Budgetary Control and Responsibility Accounting

1. Budgetary Control and Responsibility Accounting Chapter 10 Richard E. McDermott, Ph.D.

2. Presentation Approach • As much of the material is self-explanatory, this presentation will only focus on conceptual concepts that need additional explanation. • As always, students are responsible for all material in the chapter.

3. Static Budgets • Static budgets are budgets that do not vary with changes in production or sales volume. • Static budgets are of limited use for cost control or performance evaluation. • The only reason Professor McDermott can see for using a static budget (versus a flexible budget) is: • If the company can forecast volume with certainty, or • If the company cannot identify variable costs

4. Flexible Budget Formula • A formula that Professor McDermott has found to be useful to students in working flexible budgeting problems is: • Y = a + bX • Where • Y = total flexible budget • a = total fixed costs • b = variable costs per unit • X = production or sales volume

5. Example Problem • The controller of XYZ Company has provided you with the following cost information on the company’s product line. • Total fixed costs equals $200,000 • Variable cost per unit is $10 • Next year the company anticipates manufacturing 25,000 units • What should be the flexible budget for the year? • Y = 200,000 + 10(25,000) • Y = $450,000

6. Responsibility Accounting • Involves accumulating and reporting costs (and revenues where relevant) on the basis of the manager who has authority to make day-to-day decisions about the items. • Is based on the concept that managers should not be held accountable for revenues and costs over which they have no control.

7. Types of Responsibility Centers • Cost Center. Incurs costs but does not generate revenue. • Profit Center. Incurs both costs and revenues. • Investment Center. Incurs both costs and revenues. In addition has responsibility for assets used in generating revenues. • Investment center managers are evaluated on both the profitability of the center and the rate of return earned on the funds invested.

8. Responsibility Report • Prepared using the cost volume profit income statement explained in chapter 5. • Steps: • Contribution margin is calculated by subtracting variable costs from revenues. • Controllable fixed costs are subtracted from contribution margin. • The resulting balance is known as the controllable margin. • Let’s see an example!

9. Responsibility Report Format Everything here is under control of one manager!

10. Return on Investment (ROI) • ROI is used in evaluating managers of investment centers because it measures the effectiveness of the manager and utilizing the assets at his or her disposal. • Formula: • When using responsibility accounting, we divide the controllable margin (instead of operating income) by average operating assets to calculate return on investments (ROI). • Controllable margin ÷ average operating assets = ROI

11. Exercise 10-1 • Identify each of the statements on the following slide as true or false. • If false, indicate how to correct the statement.

12. Exercise 10-1 1.Budget reports compare actual results with planned objectives. True. 2. All budget reports are prepared on a weekly basis. False. Budget reports are prepared as frequently as needed. 3. Management uses budget reports to analyze differences between actual and planned results and determine their causes True.

13. Exercise 10-1 4. As a result of analyzing budget reports, management may either take corrective action or modify future plans. True. 5. Budgetary control works best when the company has an informal reporting system. False. Budgetary control works best when a company has a formalized reporting system.

14. Exercise 10-1 6. The primary recipients of the sales reporter the sales manager and the vice president of production. False. The primary recipients of the sales report are the sales manager and top management. 7. The primary recipient of the scrap report is production manager. True. 8. A static budget is a projection of budget data at one level of activity. True.

15. Exercise 10-1 9. Top management’s reaction to unfavorable differences is not influenced by the materiality of the difference False. Top management’s reaction to unfavorable differences is often influenced by the materiality of the difference. 10.A static budget is not appropriate in evaluating a manager’s effectiveness in controlling costs unlessthe actual activity level approximates the static budget level or the behavior of the cost is fixed. True.

16. Exercise 10-3 • XYZ company uses a flexible budget for manufacturing overhead based on direct labor hours. • Variable manufacturing overhead costs per direct labor hour are as follows: • indirect labor $1.00 • indirect material $0.50 • utilities $0.40

17. Exercise 10-3 • Fixed overhead costs per month are: • Supervision $4000 • Depreciation the $1500 • Property taxes $800 • The company believes it will normally operate in a range of 7,000 to 10,000 direct labor hours per month. • Prepare a monthly manufacturing overhead flexible budget for 2008 for the expected range of activity, using increments of 1,000 direct labor hours.

18. Exercise 10-3 Since we are working with a flexible budget, we must first identify the activity level. The activity level is the cost driver – the activity that drives variable costs. In this problem it is direct labor hours.

19. Exercise 10-3 Now multiply in the variable costs per activity level by the budgeted number of activities to get total variable costs.

20. Exercise 10-3 Now insert fixed costs. Then total variable and fixed costs to give a total budget at each level of activity.

21. Exercise 10-4 • Using the information from exercise 10-3, assume that in 2008, the company incurs the following manufacturing overhead costs.

22. RANEY COMPANY Manufacturing Overhead Flexible Budget Report For the Month Ended July 31, 2008 Prepare a flexible budget at 9,000 hours.

23. RANEY COMPANY Manufacturing Overhead Flexible Budget Report For the Month Ended July 31, 2008 Prepare a flexible budget at 8,500 hours.

24. Exercise 10-4 • Comment on your findings. • In case (a) the performance for the month was satisfactory. • In case (b) management may need to determine the causes of the unfavorable differences for indirect labor and indirect materials, or since the differences are small, 2.4% of budgeted cost for indirect labor and 1.2% for indirect materials, they might be considered immaterial.

25. Exercise 10-8 • As sales manager, Terry DeWitt was given the following static budget report for selling expenses in the clothing department of XYZ Company for the month of October. • As a result of this budget report, he was called in and congratulated on his fine sales performance. • He was reprimanded, however ,for allowing his cost to get out of control. • Terry was sure that something was wrong with the performance report that he had been given. However he was not sure what to do and comes to you for advice. • Prepare a budget report based on flexible budget data to help Terry.

26. Original Report

27. Corrected Variable Cost Report Then we multiply per unit cost by actual activity We calculate per unit cost first by dividing budget by units of activity.

28. Exercise 10-8 • Terry should not have been reprimanded. As shown in the flexible budget report, variable costs were $1,250 below budget.

29. Exercise 10-9 • XYZ Plumbing company is a newly formed company specializing in plumbing service for home and business. • The owner has divided the company into two segments: home plumbing services and business plumbing services. • Each segment is run by its own supervisor, all basic selling and administrative services are shared by both segments. • The president has asked you to help him create a performance reporting system that will allow them to measure each segments performance in terms of its profitability. • To that end following information has been collected on the home services segment for the first quarter of 2008.

30. Exercise 10-9

31. Exercise 10-9 • Prepare a responsibility report for the first quarter of 2008 for the home plumbing service segment. • Remember the formula: • Revenue – variable expenses – controllable fixed expenses = controllable margin

32. Responsibility ReportFor the Quarter Ended March 31, 2008 Calculate the contribution margin first:

33. Responsibility ReportFor the Quarter Ended March 31, 2008 Then subtract controllable fixed expenses:

34. Exercise 10-9 • Write a memo to the president discussing the principles that should be used when preparing a performance report.

35. Exercise 10-9 • Points to be covered: • When evaluating the performance of a company’s segments, the performance reports should: • Contain only data that are controllable by the segment’s manager. • 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.

36. The End