Mcs In Service Organisation 3k6k4n

A Central University

Department Of Management Studies Assignment on Management Control System in Non-Profit Organization Management Control System MBA 3rd Semester

2010-2011

Submitted To:

Submitted By:

Dr.B.D.Mishra Akriti Gupta Reader Iti Shrivastava M.B.A.; Ph.D Shikha Sahu Financial Management, Business Policy Shobhna Jha Strategic Management

INDEX Service Organization in General

01

1

Professional Service Organization

06

Financial Service Organization

12

Health care Organization

16

Non-profit Organization

18

Conclusion

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SERVICE ORGANIZATIONS In this Assignment, we describe the management control process in service organizationsorganizations that produce and market intangible services. We first discuss the characteristics that distinguish service organizations in general from manufacturing organizations. We then discuss the special problems that arise in professional, financial service, health care, and nonprofit organizations.

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Service Organizations in General In the 18th and the early part of the 19th century, the workforce in the United States was predominantly in agriculture. After that, it was predominantly in manufacturing. Early in the 20th century, employment in the service sector overtook employment in the manufacturing sector. By 2003, service sector employment had grown to more than twice that of manufacturing. In this chapter we provide insights into management control systems for service organizations.

Characteristics For several reasons, management control in service industries is somewhat different from management control in manufacturing companies. Some factors that have an impact on most service industries are discussed in this section. (Others, which are characteristics of particular service industries, are discussed later.) These factors apply also to the management control of legal, research and development, and other service departments in companies generally. 1. Essence of Inventory Buffer Goods can be held in inventory, which is a buffer that dampens the impact on production activity of fluctuations in sales volume. Services cannot be stored. The airplane seat, hotel room, hospital operating room, or the hours of lawyers, physicians, scientists, and other professionals that are not used today are gone forever. Thus, although a manufacturing company can earn revenue in the future from products that are on hand today, a service company cannot do so. It must try to minimize its unused capacity. Moreover, the costs of many service organizations are essentially fixed in the short run. In the short run, a hotel cannot reduce its costs substantially by closing off some of its rooms. ing firms, law firms, and other professional organizations are reluctant to lay off professional personnel in times of low sales volume because of the effect on morale and the costs of rehiring and training. A key variable in most service organizations, therefore, is the extent to which current capacity is matched with demand. Service organizations attempt this matching in two ways.. First, they try to stimulate demand in off- peak periods by marketing efforts and price concessions. Cruise lines and resort hotels offer low rates in off seasons; airlines and hotels offer low rates on weekends; public utilities offer low rates on slack periods during the day. Second, if feasible, service organizations adjust the size of the workforce to the anticipated demand by such measures as scheduling training activities in slack periods and compensating for long

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hours in busy periods with time off later. The loss from unsold services is so important that occupancy rates, “sold hours,” load factors, student enrollment, hospital issions, and similar indications of success in selling available services are normally key variables in service organizations. 2. Difficulty in Controlling Quality A manufacturing company can inspect its products before they are shipped to the consumer, and their quality can be measured visually or with instruments (tolerances, purity, weight, color, and so on). A service company cannot judge product quality until the moment the service is rendered, and then the judgments are often subjective. Restaurant management can examine the food in the kitchen, but customer satisfaction depends to a considerable extent on the way it is served. The quality of education is so difficult to measure that few educational organizations have a formal quality control system. 3. Labor Intensive Manufacturing companies add equipment and automate production lines, thereby replacing labor and reducing costs. Most service companies are labor intensive and cannot do this. Hospitals do add expensive equipment, but mostly to provide better treatment, and this increases costs. A law firm expands by adding partners and new personnel. 4. Multi- Unit Organizations Some service organizations operate many units in various locations, each unit relatively small. These organizations are fast-food restaurant chains, auto rental companies, gasoline service stations, and many others. Some of the units are owned; others operate under a franchise. The similarity of the separate units provides a common basis for analyzing budgets and evaluating performance not available to the manufacturing company. The information for each unit can be compared with system wide or regional averages, and high performers and low performers can be identified. However, because units differ in the Mix of services provide, in the resources that they use, and in other ways, care must be taken in making such comparisons. Historical Development Cost ing started in manufacturing companies because of the need to value work-inprocess and finished goods inventories for financial statement Purposes. These systems provided raw data that were easily adapted for use in setting selling prices and for other

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management purposes. Standard cost systems, separation of fixed and variable costs, and analysis of variances were built on the foundation of cost ing systems. Until a few decades ago, most texts on cost ing dealt only with practices in manufacturing companies. Many service organizations (with the notable exception of railroads and other regulated industries) did not have a similar impetus to develop cost data. Their use of product cost and other management ing data is fairly recent— mostly since World War II. Nowadays, their management control systems are rapidly becoming as well developed as those in manufacturing companies.

PROFESSIONAL SERVICE ORGANIZATIONS Research and development organizations, law firms, ing firms, health care organizations, engineering firms, architectural firms, consulting firms, advertising agencies, symphony and other arts organizations, and sports organizations (such as baseball teams) are examples of organizations whose products are professional services.

Special Characteristics 1. Goals

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A dominant goal of a manufacturing company is to earn a satisfactory profit, specifically a satisfactory return on assets employed. A professional organization has relatively few tangible assets; its principal as set is the skill of its professional staff, which doesn’t appear on its balance sheet. Return on assets employed, therefore, is essentially meaningless in such organizations. Their financial goal is to provide adequate compensation to the professionals. In many organizations, a related goal is to increase their size. In part, this reflects the natural tendency to associate success with large size. In part, it reflects economies of scale in using the efforts of a central personnel staff and units responsible for keeping the organization upto-date. Large public ing firms need to have enough local offices to enable them to audit clients who have facilities located throughout the world. 2. Professionals Professional organizations are labor intensive, and the labor is of a special type. Many professionals prefer to work independently, rather than as part of a team. Professionals who are also managers tend. To work only part time on management activities; senior partners in an ing firm participate actively in audit engagements; senior partners in law firms have clients. Education for most professions does not include education in management, but quite naturally stresses the skills of the profession, rather than management; for this and other reasons, professionals tend to look down on managers. Professionals tend to give inadequate weight to the financial implications of their decisions; they want to do the best job they can, regardless of its cost. This attitude affects the attitude of staffs and nonprofessionals in the organization; it leads to inadequate cost control.

3. Output and Input Measurement The output of a professional organization cannot be measured in physical , such as units, tons, or gallons. We can measure the number of hours a lawyer spends on a case, but this is a measure of input, not output. Output is the effectiveness of the lawyer’s work, and this is not measured by the number of pages in a brief or the number of hours in the courtroom. We can measure the number of patients a physician treats in a day, and even classify these visits by type of complaint; but this is by no means equivalent to measuring the amount or quality of service the physician has provided. At most, what is measured is the physician’s efficiency in treating patients, which is of some use in identify ing slackers and hard workers. Revenues 6

earned is one measure of output in some professional organizations, but these monetary amounts, at most, relate to the quantity of services rendered, not to their quality (although poor quality is reflected in reduced revenues in the long run). Example. There are more than 1,300 articles and books dealing with research on student ratings of teachers. They describe as many as 22 dimensions of teaching performance (e.g., “explains clearly,” “uses class time well”) and 20 variables that affect the ratings (e.g., size of course, time of day, gender, level of course). The best of these rating systems can identify very good teachers and very poor teachers, but none do a satisfactory job of ranking the 70 or 80 percent of teachers who are not at these extremes. Furthermore, the work done by many professionals is non repetitive. No two consulting jobs or research and development projects are quite the same. This makes it difficult to plan the time required for a task, to set reasonable standards for task performance, and to judge how satisfactory the performance was. Some tasks are essentially repetitive: the drafting of simple wills, deeds, sales contracts, and similar documents; the taking of a physical inventory by an auditor; and certain medical and surgical procedures. The development of standards for such tasks may be worthwhile, although in using these standards, unusual circumstances that affect a specific job must be taken into . Some professionals, notably scientists, engineers, and professors, are reluctant to keep track of how they spend their time, and this complicates the task of measuring performance. This reluctance seems to have its roots in tradition; usually, it can be overcome if senior management is willing to put appropriate emphasis on the necessity of accurate time reporting. Nevertheless, difficult problems arise in deciding how time should be charged to clients. If the normal Work week is 40 hours, should a job be charged for 1/40th of a week’s compensation for each hour spent on it? If so, how should work done on evenings and weekends be counted? (Professionals are “exempt” employees—that is, they are not subject to government requirements for overtime payments.) How to ac count for time spent reading literature, going to meetings, and otherwise keeping up to date? 4. Small Size

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With a few exceptions, such as some law firms and ing firms, professional organizations are relatively small and operate at a single location. Senior management in such organizations can personally observe what is going on and personally motivate employees. Thus, there is less need for a sophisticated management control system, with profit centers and formal performance reports. Nevertheless, even a small organization needs a budget, a regular comparison of performance against budget, and a way of relating compensation to performance. 5. Marketing In a manufacturing company there is a clear dividing line between marketing activities and production activities; only senior management is concerned with both. Such a clean separation does not exist in most professional organizations. In some, such as law, medicine, and ing, the profession’s ethical code limits the amount and character of overt marketing efforts by professionals (al though these restrictions have been relaxed in recent years). Marketing is an essential activity in almost all organizations, however. If it can’t be conducted openly, it takes the form of personal s, speeches, articles, conversations on the golf course, and so on. These marketing activities are conducted by professionals, usually by professionals who spend much of their time in production work—that is, working for clients. In this situation, it is difficult to assign appropriate credit to the person responsible for “selling” a new customer. In a consulting firm, for example, a new engagement may result from a conversation between a member of the firm and an acquaintance in a company, or from the reputation of one of the firm’s professionals as an outgrowth of speeches or articles. Moreover, the professional who is responsible for obtaining the engagement may not be personally involved in carrying it out. Until fairly recently, these marketing contributions were rewarded subjectively—that is, they were taken into in promotion and compensation decisions. Some organizations now give explicit credit, perhaps as a percentage of the project’s revenue, if the person who “sold” the project can be identified.

MANAGEMENT CONTROL SYSTEMS 1. Pricing The selling price of work is set in a traditional way in many professional firms. If the profession is one in which are accustomed to keeping track of their time, fees

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generally are related to professional time spent on the engagement. The hourly billing rate typically is based on the compensation of the grade of the professional (rather than the compensation of the specific person), plus a loading for overhead costs and profit. In other professions, such as investment banking, the fee typically is based on the monetary size of the security issue. In still others, there is a fixed price for the project. Prices vary widely among professions; they are relatively low for research scientists and relatively high for ants and physicians.In manufacturing companies, the profit component of the selling price is normally set so as to obtain, on average, a satisfactory return on assets employed. As noted above, the principal “asset” of a professional organization is the skill of its professionals, which is not measurable. Actually, the total value of the whole organization is greater than the sum of what the value of the individuals would be if they worked separately. This is because the firm already has incurred the cost of acquiring and training these individuals, has organized them according to their personality “fit” and other considerations, and has developed policies and procedures for assuring that the work is done efficiently and effectively. In this manner, the firm accepts responsibility for producing a satisfactory product, including the risk of loss if the work is not well done, and it absorbs the cost of personnel who are not working on revenue-producing work. These considerations implicitly affect the size of the “profit” component that is included in the fee.

2. Profit Centers and Transfer Pricing

units,

such

as

maintenance,

information

processing,

transportation,

telecommunication, printing, and procurement of material and services, charge consuming units for their services.

3. Strategic Planning and Budgeting In general, formal strategic planning systems are not as well developed in professional organizations as in manufacturing companies of similar size. Part of the explanation is that professional organizations have no great need for such systems. In manufacturing companies, many program decisions involve commitments to procure plant and equipment; they have a predictable effect on both capacity and costs for several future years, and, once made, they are essentially irreversible. In a professional organization, the principal assets are people; although the organization tries to avoid short-run fluctuations in personnel levels, changes in the size and composition of the staff are easier to make and are more easily reversed than changes in the capacity of a physical plant. The strategic plan of a professional organization

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typically consists primarily of a long-range staffing plan, rather than a full-blown plan for all aspects of the firm’s operation.

4. Control of Operations Much attention is, or should be, given to scheduling the time of professionals. The billed time ratio, which is the ratio of hours billed to total professional hours available, is watched closely. If, to use otherwise idle time or for marketing or public service reasons, some engagements are billed at lower than normal rates, the resulting price variance warrants close attention. The inability to set standards for task performance, the desirability of Carrying out work by teams, the consequent problems of managing a matrix organization and the behavioral characteristics of professionals all complicate the planning and control of the dayto-day operations in a professional organization. When the work is done by project teams, control is focused on projects. A written plan for each project is needed, and timely reports should be prepared that compare actual performance with planned performance in of cost, schedule, and quality.

5. Performance Measurement and Appraisal As noted above in regard to teachers, at the extremes the performance of professionals is easy to judge. Appraisal of the large percentage of professionals who are within the extremes is much more difficult. For some professions, objective measures of performance are sometimes available: The recommendations of an investment analyst can be compared with actual market behavior of the securities; the accuracy of a surgeon’s diagnosis can be verified by an examination of the tissue that was removed; and the doctors’ skill can be measured by the success ratio of operations. These measures are, of course, subject to appropriate qualifications, and in most circumstances the assessment of performance is finally a matter of human judgment by superiors, peers, self, sub ordinates, and clients. Judgments made by superiors are the most common. For these, professional organizations increasingly use formal systems to collect performance appraisals as a basis for personnel decisions and for discussion with the professional. Some systems require numerical ratings of specified attributes of performance and provide for a weighted average of these ratings. Compensation may be tied, in part, to these numerical ratings. In a matrix organization, both the project leader and the head of the functional unit that is the professional’s organizational “home” judge performance. Appraisals by a professional’s peers, or by subordinates, are sometimes part of a formal control system. In some organizations, individuals may be asked to make a self-appraisal. 10

Expressions of satisfaction or dissatisfaction from clients are also an important basis for judging performance, although such expressions may not always be readily forthcoming. Example. One firm that sells investment advice to institutional clients keeps a record of letters of commendation and criticism received from its clients, classifies these according to the analysts who made the relevant criticisms or recommendations, and uses this information as part of its performance evaluation System. The budget can be used as the basis for measuring cost performance, and the actual time taken can be compared with the planned time. Budgeting and control of discretionary expenses are as important in a professional firm as in a manufacturing company. Such financial measures are relatively unimportant in assessing a professional’s contribution to the firm’s profitability, however. The professional’s major contribution is related to quantity and above all quality of work, and its appraisal must be largely subjective. Furthermore, the appraisal must be made currently; it cannot wait until one learns whether a new building is well designed, a new control system—actually works well, or a bond indenture has a flaw. In some professions, internal audit procedures are used to control quality. In many ing firms, the report of an audit is reviewed by a partner other than the one who is responsible for it, and the work of the whole firm is “peer reviewed” by another firm. The proposed design of a building may be reviewed by architects who are not actively involved in the project.

FINANCIAL SERVICE ORGANIZATIONS Financial service organizations include commercial bank and thrift institutions, insurance companies, and securities firms. These companies are in business primarily to manage money. Some act as intermediaries; that is, they obtain money from depositors and lend it to individuals or companies. Others act as risk shifters; they obtain money in the form of s, invest these s, and accept the risk of the occurrence of specific events, such as death or damages to property. Still others are traders; they buy and sell securities, either for their own or for customers.

The Financial Services Sector Several general observations can be made about the financial services sector. 11

First, in 2002, financial services firms ed for over $400 billion, or about 5 percent, of the gross domestic product, but their importance in the overall performance of the economy is considerably greater than this percentage indicates. The financial services sector constitutes an important backbone to the U.S. and world economies. Second, 30 years ago, commercial banking, investment banking, retail brokerage, and insurance existed as distinct separate industries; firms specialized in a single industry and tended to compete in a single country. Nothing could be further from the truth today. Deregulation (e.g., the weakening of the Glass-Steagall Act) has blurred industry and geographic boundaries. Financial services firms not only operate in multiple segments (investment banking, brokerage, etc.) but also are global in scope. In the 1990s several mega mergers led to the consolidation of the financial services industry (examples: merger of Citicorp and Travelers; UBS’s acquisition of Paine Webber; Morgan Stanley’s acquisition of Dean Witter; Deutsche Bank’s acquisition of Bankers Trust). Blurring of industry boundaries, globalization, and consolidation of financial services firms will accelerate in the 21st century. Third, financial services firms have used the information technology revolution to innovate new products and discover new methods of trading. For instance, the Charles Schwab Corporation introduced TeleBroker (an automated telephone touchpad order entry system), Voice Broker (an automated voice recognition quote system), and e.Schwab (Internet-based brokerage service). New entrants such as E*Trade and Ameritrade were able to dramatically lower brokerage commissions through Web-based trading. In 2002, over 35 percent of all stock trades by individuals were done via the Internet; yet, six years earlier, this segment did not exist. Fourth, the need for controls in the financial services sector has become paramount. The Asian financial crisis during the second half of the 1990s was, in part, the result of inadequate controls in banks in Thailand, Indonesia, Japan, and other Asian countries which, in turn, allowed the banks to make highly risky and bad loans. Most notable failure among financial services firms was the collapse of Barings, Britain’s oldest merchant bank, in 1995. Deficient Control partly contributed to Barings’ debacle.

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Fifth, during the 1990s, new forms of financial instruments (such as derivatives) designed by financial service firms sometimes resulted in millions of dollars of losses for their clients. In December 1994 Orange County in California lost $1.7 billion in leveraged interest-rate products. In April 1994 Procter & Gamble sued Bankers Trust because of its loss of over $100 million on interest- rate swaps designed by Bankers Trust. In July 1994 Glaxo incurred losses of $180 million on derivatives and asset-based bonds. Finally, the corporate scandals during 2002 have created a huge push for in vestment banks to spin off their research departments. It is argued that under the current system, the interests of the investment bankers, not those of investors, drive the results of research. Research analysts are tainted by the potential for a conflict of interest because the companies that they cover also buy high-fee investment banking services from the analysts’ employers. The arguments for spin off are many: (1) This separation will ensure objective research data. (2) At present, cost of research is being subsidized by investment banks; if investors have to pay for it, they will demand higher-quality research. (3) Investor confidence will improve if they are convinced that research is unbiased. On the other hand, several arguments are offered against such a spin off: (1) The cost of research will go up if they are set up as separate firms; (2) the best research analysts will investment banks due to the higher pay scales, thereby leaving independent research firms with lower caliber employees; and (3) To keep costs down, research departments may issue short reports instead of a rich, detailed analysis of stocks as is the current practice. Example. During 2002, there were investigations into the research work of Salomon Smith Barney investment bank, a unit of Citigroup. On October 30, 2002, the Citigroup, on a voluntary basis, spun off its research analysts from investment banking.

Special Characteristics While the general principles and concepts of management control systems ap ply, they need to be adapted to the following special characteristics of the financial services industry.

1. Monetary Assets Most of the assets of financial service firms are monetary. The current value of monetary assets is much more easily measured than the value of plant and other physical assets, or

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patents and other intangible assets. Currency is the extreme example of a fungible commodity. At any time, dollars held by all companies have the same value; each dollar is worth a dollar, valued at both its face amount and its purchasing power. Its purchasing power changes with time, but at any given future time, all dollars have equal value. This means that one’s dollar has the same quality at any given moment. In the financial services industry, quality refers to the quality of services rendered and to the quality financial instruments other than money; there is no need for quality control safeguards for money.

2. Financial assets Financial assets also can be transferred from one owner to another easily and quickly. In an electronic funds transfer, money moves almost instantaneously. In other transactions, it moves in a few days at most. Its portability is tempting to thieves and forgers. For this reason, firms that handle financial as sets, especially money, must take strong measures to protect them. These involve not only physical measures to safeguard currency and documents, but also measures designed to maintain the integrity of the system for transferring money from one party to another.

3. Time Period for Transactions The ultimate financial success or failure of a bond issue, a mortgage loan to an individual, or a life insurance policy may not be known for 30 years or more. During this period, the soundness of the loan or policy may change, and the purchasing power of money will certainly change. This means that the ultimate performance of those involved in authorizing and structuring the loan, or in selling and pricing the insurance policy, cannot be measured at the time the initial decision is made. It also means that control requires that there be a means of continued surveillance of the soundness of the transaction during its life, including periodic audits of all outstanding loans. (Failure to identify “troubled loans” at an early stage is one important reason for the rash of failures of banks and thrift institutions. At the other extreme, some transactions are completed quickly. Many trades are made on the basis of information that the trader has acquired in the previous few minutes, or even seconds. For currency transactions and for listed securities, new information may become available almost instantaneously in markets throughout the world. Traders either buy or sell securities on the basis of the information they have. If they buy securities, future changes in prices will change the value of the securities held. Therefore, there is a need for a system to report held and to assess the risk to the organization if prices move against the trader’s securities. This means

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that the firm must have an accurate, prompt system for obtaining this information, for summarizing it, for estimating the risk of the securities held (if applicable), and for making this information available to traders; a computer model (“expert system”) evaluates the information and in some cases acts with, human intervention.

4. Risk and Reward Many financial services firms are in the business of accepting risks in return for rewards. Most business decisions involve a trade-off between risks and re wards. The greater the risk, the greater should be the anticipated reward. In financial services firms, this trade-off is more explicit than in business investments such as those involving the purchase of a machine or the introduction of a new product. Interest rates on loans and s on insurance policies are based on assumptions about risk that may, or may not, turn out to be accurate.

5. Technology Technology has revolutionized the financial services industry. Financial service firms have used information technology as a way to offer innovative services. Automated teller machines of banks are just one example. Insurance and mutual fluids have developed electronic marketplaces. Financial service firms, via their website on the Internet, market their products electronically to consumers. Investment banks, using concepts from quantum physics and high- level mathematics formulas, have designed new forms of financial instruments. Banks have become “virtual” by offering cyber-payment systems. Online brokerage services are a fast-growing segment.

HEALTH CARE ORGANIZATIONS Health care organizations consist of hospitals, clinics, and similar physicians’ organizations; health maintenance organizations; retirement and nursing homes; home care organizations; and medical laboratories, among others. They constitute the largest industry in the United States: 14 percent of the gross national product, which are about the same percentage as the total of all durable goods manufacturers. Although they have most of the characteristics of non profit organizations, which are discussed in the next section, many of them are profitoriented companies.

Special Characteristics 1. Difficult Social Problem

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Society is gradually coming to grips with the fact that the present health care delivery system is unworkable. Although physicians are bound by the Hippocratic oath to provide adequate health care to their patients, the system can not do this. On the one hand, the cost per treatment is inevitably increasing with the development of new equipment and new drugs; hospital expenses in creased from $28 billion in 1970 to over $400 billion by 2003. (Contrast this trend with the typical experience of manufacturing companies, in which new equipment usually reduces unit costs). On the other hand, the number of ill persons is increasing because medical advances prolong the lives of elderly people, who are the most likely to require treatment. Society cannot pay for the predictable increases if the present rate of increase in cost continues much longer. Health care providers are aware of this problem, but they don’t know how society, especially the Congiess, will deal with it. It is clear, however, that health care delivery will change drastically. Health care organizations must be alert to these changes. 2. Change in Mix of Providers Within the overall increase in health care cost, significant changes have occurred in the way in which health care is delivered and, hence, in the viability of certain types of providers. Many services that traditionally were provided in hospitals on an inpatient basis are now provided in outpatient clinics or in patients’ homes. Entrepreneurs have entered the industry to provide these new services. There also has been a shift from small local hospitals to larger regional or medical center hospitals. The number of hospital beds decreased by more than 30 percent from 1970 to 2003. To remain viable, hospitals must have the flexibility to adapt to these changes, either by providing more outpatient services themselves or by eliminating inpatient services that are no longer profitable. 3. Third-Party Payers Of the more than $900 billion total expenditures for health care in 2003, 43 per cent were financed by the government, 35 percent by insurance companies, and only 22 percent by individual patients. The largest government program is Medicare, a federal program that provides for persons age 65 and up and for younger persons with certain disabilities. The Medicaid program pays for services provided to low-income people; it is financed by the states within general guidelines set by the federal government. Until 1983, Medicare reimbursed on the basis of “reasonable” costs incurred, which gave health care providers little incentive to control costs. Currently, Medicare reimburses hospitals 16

on the basis of Diagnostic Related Groups (DRGs). Medical and surgical procedures are classified into one of about 500 DRGs, each DRG is priced annually at a set-dollar amount, and hospitals are reimbursed for these amounts, regardless of the actual length of stay or the actual costs incurred for individual patients. Other third-party payers have moved toward a similar system of reimbursement. The DRG system, and the increase in hospital costs per patient, has motivated hospitals to install sophisticated cost ing systems, usually systems that they purchase from an outside computer software organization and then adapt to their own needs. Some hospitals provide information processing services to other hospitals on a contract basis. These systems provide information on individual patients (similar to job-cost systems in automobile repair shops), and they report actual costs compared with standard costs for each DRG; costs are classified by departments and even by attending physicians within departments. This information is in addition to information traditionally collected in hospitals; it focuses on outputs (patient care), as well as on inputs (cost per laboratory test). Increasingly, health maintenance organizations (HMOs) reimburse physicians, hospitals, and other providers. They contract with companies to provide medical services to employees at a fixed cost per person covered. In turn, the HMO contracts with hospitals and other providers, in some cases at a specified amount per DRG. The HMO therefore has the difficult task of controlling its payments so that they do not exceed the fees earned, but nevertheless seeing to it that adequate health care is provided. 4. Professionals In 2003, the health care industry employed over 3 million professionals (physicians, dentists, ed nurses, and therapists), which was more than any other industry except education. The management control implications of professionals are the same as those discussed in the preceding section. Their primary loyalty is to the profession, rather than to the organization. Departmental managers typically are professionals whose management function is only parttime; the chief of surgery does surgery. Historically, physicians have tended to give relatively little emphasis to cost control. In particular, there has been an impression that they prescribe more than the optimum number of tests, partly because of the danger of malpractice suits if they don’t detect all the patient’s symptoms. 17

5. Importance of Quality Control The health care industry deals with human lives, so the quality of the service it provides is of paramount importance. There are tissue reviews of surgical procedures, peer review of individual physicians, and outside review agencies mandated by the federal government.

Management Control Process Because of the shift in the product mix and because of the increase in the quantity and cost of new equipment, the strategic planning process in hospitals is important. The annual budget preparation process is conventional. Huge quantities of information are available quickly for the control of operating activities. Financial performance is analyzed by comparing actual revenues and expenses with budgets, identifying important variances, and taking appropriate actions on them.

NONPROFIT ORGANIZATIONS A nonprofit organization, as defined in law, is an organization that cannot distribute assets or income to, or for the benefit of, its , officers, or directors. The organization can, of course, compensate its employees, including officers and , for services rendered and for goods supplied. This definition does not prohibit an organization from earning a profit; it prohibits only the distribution of profits. A nonprofit organization needs to earn a modest profit, on average, to provide funds for working capital and for possible “rainy days.” Nonprofit organizations that meet the criteria of Section 501(c) of the Internal Revenue Code are exempt from income taxes (except for their “unrelated business income”); over 1.2 million organizations satisfy these criteria in the United States. If they are religious, charitable, or educational organizations as defined in Section 501(c)(3) of the code, contributions made to

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them are tax deductible by the contributor; they are called “501(c)(3) organizations.” Many such organizations are exempt from property taxes and from certain types of sales taxes. In many industry groups, there are both nonprofit and profit-oriented (i.e., business) organizations. There are nonprofit and for-profit hospitals, nonprofit and for-profit (“proprietary schools and colleges, and even for-profit religious organizations. SRI International is a nonprofit research organization that corn pete with Arthur D. Little, Inc., a for-profit research organization.

Special Characteristics 1. Absence of the Profit Measure A dominant goal of most businesses is to earn a satisfactory profit; net income measures performance toward this goal. No such measure of performance exists in nonprofit organizations. Many of them have several goals, and an organization’s effectiveness in attaining its goals rarely can be measured by quantitative amounts. The absence of a satisfactory, quantitative, overall mea sure of performance is the most serious management control problem in a non profit organization. The income statement is the most useful financial statement in a nonprofit organization, just as it is in a business. The net income number is interpreted differently in the two types of organizations, however. In a business, as a general rule, the larger the income, the better the performance. In a nonprofit organization, net income should average only a small amount above zero. A large net income signals that the organization is not providing the services that those who supplied resources had a right to expect; a string of net losses will lead to bankruptcy, just as in a business. Although financial performance is not the dominant goal in a nonprofit organization, it is a necessary goal because the organization cannot survive if its revenues on average are less than its expenses. 2. Contributed Capital There is only one major difference between the ing transactions in a business and those in a nonprofit organization; it relates to the equity section of the balance sheet. A business corporation has transactions with its shareholders— issuance of stock and the payment of dividends—that a nonprofit organization doesn’t have. A nonprofit organization 19

receives contributed capital, which few businesses have. (In both businesses and nonprofit organizations, equity is in creased by earning income.) There are two principal categories of contributed capital: plant and endowment. Plant includes contributions of buildings and equipment, or contributions of funds to acquire these assets; works of art; and other museum objects. Endowment consists of gifts whose donors intend that the principal amount will remain intact indefinitely (or at least for many years); only the income on this principal will be used to finance current operations. The receipt (or pledge) of a contributed capital asset is not revenue—that is, neither contributions of plant nor of endowment are available to finance the operating activities of the period in which the contribution is received. Endowment assets must be kept separate from operating assets. This is a legal requirement. for a “true” endowment, and it is sound policy for a “board-designated” endowment—that is, funds that the trustees have decided to treat s endowment, even though there is no legal requirement that they do so. It follows that capital contributions should be reported separately from operating contributions, that is, from revenues from annual fund drives, grants, and other gifts in tended to finance current operations. Thus, a nonprofit organization has two sets of financial statements. One set relates to operating activities; it includes an operating statement, a balance sheet, and a statement of cash flows that are the same as those found in business. The second set relates to contributed capital; it has a statement of inflows and outflows of contributed capital during a period and a balance sheet that reports contributed capital assets and the related liabilities and equity. Inflows of contributed capital are capital contributions received in the period and gains on the endowment portfolio; outflows are the endowment income that is re ported as operating revenue, losses on the endowment and write-offs of plant. 3. Fund ing Many nonprofit organizations use an ing system that is called “fund ac counting.” s are kept separately for several funds, each of which is self-balancing (i.e., the sum of the debit balances equals the sum of the credit balances). Most organizations have (1) a general fund or operating fund, which corresponds closely to the set of operating s mentioned above; (2) a plant fund and an endowment fund, which for the contributed capital assets and equities mentioned above; and (3) a variety of other funds for special 20

purposes. Some of these other funds, such as the pension fund, are also found in business, although in business they are reported in the notes to the financial statements, rather than in the financial statements themselves. Others are useful for internal control purposes. For management control purposes, the primary focus is on the general fund. 4. Governance Nonprofit organizations are governed by boards of trustees. Trustees usually are not paid, and many of them are unfamiliar with business management. Therefore, they generally exercise less control than the directors of a business corporation. Moreover, because performance is more difficult to measure in a nonprofit organization than in a business, the board is less able to identify actual or incipient problems. The need for a strong governing board in a nonprofit organization is greater than in a business because the vigilance of the governing board may be the only effective way of detecting when the nonprofit is in difficulty. In a profit-oriented organization, a decrease in profits signals this danger automatically.

MANAGEMENT CONTROL SYSTEMS 1. Product Pricing Many nonprofit organizations give inadequate attention to their pricing policies. Pricing of services at their full cost is desirable. A “full-cost” price is the sum of direct costs, indirect costs, and, perhaps, a small allowance for increasing the organization’s equity. This principle applies to services that are directly related to the organization’s objectives. Pricing for peripheral activities should be marketbased. Thus, a nonprofit hospital should price its health care services at full cost, but prices in its gift shop should be market-based. In general, the smaller and more specific the unit of service that is priced, the better the-basis for decisions about the allocation of resources. For example, a comprehensive daily rate for hospital ca± which was common practice a few decades ago masks the revenues for the mix of

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services actually provided. Be yond a certain point, of course, the cost of the paperwork associated with pricing units of service outweighs the benefits. As a general rule, management control is facilitated when prices are established prior to the performance of the service. If an organization is able to re cover its incurred costs, management is not motivated to worry about cost control.

2. Strategic Planning and Budget Preparation In nonprofit organizations that must decide how best to allocate limited resources to worthwhile activities, strategic planning is a more important and more time-consuming process than in the typical business. The process is similar to that described in Chapter 8, except that the absence of a profit measure makes program decisions more subjective. The budget preparation process is similar to that described in Chapter 9. Colleges and universities, welfare organizations, and organizations in certain other nonprofit industries know, before the budget year begins, the approximate amount of their revenues. They do not have the option of increasing revenues during the year by increasing their marketing efforts. They budget expenses so the organization will at least break even at the estimated amount of revenue. They require that managers of responsibility centers limit spending close to the budget amounts. The budget is, therefore, the most important management control tool, at least with respect to financial activities.

3. Operation and Evaluation In most nonprofit organizations, there is no way of knowing what the optimum operating costs are. Responsibility center managers, therefore, tend to spend whatever is allowed in the budget, even though the budgeted amount may be higher than is necessary Conversely, they may refrain from making expenditures that have an excellent payoff simply because the expenditure was not included in the budget. Although nonprofit organizations have had a reputation for operating inefficiently, this perception has been changing for good reasons. Many organizations have had increasing difficulty in raising funds, especially from government resources. This has led to belttightening and o increased attention to management control. As mentioned above, the most

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dramatic change has been in hospital costs, with the introduction of reimbursement on the basis of standard prices for diagnostic-related groups.

CONCLUSION Management control in service organizations is different from that in manufacturing organizations, primarily because of the absence of an inventory buffer between production and sales, because of the difficulty of measuring quality, and because service organization are labor intensive. Professional Organizations do not have the dominant goal of return on assets employed; Professionals’ behavioral characteristics do not include attention to costs, output measurements are subjective, and there is no clear line between marketing and production activities. Performance appraisal may be achieved by peer reviews; in any case it tends to be subjective. Financial Services Organizations differ in two fundamental respects from industrial companies. First, their “raw material” is money. At any given time, the value of each unit of

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money in inventory is the same for all organizations, negation any need for control in this area; however, the cost of using money obtained from various sources varies considerably. Second the profitability of many transactions cannot be measured until years after the commitment has been made, necessitating continual periodic audits. In particular, the financial services company is profitable only if the future revenues obtained from current loans, investments and insurance s exceed the cost of the funds associated with these revenues by an amount that is sufficient to cover operating expenses and losses. Health care organizations have tried to use the DRG system to standardize costs; they and society, must face the fact that the current control and delivery system is unworkable. Non profit organizations lack the advantages for control that the profit measure provides; they must for contributed capital, a category that rarely occurs in a business. Expenditure decisions are subjective for non profits; nevertheless, they have succeeded in becoming more efficient in response to shrinking sources of funds.

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