Sunday, 15 October 2006
I originally wrote this article, “Managerial control” in July 2003.
A group of my friends have what you believe to be the opportunity of a lifetime.
They graduate this year and the father of one of my friends has asked two of them if they would like to buy the air-conditioning business he founded and operated for thirty years. It has been a very lucrative business for him; today he is a millionaire several times over. They are aware his firm is the leader in its field in their area and they see the possibility of expanding because many new homes are being built locally.
My friend's father will finance the buyout through a loan, to be paid off over the next ten years. Both of my friends have some degree of expertise in the heating and air-conditioning field since they have both worked for my friend’s father during university vacation times. My friend’s father has also agreed to be a consultant to the two of them for the first year or so if they need his advice.
The business has almost 60 well-qualified employees, a large inventory, 40 service trucks in excellent condition and a well established list of clients. At the same time the return on investment has been lower than average for the past three years, labour costs are very high, and the company has attracted only a few new clients during the past two years. In addition they have some indication that the firm is not carrying the most up-to-date heating or air conditioning equipment and the four large structures used to house showrooms and service centres are in need of refurbishment.
My friends are discussing the possibility of buying the firm. In considering the situation I reviewed the control forms and processes that I would use to ensure effective control over the operation.
I outlined the control issues and potential problems that I considered relevant to this case. I recommended control processes to be put into place to ensure the continued success of the business. Using my knowledge of the concepts and classification of controls, I applied these concepts of control to their particular situation.
The proposed purchase, by my friends, of the air-conditioning business raises many issues that are discussed. I've identified ten potential problems with the acquisition. Half of the potential problems are controllable and I propose four control process models to reduce the risk of business failure.
Organizational control of the air-conditioning business is required if my friends are to be successful in this venture. Daft (2003, p. 654) defines organizational control as the 'systematic process through which managers regulate organizational activities to make them consistent with expectations established in plans, targets and standards of performance.' The importance of control is evidenced by the fact that it is one of the four basic management functions - planning, organizing, leading, controlling, as explained by Robbins, Bergman, Stagg and Coulter (2003). Controlling is required throughout the depth of the organization (strategic, tactical and operational) and the breadth of the organization (financial, operations, information and people).
As part of the control process, they need systems to measure and compare actual performance. This will allow them to take corrective action if performance deviations are found. They should only control processes which will contribute to the success of their business. One method of selecting these particular processes is by resource-dependency, as described by Bartol (1997). The standards of the existing air-conditioning business need to be reviewed, amended and supplemented, where necessary.
Having established which of the business process performances are to be measured, my friends need to determine if measurement is to be through observation or reporting, i.e. statistical, oral or written. If they find deviations in performance against their standards then they may; take action to change the performance, alter the standard or they may choose to take no action. Depending on the business process, they should use feedback, feed-forward, concurrent control or a combination to match the application. Additionally, the results may be simply mechanically processed or may require subjective judgment.
Up to four managerial approaches to implementing controls are described by various authors. All sources include bureaucratic and clan (decentralized) control. Robbins, Bergman, Stagg and Coulter (2003, p. 558) add a third approach, described as 'market control', which uses external market mechanisms to establish standards in the system. Mullins (2002, p. 774) further identifies a fourth approach which he labels personal centralized control. This approach is found in small owner-managed organizations where decision-making and initiative are centralized around aleadership figure.
My friends need to study the managerial control style used by my friend's father. They should determine if this style is most appropriate to the operations and to the new leadership. Existing control systems and new control systems should be assessed to ensure that they have the right qualities. They also need to consider how the control systems could be misused, manipulated or be negatively viewed.
Ten potential problems
I’ve identified ten potential problems with the management of the air-conditioning business. The first five problems do not lend themselves readily to the application of control processes and they are; their inexperience, business purchase price evaluation, role of the current owner, financial loan terms and nepotism. The remaining five potential problems may be monitored through control processes and they are; inventory turnover, asset turnover, return on investment, profit margin and sales growth.
My friends have some experience in the heating and air-conditioning field, since they both worked for my friend's father during university vacation times. Whilst there are advantages of an early entry strategy into the business, Hodgetts and Kuratko (2001, p. 61) identify a disadvantage that normal mistakes tend to be viewed as incompetence in the successor. The problem centres around the ability of them to gain credibility with the firm's sixty existing employees. This is in contrast to a delayed entry strategy which would involve my friends in gaining experience outside of the business, prior to takeover. This would have the advantages of; self-confidence development outside the firm, credibility and acceptance through outside successes and a broader business perspective.
Establishing a mutually agreeable and fair purchase price with my friend's father for the air conditioning business is a potential problem. Assuming that all of the current personnel will remain, the major concerns are the inventory condition, state of other assets and quantifying the contribution of goodwill. The inventory is large and I have noticed that the firm is not carrying the most up-to-date heating or air-conditioning equipment. Storage costs for this equipment need to be considered and if the products are obsolete then they contribute minimal or no value in the inventory portion of the purchase price. The four large structures used to house showrooms and service centres are in need of refurbishment. The condition of these assets attracts significant maintenance expenditure, required within the immediate future of operating the new business, and this cost needs to be factored into the price. Quantifying the goodwill contribution to the purchase price is complicated by the fact that the company has attracted only a few new clients during the past two years.
My friend's father has agreed to be a consultant to my friends for the first year or so, if they need his advice. Despite the obvious advantages of such an arrangement, there are potential problems. Although my friends will be the owners of the new business, the presence of my friend's father could lead to management conflicts when the sixty existing employees naturally still see him as still being in control of the business. This situation could be further complicated if my friend's father previously used a personal centralized control technique. As company founder, with thirty years of experience, it would not be possible for my friends to emulate his previous style.
The terms of the financial loan need to be thoroughly investigated. Whilst the interest rate could be readily agreed upon, there are other factors of great importance to be formalized. The payment frequency, principal and interest apportioning, payment default definition, contractual terms and security all need to be negotiated.
Nepotism between my friends and my friend’s father is a delicate issue and a potential problem one friend.
As stated previously, the firm has a large amount of stock, due to low inventory turnover, and is not carrying the most up-to-date heating or air-conditioning equipment. The obsolete inventory is a burden, incurring storage costs, and reflects badly in the financial ratios of the business - if it is not already written off. They may inherit this stock if my friend's father insists on compensation for it within the business purchase price.
The four large structures used to house showrooms and service centres are in need of refurbishment. It's possible that this is a result of poor building maintenance planning. Alternatively, short-term cost savings may have been sought by avoiding building maintenance.
Return on investment for the business has been lower than average for the past three years. Labour costs are very high and the firm uses forty service trucks.
The final two potential problems are associated with the fact that the company has attracted only a few new clients during the past two years. If sales revenues are flat or declining then the ability to retain the sixty well-qualified employees, who incur very high labour costs, is in question if the profit margin on sales is to be an acceptable value. Additionally, a certain level of sales are required to achieve total asset turnover to compensate for the forty service trucks and the four large structures used to house showrooms and service centres.
Four control processes
Four processes should be implemented to control the latter five potential problems. The first two processes have the objective of testing the operations and they control inventory turnover and total asset turnover. The remaining two processes have the objective of monitoring profitability and they are profit margin and return on investment. The model of Robbins, Bergman, Stagg and Coulter (2003, p.567) is used to explain the four control processes.
Inventory turnover control process
The inventory turnover control process model is designed to make sure that all warehoused inventory is saleable. This is accomplished by setting an acceptable standard average time period, measured monthly, for all inventory. The average time assumes a standard deviation and may be adjusted so that all inventory remains within their technically and commercially useful life. Price reductions, writing off and scrapping are possible courses of action for obsolete items. The acceptance criteria may be increased if newer models are slower to reach the market and if shelf life permits.
Total asset turnover control process
Robbins, Bergman, Stagg and Coulter (2003, p. 623) identify that 'the fewer assets used to achieve a given level of sales, the more efficiently management is using the organization's total assets'. The main assets of the air-conditioning business are the four large structures used to house showrooms, service centres and the forty service trucks in excellent condition. If the total asset turnover ratio falls below an acceptance criteria then asset re-financing or disposal should be carried out.
Profit margin on sales control process
I initially estimate that the overall gross profit for the air conditioning business should be 40 percent and that the net profit margin should be 7 percent. If the profit margin on sales ratio falls below this standard then they should attempt to increase sales through increased promotion and advertising. Additionally, they may reduce business costs for either labour, materials or overheads.
Return on investment control process
I noticed that the return on investment for my friend's father's business has been lower than average for the past three years. They need to establish the cause for this and to remedy the situation. I propose that they set a standard for their return on investment, identify the cause for any under performance and take action to correct the performance. The control process model shows that they should reduce labour, material or overhead costs if the acceptance criteria is not met for the month. Additionally, the total asset costs should be reduced through re-financing or disposal.
List of references
Bartol, K.M., Martin, D.C., Tein, M. & Matthews, G. 1997, Management: A Pacific Rim Focus, 2nd edn, Sydney: McGraw-HiII pp.6SS-6S8
Daft, R.L. 2003, Management, South-Western, Mason, Ohio, U.S.
Hodgetts, R.M. & Kuratko, D.F. 2001, Effective Small Business Management, Harcourt College Publishers, Orlando, Florida, U.S.
Mullins, L.J. 2002, Management and Organizational Behaviour, Pearson, U.K.
Robbins, S.P., Bergman, R., Stagg, I. & Coulter, M. 2003, Management, Pearson, Australia.