Chapter 22: Budgetary Control and Responsibility Accounting

Four Steps in Developing the flexible budget

1. Identify the activity index and the relevant range of activity. 2. Identify 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.

Types of Responsibility Centers

3 Basic Types -Cost -Profit -Investment

• Valuation of operating assets

o Acquisition cost, book value, appraised value, or fair value. o Each provides a reliable basis for evaluating performance.

• Margin (income) measure.

o Controllable margin, income from operations, or net income. o Only controllable margin is a valid basis for evaluating performance of investment center manager.

• Indirect Fixed Costs

o Pertain to a company's overall operating activities. o Incurred for the benefit of more than one profit center. o Called common costs since they apply to more than one center. o Most are not controllable by the profit center manager.

• Direct Fixed Costs

o Relate specifically to one responsibility center. o Incurred for the sole benefit of the center. o Called traceable costs since they can be traced directly to one center. o Most direct fixed costs are controllable by the profit center manager.

Learning Objective 3: Apply responsibility accounting to cost and profit centers

• 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. • Conditions: o Costs and revenues can be directly associated with the specific level of management responsibility. o Costs and revenues can be controlled by employees at the level of responsibility with which they are associated. o Budget data can be developed for evaluating the manager's effectiveness in controlling the costs and revenues.

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. o Include only controllable costs in reports. o No distinction between variable and fixed costs.

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 incurred by the center because they vary with sales.

Responsibility Report

• Budgeted and actual controllable revenues and costs. • Uses cost-volume-profit income statement format: o Deduct controllable fixed costs from the contribution margin. o Controllable margin - excess of contribution margin over controllable fixed costs. o Noncontrollable fixed costs are not reported. • Scope of manager's responsibility affects content. • Investment center is an independent entity for operating purposes. • All fixed costs are controllable by center manager. • Shows budgeted and actual ROI below controllable margin.

Reporting Principles

• Contain only data controllable by manager of responsibility center. • Provide accurate and reliable budget data to measure performance. • Highlight significant differences between actual results and budget goals • Be tailor-made for intended evaluation. • Be prepared at reasonable intervals.

Controllable Vs. Noncontrollable Revenues and Costs

• Critical issue is whether the cost or revenue is controllable at the level of responsibility with which it is associated. A cost over which a manager has control is called a controllable cost. o All costs are controllable by top management. o Fewer costs are controllable as one moves down to each lower level of managerial responsibility. • Costs incurred indirectly and allocated to a responsibility level are noncontrollable costs.

Developing the flexible budget

• Identify the activity index and the relevant range of activity. • Identify the variable costs and determine the budgeted variable cost per unit of activity for each cost. • Identify the fixed costs and determine the budgeted amount for each cost. • Prepare the budget for selected increments of activity within the relevant range.

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. • Each higher level can obtain the detailed report for each lower level.

Principles of Performance Evaluations

• Management function that compares actual results with budget goals. • Includes both behavioral and reporting principles.

o Profit center

Incurs costs and generates revenues. Managers judged on profitability of center. Examples include individual departments of a retail store or branch bank offices

o Cost center

Incurs costs but does not directly generate revenues. Managers have authority to incur costs. Managers evaluated on ability to control costs. Usually a production department or a service department.

o Investment center

Incurs costs, generates revenues, and has investment funds available for use. Manager evaluated on profitability of the center and rate of return earned on funds. Often a subsidiary company or a product line. Manager able to control or significantly influence investment decisions such as plant expansion.

Behavioral Principles

• Managers of responsibility centers should have direct input into the process of establishing budget goals of 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.

Why Flexible Budget?

• Over budget in three of six overhead costs. o Unfavorable difference of $132,000 - 12% over budget. • Comparison based on budget data for 10,000 units - the original activity level which is not relevant. o Meaningless to compare actual variable costs for 12,000 units with budgeted variable costs for 10,000 units. o Variable cost increase with production. • Note: Budgeted variable amounts should increase proportionately with production

Responsibility Reporting

• Permits comparative evaluations. • Plant manager can rank each department manager's effectiveness in controlling manufacturing costs. • Comparative rankings provide incentive for a manager to control costs.

Flexible budget

• Projects budget data for various levels of activity o Essentially a series of static budgets at different activity levels. o Budgetary process more useful if it is adaptable to changes in operating conditions. o Can be prepared for each type of budget in the master budget. • Total Budget Cost = Fixed Costs + Variable Costs

Responsibility Accounting

• Responsibility center o any individual who has control and is accountable for activities. • May extend to any level of management. • Especially valuable in a decentralized company. o Control of operations delegated to many managers throughout the organization. o Segment - area of responsibility for which reports are prepared. • Two differences from budgeting in reporting costs and revenues: o Distinguishes between controllable and noncontrollable costs. o Emphasizes or includes only items controllable by the individual manager in performance reports. • Applies to both profit and not-for-profit entities. o Profit entities: maximize net income. o Not-for-profit: minimize cost of providing services.

ROI

• Return on investment is the primary basis for evaluating the performance of a manager of an investment center o Shows the effectiveness of the manager in using the assets at his/her disposal o Factors in ROI formula are controllable by manager • ROI = Controllable Margin / Average Operating Assets o Operating assets include current assets and plant assets used in operations by the center and controlled by the manager. o Base average operating assets on the beginning and ending cost or book values of the assets.

Budgetary Control

• The use of budgets in controlling operations o Takes place by means of budget reports which compare actual results with planned objectives. o Provides management with feedback on operations. o Budget reports can be prepared as frequently as needed. o Management analyzes differences between actual and planned results and determines causes. • Involves the following activities o Develop budgeting o Analyze differences between actual and budget o Take corrective action o Modify future plans • Works best when a company has a formalized reporting system which: o Identifies the name of the budget report. o States the frequency of the report. o Specifies the purpose of the report. o Indicates the primary recipient(s) of the report

Flexible Budget Reports

• Widely used in production and service departments. • A type of internal report. • Consists of two sections: o Production data for a selected activity index, such as direct labor hours. o Cost data for variable and fixed costs. • Widely used in production and service departments to evaluate a manager's performance.

Static Budget Reports

• is a projection of budget data at one level of activity. o When used in budgetary control, each budget included in the master budget is considered to be static. o Ignores data for different levels of activity. o Compares actual results with budget data at the activity level used in the master budget. • Uses and Limitations o Appropriate for evaluating a manager's effectiveness in controlling costs when: Actual level of activity closely approximates master budget activity level, and/or Behavior of costs is fixed in response to changes in activity. o Appropriate for fixed costs. o Not appropriate for variable costs. • Is useful in controlling costs when behavior is fixed

Management by Exception

• means that top management's review of a budget report is focused primarily on differences between actual results and planned objectives. • MATERIALITY o Without quantitative guidelines, management would have to investigate every budget difference regardless of the amount. • CONTROLLABILITY OF THE ITEM o Exception guidelines are more restrictive for controllable items than for items the manager cannot control.