The effect of organizational reputation and strategy on management control systems in professional service firms

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The effect of organizational reputation and strategy

on management control systems in professional

service firms

Name: Thom Wervenbos Student number: 11418826

Thesis supervisor: prof. dr. ir. M.J.F. Wouters Date: June 25, 2018

Word count: 20411

MSc Accountancy & Control, specialization Control Amsterdam Business School

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Statement of Originality

This document is written by student Thom Wervenbos who declares to take full responsibility for the contents of this document.

I declare that the text and the work presented in this document is original and that no sources other than those mentioned in the text and its references have been used in creating it.

The Faculty of Economics and Business is responsible solely for the supervision of completion of the work, not for the contents.

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Abstract

The purpose of this master’s thesis is to examine the relationship between organizational reputation and the tightness of management control systems (MCSs) in professional service firms (PSFs). In addition, this study examines whether this relationship is moderated for PSFs pursuing a differentiation strategy. MCS tightness is conceptualized in this study based on the four dimensions of results-, action-, personnel-, and cultural control. The study is conducted based on data from an online survey that is part of the ongoing research project Professional Service Firms Thesis Survey Project 2017-2018. The final sample population consists of 491 professionals. Results indicate that PSFs with a high organizational reputation use tighter personnel- and cultural controls than PSFs with a low organizational reputation. Moreover, as the importance of the cost leadership strategy increases, relative to the differentiation strategy, a PSF uses tighter action controls. At the same time, cultural controls are then less tight. Furthermore, no significant evidence was found that the relation between reputation and MCS tightness in PSFs is moderated by the differentiation strategy.

Keywords: professional service firm (PSF); management control system (MCS); strategy; reputation; control tightness; results controls; action controls; personnel controls; cultural controls.

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1 Introduction

The contribution that corporate reputation1_{can make to market performance in a service}

organization is greater than for any other type of business. This is a statement by Davies, Chun and Kamins (2010) and is based on their research regarding the link between an organization’s reputation and its financial performance. In the past decades, the demands of investors for increased transparency and the greater attention on social responsibility all speak for a greater focus on building and maintaining strong reputations (Argenti & Druckenmiller, 2004). Linthicum, Reitenga, and Sanchez (2010) state that in today’s global environment companies have to become more sensitive to the value of their reputation and that a firm’s reputation can influence investors. In particular, accounting firm ‘Arthur Andersen’ learned hard lessons when a loss of reputation caused by allegations surroundings its involvement in the Enron scandal resulted in negative market returns, eventually leading to the downfall of the firm (Chaney & Philipich, 2002; Davies et al., 2010).

A good and strong reputation can lead to numerous strategic benefits (Walker, 2010). A strong reputation will attract better and more employees, lower the employee turnover, lower the client’s perceived risk, and create higher credibility (Davies et al., 2010). Firms with a higher reputation can charge premium prices, which will attract new investors (Fombrun & Shanley, 1990), and are in general more likely to sustain superior financial performance over time (Roberts & Dowling, 2002). Furthermore, firms with strong positive reputations have customers who are more loyal and who buy broader ranges of products and services (Eccles, Newquist, & Schatz, 2007).

A strong organizational reputation is especially important for professional service firms (PSFs). According to Zabala et al. (2005), reputation is one of the keys to success for PSFs. Reputation is vitally important for PSFs because it acts as a social signal to clients (Greenwood, Li, Prakash, & Deephouse, 2005) and because most professional service organizations will depend upon the associations stakeholders make with their corporate names (Davies et al., 2010). Von Nordenflycht (2010) defines PSFs as organizations with high knowledge intensity, low capital intensity and a high professionalized workforce.

A strong reputation is therefore more important for PSFs than for any other type of organization. The risk of losing reputation, reputational risk, should therefore be reduced to a minimum. One of the things a PSF must do to manage its reputational risk is closing the

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reputation-reality gap (Eccles et al., 2007). PSFs can close this gap by improving the ability to meet expectations of its stakeholders. A tight management control system (MCS) could help with this.

MCSs are systems to control for the behavior and decisions of employees. It makes sure that the organization’s strategies and objectives are carried out (Merchant & Van der Stede). MCS is conceptualized in this study based on the four dimensions or types of control by Merchant and Van der Stede (2017). These control types are: (1) results controls, (2) action controls, (3) personnel controls, and (4) cultural controls.

Another important aspect in this matter is a PSF’s strategy and its relation to the MCS. Over the last decades, research was based on the premise that MCS should be tailored explicitly to support the strategy of the business to enhance competitive advantage and encourage superior performance (Langfield-Smith, 2007). Porter (1980) proposed, that regardless of industry context, organizations can choose from one of the two generic strategies to compete effectively: cost leadership and differentiation.

Given that reputation and a PSF’s business strategy are considered important, this study tries to investigate whether organizational reputation has an influence on the control tightness in PSFs. It also examines how the differentiation strategy influences this relationship. This thesis tries to answer the following research question:

To what extent does organizational reputation have an effect on management control system tightness of professional service firms and how does the differentiation strategy influence this relationship?

The study uses data from an online survey to answer the research question above. The survey is part of the ongoing research project Professional Service Firm Thesis Project 2017-2018 from the Amsterdam Business School. The final sample population consists of 491 respondents, working in various industries that classify as PSFs.

The results support the predictions of a positive relationship between reputation and the tightness of personnel- and cultural controls. The results are also in line with the expectation that there is no significant relationship between organizational reputation and results control tightness. Furthermore, the results indicate that PSFs pursuing the cost leadership, relative to the differentiation strategy, use tighter action controls. On the other hand, differentiators, relative to cost-leaders, use tighter cultural controls. Moreover, the results indicate that there is no evidence that the differentiation strategy moderates the relation between organizational reputation and MCS tightness.

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The purpose of this thesis is to add to the limited body of knowledge of the design of management control systems and its relation to strategy and organizational reputation in professional service firms. PSFs are becoming even more pronounced in economies all over the world (Delong & Nanda, 2003, as cited in Greenwood et al., 2005). However, most research in management control has traditionally focused on the manufacturing industry and not on service organizations. Moreover, no research or almost minimal research has focused on the relation between reputation, strategy, and MCS tightness. The results of this study intend to provide more understanding about how organizational reputation has an impact on the design and use of management control systems within a professional service setting.

The remainder of this study is structured as follows. In chapter two, the literature regarding PSFs, MCSs, reputation and, strategy is discussed. In the following chapter, the formulation of the hypotheses is presented. Then, in the fourth chapter, the research method and design are outlined, detailing the sample and the measurement of variables. Chapter five reports the results of the study. Finally, chapter six concludes.

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2 Literature review

To provide a basis for this study the following chapter gives an overview of relevant literature and topics in regard to the research question. The concepts of PSFs, MCSs, MCS tightness, organizational reputation, and strategy are discussed in the next sections.

2.1 Professional service firms

Generally, when speaking of PSFs, it is often not clear what is meant with this construct. According to Von Nordenflycht (2010), a significant obstacle in understanding PSFs is the lack of a concrete definition. The author states that in many instances of research on PSFs, the term is either undefined or indirectly defined by a list of examples.

PSFs do have something in common: they all provide a service. Several studies (Auzair & Langfield-Smith, 2005; Moeller, 2010; Parasuraman, Zeithaml, & Berry, 1985; Wolak, Kalafatis, & Harris, 1998) argue that a service consists of a unique set of characteristics. The unique characteristics of pure services are (1) the intangibility of services, (2) the heterogeneity in service products, (3) the inseparability of production from consumption, and (4) the perishability of services.

Intangibility of services means that a service is an experience that cannot be touched or processed. As a result of this, it is difficult to measure the performance of services. Moreover, firms may find it difficult to understand how customers perceive their service and how they evaluate the quality of the delivered service (Parasuraman et al., 1985).

Heterogeneity of service concerns the difficulty in standardizing services and the potential for high variability in service delivery (Moeller, 2010). This could be a problem for service organizations with a high labor content because the service performance is then delivered by different professionals and the performance of these professionals can vary on a daily basis (Wolak et al., 1998).

The inseparability of services refers to the simultaneously delivery and consumption of services. Wolak et al. (1998) state that it is believed that customers can affect or shape the performance and the quality of the service. The customer is part of the service, which implies that the quality of the customer input determines the output (e.g. patient in health care, student in education).

The fourth characteristic of services, perishability, refers to the fact that services cannot be stored or carried forward to a future in time. This means that unused capacity is lost.

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However, the ability to distinguish services based on these four characteristics as described above does not mean that it is clear what a PSF is. According to Von Nordenflycht (2010), this hinders research in two ways. First, it leads to a constrained body of empirical work, resulting in a narrow focus on a set of industries and there is little academic work that compares different types of professional services. Second, the lack of boundary conditions means that it is difficult to test existing theories.

To address this problem Von Nordenflycht (2010) developed a theory on how to distinguish service firms based on three distinctive characteristics. These characteristics are: (1) knowledge intensity, (2) low capital intensity, and (3) professionalized workforce.

Knowledge intensity is arguably the most fundamental characteristic of PSFs. With knowledge intensity is meant that the majority of a firm’s output relies on complex knowledge. A PSF with a high knowledge intensity relies heavily on intellectually skilled employees. Low capital intensity on the other hand, refers to the fact that a firm’s production does not involve a significant amount of nonhuman assets, such as machinery and equipment. However, a low capital intensity is not an implication of knowledge intensity. It is imaginable that there are firms that require both skilled employees and significant amounts of nonhuman assets (e.g. hospitals). The third and final distinctive characteristic is professionalized workforce. With the term professionalized workforce refers Von Nordenflycht (2010) to the presence of two institutional features of professionalization: ideology and self-regulation. Ideology refers to the professional codes of ethics while self-regulation means that professionals have strong control over their own practices.

In the PSF literature, there is also some research conducted regarding different types of service organizations. Silvestro, Fitzgerald, Johnston, and Voss (1992) proposed in their study three different service process types based on six dimensions of service organizations that are widely recognized and used in the service operations management literature. Those six dimensions are: (1) the equipment or people focus, (2) the length of customer contact time, (3) the extent of customization, (4) the extent to which customer contact personnel exercise judgement in meeting individual needs, (5) the source of value added by front or back office, and (6) the product/process focus. Based on these six dimensions Silvestro et al. (1992) proposed the following three different service organizations: (1) professional services, (2) mass services, and (3) service shops.

Professional services are organizations with relatively few transactions. Their service is highly customized and process oriented. Considerable judgment is applied in meeting customer needs. According to Auzair and Langfield-Smith (2005), a typical example of professional

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services are management consultancies and corporate banking organizations. Silvestro et al. (1992) propose that mass services are organizations where there are many customer transactions, limited contact time, and little customization between customer and the firm. Auzair and Langfield-Smith (2005) state that examples of this type of service providers include newspaper retailers and transport organizations. The last type of service organizations are service shops. This is a category which is placed between professional services and mass services (Silvestro et al., 1992). Typical examples of service shops are hotels and rental services (Auzair & Langfield-Smith, 2005).

The common characteristic in all these types of organizations is the involvement of professionals. Working with professionals can lead to some serious challenges. According to Raelin (1989), one of the most critical challenges facing management has been the ability of managing professionals. Professionals value autonomy, are difficult to monitor, and resistance to bureaucracy. Controls are therefore difficult to apply (King & Clarkson, 2015; Raelin, 1989). Moreover, Von Nordenflycht (2010) states that two challenges arise when working with intellectually skilled employees. The first challenge includes the ability to retain and direct them. Intellectually skilled professionals have strong bargaining power, relative to their firm. This is due to the fact that their skills are scare and most of the time transferable across other firms. These employees have strong outside options making it hard for a firm to retain and direct them. A second challenge is what Von Nordenflycht (2010) calls opaque quality. This refers to the fact that an expert’s output is hard for managers and customers to evaluate upon. For example, it is hard for managers to determine whether a new advertising campaign really increased sales. Or was the financial advisor’s advice the real reasons behind the organization’s bankruptcy? These controls challenges can all relate to the MCS of an organization. MCSs are discussed in the next section of this study.

2.2 Management control systems

MCSs are broadly defined to “include everything managers do to help ensure that their organization’s strategies and plans are carried out” (Merchant & Van der Stede, 2017, p. xiii). Management control includes all devices or systems that managers use to control for the behavior and the decisions of their employees. This, to make sure that their behavior and decisions are in line with the organization’s strategies and objectives. The systems to control the behavior and decisions of employees are referred to as management control systems.

Another view on MCSs are provided by Anthony and Govindarajan (2004). They define MCSs as “tools to implement strategies by influencing human behavior.” Simons (1994, p. 170)

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defines MCSs as “the formal information-based routines and procedures used by managers to maintain or alter patterns in organizational activities.” On the other hand, the management accounting literature states that MCSs generate and use information that help decision makers determine whether or not an organization is reaching its objectives. The term “control” refers here to a set of procedures, tools, performance measures, and incentives that organizations use to motivate employees to achieve organizational objectives (Atkinson, Kaplan, Matsumura, & Young, 2012).

According to Chenhall (2003), the definition of MCS has evolved over the years from focusing on more formal financial information to assist managerial decision to one that involves a much broader scope of information. According to the author this includes external information related to markets, customers, and non-financial information related to production processes.

The common characteristic in all these definitions is that all, more or less, describe how management control systems help managers to ensure that an organization reaches its objectives and strategies. An important aspect in all the definitions is the ability to influence human behavior and decision-making. In the remainder of this study the definition of Merchant and Van der Stede (2017) is used when referring to MCSs.

Many management control studies have focused on MCSs and the types of control that managers can use in these systems. One of the first studies that focused on these types of control was conducted by Ouchi (1979). According to him, there are three competing mechanisms of control that influence MCSs, namely the (1) market, (2) bureaucratic, and (3) clan control mechanisms. Market control is typically sustained in organizations through compensation schemes and promotion mechanisms. Bureaucratic control involves close personal surveillance and discretion by supervisors, while clan control involves reliance on social norms and values to regulate employee’s behavior and facilitate organizational performance.

On the other hand, Simons (1994) identifies four types of control, namely (1) belief systems, (2) boundary systems, (3) diagnostic control systems, and (4) interactive control systems. Belief systems are a set of beliefs that define basic values, purpose, and mission. Boundary systems are formally stated limits and rules which must be respected. A diagnostic control system is a formal feedback system used to monitor outcomes and correct deviations. Interactive control systems are formal systems used by top managers to involve themselves in decision activities of subordinates. According to Simons (1994), all systems can be used in an interactive manner.

Langfield-Smith and Smith (2003) use the concepts of trust and trustworthiness to identify three different patterns of control in outsourcing relationships. These three patterns of

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control are: (1) market based, (2) bureaucratic based, and (3) trust based. This framework is fairly similar to the controls discussed by Ouchi (1979). However, clan controls are in this framework replaced by a trust based pattern.

Lastly, Merchant and Van der Stede (2017) developed a framework based on the dimensions that an organization has knowledge about which actions performed by employees are desirable and whether the organization is able to measure results on important performance dimensions. Based on these dimensions, Merchant and Van der Stede (2017) distinguish results controls, action controls, personnel controls, and cultural controls. The last two are also often referred to as social controls.

Apart from having different names in the literature, each type of control mentioned above shares similarities. They either focus on input (e.g. people, tangibles), output (e.g. sales volume, customer satisfaction), or try to control during the process of service delivery or production. A comparison between the different types of control can be found in table 1.

Table 1 Control types comparison

Sources Input Process Output

Ouchi, 1979 Simons, 1994

Langfield-Smith & Smith, 2003 Merchant & Van der Stede, 2017

Clan controls Belief system Trust based pattern Social controls

Bureaucratic controls Boundary system Bureaucratic based pattern Action controls

Market controls Diagnostic system Market based pattern Results controls

This study applies the framework of Merchant and Van der Stede (2017). Results-, action-, personnel-, and cultural controls are further elaborated in the next sections.

2.2.1 Results controls

According to Merchant and Van der Stede (2017), pay-for-performance is the most powerful way to influence human behavior in organizations. Pay-for-performance is a typical example of a type of control that can be defined as results control because employees are rewarded based on their past performance. Results controls empower employees to take actions or decide about what they believe will best produce the desired results.

Results control can provide several benefits. Merchant and Van der Stede (2017) distinguish three benefits. First, well-defined results controls inform employees about what is expected and encourage them to do what is necessary to meet the desired results. Second, results controls can be effective in dealing with motivational problems. When there is a reward tied to reaching a certain target, employees are often more motivated to reach this target. Finally,

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results controls can help organizations attract and retain employees. Especially employees who are confident about their abilities to reach the desired results.

Merchant and Van der Stede (2017) also address in their framework how results controls can be used effectively. According to them there are three conditions that must be met before results control scan be used effectively. First, organizations must have the knowledge to determine what results are desired in the areas that are being controlled. Second, the employees must be able to influence these desired results in a material way. This is often referred to as the controllability principle. In situations where many uncontrollable factors or noise influence the results area it becomes harder for management to determine whether or not good decisions were made by their employees. Finally, an organization must be able to measure the controllable results effectively.

2.2.2 Action controls

Action controls, or behavior controls are meant to ensure that employees perform certain actions, known to be beneficial to the organization (Merchant & Van der Stede, 2017). An organization is only able to effectively use action controls when decisions or actions taken by employees are observable for superior managers and when managers know which actions are desirable.

According to Merchant and Van der Stede (2017), actions controls are the most direct type of control to influence the behavior of employees. The authors distinguish four basic forms of action controls, namely (1) behavior constraints, (2) pre-action review, (3) action accountability, and (4) redundancy.

Behavior constraints make it impossible for certain employees to do things they should not be doing. Those constraints can be applied physically or administratively. A typical example of a physical constraint are locks on desks, personal identification, and passwords. Administrative constraints can be used to place limits on an employee’s ability to perform a certain task. A good example of an administrative constraint is segregation of duties. Romney and Steinbart (2015) state that segregation of duties involves the separation of the accounting functions of authorization, custody, and recording. This, to minimize an employee’s ability to commit fraud.

The second basic form of action control, pre-action review, involves the inspection of action plans. Pre-action reviews usually take place during the planning and budgeting process when multiple reviewers have to approve proposed plans before they are carried out.

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The third basic form of action controls, action accountability, involves holding employees accountable for the actions they take. Actions for which employees are held accountable are communicated though rules, policies, procedures, and a company’s codes of conduct.

Finally, the last basic form of action controls, redundancy, involves the assignment of more employees to a task than necessary. By assigning more employees than necessary, an organization increases the probability that the task is completed.

Like results controls, action controls also require conditions that must be met before it is possible to use these controls effectively. Action controls are only effective when the organization can determine what actions are (un)desirable and if the organization is able to ensure that these (un)desirable actions (do not) occur (Merchant & Van der Stede, 2017). 2.2.3 Personnel controls

Personnel controls focus more on employees and their natural tendencies to control and motivate themselves. Employees have natural tendencies to do the right thing and experience satisfaction with themselves when they perform well.

Merchant and Van der Stede (2017) state that personnel controls have three core purposes. First, it helps to ensure that employees know what is expected from them by the organization. Second, some personnel controls help ensure that an employee has all the capabilities and resources to perform a good job. And third, some personnel controls increase the likelihood that employees will engage in self-monitoring. Merchant and Van der Stede (2017, p. 95) define self-monitoring as “an innate force that pushes most employees to want to do a good job, to be naturally committed.”

According Merchant and Van der Stede (2017), personnel controls can be implemented in three ways. Namely, thought (1) selection and placement, (2) training, and (3) job design and the provision of resources.

2.2.4 Cultural controls

Finally, cultural controls refer to the shared norms and values, and social pressure exerted by groups of individuals. Cultural controls are typically designed to encourage mutual monitoring. This is a powerful form of group pressure on individuals who deviate from group norms or values. Cultural controls are based on the cultures in organizations. Those cultures within organizations are built on shared traditions, norms, beliefs, values, ideologies, attitudes, and ways of behaving (Merchant & Van der Stede, 2017).

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Organizational cultures can be shaped in many ways according to Merchant and Van der Stede (2017). The authors state that shaping organizational cultures can be done by using codes of ethics, group rewards, intra-organizational transfers, physical and social arrangements, and by setting the tone at the top.

2.3 Management control system tightness

Closely related to MCSs is the control tightness of these systems. According to Van der Stede (2001), the concept of control tightness is not exactly clear in terms of its definition, its scope, and its operationalization. Moreover, relatively few researchers define tight control as a whole. Most researchers only discuss characteristics of a tight management control system. Fisher (1995) argues that the lack of a clear definition complicates the interpretation of research findings.

Merchant (1985) provided one of the first definitions regarding control tightness as a whole. He defines a tight control system as “one that provides a high degree of certainty that employees act as the organization withes.” According to Merchant (1985), tightening control can be done by defining goals as more complete and more specific, by communicating more effectively, timely, frequently, and convincingly, by monitoring more frequent and more detailed, and by enhancing the value of rewards for reaching performance targets.

Kald, Nilsson and Rapp (2000) uses the interpretation of Anthony, Dearden, and Govindarajan (1992) and conclude that if management monitors the activities of business units frequently, it may be said to exercise tight control. On the other hand, more limited monitoring of business units may then be termed as loose control. The difference between tight and loose control depends here on the degree to which management monitors the business units. This approach is also adopted by Kober, Ng, and Paul (2007). They refer to the level of monitoring exerted over operations when defining the tightness of control. According to Kober et al. (2007), the adherence to rules, policies, and plans is also important in a tight control system. Furthermore, Kald et al. (2000) argue that deviations from budget targets are not considered acceptable in a tight control system. In a loose control environment, the day-to-day involvement of management is more limited. The budget is then regarded more as a tool of planning than a binding commitment.

Merchant and Van der Stede (2017) describe that the benefit from any MCS is the increase in likelihood that an organization reaches its objectives and targets relative to what would be expected if the control system was not in place. The authors state that this benefit can

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be described in terms of MCS tightness. They define tight control in terms of a high degree of assurance that employees will behave in the organization’s best interest.

It is clear that there is a lack of consensus regarding the definition of control tightness based on the various definitions described above. The definitions that are provided by researchers are sometimes quite vague and not complete, especially when comparing them with each other. Therefore, a new definition for MCS tightness is used in this study. In this study a management control system is considered to be tight when the system is firmly and rigor, only a small amount of deviation of pre-established targets is allowed, the monitoring frequency of operations is high, and a large number of incentives is tied to the management control system.

It is also important to distinguish explicit and implicit control tightness. A tight explicit control system is defined in this study as one with a lot of controls in terms of amount and scope. On the other hand, implicit tightness focuses on the degree to which deviation from the control system is tolerated. A tight explicit control system is defined as one that tolerates little to no deviation. Results-, action-, personnel- and cultural controls can all be used to provide tighter controls. However, none of them in isolation is likely to be sufficient to provide full tight control (Merchant & Van der Stede, 2017).

The achievement of tight results controls depends on characteristics such as the definitions of the desired result areas, the performance measures, and the incentives provided by the organization (Merchant & Van der Stede, 2017). The results dimensions must be congruent with the organizational objectives. The targets must be specific. The desired results must be effectively communicated. And lastly, the measures must be complete. Explicit results control tightness refers here to the extent of use of goals, targets, and performance measure as part of the MCS. Implicit results control tightness refers to the degree to which deviation from those goals, targets, and performance measures is allowed.

Action controls, should only be considered as tight, when it is highly likely that employees will engage in all actions critical to the operation’s success and will not engage in actions that can be harmful for the organization (Merchant & Van der Stede, 2017). Good examples of tight action controls include restricting decision-making authority to a limited number of key employees and using detailed descriptions of best-practice behavior. Tight explicit action control tightness refers to the extent of use of standardized processes, procedures, rules, and routines. Implicit action control tightness refers to the extent to which deviation from these standard processes, procedures, rules, and routines is allowed.

When personnel or cultural controls dominate the MCS in an organization, they can also be considered tight in some situations (Merchant & Van der Stede, 2017). A good example of

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tight personnel controls are strict selection procedures. Explicit personnel control tightness addresses the extent of use of employee selection procedures as part of the MCS. An organization that uses extensive selection procedures to select employees with specific attributes is an example of an organization that uses tight explicit personnel control. Implicit personnel control tightness refers then to the degree to which deviation from human resource standards is tolerated.

A tight cultural control system is characterized by the use of large group-based rewards and has a dominant corporate culture. Explicit cultural control tightness refers to the extent of use of employee socialization procedures and whether these are part of the MCS. On the other hand, implicit cultural control tightness refers to the degree to which the norms, values, and beliefs of the employees are tolerated to deviate from the values from the organization. In a tight control system this is not tolerated.

2.4 Organizational reputation

The idea of organizational reputation is quite intuitive and simple to manage (Lange, Lee, & Dai, 2011). However, when investigated in management research it turns out to be surprisingly complex, as evidenced by various definitions, concepts and operationalization in different studies. Despite a reasonable number of academic literature on organizational reputation, researchers are still debating its meaning and purpose (Wæraas & Maor, 2015). Definitions as provided in the literature are often mixed up with related concepts such as legitimacy and status. Gotsi and Wilson (2001) reviewed in their study several definitions in regard to corporate reputation and found that there are certain characteristics assigned to the concept of reputation. According to the authors, corporate reputation is a dynamic concept, that takes time to build and manage, while different stakeholders may have different reputations of the same organization based on their own economic, social and personal background. Gotsi and Wilson (2001, p. 29) end their study by defining corporate reputation as “a stakeholder’s overall evaluation of a company over time.”

Walker (2010) finds that Fombrun’s definition of reputation is more frequently referenced to than any other definition. Fombrun (1996, p. 72) defines reputation “as a collective representation of a firm’s past actions and results that describe the firm’s ability to deliver valuable outcomes to multiple stakeholders.” Three key attributes can be emphasized, based on Fombrun’s definition. Firstly, reputation is based on perceptions, secondly, reputation is based on the aggregate perception of all stakeholders, and thirdly, reputation is comparative. However, according to the study of Walker (2010) there are two more attributes that define

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reputation. Reputation can be positive or negative and it is stable and enduring. Therefore, Walker (2010, p. 370) defines corporate reputation as “a relatively stable, issue specific aggregate perceptual representation of a company’s past actions and future prospects compared against some standard.”

Eckert (2017) approaches the definition of corporate reputation from a risk management perspective. He uses the definition from Walker (2010) as a starting point. According to Eckert (2017) there are two aspects lacking in this definition. Firstly, no distinction is made between stakeholder groups. And secondly, no distinction is made between issues in organizations. Therefore, he extends the definition of Fombrun (1996) and Walker (2010) by taken these two aspects into account. Eckert (2017) defines corporate reputation as “a relatively stable, issues and stakeholder group specific aggregate perceptual representation of a company’s past actions and future prospect compared against some standard by external stakeholders.” This definition by Eckert (2017) is the most developed one and is therefore used when referring to organizational reputation in the remainder of this study.

Research in corporate reputation literature has also focused on aspects that determine reputation. Rindova, Williamson, Petkova, and Sever (2005) argue that organizational reputation consists of two dimensions that reflect: (1) the extent to which stakeholders perceive an organization as being able to deliver quality goods and services, and (2) the extent to which the organization is prominent in the minds of stakeholders. On the other hand, Lange et al. (2011) argue that organizational reputation can be identified by three dominant conceptualizations, namely, (1) being known, (2) being known for something, and (3) generalized favorability. In addition, Mishina, Block, and Mannor (2012) argue that there are two forms of reputation. Stakeholders make two primary types of reputational assessments when evaluating a target organization: (1) what the organization can do, and (2) what the organization would likely do. The first one is referred to as capability reputation and the second as character reputation. Capability reputations are collective evaluations about the quality and performance of a firm. On the other hand, character reputations are collective judgements about a firm’s incentive structures and behavioral tendencies based on observations from the past.

Reputation is generally viewed as a valuable intangible asset that provides a firm with sustainable competitive advantages and positive benefits (Rindova et al. 2005). For instance, Fombrun and Shanley (1990) found that favorable reputations may enable firms to charge premium prices. Firms are able to do this because a good reputation reduces stakeholder uncertainty about the value of future exchanges (Rindova et al. 2005). Greenwood et al. (2005) found that client dependence in PSFs elevates organizational reputation into an important

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influence on performance. To succeed, PSFs must generate superior reputation. Moreover, Roberts and Dowling (2002) found in their study that organizations with a higher reputation are more likely to sustain superior financial performance over time. Furthermore, positive corporate reputation prompts consumers to believe advertising claims supporting and enhancing sales force effectiveness (Dolphin, 2004). Customer loyalty has a tendency to be higher when the perceptions of reputation are favorable (Nguyen & Leblanc, 2001). Deephouse (2000) found that a positive reputation increases the likelihood that stakeholders will contract with a given firm. He also found that a strong reputation can lead to benefits such as lowering firms cost and creating competitive barriers.

However, beside the numerous positive benefits of organizational reputation, there is also one drawback that comes in the form of reputational risk (Eccles et al., 2007). Lange et al. (2011) argue that a firm’s reputation is rooted in their historical behavior and associations. However, the reputation of a firm can abruptly change when new information about past behavior comes to light. Gatzert (2015) reviewed several empirical studies and found that these studies all emphasize that different types of reputation damaging events (e.g. downsizing, layoff, corporate crime) can have a significant negative impact on corporate reputation. There is no general agreement in defining reputational risk. However, Eckert (2017) argues that most definitions are consistent in seeing reputational risk as “risk of risks”, meaning that un underlying risk event leads to reputational losses. Underlying risk events are for instance, scandals affecting a firm. Three factors determine the extent to which a company is exposed to reputational risk (Eccles et al., 2007).

The first factor is whether a firm’s reputation exceeds its true character. Eccles et al. (2007) argue that effectively managing reputation risk begins with recognition that reputation is a matter of perception. A strong reputation among a few stakeholders across multiple categories will result in a strong positive reputation for the firm as a whole. This reputation, however, is not always the actual character or behavior of the company. When the reputation of a company is more positive than its underlying reality, then this gap (reputation-reality gap), poses a substantial risk. Eccles et al. (2007) argue that firms who want to bridge these reputation-reality gaps must either improve its ability to meet expectations of share- and stakeholders or lower expectations by promising less.

A second determinant of reputational risk is according to Eccles et al. (2007) the extent to which external beliefs and expectations form the firm in question change. When expectations are shifting, and the company’s underlying reality stays the same, the reputation-reality gap widens and risk of losing reputation increases.

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Finally, a third determinant of reputational risk is weak internal coordination (Eccles et al. 2007). This refers to poor coordination of the decisions made by different business units and functions in the same organization. If one business unit creates expectations, but the other business unit fails to meet these expectations, the organization’s reputation can be damaged. Eccles et al. (2007) give as typically example a software manufacturer that launches a new advertising campaign, promoting their new software package, before developers have ironed out all the bugs. The manufacturer is then forced to choose between selling an inferior product or introducing the product later than promised.

Some interesting more recent studies have focused on the antecedents and consequences of organizational reputation. Walsh, Mitchell, Jackson, and Beatty (2009) found that trust and customer satisfactions are typical antecedents of organizational reputation. Furthermore, Walsh et al. (2009) also found that customer loyalty and word of mouth behavior are consequences of a strong organizational reputation. Ali, Lynch, Melewar, and Jin (2015) argue that these academic antecedents and consequences of organizational reputation should be approached with considerable caution when developing and managing organizational reputation. According to Ali et al. (2015), the antecedents and consequences are depending upon the country of the study, the type of stakeholder group evaluating the reputation, and the type of reputation measure used.

2.5 Strategy

Strategy and its relation to MCSs has been hypothesized to affect management control systems design in a number of straightforward ways, depending on which strategy theory is used (Otley, 2016). According to Slater and Olson (2001), strategy is concerned with how organizations achieve competitive advantage. Porter (1996) defines strategy as the creation of a unique and value position, involving different sets of activities. Strategy requires organizations to make trade-offs in competing.

Porter (1980) was one of the first to propose two generic strategies, regardless of industry type, that could achieve competitive advantage. He distinguishes in his work the cost leadership strategy and the differentiation strategy.

The first generic strategy to achieve competitive advantage, cost leadership, involves being a leader in terms of costs in the market or industry where the firm is operating. An organization that conquers a large market share with a low price and then strives for the lowest possible selling price is a typical example of an organizations that uses the cost leadership

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strategy. Cost leadership requires tight costs and overhead control and cost minimization in areas such as research and development (R&D) (Auzair & Langfield-Smith, 2005).

The differentiation strategy involves making unique products or services that are different and better than those of an organization’s competitors. In other words, it is about creating something that is perceived by customers as being unique. This can be based on the quality of the product or service, the organization’s flexibility or after-sale customer service. When using the differentiation strategy an organization tries to conquer and retain the industry’s market through distinctiveness and quality aspect of products and services.

In the remainder of the paper the generic strategies of Porter (1980) are used when referring to an organization’s strategy.

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3 Hypothesis formulation

Based on the literature review in the previous chapter, a total of nine hypotheses are formulated in this chapter. The first set of hypotheses describes the expected direct relationship between organizational reputation and MCS tightness in PSFs. The second set, describes the expected direct relationship between a PSF’s strategy and the tightness of their MCS. Finally, the last hypothesis, expects that the relationship between reputation and MCS tightness is moderated by the differentiation strategy of a PSF. Figure 1 summarizes the hypotheses in terms of a simplified path model.

Figure 1 Hypothesized path model

3.1 Organizational reputation and control tightness

Several studies have shown that the relationship between corporate reputation and financial performance have produced conflicting results (Cravens & Oliver, 2006). The failure of managing reputation can be disastrous for a firm, especially for PSFs. Greenwood et al. (2005) found that reputation is vitally important for PSF because it serves as a social signal to clients experiencing uncertainty arising from information asymmetry.

As described in the literature review, a high organizational reputation can result in several benefits. Firms with strong positive reputations can attract better people, are perceived as providing more value, and can charge a premium. Moreover, their customers are more loyal and buy broader ranges of products and services (Eccles et al., 2007). However, those benefits can be worth nothing when firms are exposed to a significant amount of reputational risk. Eccles et al. (2007) argue that it takes many good deeds to build a strong reputation, but only one bad one can lose all reputation. One of the things a firm must do to manage its reputational risk is closing the reputation-reality gap. This can be done by improving the ability to meet

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expectations of stakeholders. Meeting these expectations can refer to reaches certain financial targets but can also refer to meeting expectations for factors such as behavior or integrity. As described in the literature review, the likelihood of meeting these targets or expectations increases when a firm uses a tight MCS. When a PSF has a strong organizational reputation, they are committed to keep this, for obvious reasons. A tight MCS can help with this. Therefore, is reputation in this study the input or the independent variable and control tightness the output or dependent variable.

In general, tight results controls are very much useful to make sure that employees focus on the task they should be performing. However, it is plausible that this does not apply in a PSF setting. Professionals value autonomy (Von Nordenflycht, 2010) and their output in performance is difficult to measure (King & Clakrson, 2015; Raelin, 1989). Moreover, professionals may not always respond well to the measures used. In particular, when they belief that the measures used do not reflect the various measurement properties (Merchant & Van der Stede, 2017). It is therefore expected that there is no relationship between the level of organizational reputation and the level of results control tightness. This hypothesis is somewhat different than the general expectation that a high organizational reputation has a positive effect on control tightness. The first hypothesis is formulated as follows:

H1a: PSFs with a higher organizational reputation use the same level of results control

tightness as PSFs with a lower organizational reputation.

Managing employees in PSFs is very important because the firm’s output relies on these employees. A PSF provides a service, which is intangible, and therefore hard to measure. Tight actions controls are then necessary to maintain a strong reputation. PSFs need to make sure that actions of employees do not harm the organization.

Moreover, Jensen and Meckling’s (1979) agency theory predicts that the interest of an employee is often not aligned with the goals and targets of an organization. Because of this self-interest of employees, tighter action controls are needed.

One would argue that professionals still prefer autonomy and informal controls over tight action controls. However, according to Brivot (2011) this is no longer the case when PSFs apply knowledge management systems aimed at codifying best practice situations. Professionals are then able to align their behavior with managerial goals, but at the same time retain their independence and their preference for autonomy. The combination of argumentation above leads to the following hypothesis:

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H1b: PSFs with a higher organizational reputation use tighter action controls than PSFs with

a lower organizational reputation.

According to Cravens and Oliver (2006), employees are not only central to the creation of organizational reputation. They are also essential in preventing a reduction of reputation in the form of reputation loss. This is especially important for employees who are in direct contact with customers and potential customers. Employees who interface with these customers on a daily basis must be aware that their actions are important in managing the reputation of the firm that they represent. A crisis in reputation is often the result from unethical actions of management or employees. The actions of a few employees who are not committed with the firm can be devastating to many others (Chaney & Philipich, 2002). Selecting and hiring the right people is therefore essential for a PSF to maintain their level of reputation.

Moreover, PSFs are highly dependent on their professional workforce. Greenwood et al. (2005) found that PSFs are forced to attract and retain qualitied people who can adapt their repertoires to meet the demands of the task. The argumentation above leads to the following hypothesis:

H1c: PSFs with a higher organizational reputation use tighter personnel controls than PSFs with a lower organizational reputation.

Tight cultural controls can also help make employees more reliable and affect an organization’s ability to generate value (Merchant & Van der Stede, 2017). Robertson and Swan (2003) found, based on a two-year case study at a knowledge intensive firm, that strong culture based on an acceptance of ambiguity (roles, power relations, organizational routines) promoted the development of loyal, committed, and effective employees. Moreover, Robertson and Swan’s (2003) research show that a strong culture engenders a form of normative control. To maintain a high level of organizational reputation, PSFs needs employees who are loyal and committed. This leads to the following hypothesis:

H1d: PSFs with a higher organizational reputation use tighter cultural controls than PSFs with a lower organizational reputation.

3.2 Strategy and control tightness

According to Langfield-Smith (1997), the MCS of a firm should be tailored explicitly to support the strategy of the business. In this way the MCS helps firms in achieving competitive advantage and superior performance. Kumar and Subramaniam (1997) found that firms

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pursuing a cost leadership strategy place greater emphasis on effective personnel policies. This is comparable with action controls (Merchant & Van der Stede, 2017). Auzair and Langfield-Smith (2005) state that cost leaders actively pursue cost reduction, tight cost, overhead control, and cost minimization. This are examples of tight results control. Moreover, research suggests that differentiation strategies are more associated with informal loose, or flexible controls. (Simons, 1987; Van der Stede, 2000).

In the context of PSFs it is also expected that cost-leaders use tighter results- and action controls than differentiators. Auzair and Langfield-Smith (2005) found that PSFs pursuing the cost leadership strategy place more emphasis on a more bureaucratic form of MCS than PSFs pursuing a differentiation strategy. According to them involves a more bureaucratic MCS more action-, formal-, tight-, restricted-, and impersonal control. Cost-leaders are likely to adopt uniform rules to focus employees on tasks and prevent them from working outside strict boundaries. This argumentation leads to the following two hypotheses:

H2a: As the importance of the cost leadership strategy increases, relative to the importance of the differentiation strategy, a PSF uses tighter results controls.

H2b: As the importance of the cost leadership strategy increases, relative to the importance of the differentiation strategy, a PSF uses tighter action controls.

On the other hand, differentiators need to create services that are perceived as unique, or better than their competitors. Auzair and Langfield-Smith (2005) argue that for this reason service organizations should allow employees more space to be creative and flexible. Results- and action controls do not give these employees more space to be creative. Only a small selection of employees is able to work in a free and creative working environment. Therefore, it is expected that differentiators use more extensive, or tight, hiring procedures. Moreover, since results- and action controls are very effective for differentiations, it is expected that these firms focus more on cultural controls. The leads to the following two hypotheses:

H2c: As the importance of the differentiation strategy increases, relative to the importance of the cost leadership strategy, a PSF uses tighter personnel controls.

H2d: As the importance of the differentiation strategy increases, relative to the importance of the cost leadership strategy, a PSF uses tighter cultural controls.

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3.3 Organizational reputation, strategy, and control tightness

Reputation plays a strategically important role in service markets because, like experience goods, the evaluation of service quality is vague and partial (Weigelt & Camerer, 1988). The last set of hypotheses expects that the differentiation strategy moderates the relation between the organizational reputation of a PSF and the tightness of their MCS.

Banker, Mashruwala, and Tripathy (2014) found that the differentiation strategy is associated with greater risk and more unstable performance. Differentiators are therefore more exposed to the reputation-reality gap (Eccles et al., 2007). Since a PSFs output is intangible (Von Nordenflycht, 2010), potential customers base their service provider most of the time on the level of reputation (Greenwood et al., 2005). And since more risk involved for PSFs pursuing the differentiation strategy it is expected that these firms value organizational reputation more than for instance, cost-leaders. It is therefore expected that the differentiation strategy moderates the relationship between organizational reputation and the tightness of a PSF’s MCS. This proposed interaction effect is visualized in figure 2. The last set of hypotheses are formulated as follows:

H3(a/b/c/d): The degree to which a PSF’s reputation influences the MCST2_{of a PSF will be}

enhanced by the application of the differentiation strategy.

Figure 2 Proposed moderation effect

2_{“MCST” is in hypotheses H3a/b/c/d in the following order either: results control tightness, action control}

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4 Research method

The fourth chapter addresses the research method used in this study. First, the survey is briefly explained. The second section discusses the survey pre-test and the third section the sample criteria. After that, the sample selection is discussed. The fifth section addresses the measurement of variables. The sixth section discusses the factor analysis and the reliability analysis. Finally, the last section addresses the statistical model.

4.1 Survey

The data used to test the hypotheses is obtained from an online survey. This survey is part of the ongoing research project Professional Service Firm Thesis Project 2017-2018. In this project, the accounting section of the Amsterdam Business School at the University of Amsterdam investigates how professional service firms design their management accounting and controls systems, and whether these systems have an effect on professionals, working in these organizations. The project aims to investigate the use of MCSs in PSFs through a pre-developed written questionnaire.

The final questionnaire consists of 159 questions/statements regarding human capital intensity, task complexity, environmental uncertainty, strategy, professionalized workforce, reputation, organizational size and type, compensation, organizational structure, customer reliance, control tightness, professional tensions, and performance.

In order to get access to the complete dataset of filled in questionnaires, participants of the PSF Project had to submit at least ten completed questionnaires from suitable respondents before the 1st_{of February 2018. The PSF Project specifically looks for mid-level employees}

with fairly limited responsibility. This means that participants are often in direct contact with suitable respondents, or just one link away. I was able to submit thirteen completed surveys, all filled in by legal councilors from the same organization. Furthermore, in order to assure the quality of the survey, all respondents were asked to send a confirmation e-mail.

4.2 Survey pre-test

In order to maximize the quality and effectiveness of the survey, two separate pre-tests were conducted by the accounting section of the Amsterdam Business School. These pre-tests were conducted before the survey could be sent out to potential respondents.

The first pre-test focused on the quality of the measurement items for the various types of management controls. The quality of these measurement items was assessed using an item sort task. Participants of the pre-test were provided with two sheets of paper and their task was

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to match eight control constructs from the first paper with 52 statements regarding those constructs from the second paper. From the twenty professionals asked to take part in the first pre-test, a total of fourteen professionals completed the test. The number of correct and incorrect matched items, provided by the professionals, were sorted and the four statements with the least incorrect matches were included in the survey.

To evaluate the quality of the online survey as a whole, a second pre-test was conducted. Twenty more professionals from various occupations were asked to provide feedback in regard to the content, clarity, and appearance of the online survey, as well as the time required to complete the entire survey. Thirteen professionals provided written feedback and the remaining seven professionals provided feedback by telephone. The feedback by the professionals participating in the second pre-test resulted in minor changes in wording and some additional answer options for a few multiple-choice statements.

4.3 Sample criteria

Potential respondents had to meet several requirements in order to qualify as a respondent in the PSF Project. First of all, all respondents should be working in a PSF. In this study the following occupations are classified as PSFs:

Table 2 Occupations classified as PSFs

Accounting Actuarial services Advertising Architecture Biotechnology Consulting Engineering Consulting IT Consulting HR Consulting Management/Strategic Consulting Technology Engineering Fashion design Financial advising Graphic design Insurance brokerage Investment banking

Investment management (hedge funds, venture capital, mutual funds) Law

Marketing/Public relations

Media production (film, television, music) Medicine/Physician practices Pharmaceutical Project management Real estate Recruiting – executive Research/R&D

Risk management services Software development Talent management/agencies

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Moreover, the sample population does not include service organizations active in non-profit, publicly owned organizations such as universities, government organizations, NGOs and social work agencies.

Professionals who were asked to fill in the survey, had to have three characteristics in order to classify as a respondent. Those three characteristics are: (1) the respondent is not owner/partner or board member of an organization, (2) the respondent works in a medium to large size organization (> 50 employees), and (3) the respondent must speak and understand English at a business level.

4.4 Sample selection

The dataset obtained from the survey had a total of 730 recorded respondents. However, from those 730 recorded respondents, 99 surveys were not completed and therefore removed from the dataset.

Furthermore, 101 respondents selected that their occupation fell in the ‘other’ category, instead of any of the standard occupations that classify as PSFs from table 2. When a respondent stated that their occupation fell in the ‘other’ category a follow-up question was asked where the respondent had the opportunity to describe their occupation. Upon inspection it was decided that 25 respondents form the ‘other’ category could also be interpreted as any other valid category. For instance, in many occasions, respondents stated that they fell in the ‘other’ category, but then described their job function as audit or controlling. It is clear that these functions also fall in the accounting category. In this way, thirteen respondents from the ‘other’ category were interpreted as accounting, one was interpreted as biotechnology, two as consulting HR, five as consulting IT, two as law, one as pharmaceutical, and one as risk management services. In the end 76 responses were deleted because it was not possible to interpreted them as any other valid PSF category and therefore did not meet the PSF requirement.

After that, it was assessed whether or not the remaining respondents had filled in all the questions regarding reputation, strategy, results control tightness, action control tightness, personnel control tightness, and cultural control tightness. This assessment resulted in deleting another 64 respondents from the dataset. The total sample selection process resulted in a deletion of 239 respondents. The final dataset consists therefore of 491 respondents. An overview of the sample selection process can be found in table 3.

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Table 3 Sample selection

Total respondents 730

Total surveys not completed - 99 Respondents who did not meet the PSF criterium - 101 Respondents from ‘other’ occupation category interpreted as:

Accounting + 13 Biotechnology + 1 Consulting HR + 2 Consulting IT + 5 Law + 2 Pharmaceutical + 1

Risk management services + 1 Respondents who did not answer all relevant questions regarding:

Reputation - 9

Strategy - 14

Results control tightness - 12 Action control tightness - 10 Personnel control tightness - 8 Cultural control tightness - 11

Final respondents 491

The largest group in the sample population are professionals working in the accounting field. A total of 16.90% of the sample population is active in this field. The second largest group is the medicine/physician practices with 9.37%, closely followed by consulting HR and consulting management/strategic with 7.74% and 7.33%. The occupations consulting engineering (0.61%), talent management/agencies (0.61%), architecture (0.41%), consulting technology (0.41%), graphic design (0.41%), advertising (0.20%), and insurance brokerage (0.20%) are barely representative in the dataset. None of the respondents are active in the field of fashion design. A graph of the occupations distribution based on the dataset can be found in Appendix B.

Descriptive characteristics for the 491 respondents are provided in table 4. The average age of the respondents is 35.21. The majority of the responses in the dataset are filled in by males (65.50%). 37.90% of the respondents have a bachelor’s degree or lower, 48.60% of the respondents are in the possession of a master’s degree, and 13.50% of the respondents have a PhD or other professional doctorate degree. Finally, respondents have on average 7.31 years of experience in their field and 6.05 years of experience in their current organization.

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Table 4 Characteristics respondents

Percentage N Min Max Mean

Standard deviation Age 488 21 64 35.21 8.809 Gender* 489 1 2 1.34 .475 Male 65.60% Female 34.40% Education** 488 1 3 1.76 .675 Bachelor’s degree or lower 37.90%

Master’s degree 48.60% PhD or other doctorate degree 13.50%

Experience in field*** 476 1 11 7.31 3.054 Experience in current organization*** 490 1 11 6.05 3.171 * Male = 1, Female = 2.

** Bachelor’s degree or lower = 1, Master’s degree = 2, PhD or other doctorate degree = 3. *** Less than 1 year = 1, 1 year = 2 etc., 10 years or more = 11.

4.5 Measurement of variables

4.5.1 Independent variables

There are two independent variables in this study based on the hypothesis formulation in chapter three. The first independent variable is organizational reputation (REP). The measurement of organizational reputation is adapted from Combs and Ketchen (1999). To measure REP, respondents were asked to indicate on a 5-point Likert scale how their organization is viewed in terms of reputation. Four questions were asked regarding REP, addressing whether the firm has a strong reputation for consistent quality and services, whether the firm has a strong brand name recognition, whether the firm is well-respected in its field, and whether the firm is perceived to provide good value for price.

The second independent variable is strategy (STRAT). The distinction between cost leadership (COST) and differentiation (DIFF) is adapted from Porter (1980). To measure COST and DIFF, respondents were asked to indicate on a 5-point Likert scale, the degree of emphasis on eleven different statements. These statements are provided in Appendix A to this study. The statements used in the survey were adapted from a study by Auzair and Langfield-Smith (2005). 4.5.2 Dependent variables

The possible effects of organizational reputation and strategy on the tightness of MCSs are examined for the four types of controls as discussed in the literature review. Results control

The effect of organizational reputation and strategy on management control systems in professional service firms