (SP - AP) * AQ
Quantity variance Quantity variance Quantity variance
(SQ - AQ) * SP (SQ - AQ) * SP (SQ - AQ) * SP
P = mateiral price/unit material P = hourly wage rate P = overhead rate per DLH
Q = amount of material used Q = # of labour hours worked Q = # of DLH, # of MH (the input on the basis of which overhead varies)
*SQ at acual activity
level cfr. flexible budget
© Prof. André Hoppe Management Accounting 35
Variance Analysis
Establishing cost standards
Direct material standards
▪ Quantity standards: bill of materials, engineering
studies, normal waste
▪ Standard prices: purchasing department
Direct labour standards
▪ Quantity standards: time calculations
▪ Standard prices: personnel department
Overhead standards
▪ Estimation of a variable overhead rate (e.g., in function
of DLH) on the basis of historical information/targets.
▪ E.g., standard variable overhead rate/DLH = $3
▪ For each DLH incurred, we expect $21 variable overhead.
© Prof. André Hoppe Management Accounting 36
Variance Analysis
Example 1: Material Variance
Standard costs Actual results
Direct materials Direct materials
• A: 2kg/unit at 10 € per kg • A: 19,000kg at 11 € per kg
• B: 1kg/unit at 15 € per kg • B: 10,100kg at 14 € per kg
Budgeted production equals 10,000 units Actual production equals 9,000 units
ACTUAL COSTS:
actual quantity x actual actual quantity x standard standard quantity for actual
price price output x standard price
A: 19,000 x 11 = 209,000 €* A: 19,000 x 10 = 190,000 € A: 2 x 9,000 x 10 = 180,000 €
B: 10,100 x 14 = 141,400 €* B: 10,100 x 15 = 151,500 € B: 1 x 9,000 x 15 = 135,000 €
Material Price Variance
Material Usage Variance
A: 19,000 € UF unfavourable
B: 10,100 € F A: 10,000 € UF
B: 16,500 € UF
A: 20,000 x 10 = 200,000 € Total Material Variance
B: 10,000 x 15 = 150,000 € A: 29,000 € A; B: 6,400 € A
© Prof. André Hoppe Management Accounting 37
Variance Analysis
Example 1: Labor Variance
Standard costs Actual results
Direct labor Direct labor
• 3 hours/unit at 9 € per hour • 28,500 hours at 9.60 € per hour
Budgeted production equals 10,000 units Actual production equals 9,000 units
ACTUAL COSTS:
actual hours x actual wage actual hours x standard standard hours for actual
rate wage rate output x standard wage
rate
28,500 x 9.60 = 273,600 €* 28,500 x 9 = 256,500 € 3 x 9,000 x 9 = 243,000 €
Wage Rate Variance
Labor Efficiency Variance
17,100 € UF
13,500 € UF
30,000 x 9 = 270,000 € Total Labor Variance
30,600 € UF
© Prof. André Hoppe Management Accounting 38
Variance Analysis
Example 2
Budgeted activity level: sales of 10,000 units of Sigma
Budgeted usage of material: 20,000 kg of material A at £ 10/kg
Actual activity level: sales of 9,000 units of Sigma
Actual usage of material: 19,000 kg of material A at £ 11/kg
Variances
Total DM cost = £ 180,000 - £ 209,000 = - £ 29,000
Material price = (SP – AP) × AQ
= (£ 10 - £ 11) x 19,000 = - £ 19,000
Material usage = (SQ – AQ) × SP
= (18,000 – 19,000) x £10 = - £ 10,000
© Prof. André Hoppe Management Accounting 39
Variance Analysis
Adverse DM usage variance – possible causes
Change in production
Purchase of method
material of
inferior quality Insufficiently
trained personnel
Adverse DM
usage variance
Bad maintenance Lack of
of machines supervision
© Prof. André Hoppe Management Accounting 40
Variance Analysis
Adverse DM usage variance – possible causes
A change in market
Purchase of material conditions
of superior quality
Adverse DM
price variance
Failure of purchase Speed purchase at
department higher price
© Prof. André Hoppe Management Accounting 41
Variance Analysis
Adverse DM usage variance – responsibilities
Who is responsible for adverse variances?
Production manager:
I am not responsible for the adverse
material usage variance. The purchase
dept. bought cheap material, which
caused a higher usage. The adverse
variance should be charged to the
purchasing department.
Purchasing department:
Too much material was used due to a bad
maintenance of machines and insufficiently
trained personnel. Moreover, the bad production
planning caused sudden purchases at a higher
price. The adverse DM is the responsibility of
the production manager.
© Prof. André Hoppe Management Accounting 42
Variance Analysis
Example 1
Budgeted activity level: sales of 10,000 units of Sigma
Budgeted usage of labor: 30,000 DLH at £ 9/DLH
Actual activity level: sales of 9,000 units of Sigma
Actual usage of labor: 28,500 DLH at £ 9.6/DLH
Variances
Total DL cost = (27,000 DLH x 9 £/DLH) - (28,500 DLH x 9.6 £/DLH)
= - £ 30,600
Wage rate = (SP – AP) × AQ = (£9 - £9.60) x 28,500 DLH
= - £ 17,100
Labour efficiency = (SQ – AQ) × SP = (27,000 DLH – 28,500 DLH) x £9
= - £ 13,500
© Prof. André Hoppe Management Accounting 43
Variance Analysis
Dysfunctional behavior as a consequence of result control
Production manager:
If I use cheaper material, my expenditures for DM will be lower and I will meet the
budget. Consequently, I will receive a bonus, BUT we might lose customers due to
the lower quality.
Lack of goal congruence
The performance indicator (PI) induces departmental behavior that is not
in line with the organizational goals
→ Introduce other PIs in addition to the DM variance
→ non-financial PIs related to quality
→ Loosen budgetary control in order to stop perverse behavior
→ Importance of value congruence / intrinsic motivation
© Prof. André Hoppe Management Accounting 44
Variance Analysis
Adverse DL usage variance – possible causes
Material of
Insufficiently trained inferior quality
personnel
Adverse labor
efficiency variance
Lack of Bad maintenance
supervision of machines
© Prof. André Hoppe Management Accounting 45
Variance Analysis
Adverse DL usage variance – possible causes
Effective negotiations
Scarcity on labor by labor unions
market
Adverse labor
price variance
Having highly educated
personnel perform basic tasks
© Prof. André Hoppe Management Accounting 46
Variance Analysis
Adverse DL cost variances: responsibility
Who is responsible for adverse variances?
Production manager:
I am not responsible for the adverse labor
efficiency variance. The purchase department
bought cheap material, which led to a longer
processing time.
Purchasing department:
Too much time is spent due to a lack of
supervision and training of personnel.
© Prof. André Hoppe Management Accounting 47
Variance Analysis
Example
Budgeted activity level: sales of 10,000 units of Sigma
Budgeted usage of DLH: 30,000 DLH at £ 9/h
Budgeted variable overhead: £ 60,000 = 30,000 DLH x £ 2/DLH
Actual activity level: sales of 9,000 units of Sigma
Actual usage of DLH: 28,500 DLH at £ 9.6/h
Actual variable overhead: £ 52,000
Variances
Total variable overhead = (£2/DLH x 9,000 units * 3 DHL/unit) – (52,000)
= + £ 2,000
Variable overhead exp. = (SP – AP) x AQ
= (£ 2/DLH – (£ 52,000/28,500 DLH)) x 28,500 DLH
= + £5,000
Variable overhead efficiency = (SQ – AQ) × SP
= ((9,000 units x 3 DLH/unit) – 28,500DLH) x £ 2/DLH
= - £3,000
© Prof. André Hoppe Management Accounting 48
Variance Analysis
Performance Evaluation
While Variances can be analyzed from a very technical perspective, i.e.,
where did the variance occur, they can also be interpreted from a performance
perspective as they can be used as performance indicators of managers of
different cost and revenue centers. However, variances can occur due to
different reasons. Even after flexibilizing the budgeted values, it is often not
100% clear, who is responsible for the variance / if the variance is under
control of the respective manager.
© Prof. André Hoppe Management Accounting 49
