Chapter 15 – Performance Evaluation
15-1
Teaching Notes for Chapter 15
This chapter begins with the fundamental concepts underlying responsibility accounting
and also provides students with a minimal explanation of flexible budgeting and variance
analysis. Students need to know that managers prepare static budgets based on the
planned volume of activity at the beginning of an accounting period. On the other hand,
managers prepare flexible budgets based on the actual volume of activity at the end of the
accounting period. Further, students will need to know the following rules for variance
analysis:
With respect to revenue, managers want the actual amount to be greater than the standard
amount. The description of revenue variances is:
When: Actual Sales > Expected (Standard) Sales, the Variance is Favorable.
When: Actual Sales < Expected (Standard) Sales, the Variance is Unfavorable.
With respect to costs, managers want the actual amount to be less than the standard amount.
The description of cost variances is:
When: Actual Costs > Expected (Standard) Costs, the Variance is Unfavorable.
When: Actual Costs < Expected (Standard) Costs, the Variance is Favorable.
You can use Exercise 15-4 as a demonstration problem on variances and Exercise15-5 as
a homework assignment to provide students the background they need to understand this
concept.
Detailed Outline of a Lesson Plan for Chapter 15
I. Introduce the concept of decentralization and the primary features of
responsibility accounting. The fundamental concepts underlying responsibility
accounting are easy to grasp. Most students can learn these basics through a
reading assignment. Assign the material from the beginning of the chapter
(approximately the first six pages) as an advance reading requirement. We
recognize that many students fail to read ahead. In fact, we teach most of our
classes assuming that students read after instead of before class. For this chapter,
we motivate students to read ahead by advising them that the first class on the
topic begins with a group exercise for which they must have read the assigned
materials. If you believe that your students will not complete the advance reading
assignment, develop a brief lecture to introduce the primary features of
responsibility accounting.
II. Distribute Demonstration Problem 15-1 and have students complete the
requirements as a group. Ask each group to choose a spokesperson. Have two
or three of the groups place their organization charts on the board. Use the charts
to stimulate a general discussion that leads to the development of a reasonable
Chapter 15 – Performance Evaluation
15-2
solution to the requirements. You can assign Exercise 15-1 as a follow up
homework assignment.
III. Work Demonstration Problem 15-2 as an in-class group learning experience.
Distribute the work paper for the problem. Have students individually complete
the missing information and compare their answers with the members of their
group. Call out or display the answers so students can check their work. Based on
time available, use Exercises 15-4 and 15-5 as in-class reinforcement or as
homework assignments.
IV. Define the terms static budget and flexible budget and show students how to
calculate sales and variable cost volume variances and flexible budget
variances.
A. A static budget is based on standard prices and costs multiplied by the
expected (standard) volume of activity (planned number of units of product).
The master budget discussed in the previous chapter is a static budget.
B. A flexible budget is based on standard prices and costs multiplied by the
actual volume of activity (actual number of units of product).
C. The actual result is obtained by multiplying actual prices and costs by the
actual volume of activity (actual number of units of product).
D. The volume (activity) variance is the difference between the static budget and
the flexible budget.
E. The flexible budget variance is the difference between the flexible budget and
the actual results.
F. The variances described above can be summarized in a chart as follows:
Static Budget
Flexible Budget
Actual Result
Standard Prices and
Costs
Standard Prices and
Costs
Actual Prices and
Costs
X
X
X
Expected (Standard)
Units
Actual Units
Actual Units
Volume Variance
Flexible Budget Variance
V. Work Demonstration Problem 15-3 to illustrate computing volume and
flexible budget variances. Work this problem in a style that keeps students
actively involved. For example, students should be able to begin work on
requirement a without prior instruction. Distribute the problem and work papers
and let them get started on their own. Circulate around the room, answer
questions, and offer assistance to those having trouble. If many students are
having trouble, interrupt the class and provide general instruction. As the faster
students begin to finish requirement a, have them move forward to requirement
b. Again, provide general instruction based on class needs.
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VI. Use any of the exercises from 15-6 through 15-10 as in-class reinforcement or
as homework. You can also assign Problems 15-19 through 15-21 as
homework.
VII. Use Demonstration Problem 15-4 to reinforce the variance analysis concepts.
This problem integrates responsibility accounting concepts with a brief
introduction to flexible budgeting and variance analysis.
VIII. Show students how to compute return on investment with the summary
formula (Operating income ÷ Operating assets). Distribute Demonstration
Problem 15-5 and have students complete requirement a. Circulate around the
room helping students understand how to calculate ROI. Ask them if a higher or
lower ROI suggests better performance. Comparing ROI with interest earned on
a savings account is a good way to give students a feel for what ROI means.
IX. Show the class how the summary ROI formula can be subdivided into two
separate ratios, margin and turnover. Describe the useful information
managers gain by analyzing the separate components. Use requirement b of
Demonstration Problem 15-5 as an in-class exercise to give students practice
computing margin and turnover, and to illustrate how these measures can provide
information to improve managerial performance. Ask your students to explain the
meaning of margin and turnover.
X. Use requirement c of Demonstration Problem 15-5 as a problem-based
learning exercise. Have students complete the requirement before you introduce
the concept of suboptimization. Let them develop solutions in their groups.
Some groups are likely to recommend accepting the investment opportunity
because its ROI exceeds the company’s average ROI. Other groups are likely to
recognize that the additional investment will reduce the Hydride Division’s
average ROI to a point that is below NiCad’s ROI. A class discussion of the
various group findings will reveal that the additional investment will increase the
company’s overall ROI but will harm the performance evaluation of Hydride’s
manager. Now introduce the term suboptimization. This requirement provides a
great segue for introducing the residual income performance measure.
XI. Show how top management can use residual income to overcome the
suboptimization problem inherent in using ROI to evaluate performance.
Use requirement d of Demonstration Problem 15-5 to illustrate how to compute
residual income. Explain the impact of using residual income on the decision of
whether to accept the additional investment.
XII. You can use Exercise 15-16 as an in-class reinforcement exercise to give
students practice computing ROI and RI. Use Problem 15-23 as a homework
assignment covering ROI and RI.
Chapter 15 – Performance Evaluation
15-4
Summary Outline of a Lesson Plan for Chapter 15
I. Introduce the concept of decentralization and the primary features of
responsibility accounting.
II. Distribute Demonstration Problem 15-1 and have students complete the
requirements as a group. Have group spokespersons put organization charts on
the board to stimulate discussion. Assign Exercise 15-1 or Problem 15-18 as
homework.
III. Work Demonstration Problem 15-2 as an in-class group learning experience.
Use Exercises 15-4, 15-5, or 15-6 as in-class reinforcement or as homework
assignments.
IV. Define the terms static budget and flexible budget and show students how to
calculate volume (activity) variances and flexible budget variances.
Static Budget
Flexible Budget
Actual Result
Standard Prices and
Costs
Standard Prices and
Costs
Actual Prices and
Costs
X
X
X
Expected (Standard)
Units
Actual Units
Actual Units
Volume (Activity) Variance
Flexible Budget Variance
V. Work Demonstration Problem 15-3 to illustrate computing volume (activity)
and flexible budget variances. Keep students actively involved, having them
work on each requirement as you circulate around the room.
VI. Use any of the exercises from 15-8 through 15-10 as in-class reinforcement or
as homework. You can also assign Problems 15-19 or 15-21 as homework.
VII. Use Demonstration Problem 15-4 to reinforce the variance analysis concepts.
VIII. Show students how to compute return on investment with the summary
formula (Operating income ÷ Operating assets). Compare ROI with interest
earned on a savings account. Distribute Demonstration Problem 15-5 and have
students complete requirement a, circulating to help as needed.
Chapter 15 – Performance Evaluation
15-5
IX. Show the class how the summary ROI formula can be subdivided into two
separate ratios, margin and turnover. Describe the useful information
provided by analyzing the separate components. Use requirement b of
Demonstration Problem 15-5 as an in-class exercise.
X. Use requirement c of Demonstration Problem 15-5 as a problem-based
learning exercise. Have students work the requirement first and then introduce
the concept of suboptimization.
XI. Show how top management can use residual income to overcome the
suboptimization problem inherent in using ROI to evaluate performance.
Use requirement d of Demonstration Problem 15-5 to illustrate how to compute
residual income. Explain the impact that using residual income has on the
decision.
XII. Use Exercise 15-16 as an in-class reinforcement exercise to give students
practice computing ROI and RI. Use Problem 15-23 as a homework
assignment covering ROI and RI.
Quiz Questions for Chapter 15
1. Which of the following is NOT considered an advantage of decentralization?
a. Decentralization often improves the quality of decision making by delegation of authority.
2. A cost center
a. incurs expenses, earns revenue, and is evaluated using return on investment.
b. needs no managerial control or supervision.
c. should be eliminated to increase profit.
d. incurs expenses and earns no revenue.
3. Which of the following would improve a firm’s return on investment?
a. Raising sales prices and incurring higher expenses.
b. Increasing earnings and investment in assets.
c. Lowering sales prices and increasing asset investment.
d. A decrease in expenses with no effect on revenues or the investment in assets.
4. Which of the following statements is false? An investment center
a. may develop its own long-term investment strategy.
b. is responsible for revenues but not expenses.
c. has many of the characteristics of an independent business.
d. may purchase long-term assets.
Use the following information to answer the next two questions: National’s cost accountant prepared
the following static budget based on expected activity of 2,000 units for the 2014 accounting period:
Sales Revenue $64,000
Chapter 15 – Performance Evaluation
15-6
Variable Costs (34,000)
Contribution Margin 30,000
Fixed Costs (18,000)
Net Income $12,000
5. If National actually produced 1,800 units, the flexible budget would show variable costs of
a. $34,000.
b. $22,666.
c. $30,600.
d. $25,500.
6. If National actually produced 1,900 units, the flexible budget would show fixed costs amounting to
a. $19,800.
b. $18,000.
c. $52,000.
d. none of the above.
Use the following information to answer the next two questions: Cox Manufacturing Company
prepared the following static budget income statement for 2014:
Sales Revenue $125,000
Variable Costs (75,000)
Contribution Margin 50,000
Fixed Cost (30,000)
Net Income $ 20,000
The budget was based on an expected sales volume of 5,000 units. Actual sales volume was 6,000 units.
7. The amount of net income based on a flexible budget of 6,000 units is expected to be
a. $24,000.
b. $26,000.
c. $30,000.
d. $45,000.
8. The sales revenue volume variance is
a. $25,000 favorable.
b. $10,000 unfavorable.
c. $4,000 unfavorable.
d. $6,000 favorable.
9. Marjorie Jewels, a maker of fashionable rings, produced and sold 6,000 rings during the recent
accounting period. The company had expected to sell 5,600 rings. Because of competition, the
company priced the rings at $20 each, $2 lower than the budgeted selling price. Based on this
information, there is
a. a favorable $8,000 sales volume variance.
b. an unfavorable $800 total sales variance.
c. an unfavorable sales price variance.
d. all of the above.
10. Which employees would most likely be held responsible for a volume variance?
a. production workers
b. marketing managers
c. purchasing agents
d. production managers
15-7
11. If the planned or expected level of activity is overstated (unreasonably high), what consequence is
likely?
a. The predetermined overhead rate will be overstated.
b. Products are likely to be underpriced.
c. Products are likely to be overpriced.
d. Per unit variable overhead costs are understated.
12. Last year, Thurco Corporation had revenues of $120,000 and expenses of $70,000. If Thurco had
$500,000 of operating assets last year, what was Thurco’s return on investment?
a. 10%
b. 15%
c. 20%
d. 16.7%
13. Last year, Thurco Corporation had revenues of $120,000 and expenses of $70,000. If Thurco had
$500,000 of operating assets last year, what was Thurco’s margin?
a. 16.6%
b. 22.2%
c. 33.3%
d. 41.7%
14. Last year, Thurco Corporation had revenues of $120,000 and expenses of $70,000. If Thurco had
$500,000 of operating assets last year, what was Thurco’s turnover?
a. .48
b. .24
c. .16
d. .40
15. LINK, Inc. has a margin of 3.5 % and a turnover of 4. What is LINK’s return on investment?
a. 10%
b. 14%
c. 88%
d. 7.5%
16. Maxwell Company established a center to provide its employee training seminars. Maxwell budgeted
costs for a weekend training seminar for managers at $300 per employee. Actual costs were $315 per
employee. The training center would be considered a (an)
a. asset center.
b. profit center.
c. cost center.
d. investment center.
17. Which of the following statements about ROI is true?
a. Using ROI avoids conflicts of interest between a department and the business as a whole.
b. ROI cannot be used to measure performance for investment centers.
c. ROI can be calculated by multiplying margin by turnover.
d. ROI is equal to net income divided by sales.
18. The management strategy that focuses on significant variances is called
a. decentralized management.
b. management by exception.
c. profit management.
d. centralized management.
Chapter 15 – Performance Evaluation
15-8
19. Kennedy Aeronautics desires an 8% ROI on all investment projects. Details of a proposed investment
include the following:
Sales Revenues $30,000
Expenses 27,000
Investment Turnover 1.5
Which of the following statements is accurate?
a. Based on ROI, the company should accept the investment project.
b. The investment project would have a 10% return.
c. The company should reject the investment project.
d. The company’s margin is 14.3%.
20. The management of Dakota Industries obtained the following information about the performance of a
major investment project.
Revenues $200,000
Average Operating Assets 300,000
Net Operating Income 30,000
Desired ROI 10%
The project’s residual income was
a. $30,000.
b. $10,000.
c. $0.
d. 10%.
21. The accounting records pertaining to a Cassidy Products investment project were recently destroyed by
fire. The company accountant was able to recall the following information:
Desired ROI 12%
Net Income $260,000
Residual Income $20,000
Based on this information, how much is the company’s investment in the project?
a. $225,000
b. $2,000,000
c. $1,460,000
d. $1,875,000
Solutions to Quiz Questions
Question
Answer
1
B
2
D
3
D
4
B
5
C
6
B
7
C
8
A
Chapter 15 – Performance Evaluation
15-9
9
C
10
B
11
B
12
A
13
D
14
B
15
B
16
C
17
C
18
B
19
A
20
C
21
B
Demonstration Problems for Chapter 15
Demonstration Problem 15-1
Organization Chart and Responsibility Centers
LiPari Personnel Services Company has two operating divisions. The Clerical Services
division places (finds jobs for) people who have clerical skills; the Computer Services
division places individuals who have computer programming skills. A secretarial labor
pool provides support to both divisions. Each of the two operating divisions has an
Employee Search department that locates individuals seeking jobs and a Client Services
department that identifies and serves companies seeking employees. LiPari has a chief
executive officer (CEO) and a vice-president of operations. The vice-president of
operations reports to the CEO and the managers of the two operating divisions report to
the vice-president. LiPari also employs an administrative manager. The manager of the
secretarial labor pool and an advertising manager report to the administrative manager,
who reports to the CEO.
Required
a. Develop an organization chart that shows reasonable lines of authority for the
primary responsibility centers of the LiPari Personnel Services Company.
b. Classify the responsibility centers shown on your organization chart as cost centers,
profit centers, or investment centers.
c. Would you expect the CEO to know if the advertising manager is paying too much
for radio advertising? Explain. Include a discussion of the decentralization concept.
Demonstration Problem 15-2 Character of Variances
Required
Chapter 15 – Performance Evaluation
15–10
Compute variances for the items shown in the following list and indicate whether each
variance is favorable (F) or unfavorable (UF).
Item
Budget
Actual
Variance
F or UF
Selling and Administrative Expenses
$ 29,000
$ 27,000
Sales Revenue
$310,000
$325,000
Materials Price
$2.00 per lb.
$2.10 per lb.
Cost of Goods Sold
$125,000
$100,000
Materials Purchases
$250,000
$265,000
Materials Usage
6,000 lbs.
5,800 lbs.
Sales Price
$550 each
$500 each
Labor Rate
$8.10 per hour
$7.95 per hour
Production Volume
950 units
900 units
Labor Usage
$96,000
$97,000
Research and Development Expense
$22,000
$25,000
Demonstration Problem 15-3 Sales Volume (Activity) and
Flexible Budget Variances
The following data apply to chairs made by the Western Chair Company.
Price and Variable Costs Per Unit:
Standard
Actual
Sales Price
$62.00
$60.00
Direct Materials Cost
16.00
16.34
Direct Labor Cost
12.00
10.92
Overhead Cost
14.00
14.20
General, Selling, and Administrative (G,S,&A) Cost
8.00
7.00
Expected Fixed Costs:
Manufacturing
$120,400
$114,000
General, Selling, and Administrative
67,000
69,000
Western planned to make and sell 43,000 chairs. It actually produced and sold 44,000
chairs.
Required
a. Prepare a pro forma income statement based on the static budget.
b. Prepare a pro forma income statement based on a flexible budget and compute the
volume (activity) variances. Indicate whether the variances are favorable or
unfavorable and speculate as to what management position would be held responsible
for each variance.
c. Prepare an income statement that shows the actual results, and compute the flexible
budget variances. Indicate whether the variances are favorable or unfavorable and
Chapter 15 – Performance Evaluation
15–11
speculate as to what management position would be held responsible for each
variance.
Demonstration Problem 15-4 Variances and Responsibility
Sweeney Company’s 2014 responsibility accounting report includes the following:
Per Unit Variable Costs:
Standard
Actual
Materials Cost
$22.00
$21.80
Customer Delivery Cost
1.90
1.95
Inspection Cost
1.20
1.16
Sales Commissions
4.00
4.20
Fixed Costs:
Manufacturing
$720,000
$708,000
Advertising
107,000
120,000
Financial Statement Software Costs
15,600
18,000
Product Liability Cost
45,400
17,900
Actual volume of production and sales was 90,000 units.
Required
a. Determine the amount of the variances for the above costs and indicate whether each
variance is favorable or unfavorable.
b. Speculate as to the management position that would be held responsible for (able to
explain) each variance.
Demonstration Problem 15-5 ROI and Residual Income
The Hydride Division of Murdoch Corporation is an investment center. It has $4,000,000
of operating assets. During 2014, the Hydride Division earned operating income of
$720,000 on $12,000,000 of sales. Murdoch’s companywide return on investment (ROI)
is approximately 14%.
Required
a. Compute the ROI for the Hydride Division.
b. Calculate the two ratios into which ROI can be subdivided, margin and turnover, for
the Hydride Division. What useful information can management gain by analyzing
these two performance measures?
c. Assume Murdoch uses ROI to rank managerial performance. The Hydride Division
has the highest ROI in the company. Hydride’s nearest internal competitor is the
NiCad Division, which has an average ROI of 17%. Murdoch needs to invest excess
capital. The manager of the Hydride Division has the opportunity to expand existing
capacity by investing an additional $4,000,000 in machinery. The expected ROI for
the machinery investment is 15%. Should Hydride’s manager accept or reject the
investment opportunity? Why?