budgetary control and responsibility accounting chapter 10

Budgetary Control and Responsibility Accounting

Chapter10

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

BUDGETARY CONTROL

Schedule below illustrates a partial budgetary control system for a manufacturing company.

Note the frequency of reports and their emphasis on control

Static Budgets and Performance Reports

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.

Hmm! Comparingstatic budgets withactual costs is likecomparing apples

and oranges.

Let’s look at CheeseCo.

Static ActualBudget 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 12,000 Insurance 2,000 2,050

Total overhead costs 89,000$ 77,350$

Static Budgets and Performance Reports

CheeseCo

Static ActualBudget 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 F Power 5,000 3,800 1,200 F

Fixed costs Depreciation 12,000 12,000 0 Insurance 2,000 2,050 50 U

Total overhead costs 89,000$ 77,350$ $11,650 F

Static Budgets and Performance Reports

U = Unfavorable variance CheeseCo was unable to achieve

the budgeted level of activity.

CheeseCo

Static ActualBudget 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 F Power 5,000 3,800 1,200 F

Fixed costs Depreciation 12,000 12,000 0 Insurance 2,000 2,050 50 U

Total overhead costs 89,000$ 77,350$ $11,650 F

Static Budgets and Performance Reports

F = Favorable variance that occurs when actual costs are less than budgeted costs.

CheeseCo

Static ActualBudget 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 F Power 5,000 3,800 1,200 F

Fixed costs Depreciation 12,000 12,000 0 Insurance 2,000 2,050 50 U

Total overhead costs 89,000$ 77,350$ $11,650 F

Static Budgets and Performance Reports

Since cost variances are favorable, havewe done a good job controlling costs?

CheeseCo

Static Budgets and Performance Reports

I don’t think Ican answer thequestion usinga static budget.

Actual activity is belowbudgeted activity which

is unfavorable.

So, shouldn’t variable costsbe lower if actual activity

is lower?

Static Budgets and Performance Reports

The relevant question is . . .

“How much of the favorable cost variance isdue to lower activity, and how much is due to good cost control?”

To answer the question,we mustthe budget to theactual level of activity.

Flexible Budgets

Improve performance evaluation.

May be prepared for any activity level in the relevant range.

Show revenues and expensesthat should have occurred at theactual level of activity.

Reveal variances due to good costcontrol or lack of cost control.

Flexible Budgets

Central Concept

If you can tell me what your activity wasfor the period, I will tell you what your costs

and revenue should have been.

Management by ExceptionManagement 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 itemscontrollable by the manager

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 remainunchanged within therelevant range. Fixed

Variable

Preparing a Flexible Budget

Let’s prepare budgets for CheeseCo.

Cost Total Flexible BudgetsFormula Fixed 8,000 10,000 12,000Per Hour Cost Hours Hours Hours

Machine hours 8,000 10,000 12,000

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 12,000$ Insurance 2,000 Total fixed costTotal overhead costs

Preparing a Flexible Budget

Fixed costs areexpressed as atotal amount.

Variable costs are expressed as a constant amount per hour.

$40,000 ÷ 10,000 hours is$4.00 per hour.

CheeseCo

Cost Total Flexible BudgetsFormula Fixed 8,000 10,000 12,000Per Hour Cost Hours Hours Hours

Machine hours 8,000 10,000 12,000

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 12,000$ Insurance 2,000 Total fixed costTotal overhead costs

Preparing a Flexible Budget

$4.00 per hour × 8,000 hours = $32,000

CheeseCo

Preparing a Flexible Budget

Cost Total Flexible BudgetsFormula Fixed 8,000 10,000 12,000Per Hour Cost Hours Hours Hours

Machine hours 8,000 10,000 12,000

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 12,000$ 12,000$ 12,000$ 12,000$ Insurance 2,000 2,000 2,000 2,000 Total fixed cost 14,000$ 14,000$ 14,000$ Total overhead costs 74,000$ 89,000$ 104,000$

CheeseCo

Preparing a Flexible Budget

Cost Total Flexible BudgetsFormula Fixed 8,000 10,000 12,000Per Hour Cost Hours Hours Hours

Machine hours 8,000 10,000 12,000

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 12,000$ 12,000$ 12,000$ 12,000$ Insurance 2,000 2,000 2,000 2,000 Total fixed cost 14,000$ 14,000$ 14,000$ Total overhead costs 74,000$ 89,000$ 104,000$

Total fixed costsdo not change in

the relevant range.

CheeseCo

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

Flexible Budget Performance ReportsFlexible 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

Cost TotalFormula Fixed Flexible ActualPer Hour Costs Budget Results Variances

Machine hours 8,000 8,000 0

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$

Flexible BudgetPerformance Report

Flexible budget is prepared for the

same activity level (8,000 hours) as

actually achieved.

CheeseCo

Cost TotalFormula Fixed Flexible ActualPer Hour Costs Budget Results Variances

Machine hours 8,000 8,000 0

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 FTotal variable costs 7.50$ 60,000$ 63,300$ $ 3,300 UFixed Expenses Depreciation 12,000$ 12,000$ 12,000$ 0 Insurance 2,000 2,000 2,050 50 UTotal fixed costs 14,000$ 14,050$ 50 UTotal overhead costs 74,000$ 77,350$ $ 3,350 U

Flexible BudgetPerformance Report

CheeseCo

Remember the question: “How much of the total variance is due to activityand how much is due tocost control?”

Flexible BudgetPerformance Report

Static ActualBudget 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 F Power 5,000 3,800 1,200 F

Fixed costs Depreciation 12,000 12,000 0 Insurance 2,000 2,050 50 U

Total overhead costs 89,000$ 77,350$ $11,650 F

Static Budgets and Performance How much of the $11,650 is due to activity

and how much is due to cost control?

Flexible BudgetPerformance Report

Difference between original static budgetand actual overhead = $11,650 F.

Overhead Variance Analysis

Static ActualOverhead OverheadBudget at at

10,000 Hours 8,000 Hours

89,000$ 77,350$

Let’s place the flexible budget for

8,000 hours here.

Flexible BudgetPerformance Report

This $15,000F variance is due to lower activity.

Overhead Variance Analysis

Activity

This $3,350U flexiblebudget variance is dueto poor cost control.

Cost control

Static Flexible ActualOverhead Overhead OverheadBudget at Budget at at

10,000 Hours 8,000 Hours 8,000 Hours

89,000$ 74,000$ 77,350$

Flexible BudgetPerformance Report

What causesthe cost

control variance?

There are two primaryreasons for unfavorablevariable overhead variances:

1. Spending too much for resources.

2. Using the resources inefficiently.

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

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

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.

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.

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

THE CONCEPT OF RESPONSIBILITY ACCOUNTING

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

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

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 CENTERSExample – 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

PROFIT CENTERSResponsibility 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 REPORTSExample – Marine Division

$60,000 of indirect fixed costs are not controllable by manager not shown

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

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

All fixed costs are controllable by the manager

INVESTMENT CENTER - RESPONSIBILITY REPORTExample – Marine Division

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

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:

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 ROIIncreasing 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 ROIIncreasing Controllable Margin

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 $600,000New ROI becomes 13.3%

IMPROVING ROI Reducing Average Operating Assets

YES!!!