CHAPTER 10
Budgetary Control and Responsibility Accounting
LEARNING OBJECTIVES
1. DESCRIBE BUDGETARY CONTROL AND STATIC
BUDGET REPORTS.
2. PREPARE FLEXIBLE BUDGET REPORTS.
3. APPLY RESPONSIBILITY ACCOUNTING TO COST
AND PROFIT CENTERS.
4. EVALUATE PERFORMANCE IN INVESTMENT
CENTERS.
*5. EXPLAIN THE DIFFERENCE BETWEEN ROI AND
RESIDUAL INCOME.
CHAPTER REVIEW
Budgetary Control and Static Budget Reports
1. (L.O. 1) The use of budgets in controlling operations is known as budgetary control. Such
control takes place by means of budget reports that compare actual results with planned
objectives. The budget reports provide management with feedback on operations.
2. Budgetary control involves:
a. Developing budgets.
b. Analyzing the differences between actual and budgeted results.
c. Taking corrective action.
d. Modifying future plans, if necessary.
3. Budgetary control works best when a company has a formalized reporting system. The system
should
a. Identify the name of the budget report such as the sales budget or the manufacturing overhead
budget.
b. State the frequency of the report such as weekly, or monthly.
c. Specify the purpose of the report.
d. Indicate the primary recipient(s) of the report.
Flexible Budgets
6. (L.O. 2) A flexible budget projects budget data for various levels of activity. The flexible budget
recognizes that the budgetary process is more useful if it is adaptable to changed operating
conditions. This type of budget permits a comparison of actual and planned results at the level of
activity actually achieved.
7. To develop the flexible budget, the following steps are taken:
a. Identify the activity index and the relevant range of activity.
b. Identify the variable costs, and determine the budgeted variable cost per unit of activity for
each cost.
9. The following formula may be used to determine total budgeted costs at any level of activity:
Total budgeted costs = Fixed costs + (Total variable cost per unit X Activity level)
10. Total budgeted costs at each level of activity can be shown graphically.
a. In a graph, the activity index is shown on the horizontal axis and costs are shown on the
vertical axis.
b. The total budgeted costs for each level of activity are then identified from the total budgeted
cost line.
Responsibility Accounting and Responsibility Centers
12. (L.O. 3) Responsibility accounting involves accumulating and reporting costs (and revenues,
where relevant) on the basis of the manager who has the authority to make the day–to-day
decisions about the items. A manager’s performance is evaluated on matters directly under that
manager’s control.
13. Responsibility accounting can be used at every level of management in which the following
conditions exist:
a. Costs and revenues can be directly associated with the specific level of management
responsibility.
14. Responsibility accounting is especially valuable in a decentralized company. Decentralization
means that the control of operations is delegated to many managers throughout the organization.
A segment is an identified area of responsibility in decentralized operations.
15. Responsibility accounting is an essential part of any effective system of budgetary control. It
differs from budgeting in two respects:
a. A distinction is made between controllable and noncontrollable items.
b. Performance reports either emphasize or include only items controllable by the individual
manager.
16. A cost is considered controllable at a given level of managerial responsibility if that manager has
the power to incur it within a given period of time. Costs incurred indirectly and allocated to a
responsibility level are considered to be noncontrollable at that level.
19. Responsibility centers may be classified into one of three types. A cost center incurs costs
(and expenses) but does not directly generate revenues. A profit center incurs costs (and
expenses) but also generates revenues. An investment center incurs costs (and expenses),
generates revenues, and has control over investment funds available for use.
Cost Centers
20. A responsibility report for cost centers compares actual controllable costs with flexible budget
data. Only controllable costs are included in the report, and no distinction is made between
variable and fixed costs.
Profit Centers
21. A responsibility report for a profit center shows budgeted and actual controllable revenues and
costs. The report is prepared using the cost-volume-profit income statement format.
22. Direct fixed costs or traceable costs are costs that relate specifically to a responsibility center
and are incurred for the sole benefit of the center. Indirect fixed costs or common costs pertain
to a company’s overall operating activities and are incurred for the benefit of more than one profit
center.
Evaluating Investment Centers
25. (L.O. 4) The primary basis for evaluating the performance of a manger of an investment center is
return on investment (ROI). The formula for computing return on investment is: Controllable
Margin ÷ Average Operating Assets = Return on Investment.
a. Operating assets consist of current assets and plant assets used in operations by the
26. A manager can improve ROI by (a) increasing controllable margin or (b) reducing average
operating assets.
28. Performance evaluation is a management function that compares actual results with budget
goals. Performance evaluation includes both behavioral and reporting principles.
*Residual Income
*29. (L.O. 5) To evaluate performance using the minimum rate of return, companies use the residual
income approach. Residual income is the income that remains after subtracting from the
controllable margin the minimum rate of return on a company’s average operating assets.
The residual income would be computed as follows:
LECTURE OUTLINE
A. The Concept of Budgetary Control.
1. The use of budgets in controlling operations is known as budgetary control.
Such control takes place by means of budget reports that compare actual
results with planned objectives.
2. Budgetary control consists of:
a. Preparing periodic budget reports that compare actual results with
planned objectives.
3. Budgetary control works best when a company has a formalized reporting
system. This system does the following:
a. Identifies the name of the budget report (i.e. sales budget).
b. States the frequency of the report, such as weekly or monthly.
4. A static budget is a projection of budget data at one level of activity. This
budget does not consider data for different levels of activity. As a result,
companies always compare actual results with budget data at the
activity level that was used in developing the master budget.
5. 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/or
B. The Flexible Budget.
1. A flexible budget projects budget data for various levels of activity. In
essence, the flexible budget is a series of static budgets at different levels
of activity.
2. To develop the flexible budget, management should:
a. Identify the activity index and the relevant range of activity.
b. Identify the variable costs, and determine the budgeted variable cost
per unit of activity for each cost.
SERVICE COMPANY INSIGHT
When the number of viewers of the television show “House,” a medical drama,
declined by almost 20%, Fox Broadcasting said it wanted to cut the license fee
that it paid to NBCUniversal by 20%. How could NBCUniversal deal with the
20% cut in revenue? Choices include cutting the size of the cast or reducing the
number of episodes, among other choices.
Explain how the use of flexible budgets might help to identify the best solution to
this problem.
Answer: A fixed budget assumes a particular level of activity. In the case of
television shows, the number of viewers can impact revenues and
costs. NBCUniversal could prepare alternative budgets at varying
3. Flexible budget reports are another type of internal report. The flexible
budget report consists of two sections:
4. The flexible budget report provides a basis for evaluating a manager’s
performance in two areas:
a. Production control.
SERVICE COMPANY INSIGHT
When the Exotic Newcastle Disease (an infectious bird disease) broke out in
Southern California in 2003, it could have spelled disaster for the San Diego Zoo.
The zoo spent almost half a million dollars on quarantine measures in 2003. It
worked: no birds got sick and the damage to the zoo’s budget was minimized by
a monthly budget reforecast.
The new planning process, introduced a year earlier, allowed the zoo to redirect
resources to ward off the disease.
The San Diego Zoo’s annual static budget was behind the times before Paula
Brock took over as CFO in 2001. Brock’s first efforts were to link strategy to the
process. Consultants believe it’s a key way to improve people’s involvement in
budgeting.
What is the major benefit of tying a budget to the overall goals of the company?
Answer: People working on a budgeting process that is clearly guided and
C. Responsibility Accounting.
1. Responsibility accounting involves accumulating and reporting costs
(and revenues) on the basis of the manager who has the authority to
make the day–to-day decisions about the items.
2. Under responsibility accounting, a manager’s performance is evaluated
on matters directly under that manager’s control.
3. Responsibility accounting can be used at every level of management in
which the following conditions exist:
a. Costs and revenues can be directly associated with the specific
level of management responsibility.
4. The reporting of costs and revenues under responsibility accounting
differs from budgeting in two respects:
MANAGEMENT INSIGHT
While many compensation and promotion programs encourage competition and
hard work, it does not foster collaboration, and can lead to distrust and disloyalty.
As a consequence, many companies now explicitly include measures of collabo–
ration in their performance measures.
How might managers of separate divisions be able to reduce division costs
through collaboration?
Answer: Division managers might reduce costs by sharing design and marketing
resources or by jointly negotiating with suppliers. In addition, they can
5. A cost over which a manager has control is called a controllable cost. It
follows that:
6. Noncontrollable costs are costs incurred indirectly and allocated to a
responsibility level.
D. Principles of Performance Evaluation.
1. Management by exception means that top management’s review of
a budget report is focused either entirely or primarily on differences
between actual results and planned objectives.
2. For management by exception to be effective, there must be guidelines
for identifying an exception. The usual criteria are:
a. Materiality—usually expressed as a percentage difference from
budget.
b. Controllability of the item—exception guidelines are more restrictive
for controllable items than for items the manager cannot control.
3. The human factor is critical in evaluating performance. Behavioral
principles include:
a. Managers of responsibility centers should have direct input into the
process of establishing budget goals of their area of responsibility.
b. The evaluation of performance should be based entirely on matters
that are controllable by the manager being evaluated.
c. Top management should support the evaluation process.
4. Performance evaluation under responsibility accounting should be
based on certain reporting principles. Performance reports should:
a. Contain only data that are controllable by the manager of the
responsibility center.
b. Provide accurate and reliable budget data to measure performance.
MANAGEMENT INSIGHT
Among automobile manufacturing facilities in the U.S., nobody has more flexible
plants than Honda. At the Honda plant, the switch from the production of one
type of vehicle to a different type of vehicle takes only minutes instead of months
like for most plants. This ability to adjust quickly to changing demand gave
Honda a huge advantage when demand for more fuel-efficient cars increased
quickly.
What implications do these improvements in production capabilities have for
management accounting information and performance evaluation within the
organization?
Answer: In order to maximize the potential of flexible manufacturing facilities
managers need to be supplied with information on a more frequent
basis. In turn, the tools used to evaluate performance need to take
5. A responsibility reporting system involves the preparation of a report for
each level of responsibility in the company’s organization chart. It also
permits management by exception at each level of responsibility. And,
E. Types of Responsibility Centers.
1. There are three basic types of responsibility centers: cost centers, profit
centers, and investment centers.
a. A cost center incurs costs (and expenses) but does not directly
generate revenues.
b. A profit center incurs costs (and expenses) and also generates
revenues.
c. Like a profit center, an investment center incurs costs (and expenses)
and generates revenues. In addition, an investment center has control
over decisions regarding the assets available for use.
2. Responsibility Reports.
b. To evaluate the performance of a profit center manager, upper
management needs detailed information about both controllable
revenues and controllable costs. The report is prepared using the
cost-volume-profit income statement. In the report:
(1) Controllable fixed costs are deducted from contribution margin.
c. The primary basis for evaluating the performance of a manager of
an investment center is return on investment (ROI).
d. Return on investment is computed by dividing controllable margin
by average operating assets.
ACCOUNTING ACROSS THE ORGANIZATION
No matter how you slice the movie business, by far the best return on investment
comes from the not-so-glamorous world of G-rated films. However, these movies
represent only 3% of the total films made in a typical year.
What might be the reason that movie studios do not produce G-rated movies as
often as R-rated ones?
Answer: Perhaps Hollywood believes that big-name stars or large budgets, both
of which are typical of R-rated movies, sell movies. However, one study
*F. Residual Income Compared To ROI.
1. Residual income is the income that remains after subtracting from the
controllable margin the minimum rate of return on a company’s average
operating assets.
20 MINUTE QUIZ
Circle the correct answer.
True/False
1. In a static budget, the data may be modified or adjusted if activity changes more than a specified
amount during the year.
True False
2. Flexible budgets can be prepared for each of the types of budgets included in the master budget.
True False
3. With a flexible budget, if production increases, budget allowances for variable costs should
increase both directly and proportionately.
True False
4. Flexible budget reports consist of two sections: production data and cost data.
True False
5. Under responsibility accounting, the evaluation of a manager’s performance is based on the
matters directly under that manager’s control.
True False
6. The terms “controllable costs” and “noncontrollable costs” are synonymous with variable costs
and fixed costs, respectively.
True False
7. Only controllable costs are included in a responsibility performance report, and there is no
distinction made between variable and fixed costs.
True False
8. A responsibility reporting system begins with the lowest level of responsibility in an
organization and moves upward to each higher level.
True False
9. There are three types of responsibility centers: cost, segment, and investment.
True False
10. The primary basis for evaluating the performance of a manager of an investment center is return
on investment.
True False
Multiple Choice
1. A static budget report is appropriate for
a. evaluating a manager’s performance in controlling variable costs.
b. fixed manufacturing costs and fixed selling and administrative expenses.
c. variable costs and fixed costs.
d. none of the above.
2. The flexible budget report includes all of the following sections except
a. cost data for variable and fixed costs .
b. data for excess of contribution margin over controllable fixed costs (controllable
margin).
c. production data for a selected activity index.
d. All of the choices are included in a flexible budget report.
3. At 40,000 direct labor hours, the flexible budget for indirect labor is $160,000. If $172,000
of indirect labor costs are incurred at 44,000 direct labor hours, the flexible budget report
should show the following difference for indirect labor.
a. $12,000 favorable.
b. $4,000 unfavorable.
c. $4,000 favorable.
d. $12,000 unfavorable.
4. Controllable fixed costs are deducted from the contribution margin to arrive at
a. income from operations.
b. net income.
c. controllable margin.
d. realized income.
5. The numerator in computing return on investment is
a. controllable margin.
b. average operating assets.
c. contribution margin.
d. net assets.
ANSWERS TO QUIZ
True/False
1. False 6. False
Multiple Choice
1. b.