ACCOUNTINGACCOUNTING PRINCIPLESPRINCIPLES

Third Canadian EditionThird Canadian Edition

Budgetary Control and Budgetary Control and Responsibility AccountingResponsibility Accounting

CHAPTER 22CHAPTER 22

Budgetary ControlBudgetary 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.

Budgetary ControlBudgetary Control A A budgetary controlbudgetary control system should: system should: a)a) Identify the name of the budget report such as Identify the name of the budget report such as

the sales budget or the manufacturing the sales budget or the manufacturing overhead budget.overhead budget.

b)State the frequency of the report such b)State the frequency of the report such as weekly, or monthly. as weekly, or monthly.

c)c) Specify the purpose of the report.Specify the purpose of the report.d)Indicate the primary recipient(s) of the d)Indicate the primary recipient(s) of the

report.report.

Static Budget ReportsStatic Budget Reports

• A A static budgetstatic budget is a projection of budget is a projection of budget data at one level of activity. data at one level of activity.

• Data for different levels of activity are Data for different levels of activity are ignored.ignored.

• As a result, actual results are always As a result, actual results are always compared with the budget data at the compared with the budget data at the activity level used in developing the master activity level used in developing the master budget.budget.

Budget and Actual Sales DataBudget and Actual Sales Data

To illustrate the role of a static budget in budgetarycontrol, 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

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 22-2Illustration 22-2Sales Budget Report: First QuarterSales Budget Report: First Quarter

The sales budget report for Wei Corporation’s 1st quarter is shown below.

$1,000 U

Illustration 22-3Illustration 22-3Sales Budget Report: Second QuarterSales 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).

Uses and LimitationsUses 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/orb)The behaviour of the costs in response to changes in activity is fixed.

Flexible BudgetsFlexible Budgets

• A A flexible budgetflexible budget projects budget data for projects budget data for various levels of activity. various levels of activity.

• The flexible budget recognizes that the The flexible budget recognizes that the budgetary process is more useful if it is budgetary process is more useful if it is adaptable to changed operating conditions.adaptable to changed operating conditions.

If demand for steelingots has increasedand 12,000 units areproduced during theyear, rather than 10,000, the budgetreport will show very large variances.This is because thecomparison is basedon budget data basedon the original activity level (10,000 steel ingots). Variablebudget allowanceshave increased withproduction.

Illustration 22-4Illustration 22-4Static Overhead Budget ReportStatic Overhead Budget Report

$ 45,000 U 52,000 U

35,000 U -0- -0- -0- $132,000

Variable Costs per UnitVariable Costs per Unit

/10,000 units $25/10,000 units 26/10,000 units 19 $70

Comparing actual variable costs with budgeted costsis 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 forthese costs at 10,000 units produces the above per unit results:

The budgeted variable costs at 12,000units, therefore, are shown above. Because FIXED costs do not change intotal as activity changes, the budgetedamounts for these costs remain the same.

Budgeted Variable CostsBudgeted Variable Costs (12,000 units) (12,000 units)

$300,000 312,000 228,000$840,000

Illustration 22-5Illustration 22-5Flexible Overhead Budget ReportFlexible Overhead Budget Report

This budgetreport basedon the flexiblebudget for 12,000 unitsof productionshows thatthe Forging Departmentis below budget-a favourabledifference.

$ 5,000 F -0-

3,000 F 8,000 F

-0- -0- -0- -0-

$8,000 F

Developing the Flexible BudgetDeveloping 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.

Flexible Budget – A Case StudyFlexible Budget – A Case StudyMaster Budget DataMaster Budget Data

Cyr Manufacturing wants to use a flexible budget for monthlycomparisons 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.

Flexible Budget – A Case StudyFlexible 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).

Flexible Budget – A Case StudyFlexible 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).

Flexible Budget – A Case StudyFlexible Budget – A Case StudyIllustration 22-6: Flexible Monthly Overhead BudgetIllustration 22-6: Flexible Monthly Overhead Budget

Step 4: Prepare the budget for selected increments of activity within the relevant range.

Flexible Budget – A Case StudyFlexible Budget – A Case StudyIllustration 22-7 Formula for Total Budgeted CostsIllustration 22-7 Formula for Total Budgeted Costs

VariableCosts

TotalBudgeted

Costs

FixedCosts +

• From the budget, the following formula may be From the budget, the following formula may be used to determine total budgeted costs at any used to determine total budgeted costs at any level of activity.level of activity.

• For Cyr Manufacturing, fixed costs are $30,000, For Cyr Manufacturing, fixed costs are $30,000, and total variable costs per unit is $4.00. and total variable costs per unit is $4.00.

• Thus, at 8,622 direct labour hours, total Thus, at 8,622 direct labour hours, total budgeted costs are:budgeted costs are:EXAMPLE

$30,000 $4.00 x 8,622 $64,488

Flexible Budget ReportsFlexible Budget Reports

• Flexible budget reportsFlexible budget reports are another type of are another type of internal report produced by managerial internal report produced by managerial accounting. accounting.

• The flexible budget report consists of two The flexible budget report consists of two sections: sections:

1) Production data such as direct labour hours and 1) Production data such as direct labour hours and 2) Cost data for variable and fixed costs. 2) Cost data for variable and fixed costs. • Flexible budgetsFlexible budgets are used to evaluate a are used to evaluate a

manager’s performance in production control manager’s performance in production control and cost control.and cost control.

Illustration 22-9Illustration 22-9Flexible Overhead Budget ReportFlexible 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.

Management by ExceptionManagement by Exception

• Management by exceptionManagement by exception means that top means that top management's review of a budget report is management's review of a budget report is focused entirely or primarily on differences focused entirely or primarily on differences between actual results and planned objectives. between actual results and planned objectives.

• For management by exception to be effective, For management by exception to be effective, there must be guidelines for identifying an there must be guidelines for identifying an exception. The usual criteria are:exception. The usual criteria are:

1)1) MaterialityMateriality- expressed as a percentage difference - expressed as a percentage difference from budget.from budget.

2)2) Controllability of the itemControllability of the item - exception guidelines - exception guidelines are more restrictive for controllable items than for are more restrictive for controllable items than for items that are not controllable by the manager.items that are not controllable by the manager.

The Concept of Responsibility The Concept of Responsibility AccountingAccounting

• Responsibility accountingResponsibility accounting involves involves accumulating and reporting costs (and accumulating and reporting costs (and revenues, where relevant) on the basis of revenues, where relevant) on the basis of the manager who has the authority to the manager who has the authority to make the day-to-day decisions about the make the day-to-day decisions about the items. items.

• A manager's performance is A manager's performance is evaluated on the matters evaluated on the matters directly under the directly under the manager's control.manager's control.

Responsibility AccountingResponsibility Accounting

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

Responsibility AccountingResponsibility Accounting

• Responsibility accounting is especially valuable Responsibility accounting is especially valuable in a decentralized company.in a decentralized company.

• DecentralizationDecentralization means that the control of means that the control of operations is delegated to many managers operations is delegated to many managers throughout the organization. throughout the organization.

• A A segmentsegment is an identified area of responsibility is an identified area of responsibility in decentralized operations.in decentralized operations.

Responsibility Accounting versus Responsibility Accounting versus Budgetary ControlBudgetary Control

Responsibility accounting is essential to Responsibility accounting is essential to any effective system of budgetary control. any effective system of budgetary control. It differs from budgeting in two respects:It differs from budgeting in two respects:

1)A distinction is made between controllable 1)A distinction is made between controllable and noncontrollable items.and noncontrollable items.

2)Performance reports either emphasize or 2)Performance reports either emphasize or include only items controllable by the include only items controllable by the individual manager.individual manager.

Controllable versus Noncontrollable Controllable versus Noncontrollable Revenues and CostsRevenues and Costs

• A cost is considered A cost is considered controllablecontrollable at a given at a given level of managerial responsibility if the level of managerial responsibility if the manager has the power to incur it within a manager has the power to incur it within a given period of time. given period of time.

• Costs incurred indirectly and allocated to a Costs incurred indirectly and allocated to a responsibility level are considered to be responsibility level are considered to be noncontrollablenoncontrollable at that level. at that level.

Responsibility Reporting Responsibility Reporting SystemSystem

• A A responsibility reporting systemresponsibility reporting system involves involves the preparation of a report for each level of the preparation of a report for each level of responsibility in the company's organization responsibility in the company's organization chart. chart.

• A responsibility reporting system permits A responsibility reporting system permits management by exception at each level of management by exception at each level of responsibility.responsibility.

Types of Responsibility CentresTypes 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.

Illustration 22-13Illustration 22-13Responsibility Accounting for Cost CentresResponsibility 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 U1,000 F 100 U

Supervision 4,000 4,000 -0- $400 F

Top managementmay want anexplanation

of these variance.

Responsibility ReportResponsibility Report

• A A responsibility reportresponsibility report for a profit centre shows for a profit centre shows budgeted and actual controllable revenues and costs. budgeted and actual controllable revenues and costs.

• The report is prepared using the cost-volume-profit The report is prepared using the cost-volume-profit income statement format. In the report:income statement format. In the report:

1)1) ControllableControllable fixed costs are deducted from fixed costs are deducted from contribution margin.contribution margin.

2)2) The excess of contribution margin over controllable The excess of contribution margin over controllable fixed costs is identified as controllable margin. fixed costs is identified as controllable margin. – Controllable margin is considered to be the best Controllable margin is considered to be the best

measure of the manager’s performance in measure of the manager’s performance in controlling revenues and costs. controlling revenues and costs.

3)3) Noncontrollable fixed costs are not reported.Noncontrollable fixed costs are not reported.

Illustration 22-14Illustration 22-14Responsibility Report for a Profit CentreResponsibility 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).

Responsibility Accounting for Responsibility Accounting for Investment CentresInvestment Centres

• An important characteristic of an investment An important characteristic of an investment centrecentre is that the manager can control or is that the manager can control or significantly influence the investment funds significantly influence the investment funds available for use.available for use.

• Thus, the primary basis for evaluating the Thus, the primary basis for evaluating the performance of a manger of an investment performance of a manger of an investment centre iscentre is return on investment (ROI)return on investment (ROI). .

• ROI is considered to be superior to any other ROI is considered to be superior to any other performance measurement because it shows performance measurement because it shows the effectiveness of the manager in utilizing the effectiveness of the manager in utilizing the assets at his or her disposal.the assets at his or her disposal.

Illustration 22-15Illustration 22-15ROI FormulaROI Formula

Investmentcentre

ControllableMargin

(in dollars)

/Average

Investmentcentre

OperatingAssets

Return onInvestment

(ROI)

• The formula for computing ROI for an investment centre, The formula for computing ROI for an investment centre, together with assumed illustrative data is shown below.together with assumed illustrative data is shown below.

• Operating assetsOperating assets consist of current assets and plant consist of current assets and plant assets used in operations by the centre. Nonoperating assets used in operations by the centre. Nonoperating assets such as idle plant assets and land held for future assets such as idle plant assets and land held for future use are excluded.use are excluded.

• Average operating assetsAverage operating assets are usually based on the are usually based on the beginning and ending cost or book values of the assets.beginning and ending cost or book values of the assets.

$1,000,000 / $5,000,000 = 20%$1,000,000 / $5,000,000 = 20%

Illustration 22-16Illustration 22-16Responsibility Report for Investment CentreResponsibility Report for Investment Centre

Other fixed costs 60,000 60,000 -0-

Controllable margin $300,000 $264,000 $36,000 U

Since an investmentcentre is an independententity for operatingpurposes,all fixed costs are controllable by the investment centremanager. Assumein this example that the managercan control $60,000of fixed costs thatwere not controllable whenthe division was a profit centre.

Responsibility Report for Responsibility Report for Investment CentreInvestment Centre

Assuming actual average operating assets are $2,000,000actual 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%).

Assumed Data for Marine DivisionAssumed 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:

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 becausecontrollable fixed costs will not change. Thus, controllablemargin becomes $690,000 ($600,000 +$90,000). The new ROI is 13.8%, calculated as follows:

ROI Calculation – ROI Calculation – Increase in SalesIncrease in Sales

13.8%$690,000 / $5,000,000 =New controllable margin / Average operating assets

ROI Calculation – ROI Calculation – Decrease in CostsDecrease in Costs

14.8%$740,000 / $5,000,000 =

Controllable margin can also be increased by reducing variable andcontrollable fixed costs. If variable and fixed costs were decreased by 10%, total costs willdecrease $140,000[($1,000,000 + $300,000) x .10]. This reduction willresult in a corresponding increase in controllable margin. Thus, thismargin becomes $740,000 ($600,000 + $140,000), and the new ROI is14.8%, calculated as follows:

New Controllable margin / Average operating assets

ROI Calculation – Decrease in ROI Calculation – Decrease in Operating AssetsOperating 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

Principles of Performance EvaluationPrinciples of Performance Evaluation

• Performance evaluationPerformance evaluation is a management is a management function that compares actual results with function that compares actual results with budget goals. budget goals.

• Performance evaluation includes both Performance evaluation includes both behavioural and reportingbehavioural and reporting principles.principles.

Behavioural PrinciplesBehavioural Principles

Behavioural principles should include:Behavioural principles should include:1) Managers of responsibility centres should have 1) Managers of responsibility centres should have

direct input into the process of establishing budget direct input into the process of establishing budget goals for their area of responsibility.goals for their area of responsibility.

2) The evaluation of performance should be based 2) The evaluation of performance should be based entirely on matters that are controllable by the entirely on matters that are controllable by the manager being evaluated.manager being evaluated.

3) Top management should support the evaluation 3) Top management should support the evaluation process.process.

4) The evaluation process must allow managers to 4) The evaluation process must allow managers to respond to their evaluations.respond to their evaluations.

5) The evaluation should identify both good and poor 5) The evaluation should identify both good and poor performance.performance.

Reporting Principles of Performance Reporting Principles of Performance EvaluationEvaluation

Performance reports should:Performance reports should:1)1) Contain only data that are controllable by the Contain only data that are controllable by the

manager of the responsibility centre.manager of the responsibility centre.2)2) Provide accurate and reliable budget data to Provide accurate and reliable budget data to

measure performance.measure performance.3)3) Highlight significant differences between actual Highlight significant differences between actual

results and budget goals.results and budget goals.4)4) Be tailor-made for the intended evaluation.Be tailor-made for the intended evaluation.5)5) Be prepared at reasonable intervals.Be prepared at reasonable intervals.

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