Chapter Fifteen

Performance Evaluation

© 2015 McGraw-Hill Education.

An accounting system thatprovides information . . .

Responsibility Accounting

Relating to theresponsibilities of

individual managers.

To evaluatemanagers on

controllable items.

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Decentralization

Improves qualityof decisions.

Encourages upper-level management toconcentrate on strategic decisions.

Improvesproductivity.

Developslower-levelmanagers.

Improvesperformanceevaluation.

Advantages

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Responsibility Centers

Investment Center

Profit Center

Cost Center

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CostCenter

ProfitCenter

InvestmentCenter

Evaluation Measures

Profitability

Return on investment (ROI) Residual income (RI)

Cost controlQuantity and qualityof services

Managerial Performance Measurement

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Since the exercise of control may be clouded,managers are usually held responsible for items

over which they have predominant ratherthan absolute control.

Since the exercise of control may be clouded,managers are usually held responsible for items

over which they have predominant ratherthan absolute control.

I’m in control

Controllability Concept

Managers shouldonly be evaluated on

revenues or coststhey control.

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Preparing Flexible Budgets

The master budget, sometimes called a static budget, is based solely on the planned volume of activity. Flexible budgets differ from static budgets in that they show expected revenues

and costs at a variety of volume levels.

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Determining Variances for Performance Evaluation

The differences between standard and actual amounts are called variances. A variance may be favorable or unfavorable. When actual sales are

less than expected, an unfavorable sales variance exists. When actual sales revenue is greater than

expected revenue, a company has a favorable sales variance.

The differences between standard and actual amounts are called variances. A variance may be favorable or unfavorable. When actual sales are

less than expected, an unfavorable sales variance exists. When actual sales revenue is greater than

expected revenue, a company has a favorable sales variance.

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Determining Variances for Performance Evaluation

Variances are not limited to the evaluation of revenues. They can also be used to understand

the differences between standard and actual amounts of costs. When actual costs are less

than standard costs, cost variances are favorable because lower costs increase net income.

Unfavorable cost variances exist when actual costs are more than standard costs.

Variances are not limited to the evaluation of revenues. They can also be used to understand

the differences between standard and actual amounts of costs. When actual costs are less

than standard costs, cost variances are favorable because lower costs increase net income.

Unfavorable cost variances exist when actual costs are more than standard costs.

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Sales Volume VariancesThe difference between the static budget sales amount and the flexible budget sales amount is a measure of

the sales volume variance.Exhibit 15.2Melrose Manufacturing Company’s Volume Variances

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Interpreting the Volume Variances

In a standard cost system, marketing managers are usually responsible for the volume variance. Because sales volume drives production, production managers

have little control over volume variance.

In the case of Melrose, the marketing manager exceeded planned sales volume by 1,000 units, resulting in an

$80,000 favorable revenue variance ($80 × 1,000). The unfavorable cost variances are somewhat misleading.

Melrose incurred higher costs because it manufactured and sold more units than planned.

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Fixed Cost Considerations

The fixed costs are the same in both the static and flexible budgets.

Spending VarianceThe difference between the

budgeted fixed costs and the actual

fixed costs

Fixed Cost Volume Variance

The difference between costs

at planned volume versus

actual volume

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Flexible Budget Variances

For effective performance evaluation, management must compare the actual results achieved to the flexible

budget based on the actual volume of activity. Here is a comparison of the standard amount and actual amount

per unit for the current period for Melrose.Standard Actual

Sales price 80.00$ 78.00$ Variable material cost 12.00 11.78 Variable labor cost 16.80 17.25 Variable overhead cost 5.60 5.75 Variable GS&A cost 15.00 14.90

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Calculating Sales Price Variance

Actual sales (19,000 × $78) 1,482,000$ Expected sales (18,000 × $80) 1,440,000 Favorable total sales variance 42,000$

Activity variance (volume) 80,000$ FSales price variance (38,000) UFavorable total sales variance 42,000$ F

or

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The Human Element Associated with Flexible Budget Variances

• The flexible budget cost variances offer insight into management efficiency.

• As with sales variances, cost variances require careful analysis.

• A favorable materials variance could mean that purchasing agents are good negotiators or it might be caused by paying low prices for inferior goods.

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The vice president of operations receives summarized information

from each unit.

Management by exception

Upper-level management does not receive operating

detail unless problems arise.

Management focuses on areas not performing as expected.

Management by Exception

Businesses cannot afford to have

managers spend large amounts of

time on operations that function

normally. 15-16

Return on Investment

Return on investment is the ratio of income to the investment used to

generate the income.

ROI = Operating IncomeOperating Assets

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Return on Investment

LumberManufacturing

Home Building

Furniture Manufacturing

=

=

=

$60,000$300,000

$46,080$256,000

$81,940$482,000

= 20%

= 18%

= 17%All other things being equal,

higher ROIs indicate better performance. 15-18

ROI = Operating IncomeOperating Assets

MarginMargin TurnoverTurnover

Factors Affecting ROI

ROI = ×Sales

Operating AssetsOperating Income

Sales

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Factors Affecting ROI

Three ways to improve ROI

1 Increase Sales

2 Reduce Expenses

3 Reduce Operating Assets

(The investment base)

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Residual Income Operating Income– Investment charge = Residual income

Operating Assets× Desired ROI = Investment charge

Investment center’scost of acquiring

investment capital

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Residual Income

Residual income encourages managers to make profitable investments that would

be rejected by managers using ROI.

Suboptimization occurs with ROI when managers

benefit themselves at the expense of the company

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End of Chapter Fifteen

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