CHAPTER 10

BUDGETARY
CONTROL AND
RESPONSIBILIT
Y ACCOUNTING
Managerial Accounting, Fourth Edition

Chapter
10-1
 The Concept of Budgetary Control
Budgetary control involves the following activities

Chapter
10-2
 The Concept of Budgetary Control

Works best when a company has a formalized

reporting system which:
 Identifies the name of the budget report
(such as the sales budget or the manufacturing
overhead budget)
 States the frequency of the report (such as
weekly or monthly)
 Specifies the purpose of the report
 Indicates recipient of the report

Chapter
10-3
 The Concept of Budgetary Control

l Schedule below illustrates a partial budgetary control

system for a manufacturing company
l Note the frequency of reports and their emphasis on
control

Chapter
10-4
 Static Budget Reports

l When used in budgetary control, each budget

included in the master budget is considered to be
static

l A static budget is a projection of budget data at

one level of activity

Ignores data for different levels of activity

Compares actual results with the budget data at

the activity level used in the master budget

Chapter
10-5
 Static Budget Reports: Sales Budget

Example – Hayes Company

Budget and actual sales data for the Kitchen-

mate product for the first and second quarters
of 2008 are:

Difference
5%, below budget
less than 1%
Significant difference
- insignificant
Chapter
10-6
 Static Budget Reports – Uses and Limitations

Appropriate for evaluating a manager’s

effectiveness in controlling costs when:
Actual level of activity closely approximates the
master budget activity level
Behavior of the costs is fixed in
response to changes in activity
 Appropriate for fixed costs
 Not appropriate for variable costs

Chapter
10-7
 Review Question

A static budget is useful in controlling costs when

cost behavior is:

a. Mixed.
Mixed
b. Fixed.
c. Variable.
d. Linear.

Chapter
10-8
 Flexible Budgets

l Budgetary process more useful

if it is adaptable to changes in
operating conditions
l Projects budget data for
various levels of activity
 Essentially, a series of static
budgets at different activity
levels
 Can be prepared for each type
of budget in the master budget

Chapter
10-9
 Flexible Budgets

Example – Barton Steel

Static budget for the Forging Department at a 10,000 unit level:

Chapter
10-10
 Flexible Budgets Example – Continued

Demand increases – produce 12,000 units rather than 10,000

Meaningless to compare actual

variable costs for 12,000
units with budgeted variable costs
for 10,000 units
Chapter
10-11 Because Variable cost increases with production
 Flexible Budgets
Example – Continued
Budget data for variable costs at 10,000 units:

Calculate variable costs at the 12,000 unit level:

Chapter
10-12
 Flexible Budgets
Example – Continued:
New budget report (no change in fixed costs):

Chapter
10-13
 Developing The Flexible Budget
Steps:
 Identify the activity index and the relevant
range of activity
 Identify the variable costs and determine the
budgeted variable cost per unit of activity for
each cost
 Identify the fixed costs and determine the
budgeted amount for each cost
 Prepare the budget for selected increments of
activity within the relevant range

Chapter
10-14
 Developing The Flexible Budget – A Case Study

Example – Fox Manufacturing Company

Monthly comparisons of actual and budgeted manufacturing
overhead costs for Finishing Department
 Master budget for the year 2008
 Expected operating capacity of 120,000 direct labor hours
 Overhead costs:

Chapter
10-15
 Developing The Flexible Budget – A Case Study

Example – Steps for Fox Manufacturing Company

 Identify the activity index and the relevant range
 activity index: direct labor hours
 relevant range: 8,000 – 12,000 direct labor hours per
month
 Identify the variable costs and determine the budgeted
variable cost per unit of activity for each cost

Chapter
10-16
 Developing The Flexible Budget – A Case Study

Example – Steps for Fox Manufacturing Company

 Identify the fixed costs and determine the
budgeted amount for each cost
Three fixed costs per month:
depreciation, $15,000
supervision, $10,000
property taxes, $5,000
 Prepare the budget for selected increments of
activity within the relevant range
Prepared in increments of 1,000 direct
labor hours
Chapter
10-17
 Developing The Flexible Budget – A Case Study
Example – Step 4 for Fox Manufacturing Company

Chapter
10-18
 Developing The Flexible Budget – A Case Study

Example – Fox Manufacturing Company

Formula to determine total budgeted costs from the budget
at any level of activity:

Determine total budgeted costs for Fox Manufacturing

Company with fixed costs of $30,000 and total variable cost
$4 per unit:
At 9,000 direct labor hours : $30,000 + ($4 X 9,000) =
$66,000
At 8,622 direct labor hours: $30,000 + ($4 X 8,622) =
$64,488
Chapter
10-19
 Developing The Flexible Budget – A Case Study
Example – Fox Manufacturing Company
Graphic flexible budget data highlighting 10,000
and 12,000 activity levels

Chapter
10-20
 Flexible Budget 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 manager’s performance in
production control and cost control

Chapter
10-21
 Flexible Budget Reports - Example

Chapter
10-22
 Management by Exception
 Focus of top management’s 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
Chapter
10-23
 Review Question
At 9,000 direct labor hours, the flexible budget for
indirect materials is $27,000. If $28,000 of indirect
materials costs are incurred at 9,200 direct labor
hours, the flexible budget report should show the
following difference for indirect materials:
a. $1,000 unfavorable.
b. $1,000 favorable.
c. $400 favorable.
d. $400 unfavorable.

Chapter
10-24
 The Concept of Responsibility Accounting

l Involves accumulating and

reporting costs on the basis of
the manager who has the
authority to make the day-to-day
decisions about the items

l Means a manager's performance

is evaluated on the matters
directly under the manager's
control

Chapter
10-25
 The Concept of Responsibility Accounting

Conditions for using responsibility accounting:

 Costs and revenues can be directly
associated with the specific level of
management responsibility
 The costs and revenues can be controlled by
employees at the level of responsibility with
which they are associated
 Budget data can be developed for evaluating
the manager's effectiveness in controlling
the costs and revenues

Chapter
10-26
 The Concept of Responsibility Accounting

Levels of responsibility for controlling costs

Chapter
10-27
 The Concept of Responsibility Accounting
 Two differences from budgeting in reporting costs
and revenues:
 Distinguishes between controllable and
noncontrollable costs
 Emphasizes or includes only items controllable
by the individual manager in performance
reports
 Applies to both profit and not-for-profit entities
Profit entities: maximize net income
Not-for-profit: minimize cost of providing
services
Chapter
10-28
 Controllable Vs. Noncontrollable
Revenues and Costs

 Can control all costs and revenues at some level of

responsibility within the company
 Critical issue under responsibility accounting:

Whether the cost or revenue is controllable

at the level of responsibility with which
it is associated

Chapter
10-29
 Controllable Vs. Noncontrollable
Revenues and Costs

l All costs controllable by top management

l Fewer costs controllable as one moves down to

lower levels of management

l Controllable costs - costs incurred directly by a

level of responsibility that are controllable at
that level

l Noncontrollable costs – costs incurred indirectly

which are allocated to a responsibility level

Chapter
10-30
 Responsibility Reporting System

l Involves preparation of a report for each level

of responsibility in the company's organization
chart
l Begins with the lowest level of responsibility
and moves upward to higher levels
l Permits management by exception at each level
of responsibility
l Each higher level can obtain the detailed report
for each lower level

Chapter
10-31
 Responsibility Reporting System - Example

Chapter
10-32
 Types of Responsibility Centers

Three basic types:

Cost centers
Profit centers
Investment centers

Type indicates degree of responsibility that

managers have for the performance of the center

Chapter
10-33
 Types of Responsibility Centers
Cost Center
• Incurs costs but does not directly generate revenues
• Managers have authority to incur costs
• Managers evaluated on ability to control costs
• Usually a production department or a service
department
Profit Center
• Incurs costs and generates revenues
• Managers judged on profitability of center
• Examples include individual departments of a retail
store or branch bank offices

Chapter
10-34
 Types of Responsibility Centers

Investment Center
Incurs costs, generates revenues, and has
investment funds available for use
Manager evaluated on profitability of center and
rate of return earned on funds
Often a subsidiary company or a product line
Manager able to control or significantly influence
investment decisions such as plant expansion

Chapter
10-35
 Responsibility Accounting for Cost Centers

Based on a manager’s ability to meet budgeted goals

for controllable costs
l 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

Chapter
10-36
 Responsibility Accounting for Cost Centers
Example – Fox Manufacturing Company
Assumes department manager can control all manufacturing
overhead costs except depreciation, property taxes, and
his own monthly salary of $4,000

Chapter
10-37
 Responsibility Accounting for Profit Centers

l Based on detailed information

about both controllable revenues
and controllable costs

l Manager controls operating

revenues earned, such as sales

l Manager controls all variable

costs incurred by the center
because they vary with sales

Chapter
10-38
 Responsibility Accounting for Profit Centers

Direct and Indirect Fixed Costs – both may be present

Direct fixed costs
Relate specifically to one responsibility center
Incurred for the sole benefit of the center
Called traceable costs since they can be traced directly
to one center
Most controllable by the profit center manager
 Indirect fixed costs
Pertain to a company's overall operating activities
Incurred for the benefit of more than one profit center
Called common costs since they apply to more than one
center
Most are not controllable by the profit center manager
Chapter
10-39
 Responsibility Accounting for Profit Centers

Responsibility Report
l Shows budgeted and actual controllable revenues
and costs
l 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 manager’s performance in
controlling revenues and costs
 Do not report noncontrollable fixed costs

Chapter
10-40
 Responsibility Accounting for Profit Centers
Example – Mantle Manufacturing Company
$60,000 indirect fixed costs not controllable by manager

Chapter
10-41
 Review Question

In a responsibility report for a profit

center, controllable fixed costs are
deducted from contribution margin to show:

a. Profit center margin

b. Controllable margin
c. Net income
d. Income from operations

Chapter
10-42
 Responsibility Accounting for
Investment Centers

Return on Investment (ROI)

 Primary basis for evaluating the performance of
a manager of an investment center
 Shows the effectiveness of the manager in using
the assets at his/her disposal
 Useful performance measure
 Factors in ROI formula are controllable by
manager

Chapter
10-43
 Responsibility Accounting for
Investment Centers
Computation of ROI (example data assumed):

 Operating assets include current assets and plant

assets used in operations by the center and
controlled by manager.
 Exclude non-operating 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
Chapter
10-44
 Responsibility Accounting for
Investment Centers

Responsibility Report
 Scope of manager’s responsibility affects
content
 Investment center is an independent entity
for operating purposes
 Allfixed costs controllable by center
manager
 Shows budgeted and actual ROI below
controllable margin

Chapter
10-45
 Responsibility Accounting for Investment Centers

Increase ROI by increasing sales

Chapter
 reducing variable and controllable fixed costs
10-46
by reducing Assets employed.
 Principles of Performance Evaluation -
Behavioral Principles
Behavioral principles – human factor critical in
evaluating performance:
 Managers should have direct input into the
process of establishing budget goals for their
area of responsibility
Without this input, managers may view goals as
unrealistic or arbitrary
Affects motivation to meet targets
o The evaluation should be based entirely on
matters that are controllable by the manager
Criticism of noncontrollable matters reduces
effectiveness of evaluation
May lead to negative reactions by manager and
doubts about fairness of evaluation
Chapter
10-47
 Principles of Performance Evaluation -
Behavioral Principles
 Top management should support the evaluation
process
Managers lose faith in process when top management
ignores, overrules, or bypasses established procedures
 The evaluation process must allow managers to
respond to their evaluations
Evaluation is not a one-way street
Managers must be able to defend their performance
Evaluation without feedback is impersonal and ineffective
 The evaluation should identify both good and poor
performance
Praise is a powerful motivator
Manager compensation should include rewards for meeting
Chapter
10-48
goals
 Chapter Review

For the year ending December 31, 2008, Kaspar

Company accumulates the following data for the
Plastics Division which it operates as an investment
center: contribution margin $700,000 budget,
$715,000 actual; controllable fixed costs $300,000
budget, $309,000 actual. Average operating assets
for the year were $2,000,000.
Prepare a responsibility report for the Plastics
Division beginning with contribution margin.

Chapter
10-49
 Chapter Review - Solution
Kaspar Company
Responsibility Report
For Year Ending December 31, 2008

Budget Actual Difference

Contribution Margin $700,000 $715,000 $15,000 F
Controllable Fixed Costs 300,000 309,000 9,000 U
Controllable Margin $400,000 $406,000 $ 6,000 F

Favorable – F
Unfavorable - U

Chapter
10-50
 RECAP : CHAPTER 10
Budgetary Control and
Responsibility Accounting

The Concept The Concept of Types of

Static Budget
of Budgetary Responsibility Responsibility
Reports
Control Accounting Centers

Budget reports Examples Controllable vs Cost centers

Control activities Use and noncontrollable Profit centers
Reporting limitations Reporting Investment
systems system centers
Performance
evaluation

Why flexible
budgets? Flexible Reports
Development Budgets Managemen
Case study t by
Chapter exception
10-51