Implications Of Differentiated Strategies On Controls

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Implications of differentiated strategies on controls

Different corporate strategies imply the following differences in the context in which control systems need to be designed:

As firms become more diversified, corporate-level managers may not have significant knowledge of, or experience in, the activities of the company's various business units. If so, corporate-level managers for highly diversified firms cannot expect to control the different businesses on the basis of intimate knowledge of their activities, and performance evaluation tends to be carried out at arm's length.

Single-industry and related diversified firms possess corporate wide core competencies. (on which the strategies of most of the business units are based. Communication channels and transfer of competencies across business units, therefore, are critical in such firms. In contrast, there are low levels of interdependence among the business units of unrelated diversified firms. This implies that as firms become more diversified, it may be desirable to change the balance in control systems from an emphasis on fostering cooperation to an emphasis on encouraging entrepreneurial spirit.

Strategic planning:
Given the low level of inter dependencies, conglomerates tend to use vertical strategic planning systems-that is, business units prepare strategic plans & submit to senior management to review & approve. The horizontal dimension might be incorporated into the strategic planning process in a number of different ways. First, a group executive might be given the responsibility to develop a strategic plan for the group as a whole that explicitly identifies synergies across individual business units within the group. Second, strategic plans of individual business units could have an interdependence section, in which the general manager of the business unit identifies the focal linkages with other business units and how those linkages will be exploited. Third, the corporate office could require joint strategic plans for interdependent business units. Finally, strategic plans
of individual business units could be circulated to managers of similar business units to critique and review.

These methods are not mutually exclusive. In fact, several of them could be pursued fruitfully at the same time.

Budgeting
The chief executives of single-industry firms may be able to control the operations of subordinates through informal and personally oriented mechanisms, such as frequent personal interactions. This lessens the need to rely as heavily on the budgeting system as the tool of control.
On the other hand, in a conglomerate it is nearly impossible for the chief executive to rely on informal interpersonal interactions as a control tool; much of the communication and control has to be achieved through the formal budgeting stem. This implies the following budgeting system characteristics in a conglomerate.Business unit managers have somewhat greater influence in developing their budgets since they, not the corporate office, possess most of the information about their respective product/market environments. Greater emphasis is often placed on meeting the budget since the chief executive has no other informal controls available.

Transfer Pricing
Transfers of goods and services between business units are more frequent in single-industry and related diversified firms than in conglomerates. The usual transfer pricing policy in a conglomerate is to give sourcing flexibility to business units and use arm's-length market prices. However, in a single-industry or a related diversified firm, synergies may be important, and business units may not be given the freedom to make sourcing decisions.

Incentive Compensation
The incentive compensation policy tends to differ across corporate strategies in the following ways-

Use of formulas:
Conglomerates, in general, are more likely to use formulas to determine business unit managers' bonuses; that is, they may base a larger portion of the bonus on quantitative, financial measures, such as X percent bonus on actual economic value added (EVA) in excess of budgeted EVA. These formula-based bonus plans are employed because senior management typically is not familiar with what goes on in a variety of disparate businesses.Senior managers of single-industry and related diversified firms tend to base a larger fraction of the business unit managers’ bonus on subjective factors. In many related diversified firms, greater degrees of interrelationship simply that one unit's performance can be affected by the decisions and actions of other units. Therefore, for companies with highly interdependent business units, formula-based plans that are tied strictly to financial performance criteria could be counterproductive.

Profitability measures:
In the case of unrelated diversified firms, the incentive bonus of the 'business unit managers tend to be determined primarily by the profitability of that unit, rather than the profitability of the firm~ Its purpose is to motivate managers to act as though the business unit were their own company.In contrast, single-industry and related diversified firms tend to base the incentive bonus of a business unit manager on both the performance of that unit and the performance of a larger organizational unit (such as the product group to which the business unit belongs or perhaps even .the overall corporation). When business units are interdependent, the more the incentive bonus of general managers emphasizes the separate performance of each unit, the greater the possibility of inter unit conflict. On the other hand, basing the bonus of general managers more on the overall corporate performance is likely to encourage greater inter unit cooperation, there by increasing managers' motivation to exploit inter dependencies rather than their individual results.

Business Unit Strategy:
Diversified corporations segment themselves into business units and typically assign different strategies to the individual business units. Many chief executive officers of multi business organizations do not adopt a standardized, uniform approach to controlling their business units; instead, they tailor the approach to each business unit's strategy.
The strategy of a business unit depends on two interrelated aspects:(1) Its mission ("What are its overall objectives?") and (2) its competitive advantage.("How should the business unit compete in its industry to accomplish its mission?"). Typically business units choose from four missions: build, hold, harvest, and divest. The business unit has two generic ways to compete and develop a sustainable competitive advantage: low cost and differentiation.

Mission
The mission for existing business units could be either build, hold, or harvest. These missions constitute a continuum, with "pure build" at one end and "pure harvest" at the other end. To implement the strategy effectively, there should be congruence between the mission chosen and the types of controls used. The mission of the business unit influences the uncertainties that general managers face and the short-term versus long-term trade-offs they make.
Management control systems can be systematically varied to help motivate the manager to cope effectively with uncertainty and make appropriate short-term versus long term trade-offs. Thus, different missions often require systematically different management control systems.

Mission and Uncertainty
"Build" units tend to face greater environmental uncertainty than "harvest" units for several reasons: Build strategies typically are undertaken in the growth stage of the product life cycle, whereas harvest strategies typically are undertaken in the mature decline stage of the product life cycle. Such factors as manufacturing process; product technology; market demand; relations with suppliers, buyers, and distribution channels; number of competitors; and competitive structure change more rapidly and are more unpredictable in the growth stage than in the mature/decline stage.
An objective of a build business unit is to increase market share. Because the total market share of all firms in an industry is 100 percent, the .battle for market share is a zero-sum game; thus, a build strategy puts a business unit in greater conflict with its competitors than does a harvest strategy. Competitors' actions are likely to be unpredictable, and this contributes to the uncertainty that build business units face.

On both the input side and the output side, build managers tend to experience greater dependencies on external individuals and organizations than do harvest managers. For instance, a build mission signifies additional capital investment (greater dependence on capital markets), expansion of capacity (greater dependence on the technological environment), increase in market share (greater dependence on customers and competitors),increase in production volume (greater dependence on raw material suppliers and labor markets), and so on. The greater the external dependencies a business unit faces, the greater the uncertainty it confronts.

Build business units are often in new and evolving industries; thus, build managers are likely to have less experience in their industries. This also contributes to the greater uncertainty that managers of build units face in dealing with external constituencies.

Mission and Time Span
The choice of build versus harvest strategies has implications for short-term versus long-term profit trade-offs.The share-building strategy includes
(a) price 'cutting,
(b)major R&D expenditures (to introduce new products),and
(c)major market development expenditures. These actions are aimed at establishing market leadership, but they depress short-term profits. Thus, many decisions that a build unit manager makes, today may not result in profits until some future period. A harvest strategy, on the other hand, concentrates on maximizing short-term profits.

Strategic Planning
When the environment is uncertain, the strategic planning process is especially important management needs to think about how to cope with the uncertainties, and this usually requll 1 longer-range view of planning than is possible in the annual budget. If the environment is stable, there may be no strategic planning process at all or only a broad-brush strategic plan. Thus, the strategic planning process is more critical and more important for build, as compared with harvest, business units. Nevertheless, some strategic planning of the harvest business units may be necessary because the company's overall strategic plan must encompass all of its businesses to effectively balance cash flows.

In screening capital investments and allocating resources, the system may be more quantitative and financial for harvest units. A harvest business unit operates in a mature industry and does not offer tremendous new investment possibilities. Hence, the required earnings rate for such a business unit may be relatively high to motivate the manager to search for project with truly exceptional returns. Because harvest units tend to experience stable environments with predictable products, technologies, competitors, and customers), discounted cash flow PCF) analysis often can be used more confidently. The required information used to evaluate investments from harvest units is primarily financial.

A build unit, however, is positioned on the growth stage of the product life cycle. Since the corporate office wants to take advantage of the opportunities in a growing market, senior management may set a relatively low discount rate, thereby motivating build managers to forward more investment ideas to corporate office. Given the product/market uncertainties, financial analysis of some projects from build units may be unreliable. For such projects, non-financial data are more important.

Budgeting
The calculation aspects of variance analysis comparing actual results with the budget identify variances as either favorable or unfavorable. However, a favorable variance does not necessarily imply favorable performance, nor does an unfavorable variance imply unfavorable performance. The link between a favorable or unfavorable variance, on the one hand, and favorable or unfavorable performance, on the other hand, depends on the strategic context of the business unit under evaluation.

Incentive Compensation System
In designing an incentive compensation package for business unit managers, the following questions need to be resolved:

1.What should the size of incentive bonus payments be relative to the general manager's base salary?Should the incentive bonus payments have upper limits?
2.What measures of performance (e.g., profit, EVA, sales volume, market share, product development) should be used when deciding the general manager's incentive bonus awards? If multiple performance measures are employed, how should they be weighted?
3.How much reliance should be placed on subjective judgments in deciding on the bonus amount?
4.How frequently (semiannual, annual, biennial, etc.) should incentive awards be made?

With respect to the first question, many firms use the principle that the riskier the strategy, the greater the proportion of the general manager's compensation in bonus compared to salary (the "risk/return" principle). They maintain that because managers in charge of more uncertain task situations should be willing.to take greater risks, they should have a higher percentage of their remuneration in the form of an incentive bonus. Thus,"build" managers are more likely than "harvest" managers to rely on bonuses.

As to the second question, when rewards are tied to certain performance criteria, behaviour ls influenced by the desire to optimize performance with respect to those criteria. Some performance criteria (cost control, operating profits, and cash flow from operations) focus more on short-term results, whereas other performance criteria(market share, new product development, market development, and people development) focus on long-term profitability.

Thus,linking incentive bonus to short-term criteria tends to promote a short-term focus on the part of the general manager and, similarly, linking incentive bonus to long-term criteria is likely to promote long-term focus.Considering the relative differences in time horizons of build and harvest managers, it may not be appropriate to use a single, uniform financial criterion, such as operating profits, to evaluate the performance of every business unit. A better idea would be louse multiple performance criteria, with differential weights for each criterion depending on the business unit's mission.

The third question asks how much subjective judgment should affect bonus amounts. At one extreme, a manager's bonus might be a strict formula-based plan, with the bonus tied to performance on quantifiable criteria(e.g., X percent bonus on actual profits in excess of budgeted profits). At the other extreme, a manager's incentive bonus amounts might be based solely on the superior's subjective judgment or discretion. Alternatively,incentive bonus amounts might also be based on a combination of formula-based and subjective approaches.Performance on most long-term criteria (market development, new-product development, and people development) is harder to measure objectively than is performance along most short-run criteria (operating profits, cash flow from operations, and return on investment).As already noted, build managers- in contrast with harvest managers, should concentrate more on the long run, so they typically are evaluated more subjectively than are harvest managers.

As to the fourth question, the frequency of bonus awards does influence the time horizon of managers. More frequent bonus awards encourage managers to concentrate on short-term performance since they have the effect of motivating managers to focus on those facets of the business they can affect in the short run.

Competitive Advantage
A business unit can choose to compete. Either as a differentiated player or as a low-cost player, Choosing differentiation 'approach, rather than a low-cost approach, increases uncertainty of a business unit's task environment for three reasons.

1.Product innovation is more critical for differentiation business units than for low cost business units.This is partly because a low-cost business unit, with primary emphasis on cost reduction, typically prefers to keep its product offerings stable over time; a differentiation business unit, with its primary focus on uniqueness & exclusivity, is likely to engage in greater product innovation.

2.A low cost business unit typically tend to have narrow product lines to minimize the inventory carry costs as well as to benefit from scale economies. Differentiation business units on the other hand tend to have a broader set of products to create uniqueness.

3.Low cost business units typically produce no-frill commodity products& these products succeed primarily because they have lower prices than competing products. However product differentiation business units succeed if customers perceive that the products have advantages over competing products. Since the customer perception is difficult to learn about, & since customer loyalty is subject tochange resulting from actions of competitors or other reasons, the demand for differentiated products istypically more difficult to predict than the demand for commodities
 
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