1. ACCOUNTING PRINCIPLES Third Canadian Edition

2. Budgetary Control and Responsibility Accounting CHAPTER 22

3. Budgetary Control Budgetary control involves: a)Developing budgets. b)Analysing the differences between actual and budgeted results. c)Taking corrective action. d)Modifying future plans, if necessary.

4. Budgetary Control A budgetary control system should: a)Identify the name of the budget report such as the sales budget or the manufacturing overhead budget. b)State the frequency of the report such as weekly, or monthly. c)Specify the purpose of the report. d)Indicate the primary recipient(s) of the report.

5. Static Budget Reports A static budget is a projection of budget data at one level of activity.A static budget is a projection of budget data at one level of activity. Data for different levels of activity are ignored.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.As a result, actual results are always compared with the budget data at the activity level used in developing the master budget.

6. Budget and Actual Sales Data To illustrate the role of a static budget in budgetary control, we will use selected data for Wei Corporation prepared in Chapter 21. Budget and actual sales data for the Kitchenmate product in the first and second quarters of 2005 are as follows: $1,000 $10,500 $11,500

7. The report shows that sales are $1,000 under budget - an unfavorable result. This difference is less that 1% of budgeted sales ($1,000/$180,000 =.0056), we will assume that top management of Wei Corporation will view the difference as immaterial and take no specific action. Illustration 22-2 Sales Budget Report: First Quarter The sales budget report for Wei Corporation’s 1st quarter is shown below. $1,000 U

8. Illustration 22-3 Sales Budget Report: Second Quarter $10,500 U The second quarter shows that sales were $10,500 below budget, which is 5% of budgeted sales ($10,500/$210,000). Top management may conclude that the difference between budgeted and actual sales in the second quarter merits investigation and will begin by asking the sales manager the cause(s).

9. Uses and Limitations A static budget is appropriate in evaluating a manager’s effectiveness in controlling costs when: a)The actual level of activity closely approximates the master budget activity level, and/or b)The behaviour of the costs in response to changes in activity is fixed.

10. Flexible Budgets A flexible budget projects budget data for various levels of activity.A flexible budget projects budget data for various levels of activity. The flexible budget recognizes that the budgetary process is more useful if it is adaptable to changed operating conditions.The flexible budget recognizes that the budgetary process is more useful if it is adaptable to changed operating conditions.

11. 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. This is because the comparison is based on budget data based on the original activity level (10,000 steel ingots). Variable budget allowances have increased with production. Illustration 22-4 Static Overhead Budget Report $ 45,000 U 52,000 U 35,000 U -0- $132,000

12. Variable Costs per Unit /10,000 units $25 /10,000 units 26 /10,000 units 19 $70 Comparing actual variable costs with budgeted costs is meaningless (due to different levels of activity), variable per unit costs must be isolated, so the budget can be adjusted. An analysis of the budget data for these costs at 10,000 units produces the above per unit results:

13. The budgeted variable costs at 12,000 units, therefore, are shown above. Because FIXED costs do not change in total as activity changes, the budgeted amounts for these costs remain the same. Budgeted Variable Costs (12,000 units) $300,000 312,000 228,000 $840,000

14. Illustration 22-5 Flexible Overhead Budget Report This budget report based on the flexible budget for 12,000 units of production shows that the Forging Department is below budget- a favourable difference. $ 5,000 F -0- 3,000 F 8,000 F -0- -0- -0- -0- $8,000 F

15. Developing the Flexible Budget To develop the flexible budget, management should take the following steps: 1)Identify the activity index and the relevant range of activity. 2)Identify the variable costs, and determine the budgeted variable cost per unit of activity for each cost. 3)Identify the fixed costs, and determine the budgeted amount for each cost. 4)Prepare the budget for selected increments of activity within the relevant range.

16. Flexible Budget – A Case Study Master Budget Data Cyr Manufacturing 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, 2005 is prepared using 120,000 direct labour hours and the following overhead costs. STEP 1: Identify the activity index and the relevant range of activity: The activity index is direct labour hours and management concludes that the relevant range is 8,000-12,000 direct labour hours.

17. Flexible Budget – A Case Study STEP 2: Identify the variable costs and determine the budgeted variable cost per unit of activity for each cost. There are 3 variable costs and the per unit variable cost is found by dividing each total budgeted cost by the direct labour hours used in preparing the master budget (120,000 hours).

18. Flexible Budget – A Case Study Step 3: Identify the fixed costs and determine the budgeted amount for each cost. There are three fixed costs and since Cyr desires monthly budget data, the budgeted amount is found by dividing each annual budgeted cost by 12 ($180,000/12 =$15,000). Step 3: Identify the fixed costs and determine the budgeted amount for each cost. There are three fixed costs and since Cyr desires monthly budget data, the budgeted amount is found by dividing each annual budgeted cost by 12 ($180,000/12 =$15,000).

19. Flexible Budget – A Case Study Illustration 22-6: Flexible Monthly Overhead Budget Step 4: Prepare the budget for selected increments of activity within the relevant range.

20. Flexible Budget – A Case Study Illustration 22-7 Formula for Total Budgeted Costs Variable Costs Total Budgeted Costs Fixed Costs + From the budget, the following formula may be used to determine total budgeted costs at any level of activity.From the budget, the following formula may be used to determine total budgeted costs at any level of activity. For Cyr Manufacturing, fixed costs are $30,000, and total variable costs per unit is $4.00.For Cyr Manufacturing, fixed costs are $30,000, and total variable costs per unit is $4.00. Thus, at 8,622 direct labour hours, total budgeted costs are:Thus, at 8,622 direct labour hours, total budgeted costs are: EXAMPLE $30,000 $4.00 x 8,622 $64,488

21. Flexible Budget Reports Flexible budget reports are another type of internal report produced by managerial accounting.Flexible budget reports are another type of internal report produced by managerial accounting. The flexible budget report consists of two sections:The flexible budget report consists of two sections: 1) Production data such as direct labour hours and 2) Cost data for variable and fixed costs. Flexible budgets are used to evaluate a manager’s performance in production control and cost control.Flexible budgets are used to evaluate a manager’s performance in production control and cost control.

22. Illustration 22-9 Flexible Overhead Budget Report $13,500 18,000 4,500 36,000 15,000 10,000 5,000 30,000 $ 66,000 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.

23. Management by Exception Management by exception means that top management's review of a budget report is focused entirely or primarily on differences between actual results and planned objectives.Management by exception means that top management's review of a budget report is focused entirely or primarily on differences between actual results and planned objectives. For management by exception to be effective, there must be guidelines for identifying an exception. The usual criteria are:For management by exception to be effective, there must be guidelines for identifying an exception. The usual criteria are: 1)Materiality- expressed as a percentage difference from budget. 2)Controllability of the item - exception guidelines are more restrictive for controllable items than for items that are not controllable by the manager.

24. The Concept of Responsibility Accounting Responsibility accounting involves accumulating and reporting costs (and revenues, where relevant) on the basis of the manager who has the authority to make the day-to-day decisions about the items.Responsibility accounting involves accumulating and reporting costs (and revenues, where relevant) on the basis of the manager who has the authority to make the day-to-day decisions about the items. A manager's performance is evaluated on the matters directly under the manager's control.A manager's performance is evaluated on the matters directly under the manager's control.

25. Responsibility Accounting Responsibility accounting can be used at every level of management in which the following conditions exist: 1) Costs and revenues can be directly associated with the specific level of management responsibility. 2)The costs and revenues are controllable at the level of responsibility with which they are associated. 3)Budget data can be developed for evaluating the manager's effectiveness in controlling the costs and revenues.

26. Responsibility Accounting Responsibility accounting is especially valuable in a decentralized company.Responsibility accounting is especially valuable in a decentralized company. Decentralization means that the control of operations is delegated to many managers throughout the organization.Decentralization means that the control of operations is delegated to many managers throughout the organization. A segment is an identified area of responsibility in decentralized operations.A segment is an identified area of responsibility in decentralized operations.

27. Responsibility Accounting versus Budgetary Control Responsibility accounting is essential to any effective system of budgetary control. It differs from budgeting in two respects: 1)A distinction is made between controllable and noncontrollable items. 2)Performance reports either emphasize or include only items controllable by the individual manager.

28. Controllable versus Noncontrollable Revenues and Costs A cost is considered controllable at a given level of managerial responsibility if the manager has the power to incur it within a given period of time.A cost is considered controllable at a given level of managerial responsibility if the manager has the power to incur it within a given period of time. Costs incurred indirectly and allocated to a responsibility level are considered to be noncontrollable at that level.Costs incurred indirectly and allocated to a responsibility level are considered to be noncontrollable at that level.

29. Responsibility Reporting System A responsibility reporting system involves the preparation of a report for each level of responsibility in the company's organization chart.A responsibility reporting system involves the preparation of a report for each level of responsibility in the company's organization chart. A responsibility reporting system permits management by exception at each level of responsibility.A responsibility reporting system permits management by exception at each level of responsibility.

30. Types of Responsibility Centres Responsibility centres may be classified into one of (3) types. 1) A cost centre incurs costs (and expenses) but does not directly generate revenues. 2) A profit centre incurs costs (and expenses) and also generates revenues. 3) An investment centre incurs costs (and expenses), generates revenues, and has control over investment funds available for use.

31. Illustration 22-13 Responsibility Accounting for Cost Centres The evaluation of a manager’s performance for cost centres is based on his or her ability to meet budgeted goals for controllable costs. Responsibility reports for cost centres compare actual controllable costs with flexible budget data. Assume that the Finishing Department manager is able to control the following costs (from Illustration 22-9) only. $ 500 U 1,000 F 100 U Supervision 4,000 4,000 -0- $400 F Top management may want an explanation of these variance.

32. Responsibility Report A responsibility report for a profit centre shows budgeted and actual controllable revenues and costs.A responsibility report for a profit centre shows budgeted and actual controllable revenues and costs. The report is prepared using the cost-volume-profit income statement format. In the report:The report is prepared using the cost-volume-profit income statement format. In the report: 1)Controllable fixed costs are deducted from contribution margin. 2)The excess of contribution margin over controllable fixed costs is identified as controllable margin. –Controllable margin is considered to be the best measure of the manager’s performance in controlling revenues and costs. 3)Noncontrollable fixed costs are not reported.

33. Illustration 22-14 Responsibility Report for a Profit Centre Controllable fixed costs Controllable margin $360,000 $324,000 $36,000 U Note that this report does not show noncontrollable fixed costs. This manager was below budgeted expectations by approximately 10% ($36,000/ $360,000).

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

35. Illustration 22-15 ROI Formula Investment centre Controllable Margin (in dollars) / Average Investment centre Operating Assets Return on Investment (ROI) The formula for computing ROI for an investment centre, together with assumed illustrative data is shown below.The formula for computing ROI for an investment centre, together with assumed illustrative data is shown below. Operating assets consist of current assets and plant assets used in operations by the centre. Nonoperating assets such as idle plant assets and land held for future use are excluded.Operating assets consist of current assets and plant assets used in operations by the centre. Nonoperating assets such as idle plant assets and land held for future use are excluded. Average operating assets are usually based on the beginning and ending cost or book values of the assets.Average operating assets are usually based on the beginning and ending cost or book values of the assets. $1,000,000 / $5,000,000 = 20% $1,000,000 / $5,000,000 = 20%

36. Illustration 22-16 Responsibility Report for Investment Centre Other fixed costs 60,000 60,000 -0- Controllable margin $300,000 $264,000 $36,000 U Since an investment centre is an independent entity for operating purposes, all fixed costs are controllable by the investment centre manager. Assume in this example that the manager can control $60,000 of fixed costs that were not controllable when the division was a profit centre.

37. Responsibility Report for Investment Centre Assuming actual average operating assets are $2,000,000 actual and budgeted ROI is calculated as follows: Return on Investment 15% 13.2% 1.8% Top management would likely want an explanation of the reasons for actual ROI being 12% below budgeted ROI (1.8% / 15%).

38. Assumed Data for Marine Division A manager can improve ROI by: (a)Increasing controllable margin or (b)Reducing average operating assets. Assume the following data for the Marine Division of Mantle Manufacturing:

39. If sales increased by 10%, or $200,000 ($2,000,000 x.10) and there was no change in the contribution margin percentage of 45%, contribution margin will increase $90,000 ($200,000 x.45). Controllable margin will increase by the same amount because controllable fixed costs will not change. Thus, controllable margin becomes $690,000 ($600,000 +$90,000). The new ROI is 13.8%, calculated as follows: ROI Calculation – Increase in Sales 13.8% $690,000 / $5,000,000 = New controllable margin / Average operating assets

40. ROI Calculation – Decrease in Costs 14.8% $740,000 / $5,000,000 = Controllable margin can also be increased by reducing variable and controllable fixed costs. If variable and fixed costs were decreased by 10%, total costs will decrease $140,000[($1,000,000 + $300,000) x.10]. This reduction will result in a corresponding increase in controllable margin. Thus, this margin becomes $740,000 ($600,000 + $140,000), and the new ROI is 14.8%, calculated as follows: New Controllable margin / Average operating assets

41. ROI Calculation – Decrease in Operating Assets 13.3% A manager can also improve ROI by reducing average operating assets. Assume that average operating assets are reduced 10% or $500,000 ($5,000,000 x.10). Average operating assets become $4,500,000 ($5,000,000 - $500,000), Since controllable margin remains unchanged at $600,000, the new ROI is 13.3%, calculated as follows: $600,000 / $4,500,000 = Controllable margin / New average operating assets

42. Principles of Performance Evaluation Performance evaluation is a management function that compares actual results with budget goals.Performance evaluation is a management function that compares actual results with budget goals. Performance evaluation includes both behavioural and reporting principles.Performance evaluation includes both behavioural and reporting principles.

43. Behavioural Principles Behavioural principles should include: 1) Managers of responsibility centres should have direct input into the process of establishing budget goals for their area of responsibility. 2) The evaluation of performance should be based entirely on matters that are controllable by the manager being evaluated. 3) Top management should support the evaluation process. 4) The evaluation process must allow managers to respond to their evaluations. 5) The evaluation should identify both good and poor performance.

44. Reporting Principles of Performance Evaluation Performance reports should: 1)Contain only data that are controllable by the manager of the responsibility centre. 2)Provide accurate and reliable budget data to measure performance. 3)Highlight significant differences between actual results and budget goals. 4)Be tailor-made for the intended evaluation. 5)Be prepared at reasonable intervals.

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