. 43
( 55 .)


It may be argued that businesses should aggressively prose-
cute offenders. The record shows, however, that most busi-
nesses are reluctant to do this, fearing the adverse publicity
surrounding legal proceedings. Many businesses adopt the pol-
icy that fraud is just one of the many costs of doing business.
They don™t encourage it, of course, and they do everything
practical to prevent it. But in the final analysis, a majority of
businesses appear to tolerate some amount of normal loss
from fraud.
As an example, suppose an employee or midlevel manager
steals inventory and sells the products for cash, which goes
into his or her pocket. A good management control reporting
system keeps a very close watch on inventory levels and cost-
of-goods-sold expense ratios. If a material amount of inven-
tory is stolen, the inventory shrinkage and/or profit margin
figures should sound alarms. The sophisticated thief realizes


this and will cover up the missing inventory. Indeed, this is
exactly what is done in many fraud cases.

In one example, a company™s internal controls were not effec-
tive in preventing the coverup; the accounting system reported
inventory that in fact was not there. Thus, inventory showed a
larger increase (or a smaller decrease) than it should have. You
might think that managers would be alert to any inventory
increase. But in the majority of fraud cases, managers have
not pursued the reasons for the inventory increase. If they had,
they might have discovered the inventory theft.
In similar fashion, fraud may involve taking money out of
collections on accounts receivable, which is covered up by
overstating the accounts receivable account. Other fraud
schemes may use accounts payable to conceal the fraud.
Managers should keep in mind that the reported profit per-
formance of the business will be overstated as the result of
undiscovered fraud. This is terribly embarrassing when it is
discovered and prior financial statements have to be revised
and restated. But fraud can be disastrous. Furthermore, it
may lead to firing the executive who failed to discover the
theft or fraud; one responsibility of managers is to prevent
fraud by subordinates and to devise ways and means of
ensuring that no fraud is going on.

The design of effective and efficient management control
reports is a real challenge. This section presents guidelines
and suggestions for management control reporting. Unfortu-
nately, there is no one best format and system for control
reporting. There is no one-size-fits-all approach for communi-
cating the vital control information needed by managers, no
more than there are simple answers in most areas of business
decision making. One job of managers is to know what they
need to know, and this includes the information they should
get in their control reports.

Control Reports and Making Decisions
The first rule for designing management control reports is
that they should be based on the decision-making analysis


methods and models used by managers. This may sound
straightforward, but it™s not nearly as easy as it sounds. This
first rule for control reports is implicit in the concept of feed-
back information discussed at the beginning of the chapter.
One problem is that control reports include a great deal of
detail, whereas the profit and cash flow models that are best
for decision-making analysis are condensed and concise.
Nevertheless, control reports should resonate as much as
possible with the logic and format of the models used by
managers in their decision-making analysis. For example, the
reports each period on the actual results of a capital invest-
ment decision should be structured the same as the man-
ager™s capital investment analysis. If the manager uses the
layout shown in Figures 14.2 and 14.3, for instance, then the
control report should be in the same format and include com-
parison of actual returns with the forecast returns from the

Need for Comparative Reports
More than anything else, management control is directed
toward achieving profit goals and meeting the other financial
objectives of the business. Goals and objectives are not estab-
lished in a vacuum. Prior-period performance is one reference
for comparison, of course. Ideally, however, the business
should adopt goals and objectives for the period that are put
into a framework of clear-cut benchmarks and standards
against which actual performance is compared. Budgeting,
discussed later in the chapter, is one way of doing this.
In practice, many companies simply compare actual per-
formance for the current period against the previous period.
This is certainly better than no comparison at all, and it does
focus attention on trends, especially if several past periods
are used for comparison and not just the most recent period.
However, this approach may sidetrack one of management™s
main responsibilities, which is to look ahead and forecast
changes in the economic environment that will affect the
Changes from previous period may have been predictable
and should have been built into the plan for the current
period. The changes between the current period and the pre-
vious period don™t really present any new information relative


to what should have been predicted. The manager should get
into a forward-planning mode. Based on forecasts of broad
average changes for the coming period, profit and cash flows
budgets are developed, which serve as the foundation for
planning the capital needs of the business during the coming
period. One danger of using the previous period for compari-
son is that the manager gets into a rear-view style of manage-
ment”looking behind but not ahead.

Management by Exception

One key concept of management control reporting is
referred to as management by exception. Managers
have limited time to spend on control reports and therefore
they focus mainly on deviations and variances from the plan
(or budget). Departures and detours from the plan are called
exceptions. The premise is that most things should be going
according to plan but some things will not. Managers need to
pay the most attention to the things going wrong and the
things that are off course.

Frequency of Control Reports
A tough question to answer is how frequently to prepare con-

trol reports for managers. They cannot wait until the end of
the year for control reports, of course, although a broad-based
and overall year-end review is a good idea to serve as the
platform for developing next year™s plan. Daily or weekly con-
trol reports are not practical for most businesses, although
some companies, such as airlines and banks, monitor sales
volume and other vital operating statistics on a day-to-day

Monthly or quarterly management control reports are the
most common. Each business develops its own practical solu-
tion to the frequency question; there™s no single general
answer that fits all companies. The main thing is to strike a
balance between preparing control reports too frequently ver-
sus too seldom. With computers and other electronic means of
communication today, it is tempting to bombard managers
with too much control information too often. Sorting out the


truly relevant from the less relevant and truly irrelevant infor-
mation is at the core of the manager™s job.

Profit Control Reports
The type of management profit report illustrated in previous
chapters is a logical starting point for designing reports to
managers for profit control. First and foremost, profit margins
and total contribution margin should be the main focus of
attention and should be clear and easy to follow. These two
key measures of performance should be reported for each
major product or product line (backed up with detailed sched-
ules for virtually every individual product) in management
profit performance reports. These are very confidential data,
which are not divulged in external income statements”or, for
that matter, very widely within the business organization.

Variable expenses should be divided between those
that depend on sales volume and those that depend
on sales revenue and broken down into a large number of
specific accounts. Sales volumes for each product and product
line should be reported. Fixed expenses should be broken
down into major components”salaries, advertising, occu-
pancy costs, and so on. Sales and/or manufacturing capacity
should be reported. Any significant change in capacity due to
changes in fixed expenses should be reported.
Management control reports should analyze changes in
profit. In particular, the impact of sales volume changes
should be separated from changes in sales price, product cost,
and variable expenses as explained in earlier chapters (see
Chapters 9 and 10). If trade-off decisions were made”for
example, cutting sales price to increase sales volume”there
should be follow-up analysis in the management control profit
reports that track how the decision actually worked out. Did
sales volume increase as much as expected?
As this chapter explains later in more detail, a fringe of
negative factors constantly threaten profit margins and bloat
fixed expenses. Each of these negative factors should be sin-
gled out for special attention in management profit control
reports. Inventory shrinkage, for example, should be reported
on a separate line, as should sales returns, unusually high bad


debts, and any extraordinary losses or gains recorded in the
period (with adequate explanations).

If there is a general fault with internal profit reports for man-
agement control purposes, it is in my opinion the failure of the
accounting staff to explain and analyze why profit increased
or decreased relative to the previous period or relative to the
budget for the period. Such profit-change analysis would be
very useful to include in the profit reports. But managers gen-
erally are left on their own to do this. The analysis tools dis-
cussed in previous chapters are very helpful for this.

Sales Price Negatives
When eating in a restaurant, you don™t argue about the menu
prices. And you don™t bargain over the posted prices at the
gas pump or in the supermarket. In contrast, sales price nego-
tiation is a way of life in many industries. Many businesses
advertise or publish list prices. Examples are sticker prices on
new cars, manufacturer™s suggested retail prices on consumer
products, and standard price sheets for industrial products.
List prices are not the final prices; they are only the point of
reference for negotiating the final terms of the sale. In some
cases, such as new car sales, neither the seller nor the buyer
takes the list price as the real price”the list price simply sets
the stage for bargaining. In other cases, the buyer agrees to
pay list price, but demands other types of price concessions
and reductions or other special accommodations.
Prompt-payment discounts are offered when one business
sells to another business on credit. For example a 2 percent
discount may be given for payment received within 10 days
after the sales invoice date. These are called sales discounts.
Buyers should view these as penalties for delayed payment.
Also, businesses commonly give their customers quantity dis-
counts for large orders, and most businesses offer special
discounts in making sales to government agencies and educa-
tional institutions.
Many consumer product companies offer their customers
rebates and coupons, which lower the final net sales price
received by the seller, of course. Businesses also make
allowances or adjustments to sales prices after the point
of sale when customers complain about the quality of the


product or discover minor product flaws after taking delivery.
Instead of having the customer return the product, the com-
pany reduces the original sales price.

Managers must decide how these sales price negatives should
be handled in their internal management control reports. One


. 43
( 55 .)