Budgetary Control and

Responsibility Accounting
Chapter10
BUDGETARY CONTROL
A major function of management is to control
operations
One element is the use of budget reports which
compare actual results with planned objectives
Provides management with feedback on operations
BUDGETARY CONTROL
Schedule below illustrates a partial budgetary control
system for a manufacturing company.
Note the frequency of reports and their emphasis on
control

Static Budgets and Performance
Reports
Static budgets are
prepared for a single,
planned level of
activity.
Performance
evaluation is difficult
when actual activity
differs from the
planned level of
activity.
Hmm! Comparing
static budgets with
actual costs is like
comparing apples
and oranges.
Lets look at CheeseCo.
Static Actual
Budget Results Variances
Machine hours 10,000 8,000
Variable costs
Ind irect labor 40,000 $ 34,000 $
Indirect materials 30,000 25,500
Power 5,000 3,800
Fixed costs
Depreciation 12,000 12,000
Insurance 2,000 2,050
Total overhead costs 89,000 $ 77,350 $
Static Budgets and Performance
Reports
CheeseCo
Static Actual
Budget Results Variances
Machine hours 10,000 8,000 2,000 U
Variable costs
Ind irect labor 40,000 $ 34,000 $ $6,000 F
Indirect materials 30,000 25,500 4,500 F
Power 5,000 3,800 1,200 F
Fixed costs
Depreciation 12,000 12,000 0
Insurance 2,000 2,050 50 U
Total overhead costs 89,000 $ 77,350 $
$11,650 F
Static Budgets and Performance
Reports
U = Unfavorable variance
CheeseCo was unable to achieve
the budgeted level of activity.
CheeseCo
Static Actual
Budget Results Variances
Machine hours 10,000 8,000 2,000 U
Variable costs
Ind irect labor 40,000 $ 34,000 $ $6,000 F
Indirect materials 30,000 25,500 4,500 F
Power 5,000 3,800 1,200 F
Fixed costs
Depreciation 12,000 12,000 0
Insurance 2,000 2,050 50 U
Total overhead costs 89,000 $ 77,350 $
$11,650 F
Static Budgets and Performance
Reports
F = Favorable variance that occurs when
actual costs are less than budgeted costs.
CheeseCo
Static Actual
Budget Results Variances
Machine hours 10,000 8,000 2,000 U
Variable costs
Ind irect labor 40,000 $ 34,000 $ $6,000 F
Indirect materials 30,000 25,500 4,500 F
Power 5,000 3,800 1,200 F
Fixed costs
Depreciation 12,000 12,000 0
Insurance 2,000 2,050 50 U
Total overhead costs 89,000 $ 77,350 $
$11,650 F
Static Budgets and Performance
Reports
Since cost variances are favorable, have
we done a good job controlling costs?
CheeseCo
Static Budgets and Performance
Reports
I dont think I
can answer the
question using
a static budget.
Actual activity is below
budgeted activity which
is unfavorable.
So, shouldnt variable costs
be lower if actual activity
is lower?
Static Budgets and Performance
Reports
The relevant question is . . .
How much of the favorable cost variance is
due to lower activity, and how much is due
to good cost control?
To answer the question,
we must
the budget to the
actual level of activity.
Flexible Budgets
Improve performance evaluation.
May be prepared for any activity
level in the relevant range.
Show revenues and expenses
that should have occurred at the
actual level of activity.
Reveal variances due to good cost
control or lack of cost control.
Flexible Budgets
Central Concept
If you can tell me what your activity was
for the period, I will tell you what your costs
and revenue should have been.
Management by Exception
Focus of top managements review of a budget
report:
differences between actual and planned results
Able to focus on problem areas
Investigate only material and controllable
exceptions
Express materiality as a
percentage difference from budget -
either over or under budget
Controllability relates to those items
controllable by the manager
Preparing a Flexible Budget
To a budget we need to know that:
Total variable costs change
in direct proportion to
changes in activity.
Total fixed costs remain
unchanged within the
relevant range.
Fixed
Preparing a Flexible Budget
Cost Total Flexible Budgets
Formula Fixed 8,000 10,000 12,000
Per Hour Cost Hours Hours Hours
Machine hours 8,000 10,000 12,000
Variable costs
Indirect labor 4.00 32,000 $
Indirect material 3.00 24,000
Power 0.50 4,000
Total variable cost 7.50 $ 60,000 $
Fixed costs
Depreciation 12,000 $
Insurance 2,000
Total fixed cost
Total overhead costs
Preparing a Flexible Budget
Fixed costs are
expressed as a
total amount.
Variable costs are expressed as
a constant amount per hour.
$40,000 10,000 hours is
$4.00 per hour.
CheeseCo
Cost Total Flexible Budgets
Formula Fixed 8,000 10,000 12,000
Per Hour Cost Hours Hours Hours
Machine hours 8,000 10,000 12,000
Variable costs
Indirect labor 4.00 32,000 $
Indirect material 3.00 24,000
Power 0.50 4,000
Total variable cost 7.50 $ 60,000 $
Fixed costs
Depreciation 12,000 $
Insurance 2,000
Total fixed cost
Total overhead costs
Preparing a Flexible Budget
$4.00 per hour 8,000 hours = $32,000
CheeseCo
Preparing a Flexible Budget
Cost Total Flexible Budgets
Formula Fixed 8,000 10,000 12,000
Per Hour Cost Hours Hours Hours
Machine hours 8,000 10,000 12,000
Variable costs
Indirect labor 4.00 32,000 $ 40,000 $ 48,000 $
Indirect material 3.00 24,000 30,000 36,000
Power 0.50 4,000 5,000 6,000
Total variable cost 7.50 $ 60,000 $ 75,000 $ 90,000 $
Fixed costs
Depreciation 12,000 $ 12,000 $ 12,000 $ 12,000 $
Insurance 2,000 2,000 2,000 2,000
Total fixed cost 14,000 $ 14,000 $ 14,000 $
Total overhead costs 74,000 $ 89,000 $ 104,000 $
CheeseCo
Preparing a Flexible Budget
Cost Total Flexible Budgets
Formula Fixed 8,000 10,000 12,000
Per Hour Cost Hours Hours Hours
Machine hours 8,000 10,000 12,000
Variable costs
Indirect labor 4.00 32,000 $ 40,000 $ 48,000 $
Indirect material 3.00 24,000 30,000 36,000
Power 0.50 4,000 5,000 6,000
Total variable cost 7.50 $ 60,000 $ 75,000 $ 90,000 $
Fixed costs
Depreciation 12,000 $ 12,000 $ 12,000 $ 12,000 $
Insurance 2,000 2,000 2,000 2,000
Total fixed cost 14,000 $ 14,000 $ 14,000 $
Total overhead costs 74,000 $ 89,000 $ 104,000 $
Total fixed costs
do not change in
the relevant range.
CheeseCo
Trepid Manufacturing Company prepared a
static budget of 40,000 direct labor hours,
with estimated overhead costs of $200,000
for variable overhead and $60,000 for fixed
overhead. Trepid then prepared a flexible
budget at 38,000 labor hours. How much is
total overhead costs at this level of activity?
a $247,000
b $250,000
c $260,000
d $190,000
Flexible Budget Performance Reports
Monthly comparisons of actual and budgeted
manufacturing overhead costs
A type of internal report
Consists of two sections:
Production data for a selected activity
index, such as direct labor hours
Cost data for variable and fixed costs
Widely used in production and service departments
to evaluate a managers performance in production
control and cost control
Cost Total
Formula Fixed Flexible Actual
Per Hour Costs Budget Results Variances
Machine hours 8,000 8,000 0
Variable costs
Indirect labor 4.00 $ 32,000 $ 34,000 $
Indirect material 3.00 24,000 25,500
Power 0.50 4,000 3,800
Total variable costs 7.50 $ 60,000 $ 63,300 $
Fixed Expenses
Depreciation 12,000 $ 12,000 $ 12,000 $
Insurance 2,000 2,000 2,050
Total fixed costs 14,000 $ 14,050 $
Total overhead costs 74,000 $ 77,350 $
Flexible Budget
Performance Report
Flexible budget is
prepared for the
same activity level
(8,000 hours) as
actually achieved.
CheeseCo
Cost Total
Formula Fixed Flexible Actual
Per Hour Costs Budget Results Variances
Machine hours 8,000 8,000 0
Variable costs
Indirect labor 4.00 $ 32,000 $ 34,000 $ $ 2,000 U
Indirect material 3.00 24,000 25,500 1,500 U
Power 0.50 4,000 3,800 200 F
Total variable costs 7.50 $ 60,000 $ 63,300 $ $ 3,300 U
Fixed Expenses
Depreciation 12,000 $ 12,000 $ 12,000 $ 0
Insurance 2,000 2,000 2,050 50 U
Total fixed costs 14,000 $ 14,050 $ 50 U
Total overhead costs 74,000 $ 77,350 $ $ 3,350 U
Flexible Budget
Performance Report
CheeseCo
Flexible Budget
Performance Report
Static Actual
Budget Results Variances
Machine hours 10,000 8,000 2,000 U
Variable costs
Indirect labor 40,000 $ 34,000 $ $6,000 F
Indirect materials 30,000 25,500 4,500 F
Power 5,000 3,800 1,200 F
Fixed costs
Depreciation 12,000 12,000 0
Insurance 2,000 2,050 50 U
Total overhead costs 89,000 $ 77,350 $
$11,650 F
Static Budgets and Performance
How much of the $11,650 is due to activity
and how much is due to cost control?
Flexible Budget
Performance Report
Difference between original static budget
and actual overhead = $11,650 F.
Overhead Variance Analysis
Static Actual
Overhead Overhead
Budget at at
10,000 Hours 8,000 Hours
89,000 $ 77,350 $
Lets place
the flexible
budget for
8,000 hours
here.
Flexible Budget
Performance Report
This $15,000F variance is
due to lower activity.
Overhead Variance Analysis
Activity
This $3,350U flexible
budget variance is due
to poor cost control.
Cost control
Static Flexible Actual
Overhead Overhead Overhead
Budget at Budget at at
10,000 Hours 8,000 Hours 8,000 Hours
89,000 $ 74,000 $ 77,350 $
Flexible Budget
Performance Report
What causes
the cost
control variance?
There are two primary
reasons for unfavorable
variable overhead variances:
1. Spending too much for
resources.
2. Using the resources
inefficiently.
THE CONCEPT OF
RESPONSIBILITY ACCOUNTING
I nvolves accumulating and
reporting costs on the basis of
the manager who has the
authority to make the day-to-
day decisions about the items
Means a manager's
performance is evaluated on
the matters directly under the
manager's control
CONTROLLABLE vs. NONCONTROLLABLE
REVENUES AND COSTS
All costs can be controlled at some level within
the company.
Fewer costs controllable as one moves down to
lower levels of management
Critical issue:

Whether the cost or revenue is
controllable at the level of responsibility
with which it is associated
Conditions for using responsibility accounting:
Costs and revenues can be directly associated
with the specific level of management
responsibility.
The costs and revenues are controllable by
those responsible.
Budget data can be developed to evaluate the
manager's effectiveness in controlling costs
and revenues.

THE CONCEPT OF
RESPONSIBILITY ACCOUNTING
Responsibility center - any
individual who has control and
is accountable.
May extend from the lowest
levels of management to the top
strata of management.
Responsibility accounting is
especially valuable in a
decentralized company
where control of operations is
delegated to many managers
throughout the organization.
THE CONCEPT OF
RESPONSIBILITY ACCOUNTING
Two differences from budgeting in reporting costs
and revenues:
Distinguishes between controllable and noncontrollable
costs
Performance reports emphasize or include only items
controllable by the individual manager.
Applies to both profit and not-for-profit entities
Profit entities: maximize net income
Not-for-profit: minimize cost of providing services

THE CONCEPT OF
RESPONSIBILITY ACCOUNTING
RESPONSIBILITY REPORTING SYSTEM
Involves preparation of a
report for each level of
responsibility in the
company's organization
chart
Begins with the lowest level
of responsibility and moves
upward to higher levels
Permits management by
exception at each level of
responsibility

Also permits comparative evaluations
Plant manager can rank the department
managers effectiveness in controlling
manufacturing costs
Comparative ranking provides incentive for
a manager to control costs

RESPONSIBILITY REPORTING SYSTEM
RESPONSIBILITY REPORTING SYSTEM
TYPES OF
RESPONSIBILITY CENTERS
Three basic types:
Cost centers
Profit centers
Investment centers
Indicates degree of
responsibility that
managers have for the
performance of the center
TYPES OF
RESPONSIBILITY CENTERS
TYPES OF RESPONSIBILITY CENTERS
RESPONSIBILITY ACCOUNTING FOR
COST CENTERS
Based on a managers ability to meet budgeted goals
for controllable costs
Results in responsibility reports which compare actual
controllable costs with flexible budget data
Include only controllable costs in reports
No distinction between variable and fixed costs

RESPONSIBILITY ACCOUNTING FOR COST
CENTERS
Example Fox Manufacturing Co.
Assumes department manager can control all manufacturing overhead costs
except depreciation, property taxes, and his own monthly salary of $4,000

RESPONSIBILITY ACCOUNTING FOR
PROFIT CENTERS
Based on detailed information
about both controllable
revenues and controllable costs
Manager controls operating
revenues earned, such as sales,
Manager controls all variable
costs (and expenses) incurred
by the center because they vary
with sales

PROFIT CENTERS
Responsibility Reports
Shows budgeted and actual controllable revenues
and costs
Prepared using the cost-volume-profit income
statement format:
Deduct controllable fixed costs from the
contribution margin
Controllable margin - excess of contribution
margin over controllable fixed costs best
measure of managers performance in
controlling revenues and costs
Do not report noncontrollable fixed costs
PROFIT CENTER -RESPONSIBILITY REPORTS
Example Marine Division
$60,000 of indirect fixed costs are not controllable by manager not shown
Controls or significantly
influences investment funds
available for use
ROI (return on investment) -
primary basis for evaluating
manager performance in an
investment center
ROI shows the effectiveness of
the manager in utilizing the
assets at his or her disposal
RESPONSIBILITY ACCOUNTING FOR
INVESTMENT CENTERS
RESPONSIBILITY ACCOUNTING FOR
INVESTMENT CENTERS - ROI
ROI is computed as follows:
Operating assets include current assets and plant
assets used in operations by the center.
Exclude nonoperating assets such as idle plant assets and
land held for future use
Base average operating assets on the beginning and
ending cost or book values of the assets


All fixed costs are controllable by the manager
INVESTMENT CENTER - RESPONSIBILITY REPORT
Example Marine Division
JUDGMENTAL FACTORS IN ROI
Valuation of operating
assets
May be valued at
acquisition cost, book value,
appraised value, or market
value
Margin (income) measure
May be controllable margin,
income from operations, or
net income
IMPROVING ROI
ROI can be improved by
I ncreasing controllable margin or
Reducing average operating assets
Assume the following data for Laser Division of
Berra Manufacturing:

Increased by increasing sales or by reducing
variable and controllable fixed costs
Increase sales by 10%
Sales increase $200,000 and contribution margin
increases $90,000 ($200,000 X 45%)
Thus, controllable margin increases to $690,000
($600,000 + $90,000)
New ROI is 13.8%
IMPROVING ROI
Increasing Controllable Margin
Decrease variable and fixed costs 10%
Total costs decrease $140,000 [($1,100,000 + $300,000) X
10%]
Controllable margin becomes $740,000 ($600,000 +
$140,000 )
New ROI becomes 14.8%
IMPROVING ROI
Increasing Controllable Margin
Reduce average operating assets by 10% or
$500,000
Average operating assets become $4,500,000
($5,000,000 X 10%)
Controllable margin remains unchanged at
$600,000
New ROI becomes 13.3%
IMPROVING ROI
Reducing Average Operating Assets
YES!!!