1. Budgetary Control and Responsibility Accounting
Chapter10
Budgetary Control and Responsibility Accounting

2. BUDGETARY CONTROL
A major function of management is to control operations
One element is the use of budget reports which compare actual results with planned objectives
Provides management with feedback on operations

3. BUDGETARY CONTROL
Schedule below illustrates a partial budgetary control system for a manufacturing company.
Note the frequency of reports and their emphasis on control

4. Static Budgets and Performance Reports
Hmm! Comparing static budgets with actual costs is like comparing apples and oranges.
Static budgets are prepared for a single, planned level of activity.
Performance evaluation is difficult when actual activity differs from the planned level of activity.
Let’s look at CheeseCo.

5. Static Budgets and Performance Reports
CheeseCo
Static
Actual
Budget
Results
Variances
Machine hours
10,000
8,000
Variable costs
Ind
irect labor
40,000 $
34,000
Indirect materials
30,000
25,500
Power
5,000
3,800
Fixed costs
Depreciation
12,000
Insurance
2,000
2,050
Total overhead costs
89,000
77,350

6. Static Budgets and Performance Reports
CheeseCo
Static
Actual
Budget
Results
Variances
Machine hours
10,000
8,000
2,000 U
Variable costs
Ind
irect labor
40,000 $
34,000
$6,000 F
Indirect materials
30,000
25,500
4,500
Power
5,000
3,800
1,200
Fixed costs
Depreciation
12,000
Insurance
2,050 50
Total overhead costs
89,000
77,350
$11,650
U = Unfavorable variance CheeseCo was unable to achieve the budgeted level of activity.

7. Static Budgets and Performance Reports
CheeseCo
Static
Actual
Budget
Results
Variances
Machine hours
10,000
8,000
2,000 U
Variable costs
Ind
irect labor
40,000 $
34,000
$6,000 F
Indirect materials
30,000
25,500
4,500
Power
5,000
3,800
1,200
Fixed costs
Depreciation
12,000
Insurance
2,050 50
Total overhead costs
89,000
77,350
$11,650
F = Favorable variance that occurs when actual costs are less than budgeted costs.

8. Static Budgets and Performance Reports
CheeseCo
Static
Actual
Budget
Results
Variances
Machine hours
10,000
8,000
2,000 U
Variable costs
Ind
irect labor
40,000 $
34,000
$6,000 F
Indirect materials
30,000
25,500
4,500
Power
5,000
3,800
1,200
Fixed costs
Depreciation
12,000
Insurance
2,050 50
Total overhead costs
89,000
77,350
$11,650
Since cost variances are favorable, have we done a good job controlling costs?

9. Static Budgets and Performance Reports
Actual activity is below budgeted activity which is unfavorable.
So, shouldn’t variable costs be lower if actual activity is lower?
I don’t think I can answer the question using a static budget.

10. Static Budgets and Performance Reports
The relevant question is . . .
“How much of the favorable cost variance is due to lower activity, and how much is due to good cost control?”
To answer the question, we must the budget to the actual level of activity.

11. Flexible Budgets
Show revenues and expenses that should have occurred at the actual level of activity.
May be prepared for any activity level in the relevant range.
Reveal variances due to good cost
control or lack of cost control.
Improve performance evaluation.

12. Flexible Budgets
Central Concept If you can tell me what your activity was for the period, I will tell you what your costs and revenue should have been.

13. Management by Exception
Focus of top management’s review of a budget report:
differences between actual and planned results
Able to focus on problem areas
Investigate only material and controllable exceptions
Express materiality as a
percentage difference from budget - either over or under budget
Controllability relates to those items
controllable by the manager
1. On the topic, “Challenges Facing Financial Accounting,” what did the AICPA Special Committee on Financial Reporting suggest should be included in future financial statements?
Non-financial Measurements (customer satisfaction indexes, backlog information, and reject rates on goods purchases).
Forward-looking Information
Soft Assets (a company’s know-how, market dominance, marketing setup, well-trained employees, and brand image).
Timeliness (no real time financial information)

14. Preparing a Flexible Budget
To a budget we need to know that:
Total variable costs change in direct proportion to changes in activity.
Total fixed costs remain unchanged within the relevant range.
Variable
Fixed

15. Preparing a Flexible Budget
Let’s prepare budgets for CheeseCo.

16. Preparing a Flexible Budget
CheeseCo
Cost
Total
Flexible Budgets
Formula
Fixed
8,000
10,000
12,000
Per Hour
Cost
Hours
Hours
Hours
Machine hours
8,000
10,000
12,000
Variable costs are expressed as a constant amount per hour.
$40,000 ÷ 10,000 hours is $4.00 per hour.
Variable costs
Indirect labor
4.00 $
32,000
Indirect material
3.00
24,000
Power
0.50
4,000
Total variable cost $
7.50 $
60,000
Fixed costs
Fixed costs are expressed as a total amount.
Depreciation $
12,000
Insurance
2,000
Total fixed cost
Total overhead costs

17. Preparing a Flexible Budget
CheeseCo
Cost
Total
Flexible Budgets
Formula
Fixed
8,000
10,000
12,000
Per Hour
Hours
Machine hours
Variable costs
Indirect labor
4.00
32,000 $
Indirect material
3.00
24,000
Power
0.50
4,000
Total variable cost
7.50
60,000
Fixed costs
Depreciation
Insurance
2,000
Total fixed cost
Total overhead costs
$4.00 per hour × 8,000 hours = $32,000

18. Preparing a Flexible Budget
CheeseCo
Cost
Total
Flexible Budgets
Formula
Fixed
8,000
10,000
12,000
Per Hour
Hours
Machine hours
Variable costs
Indirect labor
4.00
32,000 $
40,000
48,000
Indirect material
3.00
24,000
30,000
36,000
Power
0.50
4,000
5,000
6,000
Total variable cost
7.50
60,000
75,000
90,000
Fixed costs
Depreciation
Insurance
2,000
Total fixed cost
14,000
Total overhead costs
74,000
89,000
104,000

19. Preparing a Flexible Budget
CheeseCo
Cost
Total
Flexible Budgets
Formula
Fixed
8,000
10,000
12,000
Per Hour
Hours
Machine hours
Variable costs
Indirect labor
4.00
32,000 $
40,000
48,000
Indirect material
3.00
24,000
30,000
36,000
Power
0.50
4,000
5,000
6,000
Total variable cost
7.50
60,000
75,000
90,000
Fixed costs
Depreciation
Insurance
2,000
Total fixed cost
14,000
Total overhead costs
74,000
89,000
104,000
Total fixed costs do not change in the relevant range.

20. Trepid Manufacturing Company prepared a static budget of 40,000 direct labor hours, with estimated overhead costs of $200,000 for variable overhead and $60,000 for fixed overhead. Trepid then prepared a flexible budget at 38,000 labor hours. How much is total overhead costs at this level of activity? a
$247,000 b
$250,000 c
$260,000 d
$190,000

21. Flexible Budget Performance Reports
Monthly comparisons of actual and budgeted manufacturing overhead costs
A type of internal report
Consists of two sections:
Production data for a selected activity index, such as direct labor hours
Cost data for variable and fixed costs
Widely used in production and service departments to evaluate a manager’s performance in production control and cost control
1. On the topic, “Challenges Facing Financial Accounting,” what did the AICPA Special Committee on Financial Reporting suggest should be included in future financial statements?
Non-financial Measurements (customer satisfaction indexes, backlog information, and reject rates on goods purchases).
Forward-looking Information
Soft Assets (a company’s know-how, market dominance, marketing setup, well-trained employees, and brand image).
Timeliness (no real time financial information)

22. Flexible Budget Performance Report
CheeseCo
Flexible budget is prepared for the same activity level (8,000 hours) as actually achieved.
Cost
Total
Formula
Fixed
Flexible
Actual
Per Hour
Costs
Budget
Results
Variances
Machine hours
8,000
8,000
Variable costs
Indirect labor $
4.00 $
32,000 $
34,000
Indirect material
3.00
24,000
25,500
Power
0.50
4,000
3,800
Total variable costs $
7.50 $
60,000 $
63,300
Fixed Expenses
Depreciation $
12,000 $
12,000 $
12,000
Insurance
2,000
2,000
2,050
Total fixed costs $
14,000 $
14,050
Total overhead costs $
74,000 $
77,350

23. Flexible Budget Performance Report
CheeseCo
Cost
Total
Formula
Fixed
Flexible
Actual
Per Hour
Costs
Budget
Results
Variances
Machine hours
8,000
Variable costs
Indirect labor
4.00 $
32,000
34,000
$ 2,000 U
Indirect material
3.00
24,000
25,500
1,500 U
Power
0.50
4,000
3,800
200 F
Total variable costs
7.50
60,000
63,300
$ 3,300 U
Fixed Expenses
Depreciation
12,000
Insurance
2,000
2,050
50 U
Total fixed costs
14,000
14,050
Total overhead costs
74,000
77,350
$ 3,350 U

24. Flexible Budget Performance Report
Remember the question: “How much of the total variance is due to activity and how much is due to cost control?”

25. Static Budgets and Performance
How much of the $11,650 is due to activity and how much is due to cost control?
Static
Actual
Budget
Results
Variances
Machine hours
10,000
8,000
2,000 U
Variable costs
Indirect labor
40,000 $
34,000
$6,000 F
Indirect materials
30,000
25,500
4,500
Power
5,000
3,800
1,200
Fixed costs
Depreciation
12,000
Insurance
2,050 50
Total overhead costs
89,000
77,350
$11,650

26. Flexible Budget Performance Report
Overhead Variance Analysis
Let’s place the flexible budget for 8,000 hours here.
Difference between original static budget and actual overhead = $11,650 F.

27. Flexible Budget Performance Report
Overhead Variance Analysis
Activity
Cost control
This $15,000F variance is due to lower activity.
This $3,350U flexible budget variance is due to poor cost control.

28. Flexible Budget Performance Report
There are two primary reasons for unfavorable variable overhead variances:
1. Spending too much for resources.
2. Using the resources inefficiently.
What causes the cost control variance?

29. THE CONCEPT OF RESPONSIBILITY ACCOUNTING
Involves accumulating and reporting costs on the basis of the manager who has the authority to make the day-to-day decisions about the items
Means a manager's performance is evaluated on the matters directly under the manager's control

30. CONTROLLABLE vs. NONCONTROLLABLE REVENUES AND COSTS
All costs can be controlled at some level within the company.
Fewer costs controllable as one moves down to lower levels of management
Critical issue:
Whether the cost or revenue is controllable at the level of responsibility with which it is associated

31. THE CONCEPT OF RESPONSIBILITY ACCOUNTING
Conditions for using responsibility accounting:
Costs and revenues can be directly associated with the specific level of management responsibility.
The costs and revenues are controllable by those responsible.
Budget data can be developed to evaluate the manager's effectiveness in controlling costs and revenues.

32. THE CONCEPT OF RESPONSIBILITY ACCOUNTING
Responsibility center - any individual who has control and is accountable.
May extend from the lowest levels of management to the top strata of management.
Responsibility accounting is especially valuable in a decentralized company
where control of operations is delegated to many managers throughout the organization.

33. THE CONCEPT OF RESPONSIBILITY ACCOUNTING
Two differences from budgeting in reporting costs and revenues:
Distinguishes between controllable and noncontrollable costs
Performance reports emphasize or include only items controllable by the individual manager.
Applies to both profit and not-for-profit entities
Profit entities: maximize net income
Not-for-profit: minimize cost of providing services

34. 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

35. 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

36. RESPONSIBILITY REPORTING SYSTEM

37. 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

38. TYPES OF RESPONSIBILITY CENTERS

39. 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

40. 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

41. 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

42. 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

43. 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

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

45. 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

46. 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

47. INVESTMENT CENTER - RESPONSIBILITY REPORT Example – Marine Division
All fixed costs are controllable by the manager

48. 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

49. 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:

50. 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%

51. 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%

52. 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%

53. YES!!!