Class 10

1.Describe and discuss budgetary control and static budget reports.

Budgetary Control

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 reporting system does the following:

1. Identifies the name of the budget report, such as the sales budget or the manufacturing
overhead budget.
2. States the frequency of the report, such as weekly or monthly.
3. Specifies the purpose of the report.
4. Indicates the primary recipient(s) of the report.

Static Budget Reports

When used in budgetary control, each budget included in the master budget is considered to be
static. A static budget is a projection of budget data at a single level of activity before actual
activity occurs.

The difference between budget and actual is sometimes called a budget variance.
Uses and Limitations

1. The actual level of activity closely approximates the master budget activity level, and/or
2. The behavior of the costs in response to changes in activity is fixed.

A static budget report is, therefore, appropriate for fixed manufacturing costs and for fixed
selling and administrative expenses.

2.Develop a flexible budget.

Flexible Budget Reports

In contrast to a static budget, which is based on one level of activity, 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 master budget described in Chapter 9 is based on a static budget.

A static budget is not useful for performance evaluation if a company has substantial variable
costs.
The flexible budget helps management evaluate whether cost changes resulting from different
production volumes are reasonable.

This flexible budget report indicates that the Assembly Department’s costs are under budget—a
favorable difference. Instead of worrying about being fired, you may be in line for a bonus or a
raise after all! As this analysis shows, the only appropriate comparison is between actual costs
at 12,000 units of production and budgeted costs at 12,000 units.

Developing the Flexible Budget

The flexible budget uses the master budget as its basis. To develop the flexible budget,
management
uses the following steps.

1. Identify the activity index and the relevant range of activity.

2. Identify the variable costs and determine the budgeted variable cost per unit of activity for
each cost.
3. Identify the fixed costs and determine the budgeted amount for each cost.
4. Prepare the budget for selected increments of activity within the relevant range.

Flexible Budget—A Case Study

Step 1. Identify the activity index and the relevant range of activity. The activity index is direct
labor hours. The relevant range is 8,000–12,000 direct labor hours per month.

Step 2. Identify the variable costs and determine the budgeted variable cost per unit of activity
for each cost.

Step 3. Identify the fixed costs and determine the budgeted amount for each cost.

Step 4. Prepare the budget for selected increments of activity within the relevant range.
Flexible Budget Reports

Flexible budget reports are another type of internal report. The flexible budget report consists of
two sections: (1) production data for a selected activity index, such as direct labor hours, and (2)
cost data for variable and fixed costs.
3.Distinguish between controllable vs. noncontrollable revenues and costs.

There are more, not fewer, controllable costs as you move to higher levels of management.

Under responsibility accounting, the critical issue is whether the cost or revenue is controllable at
the level of responsibility with which it is associated. A cost over which a manager has control is
called a controllable cost. From this definition, it follows that:

1. All costs are controllable by top management because of the broad range of its authority.
2. Fewer costs are controllable as one moves down to each lower level of managerial
responsibility because of the manager’s decreasing authority.

In general, costs incurred directly by a level of responsibility are controllable at that level. In
contrast, costs incurred indirectly and allocated to a responsibility level are noncontrollable
costs at that level.

The longer the time span, the more likely that the cost becomes controllable.

4.Discuss the principles of performance evaluation.

Management by Exception
Management by exception means that top management’s review of a budget report is focused
either entirely or primarily on significant differences between actual results and planned
objectives. This approach enables top management to focus on problem areas.

Materiality. Without quantitative guidelines, management would have to investigate every

budget difference regardless of the amount. Materiality is usually expressed as a percentage
difference from budget.

Controllability of the Item. Exception guidelines are more restrictive for controllable items
than for items the manager cannot control. In fact, there may be no guidelines for
noncontrollable items.

Behavioral Principles

1. Managers of responsibility centers should have direct input into the process of establishing
budget goals of their area of responsibility.
2. The evaluation of performance should be based entirely on matters that are controllable by the
manager being evaluated.
3. Top management should support the evaluation process.
4. The evaluation process must allow managers to respond to their evaluations.
5. The evaluation should identify both good and poor performance.

Reporting Principles

1. Contain only data that are controllable by the manager of the responsibility center.
2. Provide accurate and reliable budget data to measure performance.
3. Highlight significant differences between actual results and budget goals.
4. Be tailor-made for the intended evaluation by ensuring only controllable costs are included.
5. Be prepared at reasonable time intervals.

5.Explain what a responsibility reporting system is and describe the types of responsibility
centers.

A responsibility reporting system involves the preparation of a report for each level of
responsibility in the company’s organization chart.
Responsibility reports help to hold individual managers accountable for the costs and revenues
under their control.

The responsibility reporting system begins with the lowest level of responsibility for controlling
costs and moves upward to each higher level.

Types of Responsibility Centers

A cost center incurs costs (and expenses) but does not directly generate revenues. Managers of
cost centers have the authority to incur costs. They are evaluated on their ability to control costs.
Cost centers are usually either production departments or service departments. Production
departments participate directly in making the product. Service departments provide only support
services.
A profit center incurs costs (and expenses) and generates revenues. Managers of profit centers
are judged on the profitability of their centers.
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.

Responsibility Accounting for Cost Centers

The evaluation of a manager’s performance for cost centers is based on his or her ability to meet
budgeted goals for controllable costs. Responsibility reports for cost centers compare actual
controllable costs with flexible budget data.

Responsibility Accounting for Profit Centers

Direct and Indirect Fixed Costs. A profit center may have both direct and indirect fixed costs.
Direct fixed costs relate specifically to one center and are incurred for the sole benefit of that
center. Since these fixed costs can be traced directly to a center, they are also called traceable
costs. Most direct fixed costs are controllable by the profit center manager.

In contrast, indirect fixed costs pertain to a company’s overall operating activities and are
incurred for the benefit of more than one profit center. Management allocates indirect fixed costs
to profit centers on some type of equitable basis. Because these fixed costs apply to more than
one center, they are also called common costs. Most indirect fixed costs are not controllable by
the profit center manager.

Responsibility Report. The responsibility report for a profit center shows budgeted and actual
controllable revenues and costs.

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.

Recognize that we are emphasizing financial measures of performance. Companies are now
making an effort to also stress nonfinancial performance measures such as product quality, labor
productivity, market growth, materials’ yield, manufacturing flexibility, and technological
capability.

Controllable margin is considered to be the best measure of the manager’s performance in

controlling revenues and costs.

6.Fully explain the concept of return on investment (ROI) and how it is used to evaluate
investment centers.

Thus, the primary basis for evaluating the performance of a manager of an investment center is
return on investment (ROI). The return on investment is considered to be a useful performance
measurement because it shows the effectiveness of the manager in utilizing the assets at his or
her disposal.

Return on Investment (ROI)

The ROI formula helps managers determine if the investment center has used its assets
effectively.

Responsibility Report

The scope of the investment center manager’s responsibility significantly affects the content of
the performance report. Since an investment center is an independent entity for operating
purposes, all fixed costs are controllable by its manager.

Judgmental Factors in ROI

1. Valuation of operating assets.

2. Margin (income) measure.

Improving ROI
Increasing Controllable Margin

1. Increase sales 10%.

2. Decrease variable and fixed costs 10%.

Reducing Average Operating Assets