budgetary control and responsibility accounting chapter 10
TRANSCRIPT
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!!!