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STANDARD COSTING

Standards are benchmarks for measuring performance. These also are widely used in managerial accounting,
where they relate to the quantity and acquisition price (or cost) of the inputs used in making a product or
providing services. Managers have to decide regarding the prices of materials or salaries to pay and the
quantities or labor hours to use, including overhead costs. Price standards specify how much should be paid
for each unit of the input. If either the quantity or acquisition price of an input departs significantly from the
standard, managers investigate the discrepancy to find the cause of the problem and eliminate it (Garrison et
al., 2018).

Companies set standards at one (1) of two (2) levels: ideal or normal.
1. Ideal standards represent optimum levels of performance under perfect operating conditions.
2. Normal or practical standards represent efficient levels of performance that are attainable under
expected operating conditions.

Some managers believe ideal standards will stimulate workers to constant improvement. However, most
managers believe that ideal standards lower the morale of the entire workforce because they are so difficult, if
not impossible, to meet.

Standard Costing System

Any control system has three (3) basic parts: (1) a predetermined or standard performance level, (2) a measure
of actual performance, and (3) a comparison between standard and actual performance. For example, a
thermostat is a control system with which people are all familiar. First, a thermostat has a predetermined
temperature that can be set at any desired level. If someone wants the temperature in a room to be 68 degrees,
they will set the thermostat at the standard of 68 degrees. Then, the thermostat contains a thermometer that
measures the actual temperature in the room. Lastly, the thermostat compares the preset or standard
temperature with the actual room temperature. If the actual temperature deviates by more than a small amount
from the preset or standard temperature, the thermostat will trigger a response, activating a heating or cooling
device (Hilton & Platt, 2017).

Figure 1. Cost control system

Source: Managerial Accounting: Creating Value in a Dynamic Business Environment, 2017. p. 421

In management accounting, standard costing system is a cost control system that works like a thermostat.

First, a predetermined or standard cost is set. In essence, a standard cost is the company’s best estimate of
the average cost to produce a single unit of product or service. This cost estimate serves as the starting point
for creating the relevant budgets. When the firm plans to produce multiple units, managers use the standard
unit cost to determine the total standard or budgeted cost of production. Standard cost is the predetermined unit
cost that is used as a measure of performance. Suppose the standard cost of the milk (a direct material) used
to make one gallon of ice cream is P40, and the company expects to manufacture 20,000 gallons. The total
standard or budgeted direct-material cost of ice cream for 20,000 gallons is P800,000 (P40 × 20,000).

Second, the cost control system measures the actual cost incurred in the production process. Suppose the
company produced 20,000 gallons of ice cream, as planned, and the actual cost of milk used in production is
measured by the cost control system at P820,000.

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Third, the manager compares the actual cost of milk with the budgeted or standard cost. Any difference between
the two is called cost variance. Cost variances are then used in controlling costs. The P20,000 cost variance
in this example (P820,000 – P800,000) tells the company that their planning figures were incorrect and that they
were not able to produce the quantity of product anticipated at the cost of materials anticipated. This information
may lead the company to look for an explanation for the incorrect prediction. After computing the variance, the
management may take corrective action when needed or revise standards if necessary. Notice that because
the variance in the example was specifically measured for a direct material, there can be specific reasons for
the cost variance. Maybe the market price for the milk had risen unexpectedly after the budget was finalized.
By setting standard costs and measuring cost variances for specific types of costs, meaningful explanations for
the variances can be found. For that reason, standards are set and variances are measured for direct materials,
direct labor, and overhead (Hilton & Platt, 2017).

Standards vs. Budgets

In theory, standards and budgets are essentially the same. Both are predetermined costs, and both contribute
to management planning and control. They only differ in the way the terms are expressed. A standard is the
unit amount. A budget is the total amount. For example, the standard cost of direct labor for a unit of product is
P10. If 10,000 units of the product are to be produced, the P100,000 of direct labor is the budgeted direct labor
cost. (Budgets will be further discussed in the Business Planning and Short-Term Budgetary Systems topic.)

Advantages of Standard Costing System

Standard costs offer several advantages to an organization. These advantages are available only when
standard costs are carefully established and prudently used.

1. Facilitate management planning.

Planning requires estimates of the future. Managers can use current standards to estimate future costs
and quantities. This is achieved through flexible budget, a budget that changes based on the level of
activity. It is a useful tool in comparing actual costs incurred to the cost allowable for the actual output
(or activity level) achieved.
2. Promote greater economy and efficiency by making employees more cost-conscious.
Standards serve as the information for management’s expectations to workers. Standards should be
achievable and workers should be informed of rewards for the attainment of those standards. In this
way, they are more likely to be motivated to strive and do their best to accomplish their tasks.
3. Help set selling prices.
As standard costs are set, management can determine how much to charge for a product so that it can
produce the desired net income. As the business actually incurs these costs, management determines
if the selling prices set are still reasonable and, when necessary, considers some price adjustments
after taking competition into account.
4. Contribute to management control by providing a basis for evaluation of cost control.
The controlling function starts with the establishment of standards that provide a basis for comparing
actual costs to determine variances, if any. A well-designed variance analysis system captures
variances as early as possible. The system helps managers who or what is responsible for each
variance and who is best able to explain it. An early measurement and reporting system allow managers
to monitor operations to take remedial action on issues, evaluate performance, and motivate workers
to achieve the standards set.
5. Help highlight variances in management by exception.
Management by exception is the practice of giving attention only to those situations in which large
variances occur so that management may have more time for more important problems of the business,
not just routine supervision of subordinates.
When the top management receives variance reports highlighting the operating performance of the
subordinate managers, the top management would be able to know when costs were not controlled and
by which managers. It allows the top management to provide feedback to subordinates, investigate
areas of concern, and make performance evaluations about who needs additional supervision, who
should be replaced, or who should be promoted.

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6. Simplify the costing of inventories and reduce clerical costs.

A company using standard costs usually utilizes lesser clerical time and effort in determining costs
necessary for decision making than in an actual costing system. This is because when using standard
costing, costs are assumed to be constant for some period. In actual costing system, costs are
continuously computed as activity level changes. Costs can be assigned to inventory at a predetermined
rate regardless of actual conditions.

Variance Analysis
To establish the standard cost of producing a product, establishing standards for each manufacturing cost
element—direct materials, direct labor, and manufacturing overhead—is necessary. The standard for each
element is determined from the standard price to be paid and the standard quantity to be used.

Total variance is the difference between the total actual cost incurred and the total standard cost applied to the
actual output produced or achieved during the period.
Actual Cost (Actual price
of actual input used)
Total Variance
(Favorable or
Standard Cost (Standard Unfavorable)
price of actual output
produced)

The total variance does not provide useful information for determining why cost differences occurred. To help
managers in achieving their objectives, total variances are subdivided and further analyzed into price and usage
components. Price variances and quantity variances usually have different causes. In addition, different
managers are usually responsible for buying and using inputs. For example, in the case of a raw material, the
purchasing manager is responsible for its price and the production manager is responsible for the amount of
the raw material actually used to make products. Therefore, clearly distinguishing between deviations from price
standards (the responsibility of the purchasing manager) and deviations from quantity standards (the
responsibility of the production manager) is important.

General Model for Standard Costing

Where: AP = Actual Price

AQ = Actual Quantity
SP = Standard Price
SQ = Standard Quantity

Standard price or rate is the amount that should be paid for one (1) unit of input factor.
Standard quantity is the amount of input factor that should be used to make a unit of product.
* Both standards relate to the input factors: direct materials, direct labor, and manufacturing overhead
The model can be used to compute a price variance and a quantity variance for each of the three (3) variable
cost elements—direct materials, direct labor, and variable manufacturing overhead—even though the variances
have different names. The following must be considered in determining the standard costs (Garrison et al.,
2018):

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1. Direct Materials
• The standard price per unit is the cost per unit of direct materials that should be incurred. This
standard should be based on the purchasing department’s best estimate of the cost of raw
materials.
• The standard quantity per unit defines the number of direct materials that should be used for each
unit of the finished product, including an allowance for normal inefficiencies, such as waste and
spoilage.
2. Direct Labor
Direct labor quantity and price standards are usually expressed in terms of labor hours or labor rate.
• The standard hours per unit defines the amount of direct labor hours that should be used to produce
a unit of product.
• The standard rate per hour defines the company’s expected direct labor wage rate per hour,
including employment taxes and fringe benefits.
3. Variable manufacturing overhead
As with direct labor, the quantity and price standards for variable manufacturing overhead are usually
expressed in terms of hours and a rate.
• The standard hours per unit for variable overhead measures the amount of the allocation base from
a company’s predetermined overhead rate that is required to produce one (1) unit of finished goods.
• The standard rate per unit that a company expects to pay for variable overhead equals the variable
portion of the predetermined overhead rate.

Price variance reflects the difference between what was paid for inputs and what should have been paid for
inputs.
𝑃𝑟𝑖𝑐𝑒 𝑣𝑎𝑟𝑖𝑎𝑛𝑐𝑒 = (𝐴𝑃 − 𝑆𝑃)𝑥 𝐴𝐴𝐴

Usage variance shows the difference between how much of the input was actually used and how much should
have been used for the actual level of output.
𝑈𝑠𝑎𝑔𝑒 𝑣𝑎𝑟𝑖𝑎𝑛𝑐𝑒 = (𝐴𝐴𝐴 − 𝑆𝐴𝐴)𝑥 𝑆𝑃

Another diagram could be presented as follows:

Figure 2. General model for standard cost variance analysis

Source: Managerial Accounting, 2017. p. 455

Price variance is called materials price variance (MPV) in the case of direct materials, labor rate variance (LRV)
in the case of direct labor, and variable overhead rate variance (VRV) in the case of variable manufacturing
overhead.

Quantity variance is called materials quantity variance (MQV) in the case of direct materials, labor efficiency
variance (LEV) in the case of direct labor, and variable overhead efficiency variance (VEV) in the case of variable
manufacturing overhead.

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All the columns in the figure are based on the actual amount of output produced during the period. Even the
standard or budgeted cost in Column 3 depicts the standard cost allowed for the actual amount of output
produced during the period.

The standard quantity (SQ) allowed (when computing direct materials variances) or standard hours allowed
(when computing direct labor and variable manufacturing overhead variances) refers to the amount of an input
that should have been used to manufacture the actual output of finished goods produced during the period. It is
computed by multiplying the actual output by the standard quantity (or hours) per unit. The standard quantity
(or hours) allowed is then multiplied by the standard price (or rate) per unit of the input to obtain the total cost
according to the flexible budget. For example, if a company actually produced 50 units of product during the
period and its standard quantity per unit of product for direct materials is five (5) pounds, then its standard
quantity allowed would be 250 pounds, i.e., 50 units × 5 pounds per unit. If the company’s standard cost per
pound of direct materials is P2, then the standard or budgeted direct materials cost would be P500 (250 pounds
× P2 per pound).

Also, the spending, price, and quantity variances, as seen in the diagram, are computed the same way
regardless of whether it is dealing with direct materials, direct labor, or variable manufacturing overhead. In all
of these variance calculations, a positive number should be labeled as an unfavorable (U) variance and a
negative number should be labeled as a favorable (F) variance.

An unfavorable price variance indicates that the actual price (AP) per unit of the input was greater than the
standard price (SP) per unit. A favorable price variance indicates that the actual price (AP) of the input was less
than the standard price (SP) per unit. An unfavorable quantity variance indicates that the actual quantity (AQ)
of the input used was greater than the standard quantity allowed (SQ). Conversely, a favorable quantity variance
indicates that the actual quantity (AQ) of the input used was less than the standard quantity allowed (SQ).

In addition, fixed overhead (FOH) variances can also be computed using the general model. However, instead
of using adjusted cost or actual quantity of input at standard price, the budgeted cost at budgeted level of activity
is used. The total variance for fixed factory overhead is further analyzed into the following:
a. FOH Spending Variance – It is the difference between the actual FOH and the budgeted FOH based on
budgeted input activity.
b. FOH Volume Variance – It is the difference between the budgeted FOH based on budgeted input activity
and the applied or standard FOH based on actual output achieved. It is caused solely by producing at a
level that differs from that used to compute the predetermined fixed overhead rate.

ILLUSTRATION:
Assume that a company manufactures smoked crabs in its smoking department with the following ingredients
on a per lot basis:
Material standard
3,000 pounds of carbs at P5.00 per pound P15,000
Labor standard
40 hours at P15 per hour 600

Variable overhead standard

5 hours at P150 per machine hour 750
P150 = Budgeted monthly variable overhead
of P15,000 at a budgeted activity of 100
machine hours

Fixed overhead standard

8 hours at P140 per hour of move or wait time
(P140 = Budgeted monthly fixed overhead of
P28,000 at a budgeted activity of 200 hours) 1,120
Total cost for one (1) lot of smoked crabs P17,470

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Actual data for the month in the smoking department are as follows:
Number of lots produced (47,500 pounds) 20 lots
Pounds of crabs purchased 60,450
Pounds of crabs used 60,450
Price per pound of crabs purchased P6.00
Direct labor hours incurred 1,000
Total direct labor cost incurred P14,500
Total variable overhead cost P19,000
Machine hours incurred 87
Total fixed overhead cost P30,000
Hours of move/wait time incurred 140

SOLUTION:
Variance analysis can be done using the general model:

1. Direct material variances

Actual Quantity of Input at Actual Quantity of Input at Standard Quantity Allowed for
Actual Price Standard Price Actual Output at Standard Price
(AQ x AP) (AQ x SP) (SQ x SP)
SQ= 20 lots x 3,000 lbs = 60,000
60,450 lbs x P6.00 60,450 lbs x P5.00
60,000 lbs. x P5.00
= P362,700 = P302,250
=P300,000

MPUV P60,450 unfavorable MQV P2,250 unfavorable

Spending Variance (SV) P62,700 unfavorable

MPUV = Material price usage variance

Normally, materials price variance is assumed to be the price usage variance to be consistent with that of the
quantity variance. It is more meaningful as it concerns production rather than the purchasing function. However,
this model can be used to compute direct materials variances only when the actual quantity of materials
purchased equals the actual quantity of materials used in production.

There are cases where these two (2) are different. Because the material price variance relates to the purchasing
function, the materials price variance is computed using the quantity of materials purchased rather than the
quantity of materials used. The variance is called material purchase price variance (MPPV) because it is based
on the quantity of materials purchased. It is best to recognize the price variance for direct materials when the
materials are purchased.

2. Direct labor variances

Actual Hours of Input at Actual Hours of Input at Standard Hours Allowed for
Actual Rate Standard Rate Actual Out put at Standard Rate
(AH x AR) (AH x SR) (SH x SR)
SQ= 20 lots x 40 hrs/lot = 800 hrs
1,000 hrs x P14.50 1,000 hrs x P15.00
800 hrs. x P15.00
= P14,500 = P15,000
=P12,000

LRV P500 favorable LEV P3,000 unfavorable

SV P2,500 unfavorable

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3. Variable overhead variances

Actual Hours of Input at Actual Hours of Input at Standard Hours Allowed for
Actual Rate Standard Rate Actual Output at Standard Rate
(AH x AR) (AH x SR) (SH x SR)
SQ= 20 lots x 5 hrs = 100 hrs
87 hrs x P150.00
P19,000 100 hrs x P150.00
= P13,050
=P15,000

VOH rate variance (VRV) VOH efficiency variance (VEV)

P5,950 unfavorable P1,950 favorable

Total variance P4,000 unfavorable

4. Fixed overhead variance

Actual Hours of Input at Standard Hours Allowed for

Budgeted Fixed Overhead
Actual Rate Actual Output at Standard Rate
(Budgeted Capacity x SR)
(AH x AR) (SH x SR)
SQ = 20 lots x 8 hrs = 160 hrs
200 hrs x P140.00
P30,000 160 hrs x P140.00
= P28,000
=P22,400

FOH spending variance (FSV) FOH volume variance (FVV)

P2,000 unfavorable P5,600 unfavorable

Total variance P7,600 unfavorable

References:
Garrison, R. H., Noreen, E. W., & Brewer, P. C. (2018). Managerial accounting. McGraw-Hill Education.
Hilton, R. W., & Platt, D. E. (2017). Managerial accounting: Creating value in a dynamic business environment.
McGraw-Hill Education.
Weygandt, J. J., Kimmel, P. D., Kieso, D. E., & Aly, I. M. (2018). Managerial accounting: Tools for business
decision-making. John Wiley & Sons, Inc.

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SHORT-TERM BUDGETING

Companies consider budgeting as one of the most important functions of management. Budgeting is the
process of stating in quantitative terms the company’s operations, usually in units and pesos, and planning their
organizational activities for a period of time. A budget is a detailed plan, expressed in quantitative terms, that
specifies how resources will be acquired and used during a specified period of time (Hilton & Platt, 2017).

Budgets are used for two (2) distinct purposes—planning and control. Planning involves developing goals and
preparing various budgets to achieve those goals. Control involves gathering feedback to ensure that the plan
is being properly executed or modified as circumstances change. To be effective, a good budgeting system
must provide for both planning and control. Good planning without effective control is a waste of time and effort
(Garrison, et. al., 2018).

Objectives of Budgeting

Budgeting has five (5) primary purposes (Hilton & Platt, 2017):

1. It compels planning.
The most obvious purpose of a budget is to quantify a plan of action. The process of creating a budget
forces the individuals who make up an organization to plan ahead. For example, the development of a
quarterly budget for a hotel, forces the hotel manager, the reservation manager, and the food and
beverage manager to plan for the staffing and supplies needed to meet anticipated demand for the
hotel’s services.

2. It facilitates cooperation, communication, and coordination

For any organization to be effective, each manager throughout the organization must be aware of the
plans made by other managers. For example, in an airline company, to plan reservations and ticket
sales effectively, the reservations manager must know the flight schedules developed by the airline’s
route manager. The budgeting process pulls together the plans of each manager in an organization.

3. It is useful in allocating resources.

An organization’s resources may be limited and they have to make the best use of such resources.
Budgets provide means of allocating resources among competing uses. For example, in city
government, it must allocate its revenue among basic life services (such as police and fire protection),
maintenance of property and equipment (such as city streets, parks, and vehicles), and other
community services (such as childcare services and programs to prevent alcohol and drug abuse).

4. It helps in controlling profit and operations.

A budget is a plan, and plans are subject to change. Nevertheless, a budget serves as a useful
benchmark with which actual results can be compared. For example, Prudential Insurance Company
can compare its actual sales of insurance policies for a year against its budgeted sales. Such a
comparison can help managers evaluate the firm’s effectiveness in selling insurance.

5. It provides a framework for performance evaluation.

Comparing actual results with budgeted results also helps managers evaluate the performance of
individuals, departments, divisions, or entire company. Since budgets are used to evaluate
performance, they also can be used to provide incentives for people to perform well. For example, a
company provides incentives for managers to improve profits by awarding bonuses to managers who
meet or exceed their budgeted profit goals.

Limitations or Problems Associated with Budgeting

1. Accuracy of estimates. Since budgeting means planning for the future, the plan itself, as well as the
figures therein, are merely estimates, requiring a certain amount of judgment.
2. Adverse reactions from employees. To be successful, a budgetary system requires the cooperation
and participation of all the members of the organization.

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3. Amount of work involved in developing a good budget. The development and installation of a good
budget may be time-consuming and too costly for some organization, costs may outweigh the benefits
that can be derived from budgeting.
4. It limits flexibility. Some managers think that budget restricts their investments and limits their
decision-making power, making it difficult to sell the idea of budgeting to some people in the
organization.

Components of A Master Budget

In small companies, the budgeting process is often informal. In larger companies, responsibility for coordinating
the preparation of the budget is assigned to a budget committee. The committee ordinarily includes the
president, treasurer, chief accountant (controller), and manager from each of the major segments or
departments of the company, such as sales, production, and purchasing. The budget committee acts as a
review board where managers can defend their budget goals and requests. Differences are reviewed, modified
if necessary, and reconciled. The budget is then put in its final form by the budget committee, and is approved
and distributed (Weygandt, et. al., 2018).

The budget period is not necessarily one (1) year in length. A budget may be prepared for any period of time.
Various factors influence the length of the budget period. These factors include the type of budget, the type of
organization, the need for a periodic appraisal, and actual business conditions. For example, cash may be
budgeted monthly, whereas a plant expansion budget may cover a five-year period. The budget period should
be long enough to provide an attainable goal under normal business conditions.

Types of Budgets
1. Annual budget – A budget prepared for one (1) fiscal year.
2. Continuous or rolling budget – It is one that is revised on a regular (continuous) basis; typically, the
budget is extended for another month or quarter in accordance with new data as current month or
quarter ends.
3. Fixed or static budget – It is a budget based on only one (1) level of activity of production.
4. Flexible or variable budget – It is a series of budgets prepared for many levels of activity.

Definition of Terms
• Master Budget – It represents the overall plan of the organization for a given budget period. It consists
of all the individual budgets for each of the segment or department of the organization aggregated or
consolidated into one (1) overall budget for the entire firm.
• Operating budget – It is the detailed schedule for each item in the operations of the business (i.e.,
sales, production, purchases, selling and administrative expenses).
• Financial budget – It is composed of the cash budget and budgeted balance sheet
• Sales budget – It is the starting point in preparing the master budget because estimated sales volume
influences nearly all other items appearing throughout the master budget. It indicates the quantity of
products expected to be sold.
• Production budget – After the sales are budgeted, the production budget can be determined. The
number of units expected to be produced to meet the budgeted sales, as well as the required inventory,
are set forth in this budget. Production budget is supported by the following:
o Direct material budget – It is prepared to show how much material will be required for
production and how much must be purchase to meet the required production.
o Direct labor budget – It is prepared to show how many direct labor hours are required to meet
the production requirements. To compute, multiply the expected production required by the
number of direct labor hours required to produce one (1) unit of product. It is then multiplied to
the cost per unit to arrive at the budgeted direct labor cost.
o Manufacturing overhead budget – This budget shows the manufacturing costs other than
direct materials and direct labor
• Ending inventory budget – This budget helps in computing for the cost of goods sold and ending
materials and finished goods inventory.

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• Selling and administrative expense budget – It lists the operating expenses involved in selling the
products and in operating the business.
• Cash budget – This is prepared for the purpose of cash planning and control. It presents the cash
receipts (cash inflow or collections) and the cash disbursements (cash outflows or payments) within the
budget period. It helps the management in keeping cash balances in reasonable relationship to its
needs.

The diagram below shows the budgeting process:

Figure 1. The Budgeting Process

Source: Managerial Accounting, 2017, p.366

The first step in the budgeting process is preparing a sales budget, which is a detailed schedule showing
the expected sales for the coming year. An accurate sales budget is the key to the entire budgeting process.
As seen in the figure, all other parts of the master budget depend on the sales budget. If the sales budget is
inaccurate, the rest of the budget will also be inaccurate.

The sales budget influences the variable portion of the selling and administrative expense budget and it feeds
into the production budget, which defines how many units need to be produced during the budget period. The
production budget in turn is used to determine the direct materials, direct labor, and manufacturing overhead
budgets. After preparing the manufacturing cost budgets, it can prepare the ending finished goods inventory
budget. The master budget concludes with the preparation of a cash budget, income statement, and balance
sheet. Information from the sales budget, selling and administrative expense budget, and the manufacturing
cost budgets all influence the preparation of the cash budget. A cash budget is a detailed plan showing how
cash resources will be acquired (cash receipts) and used (cash disbursements). The budgeted income
statement provides an estimate of net income for the budget period and it relies on information from the sales
budget, ending finished goods inventory budget, selling and administrative expense budget, and the cash
budget. The balance sheet estimates a company’s assets, liabilities, and stockholders’ equity at the end of a
budget period (Garrison, et. al., 2018).

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ILLUSTRATION 1:
ABC Corporation manufactures and sells two (2) products. Alpha and Omega. In July 201A, ABC’s budget
department gathered the following information in order to project sales and budget requirements for 201B.

Product Alpha Product Omega

Projected Sales
Units 60,000 40,000
Price P70 P100
201B Inventory in units
Expected beginning inventory 20,000 8,000
Desired ending inventory 25,000 9,000

In order to produce one (1) unit of Alpha and Omega, the following raw materials are used:
Raw Amount used per unit (in kg)
Materials Alpha Omega
A 4 5
B 2 3
C - 1

Projected data for 201B with respect to materials are as follows:

Raw Expected Expected Beginning Desired Ending Inventory,
Materials Purchase Price Inventory, January 1, 201B December 31, 201B
A P8.00 32,000 kilos 36,000 kilos
B 5.00 29,000 kilos 32,000 kilos
C 3.00 6,000 kilos 7,000 kilos

Projected direct labor requirements for 201B are as follows:

Product Hours per unit Rate per hour
Alpha 2 P3.00
Omega 3 4.00

Overhead is applied at a rate of P2.00 per direct labor hour.

Required:
Based on the above projections and budget requirements for Alpha and Omega, prepare the following budgets
for 201B.
a. Sales budget (in pesos)
b. Production budget (in units)
c. Direct materials budget (in pesos)
d. Direct labor budget

SOLUTION:
a. Sales budget
Products Units Price Total
Alpha 60,000 P70.00 P4,200,000
Omega 40,000 100.00 4,000,000
P8,200,000

b. Production budget
Alpha Omega
Projected Sales 60,000 40,000
Desired inventory, Dec. 31, 201B 25,000 9,000
Total 85,000 49,000
Expected Inventory, Jan. 1, 201B 20,000 8,000
Production required 65,000 41,000

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c. Direct materials budget

Material A Material B Material C
Units to be produced:
Alpha (65,000 units) 260,000 130,000 -
Omega (41,000 units) 205,000 123,000 41,000
Production needs 465,000 253,000 41,000
Desired inventory, Dec. 31, 201B 36,000 32,000 7,000
Total 501,000 285,000 48,000
Expected Inventory, Jan. 1, 201A 32,000 29,000 6,000
Direct materials to be purchased 469,000 256,000 42,000
Unit cost P8.00 P5.00 P3.00
Total purchase cost P3,752,000 P1,280,000 P126,000

d. Direct labor budget

Alpha Omega
Units produced 65,000 41,000
Direct labor time per unit 2 3
Total hours needed 130,000 123,000
Cost per hour 3 4
Total direct labor cost P390,000 P492,000

ILLUSTRATION 2:
XYZ Store seeks your assistance to develop cash and other budget information for May, June, and July, 201A.
At April 30, 201A, the company had cash of P5,500, accounts receivable of P437,000, inventories of P309,400,
and accounts payable of P133,055.

The budget is based on the following assumptions:

a. Sales
1. Each month’s sales are billed on the last day of the month.
2. Customers are allowed 3% discount if payment is made within 10 days after the billing date.
3. Sixty percent (60%) of the billings are collected within the discount period, 25% are collected by the end
of the month, 9% are collected by the end of the second month, and 6% are proved uncollectible.
b. Purchases
1. Fifty-four percent (54%) of all purchases of materials and selling and administrative expenses are paid
the month purchased and the remainder in the following month.
2. Each month’s units of ending inventory is equal to 130% of the next month’s units of sales.
3. The cost of each unit of inventory is P20.00.
4. Selling and administrative expenses are equal to 15% of the current month’s sales.

Actual and projected sales are as follows:

Month In pesos In units
March P354,000 11,800
April 363,000 12,100
May 357,000 11,900
June 342,000 11,400
July 360,000 12,000
August 366,000 12,200

Required:
Prepare cash budget for May, June and July, 201A, based on the above data and supported by the following
schedules:
a. Cash receipts from accounts receivable
b. Purchases of inventory
c. Cash disbursements on accounts payable
d. Cash disbursements on selling and administrative expenses
e. Cash budget

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SOLUTION:

a. Cash receipts budget

May June July
March (P354,000 x 9%) P31,860
April
P363,000 x 60% x 97% 211,266
P363,000 x 25% 90,750
P363,000 x 9% P32,670
May
P357,000 x 60% x 97% 207,774
P357,000 x 25% 89,250
P357,000 x 9% P32,130
June
P342,000 x 60% x 97% 190,044
P342,000 x 25% 85,500
Total P333,876 P329,694 P316,674

As each month’s sales are billed on the last day of the month, it is more likely that nothing will be collected on
the month of sale. The management expects that 85% of current month’s sales will be collected next month,
60% of which are collected within the discount period. Then, 9% will be collected on the second month after the
month of sale.

b. Purchases budget
May June July
Expected sales in units 11,900 11,400 12,000
Desired ending inventory 14,820 15,600 15,860
Total 26,720 27,000 27,860
Expected beginning inventory 15,470 14,820 15,600
Purchases in units 11,250 12,180 12,260
Unit cost P20.00 P20.00 P20.00
Total purchase cost P225,000 P243,600 P245,200

Since each month’s units of ending inventory is equal to 130% of the next month’s units of sales, the following
are the desired ending inventories for the month of March to July:

March (12,100 x 1.30) 15,730 units

April (11,900 x 1.30) 15,470 units
May (11,400 x 1.30) 14,820 units
June (12,000 x 1.30) 15,600 units
July (12,200 x 1.30) 15,860 units

Note that the ending inventory for the current month will be the beginning inventory for the next month. For
example, the ending inventory for April, P15,470, will be the beginning inventory for May.

c. Cash disbursements budget

May June July
April (P236,800 x 46%) P108,928
May
P225,000 x 54% 121,500
P225,000 x 46% P103,500
June
P243,600 x 54% 131,544
P243,600 x 46% P112,056
July (P245,200 x 54%) 132,408
Total P230,428 P235,044 P244,464

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The total purchases for the month of April is as follows:

April
Expected sales in units 12,100
Desired ending inventory 15,470
Total 27,570
Expected beginning inventory 15,730
Purchases in units 11,840
Unit cost P20.00
Total purchase cost P236,800

d. Selling and administrative expenses

May June July
April (P363,000 x 15% x 46%) P25,047
May
P357,000 x 15% x 54% 28,917
P357,000 x 15% x 46% P24,633
June
P342,000 x 15% x 54% 27,702
P342,000 x 15% x 46% P23,598
July (P360,000 x 15% x 54%) 29,160
Total P53,964 P52,335 P52,758

The selling and administrative expenses for the purpose of preparing the cash budget do not include
depreciation as it does not include any cash outflow when incurred.

e. Cash budget
May June July
Beginning cash balance P5,500 P54,984 P97,299
Cash receipts 333,876 329,694 316,674
Total cash available P339,376 P384,678 P413,973
Disbursements:
Cash disbursements 230,428 235,044 244,464
Selling and Administrative Expenses 53,964 52,335 52,758
Total cash needed 284,392 287,379 297,222
Ending cash balance P54,984 P97,299 P116,751

References
Garrison, R. H., Noreen, E. W., & Brewer , P. C. (2018). Managerial Accounting. McGraw-Hill Education.
Hilton, R. W., & Platt, D. E. (2017). MAnagerial Accounting: Creating Value in a Dynamic Business Environment. McGraw-
Hill Education.
Weygandt, J. J., Kimmel, P. D., Kieso, D. E., & Aly, I. M. (2018). Managerial Accounting: Tools for Business Decision-
Making. John Wiley & Sons, Inc.

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RESPONSIBILITY ACCOUNTING AND PERFORMANCE MEASUREMENT

Two General Forms of Management

As discussed in the earlier topics, management functions include forecasting, planning, performing and
performance evaluation. Management achieves those functions depending on the management style
implemented in the organization. Management style can be centralized or decentralized.

1. Centralization – It is a management style where the firm requires the top management to make most
decisions, and controls most activities of the organizational units from the company’s central offices.
The president of the company or the owner performs all decision making and maintains full authority
and responsibility for such organization or firm.
2. Decentralization – It is a management style where the firm is divided into smaller units. These units
are called by different names, such as divisions, segments, units, centers, or departments. Sometimes,
a unit can also be divided into subunits. Each unit and subunit have an assigned responsible officer or
manager who does the managerial functions. This style allows top management to delegate to
subordinate managers a significant degree of autonomy and independence in operations and decision-
making for their respective segments or unit, which are covered by their area of responsibility.
In a decentralized organization, decision-making authority is spread throughout the organization rather than
being confined to a few top executives. As noted above, out of necessity, all large organizations are
decentralized to some extent. Organizations do differ, however, in the extent to which they are decentralized.
In strongly centralized organizations, decision-making authority is reluctantly delegated to lower-level managers
who have little freedom to make decisions. In strongly decentralized organizations, even the lowest-level
managers are empowered to make as many decisions as possible. Most organizations fall somewhere between
these two (2) extremes.

Advantages of Decentralization
1. Training. Granting decision-making authority helps train lower-level managers for higher-level
positions.
2. Enhanced specialization. The managers of the subunits must be considered specialists. Through
training, they develop specialized skills that enable them to manage effectively.
3. Motivated managers. Managers with some decision-making authority usually exhibit greater
motivation than those who merely execute the decisions of others. Empowering lower-level managers
to make decisions can increase their motivation and job satisfaction.
4. Defined span of control. Responsible managers are given specified span of control to which they can
be more focused on; thus, avoiding conflicts between managers of other departments.
5. Greater focus on strategic planning. Delegating some decisions to lower-level managers provides
time-relief to upper-level managers, enabling them to devote more time to strategic planning. By
delegating day-to-day problem solving to lower-level managers, top-level managers can concentrate on
bigger issues, such as overall strategy.
6. Faster decision making. Delegating decision-making to the lowest level possible enables an
organization to give a timely response to opportunities and problems as they arise. By eliminating layers
of decision making and approvals, organizations can respond more quickly to customers and to
changes in the operating environment.
While decentralization has benefits to the organization, top management must resolve the following concerns
in relation to decentralization:

1. Need for competent people. Without competent people, the best policies break down and the
incompetence of the managers reduce the efficiency and effectiveness of the operations.
2. Need for establishing the most suited measurement system. The measurement system should be
used for all divisions. Top management needs to develop policies that provide consistency in reporting
period, methods of reporting and data collection. If lower-level managers make their own decisions
independently of each other, coordination may be lacking.
3. Inherent sub-optimization issues on segment’s manager. The segment managers may work for
their own interests without the consideration of benefits to the entire organization. Lower-level managers

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may make decisions without fully understanding the company’s overall strategy. Also, lower-level
managers may have objectives that clash with the objectives of the entire organization. For example, a
manager may be more interested in increasing the size of his or her department, leading to more power
and prestige, than in increasing the department’s effectiveness.

Spreading innovative ideas may be difficult in a decentralized organization. Someone in one part of the
organization may have a terrific idea that would benefit other parts of the organization, but without strong central
direction the idea may not be shared with, and adopted by, other parts of the organization.

Responsibility Accounting
Responsibility Accounting is an accounting system wherein costs and revenues are accumulated and
reported by levels of responsibility or by responsibility centers within the organization.
Decentralized organizations need responsibility accounting systems that link lower-level managers’ decision-
making authority with accountability for the outcomes of those decisions. Goal congruence results when the
managers of subunits throughout an organization strive to achieve the goals set by top management. The basis
of a responsibility-accounting system is the designation of each subunit in the organization as a particular type
of responsibility center. A responsibility center is a subunit in an organization whose manager is held
accountable for specified financial results of the subunit’s activities. The three (3) primary types of responsibility
centers are cost centers, profit centers, and investment centers (Garrison et al., 2018)

1. Cost center
The manager of a cost center has control over costs, but not over revenue or the use of investment
funds. Service departments such as accounting, finance, general administration, legal, and personnel
are usually classified as cost centers. In addition, manufacturing facilities are often treated as cost
centers. The managers of cost centers are expected to minimize costs while providing the level of
products and services needed by other parts of the organization. For example, the manager of a
manufacturing facility would be evaluated at least in part by comparing actual costs to how much costs
should have been for the actual level of output during the period. Standard cost variances and flexible
budget variances, such as those discussed in earlier chapters, are often used to evaluate cost center
performance.

2. Profit center
The manager of a profit center has control over both costs and revenue, but not over the use of
investment funds. For example, the manager in charge of an amusement park would be responsible for
both the revenues and costs, and hence the profits, of the amusement park, but may not have control
over major investments in the park. Profit center managers are often evaluated by comparing actual
profit to targeted or budgeted profit.

3. Investment center
The manager of an investment center has control over cost, revenue, and investments in operating
assets. For example, General Motors’ vice president of manufacturing in North America would have a
great deal of discretion over investments in manufacturing—such as investing in equipment to produce
more fuel-efficient engines. Once General Motors’ top-level managers and board of directors approve
the vice president’s investment proposals, he is held responsible for making them pay off. As discussed
in the next section, investment center managers are often evaluated using return on investment (ROI)
or residual income measures.
An investment-center manager also decides whether the profits of the investment center are paid as
bonuses, reinvested in research and development, used for expansion, distributed to shareholders, and
so forth. A small start-up company and a geographic division of a large corporation are both typically
designated as investment centers.

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Responsibility Accounting Performance Evaluation Methods

Cost Center and Profit Center
Cost center uses variance analysis approach. It is the comparison between the budgeted and actual amounts.
For profit center, the budgeted revenues and costs will be evaluated using flexible budgets. A flexible budget
is a recomputed budget based on actual activity results.
A static planning budget is suitable for planning but is inappropriate for evaluating how well costs are controlled.
If the actual level of activity differs from what was planned, it would be misleading to compare actual costs to
the static, unchanged planning budget. If activity is higher than expected, variable costs should be higher than
expected; and if activity is lower than expected, variable costs should be lower than expected.
Flexible budgets consider how changes in activity affect costs. A flexible budget estimates what revenues and
costs should have been, given the actual level of activity for the period. When a flexible budget is used in
performance evaluation, actual costs are compared to what the costs should have been for the actual level of
activity during the period rather than to the static planning budget. This is a very important distinction. If
adjustments for the level of activity are not made, it is very difficult to interpret discrepancies between budgeted
and actual costs.
For the cost center, variance analysis could be used to measure the performance of the responsible officer and
to measure the performance of the center itself.

a. Performance of the responsible officer

Performance evaluation for the responsible officer based on the total variances would be misleading,
since the officer may not significantly influence some costs incurred by the segment under his
management. Therefore, the costs need to be classified as controllable and uncontrollable.
• Controllable costs – These are costs that may be influenced by unit managers in a given time
period. The responsible officer can influence the amount spent, like direct materials, direct labor,
variable overhead, and other direct fixed costs.
• Uncontrollable costs – These are costs assigned only to the responsibility center by upper
management, and are not under the control of the responsible officer. An example is the rental
costs assigned to a particular department.

b. Performance of the responsibility center

Performance evaluation based on segment’s net income would likewise be misleading since a portion
of its costs were just allocated from the costs incurred by the whole organization. Therefore, the costs
need to be classified as direct and indirect.
• Direct costs – These are costs directly incurred by the center. They could be both variable and
fixed costs. These costs exist by the existence of the center, i.e., the costs could be eliminated by
the elimination of the center. These are also called avoidable costs.
• Indirect costs – These are costs assigned only to the center as its share in the total costs incurred
by the entire organization. The elimination of the center will not eliminate or reduce the total costs
incurred by the organization. These costs are also called unavoidable costs.

Proforma Contribution Approach Income Statement

Total Segment A Segment B
Sales P600 P350 P250
Less: Variable manufacturing costs 220 115 105
Manufacturing contribution margin 380 235 145
Less: Variable nonmanufacturing costs 100 70 30
Contribution margin 280 165 115
Less: Controllable fixed costs 80 35 45
Controllable contribution margin 200 130 70
Less: Direct, uncontrollable fixed costs 90 60 30
Segment margin 110 70 40
Less: Common costs allocated 50 30 20
Operating income 60 40 20

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ILLUSTRATION 1 (Flexible Budget)

Andrew & James Co. produces sofas. The budgeted and actual amounts for the current year are as follows:
Costs Budget at 5,000 Actual amounts
units at 5,800 units
Direct materials P110,000 P130,000
Direct labor 140,000 162,000
Equipment depreciation 10,000 10,000
Indirect labor 15,000 17,200
Indirect materials 18,000 19,200
Rent and insurance 24,000 26,000
Required: Prepare a performance report for the company for the year just ended using flexible budget.
SOLUTION:
Andrew & James Co.
Manufacturing Performance Budget Report
For the Year Ending December 31, 201A
Budget Actual Difference
Direct materials P127,600 P130,000 P2,400 U
Direct labor 162,400 162,000 400 F
Equipment depreciation 10,000 10,000 0
Indirect labor 17,400 17,200 200 F
Indirect materials 20,880 19,200 1,680 F
Rent and insurance 24,000 26,000 2,000 U
Total P362,280 P364,400 P2,120 U
Budgeted amounts are equal to budgeted cost divided by budgeted units, multiplied by actual units or actual
level of activity.

ILLUSTRATION 2
The following information pertains to the product produced by the Men’s Belt Division of Good Leather
Corporation:
Per unit
Selling price P150
Manufacturing costs:
Prime costs 75
Variable manufacturing overhead 15
Fixed manufacturing overhead (Total is P80,000) 8
Selling and administrative costs:
Variable 18
Fixed (Total is P60,000) 6
During the period, the Division produced 20,000 units and sold 18,000 units, both as budgeted. There were no
beginning and ending work-in-process inventories, and there was no beginning finished goods inventory during
the period. Assume that 60% of the Division’s total fixed costs is controllable by the Division Manager.
There was no difference between the total budgeted and actual fixed costs. Variable manufacturing costs vary
with production while variable selling costs vary with sales. Central administration costs are allocated to the
different divisions of the company. For this period, central administration cost allocated to Men’s Belt Division
amounted to P180,000.
Required: Prepare a contribution approach income statement.

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SOLUTION:
Sales (18,000 x P150) P2,700,000
Less: Variable manufacturing costs (18,000 x [P75 + P15]) 1,620,000
Manufacturing contribution margin 1,080,000
Less: Variable nonmanufacturing costs 324,000
Contribution margin 756,000
Less: Controllable fixed costs (60% x [P80,000 + P60,000]) 84,000
Controllable contribution margin 672,000
Less: Direct, uncontrollable fixed costs (40% x [P80,000 + P60,000]) 56,000
Segment margin 616,000
Less: Common costs allocated 180,000
Operating income P436,000
Investment center:
In an investment center, both measures described for profit and cost centers could be used in the same manner.
However, additional methods can be used to determine the profitability of the investment center. An investment
center is responsible for earning an adequate return on investment. The following present two (2) methods for
evaluating this aspect of an investment center’s performance. The first method is called return on investment
(ROI). The second one is called residual income.

1. Return on investment (ROI) is defined as net operating income divided by average operating assets:

𝑁𝑒𝑡 𝑜𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑖𝑛𝑐𝑜𝑚𝑒

𝑅𝑂𝐼 =
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑜𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑎𝑠𝑠𝑒𝑡𝑠

The higher a business segment’s return on investment (ROI), the greater the profit earned per peso invested
in the segment’s operating assets.
Net operating income is income before interest and taxes and is sometimes called as EBIT (earnings
before interest and taxes). In this topic, the terms segment income and controllable income can also be
used. Operating assets include cash, accounts receivable, inventory, plant and equipment, and all other
assets held for operating purposes. Examples of assets that are not included in operating assets (i.e.,
examples of non-operating assets) include land held for future use, an investment in another company, or
a building rented to someone else. These assets are not held for operating purposes and therefore are
excluded from operating assets. The operating assets base used in the formula is typically computed as
the average of the operating assets between the beginning and the end of the year.
The equation for ROI, net operating income divided by average operating assets, does not provide much
help to managers interested in taking actions to improve their ROI. It only offers two levers for improving
performance—net operating income and average operating assets. ROI can also be expressed as follows
(DuPont Model):

𝑅𝑂𝐼 = 𝑃𝑟𝑜𝑓𝑖𝑡 𝑀𝑎𝑟𝑔𝑖𝑛 𝑥 𝐴𝑠𝑠𝑒𝑡 𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟

𝑁𝑒𝑡 𝑜𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑖𝑛𝑐𝑜𝑚𝑒

𝑃𝑟𝑜𝑓𝑖𝑡 𝑀𝑎𝑟𝑔𝑖𝑛 =
𝑆𝑎𝑙𝑒𝑠

𝐴𝑠𝑠𝑒𝑡 𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟 = 𝑆𝑎𝑙𝑒𝑠

𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑜𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑎𝑠𝑠𝑒𝑡𝑠
Note that the sales terms in the margin and turnover formulas cancel out when they are multiplied together,
arriving at the original formula for ROI stated in terms of net operating income and average operating assets.

Margin and turnover are important concepts in understanding how a manager can affect ROI. All other
things the same, margin is ordinarily improved by increasing selling prices, reducing operating expenses,
or increasing unit sales. Increasing selling prices and reducing operating expenses both increase net

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operating income and therefore margin. Increasing unit sales also ordinarily increases the margin because
of operating leverage.

As discussed in CVP Analysis topic, because of operating leverage, a given percentage increase in unit
sales usually leads to an even larger percentage increase in net operating income. Therefore, an increase
in unit sales ordinarily has the effect of increasing margin. Some managers tend to focus too much on
margin and ignore turnover. However, turnover incorporates a crucial area of a manager’s responsibility—
the investment in operating assets. Excessive funds tied up in operating assets (e.g., cash, accounts
receivable, inventories, plant and equipment, and other assets) depress turnover and lower ROI. In fact,
excessive operating assets can be just as much of a drag on ROI as excessive operating expenses, which
depress margin.

2. Residual Income
Residual income (RI) is another approach to measuring an investment center’s performance. Residual
income is the net operating income that an investment center earns above the minimum required return on
its operating assets. In equation form, residual income is calculated as follows:

𝑅𝐼 = 𝑁𝑒𝑡 𝑜𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑖𝑛𝑐𝑜𝑚𝑒 − (𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑜𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑎𝑠𝑠𝑒𝑡𝑠 𝑥 𝑀𝑖𝑛𝑖𝑚𝑢𝑚 𝑟𝑒𝑞𝑢𝑖𝑟𝑒𝑑 𝑟𝑎𝑡𝑒 𝑜𝑓 𝑟𝑒𝑡𝑢𝑟𝑛)
The minimum required rate of return is also called as the imputed interest rate. This rate is ordinarily set by
the company’s management and is often equal to the weighted average cost of capital Also, in some
instances, if the average operating assets cannot be determined, the initial invested capital can be used.
A new project that is expected to have an ROI greater than the minimum required rate of return is also expected
to have a positive residual income. In that case, the project should be accepted.
ILLUSTRATION 3
Consider the following data for an investment center – the Ladies’ Belt Division of Good Leather Corporation.
Average operating assets P1,000,000
Net operating income 200,000
Minimum required rate of return 15%
Good Leather Corporation had a policy of using ROI to evaluate its investment center managers, but it is
considering switching to residual income. The controller of the company, who is in favor of the change to residual
income, has provided the following table that shows how the performance of the division would be evaluated
under each of the two methods:
Alternative Performance
Measures
Residual
ROI
Income
Average operating assets P1,000,000 P1,000,000
Net operating income 200,000 200,000
ROI (P200,000/P1,000,000) 20%
Minimum required return (15% x P1,000,000) 150,000
Residual Income 50,000

Note: The minimum required return is also called as imputed income.

The company can earn a rate of return of at least 15% on its investments. Because the company has invested
P1,000,000 in the Ladies’ Belt Division in the form of operating assets, the company should earn at least
P150,000 (15% × P1,000,000) on this investment. Because the division’s net operating income is P200,000,
the residual income above and beyond the minimum required return is P50,000. If residual income is adopted
as the performance measure to replace ROI, the manager of the Ladies’ Belt Division would be evaluated based
on the growth in residual income from year to year.
One of the primary reasons why the controller of Good Leather Corporation would like to switch from ROI to
residual income relates to how managers view new investments under the two (2) performance measurement
methods. The residual income approach encourages managers to make investments that are profitable for the
entire company but that would be rejected by managers who are evaluated using the ROI formula.

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To illustrate this problem with ROI, suppose that the manager of the Ladies’ Belt Division is considering
purchasing a machine to be used for manufacturing ladies’ belts. The machine would cost P250,000 and is
expected to generate additional operating income of P45,000 a year. From the company’s point of view, this
would be a good investment because it promises a rate of return of 18% (P45,000 ÷ P250,000), which exceeds
the company’s minimum required rate of return of 15%. If the manager of the Ladies’ Belt Division is evaluated
based on residual income, he would be in favor of the investment in the new machine as shown below:
Present New Project Overall
Average operating assets P1,000,000 P250,000 P1,250,000
Net operating income 200,000 45,000 245,000
Minimum required return (15%) 150,000 37,500 187,500
Residual Income P50,000 P7,500 P57,500
Because the project would increase the residual income of the Ladies’ Belt Division by P7,500, the manager
would choose to accept the new project.
Supposed that ROI is used to evaluate the Ladies’ Belt Division, this will be the effect of the new project on the
division:
Present New Project Overall
Net operating income 200,000 45,000 245,000
÷ Average operating assets P1,000,00 P250,000 P1,250,00
0 0
ROI 20% 18% 19.6%
The new project reduces the division’s ROI from 20% to 19.6%. This happens because even if it the 18% ROI
is above the company’s 15% minimum required rate of return; it is below the division’s current ROI of 20%.
Therefore, the new project would decrease the division’s ROI even though it would be a good investment from
the view of the company as a whole. If the manager of the division is evaluated based on ROI, he will be reluctant
to even propose such an investment.
Generally, a manager who is evaluated based on ROI will reject any project whose rate of return is below the
division’s current ROI even if the rate of return on the project is above the company’s minimum required rate of
return. On the other hand, managers who are evaluated using residual income will pursue any project whose
rate of return is above the minimum required rate of return because it will increase their residual income.
Because it is in the best interests of the company as a whole to accept any project whose rate of return is above
the minimum required rate of return, managers who are evaluated based on residual income will tend to make
better decisions concerning investment projects than managers who are evaluated based on ROI.
ROI is a certain percentage, while residual income is a peso amount. Residual income may be more consistent
with maximizing profit, not only of the investment center but also of the whole firm. Residual income is, therefore,
often touted as superior to ROI. The residual income approach has one major disadvantage. It can’t be used to
compare the performance of divisions of different sizes. Larger divisions often have more residual income than
smaller divisions, not necessarily because they are better managed but simply because they are bigger.

References
Garrison, R. H., Noreen, E. W., & Brewer , P. C. (2018). Managerial Accounting. McGraw-Hill Education.
Payongayong, L. S. (2016). Management Services Part 2. Manila: Polytechnic University of the Philippines.
Weygandt, J. J., Kimmel, P. D., Kieso, D. E., & Aly, I. M. (2018). Managerial Accounting: Tools for Business Decision-
Making. Canada: John Wiley & Sons, Inc.

09 Handout 1 *Property of STI

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