the basis of its costs, or Subsidiary B on the basis of its prices, these decisions might be completely erroneous from the company viewpoint.

When this situation exists, the profit budget can be presented and approved based on transfer prices that would exist if the subsidiaries were independent companies. After approval, the budget is adjusted to the expected transfer prices. Thus, a budget showing Sx profits might be approved and adjusted to Sy loss when the costs were adjusted to the artificial transfer prices. This would be the profit objective against which the subsidiary manager would be evaluated. The subsidiary manager would be expected to make his day-to-day decisions on the basis of the company's marginal costs, which would be provided to him.

Where company marginal costs differ significantly from subsidiary marginal costs, an appropriate adjustment would be made centrally to the subsidiary profit performance.

As in other intra-company pricing situations, the important point is to recognize where wrong decisions may be made as a result of local information being incorrect and to take some action to insure that correct information is available.

IX

Recommendations: The Intangibles

As

WE INDICATED IN CHAPTER II, a formal financial control system consists of establishing a financial goal, and subsequently reporting actual performance against this goal. The establishment of the goal communicates the profit expectations of the subsidiary. After approval, it becomes a means for evaluating and motivating subsidiary management. It is also a means of managing by exception. If a subsidiary is meeting its financial objectives. presumably no headquarters action is required. Top management's time and attention, therefore, can be directed to those areas that require help. as indicated by the performance against the goal.

The answers to our questionnaire show that nearly all responding companies have formal profit budget systems and report performance against these profit budgets monthly, or if not that, at least quarterly. Our survey does show a high degree of consistency among companies with respect to the physical characteristics of their control systems.

The answers to our questionnaire and, in particular, our interviews. however, show wide differences in the way different companies administer these systems. The administration of profit budget systems differs widely for two principal reasons: [1] the control philosophy of headquarters management; and, [2] the ability of a company to develop profit budgets reliable enough to use in evaluating subsidiary management.

The purpose of this chapter is to describe these differences, to analyze why they exist, and to develop some conclusions concerning effective administrative practices.

Management Philosophy

The way a financial control system is administered often reflects management's attitude towards the process of managing people.

At one extreme is the conviction that people accomplish the most when they are under constant pressure to achieve specific goals and, therefore, frequent checks of performance will result in greater management efficiency. In French, this philosophy is expressed with the term "defiance", which, roughly translated, means "mistrust." In fact, this control philosophy approximates closely the "Theory X" of Douglas McGregor.!

The opposite extreme can be summarized by the philosophy of one manager who stated: "I hire good people and I leave them alone to do the job." This would correspond to Douglas McGregor's "Theory Y." Most companies are, of course, somewhere between these two extremes. It is very important, however, that the management philosophy be consistent with the financial control system because the inconsistency between management's attitude toward the system and the ability of the system to provide adequate short-term control is the cause of most serious problems in administering these systems.

The tight control approach. The tight control approach treats the annual profit budget as a hard and fast commitment against which performance is measured. When a subsidiary manager fails to meet his objective, he is given, as one manager put it, "an uncomfortable time." Typically, each month the actual profits and the latest forecast profits for the year are compared to budget, and differences are analyzed. Before a subsidiary manager is allowed to admit that he cannot meet his profit goal, he must convince headquarters management that he has taken all possible corrective actions.

The key to the effectiveness of a system to provide tight, short-term financial control is the accuracy of the profit budget. This, of course, is obvious. If a profit budget does not represent an accurate goal, how can it be

1 In Chapter 3 of his book The Human Side of Enterprise, (McGraw-Hill 1960), Professor McGregor describes Theory X as the traditional view of direction and control, based on the assumption that people dislike work and will put their best efforts only when carefully controlled. In Chapter 4 he describes Theory Y (the opposite of Theory X), based on the assumption that work is natural and that man will exercise self-direction and self-control in the service of objectives to which he is committed.

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used for evaluation? If it does not represent an accurate goal, management's attention may be directed to subsidiaries that are operating effectively, while the fact that other subsidiaries require management attention is obscured.

The problem is that there can be a wide difference among companies and even among divisions of the same company in answering the critical question: "How much should this subsidiary earn this year?" The purpose of this part of the chapter is to describe the causes for the differences.

Ability to forecast. Perhaps the most significant variable in profit budgeting is the ability to predict non-controllable determinants of profitability or to calculate the impact on profits of changes in these determinants. A profit budget represents a management commitment to accomplish certain things on the basis of a set of assumptions. A profit target may be missed because management failed to meet its commitment or because actual conditions differed from those assumed. (Or, possibly, management could miss its commitments and yet earn the budgeted profits because actual conditions were more favorable than those assumed in the budget.)

Since the manager is presumably evaluated on the basis of his ability to manage rather than his ability or good fortune in forecasting conditions (often many of these conditions are prescribed by headquarters), it is necessary to be able to predict these conditions accurately or to be able to calculate the impact of changes in these conditions if performance is to be evaluated accurately.

The problems of forecasting tend to be much more difficult for revenues than for costs. This is because costs are less subject to outside influences than revenues. Also, where costs do change, it is usually much easier to determine the extent to which these changes were controllable by subsidiary management because the information is available internally. Where long-term contracts exist, for example, or where sales are limited by production, a budgeted profit will largely be controllable by management and can be used to evaluate performance. Also, where accurate industry and economic data are available, it may be possible to measure the impact of forecasting errors on performance with a reasonable degree of accuracy.

If these conditions do not exist, however, it can be quite difficult to establish a goal and measure results in the short run. Under these circumstances, therefore, a company may find that it is evaluating luck in forecasting conditions rather than ability to manage a subsidiary.

Time-span. A second important variable in profit budgeting is the time-span of the job being measured. In some instances, the financial impact of a decision may not be reflected in profits until a considerable time (perhaps several years) after the decision has been made. This means that current profits may be the result of decisions made earlier, while today's critical decisions will not be evaluated until several years hence.

This is somewhat true, for example, in the automobile business. The styling and product decisions being made today may not be reflected in profits until three years from now. Under these conditions, a profit budget. control system (or for that matter any financial control system) will be a very poor technique for exercising short-term management control. This has two implications for United States companies with foreign subsidiaries with long time-spans:

1] It is necessary to face the fact that the profit budget system is not providing short-term control and take some non-financial action such as:

a. Assign closer intermediate

b.

C.

operations;

supervision of

Be sure the subsidiaries with long time-spans are managed by proven executives;

Try to evaluate the quality of the management decisions. (If you can do this, you do not need to wait until the effects of these decisions are reflected in profits.)

2] Headquarters management should be very careful about using pressure on the local managers to meet current budgeted profits. If the time-span is long, he really cannot do much in the short-term to change his profits. Consequently, he may be forced to take action to improve his profits in the short run that will be less optimum in the long run.

Age of subsidiary. A third critical variable in establishing accurate profit budgets is the length of time that a subsidiary has been operating and, particularly, how long it has been owned. This is fairly obvious. The more experience headquarters has had with a foreign subsidiary, the better it is able to judge its profit potential. Also, a company can be evaluated over a time-span longer than a year if reliable historical information is available and the scope of the operation has not changed significantly. (The analysis of the