APPLICABILITY OF CONTROLLABILITY PRINCIPLE IN DIVISIONAL MANAGERIAL PERFORMANCE

MEASUREMENT IN MANUFACTURING SECTOR

A RESEARCH PROPOSAL
SUBMITTED TO PROF. HAFIZ ZAFAR AHMAD

SUBMITTED BY FARHANA ARSHAD MC10-050 SECTION A MORNING

Introduction Many large organizations have multiple divisions in order to handle their process. Because divisional organizational structure gives a business the ability to segregate large groups of a company into small, easy to manage structure. These divisions are normally self-managed and focused on a narrow aspect. A divisional organizational structure usually consists ofseveral teams focusing on a single product line. This study discusses the controllability principle in order to measure divisional performance. While evaluating divisional performance controllability principle must be applied to segregate the results of controllable and uncontrollable factors. One of the most important issues of principles of control is that individuals are responsible for items, they can control. This is the expression of controllability principle. Controllability principle needs consideration while evaluating the divisional performance of an organization. It is self-evident proposition that managers should be answerable for what under control of them. But in practice, controllability principle is ignored and managers are responsible for items in which they have little control(Merchant, 1998). Controllability principle is used to discriminate managerial and economic performance of a division. The way in which divisional performance is measured and control is of considerable importance. During 1970s the selection of suitable measure of divisional performance was widely addressed in management accounting literature. There are two extremes regarding its application; the first one is no application of controllability principle it means managers are responsible for all uncontrollable factors. And the second one is full application of controllability principle where managers are responsible only for controllable factors. It has been widely debated whether divisional managers should be held responsible for uncontrollable items or not. Protectionist of controllability principle argues that divisional managers should be held responsible for only those items which are under control of him. But in practice, many companies dont follow this controllability principle and companies allocate uncontrollable cost to divisional managers.

The key issue of this study is to determine that managers responsibility towards controllable and uncontrollable items. The conventional wisdom of management accounting held divisional managers responsible for only those items which they can control. Several performance measures are used to measure economic and managerial performance of a division. Controllability principle is used to differentiate managerial and economic performance of a division. Economic measures include all cost whether it is controllable or not whereas divisional performance measures exclude cost which is not controllable by applying controllability principle. The choice of appropriate divisional performance measures is critical. Because one area of debate argues that controllability principle should be applied. On the other hand financial measures such as profit before interest and taxes, residual income and return on investment should be used. The aim of this study is to identify the extent to which controllability principle is applied to uncontrollable factors and to assess the level of satisfaction of organizational management by applying controllability principle. Traditional measures of divisional performance are return on equity, net profit before interest and taxes and residual income etc. these measures have some deficiencies such as hey focus on short term period, deal only with current period, based on historical concept thus these are poor estimators and dont provide clear picture but on the other hand, controllability principle gives a clear picture. Research objective are 1. To know the controllability principle 2. To know whether the controllability principle is useful or not 3. To identify controllable and uncontrollable factors of a division 4. To assess the level of application of controllability principle in a division

Literature review The manner in which divisions are evaluated is considerable importance. Much of the research relating to divisional performance measurement is 20 years old(El-shishini). Division Large organizations have a large set of activities which they carry out at different places. In order to manage such a wide range of activities organizations may be divided into separate units. Each of which is held responsible for planning and controlling of its own activities. These separate units are called division of an organization. Divisions are responsible for generating revenues, controlling cost and generating revenues for the organization(Drury & EL-Shishini). Advantages of division are: 1. When managers have decision making power, their decisions are readily available when organization need changes about divisions, fi all decision are taken by top management the decisions may be delayed which slow down organizational processes and activities. 2. Divisional managers are more motivated because they are responsible for divisional performance(Nanni, Dixon, & Vollmann, 1992). 3. Divisions also give a sense of identity with the operation of division because they carry out a different operation from the rest of organization 4. Organizations with divisional structures work well because they focus only specific product or service line. Divisions have its own president or vice president so it is more likely that divisions receive more from the company according to its needs(Drury & ELShishini) Disadvantages of division are 1. As divisional managers have discretion to take decisions about division so often they take decisions which are not aligned according to organizational objectives 2. Economies of scales may not be attained because of separate units 3. Top managers remain unaware of day to day operations

4. companies have to focus on divisional policies along with organizational policies which divert company attention from its main objectives(Lincoln). Divisional performance measurement has vital importance while measuring organizational performance. There are many incentives to measure organizational performance separately e.g. divisional performance. Major incentive is divisional managers efficiently perform their operations because they know they would held responsible for divisional

performance(Zimmerman, 1997).Measurement of managerial competencies is necessary. Appraisal of managerial competencies enhances competencies effectiveness. If competencies are not appraised then managerial performance appraisal program may be failed(Abraham, Karns, Shaw, & Mena, 2001).Managerial performance measurement system required the discrimination of controllable and uncontrollable factors(Hurst & Jee-Hughes, 2001). There are 3 categories of uncontrollable items 1. Uncontrollable common resources 2. Economic and competitive conditions 3. Interdependencies among divisions The term common resources refers to sources provided by the head office for the sake of benefits to two or more divisions such as research and development, training programs, internal auditing(El-shishini). The controllability principle can be used in order to check the responsibility of managers. According to this principle managers are responsible for only those outcomes which are under their control(Bevan & Messner, 2008). Controllability principle needs consideration while distinguishing between managerial and economic performance measure of a division(Drury & EL-Shishini). The management accounting literature distinguishes managerial and economic performance of a division on the basis of controllability. However, in practice companies tend to hold divisional managers responsible for uncontrollable factors(El-shishini).

Management accounting advocates that evaluation of managers performance should consist of only those factors which are under managers control. Performance measurement of a division should be based on controllability factor(Drury & EL-Shishini). Controllability principle does not applied in practice. There are two extremes regarding its application; the first one is no application of controllability principle it means managers are responsible for all uncontrollable factors. And the second one is full application of controllability principle where managers are responsible only for controllable factors. But in between there are some situations where managers are responsible for some uncontrollable factors(Drury & ELShishini). Managers must held responsible for results which are not under control of him but managerial decisions alter these decisions(LIU, 1999).Managers must be responsible for items for which they are responsible and not liable for those results which are not under control of him(Fischer, 2010; LIU, 1999).The selection of appropriate divisional managerial performance tool has been widely discussed in managerial accounting literature. The investment areas where divisional managers are responsible for decisions regarding investment in working capital, residual income is appropriate measure of divisional performance. Where managers are not responsible for investment in working capital, return on investment or target absolute profit(assets employed in the division target return on investment) should be used(Amey, 1969).

Level of application of the controllability principle There are two levels regarding the application of the controllability principle. The first one is low level of application. Low level of application is used where 1. Uncontrollable common resources cost are allocated to division 2. When divisional interdependencies are not taken into account while measuring divisional performance The second one is high level of application of controllability principle which is used when 1. Uncontrollable common resources cost are not allocated to division 2. When divisional interdependencies are taken into account while measuring divisional performance(Drury & EL-Shishini).

Classification of sources of uncontrollable factors: 1. Uncontrollable factors are economic and competitive factors; acts of

nature;uncontrollable costs; andinterdependencies 2. Economic and competitive factors include the impact of: business cycles;competitors actions; changes in customers tastes;changes in law and regulations; and foreign exchange rates(Merchant, 1989). Responses to such uncontrollable factors are an integral part of managers job so excluding such factors while evaluating divisional managers performance is not a wise choice(Merchant, 1998) Act of nature such like earthquake, flood and strikes are beyond the ability of managers to predict so managers are not responsible for such factors. Management accounting practices advocates that cost which is incurred due to natural disasters cannot be controlled hence managers are not liable for such cost(Merchant, 1989). Organizations which have divisional structure are positively related to the level of information and performance measurement tool must be selected according to the level of interdependencies among divisions. Decentralization (divisional structure) and use of performance measures are complementary(Abernethy, Bouwens, & Lent, 2004). While appraising the performance of divisional managers no matter outside the divisions control should be taken(Solomons, 1965). As described above, conventional wisdom advocates that divisional manager held responsible for the results only they can control. For this purpose the concept of controllability must be understood.Managers are responsible for the cost which they can control but the question arise about uncontrollable cost which is not under control of division, this study determine the criteria relating to the allocation of uncontrollable cost(Drury & EL-Shishini).

Research Methodology As the purpose of this study is to assess the application of controllability principle whilst evaluating managerial performance of a division so due to time, finance and other constraints this study is limited to manufacturing industry. Population: In this study the population is manufacturing industries because controllability principle is more applicable in manufacturing industries. Sample: Food and beverages industries are targeted as sample. Only those companies are used as sample which have high turnover because there is a high probability of divisional structure of companies having high turnover. Sampling technique: Stratified random sampling technique is used to select sample then simple random sampling would be applied on strata. Instrument of data collection: Interviews of divisional managers who measure divisional performance will be conducted in order to know whether they apply controllability principle or not and if they use then how and to what extent they apply this principle. Data analysis: After the data collection, it would be compiled, classified and analyzed with the help of Nvivo. .

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Merchant, K. A. (1998). Modern Managrment Control. text and cases. Retrieved from http://fisher.osu.edu/~young_53/Merchant%20Controllability Nanni, A. J. J., Dixon, J. R., & Vollmann, T. E. (1992). Integrated Performance Measurement: Management Accounting to Support the New Manufacturing Realities. Journal of Management Accounting Research, 4, 1-19. Solomons, D. (1965). Divisional Performance, Measurement and control Available from http://books.google.com/books/about/Divisional_performance.html?id=NnlEAAAAIAAJ Zimmerman, J. L. (1997). EVA and Divisional Performance Measurement: Capture Synergies and Other Issues. Journal of Applied Corporate Finance, 10(2).