CHAPTER 24
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.
CHAPTER REVIEW
Budgetary Control
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.
Static Budget Reports
4. A static budget does not modify or adjust data regardless of changes in activity during the year.
As a result, actual results are always compared with the budget data at the activity level 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
behavior of the costs in response to changes in activity is fixed.
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.
c. Identify the fixed costs, and determine the budgeted amount for each cost.
d. Prepare the budget for selected increments of activity within the relevant range.
8. For manufacturing overhead costs, the activity index is usually the same as the index used in
developing the predetermined overhead rate; that is, direct labor hours or machine hours. For
selling and administrative expenses, the activity index usually is sales or net sales.
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.
11. Flexible budget reports are another type of internal report produced by managerial accounting.
The flexible budget report consists of two sections: (a) production data such as direct labor
hours and (b) cost data for variable and fixed costs. It also shows differences between budget and
actual results.
Responsibility Accounting
12. 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.
b. The costs and revenues are controllable at the level of responsibility with which they are
associated.
c. Budget data can be developed for evaluating the manager’s effectiveness in controlling the
costs and revenues.
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.
17. Performance evaluation is a management function that compares actual results with budget
goals. Performance evaluation includes both behavioral and reporting principles.
18. Management by exception means that top management’s review of a budget report is focused
either entirely or primarily to differences between actual results and planned objectives. The
guidelines for identifying an exception are based on materiality and controllability.
19. A responsibility reporting system involves the preparation of a report for each level of respon-
sibility shown in the company’s organization chart. A responsibility reporting system permits
management by exception at each level of responsibility within the organization.
20. 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
21. (L.O. 3) 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.
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.
Profit Centers
23. 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.
24. In the responsibility report for a profit center:
a. Controllable fixed costs are deducted from contribution margin.
b. The excess of contribution margin over controllable fixed costs is identified as controllable
margin.
c. Noncontrollable fixed costs are not reported.
25. Controllable margin is considered to be the best measure of the manager’s performance in
controlling revenues and costs.
Investment Centers
26. (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: Investment
Center Controllable Margin (in dollars) ÷ Average Investment Center Operating Assets = Return
on Investment.
a. Operating assets consist of current assets and plant assets used in operations by the center.
Nonoperating assets such as idle plant assets and land held for future use are excluded.
b. Average operating assets are usually based on the beginning and ending cost or book
values of the assets.
27. A manager can improve ROI by (a) increasing controllable margin or (b) reducing average
operating assets.
28. The return on investment approach includes two judgmental factors:
a. Valuation of operating assets—cost, book value, appraised value, or market value.
b. Margin (income) measure—controllable margin, income from operations, or net income.
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. Developing periodic budget reports that compare actual results with
planned objectives.
b. Analyzing the differences to determine their causes.
c. Taking appropriate corrective action.
d. Modifying future plans, if necessary.
3. Budgetary control works best when a company has a formalized reporting
system. This system should do the following:
a. Identify the name of the budget report (i.e., sales budget).
b. State the frequency of the report, such as weekly or monthly.
c. Specify the purpose of the report.
d. Indicates the primary recipient(s) of the report.
4. A static budget is a projection of budget data at one level of activity.
These budgets do 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. The 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 behavior of the costs in response to changes in activity is fixed.
6. A static budget report is appropriate for fixed manufacturing costs and
for fixed selling and administrative expenses.
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.
c. Identify the fixed costs, and determine the budgeted amount for
each cost.
d. Prepare the budget for selected increments of activity within the
relevant range.
3. Flexible budget reports are another type of internal report. The flexible
budget report consists of two sections:
a. Production data for a selected activity index, such as direct labor
hours.
b. Cost data for variable and fixed costs.
4. The flexible budget report provides a basis for evaluating a manager’s
performance in two areas:
a. Production control.
b. Cost control.
5. Flexible budget reports are appropriate for evaluating performance since
both actual and budgeted costs are based on the actual activity level
achieved.
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 improvement in
budgeting.
What is the major benefit of tying a budget to the overall goals of the company?
C. The Concept of 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.
b. The costs and revenues can be controlled by employees at the level
of responsibility with which they are associated.
c. Budget data can be developed for evaluating the manager’s effec–
tiveness in controlling the costs and revenues.
4. The reporting of costs and revenues under responsibility accounting
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 control-
lable by the individual manager.
MANAGEMENT INSIGHT
While many compensation and promotion programs encourage competition and
hard work, they do not foster collaboration, and can lead to distrust and
disloyalty. As a consequence, many companies now explicitly include measures
of collaboration 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:
a. All costs are controllable by top management because of the broad
range of its activity.
b. Fewer costs are controllable as one moves down to each lower level
of managerial responsibility because of the manager’s decreasing
authority.
6. Noncontrollable costs are costs incurred indirectly and allocated to a re-
sponsibility level.
D. Management by Exception.
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. A responsibility reporting system involves the preparation of a report for
each level of responsibility in the company’s organization chart.
4. Responsibility reports for cost centers compare actual costs with flexible
budget data. The reports show only controllable costs and no distinction
is made between variable and fixed costs.
E. Principles of Performance Evaluation.
1. 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.
2. 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 responsi-
bility center.
b. Provide accurate and reliable budget data to measure performance.
c. Highlight significant differences between actual results and budget
goals.
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 improvement in production capabilities have for
management accounting 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
3. 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.
4. Responsibility Reports.
a. The evaluation of a manager’s performance for cost centers is based
on his or her ability to meet budgeted goals for controllable costs.
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.
(2) The excess of contribution margin over controllable fixed costs
is identified as controllable margin.
(3) Noncontrollable fixed costs are not reported.
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.
e. Judgmental factors in ROI are (1) valuation of operating assets and
(2) margin (income) measure.
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
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 manufacturing overhead budget (1) provides the basis for computing the
predetermined overhead rate for the year, and (2) is used in costing work in process and
finished goods inventories. Is the above statement true for
a. (1) only.
b. (2) only.
c. both (1) and (2).
d. neither (1) nor (2).
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(n)
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. True 6. False
Multiple Choice
1. b.
2. d.