Service Organisations:

SLIDE 2

The characteristics that distinguish service organizations in general from manufacturing organizations are mainly covered below. We then discuss the special problems that arise in professional, financial service, health care, and non-profit organizations

1. Essence of Inventory Buffer:

Goods can be hold in inventory, which is a buffer that dampens the impact on production activity of fluctuations in sales volume. Services cannot be stored. Although manufacturing companies can earn revenue in the future from products that are on hand today, a service company cannot do so. It must try to minimize 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. Accounting firms, law firms, and other professional organizations are reluctant to lay off professionalism times of low sales volume because of the effect on morale and the cost of rehiring and training. A key variable for service organizations is to match the current capacity with demand. First they try to simulate demand in off-peak periods by marketing efforts and price concessions. For example the airlines and hotels offer heavy discounts during the off-season to increase demand. Second adjust the size of the work force to the anticipated demand.

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, colour, 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. Labour Intensive

Manufacturing companies add equipment and automate production lines, thereby replacing labour and reducing costs. Most service companies are labour 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 support 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 analysing 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.

SLIDE 3 – Professional Service Organisation

Special Characteristics

1. Goals

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 asset 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 up to-date. Large public accounting 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 labour intensive, and they employ individuals who are specialists in respective fields. 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 accounting 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 support staffs and non-professionals 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 terms, 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 identifying slackers and hard workers. In some cases, the revenues earned indicate the measure of output, but only in terms of quantity. In a professional service organization, the non-repetitive nature of work compounds the problem of measuring output. Since no two professionals work in the same way, it is difficult to set standards in terms of the time spent for a task and the way in which the task is performed.

4. 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 accounting, the profession’s ethical code limits the amount and character of overt marketing efforts by professionals (although 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 contacts, speeches, articles, conversations on the golf course, and so on. Thus, it becomes difficult to identify a single employee who is responsible for promoting the organization.

5. Small Size

Most professional organizations are relatively small in size and operate in a single location, with the exception of some law and accounting firms. Senior management personally monitors and motivates their subordinates. This brings down the need for sophisticated control systems. Even though professional organizations are small, they still need to prepare budgets, compare the budgeted and actual performance, and compensate employees on the basis of their performance.

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 members are accustomed to keeping track of their time, fees 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. Prices of services offered differ from profession to profession. The prices are high for accountants and physicians compared to research scientists, for instance.

2. Profit Centres and Transfer Pricing

Support 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 is not as comprehensive as that of a manufacturing organization. It is mainly a long range staffing plan and does not cover other functions.

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.

5. Performance Measurement and Appraisal

In professional organizations, it is easy to analyse the performance of employees at the top most and the lowest hierarchical level. Appraisal of the large percentage of professionals who are within the extremes is much more difficult. The main reason for this is the absence of objective criteria for performance appraisal. For some professions, objective measures of performance are sometimes available: The recommendations of an investment analyst can be compared with actual market behaviour 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.

SLIDE 4 – Financial Services Organization

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 premiums, invest these premiums, 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 account or for customers.

Special Characteristics

1. Monetary assets

The current value of monetary assets is much more easily measured than the value of plant and other physical assets 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. Its purchasing power changes with time, but at any given future time, all dollars have equal value. This means that everyone’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 of financial instruments other than the money; there is no need for quality control safeguards for money.

Financial assets also can be transferred from one owner to another easily and quickly e.g. electronic funds transfer. Its portability is tempting to thieves and forgers. For this reason, firms that handle financial assets 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.

2. 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 be not known for 30 years or more. During this period, the soundness may change and the purchasing power of money will certainly change. This means that the ultimate performance of those involved in authorising and structuring the product cannot be measure at the time the initial decision is made. Control is required as means of continued surveillance of the soundness of the transaction during its life.

At the other extreme, some transactions are completed quickly. For currency transactions and for listed securities, new information may become available almost instantaneously in markets throughout the world. With trading of securities, there is change in the prices of the securities. Therefore there is a need for a system to report securities held and to assess the risk to the organisation. Firms must have an accurate, prompt system for obtaining this information, for summarizing it, for estimating the risk of the securities held and for making this information available to the traders.

3. Risk and reward

Many financial services firms are in the business of accepting risks in return for rewards. Greater the risk, greater should be the anticipated reward. In financial firms, this tradeoff is more explicit than in the business investments such as those involving the purchase of a machine or the introduction of a new product. Interest rates on loans and premiums on insurance policies are based on assumptions about risk that may or may not turn out to be accurate

4. Technology

Financial services firms have used information technology as a way to offer innovative services. Automated teller machines of banks are just one example. Insurance and mutual funds have developed electronic market places. Firms market their products electronically to their consumers using websites on the internet. Investment banks, using concepts from quantum physics and high level mathematics formulae, have designed new forms of financial instruments. Banks have become virtual by offering cyber payment services. Online brokerage services are a fast growing segment.

Management Control Systems

General principles and concepts of MCS apply but they need to be adapted to the above mentioned special characteristics

SLIDE 5 – Healthcare Services Organization

Health care organisations consist of hospitals, clinics and similar physicians’ organisations, health maintenance organisations, retirement and nursing homes, home care organisations and medical laboratories, among others.

Special Characteristics

1. Difficult social problem

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 patients, the system cannot do this. On one hand, the cost per treatment is inevitably increasing with the development of new equipment and new drugs. 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 will deal with it. It is clear, however, that health care deliver will change drastically.

2. Change in mix of providers

Many services that traditionally were provided in hospitals on an inpatient basis are now provided in outpatient clinics or in the patients’ homes. Entrepreneurs have entered the industry to provide these new services. 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

In the US, there is a government program called Medicare, which provides support for persons age 65 and up and for younger persons with certain disabilities. Another program, Medicaid, pays for services provided to low income people. Medicare reimbursed on the basis of “reasonable” costs incurred, which gave health care providers little incentive to control costs. Currently, hospitals are reimbursed on a set of guidelines regardless of the actual length of stay or the actual costs incurred for individual patients.

The increase in hospital costs per patient has motivated hospitals to install sophisticated cost accounting 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 and they report actual costs compared with standard costs. 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 organisations (HMO) 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. 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

The primary loyalty is to the profession, rather than to the organization. Departmental managers typically are professionals whose management functions is only part time, the chief of surgery still performs 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 to detect all the patient’s symptoms.

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 government.

Management Control Systems

Subject to the characteristics just described, the management control process in the healthcare industry is similar to the other organisations. 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 analysed by comparing actual revenues and expenses with budgets, identifying important variances, and taking appropriate actions on them.

SLIDE 6 – Non Profit Services Organization

A non-profit organisation, as defined by law, is an organisation that cannot distribute assets or income to, or for the benefit of, its members, officers, or directors. The organisation can, of course, compensate its employees, including officers or directors, for services rendered and for goods supplied. This definition does not prohibit an organisation from earning a modest profit, on average, to provide funds for working capital and for possible “rainy days”.Many non-profit organizations give inadequate attention to their pricing policies. Pricing of services at their full cost is desirable

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 non-profit organisations. Many of them have several goals, and an organisation’s effectiveness in attaining its goals rarely can be measured by quantitative amounts. The absence of a satisfactory, quantitative, overall measure of performance is the most serious management control problem in a non-profit organisation.

The income statement is the most useful financial statement in a non-profit organisation, just as it is in a business. However, the net income number is interpreted differently. In a business, the larger the income, the better the performance. In a non-profit organisation, net income should average only a small amount above zero. A large net income signals that the organisation 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 non-profit organisation, it is a necessary goal because the organisation cannot survive if its revenues on average are less than its expenses.

2. Contributed Capital

A business corporation has transactions with its shareholders – issuance of stock and the payment of dividends – that a non-profit organization doesn’t have. A non-profit organization received contributed capital, which few businesses have.

There are two principal categories of contributed capital: plant and endowment. Plant includes contributions of buildings and equipment, or contributions of funds to achieve these assets. Endowment consists of gifts whose donors intend that the principal amount will remain intact indefinitely; only the income on this principal will be used to finance current operations. The receipts of a contributed asset is not revenue – that is, neither contribution 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.

Thus, a non-profit organisation 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 statement of inflows and outflows of contributed capital assets and the related liabilities and equity.

3. Fund Accounting

Accounts are kept separately for several finds, each of which is self-balancing (debit = credit). Most organizations have (1) a general fund or operating fund, which corresponds closely to the set of operating accounts mentioned; (2) a plant fund and an endowment fund, which account for the contributed capital assets and equities mentioned earlier; and (3) a variety of other funds for special 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 statement themselves. Others are useful for internal control purposes. For management control purposes, the primary focus is on the general fund.

4. Governance

Non-profit organizations are governed by boards of trustees. Trustees usually are not paid, and many of them are unfamiliar with business management. Therefore, the generally exercise less control than the directors of a business organization. Moreover, because performance is more difficult to measure in a non-profit organization than in a business, the board is less able to identify actual or independent problems.

The need for a strong governing board in a non-profit organization is greater than in a business because the vigilance of the governing board may be the only effective way of detecting when the non-profit is in difficulty. In a profit oriented organization, a decrease in profits signals this danger automatically.

Management Control System

1. Product pricing

Many non-profit 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 organizations equity. This principle applies to services that are

directly related to the organization’s objectives. Pricing for peripheral activities should be market-based. Thus, a non-profit 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 care, which was a common practice a few decades ago, masks the revenues for the mix of services actually provided. Beyond a certain point, of course, the cost of 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 recover its incurred costs, management is not motivated to worry about cost control.

2. Strategic planning and budget preparation

In non-profit organizations that must decide how best to allocate limited resources to worthwhile activities, strategic planning is more important and more time consuming process than in the typical business. Colleges and universities, welfare organizations, and organizations in certain other non-profit 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 non-profit organizations, there is no way of knowing what the optimum operating costs are. Responsibility centre 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 non-profit 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 belt-tightening and to increased attention to management control.

CASE STUDY

1. O’Reilley Associates(Xerox) – Professional Services Organisation

SOLUTION INCLUDED IN PPT

2. Southwest Airlines Corporation (PDF) – Professional Services Organisation(SLIDE CONTENT FROM CASE STUDY PDF AND THESE SOLUTIONS)

SOLUTION

Southwest Airlines Corporation

1. What is Southwest’s strategy? What is the basis on which Southwest builds its competitive advantage?

Southwest follows low cost leadership strategy. Southwest’s strategy is to improve efficiency and pass cost saving to its passengers by offering them low prices. The bases on which Southwest builds its competitive advantage is by putting employees first. “Employees first” philosophy helps the organization to keep its employees highly engaged, which in turn motivates the employees to serve the customers better resulting in high customer satisfaction. Loyal customers in turn result in generation of revenues for the company, thus increasing shareholder value.

Southwest has lowest operational cost due the various initiatives taken to cut cost. This helps it to offer lowest fares. Southwest flies point to point unlike other airlines which use hub & spoke model. It uses a short and medium haul approach. Crew is paid per trip. Pilots are unionized independently, allowing them to fly far more hours than pilots at other airlines, who are nationally unionized. It uses less congested airports, which helps it ensure fewer delays. The turnaround time from landing to take-off and crew required is lesser (approx. 20-25 mins. & required a ground crew of 4+2 people by the gate, as against United Airlines which took about 35mins & a ground crew of 12+3 gate agents). 80 % of its passengers fly on non- stop flight routes. This helps to save flight time, operate more flights, cut other additional cost on crew, gas and maintenance. Low employee turnover rate helps Southwest to save on cost of hiring and training. About 60% of Southwest’s passenger revenue was generated by online booking via Southwest.com resulting in cost, time and manpower savings.

2. How do Southwest’s control systems help execute the firm’s strategy?

Southwest strives for goal congruence. The actions people are led to take in accordance with their perceived self-interest are also in the best interest of the organization.

Southwest’s control systems helps in influencing behaviour of its people in a goal congruent manner. Its control system help execute the firm’s strategy of low cost leadership by implementing short haul and medium haul, encouraging on-line booking, ensuring lesser time spent at the gate, hedging fuel and oil (It used hedging for 85% of its fuel & oil needs & saved about $455 million). It has an open and inclusive culture. It boosts of a culture of hard work, high energy, fun, local autonomy, and creativity. The hiring process at Southwest is unique. Peers screen candidates & conducted interviews. E.g. pilots hired pilots, gate agents hired gate agents etc. Also, it initiated the 1st profit sharing plan with its employees in the U.S. airline industry, through which the employees owned about 10% of the company stock. These initiatives have helped in developing feeling of ownership in employees. Southwest has a charismatic leader in CEO Herb Kelleher. Southwest encourages pro-activeness by providing recognition to personal initiatives taken by its employees. It ensures task control thorough automation (e.g.: 60% revenue through online booking, Ding! The desktop application that provides customers with exclusive deals). Southwest consistently tries to find ways to improve its efficiencies and pass on the cost savings to its passengers.