Accounting & business performance
The current business environment is characterized by a high level of competitiveness and business organizations have to go through a constant process of change in order to develop and maintain a competitive edge that will allow them to maximize their profits.
Profit maximization leads to maximization of shareholder wealth and therefore it is the ultimate objective that the management in every business organization strives to attain in the long term. However shareholders are not the only stakeholders to a business organization.
Customers and employees are also important stakeholders and satisfying their demands is critical to maintaining the competitiveness of a business organization (cited in Spitzer, 2007). The process of satisfying customers is called customer relationship management.
The process of satisfying the employees is called human resource management (cited in Armstrong, 2005). A critical aspect of human resource management is compensation management. Inasmuch as compensation management motivates employees and directly impacts the level of their performance, it is a serious concern for the management of a business organization.
Compensation management, by influencing employees to target their efforts towards enhancing organizational effectiveness, forms an integral part of the management control system in a business organization.
The management control system ensures that resource allocation happens in a manner calculated to maximize organizational effectiveness. This effectiveness is achieved through strategic alignment. As mentioned before, every business organization has to develop a competitive edge.
This enables business organizations to set themselves apart so that customers are more willing to spend money for their products and services rather than for their competitors. Having a strategic focus is integral to developing and maintaining a competitive edge. In order to develop a strategic focus, the management of a business organization has to identify its core competencies.
These competencies possessed by a particular business organization define what the strategic focus for that organization should be and the organization’s resources are allocated accordingly. One of the most important resources that an organization possesses is its employees. However employees do not possess the big picture.
Therefore they are unable to structure the application of their skills efficiently and effectively on their own. That is why the management control system is of critical importance. The management control system in this regard works by means of a framework of rewards and penalties.
An organization is a collective term (cited in Armstrong, 2005). It consists of a group of people working together to reach a common target which for a business organization, as mentioned before, is profit maximization. According to the definition above, how employees relate to one another in the organizational setting is a concern of the utmost importance.
The effort here is one of identifying a structural framework which can be applied generally to understanding the nature of these relationships. Understanding the nature of the relationship between the superior and his subordinates reveals the set of motives and interests which the senior management of an organization can depend upon to improve the performance of their employees. One such structural framework is the agency theory.
According to the agency theory, agents and principals have different motives and interests which guide their behavior and therefore conflicts of interest arise (cited in Atkinson, 2006). These conflicts must be eliminated if their efforts are to be directed to the common good of the organization.
Examples of principals are the senior management of an organization while examples of agents may be the managers who work under them. An example of a conflict of interest may be a scenario where the senior management encourages a high level of risk-taking when it comes to business ventures but the managers they are delegating tasks to do not like to take risks.
In this respect, the common goal for both agents and principals to maximize profits is compromised because the two parties are following different approaches. Unless this conflict is resolved, it will be impossible for the senior management of an organization to maintain its strategic focus.
How to resolve this conflict has been the subject of considerable research and there is widespread agreement in the scholarly circles that designing the right system of rewards and penalties is the critical issue in this regard.
The highly competitive nature of the current business environment requires organizations to change their internal processes in a continuous improvement process. Because the industry is changing fast in terms of products and services and production technologies, the business organization operating in that industry also has to change in order to stay competitive.
One of these changes is that business organizations can no longer afford to keep their performance measurement systems aligned to the past. That is why the balanced scorecard system is now being implemented in diverse industries in a wide variety of organizations to keep the performance measurement system forward-looking.
According to the balanced scorecard, the management of a business organization has to look at the organization in terms of four perspectives: financial, customer, learning and growth and internal processes (cited in Spitzer, 2007).
The balanced scorecard links these four perspectives under the framework of total quality management. According to the theory of total quality management, the process of quality control has to be embedded in all the processes organization-wide.
The balanced scorecard puts this theory into practice by focusing management control on four key areas of an organizational structure. However once again, implementing the balanced scorecard requires the right system of rewards and penalties.
It has been mentioned before that managers and employees have different goals and therefore delegation of duties and responsibilities is hampered. Removing this barrier to strategic alignment between management goals and the goals of their subordinates defines agency theory. The agency theory is very much relevant even when it comes to the implementation of the balanced scorecard.
According to this methodology, the managers responsible for particular work processes have to design hierarchies of objectives, measures, targets and initiatives which will assess to what extent those work processes are meeting organizational standards (cited in Spitzer, 2007).
Conflicts of interest between the senior management and its subordinates will arise because the senior management will require that lower level managers set aggressive targets for their work processes in the balanced scorecard. However the lower level managers will be unwilling to set aggressive targets because in the event these aggressive targets are not met, they risk losing their jobs. The senior management likes to take risks because it has a lot of choices in this respect, i.e. hiring other employees more suited to the task.
However the employees will have a hard time finding another job and therefore they set easily attainable targets in order to ensure job security. This conflict can be resolved only through the right system of rewards and penalties.
In designing the right system of rewards and penalties, the management has to decide whether the compensation should be behavior-based (fixed salary) or outcome-based (bonus, stock options, profit sharing) (cited in Armstrong, 2005).
This decision is reached on the basis of whether the task in question is highly programmable, where senior management can specifically prescribe the behavioral requirements for the task, or not (cited in (cited in Spitzer, 2007).
For example, when it comes to maximizing sales, the management has to offer its sales employees a certain degree of latitude so that the sales employees exercise creativity in maximizing the number of sales in a specific period of time.
In this respect, the senior management has no way of monitoring employee behavior and therefore the rewards or penalties are administered based on whether the number of sales reached the target or not. That is why rewards and penalties are important for the management control system.
The objective of the management control system in this example is to make sure that in maximizing sales, employees put in their best efforts, which they will not according to the agency theory. That objective of the management control system is reached only through well thought out rewards and penalties which make employees extend their best efforts in attaining the organizational objectives.
Spitzer, Dean R. Transforming Performance Measurement: Rethinking the Way We
Measure and Drive organizational Success. Prentice Hall. (2007).
Armstrong, Michael. Strategic Human Resource Management. Prentice Hall. (2005)
Atkinson, Anthony A., et al. Management Accounting. McGraw Hill/Irwin. (2006).
Horngren, Charles T., et al. Introduction to Management Accounting. Prentice Hall. (2005).