CONTROLLABLE VS NONCONTROLLABLE REVENUES AND COSTS

Can control all costs and revenues at some level of responsibility within the company

Critical issue under responsibility accounting:

Whether the cost or revenue is controllable

at the level of responsibility with which

it is associated

CONTROLLABLE VS NONCONTROLLABLE REVENUES AND COSTS

All costs controllable by top management

Fewer costs controllable as one moves down to lower levels of management

Controllable costs - costs incurred directly by a level of responsibility that are controllable at that level

Noncontrollable costs – costs incurred indirectly which are allocated to a responsibility level

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

RESPONSIBILITY REPORTING SYSTEMExample – Francis Chair Co.

RESPONSIBILITY REPORTING SYSTEM

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

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 CENTERS

Example – 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

RESPONSIBILITY ACCOUNTING FOR PROFIT CENTERS

Direct and Indirect Fixed Costs

May have both direct and indirect fixed costs Direct fixed costs

Relate specifically to a responsibility center Incurred for the sole benefit of the center Most controllable by the profit center manager

Indirect fixed costs Pertain to a company's overall operating activities Incurred for the benefit of more than one profit center Most not controllable by the profit center manager

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

RESPONSIBILITY ACCOUNTING FOR INVESTMENT CENTERS

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 - 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

INVESTMENT CENTERS - Responsibility Report Example – Marine Division

All fixed costs are controllable by manager

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:

IMPROVING ROIIncreasing Controllable Margin

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 ROIReducing Average Operating Assets

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 $600,000

New ROI becomes 13.3%

PRINCIPLES OF PERFORMANCE EVALUATION

Management function that compares actual results with budget goals

At center of responsibility accounting

Includes both behavioral and reporting principles

PRINCIPLES OF PERFORMANCE EVALUATION

Behavioral Principles

Human factor – critical in performance evaluation

Behavioral principles: Managers of responsibility centers should have direct input

into the process of establishing budget goals for 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

PRINCIPLES OF PERFORMANCE EVALUATION

Reporting Principles

Reporting principles for performance reports include reports which Contain only data that are controllable by the manager of

the responsibility center

Provide accurate and reliable budget data to measure performance

Highlight significant differences between actual results and budget goals

Are tailor-made for the intended evaluation

Are prepared at reasonable intervals

Summary of Study Objectives

Describe the concept of budgetary control. Preparing periodic budget reports to compare actual results

with planned objectives Analyzing the differences to determine causes Taking appropriate corrective action Modifying future plans, if necessary

Evaluate the usefulness of static budget reports Useful in evaluating the progress toward planned sales and

profit goals Also appropriate in assessing manager’s effectiveness in

controlling cost when

• Actual activity approximates budget activity level and/or

• Costs are fixed

Summary of Study Objectives

Explain the development of flexible budgets and the usefulness of flexible budget reports. Identify the activity index and the

relevant range Identify variable costs and determine

the budgeted variable cost per unit Identify fixed costs and the budgeted

amount for each cost Prepare budget for selected increments

of activity within relevant range Flexible budget reports permit

evaluation of manager’s performance

Summary of Study Objectives

Describe the concept of responsibility accounting. Accumulating and reporting revenues and costs on the basis of the

individual who has the authority to make the decisions

Manager’s performance judged on matters directly under manager’s control

Necessary to distinguish between controllable and noncontrollable fixed costs

Must identify three types of responsibility centers

• Cost centers

• Profit centers

• Investment centers

Summary of Study Objectives Indicate the features of responsibility

reports for cost centers. Compare actual costs with flexible

budget data

Reports show only controllable costs

No distinction is made between variable and fixed costs

Identify the content of responsibility reports for profit centers. For each profit center show

Contribution margin

Controllable fixed costs

Controllable margin

Summary of Study Objectives Explain the basis and formula used in evaluating

performance in investment centers. Primary basis for evaluating performance : return on investment

(ROI)

Formula for ROI:

Controllable margin ÷ average operating assets

Let’s ReviewLet’s Review

Under responsibility accounting, the evaluation of a manager’s performance is based on matters that the manager:

a. Directly controls

b. Directly and indirectly controls

c. Indirectly controls

d. Has shared responsibility for with another manager

Let’s ReviewLet’s Review

Under responsibility accounting, the evaluation of a manager’s performance is based on matters that the manager:

a. Directly controls

b. Directly and indirectly controls

c. Indirectly controls

d. Has shared responsibility for with another manager

APPENDIX: RESIDUAL INCOME – ANOTHER PERFORMANCE

MEASUREMENT

Most companies use ROI to evaluate investment performance

Significant disadvantage - ignores the minimum rate of return on operating assets Rate at which cost are covered and a

profit earned

APPENDIX: RESIDUAL INCOME – ANOTHER PERFORMANCE MEASUREMENT

Example – Electronics Division of Pujols Manufacturing Co.

Electronics Division has the following ROI:

Considering producing a new product – Tracker To produce the product, operating assets increase $2,000,000 Tracker expected to generate an additional $260,000 of

controllable margin

APPENDIX: RESIDUAL INCOME – ANOTHER PERFORMANCE MEASUREMENT

Example – Electronics Division

Making Tracking reduces ROI from 20% to 18%:

If only use ROI, would not produce Tracker However, if Electronics has a minimum rate of return of 10%,

Tracker would be produced because its ROI, 13%, is greater

APPENDIX: RESIDUAL INCOME COMPARED TO ROI

Use the residual income approach to evaluate performance using the minimum rate of return

Residual Income:

The income that remains after subtracting

from controllable margin the minimum rate of

return on average operating assets

APPENDIX: RESIDUAL INCOME COMPARED TO ROI

Example – Electronics Division

The residual income for Tracking:

With Tracker, Electronics’ residual income increases:

Thus, ROI can be misleading by rejecting a project that actually increases income

APPENDIX: RESIDUAL INCOME WEAKNESS

Attempting to evaluate a company only on maximizing residual income ignores the fact that

one division might use substantially fewer assets

to attain the same level of residual income

Electronics Division used $2,000,000 of average operating assets to generate $260,000 of residual income

Can a different division use fewer operating assets to generate a greater amount of residual income?

APPENDIX: RESIDUAL INCOME WEAKNESS

Example – Electronics Division vs. Seadog Division Seadog used $4,000,000 to generate $460,000 of controllable

margin

Using the residual income approach, both investments are equal However, this ignores the fact that Seadog

Required twice as many operating assets to achieve

the same level of residual income

Summary of Study Objective (Appendix)

Explain the difference between ROI and residual income. ROI is controllable income divided by average operating assets

Residual income is the income remaining after subtracting the minimum rate of return on average operating assets

ROI can provide misleading results because

Profitable investments can be rejected

when the investment reduces ROI

but increases overall profitability

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Copyright © 2005 John Wiley & Sons, Inc. All rights reserved. Reproduction or translation of this work beyond that permitted in Section 117 of the 1976 United States Copyright Act without the express written consent of the copyright owner is unlawful. Request for further information should be addressed to the Permissions Department, John Wiley & Sons, Inc. The purchaser may make back-up copies for his/her own use only and not for distribution or resale. The Publisher assumes no responsibility for errors, omissions, or damages, caused by the use of these programs or from the use of the information contained herein.

Copyright © 2005 John Wiley & Sons, Inc. All rights reserved. Reproduction or translation of this work beyond that permitted in Section 117 of the 1976 United States Copyright Act without the express written consent of the copyright owner is unlawful. Request for further information should be addressed to the Permissions Department, John Wiley & Sons, Inc. The purchaser may make back-up copies for his/her own use only and not for distribution or resale. The Publisher assumes no responsibility for errors, omissions, or damages, caused by the use of these programs or from the use of the information contained herein.