Budgetary Control and Responsibility Accounting

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Chapter 7
Managerial Accounting Weygandt, Kieso, Kimmel

• Budgetary Control and Responsibility Accounting

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Budgetary Control

• The use of budgets in controlling operations is
  known as budgetary control.
• The centerpiece of budgetary control is the use
  of budget reports that compare actual results
  with planned objectives.
• The budget reports provide the feedback needed by
  management to see whether actual operations are
  on course.

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Budgetary Control

• Budgetary control involves
• Developing budgets.
• Analyzing the differences between actual and
  budgeted results.
• Taking corrective action.
• Modifying future plans, if necessary.
• Repeating the cycle.

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Static Budget Reports

• A static budget is a projection of budget data at
  one level of activity.
• In such a budget, data for different levels of
  activity are ignored.
• As a result, actual results are always compared
  with the budget data at the activity level used
  in developing the master budget.

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Static Budget Reports Illustration

• To illustrate the role of a static budget in
  budgetary control, we will use selected budget
  data for Hayes Company prepared in Chapter 6.
• Budget and actual sales data for the Kitchen-mate
  product in the first and second quarters of 1999
  are as follows

Sales First Quarter Second Quarter Total
Budgeted 180,000 210,000 390,000Actual 179,00
0 199,500 378,500Difference 1,000
10,500 11,500
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Static Budget Reports Illustration

• Managements analysis should start by asking the
  sales manager the cause(s) of the shortfall. The
  need for corrective action should be considered.
  
• For example, management may decide to spur sales
  by offering sales incentives to customers or by
  increasing advertising. On the other hand, if
  management concludes that a downturn in the
  economy is responsible for the lower sales, it
  may decide to modify planned sales and profit
  goals for the remainder of the year.

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Static Budget Reports

• A static budget is appropriate in evaluating a
  managers effectiveness in controlling costs
  when
• the actual level of activity closely approximates
  the master budget activity level, or
• the behavior of the costs in response to changes
  in activity is fixed.

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Flexible Budgets

• A flexible budget projects budget data for
  various levels of activity.
• In essence, the flexible budget is a series of
  static budgets at different levels of activity.
• The flexible budget recognizes that the budgetary
  process has greater usefulness if it is adaptable
  to changed operating conditions.
• This type of budget permits a comparison of
  actual and planned results at the level of
  activity actually achieved.

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Why Flexible Budgets?An Illustration

• Barton Steel prepares the following static budget
  for manufacturing overhead based on a production
  volume of 10,000 units of steel ingots.

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Why Flexible Budgets?An Illustration

• If demand for steel ingots has increased and
  12,000 units are produced during the year, rather
  than 10,000, the budget report will show very
  large variances.

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Why Flexible Budgets?An Illustration

• Since the comparison of actual variable costs
  with budgeted costs is meaningless at different
  levels of activity, variable per unit costs must
  be isolated so the budget can be adjusted. An
  analysis of the budget data at 10,000 units
  produces the following per unit results

• The budgeted variable costs at 12,000 units are
  as shown on the right. Because fixed costs do not
  change in total as activity changes, the budgeted
  amounts for these costs remain the same.

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Why Flexible Budgets?An Illustration

• The budget report based on the flexible budget
  for 12,000 units is shown.

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Flexible Budget A Case StudyMaster Budget Data

• Fox Company wants to use a flexible budget for
  monthly comparisons of actual and budgeted
  manufacturing overhead costs. The master budget
  for the year ended December 31, 1999 is prepared
  using 120,000 direct labor hours and the
  following overhead costs.

• STEP 1 Identify the activity index and the
  relevant range of activity
• The activity index is direct labor hours and
  management concludes that the relevant range is
  8,000-12,000 direct labor hours.

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Flexible Budget A Case StudyVariable Costs per
Labor Hour

• STEP 2 Identify the variable costs and determine
  the budgeted variable cost per unit of activity
  for each cost.
• For Fox, there are 3 variable costs and the per
  unit variable cost is found by dividing each
  total budgeted cost by the direct labor hours
  used in preparing the master budget (120,000
  hours).

Variable Cost per Variable Costs
Computations Direct Labor Hour Indirect
materials 180,000 ? 120,000 1.50 Indirect
labor 240,000 ? 120,000 2.00 Utilities 60,000
? 120,000 .50 Total 4.00
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Flexible Budget A Case StudyFixed Costs

• Step 3 Identify the fixed costs and determine
  the budgeted amount for each cost.
• There are three fixed costs and since Fox
  Manufacturing desires monthly budget data, the
  budgeted amount is found by dividing each annual
  budgeted cost by 12.
• The monthly budgeted fixed costs are
• Depreciation 15,000,
• Supervision 10,000, and
• Property taxes 5,000.

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Flexible Budget A Case StudyThe Flexible Budget

• Step 4 Prepare the budget for selected
  increments of activity within the relevant range.

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Flexible Budget A Case StudyFormula for Total
Budgeted Costs

• From the budget, the formula shown below may be
  used to determine total budgeted costs at any
  level of activity.
• For Fox Manufacturing, fixed costs are 30,000,
  and total variable costs per unit is 4.00.
• Thus, at 8,622 direct labor hours, total budgeted
  costs are

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Flexible Budget Reports

• Flexible budget reports represent another type of
  internal report produced by managerial
  accounting.
• The flexible budget report consists of two
  sections
• Production data such as direct labor hours, and
• Cost data for variable and fixed costs.
• Flexible budgets are used to evaluate a managers
  performance in production control and cost
  control.

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Flexible Budget A Case StudyFlexible Budget
Report

• In this budget report, 8,800 DLH were expected
  but 9,000 hours were worked. Budget data are
  based on the flexible budget for 9,000 hours.

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Management by Exception

• Management by exception means focusing on major
  differences.
• For management by exception to be effective,
  there must be some guidelines for identifying an
  exception. The usual criteria are
• Materiality- usually expressed as a percentage
  difference from budget may also have a dollar
  limit.
• Controllability - exception guidelines are more
  restrictive for controllable items than for items
  that are not controllable by the manager being
  evaluated.

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The Concept of Responsibility Accounting

• Responsibility accounting involves accumulating
  and reporting costs (and revenues, where
  relevant) on the basis of the individual manager
  who has the authority to make the day-to-day
  decisions about the items.
• The evaluation of a manager's performance is then
  based on the costs directly under the manager's
  control.

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Responsibility Accounting

• Responsibility accounting personalizes the
  managerial accounting systems. Under
  responsibility accounting, any individual who has
  control and is accountable for a specified set of
  activities can be recognized as a responsibility
  center.
• Responsibility accounting is especially valuable
  in a decentralized company.
• Decentralization means that the control of
  operations is delegated by top management to many
  individuals (managers) throughout the
  organization.
• A segment is an identified area of responsibility
  in decentralized operations.

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Responsibility Accounting versus Budgetary Control

• Responsibility accounting is essential to any
  effective system of budgetary control. It
  differs from budgeting in two respects
• A distinction is made between controllable and
  non-controllable items.
• Performance reports either emphasize or include
  only items controllable by the individual manager.

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Controllable versus Non-controllable Revenues and
Costs

• All costs and revenues are controllable at some
  level of responsibility within the company. A
  cost is considered controllable at a given level
  of managerial responsibility if that manager has
  the power to incur it within a given period of
  time. In general, costs incurred directly by a
  level of responsibility are controllable at that
  level.
• Costs incurred indirectly and allocated to a
  responsibility level are considered to be
  non-controllable at that level.

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Responsibility Reporting System

• A responsibility reporting system involves the
  preparation of a report for each level of
  responsibility shown in the company's
  organization chart.
• A responsibility reporting system permits
  management by exception at each level of
  responsibility within the organization.

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Types of Responsibility Centers

• Responsibility centers may be classified into one
  of three types
• A cost center incurs costs and expenses but does
  not directly generate revenues.
• A profit center incurs costs and expenses but
  also generates revenues.
• An investment center incurs costs and expenses,
  generates revenues, and has control over
  investment funds available for use.

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Examples of Responsibility Centers
Cost center usually a production center or
service department Profit center individual
departments of retail stores and branch offices
of banks Investment center subsidiary companies
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Responsibility Accounting for Cost Centers

• The evaluation of a managers performance for
  cost centers is based on the managers ability to
  meet budgeted goals for controllable costs.
  Responsibility reports for cost centers compare
  actual controllable costs with flexible budget
  data.
• Only controllable costs are included in the
  report, and fixed and variable costs are not
  distinguished.

• Assume that the Finishing Department manager is
  able to control the costs in the report to the
  right.

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Responsibility Accounting

• To determine the controllability of fixed costs
  it is necessary to distinguish between direct and
  indirect fixed costs.
• Direct fixed costs (traceable costs) are costs
  that relate specifically to a responsibility
  center and are incurred for the sole benefit of
  the center. Most direct fixed costs are
  controllable by the center manager.
• Indirect fixed costs (common costs) pertain to a
  company's overall operating activities and are
  incurred for the benefit of more than one profit
  center. Thus, most indirect costs are not
  controllable by the center manager.

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Responsibility Report for Profit Centers

• A responsibility report for a profit center shows
  budgeted and actual controllable revenues and
  costs.
• The report is prepared using the
  cost-volume-profit income statement format. In
  the report
• Controllable fixed costs are deducted from
  contribution margin.
• The excess of contribution margin over
  controllable fixed costs is identified as
  controllable margin.
• Non-controllable fixed costs are not reported.
• Controllable margin is considered to be the best
  measure of the managers performance in
  controlling revenues and costs.

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Responsibility Report for a Profit Center

• This manager was below budgeted expectations by
  approximately 10 (36,000/ 360,000).
• Top management would likely investigate the
  causes of this unfavorable result.

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Responsibility Accounting for Investment Centers

• An important characteristic of an investment
  center is that the manager can control or
  significantly influence the investment funds
  available for use.
• Thus, the primary basis for evaluating the
  performance of a manger of an investment center
  is return on investment (ROI).
• ROI is considered to be superior to any other
  performance measurement because it shows the
  effectiveness of the manager in utilizing the
  assets at the managers disposal.

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Return on Investment

• The formula for computing ROI for an investment
  center, together with assumed illustrative data
  is shown below.
• Operating assets consist of current assets and
  plant assets used in operations by the center.
  Average operating assets are usually based on the
  beginning and ending cost or book values of the
  assets.

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Responsibility Report for a Profit Center

• Since an investment center is an independent
  entity for operating purposes, all fixed costs
  are controllable by the investment center
  manager.
• Notice the report shows budgeted and actual ROI.

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Improving ROI

• A manager can improve ROI by
• increasing controllable margin, and/or
• reducing average operating assets.
• Controllable margin can be increased by
  increasing sales or by reducing variable and
  controllable fixed costs.
• A reduction in operating assets should not
  adversely affect future growth or operations

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Judgmental Factors in ROI

• The return on investment approach includes two
  judgmental factors
• Valuation of operating assets Operating assets
  may be valued at acquisition cost, book value,
  appraised value, or market value.
• Margin (income) measure This measure may be
  controllable margin, income from operations, or
  net income.

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Principles of Performance Evaluation

• Performance evaluation is at the center of
  responsibility accounting. Performance
  evaluation is a management function that compares
  actual results with budget goals.
• Performance evaluation includes both behavioral
  and reporting principles.

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Principles of Performance Evaluation Behavioral

• The human factor is critical in evaluating
  performance. Behavioral principles include the
  following
• Managers of responsibility centers should have
  direct input into the process of establishing
  budget goals for their area of responsibility.
• The evaluation of performance should be based
  entirely on matters that are controllable by the
  manager being evaluated.
• Top management should support the evaluation
  process.
• The evaluation process must allow managers to
  respond to their evaluations.
• The evaluation should identify both good and poor
  performance.

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Principles of Performance Evaluation Reporting

• Performance reports (which are primarily
  internal) should
• Contain only data that are controllable by the
  manager of the responsibility center.
• Provide accurate and reliable budget data to
  measure performance.
• Highlight significant differences between actual
  results and budget goals.
• Be tailor-made for the intended evaluation.
• Be prepared at reasonable intervals.

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