How to control the Overhead?
Management control mechanisms for overheads in public sector organizations
Joëlline Goossen
Master Thesis University of Groningen Faculty of Economics and Business
MSc. Business Administration
Specialization: Organizational and Management Control July 2010
Management control mechanisms for overheads in public sector organizations 2
How to control the Overhead?
Management control mechanisms for overheads in public sector organizations
Joëlline Goossen
Master Thesis University of Groningen Faculty of Economics and Business
MSc. Business Administration
Specialization: Organizational and Management Control July 2010 Joëlline Goossen Saffierstraat 142 9743 LL Groningen (06) 55 80 20 95 j.h.j.goossen@student.rug.nl Studentnumber: 1564633
Management control mechanisms for overheads in public sector organizations 3
Preface
This thesis was written in the context of the Master of Business Administration, specialisation Organizational & Management Control at the University of Groningen. It is a report of my findings and conclusions drawn from my graduating research in the second semester of the academic year 2009/2010.
When the economy stagnates - and certainly when the economic activity takes a longer time to recover – the moment comes up in many companies at which the control system for controlling costs is examined more closely. Organizations will have to ask themselves: “Can we afford a gradual reduction of costs or is there a need for drastic cuts?” In case of the latter, the overhead costs will also have to be addressed rigorously. In many organizations, the costs of these services and related staff departments form a great share of total costs – indiscriminate of the question whether they are enterprises, non-profit or government organizations. When one defines the total costs of an organization as the sum of costs and overhead, then we can see a tendency; overhead costs have increased for years when looked at as a percentage of total costs. Painful cost reductions can often be prevented by controlling overhead costs in a continuous process. This thesis develops a theoretical framework of management control mechanisms for controlling overheads which indicates what factors influence the choice of the management control mechanisms.
I have had a good and interesting time and have been able to work on an attractive and challenging research, which has lead to the establishment of a management control framework for the control of overhead costs. I would like to thank all those involved for this. Firstly I would like to thank my supervisor, professor Dr. G.J. van Helden, for his supervision and support. I have received good feedback and interesting tips from him during the entire process, for which I am very grateful. He was always interested in the developments and has frequently provided me of help and information. I would also like to express my gratitude to Mr. M. Huijben, who was enthusiastic and willing to read along as I was writing my master thesis. Of course I would also like to thank my family and friends for their involvement and support during the entire graduating process.
Management control mechanisms for overheads in public sector organizations 4 Executive summary
The aim of the current thesis is to investigate how organizations can control their overhead costs, to improve indirect cost conscious behaviour and effective use of overhead activities. It has led to a theoretical framework of management control mechanisms, based on the main attributions and assumptions of Transaction Costs Economics (TCE), and indicates which factors influence the choice of the management control mechanisms of overheads in public sector organizations.
Overhead is a subject that often solicits an angry response. The image is that there is too much overhead. To prevent or overcome overhead problems, for example large increases in overhead costs or size, it is important to continually control overhead functions. A main issue for organizations is to determine which management control mechanisms of overhead are appropriate. Overhead is mainly characterized by the TCE characteristics uncertainty and asset specificity. All four control types of Merchant and Van der Stede, i.e. Results control, Action Control and Personnel and Cultural control can be presented in the control framework for overheads which is determined by the relevant TCE characteristics.
The main conclusion is that all four control types of Merchant and Van der Stede (2007) are appropriate for controlling overheads in public sector organizations, depending on the situation it can be determined which control type will fit best. Because of the absence of economic efficiency in public sector organizations, the ability to measure quality is an important attribution that influences the choice of the management control mechanism for transaction of overhead services. The framework for control mechanism for overheads can be enriched with the quality attribution to encourage that transactions in public sector organizations are managed with the most suitable control mechanisms. Furthermore, it will improve indirect cost conscious behaviour and effective use of overhead activities
Academic literature proves that action control is often the most appropriate control mechanism for controlling overheads in public sector organizations. Because many overhead functions are heterogeneous and outputs are hard to define and quantify, it is often desirable to turn to action control, with the addition of relevant quality indicators.
Keywords: Transaction Cost Economics, Control mechanisms, Overhead services, Public sector organizations
Management control mechanisms for overheads in public sector organizations 5 Table of Contents Preface... 3 Executive summary... 4 1. Introduction ... 6 2. Research design... 8 2.1 Introduction ... 8 2.2 Research objective ... 8 2.3 Research question ... 8 2.4 Sub-questions... 8 2.5 Research method... 9
2.6 Structure of the thesis... 9
3. Management accounting and control ... 10
3.1 Introduction ... 10
3.2 Theoretical background of management accounting and control ... 10
3.3 Cost allocation ... 11
3.4 Control types... 12
3.5 Tightness: loose or tight ... 15
3.6 Contingency approach to management control... 16
4. Building a TCE Framework for controlling overheads ... 17
4.1 Introduction ... 17
4.2 Theoretical background of TCE... 17
4.3 TCE Framework for controlling overheads ... 20
4.4 Control archetypes of Speklé and Vosselman ... 25
4.5 Comparison between the control framework of overheads and the control archetypes of Speklé and Vosselman ... 27
5. Management control in public sector organizations ... 34
5.1 Introduction ... 34
5.2 Management control in public sector organizations ... 34
5.3 Transaction Cost approach to public sector organizations ... 36
5.4 Enriched framework for controlling overheads in public sector organizations ... 38
6. Conclusions and implications for further research... 40
6.1 Introduction ... 40
6.2 Answers to sub-questions ... 40
6.3 Answer to the research question ... 41
6.4 Implications for further research... 42
References ... 44
1. Introduction
Times of economic recession usually cause a renewed interest in rigorous, detailed and effective cost-management practices. Organizations will ask their financials to search for possible cost savings and reductions. In the present economic climate, effective organizations look even more critical at their indirect expenses than at their direct expenses. Only then can they prevent painful reductions of jobs and productive capacity. These reductions would finally weaken the organizations, and when the economy improves again they are no longer able to be fully profitable. Businesses can realize more cost reductions, even relatively painless, if they approach the indirect expenses with the same discipline as the direct expenses.
On 5 January 2010, Mark Huijben consultant of Berenschot, spoke in a guest lecture at the University of Groningen about overhead in organizations. He triggered me with his questions: What is overhead? How to determine the optimal level of overhead? How does overhead of one organization compare with that of others in the same sector?
Overhead is a subject that often solicits an angry response. The image is that there is too much overhead, especially in public sector organizations. The discussion on overhead is mostly about size, not about benefit or advantage, although a quarter of the working population is working in an overhead position. A number of private and public sector organizations seem to struggle with their overhead functions. An interesting aspect of overhead is that it is always strongly related to the primary process of the organization. Therefore, continuity in the service relation between overheads and primary processes is very important. To prevent or overcome overhead problems, for example large increases in overhead costs or size, it is important to continually control overhead functions. A main issue for organizations is to determine which management control mechanisms of overhead are appropriate.
Overhead is a very broad concept. On the one hand it encompasses the ‘manufacturing overhead’, i.e. indirect production costs which are indeed not necessarily caused by the technical side of the production process, but do relate strongly to primary processes in the organization. On the other hand it encompasses costs of which the size depends solely on what the management determines. In this context we speak of ‘management dependent costs’. This involves activities such as fundamental and applied research, market research, product and process development, marketing, service, planning and administration, personnel management, training and education, legal advise, security and management consulting. The costs of management itself, of the board of directors and the supervisory board also fall into this category of overhead costs.
There are two basic definitions for overhead. These seem to be the same, however there are fundamental differences. Both definitions are not sharp and not detailed enough; a third problem is that the tasks of overheads will change over time (Huijben and Geurtsen, 2008).
Porter clearly distinguishes the primary activities of an organization from the support activities (Porter 1998). Keuning and Eppink (2008) describe this distinction as follows: ”Primary activities can be divided in incoming stream from goods, production, marketing and sales and services. The supporting activities consist of purchase of products and services to the benefit of the primary and supporting activities, development of technology, such as research and development, the managing of human potential and organizational structure, for instance general management, financing and legal affairs. An organization has the right to exist as a result of the primary process, according to the value adding process. All remaining business processes have a supporting position to the primary process.”
The second basic definition, the difference between primary and secondary activities, forms a suitable starting point. From this perspective, Huijben and Geurtsen presented in their book ‘Has Anyone Seen Our Overhead?’ (2008), a third definition of overhead: “Overhead is the whole of positions directed to the control and support of the employees in the primary process. Moreover, until overheads belong all the positions that serve this aim.” Overhead functions have no direct relation to the service of the customer, although they furnish an indirect contribution to the organization.
One of the characteristic features of technological development, The Industrial Revolution, is the increasing importance of overheads in the cost structure of organizations. In the early 1900s, when many organizations first installed formal cost systems, the total costs where almost entirely associated with materials and labour costs. However, the introduction of expensive power driven machinery immediately produces those additional problems arising for the existence of ‘common’ cost or ‘overhead’ costs. Overhead costs have long provided a series of challenges and problems for accountants and managers. Indeed some of the earliest publications on the subject of management accounting focus on the practical difficulties of overhead costing (e.g. Solomons, 1968; Thomas, 1969).
2. Research design
2.1 Introduction
The main input for the research is the problem statement. The problem statement can be subdivided in the research objective, the research question, restrictions, and prerequisites (De Leeuw, 2001). This chapter will first clearly describe the purpose of the research, the way in which the problem situation will be analysed and how insight will be obtained in the knowledge which is required for achieving the objective. Thereafter, the research objective will be used to formulate the research question and the sub-questions. Finally, the structure of the research and the methodology will be discussed.
2.2 Research objective
The two broad subjects of this research are Management Control and Overhead. The general purpose of this thesis is to explore the possible management control mechanisms to control overhead in organizations in order to improve cost conscious behaviour and efficient use of overhead functions. First, the nature of overhead costs, diverse management control mechanisms, the concepts of cost allocation and transaction costs economics are explained. After that, the analysis aims to establish which control mechanisms for overheads fits best in different situations and circumstances.
The ultimate goal of this research is to get an insight into the mechanisms for controlling overheads in public sector organizations in order to improve the efficiency and effectiveness of the organization. The aim of this thesis is to develop a basic theoretical framework, based on main concepts of the Transaction Costs Economics theory, to explore the relevance of some important aspects of this framework for a better understanding and explanation of controlling overheads in the public sector.
2.3 Research question
Based on the brief introduction above and the research objective, the question on which this thesis will focus is:
• Which control mechanisms for overheads in public sector organizations are most suited in different situations and circumstances?
2.4 Sub-questions
In order to find a clear answer to the research question, the following sub-questions are used for a further literature review:
1. What is cost allocation and is it a desirable mechanism for effective use of overhead activities?
2. Which control mechanisms are needed to plan and to maintain control over certain activities or transactions and are these relevant for controlling overhead costs? 3. How can the transaction cost perspective be described and which factors are
2.5 Research method
The research will be based on a literature study. The objective of the theoretical explorations presented in the thesis is to gain more insight for further investigation. The thesis is fully theoretical of nature and leaves the testing of the propositions for future research. The research will lead to a framework concerning the structuring of management control mechanisms for controlling overheads drawing on factors which are derived from concepts of the transaction cost theory and other relevant theoretical aspects. Furthermore, the results of this research could serve as a basis for further research into embedding overhead allocation into management control research. This is supposed to be a first step towards empirical case-study research in a next stage and probably followed by a more extensive field research in various organizations (Scapens, 2004).
2.6 Structure of the thesis
3. Management accounting and control
3.1 Introduction
This chapter will describe the essence of management accounting and control. First the theoretical background of management accounting and control will be outlined, based on the work of several authors, such as Ouchi, Hofstede and Otley. In order to control overheads, there is subsequently a need to attain clarity in different kinds of costs and gain insight in the allocation of costs. In section 3.3 both will be defined and explained. Management controls can be categorized in many ways. In section 3.4 the diverse control types that are relevant to this thesis will be discussed. The four control types as they were defined by Merchant and Van der Stede (2007) will be described, furthermore the circumstances will be explained in which these types of control function best. In addition, the conceptual framework for the design of organizational control mechanisms of Ouchi (1979) will be explained. Another important factor that characterises management control is the degree to which the management control systems can be described as tight or loose. Tightness and looseness of management controls will be described in section 3.5. Section 3.6 finally, clarifies the influence of the contingency theory on controlling overheads. 3.2 Theoretical background of management accounting and control
Management accounting is concerned with the preparations and use of accounting information for managers within organizations, to make informed business decisions. According to the CIMA (Chartered Institute of Management Accountants), Management accounting is "the process of identification, measurement, accumulation, analysis, preparation, interpretation and communication of information used by management to plan, evaluate and control within an entity and to assure appropriate use of and accountability for its resources”.
Management control is one of the managerial functions such as organizing, staffing, planning and directing. In 1916, Henri Fayol formulated one of the first definitions of control as it pertains to management. Control consists of verifying whether everything is being carried out in conformity with the plan adopted, the instructions issued, and principles established. The object of management control is to point out weaknesses and errors in order to rectify them and prevent recurrence (Fayol, 1949). Management control issues primarily have an internal focus; it is mostly about processes which can influence employees’ behaviours in desired ways (Flamholtz et al., 1985).
Management control was defined by Anthony (1965) as “the process by which managers ensure that resources are obtained and used effectively and efficiently in the accomplishment of the organization’s objectives.” This definition separates management control from strategic control and operational control.
Perfect control does not exist, because good management control still allows for some probability of failure. Optimal control can be achieved if control losses are expected to be smaller than the cost of implementing more controls. According to Merchant and Van der Stede (2007, p. 12), organizations can avoid some of their control problems by four avoidance strategies, i.e. activity elimination, automation, centralization, and risk sharing. For the control problems which cannot be avoided, organizations should implement control mechanisms that are generally called management controls or management control systems (MCS). There is a difference in breadths of inter-organizational controls; figure 1 shows the varying breadths of management controls. According to Caglio and Ditillo (2008) control archetypes define mixes of different control mechanisms, management control mechanisms specify more explicitly the elaboration of certain control archetypes, and cost and accounting controls are control mechanisms based on cost and accounting information.
Figure 1: The varying breadths of inter organizational controls.
Source: Caglio and Ditillo (2008), p. 866. 3.3 Cost allocation
In management accounting, the term ‘cost’ is used in many different ways. This is because there are many types of costs, and these costs are classified differently according to the immediate needs of management. The most common definition of cost is the monetary value of goods and services expended to obtain current or future benefits (Atkinson et al, 2007). An old adage in management accounting advocates “Different costs for different purposes.” This suggests that there is no universal way to compute the cost of something. The way that a cost will be used defines the way it should be computed.
of the resource is used by more than one cost object (Seal et al., 2006). The allocation of indirect costs to products or services is called cost allocation.
Management accounting literature shows that the relevance of cost allocation is a controversial topic. On the one hand, cost allocation is expected to contribute to the efficient use of internal services, but on the other hand, allocation of indirect costs is adversely affected by arbitrary elements (van Helden, 2000). Horngren (1977, pp. 52-53 and 508) suggests that cost allocations are desirable mechanisms for motivating and controlling managers.
3.4 Control types
The management of an organization is continually focussed on the processes of organizing resources and directing activities for the purpose of achieving organizational objectives. The management functions can be separated along a process continuum involving objective setting, strategy formulation and management control. Management control is the back end of the management process.
Controls have been categorized in many ways. For instance, formal and informal controls (Anthony et al., 1989) output and behaviour controls (Ouchi, 1977) market, bureaucracy and clan controls (Ouchi, 1979) administrative and social controls (Hopwood, 1976) and results, action and personnel controls (Merchant, 1985).
The theory of management control used in this thesis is that of Merchant and Van der Stede (2007), because it distinguishes a broad variety of control types. Moreover it includes all control types of earlier authors. Merchant and Van der Stede distinguish four types of controls based on the object of control, which can focus on the results produced (results control), the actions taken (action control) or the types of people employed and their shared norms and values (personnel and cultural control). Depending on the situation they occur alone or in a combination. There is no optimal form and every form has its advantages and disadvantages. According to Merchant and Van der Stede (2007) the four control types can be described as follows: include
1. Results control
Results controls are an indirect form of control because they do not focus explicitly on the employees' actions. Results controls influence actions because they cause employees to be concerned about the consequences of the actions they take. They are effective only where organizations can determine what results are desired in the areas being controlled, and when the employees whose behaviours are being controlled have significant influence on the results for which they are being held accountable, and finally if organizations can measure the results effectively. Results controls work best only when all three of the mentioned conditions are present. In addition, results controls can yield good control while allowing the employees whose behaviours are being controlled are unclear. This is particularly the case higher in the organizational hierarchy, where there is a form of high autonomy.
2. Action control
do things that should not be done. The constraints can be applied physically or administratively. Pre-action reviews involve the analysis of the action plans of the employees being controlled. Action accountability concerns holding employees accountable for the actions they take. Redundancy involves assigning more employees or machines to a task than is strictly necessary, or at least having backup employees or machines available. Action controls are feasible and effective only when organizations can determine what actions are (un)desirable and when organizations are able to ensure that the (un)desirable actions (do not) occur.
3. Personnel control
Personnel controls are designed to make it more likely that employees will perform the desired tasks satisfactorily on their own. Personnel controls serve any of three basic purposes. First, some of them clarify expectations, they help ensure that each employee understands what the organization wants. Second, some of them help ensure that each employee is able to do a good job; that they have all the capabilities and resources needed to do a good job. And third, some of the personnel controls increase the likelihood that each employee will engage in self-monitoring. Three major methods of implementing personnel controls are through selection and placement of employees, training, and job design.
4. Cultural control
Cultural controls exist to shape organizational behavioural norms and values to encourage employees to monitor and influence each other’s behaviour. Organizational cultures remain relatively fixed over time, even while goals and strategies necessarily adapt to changing business conditions (Kilmann and Saxton, 1985). The cultural norms are embodied in written and unwritten rules that govern employees' behaviours. Codes of conduct and group rewards are among the most important methods of shaping culture, and thus effecting cultural controls. Other approaches include intra-organizational transfers, physical and social arrangements, and tone at the top.
Results controls usually are the major elements of the management control system used in numerous organizations. However, results controls do not fit in every situation and are often supplemented by action, personnel and cultural controls. In recent years, personnel and cultural controls, which are sometimes referred to as soft controls, have become more important. In environments with wide spans of control and empowered employees', shared organizational norms and values have become more important for ensuring that employees act in the best interest of the organization.
The underlying essential element of any bureaucratic or market form of control is the assumption that it is feasible to measure, with reasonable precision, the performance that is desired. Indeed, the ability to measure either output or behaviour which is relevant to the desired performance is critical to the rational application of market and bureaucratic forms of control. The things that can be measured to control an organization are limited to the behaviour of employees or the results, i.e. the outputs of those behaviours. Table 1 specifies the contingencies which determine whether or not measurement is possible. Table 1: Conditions determining the measurement of behaviour and of output.
Knowledge of the transformation process
Perfect Imperfect
High A: Behaviour or Output
measurement
B: Output measurement
Ability to measure outputs
Low C: Behaviour measurement D: “Clan” control
Source: Ouchi (1979), pp. 833-847.
Cell A: High ability to measure output and perfect knowledge of the transformation process.
In this situation there is perfect knowledge of the transformation process and a perfect ability to measure output. A choice of behaviour or output control is available, and results control will be preferred as it is the lowest-cost mechanism. The reason is that the cost of one failure is prohibitive.
Cell B: High ability to measure output and imperfect knowledge of the transformation process.
If it is easy to measure the desired output but difficult to specify the best method of achieving this output or observe exactly how it is being achieved, then output rather than behaviour measurement will be most appropriate.
Cell C: Low ability to measure output and perfect knowledge of the transformation process.
In some situations it may not be possible to identify the output of employees, but it is possible to monitor the actions and activities taking place. The actual output of individuals is difficult to measure, however it is possible to observe the work of each person and behaviour measures are therefore appropriate.
Cell D: Low ability to measure output and imperfect knowledge of the transformation process.
It can be really difficult to measure output or actions. The control form that will fit the best here is clan or cultural control, in which shared norms and values will mean that the employees will act to achieve organizational objectives.
control forms shape organizational behavioural norms and values to encourage employees to monitor and influence each other behaviours. Whereas output and behaviour control can be implemented through a market or a bureaucracy, ceremonial forms of control (personnel or cultural) can be implemented through a clan mechanism.
3.5 Tightness: loose or tight
Another important factor that characterises management control is the degree to which the management control systems can be described as tight or loose. Tight management control can be defined here in terms of a higher degree of certainty that employees will act as the organization wishes. Tight control should be implemented, if there is good knowledge about one or more objects of control (actions, results or personnel and cultural) that relate to the organization’s objectives and if these control forms can be implemented effectively. Merchant (1998) presents an overview of the characteristics of each of the control types that can be varied to produce tight control.
Table 2: Overview of tight control characteristics.
Type of Control Characteristics
Results or action accountability Definition of desired results or actions: - Congruent with true organization skills - Specific
- Effectively communicated and internalized - Complete
Measurement of results or tracking of actions: - Congruent - Precise - Objective - Timely - Understandable Rewards or punishments:
- Significant to person(s) involved
- Direct and definite link to results or actions Behavioural constraints Reliable
Restrictive Preaction reviews Frequent
Detailed
Performed by informed person(s)
Personnel and cultural controls Certainty and stability of knowledge linking personnel and cultural characteristics with desired actions
Source: Merchant (1998), p. 166.
forms of control can not be implemented effectively, the management control systems should be looser.
3.6 Contingency approach to management control
The contingency theory is based on the assertion that there is no universally suitable accounting or control system, which applies equally to all organizations in all circumstances. The contingency approach emphasises that the design of any planning and control system is situation specific.
Otley (1980) explores three concepts, particularly technology, organization structure and environment, which can be invoked to explain why accounting systems differ from one situation to another. Woodward (1965) explains that the nature of the production process (e.g. unit production, small batch, large batch, mass production and process production) influences the design of internal accounting systems. Piper (1978) makes obvious that the complexity of the task faced by an organization is relevant to defining an appropriate financial control structure. Moreover, Daft and Macintosh (1978) identify task variety and task knowledge as factors which affect the design of an appropriate management information system. Furthermore, there is evidence to suggest that the organization structure affects the control system.
4. Building a TCE Framework for controlling overheads
4.1 Introduction
Transaction Costs Economics (TCE) can be used as a starting point for characterizing control variety for overheads and determine a theoretical framework for controlling overheads. Section 4.2 describes first and foremost the theoretical background of TCE. It continues with linking the three main transaction attributions of the TCE to the management control types of Merchant and Van der Stede. In section 4.3 this leads to a control framework for overheads. Furthermore, this section describes the transaction characteristics of diverse overhead functions. Consequently can be concluded which control type fits the situation best and can effectively control overhead costs. Beside the conceptual frameworks of Ouchi (1979) and Merchant and Van de Stede for the design of organizational control mechanisms there are some others in the management control field of expertise that describe diverse types of management control. Section 4.4 describes the control frameworks of Speklé (2001) and Vosselman (2002). In the last section the control framework for overheads that is developed will be compared with the control frameworks as formed by Speklé and Vosselman. Furthermore, there will be given an insight into similarities in the diverse determinants and the control archetypes and mechanisms used. 4.2 Theoretical background of TCE
The transaction cost economics theory represents one of the first and most influential attempts to develop an economic theory that fundamentally discusses the structure of firms. It tries to explain the particular structure of a firm and to which extent it will integrate vertically.
Transaction cost economics has its origins in law, economics and organization in the 1930s (Coase, 1937). The transaction cost approach argues that organizations want to economize on the sum of production and transaction costs. It assumes that firms are profit maximising, and that profit maximisation involves costs minimisation. TCE poses the problem of economic organization as a contracting problem. Kenneth Arrow has defined transaction costs as the "costs of running the economic system" (1969, p. 48). According to Williamson, a transaction occurs when a good or service is transferred across a technologically separable interface (Williamson, 1985, p. 552). Transactions involve costs, which are incurred by finding a counterpart, drawing up a contract or monitoring task completion.
Figure 2: Basic structure of TCE.
Source: Williamson (2002), pp. 171-195.
Williamson distinguished two types of transaction costs: ex ante and ex post. Ex ante transaction costs, occur before agreeing on the contract, which includes costs of drafting, negotiating and safeguarding the agreement. Ex post transaction costs, arise after the contract-agreement and take several forms, such as costs associated with faulty or inadequate adaptation, haggling, set-up and running costs, and bonding costs.
The two underlying assumptions of transaction-cost economics are bounded rationality and opportunism. Bounded rationality refers to the fact that rationality of individuals is limited by the available information, the limited cognitive processing power, limited knowledge and memories and the finite amount of time to make decisions. Given bounded rationality, it is impossible to deal with complexity in all contractually relevant respects. As a consequence, incomplete contracting is the best that can be achieved (Williamson, 1985, pp. 553-554). The other assumption that affects economic exchange is motivational in nature. It is possible that some participants in transactions will act in a self-interested way. They may not be entirely truthful about their intentions and they will give dishonest and guileful behaviour, which gives them the chance to exploit others and take self the advantages. These two TCE assumptions will have some consequences for controlling organizational transactions.
With these assumptions as a point of departure, transactions cost economics explicitly queries the efficiency of various governance structures around transactions (Williamson, 1996, 2002). The most efficient governance structure incurs the lowest possible transaction costs, therefore an organization can be competitive and survive in the long run. According to Williamson (1979, p. 239), a governance structure is a combination of methods, techniques, procedures and organizational forms, which are needed to plan and to maintain control over certain activities or transactions. Different governance structures like hierarchical, market or hybrid forms are distinguished by the dimensions of authority, ownership and incentives of the organization (Makadok and Coff, 2009).
a wider variety of sensitive incentive and control processes to be activated. Furthermore, it will result in enormous savings in governance costs.
The efficient form of governance structure is a function of certain properties of the underlying transaction or transactions. The differences between the forms of governance relate to differences in incentives, administrative control mechanisms, and the ability to adapt to internal and external changes.
As far as transactions are concerned TCE focuses on three critical attributes: - the degree of uncertainty of transactions;
- the frequency with and scale on which transactions take place; - the specificity of assets needed for production.
When the degree of uncertainty and or complexity increases, the need for future adaptations will be more likely. The second dimension that Williamson identifies is frequency and volume, which is the extent of buyer activity. The third dimension is the asset specificity and has reference to the degree to which an asset can be redistributed to alternative uses and by alternative users without sacrifice of productive value. When asset specificity increases, their will also be an increase in transaction switching costs.
These three variables or dimensions are used to characterise any transaction. Transactions can be frequent or infrequent; have high or low uncertainty; or involve specific or non-specific assets. These three variables will, according to the theory, determine whether transaction costs will be lowest in a market or in a hierarchy.
Asset specificity, as the most important characteristic of transactions in Williamson’s point of view, helps to illustrate the differences of the three governance modes best. Figure 3: Governance costs as a function of asset specificity.
Source: Williamson (2002), pp. 171-195.
transaction then forces the system to be managed under the hierarchy governance structure, as seen at point K2.
Beside asset specificity, the TCE characteristics frequency and uncertainty are also critical to the governance structure of an organization. It will be claimed that these three characteristics of transaction relationships are relevant for choosing the most suitable governance structure.
The following table gives an overview of the relationship between asset specificity, uncertainty, frequency and governance structure.
Table 3: Transaction characteristics in relation to governance structure. Asset specificity
Low High
Low Market Hybrid Hybrid/Hierarchy
Uncertainty
High Market Hybrid/Hierarchy Hierarchy
Occasional Recurrent Frequency
Source: Williamson (1985).
For reasons of clarity, the two most extreme governance structures will be presented first: the market governance structure and the hierarchy governance structure. The hybrid governance structure will be discussed next.
The transactions for a market governance structure are characterized by a low level of asset specificity. That is why there are many participants during all phases of the transaction. The quantity and quality of the assets can be accurately described and measured. The frequency is not relevant, because all transactions are repetitive in a transaction period. The transaction environment is characterized by low uncertainty, even when the environment is very dynamic. If one of the participants behaves opportunistically, the other participant can choose another contracting party without high switching costs. These parties are in the same negotiation position and their risk attitude has no relevance due to low uncertainty.
A hierarchy governance structure can be expected as the transactions are characterized by types of high asset specificity which can be protected by contractual rules. Frequency of the transactions is recurrent. The transaction environment is characterized by more or less uncertainty; different future circumstances are difficult to predict.
The transactions which will be controlled by a hybrid governance structure are characterized by a moderate or high degree of asset specificity. When uncertainty becomes high, it depends on the contracting costs if a hybrid or a hierarchy governance structure is more appropriate.
4.3 TCE Framework for controlling overheads
Given the aim to develop a framework for controlling overheads, this section relates the control types of Merchant and Van de Stede (2007) to the TCE characteristics.
are critical to the control of organizations. The four control types of Merchant and Van der Stede (2007) can be determined by these TCE characteristics. Overhead is mainly characterized by the TCE characteristics uncertainty and asset specificity. Frequency is of lesser relevance to the control of overhead costs because the transactions take place on a frequent basis. This is why frequency is ignored in the establishment of the control framework. To make the control framework more concrete, several overhead functions and tasks will be described and the mechanisms needed for controlling overheads will be discussed. Based on examples of diverse overhead tasks, a reasoning for relating overheads characteristics to control mechanisms will be developed.
Overhead fulfils a great variety of tasks. Listing all of them in full would probably result in a list of many hundreds of tasks. In order to be able to say anything significant about the control of overheads it is not useful to zoom in to this level of detail. Huiben and Geurtsen (2008) have made a classification of functions and tasks to enable us to clearly portray and compare overheads of organizations. Their survey is neither too crude nor too detailed and the classification is applicable in each and every organization. The survey of tasks is furthermore both exclusive and exhaustive. Huiben and Geurtsen distinguish between two kinds of overhead: generic overhead and sector specific overhead. Generic overhead pertains to functions that are found in all sectors. The nature of sector specific overhead differs per sector. In generic overhead, they include all central and decentralized departments that are charged with the following seven functions:
1. Board of directors, management and secretarial support 2. Human resource management
3. Computerization and automation 4. Accounting and control
5. Communication 6. Legal affairs
7. Facility management
In Appendix 1 an overview of the list with the seven functions and tasks is given.
Based on the TCE characteristics it will now be explained which mechanisms, according to Merchant and Van de Stede, are needed for the control of overhead tasks. Furthermore a selection of different overhead functions and tasks will be described.
cleaning team. This is because the output is easy to identify, i.e. the number of square meters of office space that are to be cleaned. The costs of personnel and salary administration can be controlled in a similar way. The processing of personnel mutations and the processing of salaries are standardized tasks and the uncertainty is small. The processes of beginning and ending of employment are generally speaking the same for everyone and can be described accurately, the frequency of occurrence hardly varies. In the case of the salary administration, every month more or less the same amount of salaries has to be paid and salary strips have to be sent, in the same way. Control of the costs of the transactions can be executed be means of a results control mechanism. Security can also be controlled by means of a results control mechanism. The tasks of the security personnel are not complicated, the specificity is small. In the contract between both parties agreements are made on the office spaces and people that are to be secured. Besides this clear agreements are made regarding the distribution of responsibilities. The security costs can be declared on the basis of worked hours devoted to clearly specified tasks. This means that results control is most suited in this situation.
When the uncertainty is low and the asset specificity is high (cell 2), the tasks of overheads are specific and customized, however the (service) processes and procedures are standardized and can be described. In this situation it is difficult to determine the desired results, because customization will result in a broad range of different products and services. However it is possible to specify the processes for achieving the results. Hence action control will be most suited. Several overhead functions fall into this category, in which the specificity is high and the uncertainty low. Examples of overhead tasks are HRM, Computerization and Automation, Accounting and Control and Communication. The tasks of these overhead functions are generally diverse and customized. The tasks are usually carried out by experts, such as HRM consultants, recruiters, information analysts, controllers and marketing and communication specialists. Examples are the activities in the area of recruitment and selection. The recruiters are responsible for the recruitment and selection of new members of personnel. Their tasks are diverse, because the way in which personnel can be recruited can vary per vacancy. One can think of writing and publishing a vacancy advertisement on websites, in newspapers or magazines or the use of intermediaries, up to the selection of the most suited candidate by means of assessments or job interviews. Besides this the environment also influences the tasks of the recruiters. Depending on the job market, it can vary which means are needed in recruitment and selection. On an annual basis, it is determined roughly how many employees have to be recruited to maintain the desired staffing. Besides this, it can be clearly agreed per vacancy that the most suited person has to be found. In this situation it is difficult to determine the desired results but uncomplicated to specify and describe the processes for achieving this result. Hence action control will be most suited.
Furthermore, when uncertainty is high, but asset specificity is low (cell 3), the complexity increases and the need for future adaptations will be more likely. The tasks of overheads are standardized but will change very often, because of adaptation to different situations. In this situation it may not be possible to monitor the actions and activities taking place, however it is possible to identify the results of overheads. Therefore results control is generally suitable. In this situation one can think of a helpdesk or of specific departments for advice in the area of construction or ICT. When an organization possesses a lot of real estate, there will be a department for specifically for advice regarding construction. They are tasked with providing advice for large development, expansion and renovation projects. They will also advise management on small and larger maintenance on the real estate. The tasks of the construction advice team are standardized, but they are uncertain, because they depend on the service that management demands. Depending on the number of buildings, the state of their maintenance and the construction or renovation plans of the organization, the advice demand will vary. The results of the tasks of the advise team can be identified, however because of changing demand situations it is difficult to monitor the actions and activities taking place. Therefore, results control mechanism is generally suitable in this situation.
When there is a high degree of uncertainty and high asset specificity (cell 4), the tasks of overheads and the transactions taking place are specific and will constantly change. The type of control that will fit best here is personnel or cultural control, in which shared norms and values will mean that the employees will act to achieve organizational objectives. In order to nevertheless somewhat limit the behaviour of employees, they can be held accountable for some elements of cost by means of discretionary cost centers (Merchant and Van de Stede, 2007). The outputs of employees in this situation are not easy to value in monetary terms and the relationship between resources and products or services is not well known. Consequently, performances of employees are difficult to evaluate and very subjective. Discretionary cost centers exercise control by ensuring that budgeted level of expenditures are adhered while successfully accomplished the tasks assigned to it.
The situation in cell 4 often concerns management functions, because the specificity and uncertainty of tasks at a strategic level are usually very high. Managers have to be able to respond flexible to changes in the internal or external environments and act depending on the given situation. Trends and developments in the organization or in the market can form opportunities or threats to the organization, such as technological developments, the power of buyers or providers, new parties that may enter the market and the internal competition in the market. When situations evolve, a manager will have to be able to easily adapt the strategy or goals, in order to reach a good result. Tasks and results of management are hard to identify and describe, therefore personnel or cultural control is the most suited control mechanism.
manager does not spend over his budget and seems to get his job done, his performance is judged to be adequate.
Besides strategic management there are also several specialised overhead functions that can be controlled best by personnel or cultural control. An example of this is development or computerization and automation. Designing and developing of new ICT products and structures is a complex task, for which a lot of specific knowledge and experience are needed. In a continuously changing and dynamic environment, the developer will also have to be able to act on technological developments and ever changing demands from the organization
Control mechanisms should not limit the developer in his creativity or development capacity. Tasks and results of the developer are hard to identify and describe, therefore personnel or cultural control is most suited in this case as well.
The description of the above situations leads to the control framework as displayed in the chart below (table 4).
Table 4: Conditions determining the control of overhead Asset Specificity
Low High
Low 1. Results control 2. Action control
Uncertainty
High 3. Results control 4. Personnel/cultural control
(with boundaries)
In conclusion, all four control types of Merchant and Van der Stede can be presented in the control framework which is determined by the TCE characteristics uncertainty and asset specificity (table 4). Obviously, uncertainty is only discriminating in combination with high asset specificity. Furthermore, in a situation of low asset specificity, the degree of uncertainty is not relevant. In both situations overheads can be controlled by the control type results control. In a situation of high asset specificity, the degree of uncertainty is very relevant for the control of overheads. Dependent on the degree of uncertainty, the transactions of overheads can be controlled by action control or personnel and cultural control.
4.4 Control archetypes of Speklé and Vosselman
In the previous section a control framework for overhead costs is developed, based on the transaction cost theory of Williamson and the control types of Merchant and Van de Stede. Beside the conceptual frameworks of Ouchi (1979) and Merchant and Van de Stede for the design of organizational control mechanisms there are some others in the management control field of expertise that describe diverse types of management control. For instance Speklé (2001) proposes a framework that explicates the link between different control archetypes and organizational activities, which is based on Transaction Cost Economics. Furthermore, Vosselman (2002), describes a tailor-made design of management control systems.
Speklé’s framework for control archetypes and organizational activities is more complex and advanced than Ouchi’s conceptual framework for the design of organizational control mechanism. (Table 5).
Table 5: Control archetypes and their determinants.
Programmability Asset specificity Information impactedness
Management Control Type
Low Market Control – Control based on competition
Moderate Arms’ length Control (hierarchical or hybrid) –
(Quasi) independent: outcome control based on market derived standards or predefined contractual provisions
High
High Machine Control – Administrative control based on
codification of behaviour (action oriented) or predefined performance targets (results oriented)
Low Market Control – Control based on competition
Low Exploratory Control (hierarchical or hybrid) – Control based on converging insights that accrue and spread during the process. Convergence either administratively induced or based on market-disciplined information sharing
Moderate
High Boundary Control (hierarchical or market-based) – Market procurement if reputation effects are reliable; otherwise proscriptive control of administrative origins
Low Exploratory Control (hierarchical) – Administrative
control based on converging insights that accrue and spread during the process
Low
High
High Boundary Control (hierarchical) – Administrative control through interdictions, emphasizing behaviour to be avoided
Speklé argues that according to TCE, transactions have the following characteristics: - Asset specificity or idiosyncrasy (availability of market incentives)
- Uncertainty or un-programmability (availability of standards) - Frequency (often frequent transactions)
- (Ex post) Information impactedness (what is good performance)
The characteristics determine the appropriate management control type. Speklé uses these variables and their consequences to explain nine different control archetypes.
The framework of Speklé (2001) for control archetypes and organizational activities is too complex to effectively control contractual problems of organizational transactions. The use of this framework for the control of overhead costs will cost a lot of time and money. In section 4.5 Speklé’s framework will be compared with the developed control framework for overheads. Moreover, there will be a search for possible similarities between the determinants and the control archetypes of both control frameworks.
In addition, Vosselman (2002) describes a tailor-made design of management control systems. He claims that inside organizations there is a tendency to concentrate the execution and centralize the task control of certain activities and services. He says that many overhead activities, such as HRM, IT, accounting and control, security and cleaning services, tend to be separated from the core activities of other organizational departments and concentrated in so called ‘shared service centres’. The control of these activities is being shifted to a central level, because of flexibility, speed and quality of the firm’s core business processes. Vosselman argues that in order to improve the effectiveness and efficiency of activities in shared service centres, management control relationships should be reshaped. He has made a distinction between vertical management control (strongly or weakly bureaucratic), horizontal management control (captive- or free buying and selling) and external buy-out and outsourcing.
Choices of horizontal management control systems can be analysed by using the transaction costs theory. Archetypes were linked by Vosselman to the characteristics of the service involved, the extent of the user’s needs and the degree of uncertainty surrounding the performance of services. In accordance to the asset specificity of the TCE, Vosselman has made a distinction between:
1. highly specific products and services with a high degree of asset specificity, 2. customized services and products with a medium degree of asset specificity, and 3. standardized products and services with a low degree of asset specificity.
Table 6: Transaction features and archetypes of management control.
Characteristics of the services
Frequency and volume Degree of uncertainty/ complexity
Archetype(s)
Standard services Occasional to recurring Low to high Horizontal management control with free buying and selling; external buy-out; complete outsourcing
Customized services Occasional Low to high Horizontal management
control with a tendency towards captive buying and selling
Customized services Recurring Low to intermediate Horizontal management control with captive buying and selling
Customized services Recurring High No centralization at all
(decentralization) Highly specialized
services
Occasional Low to intermediate Horizontal management
control systems with captive buying and selling
Highly specialized services
Occasional High No centralization at all
(decentralization) Highly specialized
services
Recurring Low to high No centralization at all
(decentralization) Source: Vosselman (2002), pp. 131-148.
The framework of Vosselman (2002) for archetypes of management control is too complex to effectively control contractual problems of organizational transactions. The use of this framework for the control of overhead costs will cost a lot of time and money. In the next section Vosselman’s framework will be compared with the control framework for overheads that is developed. Moreover, there will be a search for possible similarities between the determinants and the control archetypes of both control frameworks.
4.5 Comparison between the control framework of overheads and the control archetypes of Speklé and Vosselman
In this section the control framework for overheads that was developed will be compared with the control frameworks as formed by Speklé and Vosselman. Furthermore, there will be a look at possible similarities in the diverse determinants and the control archetypes and mechanisms used.
Speklé’s control framework the characteristic ‘frequency’ is also ignored. The first determinant for control archetypes Speklé names is programmability. High programmability equals low uncertainty and vice versa, low programmability equals high uncertainty. In TCE, uncertainty is a condition that can arise from many sources, for example environmental complexity, market dynamics and task uncertainty. How different the sources, the effects are similar: the degree of programmability of the transactions. Asset specificity is a second determinant Speklé names. He distinguishes between high, moderate and low degree of uncertainty. In this comparison the moderate degree of asset specificity will be ignored in order to correctly compare with the control framework for overheads. Speklé’s third determinant, information impactedness, can not be taken directly from TCE. This is why information impactedness will be ignored in this comparison. Speklé’s reduced control framework is displayed in table 7.
Table 7: Speklé's reduced control archetypes and their determinants. Programmability Asset
specificity
MC Type
Low Market Control – Control based on competition
High
High Machine Control – Administrative control based on
codification of behaviour (action oriented) or predefined performance targets (results oriented)
Low Market Control – Control based on competition Exploratory Control (hierarchical) – Administrative
control based on converging insights that accrue and spread during the process
Low
High
Boundary Control (hierarchical) – Administrative
control through interdictions, emphasizing behaviour to be avoided
The control framework for overheads is displayed in table 8. Table 8: Control framework for overheads.
Asset Specificity
Low High
Low 1. Results control 2. Action control
Uncertainty
tasks of overheads are standardized and unambiguous. There is a perfect knowledge of the tasks of overheads, the mutual transactions and the expected results.
The next thing that strikes the eye is that the characteristics in cell 2 of the control framework of overheads, low uncertainty and high asset specificity correspond to the determinants of Speklé’s control archetypes, high programmability and high asset specificity. Speklé argues that in this situation transactions must be controlled by means of Machine control, in which control is exercised within the hierarchy, either by behavioural rules (action oriented) or by performance standards (result oriented). Characteristic in machine control is the high measure of standardisation of behaviour and results, the use of relatively hard, task assigning budget targets, intensive monitoring, systematic performance testing and judging and an accurate definition of tasks and responsibilities reflected in the organizational structure. Machine control is connected with well defined and routine activities. Action control hence shows many similarities with machine control. As is displayed in table 8 action control for overheads can best be applied in this situation of low uncertainty and high asset specificity. Just like in machine control there is customization and also a high degree of standardisation and monitoring of tasks and processes.
According to the control framework for overheads a situation of low asset specificity and high uncertainty can best be controlled by means of results control (cell 3). These characteristics that determine the control mechanism are the same as Speklé’s determinants of low asset specificity and low programmability. Table 7 shows that here too the archetype market control provides the best control measures. As described before, both types of control are most effective in situations in which tasks of overheads are standardized and unambiguous. There is a perfect knowledge of the tasks of overheads, the mutual transactions and the expected results. In this situation it may not be achievable to monitor the actions and activities taking place, however it is realizable to identify the results of overheads.
other’s behaviour. Nevertheless, there are also evident differences between exploratory control or boundary control and personnel control or cultural control. Exploratory and boundary control are more explicit and clear control mechanisms than personnel and cultural control. Exploratory and boundary controls are explicit systems embedded in formal or informal processes in the organization that define and communicate specific situations or behaviours to be avoided or directly executed. Personnel and cultural control are less explicit norms and values that are in force in the organization and contribute to desired behaviour of employees, which encompasses that they will act to achieve the organization’s objectives. In this context, less explicit boundaries apply than in a form of boundary control that describes what to avoid and a clear setting of financial and ‘domain’ boundaries. The least similarity is found between exploratory control and personnel or cultural control. The focus of exploratory control on learning about good performance is absent in personnel and cultural control.
Besides this a comparison can be made of the control framework for overheads that is developed and the control frameworks of Vosselman. There will be a look for possible similarities in the diverse determinants and the control archetypes applied.
In order to compare the control framework for overheads developed with the control framework of Vosselman, again the transaction costs attributes will be evened out. The transaction cost attributes ‘asset specificity’, ‘uncertainty’ and ‘frequency’ are critical to the control of organizations. Frequency is of lesser relevance to the control of overhead costs because the transactions take place on a frequent basis. This is why frequency is ignored in the control framework for overheads and the control framework of Vosselman. Following Williamson (1979), Vosselman had made a distinction on the degree of asset specificity into standardized products and services with a low level of asset specificity, customized services and products with a medium level of asset specificity and highly specific services and products with a high level of asset specificity. The characteristics of the services of Vosselman can be compared to the asset specificity of Williamson. The reduced control framework of Vosselman is displayed in table 9.
Table 9: Transaction features and archetypes of management control of Vosselman (reduced). Characteristics of the services Degree of uncertainty/ complexity Archetype(s)
Standard services Low to high Horizontal management control with free buying and selling; external buy-out; complete
outsourcing
Customized services Low to intermediate Horizontal management control with captive buying and selling
Customized services High No centralization at all (decentralization) Highly specialized
services
