CONTROLLABLE VS NONCONTROLLABLE REVENUES AND COSTS Can control all costs and revenues at some level of responsibility within the company Critical issue under responsibility accounting: Whether the cost or revenue is controllable at the level of responsibility with which it is associated

CONTROLLABLE VS NONCONTROLLABLE REVENUES AND COSTS All costs controllable by top management Fewer costs controllable as one moves down to lower levels of management Controllable costs - costs incurred directly by a level of responsibility that are controllable at that level Noncontrollable costs – costs incurred indirectly which are allocated to a responsibility level

RESPONSIBILITY REPORTING SYSTEM Involves preparation of a report for each level of responsibility in the company's organization chart Begins with the lowest level of responsibility and moves upward to higher levels Permits management by exception at each level of responsibility

RESPONSIBILITY REPORTING SYSTEM Example – Francis Chair Co.

RESPONSIBILITY REPORTING SYSTEM Also permits comparative evaluations Plant manager can rank the department manager’s effectiveness in controlling manufacturing costs Comparative ranking provides incentive for a manager to control costs

RESPONSIBILITY REPORTING SYSTEM

TYPES OF RESPONSIBILITY CENTERS Three basic types: Cost centers Profit centers Investment centers Indicates degree of responsibility that managers have for the performance of the center

TYPES OF RESPONSIBILITY CENTERS

TYPES OF RESPONSIBILITY CENTERS Examples: 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

RESPONSIBILITY ACCOUNTING FOR COST CENTERS Based on a manager’s ability to meet budgeted goals for controllable costs Results in responsibility reports which compare actual controllable costs with flexible budget data Include only controllable costs in reports No distinction between variable and fixed costs

RESPONSIBILITY ACCOUNTING FOR COST CENTERS Example – Fox Manufacturing Co. Assumes department manager can control all manufacturing overhead costs except depreciation, property taxes, and his own monthly salary of $4,000

RESPONSIBILITY ACCOUNTING FOR PROFIT CENTERS Based on detailed information about both controllable revenues and controllable costs Manager controls operating revenues earned, such as sales, Manager controls all variable costs (and expenses) incurred by the center because they vary with sales

RESPONSIBILITY ACCOUNTING FOR PROFIT CENTERS Direct and Indirect Fixed Costs May have both direct and indirect fixed costs Direct fixed costs Relate specifically to a responsibility center Incurred for the sole benefit of the center Most controllable by the profit center manager Indirect fixed costs Pertain to a company's overall operating activities Incurred for the benefit of more than one profit center Most not controllable by the profit center manager

PROFIT CENTERS Responsibility Reports Shows budgeted and actual controllable revenues and costs Prepared using the cost-volume-profit income statement format: Deduct controllable fixed costs from the contribution margin Controllable margin - excess of contribution margin over controllable fixed costs – best measure of manager’s performance in controlling revenues and costs Do not report noncontrollable fixed costs

PROFIT CENTER -RESPONSIBILITY REPORTS Example – Marine Division $60,000 of indirect fixed costs are not controllable by manager not shown

RESPONSIBILITY ACCOUNTING FOR INVESTMENT CENTERS Controls or significantly influences investment funds available for use ROI (return on investment) - primary basis for evaluating manager performance in an investment center ROI shows the effectiveness of the manager in utilizing the assets at his or her disposal

RESPONSIBILITY ACCOUNTING FOR INVESTMENT CENTERS - ROI ROI is computed as follows: Operating assets include current assets and plant assets used in operations by the center. Exclude nonoperating assets such as idle plant assets and land held for future use Base average operating assets on the beginning and ending cost or book values of the assets

INVESTMENT CENTERS - Responsibility Report Example – Marine Division All fixed costs are controllable by manager

JUDGMENTAL FACTORS IN ROI Valuation of operating assets May be valued at acquisition cost, book value, appraised value, or market value Margin (income) measure May be controllable margin, income from operations, or net income R O I

IMPROVING ROI ROI can be improved by Increasing controllable margin or Reducing average operating assets Assume the following data for Laser Division of Berra Manufacturing:

IMPROVING ROI Increasing Controllable Margin Increased by increasing sales or by reducing variable and controllable fixed costs Increase sales by 10% Sales increase $200,000 and contribution margin increases $90,000 ($200,000 X 45%) Thus, controllable margin increases to $690,000 ($600,000 + $90,000) New ROI is 13.8%

IMPROVING ROI Increasing Controllable Margin Decrease variable and fixed costs 10% Total costs decrease $140,000 [($1,100,000 + $300,000) X 10%] Controllable margin becomes $740,000 ($600,000 + $140,000 ) New ROI becomes 14.8%

IMPROVING ROI Reducing Average Operating Assets Reduce average operating assets by 10% or $500,000 Average operating assets become $4,500,000 ($5,000,000 X 10%) Controllable margin remains unchanged at $600,000 New ROI becomes 13.3%

PRINCIPLES OF PERFORMANCE EVALUATION Management function that compares actual results with budget goals At center of responsibility accounting Includes both behavioral and reporting principles

PRINCIPLES OF PERFORMANCE EVALUATION Behavioral Principles Human factor – critical in performance evaluation Behavioral principles: 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

PRINCIPLES OF PERFORMANCE EVALUATION Reporting Principles Reporting principles for performance reports include reports which 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 Are tailor-made for the intended evaluation Are prepared at reasonable intervals

Summary of Study Objectives Describe the concept of budgetary control. Preparing periodic budget reports to compare actual results with planned objectives Analyzing the differences to determine causes Taking appropriate corrective action Modifying future plans, if necessary Evaluate the usefulness of static budget reports Useful in evaluating the progress toward planned sales and profit goals Also appropriate in assessing manager’s effectiveness in controlling cost when Actual activity approximates budget activity level and/or Costs are fixed

Summary of Study Objectives Explain the development of flexible budgets and the usefulness of flexible budget reports. Identify the activity index and the relevant range Identify variable costs and determine the budgeted variable cost per unit Identify fixed costs and the budgeted amount for each cost Prepare budget for selected increments of activity within relevant range Flexible budget reports permit evaluation of manager’s performance

Summary of Study Objectives Describe the concept of responsibility accounting. Accumulating and reporting revenues and costs on the basis of the individual who has the authority to make the decisions Manager’s performance judged on matters directly under manager’s control Necessary to distinguish between controllable and noncontrollable fixed costs Must identify three types of responsibility centers Cost centers Profit centers Investment centers

Summary of Study Objectives Indicate the features of responsibility reports for cost centers. Compare actual costs with flexible budget data Reports show only controllable costs No distinction is made between variable and fixed costs Identify the content of responsibility reports for profit centers. For each profit center show Contribution margin Controllable fixed costs Controllable margin

Summary of Study Objectives Explain the basis and formula used in evaluating performance in investment centers. Primary basis for evaluating performance : return on investment (ROI) Formula for ROI: Controllable margin ÷ average operating assets

Let’s Review Under responsibility accounting, the evaluation of a manager’s performance is based on matters that the manager: Directly controls Directly and indirectly controls Indirectly controls Has shared responsibility for with another manager

Let’s Review Under responsibility accounting, the evaluation of a manager’s performance is based on matters that the manager: Directly controls Directly and indirectly controls Indirectly controls Has shared responsibility for with another manager

APPENDIX: RESIDUAL INCOME – ANOTHER PERFORMANCE MEASUREMENT Most companies use ROI to evaluate investment performance Significant disadvantage - ignores the minimum rate of return on operating assets Rate at which cost are covered and a profit earned

APPENDIX: RESIDUAL INCOME – ANOTHER PERFORMANCE MEASUREMENT Example – Electronics Division of Pujols Manufacturing Co. Electronics Division has the following ROI: Considering producing a new product – Tracker To produce the product, operating assets increase $2,000,000 Tracker expected to generate an additional $260,000 of controllable margin

APPENDIX: RESIDUAL INCOME – ANOTHER PERFORMANCE MEASUREMENT Example – Electronics Division Making Tracking reduces ROI from 20% to 18%: If only use ROI, would not produce Tracker However, if Electronics has a minimum rate of return of 10%, Tracker would be produced because its ROI, 13%, is greater

APPENDIX: RESIDUAL INCOME COMPARED TO ROI Use the residual income approach to evaluate performance using the minimum rate of return Residual Income: The income that remains after subtracting from controllable margin the minimum rate of return on average operating assets Residual Income

APPENDIX: RESIDUAL INCOME COMPARED TO ROI Example – Electronics Division The residual income for Tracking: With Tracker, Electronics’ residual income increases: Thus, ROI can be misleading by rejecting a project that actually increases income

APPENDIX: RESIDUAL INCOME WEAKNESS Attempting to evaluate a company only on maximizing residual income ignores the fact that one division might use substantially fewer assets to attain the same level of residual income Electronics Division used $2,000,000 of average operating assets to generate $260,000 of residual income Can a different division use fewer operating assets to generate a greater amount of residual income?

APPENDIX: RESIDUAL INCOME WEAKNESS Example – Electronics Division vs APPENDIX: RESIDUAL INCOME WEAKNESS Example – Electronics Division vs. Seadog Division Seadog used $4,000,000 to generate $460,000 of controllable margin Using the residual income approach, both investments are equal However, this ignores the fact that Seadog Required twice as many operating assets to achieve the same level of residual income

Summary of Study Objective (Appendix) Explain the difference between ROI and residual income. ROI is controllable income divided by average operating assets Residual income is the income remaining after subtracting the minimum rate of return on average operating assets ROI can provide misleading results because Profitable investments can be rejected when the investment reduces ROI but increases overall profitability

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