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Budgetary Control. The use of budgets in controlling operations is known as budgetary control. The centerpiece of budgetary control is the use of budget reports that compare actual results with planned objectives. The budget reports provide the feedback needed by management to see whether actual operations are on course..
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1. Chapter 7 Budgetary Control and Responsibility Accounting
2. Budgetary Control The use of budgets in controlling operations is known as budgetary control.
The centerpiece of budgetary control is the use of budget reports that compare actual results with planned objectives.
The budget reports provide the feedback needed by management to see whether actual operations are on course.
3. Budgetary Control Budgetary control involves:
Developing budgets.
Analyzing the differences between actual and budgeted results.
Taking corrective action.
Modifying future plans, if necessary.
Repeating the cycle.
4. Static Budget Reports A static budget is a projection of budget data at one level of activity.
In such a budget, data for different levels of activity are ignored.
As a result, actual results are always compared with the budget data at the activity level used in developing the master budget.
5. Static Budget Reports: Illustration To illustrate the role of a static budget in budgetary control, we will use selected budget data for Hayes Company prepared in Chapter 6.
Budget and actual sales data for the Kitchen-mate product in the first and second quarters of 1999 are as follows:
6. Management’s analysis should start by asking the sales manager the cause(s) of the shortfall. The need for corrective action should be considered.
For example, management may decide to spur sales by offering sales incentives to customers or by increasing advertising. On the other hand, if management concludes that a downturn in the economy is responsible for the lower sales, it may decide to modify planned sales and profit goals for the remainder of the year. Static Budget Reports: Illustration
7. Static Budget Reports A static budget is appropriate in evaluating a manager’s effectiveness in controlling costs when:
the actual level of activity closely approximates the master budget activity level, or
the behavior of the costs in response to changes in activity is fixed.
8. Flexible Budgets 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.
The flexible budget recognizes that the budgetary process has greater usefulness 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.
9. Why Flexible Budgets? An Illustration Barton Steel prepares the following static budget for manufacturing overhead based on a production volume of 10,000 units of steel ingots.
10. Why Flexible Budgets? An Illustration If demand for steel ingots has increased and 12,000 units are produced during the year, rather than 10,000, the budget report will show very large variances.
11. Why Flexible Budgets? An Illustration The budgeted variable costs at 12,000 units are as shown on the right. Because fixed costs do not change in total as activity changes, the budgeted amounts for these costs remain the same.
12. Why Flexible Budgets? An Illustration The budget report based on the flexible budget for 12,000 units is shown.
13. Flexible Budget – A Case Study Master Budget Data Fox Company wants to use a flexible budget for monthly comparisons of actual and budgeted manufacturing overhead costs. The master budget for the year ended December 31, 1999 is prepared using 120,000 direct labor hours and the following overhead costs. STEP 1: Identify the activity index and the relevant range of activity:
The activity index is direct labor hours and management concludes that the relevant range is 8,000-12,000 direct labor hours.
14. STEP 2: Identify the variable costs and determine the budgeted variable cost per unit of activity for each cost.
For Fox, there are 3 variable costs and the per unit variable cost is found by dividing each total budgeted cost by the direct labor hours used in preparing the master budget (120,000 hours). Flexible Budget – A Case Study Variable Costs per Labor Hour
15. Step 3: Identify the fixed costs and determine the budgeted amount for each cost.
There are three fixed costs and since Fox Manufacturing desires monthly budget data, the budgeted amount is found by dividing each annual budgeted cost by 12.
The monthly budgeted fixed costs are:
Depreciation $15,000,
Supervision $10,000, and
Property taxes $5,000.
Flexible Budget – A Case Study Fixed Costs
16. Step 4: Prepare the budget for selected increments of activity within the relevant range. Flexible Budget – A Case Study The Flexible Budget
17. From the budget, the formula shown below may be used to determine total budgeted costs at any level of activity.
For Fox Manufacturing, fixed costs are $30,000, and total variable costs per unit is $4.00.
Thus, at 8,622 direct labor hours, total budgeted costs are: Flexible Budget – A Case Study Formula for Total Budgeted Costs
18. Flexible Budget Reports Flexible budget reports represent another type of internal report produced by managerial accounting.
The flexible budget report consists of two sections:
Production data such as direct labor hours, and
Cost data for variable and fixed costs.
Flexible budgets are used to evaluate a manager’s performance in production control and cost control.
19. Flexible Budget – A Case Study Flexible Budget Report In this budget report, 8,800 DLH were expected but 9,000 hours were worked. Budget data are based on the flexible budget for 9,000 hours.
20. Management by Exception Management by exception means focusing on major differences.
For management by exception to be effective, there must be some guidelines for identifying an exception. The usual criteria are:
Materiality- usually expressed as a percentage difference from budget; may also have a dollar limit.
Controllability - exception guidelines are more restrictive for controllable items than for items that are not controllable by the manager being evaluated.
22. The Concept of Responsibility Accounting Responsibility accounting involves accumulating and reporting costs (and revenues, where relevant) on the basis of the individual manager who has the authority to make the day-to-day decisions about the items.
The evaluation of a manager's performance is then based on the costs directly under the manager's control.
23. Responsibility Accounting Responsibility accounting personalizes the managerial accounting systems. Under responsibility accounting, any individual who has control and is accountable for a specified set of activities can be recognized as a responsibility center.
Responsibility accounting is especially valuable in a decentralized company.
Decentralization means that the control of operations is delegated by top management to many individuals (managers) throughout the organization.
A segment is an identified area of responsibility in decentralized operations.
24. Responsibility Accounting versus Budgetary Control Responsibility accounting is essential to any effective system of budgetary control. It differs from budgeting in two respects:
A distinction is made between controllable and non-controllable items.
Performance reports either emphasize or include only items controllable by the individual manager.
25. Controllable versus Non-controllable Revenues and Costs All costs and revenues are controllable at some level of responsibility within the company. 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. In general, costs incurred directly by a level of responsibility are controllable at that level.
Costs incurred indirectly and allocated to a responsibility level are considered to be non-controllable at that level.
26. Responsibility Reporting System A responsibility reporting system involves the preparation of a report for each level of responsibility shown in the company's organization chart.
A responsibility reporting system permits management by exception at each level of responsibility within the organization.
27. Types of Responsibility Centers 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.
28. Examples of Responsibility Centers
29. Responsibility Accounting for Cost Centers The evaluation of a manager’s performance for cost centers is based on the manager’s ability to meet budgeted goals for controllable costs. Responsibility reports for cost centers compare actual controllable costs with flexible budget data.
Only controllable costs are included in the report, and fixed and variable costs are not distinguished.
30. Responsibility Accounting To determine the controllability of fixed costs it is necessary to distinguish between direct and indirect fixed costs.
Direct fixed costs (traceable costs) are costs that relate specifically to a responsibility center and are incurred for the sole benefit of the center. Most direct fixed costs are controllable by the center manager.
Indirect fixed costs (common costs) pertain to a company's overall operating activities and are incurred for the benefit of more than one profit center. Thus, most indirect costs are not controllable by the center manager.
31. Responsibility Report for Profit Centers 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. In the report:
Controllable fixed costs are deducted from contribution margin.
The excess of contribution margin over controllable fixed costs is identified as controllable margin.
Non-controllable fixed costs are not reported.
Controllable margin is considered to be the best measure of the manager’s performance in controlling revenues and costs.
32. Responsibility Report for a Profit Center This manager was below budgeted expectations by approximately 10% ($36,000/ $360,000).
Top management would likely investigate the causes of this unfavorable result.
33. Responsibility Accounting for Investment Centers An important characteristic of an investment center is that the manager can control or significantly influence the investment funds available for use.
Thus, the primary basis for evaluating the performance of a manger of an investment center is return on investment (ROI).
ROI is considered to be superior to any other performance measurement because it shows the effectiveness of the manager in utilizing the assets at the manager’s disposal.
34. Return on Investment The formula for computing ROI for an investment center, together with assumed illustrative data is shown below.
Operating assets consist of current assets and plant assets used in operations by the center. Average operating assets are usually based on the beginning and ending cost or book values of the assets.
35. Responsibility Report for a Profit Center Since an investment center is an independent entity for operating purposes, all fixed costs are controllable by the investment center manager.
Notice the report shows budgeted and actual ROI.
36. Improving ROI A manager can improve ROI by:
increasing controllable margin, and/or
reducing average operating assets.
Controllable margin can be increased by increasing sales or by reducing variable and controllable fixed costs.
A reduction in operating assets should not adversely affect future growth or operations
37. Judgmental Factors in ROI The return on investment approach includes two judgmental factors:
Valuation of operating assets – Operating assets may be valued at acquisition cost, book value, appraised value, or market value.
Margin (income) measure – This measure may be controllable margin, income from operations, or net income.
38. Principles of Performance Evaluation Performance evaluation is at the center of responsibility accounting. Performance evaluation is a management function that compares actual results with budget goals.
Performance evaluation includes both behavioral and reporting principles.
39. Principles of Performance Evaluation: Behavioral The human factor is critical in evaluating performance. Behavioral principles include the following:
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.
40. Performance reports (which are primarily internal) should:
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.
Be tailor-made for the intended evaluation.
Be prepared at reasonable intervals.
Principles of Performance Evaluation: Reporting
