Part One Developing the model

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“What gets measured

gets done!”

By Bas Schrama

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Faculty of Management and Organization, University of Groningen 2

‘The author is responsible for the contents of this thesis; the copyright of the thesis is held by the author.’

Title: “What gets measured gets done!”

Author: Bas Schrama, 1151916 Principals: Drs. M.P. van der Steen

Prof. Dr. J. Wijngaard

Place/Date: Groningen, 14^th of March 2004

Faculty of Management and Organization University of Groningen

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Faculty of Management and Organization, University of Groningen 3 Preface

From the first day I started this research, I realized that it was certainly not going to be easy to develop a generic, theory-based model to measure divisional as well as

managerial profit performance within sales-driven organizations such as Ring. However, after six months of research, I think this final thesis could at least be of substantial support to organizations that are (or should be) dealing with the same kind of issues as Ring did when it wanted to more accurately measure profit performance of and within its product divisions.

Doing a six-months internship within Ring gave me the fantastic opportunity to apply all the theoretical knowledge that I acquired during the past four years into practice.

Although I still realise that there will always exist a gap between daily practice and available theories, I learned that the latter can at least serve as a valuable guide when trying to solve or prevent problems or issues occurring in ‘real life’.

I would especially like to thank Drs. M.P. van der Steen, who monitored this research on behalf of the Faculty of Management and Organization of the University of Groningen.

His contents related-, methodological- and general suggestions have been of crucial importance for the outcomes of this research. I would also like to thank Prof. Dr. J.

Wijngaard, who especially was of great support during the research’ final phase, the phase in which the actual thesis had to be written.

Next to this, I would also like to thank Hans de Wit and Fred van Noord, who both monitored this research on behalf of Ring. Without their practical guidance and contributions, results would never had been that valuable as they are now.

Finally, I would like to thank all ‘colleagues’ of Ring’s Finance department, where I was located for six months. When you don’t participate in daily operations, you can easily become a sort of island that is isolated from the rest. Luckily I have never felt like this at all, something that was mainly caused by the great atmosphere that was part of the department.

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Faculty of Management and Organization, University of Groningen 4 Executive Summary

In this theoretically based thesis the following main question will be answered, by explicitly making use of the concepts of ‘Divisional profitability measurement’ and

‘Responsibility accounting’:

"How can a sales-driven organization such as Ring make use of accounting information in order to aid the decentralization of responsibilities to

divisional units and to effectively measure divisional profitability as well as profit performance of managers within those divisions?"

Divisionalised sales-driven organizations are organizations that sharply focus on ways to improve and increase sales, which always is clearly reflected in the formulated strategy that guides the organization. Because of this focus, marketing-, design-, R&D-, Purchase

& Logistics- and distribution departments or activities are of crucial importance to the organization’s overall success. Usually production is outsourced and all products fall within the same general category (for example fashion), thereby serving similar purposes.

Consequently, divisions will similarly make use of corporate services, of which there will usually exist quite some (which on its turn results in a great amount of corporate costs).

Every time a model to measure divisional profitability internally is being configured, four general objectives should guide this ‘development process’. Besides, the objectives should also serve as the main criteria on which the eventual model is evaluated.

In general one could therefore say that a model to measure divisional profits should:

1. Guide central management in assessing the efficiency of each division as an economic entity;

2. Help central management in assessing the efficiency with which divisional managers discharge their responsibilities in running their divisions;

3. Guide divisional managers in making decisions in respect of the daily activities of their own divisions;

4. Make divisional managers aware of all costs that are made at corporate level in order to show them their bottom line profitability as well as the effect(s) that risky investments could have on corporate performance.

Next to the traditional distinction between ‘controllable’ and ‘non-controllable’ costs there should be recognized two extra ‘degrees of cost control’. First, there are costs which divisional managers can only partly control, the other part usually being centralized. One can think of a centralized marketing departments where there also takes place quite some divisional marketing. Second, there also are costs which divisional managers can only influence indirectly. Holding them partially accountable for these costs would make them pay attention to these costs and would consequently make them think along with

(functional) managers who are primarily responsible for the specific costs.

On the whole the ‘benefits-received basis’ (which is based on the thought that certain divisions benefit more from specific costs compared to others and should therefore be allocated a larger part of them) and the ‘equal split method’ should be preferred when actually allocating costs to the divisional level. Sometimes (when non-controllable costs

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Faculty of Management and Organization, University of Groningen 5 that are to be allocated are unpredictable and vary strongly) an organization can also choose to charge divisions with a lump sum each period.

The configured model contains six profit levels, each level serving completely different purposes, requiring different bases of allocation and besides being capable of realizing different general guiding objectives and other advantages: next to the four general objectives described on the former page, use of the model will also lead the way to a higher quality rewarding system and better motivated divisional managers. The model separates managerial profit performance from total profitability of divisions as economic entities in a way that doesn’t seem to exist in current literature.

Ring’s objectives of measuring divisional profitability closely relate to the ones that guided the development of the model. In order to actually apply the model to its own organization a generic manual containing four steps has to be followed. Walking through each step should enable central management to respectively determine the degree(s) in which each (corporate) cost within the organization can be controlled by divisional managers (step 1), to determine the bases of allocation that could best be used (step 2), to determine what cost drivers could best be defined (step 3) and to actually ‘fill in’ the model (step 4). In order to do all this effectively, during each step central management should take into account some very important guidelines. For example, it should never hold divisional managers accountable for too many costs over which they have little influence and they should never make use of the same cost driver too much.

When the model is filled in and compared with Ring’s externally reported profitability measure of profit performance (called Divisional Operating Profit), three out of six divisions suddenly appear to provide losses instead of being profitable (as seems to be the case when taking a look at the reported DOP’s). Next to this, by making use of the model divisional managers can be held (at least partially) accountable for an extra (in total) of 13.927.590 (as part of a net sales total of 185.294.800) of corporate costs compared to the total amount of costs for which they can be held accountable within the reported DOP.

By taking a look at these quantitative implications of the model, Ring’s central management should now be better able to assess the total profitability of its product divisions as well as to evaluate managerial profit performance within these divisions.

Generally spoken the model should first be implemented in real life in order to be able to proof the true value that it could possibly offer sales driven organizations such as Ring.

However, if one believes in the thoughts behind the model, testing its (or elements of it) practical application could absolutely be worthwhile. Sales-driven organizations’

strategies, main characteristics and organizational structures (which usually are highly centralised) all seem to be well reflected by the main strengths that the configured model seems to be capable of offering. Next to this, all general elements that have contributed to the configured model and its development have the potential to add value in all kinds of organizations. With respect to this one should especially think of the extra degrees of cost control that should be identified, the pros and resulting implications that allocating totally uncontrollable costs down to the divisional level could have and last but not least, the identification of an income statement that explicitly acknowledges the existence of the extra degrees of control by defining profit levels (that haven’t yet been defined in current literature), each level serving completely different purposes.

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Faculty of Management and Organization, University of Groningen 6 Table of contents

Preface 3

Executive Summary ... 4

Table of contents ... 6

Background 8 Introduction 9 Chapter 1 Research Design ... 11

§1.1 Introduction ... 11

§1.2 Problem statement ... 11

§1.3 Research constraints ... 12

§1.4 Conceptual model ... 13

§1.5 Research process ... 14

§1.6 Clarification of terms ... 16

§1.7 Research methods ... 16

§1.7.1 Research classification ... 16

§1.7.2 Specification of data sources and procedures... 16

§1.7.3 Plan of data analysis... 17

Part One Developing the model Chapter 2 Defining sales-driven organizations... 20

§2.2 Most important characteristics ... 20

§2.3 Ways in which strategies are formulated ... 21

§2.4 Types of financial responsibility centres ... 22

§2.5 Typical financial responsibility centres in a divisionalised organization ... 23

§2.6 Modifications for sales-driven organizations ... 25

§2.7 Conclusions ... 26

Chapter 3 Measuring divisional profitability ... 28

§3.2 Focus of this research within the field of management control systems ... 28

§3.3 Objectives of measuring divisional profitability ... 30

§3.3.1 Three most common objectives ... 30

§3.3.2 Adding a fourth objective... 30

§3.3.3 Conclusion ... 31

§3.4 Identifying multiple levels of profit within the income statement ... 31

Chapter 4 Decentralization of responsibilities... 36

§4.2 Responsibility accounting and its controllability principle... 36

§4.3 Definitions... 37

§4.3.1 Responsibility accounting ... 37

§4.3.2 Controllability principle ... 38

§4.4 Constructing a ‘controllability continuum’... 40

§4.5 Bases and methods of cost allocation ... 42

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§4.6 Linking different degrees of control to different bases of allocation ... 43

§4.7 Advantages and disadvantages of using individual bases to allocate costs within different degrees of control... 44

§4.7.1 Total control ... 44

§4.7.2 Partial control... 44

§4.7.3 Indirect influence ... 44

§4.7.4 No control... 46

§4.8 Dealing with totally uncontrollable costs ... 47

Chapter 5 Designing the model ... 51

§5.2 Using the defined objectives of measuring divisional profit as a central guide.... 51

§5.3 Main advantages of adding ’extra’ degrees of control to the income statement ... 52

§5.4 Presenting the model... 54

Part Two The Mexx case study Explaining the case... 62

Chapter 6 Applying the designed model to the specific case of Ring... 65

§6.2 Ring’s objectives of measuring divisional profitability... 65

§6.3 Ring’s objectives related to general objectives and main advantages of the configured model to measure divisional profitability internally... 66

§6.4 Manual to allocate corporate costs ... 67

§6.5 Walking through the manual for Ring ... 71

§6.6 Comparing the model with the externally reported DOP ... 73

§6.6.1 Introduction ... 73

§6.6.2 Comparing the two measures of divisional profitability... 74

§6.6.3 Conclusion ... 75

§6.7 Quantitative implications of using the model ... 75

§6.8 Performing a sensitivity analysis on the equal split basis of cost allocation ... 77

§6.9 Possible organizational implications when the model would be implemented... 78

Part Three Generalizing most important findings Chapter 7 General implications of this research ... 83

§7.2 Measuring profit performance of non-divisional entities ... 83

§7.3 Research implications for sales-driven organizations such as Ring... 84

§7.4 Research implications for organizations in general... 85

Chapter 8 Conclusions... 88

Chapter 9 Recommendations ... 90

References ... 92

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Faculty of Management and Organization, University of Groningen 8 Background

Because I think that it could facilitate in understanding the way this research is structured, I will now first explain how this specific research originated.

In the beginning of August 2003 I started within Ring to do a theoretical based research for six months. The main purpose of the research was to develop a model or system with which Ring would be able to more accurately measure the profitability of its product divisions internally. Although the ‘to be configured model’ had to be developed out of the specific case of Ring and besides had to be applicable to this case of Ring, it (or at least parts of it) directly seemed to have the potential to be generalized. This way it could also be of value to organizations such as Ring and organizations dealing with similar problems or issues.

I therefore decided to use the practical knowledge and general organizational settings and characteristics of Ring (which could be obtained during my stay within the organization) to develop a theoretical based, generic model or system to measure divisional profitability internally. Thereafter I would apply the configured model to the Ring case, thereby testing and hopefully proving its worth or the potential value that it could have when an organization decides to make use of it. Finally, serious efforts would be undertaken to generalize the configured model and its implications, specific findings out of the case of Ring as well as findings out of the process (or approach) of developing a model or system to measure divisional profitability internally.

Although I recognize that it could be misleading and potentially dangerous to generalise from the findings of a single case study, this type of research approach can certainly offer some rich descriptions of innovative management accounting systems. These descriptions could facilitate the development of understanding this discipline in practice (Moon and Fitzgerald, 1996). Therefore, in headlines, this will be the approach or path that I will be following within the remainder of this research. For reasons of confidentiality I have changed the name of the organization in which the case study took place as well as other terms that could possibly reveal its identity.

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Faculty of Management and Organization, University of Groningen 9 Introduction

In most literature it is explicitly being recognized that external reporting (in most cases) strongly differs from internal reporting and that profit performance of organizational units is very different from performance of the units’ managers’ (Merchant, 1998). In contrast to this, a research of Reece and Cool (1978) indicated that 40% of 594 surveyed

companies calculated income the same way for both internal decision and control

purposes and for external reporting purposes. Moreover, more than half of the remaining 60% also allocated corporate costs to calculate income for managerial purposes¹.

Why do so many organizations continue to measure profit performance for external purposes in the same way as they are measuring it for internal purposes? In my opinion it should be obvious that external reporting usually serves completely different purposes compared to reporting for internal purposes. In most cases the latter should lead the way to maximum profitability by optimizing control and economical decision-making within lower level entities, while external reporting should be more concerned with providing a reliable view of total corporate performance to relevant stakeholders (and that therefore should not be too detailed). This is why the methods through which internal and external profit performance will be measured should be developed separately and why they should be measured independently. In this research I will focus on reporting for internal

purposes.

Next to this one might ask why it happens so often that seemingly non-controllable corporate costs or expenses are allocated to lower level entities when measuring their economic performance. Even more extreme, one might ask why these costs or expenses are so often being allocated when measuring the performance of lower level managers, even though the costs are classified as clearly being completely out of their control. At first sight these accounting practices seem rather arbitrary and therefore they seem to require some further research.

As I mentioned when discussing its background, in this research I will develop a generic model or framework (which, as said above, will only serve internal purposes) with which organizations will be able to monitor profitability of their lower level divisional entities in an effective and reasonable way, while at the same time being able to get a clear view of as well as guide managerial performance within those divisions. It should be obvious that topics like responsibility and controllability will play a crucial role when developing such a model. When it is finished the model will be applied to the specific case of Ring. I will mainly use this case to show how the model can be put into practice as well as to be able to analyze the quantitative and organizational implications that its use could have.

Within the research, the following main question should be answered:

1 See Horngren (1982, p.506) for a summary of this survey

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Faculty of Management and Organization, University of Groningen 10 In chapter 1 I will present the research design that have guided me while doing this research. In chapter 2 I will try to define ‘sales-driven organizations’ such as Ring. I will do this by listing and explaining Ring’s most important characteristics. The next two chapters, respectively chapters 3 and 4, will be formed by several theoretical concepts about ‘accounting information and practices’ and ‘decentralizing responsibilities’ (both derived out of the main question just presented) that could be relevant within the scope of this research. Besides, when required or supposed to be value adding, I will complement these theoretical insights with some analyses of my own. In chapter 5 I will actually configure and present the final generic model with which a sales-driven organization such as Ring should be able to accurately measure profit performance of its divisions as well as performance of its managers within those divisions. When this is done the purely theoretical part of this research is finished.

In part two (chapter 6) I will actually apply the model to the specific case of Ring. Doing this should illustrate how the model could actually be put into practice as well as proof its worth. However, in this chapter I will also analyse the possible implications that use of the model could have within Ring.

To conclude this research, I will discuss the general implications of this research as well as present its final conclusions and recommendations in respectively chapters 7, 8 and 9.

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Faculty of Management and Organization, University of Groningen 11 Chapter 1 Research Design

§1.1 Introduction

In this first chapter I will present the main question (accompanied by an appropriate set of sub questions) and the central objective that should guide this research. Besides I will also show the conceptual model as well as provide the process planning that should both supplement achievement of this research’ main goal. Finally, I will conclude this first chapter with some other relevant topics such as explanations of terms that will be frequently used and a solid description of the research methods that I will be using.

§1.2 Problem statement

As has already been discussed in the introduction, the primary purpose of this research will be defining a profit performance measurement model that can be used for internal purposes in organizational settings similar to Ring. In other words, I will present findings of this research in a way that makes them be of value to other sales-driven organizations that are or should be dealing with the question on how to measure profitability of their divisions internally. These thoughts have made me configure the following main research objective and the following set of research questions (the main question already being presented in the introduction).

Research objective:

Configuring a model with which sales-driven organizations such as Ring can make use of accounting information in order to aid the decentralization of responsibilities to divisional units and to be able to measure divisional as well as managerial profit performance internally.

Main question:

Sub questions:

1. What are relevant aspects and characteristics of divisional sales-driven

organizations in general?

2. What theoretical insights on accounting practices are relevant regarding sales- driven organizations such as Ring?

3. What theoretical insights on decentralizing responsibilities are relevant regarding sales-driven organizations such as Ring?

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Faculty of Management and Organization, University of Groningen 12 4. What model for internal divisional profitability measurement should be

defined for sales-driven organizations such as Ring?

5. How can this model be applied to the specific case of Ring?

6. What implications could use of the configured model for internal profitability measurement have within Ring?

7. What are the implications for (sales-driven) organizations in general, when taking a narrow look at the findings of this research?

Most of the above sub questions will be covered in an individual chapter. For reasons of clarity and convenience I would like to provide the following table, which shows the chapters in which the different sub questions will be captured.

Sub question Chapter

1 2 2 3 3 4 4 5 5 6 6 6 7 7

Table 1.1 Linking sub questions to chapters

§1.3 Research constraints

• The research will be conducted within the time period of eight months.

• When the research period is finished a final report on the most important findings should have been written, which will be handed over to Ring at the end of

January.

• Next to this a thesis will be written on behalf of the Faculty of Management and Organization from the University of Groningen.

• The thesis will have to be finished before March the 29^th2004.

• The research will focus on the subject of measuring divisional profitability and managerial profit performance. It will therefore not go very deep into the concept of rewarding systems.

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§1.4 Conceptual model

Figure 1.1 Conceptual model

Relevant theoretical insights on accounting practices

Relevant theoretical insights on decentralizing

responsibilities

Design of a model to measure divisional profitability and managerial performance

internally

General implications with respect to performance measurement within

(sales-driven) organizations Relevant aspects and characteristics of

sales-driven organizations in general

Application of the model to the specific case of Ring

Possible implications for Ring when it would be making use of the configured

model

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Faculty of Management and Organization, University of Groningen 14 Explanation model

One might have noticed that most elements of the model already have been mentioned (some more explicitly than others) in the sub questions described in paragraph two.

First, before I will really dig my way into the research, I think that I will first have to get a grip on the way business is conducted within sales-driven organizations in general, thereby creating a necessary understanding of the main characteristics and aspects of this type of organization. My stay within Ring should enable me to obtain this basic

understanding, which should especially facilitate and contribute when developing the generic model on behalf of organizations such as Ring later on in this research.

When the required basic understanding is obtained, I will start with determining which theoretical insights could support the configuration of a model to measure profit performance internally within sales-driven organizations. These ‘insights’ will mostly concern theoretical concepts related to ‘accounting practices’ and the ‘decentralization of responsibilities’, which are the two central terms out of the main question that seem to require further explanation and that will therefore both need to be defined more narrowly.

After having found a sufficient set of useful theoretical concepts, I will undertake efforts to combine them in an effective way and besides add some insights of my own. This will hopefully result in the design of a generic model that can at least be of support to

organizations that are planning to design a model to measure profit performance (of their divisions and divisional managers) themselves as well.

When constructed the model I will try to apply it to the very specific case of Ring. Doing this should illustrate and proof its potential worth and besides could function as a good example in showing how the model could be put into practice. The model should at least enable Ring to decentralize responsibilities in a proper and reasonable way. More specifically, use of the model should enable Ring’s central management to separate divisional profitability from managerial performance within those divisions in the most effective way. After this, I will also analyse the possible implications that use of the model could have within Ring. I will mainly do this by comparing the possible outcomes of using the model with the outcomes that would show up when Ring would use its external measure of profit performance (called Divisional Operating Profits) to control its business internally as well.

To conclude this research I will try to generalize the research’ most important findings.

Doing this should make findings be of value to organizational settings such as Ring as well as to organizations that are planning to design a profit performance measurement system for internal purposes or that are dealing with similar issues as the ones that deserved primary attention within this specific research.

§1.5 Research process

On the following page I will graphically present the exact process that I will follow during this research. Although it looks a lot like the conceptual model presented in the former paragraph, it should be better able to function as an operational guide when trying to answer the main question and besides clarifies more exactly how different elements of

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Faculty of Management and Organization, University of Groningen 15 Decentralizing responsibilities

the research relate to each other. Next to this, in front of each box, I will point out through which way(s) or methods I will try to collect the required data within that box.

As one may notice the model looks like an hourglass. This form is illustrative for the way the research is structured: While it starts with a broad view, it will soon take a narrower focus. Finally, after application of the model to the Ring case, the research will conclude with a broader view again, mainly in order to be able to generalize findings.

- Personal Analysis

- Theories

- Personal Analysis

- Theories

- Personal Analysis

- Personal

Analysis

- Personal Analysis

- Personal

Analysis

Figure 1.2 Research Process model

Defining sales-driven organizations such as Ring

Apply the configured model to the case of Ring

Analyze general implications of research for sales-driven organizations as well as for organizations in general Analyze possible implications when Ring would be

making use of the configured model Accounting practices

Configuring a model to measure divisional profitability and managerial performance

internally

Part 3 Part 2 Part 1

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§1.6 Clarification of terms

Accounting practices and decentralizing responsibilities

For the meaning of these terms I would like to point to the chapters (respectively chapters 3 and 4) where they will discussed thoroughly. There I will also define each of them by making use of existing theoretical explanations as well as some analysis of my own.

Profit performance measurement system for internal purposes

This will be the profit performance measurement system that an organization uses for internal purposes. It should accurately reflect profit performance of divisional entities as well as performance of managers within those divisions. Besides it should also guide economical decision-making about and within lower level entities and form the basis of an organization’s rewarding (and penalty) structure.

§1.7 Research methods

§1.7.1 Research classification

To explain how this research can best be classified, I would like to refer to the research process model presented in paragraph 5. There I showed that the research is divided into three main parts. I will now try to describe how each part can be classified.

Although the first part contains some diagnostic elements, it should primarily be looked upon as being a design. In the second part I will present the specific case of Ring in order to proof the model’s worth and to show how the configured model can be put into

practice. In other words, this part should mainly justify the thoughts behind and elements of part one’s actual design. It should therefore be obvious that this part can be typed as being ‘design-focused’ as well. Finally, in part three, I will try to generalize the findings out of this research in order to make them be of value for organizations such as Ring as well as for organizations in general. One could say that, within this final part, the relevance of this research on behalf of (sales-driven) organizations in general is being examined, which again reinforces the research’ design-focused nature.

§1.7.2 Specification of data sources and procedures

Of course, when doing this research, I will make use of several data sources. I will now present the sources that I will use most during this research.

Primary data available out of interviews within Ring

Ring will monitor the research on a continuous basis. By organizing several interviews and meetings, I should be able to acquire a lot of relevant Ring-specific data. This data should especially be of value during the development phase of the model as well as when applying it to the case of Ring.

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Faculty of Management and Organization, University of Groningen 17 Secondary data available within Ring

Doing the research internally at Ring for six months should also make it possible to get access to all kinds of secondary data. Monthly and yearly reports (containing quantitative as well as qualitative data) will especially be of interest for this research. Next to this documentation on the organizational structure, business processes, interrelations and other practices could be of help, especially in the beginning of the research.

Library of Faculty of Economics in Den Haag/ Library of Faculty Management and Organization & Economics in Groningen

By making use of these sources, I expect to find a lot of useful theories about profit performance of divisions as well as divisional managers, accounting practices and decentralization of responsibilities within divisional organization structures.

Internet (Business source premier, Google etcetera)

Finally, the Internet should provide me with all kinds of data that could be interesting or relevant with respect to this research.

§1.7.3 Plan of data analysis

Most data analysis within part one will follow a very qualitative, non-statistical approach.

This is the consequence of the fact that the part’s main purpose is configuring a model to measure divisional as well as managerial profit performance internally, which can also be seen as a sort of framework that can be filled in or used by other organizations as well.

Providing a qualitative understanding is of crucial importance when developing such a framework. However, when the model is finished and the model will be applied to the specific case of Ring, I will make use of supportive quantitative data. Doing this should facilitate and increase the understanding of the presented qualitative data. Besides, these quantitative analyses should demonstrate the true value that the configured model should be capable of offering and, next to this, the implications that its implementation could have within an organization’s total reporting system.

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Part One Developing the model

In this first part of the research I will develop and actually design the model to measure divisional profit performance as well as performance of managing directors within those divisions. The model will especially be applicable in sales-driven organizations such as Ring and should primarily be used for internal purposes.

As can be seen from the conceptual model on the following page, in chapter 2 I will first explain what sales-driven organizations are and how they usually are structured. Besides I will see whether they employ similar strategies and what implications these strategies could have on the way(s) in which divisional profitability as well as managerial performance within such divisions should be measured. In the following two chapters (respectively chapters 3 and 4), I will discuss the concepts of profitability measurement and responsibility accounting, which’ relevance also is illustrated by the configured main question. The concepts are supposed to form the theoretical foundation of this research.

When required or supposed to be value adding I will also do some personal analyses.

Finally, in chapter 5, I will combine all insights out of former chapters and actually design the generic model. It will not be surprising that the final model will form the necessary input of the next two parts.

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Faculty of Management and Organization, University of Groningen 19 Next field of focus within the conceptual model

responsibilities

internally

model

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Faculty of Management and Organization, University of Groningen 20 Chapter 2 Defining sales-driven organizations

As I already stated explicitly in chapter 1, when developing a model in the following chapters, I will especially make use of several theoretical concepts. However, I will also make use of a lot of personal experiences that I obtained during my stay within Ring. As a consequence, the model will especially be capable of adding value in organizations that are similar to Ring. As one can see when taking a look at the main question, I have classified these ‘similar organizations’ as being ‘sales-driven’. Of course this term is rather vague and needs some further explanation to really be of use within this research.

Therefore, in this first chapter of part one, I will try to provide a clear explanation of what can be recognized as being the most important aspects of ‘sales-driven organizations’.

The chapter is covered by the following sub question out of chapter one’s research design:

What are relevant aspects and characteristics of divisionalised sales-driven organizations in general?

In paragraph 2 I will first discuss the most common characteristics of sales-driven organizations such as Ring. Because strategy is supposed to play a very important role within the design of all performance measurement systems (Otley, 1999), in paragraph 3 I will show the kind of strategies that are being employed within sales-driven

organizations. While doing this, I will explicitly make use of the specific strategy that is formulated within Ring. In paragraph 4 I will first explain the concept of financial responsibility centres. After this, in paragraph 5, I will show how these ‘financial responsibilities’ are structured within the most common divisionalised organizations. In paragraph 6 I will modify findings out of paragraph 5 on behalf of sales-driven

organizations such as Ring. I will end this chapter with providing its most relevant conclusions.

§2.2 Most important characteristics

I will now first briefly describe some general characteristics that should occur or can be found in every ‘sales-driven’ organization. All findings are based on Ring’s specific situation.’

First of all, the organization has to sell products that serve similar general purposes and that are therefore subject to similar processes. For example, when regarding the case of Ring, it should be obvious that all products are sold within the clothing industry. From a more general perspective this implies that all lower level entities will rather similarly make use of (the same) corporate services within the organization. This will result in the fact that most ‘sales supporting’ and other shared services’ (such as IT and HR, see Goold and Campbell, 2003) activities or functions will be centralized, something that will

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Faculty of Management and Organization, University of Groningen 21 especially be done in order to realize scale advantages. I will come back to this more thoroughly in paragraph 6.

Another important characteristic of sales-driven organizations within the scope of this research is that their production is being outsourced. This doesn’t imply that the company isn’t involved in the production process. Just as is the case with Ring, the company will usually determine what has to be produced (by specifying designs) and will besides always check whether products obtain the specified quality levels. At Ring these activities are performed by the Purchase & Logistics department, which, as I will argue below, should be typed as being a ‘Core resource unit’. However, the organization will certainly not be involved in improving the efficiency of actual production processes. As a consequence, the organizations are enabled to sharply focus on sales, which obviously is the main reason why they are typed as being ‘sales-driven’.

However, next to creating a strongly sales-minded organization, the outsourced production will also enable the organization to focus on the functions of marketing, research and development, design, Purchase & Logistics (P&L) and distribution. Within Ring these are all essential drivers of the organization’s success. According to Goold and Campbell (2003), these ‘crucial’ functions should be called ‘Core resource units’.

First of all, Marketing should especially support and emphasize the strong brand name of the organization as well as promote the products sold by its divisions. There has to be sought for an appropriate balance between these different levels of marketing. Research and development and design functions support the innovative nature of the products sold.

The functions will always try to make products better match the demands of their customer groups. Again the right balance has to be sought between central and lower level specific activities (especially within divisions). Last but not least sales-driven organizations will pay a lot of attention to their P&L and distribution functions. Usually the organization conducts business with several (outsourced) production centres, while it owns several central distribution centres where products arrive, where they are stored and from where they are distributed to the locations or subsidiaries where they will actually be sold. The organization will extensively look (on a continuous basis) how it can make its total set of P&L and distribution activities as efficient and effective as possible.

§2.3 Ways in which strategies are formulated

According to Otley (1999), an organization’s model to measure divisional profitability should always be consistent with its formulated strategy. Now that I have shown what can be seen as being the main characteristics of sales-driven organizations, one would be tempted to say that these characteristics should also be reflected in the strategies that are formulated by them. I will examine this by taking a narrow look at the specific strategy of Ring, which can be formulated as follows:

“To become the leading cell phone and accessories company in the world by addressing different consumer segments, via multiple channels of distribution, focusing on core markets and to provide sustained premium to stakeholders.”

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Faculty of Management and Organization, University of Groningen 22 All characteristics out of the former paragraph are (at least implicitly) reflected by the above strategy. First, the desire to become ‘the leading company in fashion and accessories in Europe’ tells us that all products serve similar purposes. Consequently, divisions will only differ on customer segments that they serve. Next to this, the

formulated strategy also clearly reveals the sales focus that is present within sales-driven organizations. It wants to grow in different consumer segments (while remaining focused on core markets) via multiple brands and different channels of distribution. Finally, the formulated strategy also implicitly aligns the focus on marketing, design and distribution functions that is or should be present within sales-driven organizations. To become a leading company (in fashion for the case of Ring), marketing will always be one of the leading proponents. Next to this, the company should have a strong design function in order to be able to meet (frequently changing) customer demands. Last, distribution will also deserve top management’s primary attention, something that is perfectly illustrated by the fact that Ring wants to sell its products to different customer segments by making use of various distribution channels (especially wholesale and retail channels).

§2.4 Types of financial responsibility centres

According to Merchant (1998), it’s very important to obtain a clear view on the ways in which financial responsibilities are divided when designing a model to measure

profitability internally. Therefore, in the following paragraphs, I will discuss the concept of ‘Financial responsibility centres’ and apply this concept to divisional sales-driven organizations such as Ring in order to let it be of value within this specific research According to Ezzamel (1992), the design and use of performance evaluation mechanisms is largely dependent upon the type of financial responsibility centre being dealt with. It is therefore very important that the precise nature of the centre is established clearly before any meaningful discussion of ways in which to measure profitability takes place. Since the main purpose of this research is developing a model to measure divisional profit performance internally, one will realize why discussing this concept in this early stage of the research is crucial. The following types of financial responsibility centres are the ones that are being recognized most often in theories (Kaplan and Atkinson, 1998, Merchant &

van der Stede, 2003). Where needed, I will slightly adjust descriptions in order to let them be of more value within the specific scope of this research.

• Cost Centre (CC): Usually a cost centre exists where one can define and measure output well and besides where one can specify the amounts of inputs required to produce each unit of output. However, cost centres are also appropriate for units that produce outputs that are not measurable in financial terms or for units where no strong relation exists between resources expended (inputs) and results achieved (outputs). Generally support (or service) departments can be typed cost centres.

• Revenue Centre (RC): Revenue centres exist in order to organize marketing activities and usually is solely evaluated on sales (gross revenues, volume or mix of sales, depending on who is determining price policy). Revenue centre managers are mainly held responsible for revenues, which is a financial measure of output.

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• Profit Centre (PC): Profit centre managers are responsibility centres whose managers are held accountable for profit, which is a measure of the difference between the revenues generated and costs of generating those revenues. However, it is important to recognize that profit centres come in many different forms, some of which are considerably more limited in scope of operations than others.

• Investment Centre (IC): These are responsibility centres whose managers are held accountable for the accounting returns (profits) on the investment made to generate those returns.

Performance is measured in very different ways. Cost centres are often monitored through the use of detailed cost standards and budgets, whereas profit centres are mostly being monitored by means of summary profit statistics such as ‘controllable profit’ or

‘net profit’ figures (Merchant, 1998). Because of this, I think it can be very useful to determine what responsibility centres are being recognized in most divisional

organizations, something that is exactly what I will be doing in the next paragraph.

§2.5 Typical financial responsibility centres in a divisionalised organization

According to Merchant (1998), the following types of financial responsibility centres can be found within the most common divisionalised organizations. It should be obvious that the focus should be on the divisional level.

Figure 2.1 Typical financial responsibility centres in a divisionalised organization (Merchant,1998)²

2 Source: K.A. Merchant, Modern Management Control Systems: Text and Cases (Upper Saddle River, NJ:

Prentice Hall, 1998), p. 309

President (IC)

Group Vice President (IC)

Administrative &

Financial Vice Presidents (CC)

Division Manager (PC)

Division Manager

(PC)

Division Manager (PC)

Marketing Manager

(RC)

Functional Managers

(CC)

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Faculty of Management and Organization, University of Groningen 24 First, looking at figure 2.1 learns that in a typical divisional structured organization investments are not seen as being the responsibility of divisional managers, whose divisions are typed as being profit centres. As can be seen members of the board of directors make (most) investments decisions and therefore these are the ones that are held responsible for them.

Second, another element that doesn’t seem to fall under the responsibility of divisional managers concerns costs that are centralized and that arise at administrative as well as financial staff departments. In most cases, costs made on behalf of these organizational areas are being compared to their budgeted amounts, illustrated by the fact that they are typed as being cost centres. It should be obvious that the costs will usually fall

completely outside the control of divisional managers. This is why departmental heads are the ones who are (primarily) held responsible for these costs. According to Goold and Campbell (2003), these types of functions should be typed Shared service units, meaning that they are responsible for providing their services to other organizational units in a way that is cost-effective and responsive.

Third, when taking a close look at the lower part of figure 2.1, one can see that there also is a part of the (financial) responsibilities of divisional managers that is (partly)

decentralized to lower managerial levels that are classified as being revenue centres. For example, by being classified as a revenue centre, the marketing department is partly being held responsible for revenues. More specifically, its performance is being measured by looking at the amount of divisional sales. Often costs made by the department (salaries, materials, etc.) are subtracted from this revenue level in order to measure net

performance. It should be obvious that the divisional manager will be primarily held responsible for the measured performance of its marketing manager or department.

Therefore this divisional manager can be expected to be able to control these marketing costs directly. In terms of Goold and Campbell (2003), the marketing department should be called a ‘core resource unit’ (as I already pointed out in paragraph 2) or a ‘business function’ (depending on whether or not responsibilities are totally decentralized to the divisional level).

Finally, responsibilities regarding other functional departments (like for example Human Resources, IT etc.) are also located below the divisional level. However, instead of rating costs against divisional revenues, managers of these departments are solely held

responsible for (a part of the) costs made within their department. Most of the times this implies costs made during a certain period are compared with the amount that was budgeted for that same period. The reason for only holding them responsible for costs is the assumption that no possible causal relationship exists between the costs made by the department and the revenues earned by the division as a whole. Such a causal relationship does exist to a certain extent for the marketing department mentioned above.

The difference with for example costs of the finance department is that these costs (such as Human Resource costs) are decentralized to the divisional level and therefore will be included when measuring performance of the division’s manager as well. As a logical consequence, divisional managers can again be expected to control these costs directly.

According to Goold and Campbell (2003), these ‘functional’ departments should be called business functions.

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§2.6 Modifications for sales-driven organizations

In the former paragraph I presented the financial responsibility centres that exist within the most common divisional structures. As should be obvious by now, the model that I will be developing within this research will be focused on divisional sales-driven organizations such as Ring. As a consequence, it will be much less applicable to

(completely) other organizational settings. According to the identified characteristics in paragraph 2, there will usually exist a fundamental different financial responsibility structure within sales-driven organizations. In this paragraph I will therefore try to modify financial responsibility centres out of figure 2.1 for sales-driven organizations.

Again I will use the case of Ring (and my experiences within the organization) as a role model in order to actually achieve this. I will only mention differences that, according to me, could be relevant within the scope of this research.

• Divisions can be profit centres as well as investment centres

As was noted in the former paragraph, divisions do not have any investment authorities within most divisional organizations. Within this research I will not just copy these thoughts, mainly since I think that especially divisions that are part of sales-driven organizations cannot always be typed as being profit centres. For example, they will sometimes be authorized to do investments regarding the opening of a new sales point (where only their products will be sold) or to invest in the design of a new line of

products. Maybe certain divisions (for example in very large multinationals) will even be authorized to independently acquire or take over another ‘small’ company. Because of this, investments (and thus investment centres) will certainly be taken into account when actually designing the model to measure divisional profitability internally in chapter 5.

• Marketing-, Design-, R&D-, Purchase and Logistics- and Distribution responsibilities are divided between the specific departments and divisions

Within Ring the marketing department is still centralized and thus the department will also have overall marketing manager. All products are sold under the same brand name and therefore there will take place a lot of corporate marketing activities, which I again already noticed in paragraph 2. There I also stated that the department should be looked upon as being a core resource unit (as defined by Goold and Campbell, 2003), mainly since the function represents one of the core areas of focus within the organization. Most of the times there will also take place some divisional marketing activities. However, as opposed to figure 2.1, managers responsible for this type of marketing will can be located within the centralised marketing department as well as within specific divisions. The actual situation will depend on a case-to-case basis.

Financial responsibilities for Design-, Research and Development-, Purchase &

Logistics- and Distribution activities (all departments being core resource units) are structured on the same grounds as marketing responsibilities, depending on the most appropriate balance between centralised and decentralised activities.

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• Most functional departments are centralized

As I already stated in paragraph 2, most functional departments within sales-driven organizations will be centralized (as is the case within Ring). Mostly it does not make sense to decentralize these functions, since each division practically makes use of these functions in the same way. In other words, providing these services or resources is not very division specific. One will realize that they can still be called cost centres in terms of Kaplan and Atkinson (1998), so things haven’t changed in this field. However, according to Goold and Campbell (2003), a large part of functional departments should now rather be called ‘shared service units’ instead of ‘business functions’. As a consequence, divisional managers won’t be the ones who will be primarily held responsible for results in these ‘functional’ areas within sales-driven organizations. For example, since all divisions (and other entities) within Ring make use of the same distribution system, related IT services are centralized and should therefore be called a shared service unit.

The same applies for Human Resource-, Legal- and Sourcing services.

§2.7 Conclusions

In this chapter I explained for what type of organization findings of this research will be of most value. On the whole a sales-driven organization should be seen as:

“An organization that sharply focuses on ways to improve sales, a focus that will often be realised by outsourcing physical production and by centralising most of the services that are performed on behalf of different divisions. Its divisions can be profit centres as well as investment centres. Next to this, a sales-driven organization will especially try to outperform competitors in the fields of Marketing, Design, Research and Development, Purchase & Logistics and Distribution. Although these functions will often be centralised as well, they might also be decentralised to the divisional level up to a certain extent.”

I illustrated that all of the above characteristics are reflected by Ring’s formulated strategy, a strategy that I used as being representative for strategies within sales-driven organizations in general. According to Otley (1999), an organization’s model to measure divisional profitability should always be consistent with its formulated strategy. All of the mentioned characteristics should therefore be taken into account very closely when developing the ‘model to measure divisional as well as managerial performance’ in following chapters. Moreover, the eventual model should especially provide specific tools that will enable central management within a ‘sales-driven organization’ to effectively deal with these most important characteristics.

After reading this chapter it should be clear what exactly is meant with ‘sales-driven organizations’. Now efforts should be undertaken to see what theoretical concepts or thoughts could be used when designing a model to measure divisional profitability internally. On the next page, by again referring to chapter one’s conceptual model, one will see that I will start with this by try to find relevant theoretical insights on ‘accounting practices’.

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Faculty of Management and Organization, University of Groningen 27 Next field of focus within the conceptual model

responsibilities

internally

model

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Faculty of Management and Organization, University of Groningen 28 Chapter 3 Measuring divisional profitability

From now on I will focus on the design of a model to measure divisional profitability within a sales-driven organization such as Ring. In my opinion one should first take a close look at the field of measuring divisional profitability before doing research to the ways in which responsibilities could be decentralized. In this chapter I will therefore present some relevant theoretical findings on divisional profitability measurement that could be value adding when designing the actual profitability measurement model in chapter 5. Originally I related this chapter to the following sub question out of the research design:

What theoretical insights on accounting practices are relevant regarding sales-driven organizations such as Ring?

In paragraph 2 I will first show how the focus of this research could be theoretically embedded within the broader field of management control systems. After this, in paragraph 3, I will point out what most divisional organizations want to achieve with measuring divisional profitability. In paragraph 4 I will analyze Merchant’s (1998) theoretical framework on measuring divisional profitability, which will serve as a role model when further developing the model that will actually be designed in chapter 5.

Finally, in paragraph 5, I will end this chapter with some conclusions.

§3.2 Focus of this research within the field of management control systems

According to Merchant (1998), (some form of) performance measurement systems will always be an important component of management control systems. However, there is no general model that conveys a precise constitution of such a system (Merchant, 1998).

Partly, this is due to our living in ‘an imperfect world’ where accounting measures are not

‘complete, accurate and neutral’, so that any system will have in-built biases, which are likely to have adverse consequences (Wilson and Chua, 1993). According to Ezzamel (1992) it could be argued that if better accounting systems were employed by especially divisionalised companies, then their level of success could have been far greater than that so far observed. Partly, too, the absentness of a generic model is due to a contingency theory argument that ‘the most appropriate control system for an organization depends on certain contingent variables; that is the system must be matched with the circumstances’

(Otley, 1999). Each system will vary according to a wide range of variables in which the chosen strategy should largely determine what is relevant. That is, different organizations will be pursuing different strategic objectives, be operating in different environments with different technologies, and so will require different performance measures

(Fitzgerald et al., 1991). It should be obvious that all these facts justify the focus of this research, which is especially supposed to be of value to sales-driven organizations such as Ring. By recognizing that it will be impossible and unrealistic to develop a model or framework to measure divisional profitability that can be used by all types of

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Faculty of Management and Organization, University of Groningen 29 organizations, this research takes the narrower focus that is required in order to let results be of substantial value.

As a consequence, this research will undertake serious efforts to contribute to ‘filling up’

theory shortcomings in the field of measuring profits within sales-driven organizations such as Ring. The research will not take into account other important elements that are or should be part of management control systems, like for example planning and budgeting or capital budgeting (Merchant, 1998). Besides, because it will focus on accounting information, other important tools of management control within management control systems, such as direct supervision, employee hiring standards and codes of conduct, will fall outside the scope of this research as well (Merchant, 1998).

Finally, the choice remains on what measures of accounting information will be focused, financial or non-financial measures. I already explicitly argued that divisional accounting profits with no doubt are of primary relevance within sales-driven organizations such as Ring. I’ve also explained that the ‘to be configured model’ should especially enable a sales-driven organization to measure the profitability of its divisions. This obviously justifies a focus on financial measures of performance measurement.

Below, in figure 3.1, I will graphically present all choices described above. The coloured sections represent the set of elements on which I will focus within this specific research.

Figure 3.1 Research focus within the field of management control systems (Merchant, van der Stede,1998)³

* Merchant (1998) replaces ‘performance measurement’ by ‘internal reporting’ and ‘analysis and interpretation’. In my opinion, however, both terms are almost perfectly covered by ‘performance measurement’, a term that better fits within the scope of this specific research.

3Merchant K.A., Modern Management Control systems: Text and Cases, Upper Saddle River, NJ:

Prentice hall, 1998

Management control systems

Performance measurement*

Planning and budgeting

Capital budgeting

Direct supervision

Employee hiring standards

Accounting information

Codes of conduct

Financial measures

Non-financial measures

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§3.3 Objectives of measuring divisional profitability

§3.3.1 Three most common objectives

Before a company undertakes all kinds of efforts to identify the most appropriate way(s) of measuring profitability of its divisions, I think it should first define the objectives of measuring profits of such organizational units, i.e., it should first determine why it would measure divisional profitability at all. Traditionally, literature indicates three main reasons for which an index of divisional profitability would be sought (Ezzamel, 1992):

1. To guide central management in assessing the efficiency of each division as an economic entity, in order to facilitate making divisional viability decisions (e.g.

whether to expand or reduce the activities of a particular division).

2. To help central management in assessing the efficiency with which divisional managers discharge their responsibilities in running their divisions. This need not be identical to (1) above, since some of the elements which impact upon the profit performance of a division may be beyond the control of its manager (for example, divisional share of head office expenses) and thereby should be excluded from the performance index of the latter.

3. To guide divisional managers in making decisions in respect of the daily activities of their own divisions. It is demonstrated in many theories that the manner in which central management assesses the performance of divisional managers has a strong impact on the way managers make decisions.

These three objectives offer useful insights with respect to the underlying objectives of divisional profitability measurement, despite the fact that they are sometimes criticized for being narrowly conceived (Ezzamel, 1992):

(a) They exclude internal uses of divisional profit performance measures below the divisional manager level, and

(b) They focus only on internal uses, to the exclusion of external uses.

The fact that the objectives exclude internal uses of divisional profit performance measures below the divisional manager level will not be of harm to this research. It is focused on providing a way in which corporate level will be able to alter the profit performance achieved at the divisional level, both of the divisional entity as a whole as well as of divisional managers.

It should be obvious that the second ‘perceived limitation’, which criticizes the focus on internal uses and the exclusion of external uses, will only be in favour of this research. As already mentioned in the introduction, the model that is to be developed will only serve internal purposes and therefore is independent of profit performance measures that are used for external purposes, which usually serve completely different objectives.

§3.3.2 Adding a fourth objective

Next to the three mentioned above, I would like to add another objective. Horngren (1965) and Ezzamel (1992) explicitly recognise it as being another important objective of