CHAPTER 6

Performance Management of Investment Center Managers

Falconer Mitchell and Hanne Nørreklit

Insights from This Case Study

The governance of decentralized corporations involves the HQ-management transfer of their decision-making authority to investment center managers. Conventional thinking of principal–agent theory looks at the investment center managers as opportunistic agents who should be motivated and monitored through performance contracts. However, performance measures are reductive and can have serious dysfunctional consequences. This chapter argues that managers in practice can deal with some of the problems of the imperfections of accounting measurement through the application of an interactive communicative method of coauthoring and a reflective learning model of truth.

Introduction¹

One purpose of management accounting is to contribute to the performance management of the investment center managers of decentralized organizations (Solomon 1965; Anthony and Govindarajan 2007; Kaplan and Atkinson 2015). The governance of decentralized corporations involves the HQ-management transfer of decision-making authority to investment center managers. For instance, consider the following case:

A division sells a wide range of building materials to professional customers. The division consists of forty units organised as autonomous investment centres, each with its own local manager. Each investment centre is strategically restricted to its business area (products and market segments). Investments have to be approved by the HQ-management. But apart from that, each investment centre enjoys considerable freedom as regards sourcing, sales and marketing, product mix, and operational management (NØrreklit et al. 2006).

Outlined in the following is the principal–agent theory framework, which is the most common approach to the performance measurement of investment centers. Then, a contrasting approach based on pragmatic constructivism is presented.

Principal–Agent Theory

Principal–agent theory looks at the investment center managers as opportunistic agents with more information about alternative actions and their consequences than the principal, that is, the HQ manager (the so-called problem of asymmetric information; Kaplan and Atkinson 2015; Jensen and Meckling 1976). This constitutes the agency problem of moral hazard, that is, the question of how the agent is motivated to act in the interest of the principal. Due to the problem of moral hazard, a demand exists from the top management for information about the performance of the investment center management. The visibility of performance measurement should ensure the investment center manager is held accountable for their performance. This helps to ensure that the division manager has the motivation to pursue decision alternatives that are not only in their self-interest but also benefit the HQ management. A key issue is to ensure that the investment center manager produces credible information for the HQ’s management planning and decision making.

Accounting measurement tools are, thus, seen as a mechanical instrument to govern the principal–agent relationship. Measuring the actual financial performance controllable by the agent and linking these results to the divisional manager’s reward is suggested to be effective in motivating employees to work toward stated targets. Typically investment center managers are assumed to control sales, costs, and assets and can, therefore, be held accountable for financial figures, such as return on investment, assets, net assets, or equity (ROI, ROA, RONA, ROE) and economic value added (EVA). EVA is argued to be superior to the others because it does not take the cost of equity capital into account. The philosophy of EVA rate is that a company only creates value to its shareholder if the ROE is higher than the weighted average cost of capital (WACC). Thus, a proprietary and financially oriented set of performance measures are the tradition in this context.

In order to provide undistorted incentives, performance contracts for divisional managers should be constructed in such a way that the agent knows the desirable results and that the results are controllable and measurable in a quantitative and unequivocal way (Merchant 1985). However, in practice, this is a challenging task (Puxty 1985).

First, there is the inability to isolate the investment of the divisional manager’s unique contributions to results. For example, different environmental conditions (technological, economic, political, etc.) and decisions and costs imposed by headquarters usually affect the performance of a subsidiary’s operation. Therefore, accounting performance measures are usually distorted by noncontrollable factors, and, hence, it becomes impossible to provide performance measures that consist exclusively of factors controllable by the divisional manager. Also, these differences prevent a direct comparison of operations across divisions and in one division over time and so create ambiguity as to the appropriate performance norm.

Furthermore, there is an inability to measure financial results objectively. Accountants have traditionally advocated and used the system of historic cost accounting that, for much of its content, strives for a referential observational system that allows verification from past transaction records and documentation (i.e., original purchase costs and revenue recognition). However, a major problem of historical accounting figures is that the financial consequences of the uncompleted chains of action extend beyond the time of measurement. The historic cost accounting model implies that value measurement is restricted to assets that have been subject to factual transactions and hence ignores the wealth inherent in such factors as the creation of firm reputation, research in progress, and employee expertise and motivation. While it is a possibility that these types of attributes will have great value, they are not factual. Also, there are practical flexibilities concerning measurement issues (such as depreciation of fixed assets, valuation of stock, establishment of provisions, recognition of income, variation in the purchasing power of the measurement currency, and segregation of capital and revenue expenditures) that make it difficult to produce indisputable factual information (Sterling 1979; Chambers 1966). In addition, some of the measures involve the need to make future estimates, for example, assets’ life, consumption patterns and residual values, debtor receipts, and stock selling prices. The distortion of historical accounting statements might be further aggravated by pressure on the divisional manager (whose rewards are linked to results) to produce ever-improving results. This can push the divisional manager to achieve short-term financial results rather than striving to make long-term investments in growth and innovation potential. Also, financial accountability controls may induce non–goal-congruent behavior (the opposite of their intention) and management myopia (Merchant 1985).

Some have advocated that the financial results’ focus should be on income and asset value calculated on the basis of a net present value (NPV) approach, where evaluation is made on the basis of expectations about future cash flow. As future receipts must be anticipated or predicted and cannot, by definition, be measured, under this approach, manager’s expectations or feelings about the future should be taken into consideration. In practice, this economics-based tradition does not meet any criterion of realism, and this is one of the reasons why it has been rejected for serving the stewardship role of financial accounting. Alternatively, the market view can enter financial accounting practice as a basis for determining income and value. It is argued to provide an objective point of reference for financial statements. However, when market price does not exist, a “fair value” surrogate has to be used. Fair value is about the estimation of a fair price from an orderly transaction between two parties at the date of measurement. Similar to economics-based values, market-based prices (including fair values) involve the recognition of unrealized income that may or may not translate into cash benefits for the stakeholder.

In view of the above, it is questionable where this mechanical instrumental approach to control is effective in the performance management of the managers of the investment centers. There is a need for developing methods for the performance management of investment centers in order to create more trustworthy knowledge. In the following, we outline an alternative framework for how organizations can structure their performance management of investment centers and incorporate management accounting information into it. We will demonstrate the framework by elaborating on the case introduced previously.

Pragmatic Constructivist Approach

Pragmatic constructivism is based on the assumption that managers in practice can deal with some of the problems of imperfectness in the production and use of accounting measurements through methods of coauthoring and by adopting a learning theory of truth (NØrreklit 2017; NØrreklit et al. 2010).

Coauthoring and Learning Theory of Truth

In practice, HQ management are unlikely to delegate all decision and action authority to the divisional manager. Thus, managers at both levels can be actors involved in authoring the activities of the centers, and, hence, they are co-actors in the creation of the investment center performance. More specifically, organizational practice is a factory of interwoven and interconnected narratives about local activities in which all the actors involved are constantly concerned with creating a local function narrative while simultaneously functioning together with others in coauthoring and, thereby creating, a coordinated set of actions representing functioning practice. Accounting numbers are produced that acquire meaning within specific narratives. Thereby, the principal–agent relationship might be formulated in a less oppositional manner and performance measurement might be used less instrumentally since it gets integrated with divisional managers’ leadership process. For instance, in the case introduced previously,

The HQ manager regularly meets with the local divisional centre managers several times each year. The meeting agenda includes items such as the debating of the plan, the follow-up of the plan, and the motivating of efficiency and performance. The communicative interaction between the HQ manager and the divisional manager takes the form of a dialogue. An overall strategy of the division forms the background knowledge for the meetings. It is revised and formulated every third year.

Managers of investment centers are actors (i.e., they take actions) who are the source of intentions and activities of organizational units. They mold and participate in the construction of the organization’s value system and the activities in their investment center. Through communicative interaction and performance measurement, the HQ’s management can influence the divisional investment center managers’ intentions and activities and vice versa.

Also, in practice, the historical and future dimension of accounting might not be abruptly separated but rather integrated in a continuous observational process of proactive and pragmatic truths. In practice, measurements might be linked to narratives that are of holistic and reflective nature in order to get trustworthy meaning to the numbers below the surface levels. In particular, the interplay between pragmatic truth and proactive truth forms the basis for the ongoing improvement of the ability to generate historical and future-oriented accounting information and so establish an integrated learning-based theory of truth.

In the following, we illustrate how the HQ manager can engage in interactive communication and orchestrated interplay between pragmatic and proactive truths in the production and use of accounting models and information at both the HQ and the local divisional unit levels. Thus, in the organization, they work with the learning theory of truth in a broad range of activities, such as evaluation of local divisional managers’ business performance, developing the performance measurement model, and production of accounting information.

Evaluating Local Managers’ Business Performance

The division manager grounds a great deal of their total assessment in the local manager’s past financial results. There are no bonuses linked to financial results, but it influences the negotiation of the following years’ salary. Rather than getting a bonus, financially successful managers can look for new, although risky, possibilities that may create more value to the company. As most local managers like a high degree of autonomy, the HQ management motivates them to pursue their own values. However, their trust and confidence in the local managers’ business models are proportional to the local manager’s historical ability to generate sufficient profit. Overall, if an investment center is doing well, it will not get much attention; however, if a local manager is not performing, the HQ manager will intensify the dialogues with the local manager in an attempt to strengthen the business model. If a HQ manager is not able to mobilize the will and energy of the local manager to develop their own business models, then the HQ manager decides to let go the local manager.

Accordingly, the historical ability to meet profit targets may be used as a significant indication of the proactive truth of the local manager’s business model. Hence, the ability to create pragmatic truth is used as an indication of proactive truth plans. However, planning and decision making involve the estimations of realistic expectations of future performance in order to facilitate arrangement of investments, overdraft, and other funding requirements and the acquisition at appropriate times of the volume of resources necessary to achieve the planned activity levels. As a great deal of accounting information does not hold over time and hence cannot be generalized over time, they need budgets. Therefore, there is a need to evaluate whether the budgets represent proactive truth.

When evaluating the proactive truth of the local managers’ budget, the HQ manager analyses their business models, including their reflections on how to infer the activities necessary, to go from the existing reality construction to another future reality construction. Any reasoned or well-argued budget is based on valid business models, which implies that they have to express a solid understanding of the nature of integration in order to successfully guide organizational actions.

In validating the business models, the division manager assesses the proactive truth of the local managers’ action plans and budgets. Their view is that budgets must be realistic. The targets are consciously set by the local managers at an achievable level (i.e., factually possible), while guarding against budget targets that are too optimistic or pessimistic. The HQ manager tries to assess the proactive truth of the budget data and plans for each local manager through a dialogical communication strategy that enables them to assess the integration of the local manager’s business model.

In evaluating the factual possibility of the plan, the HQ manager tries to assess the factual basis and judgment behind the local manager’s decisions and, in particular, to assess how confident they are in the integration embedded in their own plans. Especially in a situation in which the structure of the division includes autonomous investment centers, the assessment is critically important because responsibility and control have been decentralized. If the manager in charge of the center exercises poor judgment, it will, ceteris paribus, decrease the performance of his unit.

During budget meetings, the HQ manager listens to the local manager’s budget proposal expressing values, possibilities, and factual conditions. Then, they challenge the proposal partly by disclosing the subjective judgment involved and partly through the negation of factual assumptions:

When I meet with the local managers, they have described their plans and I ask them what they have not described. What are you afraid of? If there is a problem, I ask them what they feel like doing about it, and then they find the solution.

Thus, the HQ manager attempts to uncover the local manager’s perception of the extent to which the budget reasoning will work in practice and, consequently, the extent to which facts, possibilities, and values are integrated. The HQ manager questions weak factual possibilities and value support in the plan. If there is a problem, the division manager’s enquiries induce the local manager to find solutions that may negate the nonsupporting fact, weak possibilities, and values.

In applying their communication model, the HQ manager not only checks but also strengthens the judgment of the local manager and so improves the local manager’s ability to control the center. Specifically, if the local manager is uncertain about how to create integration, then the HQ manager applies their communication strategy in an attempt to encourage the local manager to find ways to build integration.

In addition, for the evaluation of the realism of the budget (moral hazard) the HQ manager assesses the extent to which the factual possibilities embedded in the external conditions of a particular investment center fit the organizational objectives. Interpreting the numbers requires an experienced and knowledgeable manager who can assess the results of the units in a particular context. To be able to follow developments and interpret the figures, the manager’s subjective knowledge and insights about the units being assessed is important.

Previously, we revealed an interactive narrative that forms the basis for cooperative managers’ reflective evaluation and learning processes concerning the manager of the investment centers’ business strategy and actions. The HQ manager uses both historically based accounting information and future-oriented accounting estimations as elements in a more complex knowledge and judgment system including methods for assessing both the proactive truth and pragmatic truths of local manager’s business models. A truth gap gives rise to an intensive learning process driven by the HQ manager.

Performance Measurement Model

Also, the HQ manager works with a learning theory of truth in the development of performance measurement ratios. Fundamentally, to provide useful accounting information, a performance measurement system should be designed to serve the purpose (intentional value) it has in the reality construction. The conceptual items of accounting measurement models are outlined by the formulation of conceptual content and criteria that are exemplar and structurally linked together through logical relationships. As logic cannot be positively observed, their truth cannot be found by empirical correspondence. It is only through reflective reasoning in relation to the specific practice that accounting models such as historical versus economic value model and ROI versus EVA can be assessed in terms of their usefulness in the real world. The interplay between pragmatic truth and proactive truth forms the basis for an ongoing improvement of the model in use.

In our case, the financial objective of the organization is to produce the highest ROI in the industry and to have “balanced” financing of their growth. Aiming to serve these objectives, the investment centers are measured on the basis of a blend of EVA and RONA. Thus, their profits are calculated after deducting 1 percent interest per month on the invested working capital. The hurdle rate of ROI required is a minimum of 14 percent. But in fact some units have a rate of return of 40 percent while others have less than 14 percent. Rates above 14 percent are considered positively, while rates below 14 percent are considered a danger. In addition, the division requires 40 percent of gross profits for personnel costs—this percentage depends on whether the yard has its own transportation company. Also, the market share and the monthly turnover rate of accounts receivable and stocks are measured.

Prior to the introduction of this system, the ROI was used. The new system of calculating profits after the reduction of interest on working capital was developed some years ago. The reason was that some of the investment centers exploited the fact that they could get higher interest from their debtors than ROI. Debtors were a very real problem, and some of the investment centers suffered substantial losses because of this situation. The hurdle rate implies that there is no incentive to pursue alternatives with returns lower than the cost of capital. The organization does not use the full EVA, as they do not want the local managers to promote investments that go to close to the border of WACC.

Overall, we witness that the top management aims to develop a model that fits the purpose and that there is managerial reflection on the pragmatic effect of the model.

Financial Statements

Finally, it should be noted that the learning theory of truth governs the production of numbers in financial accounting reporting. The financial reports are made based on the standards and principles of financial accounting. The conceptual system of financial accounting is used to measure managers’ performance.

Generally, in practice, historical accounting information builds on the interplay between proactive truth and pragmatic truth. Consequently, historic cost accounting’s limitations as an objective referential observational system might not be so much a problem in practice. Rather, it is crucial for trustworthiness in accounting to ascertain whether the referent is real or illusionary. To be real, financial accounting statements should integrate all the four dimensions of pragmatic constructivism. Many, but not all, of the contents of historic cost–based financial statements are based on references to factual financial transactions. However, these are not objective or physical facts, but facts based on constructs integrated with the possibilities and human values that determine their selection. Financial statements are based on what has been factually possible to do. Much of the linking to possibilities is historically based; for example, inventory is based on historical evidence of its existence and that it has been factually possible to produce a certain item at a certain historic cost. Some of the measures in financial statements involve the need to make future estimates, for example, assets’ life, consumption patterns and residual values, debtor receipts, and stock selling prices. Thus, historical reporting is also based on what is assumed to be factually possible to do. The use of future information inevitably makes accounting information moderately subjective. However, to make the numbers trustworthy, accounting practices draw on the elements of proactive and pragmatic truths when making judgments. Thus, guiding the subjective judgment in financial statements are principles of going concern, conservatism, consistency, and reliability. For example, evaluations of debtor receipts and stock selling prices are reflectively based on a judgment of whether the debtors will pay and whether the goods in stock will sell for that price. The proactive judgment is an integrated part of a pragmatic observation of whether debtors are paying and stock is selling. In this way, the assumptions about what may be factually possible to do and values to be employed in reporting are linked to the conservative projections of historically rooted business.

In our case, the willingness and factual possibilities of customers’ ability to pay are checked proactively at the order stage, and, after delivery, debtors are controlled tightly. More specifically, they have a credit maximum, so that debtors of more than a certain amount are referred to the HQ manager. The HQ manager approves debtors who are of acceptable financial status, that is, those who proactively seem to be able and willing to pay. For everybody else, the local manager has to give a trustworthy explanation for selling to such customers. Also, the HQ manager checks that the company’s policies are followed and that the debtors are actually paying. For example, they regularly check the debtors of the investment centers, and any center with unapproved or problematic debtors has to submit an explanation. In this way, they manage to get the debtors under control. As a matter of fact, they have been able to reduce the accounts receivable turnover rate from the average credit period of 105 days down to 36 days.

Similarly, the HQ manager ensures that buildings are not neglected. During the meetings, the HQ manager examines the state of the buildings and stores. In addition, the people who evaluate the condition of the buildings sometimes also attend the meetings.

Thus, although in a dynamic business context historically based conservative information might be considered misleading in respect of what is factually possible and valuable in the future, it might provide a solid foundation for the proactive judgment of the effect of operational actions or nonactions.

Conclusions

Earlier in this chapter, we discussed how a HQ manager engaged in reflective communicative interaction with local managers about past and future business actions. The top management did not handover all the authority to the center managers to determine what to do; instead, they created a climate of co-actorship in the creation of the investment center performance. The proactive and pragmatic evaluation of the integration of the local managers’ business models is crucial when the HQ manager validates the local manager’s actions. The production and use of trustworthy and meaningful accounting information and methods is a focal point in narrating this evaluation. The interplay between pragmatic truth and proactive truth information forms the basis for an ongoing improvement of the ability to generate historical and future-oriented accounting information and so establish an integrated learning-based theory of truth. Accordingly, pragmatic constructivism provides a basis for the performance management of investment centers that is rather different from the instrumental and mechanical leadership style embedded in the principal–agent theory that currently dominates the conventional wisdom on the performance management of investment centers.

Discussion Questions

1. How does the principal–agent theory relate to the four dimensions of pragmatic constructivism (facts, possibilities, values, and communication)? What are the blind spots of integration embedded in the principal–agent theory thinking?
2. Drawing on pragmatic constructivism, you are asked to design a performance management system for a divisionalized organization! What measures will you suggest? How will you validate the quality of the information? How will you use the accounting information?