Management Control hoorcollege 1
Two basic assumptions of economic models:
- Greed (prefer more over less)
- Risk-aversion
Risk aversion: utility increases at decreasing rate with each additional unit of income, this can be
illustrated through concavity of the utility function.
The note illustrates a choice between 1) a fixed amount of 3000 and 2) 50% probability of 1000 and
50% probability of 5000. The second must be equal to 3000, but due to risk aversion people tend to
choose option 1.
Asymmetric information models:
Moral hazard: Hidden actions/effort, the uninformed party moves first. Moral hazard occurs when
someone increases their exposure to risk when insured. (in dutch: moreel wangedrag).
Agent has private information about effort choices. Misallignment of interest between principal and
agent. Principal may prefer high and productive effort, while the agent prefers leisure activities. The
principal can stimulate high and productive effort by offering contracts contingent on performance
measures rewarding agents for productive effort. (Example: Executive compensation contracts).
Screening/ Adverse selection: Hidden characteristics + uninformed party moves first. Agent has
private information about characteristics. Example: only a certain type of people are attracted by a
contract, this example is in real life visible with the health insurance.
Signaling: Hidden Characteristics + informed party moves first. By signaling the informed party
informs the uninformed party about its hidden characteristics. Example: Education is a way in which
an employee sends a signal to an employer which tells something about its characteristics.
Education is more costly for the low type, so for high type this is a credible way of communication
about ability.
Management control: Process by which management ‘ensures’ that employees carry out
organizational objectives and strategies. (i.e. act in the organization’s best interest). Influence
behavior of employees to increase probability that organization’s objectives and strategies will be
achieved. Management accounting is a tool which genereates information where management
control relies on.
, Why do we need control?
Knowledge is valuable in decision making
Two options to allocate decision right to the person with the right knowledge
1 Moving knowledge to those with decision right (Knowledge transfer cost KTC)
An example is moving the knowledge to the CEO, whom makes the decisions. If chosen for this
options two problems can occur: right assignment problem and an agency problem.
2 Moving decision right to those with knowledge (Control cost CC)
An example is moving decision rights to a divisional level.
The choice between these two options depends on the type of knowledge: Specific knowledge has
high transfer
costs, and general
knowledge has
lower transfer
costs.
Centralized means all decision right remain at the top of the organization. Decentralized means that
decision rights are delegated to lower levels in the organization.
Merchant and van de Stede (IN slides M&VDS conceptual framework)
They state that employees’ actions are not perfectly aligned with firm objectives. They state that
there are three causes:
1 Lack of direction: employees do not know what is expected form them.
2 Lack of motivation: employees serve personal objectives that do not coincide with firm’s objective.
3 Lack of ability: Employees do not have the skills required.
To solve this control problem they state that a firm has two options:
1) can avoid these control problems by either centralize (reclaim decision-making authority), or
eliminate uncontrollable activity/engage in risk sharing (outsourcing).
2) implement a comprehensive management control system. Two issues for designing a control
system: 1) which combination of controls should be used? 2) how tight should each control be?
Two basic assumptions of economic models:
- Greed (prefer more over less)
- Risk-aversion
Risk aversion: utility increases at decreasing rate with each additional unit of income, this can be
illustrated through concavity of the utility function.
The note illustrates a choice between 1) a fixed amount of 3000 and 2) 50% probability of 1000 and
50% probability of 5000. The second must be equal to 3000, but due to risk aversion people tend to
choose option 1.
Asymmetric information models:
Moral hazard: Hidden actions/effort, the uninformed party moves first. Moral hazard occurs when
someone increases their exposure to risk when insured. (in dutch: moreel wangedrag).
Agent has private information about effort choices. Misallignment of interest between principal and
agent. Principal may prefer high and productive effort, while the agent prefers leisure activities. The
principal can stimulate high and productive effort by offering contracts contingent on performance
measures rewarding agents for productive effort. (Example: Executive compensation contracts).
Screening/ Adverse selection: Hidden characteristics + uninformed party moves first. Agent has
private information about characteristics. Example: only a certain type of people are attracted by a
contract, this example is in real life visible with the health insurance.
Signaling: Hidden Characteristics + informed party moves first. By signaling the informed party
informs the uninformed party about its hidden characteristics. Example: Education is a way in which
an employee sends a signal to an employer which tells something about its characteristics.
Education is more costly for the low type, so for high type this is a credible way of communication
about ability.
Management control: Process by which management ‘ensures’ that employees carry out
organizational objectives and strategies. (i.e. act in the organization’s best interest). Influence
behavior of employees to increase probability that organization’s objectives and strategies will be
achieved. Management accounting is a tool which genereates information where management
control relies on.
, Why do we need control?
Knowledge is valuable in decision making
Two options to allocate decision right to the person with the right knowledge
1 Moving knowledge to those with decision right (Knowledge transfer cost KTC)
An example is moving the knowledge to the CEO, whom makes the decisions. If chosen for this
options two problems can occur: right assignment problem and an agency problem.
2 Moving decision right to those with knowledge (Control cost CC)
An example is moving decision rights to a divisional level.
The choice between these two options depends on the type of knowledge: Specific knowledge has
high transfer
costs, and general
knowledge has
lower transfer
costs.
Centralized means all decision right remain at the top of the organization. Decentralized means that
decision rights are delegated to lower levels in the organization.
Merchant and van de Stede (IN slides M&VDS conceptual framework)
They state that employees’ actions are not perfectly aligned with firm objectives. They state that
there are three causes:
1 Lack of direction: employees do not know what is expected form them.
2 Lack of motivation: employees serve personal objectives that do not coincide with firm’s objective.
3 Lack of ability: Employees do not have the skills required.
To solve this control problem they state that a firm has two options:
1) can avoid these control problems by either centralize (reclaim decision-making authority), or
eliminate uncontrollable activity/engage in risk sharing (outsourcing).
2) implement a comprehensive management control system. Two issues for designing a control
system: 1) which combination of controls should be used? 2) how tight should each control be?
