Decision making by using strategic and operational controlling instruments

Table of Contents

Executive Summary

List of figures

1. Introduction
1.1 Problem statement
1.2 Methodology and structure of the work

2. Terminology and functions of controlling
2.1 Levels of controlling
2.2 Functions of controlling

3. Strategic Instruments of controlling
3.1 Activity based costing

4. Operative instruments of controlling
4.1 Gross margin accounting
4.2 Break-even analysis

5. Summary and conclusion

ITM

Bibliography

List of figures

Figure 1: Total costs according to traditional cost accounting

Figure 2: Determination of cost drivers

Figure 3: Actual costs per unit according to activity based costing

Figure 4: Determination of the break-even point

Executive Summary

Controlling is an important economic discipline and a key function of management.^[1] It is also crucial for the organizational success, because the absence of adequate control would lead to random actions and individuals would turn their attention to different and irreconcilable directions.^[2] With respect to the outstanding importance of controlling, the aim of the present work is to introduce various instruments of controlling which relate to both operational as well as strategic levels of a company. The instruments and techniques that are considered in more detail here are activity based costing, benchmarking, gross margin analysis and break-even analysis.

Starting with a theoretical part, in which the term “control” will be defined and explained, the second chapter of this work will show a discussion about the different levels and functions of controlling. Later on, the strategic and operational instruments of controlling will be presented and analyzed in order to answer the following question: how suitable are strategic and operational controlling instruments for effective control and how do they assist decision-making in an enterprise?

Finally, this work shows that the exercise of control at the operational level of a company is not less important than at the strategic level. Although the direction in which a company develops is determined within the strategic level of a company, these theoretical plans are practically implemented at the operational level of the company, where the daily operational processes take place. Control is thus applied at the strategic level in order to harmonize the interests and actions of the stakeholders, while control is exercised at the operational level in order to regulate the performance of the employees and to specify the strategic direction of the company. However, despite the obvious differences, both forms of control are of equal importance for decision–making within a company and for its long-term success.^[3]

1. Introduction

Controlling is an important economic discipline and a key function of management^[4]. It is a very detailed and comprehensive approach, which helps to ensure that all activities within an organization are organized and coordinated. Ultimately, the goal of controlling is to ensure that all objectives of an organization or a company can be reached. These objectives are generally summarized in the mission statement of a company.^[5]

This central aspect of controlling is of fundamental importance for organizational success, because the absence of adequate control would lead to random actions and individuals would turn their attention to different and irreconcilable directions.^[6]

In a company, both planning and the process of controlling are divided in different stages.^[7] These levels are generally classified as strategic, tactical and operational levels of entrepreneurial activity. Often, it is not possible to distinguish clearly between the different levels and business activities are allocated subjectively and randomly. Nevertheless, these levels are strongly interconnected and definition of objectives and monitoring of results are equally important in order to ensure the company’s success.^[8] For this purpose a variety of instruments and techniques are available to the management, which can be used to monitor the performance of an entire company.

With respect to the outstanding importance of controlling, the aim of the present work is to introduce various instruments of controlling which relate to both operational as well as strategic levels of a company. In order to achieve this purpose this paper presents a critical evaluation of specific instruments, which can be used to improve the effectiveness of entrepreneurial activity on both levels. The instruments and techniques that are considered in more detail here are activity based costing, benchmarking, gross margin analysis and break-even analysis.

1.1 Problem statement

The traditional functions of management were once quite simple. Due to the absence of advanced technologies, global markets, manual production and high trade barriers, the use of additional techniques and instruments to ensure the company's success was largely unnecessary. Nowadays, management processes have become very complex and they are mostly affected by a global competitive environment.^[9] Both, the external and the internal environment of a company are subject to constant change.^[10] For this reason, techniques that were previously effective are now ineffective and no longer capable of handling the turbulent business in today’s modern world.^[11]

Markets are rapidly changing and even competitive advantages of leading companies in different industries are at stake. In order to maintain a competitive advantage, the management of affected companies permanently implements processes and actions. Under these circumstances, management has only little time to focus attention on control. Therefore, it is essential that superior tools and techniques of controlling are implemented, in order to focus the attention of managers and employees in the desired direction and to assist decision-making. In this paper the tools and techniques which are able to control a company's performance on both the operational and strategic levels are presented and evaluated.

1.2 Methodology and structure of the work

The present work is based on information, which was mainly collected from scientific publications. The sources required to prepare this paper include, above all, current books, journals and scientific articles.

In the first step, the term “control” will be defined and explained in with respect to business administration. Following this, the different levels and functions of controlling are discussed. In the course of this discussion the strategic and operational instruments of controlling are presented.

Among the instruments of strategic controlling, the tools of activity based costing and benchmarking will be described. The instruments of operational controlling, which are considered more in detail in the present study, are gross margin accounting and break-even analysis. Finally, the instruments are evaluated critically with a focus on how suitable they are for effective control.

2. Terminology and functions of controlling

Controlling is defined as a process that managers use to influence other members of an organization in order to implement an organization’s strategies^[12]. A longer period of time is necessary to achieve this goal, starting with the phase of programming and budgeting, to the phase of implementation and monitoring, and finally ending with the phase of controlling results and reports.^[13]

During the planning phase periodical targets are determined and appropriate budgets are set to achieve these goals^[14]. During the monitoring phase, a continuous evaluation of the actual performance takes place and compared to fixed standards. During this phase the management tries to correct any deviations from the standards. For example, the actual expenditures can be compared continuously to the fixed budget in order to predict the expected deviation from the budget plan.^[15]

In the control phase the actual results are compared to the set targets. By comparing the results, the management can determine whether the targets have been achieved, and in case they have not been achieved, identify the reasons for this. Based on the results new objectives can be defined on the basis of prior experience. Therefore, controlling is necessary for a continuous learning process within an organization.^[16]

Mockler defines controlling as a systematic effort of managers in which performance is compared to pre-set standards and in which adjustments are made if necessary.^[17] Such corrections are an integral part of the controlling process. Due to the fact that not all business activities are carried out exactly as planned, such corrections are usually required. An example for a correction could be the increase of budget for a special department if the department needs more financial resources to achieve its planned objectives. But it can also lead to a correction of goals if previously set targets seem unattainable.

The different types of control, which can be identified in a company, include both internal and external controls^[18], formal and informal controls^[19], preventive and corrective controls as well as financial and non-financial controls^[20]. Despite these differences, however, all these types of control have the common goal of ensuring that all activities in an organization meet the defined standards and objectives.

2.1 Levels of controlling

Controlling in a company is divided into different levels. The objective of strategic control is to question the alignment of the corporate strategy proactively and thus to guide the company in the desired direction.^[21] In the management level long-term strategic plans are designed. These plans include both forecasts of future developments as well as the creation of the master budget. In the strategic level controlling serves for monitoring and for ensuring compliance so that entrepreneurial activities can correspond to the strategic decisions. Therefore, the ultimate goal at this level is to ensure that the company's performance is consistent with the strategic plans, and that the goals of the company’s mission statement can be achieved. In case of a discrepancy, corrective actions are required on the part of the management.

On the other hand, there is operational control. The purpose of operational control is monitoring the operations of the daily operating business and of its related activities.^[22] Operational controls help strengthen a company’s foundation. It is the operational level of a company in which theoretical plans are implemented gradually with the help of small and incremental improvements in performance. The control at this level is often very comprehensive and covers even the smallest details. It is the responsibility of operational control to distribute tasks among employees. For example, operational control includes distribution of weekly tasks, control of production times, supervision of the activities, analysis of a possible need for overtime and planning of the logistics.

2.2 Functions of controlling

The instruments of controlling fulfill different tasks within a company. First, the basic function of control starts with the setting of standards. Such standards are defined, classified and implemented in the different levels of an organization. The purpose of these standards is to formulate specific and immediate goals in order to attract the staff’s attention and guide their actions.^[23] In the financial context these standards are fixed budgets, revenue-rates and cost- or profit-specifications.^[24] In the non-financial context, however, examples of such standards are customer retention rates, employee turnovers or production targets. The definition of standards is used to prepare the employees mentally and to communicate what is expected of them.^[25]

Once the standards are established and the staff has focused its attention and efforts accordingly, controlling is used to measure performance^[26]. At each level of a company, individuals, teams, groups, units, functions or divisions influence performance. Measuring and monitoring performance is an ongoing task of the management. If performance is not consistently measured, performance gaps may arise. Over time, these performance gaps tend to expand and potentially leading to negative consequences for the company.^[27] For this reason, it must be the goal of control to deal with any discrepancies proactively and promptly as soon as they arise. Insofar the role of control in a company is to keep relevant losses away from the organization.

In the context of control actual results are measured and compared to the defined standards.^[28] Where an exceptionally good performance is identified, an appropriate reward is often given that serves as an encouragement for achieving other goals. On the other hand, poor performance is often punished and the results are analyzed in order to find reasons for performance failure. If the results of this analysis reveal that reasons for poor performance were beyond the control of the responsible individual or if the standards were simply set too high, then punishment should be waived. In such situations positive and constructive feedback is very important to maintain the motivation of subordinate employees^[29]. Nonetheless, corrective measures have to be introduced after the examination of the reasons for the poor performance and the findings, which are obtained in this process during the review phase,^[30] must form a part of the future control mechanisms.

3. Strategic Instruments of controlling

3.1 Activity based costing

Cost accounting is a key function of controlling,^[31] whose origin is rooted in the strategic level of a company. Nevertheless, controls that deal with costs are carried out on tactical and operational levels of a company, too. The traditional instruments of cost accounting are mostly based on volume-based instruments such as labor or machine hours, which are forwarded to the appropriate cost center as overhead-costs. As production in the past was labor-intensive, traditional methods of cost accounting, such as absorption costing, were very helpful in allocating costs. These techniques required little input and were very efficient, as far as they concerned the cost-benefit ratio.^[32]

Activity based costing is an approach of cost accounting, which is based on the assumption that specific activities have to be assigned to cost-objects on the basis of their estimated resource consumption.^[33] The technique involves the identification of so-called "drivers" that cause costs associated with these activities. Thus, activity based costing is an approach that is significantly more developed compared to the traditional instruments of cost accounting. Using this technique, it is possible to identify the cause of the costs and to link them to specific activities.^[34] This technique helps management to control the activities within the company and gives additional information on the business value. The assignment of costs to specific activities makes it possible to identify and eliminate those activities, which do not add to business value. Because of these qualities, activity based costing is considered an approach of cost accounting, with which the actual cost of production of a specific product can be determined more accurately than with other instruments.^[35]

In order to better understand this approach, it is illustrated in the following table through an example. In this example a fictitious company produces two unspecified products. 25,000 units of unit 1 are produced yearly while the production of product 2 is only 5000. The cost of direct materials for the two products differs while the effort required to produce a unit is equally high. Working hours are used as a basis for equal distribution of overhead costs among the units produced. This leads to the following costs per unit produced:

illustration not visible in this excerpt

Figure 1: Total costs according to traditional cost accounting^[36]

To implement Activity Based Costing into a company the overhead costs of production must be analyzed. In the case of the abovementioned exemplary production company costs that cannot be attributed directly can be calculated by setting up, by using and by continuously inspecting a machine. In this case, these amount to a total of 900,000 units of money per year. The following figure shows which cost drivers can be identified in a company:

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^[1] Cf. Langabeer (2008), p. 16

^[2] Cf. Witt (1998), p. 175

^[3] Cf. Bogdanoiu (2013), p. 203

^[4] Cf. Langabeer (2008), p. 16

^[5] Cf. Leuthesser/ Kohli (1997), p. 59

^[6] Cf. Witt (1998), p. 175

^[7] Cf. Bogdanoui (2013), p. 203

^[8] Cf. Bogdanoui (2013), p. 203

^[9] Cf. Horvathova (2010), p. 33 f.

^[10] Cf. ibid

^[11] Cf. Johnson/ Kaplan (1987), p. 24

^[12] Cf. Anthony / Govindarajan (2007), p. 3 ff

^[13] Cf. Heer (2011), p. 50 f.

^[14] Cf. Reddy (2004), p. 177

^[15] Cf. Gardner et al. (2011), p. 10

^[16] Cf. Tulvinschi (2010), p. 51

^[17] Cf. Mockler (1970), p. 14 ff

^[18] Cf. Rotter (1990), p. 489

^[19] Cf. Chandra (2011), p. 9 f

^[20] Cf. Collier/ Agyei-Ampomah (2008), p. 170 f

^[21] Cf. Rao/ Krishna (2004), p. 608

^[22] Cf. Hansen et al., (2007), p. 6

^[23] Cf. Chandra (2011), p. 6 f

^[24] Cf. Merchant/ Van der Stede (2007), p. 269

^[25] Cf. Pulakos (2009), p. 67

^[26] Cf. Merchant/ Van der Stede (2007), p. 5

^[27] Cf. Reid (2006), p. 32

^[28] Cf. Anbuvelan (2007), p. 247

^[29] Cf. Fischbach et al. (2010), p. 517

^[30] Cf. Ward (1998), p. 71 f

^[31] Cf. Sahaf (2009), p. 11

^[32] Cf. Cokins et al. (2012), p. 38

^[33] Cf. Edward (2008), p. 3

^[34] Cf. Cooper/ Kaplan (1991), p. 131

^[35] Cf. Banker et al. (2008), p. 1; Cooper/ Kaplan (1991), p. 130 ff

^[36] Cf. Weygandt et al., (2010),p. 989