CHAPTER THREE

Master Budget and Responsibility Accounting

Budgeting is a common accounting tool that companies use for implementing strategy.
Management uses budgets to communicate directions and goals throughout a company. Budgets
turn managers’ perspectives forward and aid in planning and controlling the actions managers
must undertake to satisfy their customers and succeed in the marketplace. Budgets provide
measures of the financial results a company expects from its planned activities and help define
objectives and timelines against which progress can be measured. Through budgeting, managers
learn to anticipate and avoid potential problems. Interestingly, even when it comes to
entrepreneurial activities, business planning has been shown to increase a new venture’s
probability of survival, as well as its product development and venture organizing activities.
Budgets are tools that, by themselves, are neither good nor bad. Budgets are useful when
administered skillfully. Therefore, this chapter focuses on the different components of master
budget and their preparation.

3.1 Budget and the budgeting process

A budget is a quantitative expression of a proposed plan of action by management for a future
time period and is an aid to the coordination and implementation of the plan. It can cover both
financial and non-financial aspects of these plans and acts as a blueprint for the company to
follow in the forthcoming period. Plan is what an organization wants to do and the way to do it.

Budgets covering financial aspects quantify management’s expectations regarding future income,
cash flows and financial position. Just as individual financial statements are prepared covering
past periods, so they can be prepared covering future periods – for example, a budgeted income
statement, a budgeted cash-flow statement and a budgeted balance sheet. Underlying these
financial budgets can be non-financial budgets for, say, units manufactured, number of new
products introduced to the market, or head count.

Strategic plans are expressed through long-run budgets and operating plans are expressed via
short-run budgets. Budgets help managers assess strategic risks and opportunities by providing
them with feedback about the likely effects of their strategies and plans. Sometimes the feedback
signals to managers that they need to revise their plans and possibly their strategies.

Well-managed companies usually cycle through the following budgeting steps during the course
of the fiscal year:
1. Working together, managers and management accountants plan the performance of the
company as a whole and the performance of its subunits (such as departments or divisions).
Taking into account past performance and anticipated changes in the future, managers at all
levels reach a common understanding on what is expected.

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2. Senior managers give subordinate managers a frame of reference, a set of specific financial or
non-financial expectations against which actual results will be compared.
3. Management accountants help managers investigate variations from plans, such as an
unexpected decline in sales. If necessary, corrective action follows, such as a reduction in price
to boost sales or cutting of costs to maintain profitability.
4. Managers and management accountants take into account market feedback, changed
conditions, and their own experiences as they begin to make plans for the next period.
For example, a decline in sales may cause managers to make changes in product features for the
next period.

3.2 Advantages of budget

Budgets are an integral part of management control systems. When administered thoughtfully by
managers, budgets do the following:
- Promote coordination and communication among subunits within the company
Coordination is meshing and balancing all aspects of production or service and all departments
in a company in the best way for the company to meet its goals. Communication is making sure
those goals are understood by all employees. Coordination forces executives to think of
relationships among individual departments within the company, as well as between the
company and its supply chain partners.
- Provide a framework for judging performance and facilitating learning
Budgets enable a company’s managers to measure actual performance against predicted
performance. Budgets can overcome two limitations of using past performance as a basis for
judging actual results. One limitation is that past results often incorporate past miscues and
substandard performance. The other limitation of using past performance is that future conditions
can be expected to differ from the past. It is important to remember that a company’s budget
should not be the only benchmark used to evaluate performance. Many companies also consider
performance relative to peers as well as improvement over prior years.
- Motivate managers and other employees
Challenging budgets improve employee performance because employees view falling short of
budgeted numbers as a failure. Most employees are motivated to work more intensely to avoid
failure than to achieve success.
Note: Before budget preparation the management should consider the benefits and costs of
budget. Budgets should be prepared when their expected benefits exceed their expected costs.
Generally budgets have the following advantages:
1. Budgets communicate management’s plans throughout the organization.
2. Budgets force managers to think about and plan for the future. In the absence of the necessity
to prepare a budget, many managers would spend all of their time dealing with day-to-day
emergencies.
3. The budgeting process provides a means of allocating resources to those parts of the
organization where they can be used most effectively.
4. The budgeting process can uncover potential bottlenecks before they occur.

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5. Budgets coordinate the activities of the entire organization by integrating the plans of its
various parts. Budgeting helps to ensure that everyone in the organization is pulling in the same
direction.
6. Budgets define goals and objectives that can serve as benchmarks for evaluating subsequent
performance.
3.3 Time coverage of budget
The most frequently used budget period is one year. The annual budget is often subdivided by
months for the first quarter and by quarters for the remainder of the year. The budgeted data for a
year are frequently revised as the year unfolds. For example, at the end of the first quarter, the
budget for the next three quarters is changed in light of new information.
 Strategic Plan: - It is the most forward looking plan which sets overall goals and objectives of
the organization.Long – range budgets (LRB), are coordinated with capital budgets. It
provides forecasted financial statement for 5 to 10 years periods. In other word, LRB is the
quantitative expression of strategic plan.Capital budget is a budget that details the planned
expenditures for facilities, equipment, new products and other long-term investments.
 Operating plan: is short term quantitatively expressed by using short term budget or master
budget. Master budget is an extensive analysis of the first year of the long-range plan. It
summarizes the planning activities of all subunits of an organization- sales, production,
distribution and finance. It is the quantitative expression of operating plans.
 Long – range budgets: - LRB, are coordinated with capital budgets. It provides forecasted
financial statement for 5 to 10 years periods.
 Capital budget: - A budget that details the planned expenditures for facilities, equipment,
new products and other long-term investments.
 Master budget: - it is an extensive analysis of the first year of the long-range plan. It
summarizes the planning activities of all subunits of an organization- sales, production,
distribution and finance.
 Continuous or Rolling budgets: - It is a form of master budget that adds one period in the
future as the period just ended is dropped. Budgeting thus becomes an ongoing instead of
periodic process. Continuous budgets force managers to always think about the next 12
methods, not just the remaining months in a fixed budgeting cycle.
3.4 The master budget

The working document at the core of budgeting process is called the master budget. The master
budget expresses management’s operating and financial plans for a specified period (usually a
fiscal year), and it includes a set of budgeted financial statements. The master budget is the initial
plan of what the company intends to accomplish in the budget period.

A master budget coordinates or summarizes the financial projections of all the organizations
individual budgets. It includes the impact of both operating and financing decisions. Operating
decision, centers on the acquisition and uses of scarce resources. Financing decisions centers on

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how to get the funds to acquire resources. It focuses on the impact of operations and capital
outlay in cash.

Thus, the major components of master budget are operating budget and financial budget.
Operating budget is budgeted income statement and it’s supporting budget schedules. It includes
revenue, production, direct material usage and purchases, direct labor, manufacturing overhead,
ending inventory, cost of goods sold, operating expenses, budget and budgeted income
statement. Financial budget comprises the capital budget, cash budget, budgeted balance sheet
and budgeted statement on cash flows. Both budgeted statement and financial statements are the
same in the content. However, budgeted statement is budgeted for the future period and in order
to do this you have to predict the future and the content of financial statements because the
amount is not actual whereas financial statement is stated on past actual data.

The terminology used to describe budgets varies among organizations. For example, budgeted
financial statements are sometimes called pro forma statements. The budgeted financial
statements of many companies include the budgeted profit statement, the budgeted balance sheet,
and the budgeted statement of cash flows.

3.5 Parts of master budget

Operating budget:
The operating budget is the budgeted income statement and its supporting budget schedules. The
starting point for the operating budget is generally the revenues budget. The following
supporting schedules are derived from the revenues budget and the activities needed to support
the revenues budget: production budget, direct material usage budget, direct material purchases
budget, direct manufacturing labor cost budget, manufacturing overhead costs budget, ending
inventories budget, cost of goods sold budget, R&D/product design cost budget, marketing cost
budget, distribution cost budget, and customer-service cost budget.
1. Revenue budget: The revenue budget (schedule 1) is the usual starting point for budgeting.
Why? Because production (and hence costs) and stock levels generally depend on the
forecast level of revenue. Many factors influence the sales forecast, including the sales
volume in recent periods, general economic and industry conditions, market research studies,
pricing policies, advertising and sales promotions, competition, and regulatory policies.
Pressures can exist for budgeted revenues to be either over- or underestimates of the expected
amounts. Pressure for employees to underestimate budgeted revenues can occur when a company
uses the difference between actual and budget amounts to evaluate marketing managers. These
managers may respond by giving highly conservative forecasts. Padding the budget or
introducing budgetary slack refers to the practice of underestimating budgeted revenues (or
overestimating budgeted costs) in order to make budgeted targets more easily achievable.
Introducing budgetary slack makes it more likely that actual revenues will exceed budgeted
amounts. From the marketing manager’s standpoint, budgetary slack hedges against unexpected
adverse circumstances.

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Occasionally, revenues are limited by available production capacity. For example, unusually
heavy market demand, shortages of personnel or materials, or strikes may cause a company to
exhaust its finished goods stock completely. Additional sales cannot be made because no stock
of the product is available. In such cases, the production capacity – the factor that limits revenue
– is the starting point for preparing the revenue budget.

Budgeted revenue = target selling price per unit * budgeted sells (units)

2. Production budget (in units): After revenues are budgeted, the production budget (schedule
2) can be prepared. The total finished goods units to be produced depends on planned sales
and expected changes in stock levels:

Budgeted production (units) = Budgeted sales (units) +Target ending finished goods inventory
(units) – Opening finished goods inventory (units)

When unit sales are not stable throughout the year, managers must decide whether (1) to adjust
production levels periodically to minimize stock held, or (2) to maintain constant production
levels and let stock rise and fall. Increasingly, managers are choosing to adjust production.
Chapter 21 discusses just-in-time production systems whose objective is to keep extremely low
levels of stock throughout the year.

3. Direct materials usage budget and direct materials purchases budget: The decision on
the number of units to be produced (schedule 2) is the key to computing the usage of direct
materials in quantities and in birr’s.
The purchasing manager prepares the budget for direct material purchases, calculated in
Schedule 3B, based on the budgeted direct materials to be used, the beginning inventory of direct
materials, and the target ending inventory of direct materials:
Purchases of direct materials = Usage of direct materials + Target ending inventory of direct
materials - Beginning inventory of direct materials
Budgeted direct materials usage = budgeted production (units) * budgeted direct material usage
per unit.
4. Direct manufacturing labor budget: In this step, manufacturing managers use labor
standards, the time allowed per unit of output, to calculate the direct manufacturing labor
costs budget in Schedule 4.These costs depend on wage rates, production methods and hiring
plans. The computation of budgeted direct manufacturing labor costs appear in schedule 4.
Budgeted direct labor usage (hours) = budgeted production (units) * budgeted direct labor hour
per unit
Budgeted direct labor cost = budgeted direct labor usage (hours) * budgeted wage rate
1. Manufacturing overhead budget: The total of these costs depends on how individual
overhead costs vary with the assumed cost driver or allocation base. The specific
variable- and fixed-cost categories may be obtained, following discussions with company

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 personnel in different areas. The calculations of budgeted manufacturing overhead costs
appear in schedule 5.
Budgeted variable MOH cost = allocation base (hours or units) * budgeted rate per allocation
base.
2. Ending inventory budget: Schedule 6Ashows the computation of unit costs for the
different products. These unit costs are used to calculate the costs of target ending
inventory of direct materials and finished goods in schedule 6B.
Budgeted ending inventory = budgeted manufacturing cost per unit * budgeted ending inventory
(units)
3. Cost of goods sold budget: The information from schedules 3 to 6 leads to schedule 7:
Budgeted cost of goods sold = beginning finished goods inventory + budgeted cost of production
– budgeted cost of ending finished goods inventory.
Budgeted cost of production = budgeted direct materials usage cost + budgeted direct labor
usage cost + budgeted manufacturing overhead cost.
4. Other (non-production) costs budget: include budget of variable and fixed costs for
other value chain activities like Research and Development, marketing, distribution, and
customer service and administrative.
5. Budgeted operating profit statement Schedules 1, 7 and 8 provide the necessary
information to complete the budgeted operating profit statement. Of course, more details
could be included in the profit statement, and then fewer supporting schedules would be
prepared.
Top management’s strategies for achieving revenue and operating profit goals influence the costs
planned for the different business functions of the value chain. As strategies change, the budget
allocations for different elements of the value chain will also change. For example, a shift in
strategy towards emphasizing product development and customer service will result in increased
resources being allocated to these parts of the master budget. The actual data resulting from this
strategy will be compared with budgeted results. Management can then evaluate whether the
focus on product development and customer service has been successful. This feedback is an
important input in subsequent plans.
Illustration:
Consider the following data XY-furniture company producing and selling two types of dining
tables: casual and deluxe. The company plan to use two types of direct materials which are red
oak and granite.

 The bill of materials would indicate that 12 board feet of red oak and 6 square feet of
granite are needed to produce each Casual coffee table, and 12 board feet of red oak and 8
square feet of granite to produce each Deluxe coffee table. Each board feet red oak costing
birr 7 and each square feet of granite costing birr 10.
 Four and six direct labor hours are required for producing a single casual and deluxe table
respectively and budgeted at Br 20 per hour.

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  Variable overhead is budgeted at Br 8 per direct labor hour (cost driver).

 Fixed overhead is budgeted at Br 5,000,000 per year. 2,000,000 of casual table and
3,000,000 of Deluxe table.

 Variable non-manufacturing costs are expected to be Br 0.14 per Birr of revenue.

 Fixed non-manufacturing costs are Br 3,000,000 for casual table and 4,000,000 for deluxe
table per year.

 The company expects to sell 50,000 casual tables and 10,000 units of deluxe tables at a
target price of birr 600 and 800 respectively.

 Assume that target ending finished goods inventory is 11,000 units of casual and 500 units
of deluxe tables. At the beginning of the year 2013, the company has 1,000 and 500 units
of casual and deluxe tables’ respectively.

 Desired direct materials ending inventory equals 10 percent of the materials required to
produce next month’s sales. And the company plan to sell 55,000 casual tables and 13,000
deluxe tables by the coming year (i.e. 2014).

Required: Prepare the supporting scheduled of operational budget and budgeted income
statement for XY-Furniture Company for the year 2013
Schedule 1: Revenues Budget
For the Year Ending December 31, 2013
Budgeted sales units Target selling price Budgeted revenue
Casual table 50,000 Birr 600 Birr 30,000,000
Deluxe table 10,000 800 8,000,000
Total budgeted revenue Birr 38,000,000

Schedule 2: Production Budget (in Units)

For the Year Ending December 31, 2013
Product Casual Deluxe
Budgeted unit sales (Schedule 1) 50,000 10,000
Add target ending finished goods inventory 11,000 500
Total required units 61,000 10,500
Deduct beginning finished goods inventory 1,000 500
Units of finished goods to be produced (budgeted production) 60,000 10,000

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 Schedule 3A: Direct Material Usage Budget in Quantity and Birrs
For the Year Ending December 31, 2013
Materials
Red Oak Granite Total
Physical Units Budget
Direct materials required for Casual tables 720,000 b.f. 360,000 sq. ft.
(60,000 units * 12 b.f. and 6 sq. ft.)
Direct materials required for Deluxe tables 120,000 b.f. 80,000 sq. ft.
(10,000 units * 12 b.f. and 8 sq. ft.)
Total quantity of direct materials to be used 840,000 b.f. 440,000 sq. ft.
Cost Budget
Available from beginning direct materials
inventory
(under a FIFO cost-flow assumption) Birr 490,000
- Red Oak: 70,000 b.f. * $7 per b.f. $ 490,000 Birr 600,000
- Granite: 60,000 sq. ft. * $10 per sq. ft. $
600,000
To be purchased this period
- Red Oak: (840,000 – 70,000) b.f. * birr7 per 5,390,000
b.f. 3,800,000
- Granite: (440,000 – 60,000) sq. ft. * birr 10
per sq. ft.
Direct materials to be used this period Br. 5,880,000 Br. 4,400,000 Br. 10,280,000

Schedule 3B: Direct Material Purchases Budget

For the Year Ending December 31, 2013
Material
Red Oak Granite Total
Physical Units Budget
To be used in production (from Schedule 3A) 840,000 b.f. 440,000 sq. ft.
Add target ending inventory 80,000 20,000
Total requirements 920,000 460,000
Deduct beginning inventory 70,000 60,000
Purchases to be made 850,000 b.f. 400,000 sq. ft.
Cost Budget
Red Oak: 850,000 b.f. * birr 7 per b.f. Birr 5,950,000
Granite: 400,000 sq. ft. * birr 10 per sq. ft. Birr 4,000,000

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Purchases Birr 5,950,000 Birr 4,000,000 Br. 9,950,000

Schedule 4: Direct Manufacturing Labor Costs Budget

For the Year Ending December 31, 2013
Budgeted Direct Total Hours Hourly Total direct
production Manufacturing Wage labor cost
(Schedule 2) Labor-Hours Rate budget
per Unit
Casual 60,000 4 240,000 Birr 20 Birr 4,800,000
Deluxe 10,000 6 60,000 20 1,200,000
Total 300,000 Birr 6,000,000

Schedule 5: Manufacturing Overhead Costs Budget

For the Year Ending December 31, 2012
Casual Deluxe Total
Variable manufacturing overhead
 Casual (birr 8 per dl hour * 240,000 dl hrs) Br. 1,920,000
 Deluxe (birr 8 per dl hour * 60,000 dl hrs) Br. 480,000 Br. 2,480,000

Fixed manufacturing overhead 2,000,000 3,000,000 5,000,000

Total budgeted manufacturing overhead Br. 3,920,000 Br. 3,480,000 Br. 7,480,000

Schedule 6A: Unit Costs of Ending Finished Goods Inventory

December 31, 2012
Product
Casual Tables Deluxe Tables
Cost per Unit Input per Unit Total cost per Input per Unit Total cost per
of Input of Output unit of output of Output unit of output
Total
Red Oak Birr 7 12 b.f. Birr 84 12 b.f. Birr 84
Granite 10 6 sq. ft. 60 8 sq. ft. 80
Direct 20 4 hrs 80 6 hrs 120
manufacturing
labor
Variable 32 and 8 4 128 4 32
Manufacturing respectively
overhead
Fixed 33.3 and 300 33.3 300
manufacturing respectively
overhead

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Total Birr 301.3 Birr 616

Under the FIFO method, this unit cost is used to calculate the cost of target ending inventories of
finished goods in Schedule 6B.

Schedule 6B: Ending Inventories Budget

December 31, 2013
Quantity Cost per Unit Total
Direct materials
- Red Oak 80,000 Br. 7 Br. 560,000
- Granite 20,000 10 200,000 760,000
Finished goods
- Casual 11,000 301.3 3,314,000
- Deluxe 500 616 308,000 3,622,000
Total ending inventory Br. 4,382,000

Schedule 7: Cost of Goods Sold Budget

For the Year Ending December 31, 2012
From Total
schedule
Beginning finished goods inventory, Jan. 1, 2012 Given* Br. 646,000
Direct materials used 3A Br. 10,280,000
Direct manufacturing labor 4 6,000,000
Manufacturing overhead 5 7,480,000
Cost of goods manufactured 23,760,000
Cost of goods available for sale 24,406,000
Deduct ending finished goods inventory, December 6B 3,622,000
31, 2012
Cost of goods sold 20,784,000

Schedule 8: Nonmanufacturing Costs Budget

For the Year Ending December 31, 2012
Variable non-manufacturing costs 0.14 * 38,000,000 Br. 5,320,000
Fixed non-manufacturing costs 7,000,000
Total budgeted non-manufacturing costs Br. 12,320,000

XY-Furniture Company
Budgeted income statement
For the year ended on December, 2013
Revenue Schedule 1 Birr 38,000,000

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Cost of goods sold Schedule 7 (20,784,000)
Gross margin 17,216,000
Non-manufacturing costs Schedule 8 (12,320,000)
Operating income Birr 4,896,000

Financing budget:
The financial budget includes the cash budget, the capital budget, the budgeted balance sheet,
and the budgeted statement of cash flows.
Cash budget: The cash budget, or statement of budgeted cash receipts and payments, details
how the business expects to go from the beginning cash balance to the desired ending balance. In
other words, the cash budget is a schedule of expected cash receipts and disbursements. It
predicts the effects on the cash position at the given level of operations. In practice, monthly—
and sometimes weekly or even daily—cash budgets are critical for cash planning and control.
Cash budgets help avoid unnecessary idle cash and unexpected cash deficiencies. They thus keep
cash balances in line with needs. Ordinarily, the cash budget has these main sections:
a. Cash available for needs (before any financing). The beginning cash balance plus cash
receipts equals the total cash available for needs before any financing. Cash receipts depend on
collections of accounts receivable, cash sales, and miscellaneous recurring sources, such as rental
or royalty receipts. Information on the expected collectability of accounts receivable is needed
for accurate predictions. Key factors include bad-debt (uncollectible accounts) experience (not an
issue in the Stylistic case because Stylistic sells to only a few large wholesalers) and average
time lag between sales and collections.
b. Cash disbursements. Cash disbursements by Stylistic Furniture include the following:
i. Direct material purchases. Suppliers are paid in full three weeks after the goods are delivered.
ii. Direct labor and other wage and salary outlays. All payroll-related costs are paid in the
month in which the labor effort occurs.
iii. Other costs. These depend on timing and credit terms. (In the Stylistic case, all other costs are
paid in the month in which the cost is incurred.) Note, depreciation does not require a cash
outlay.
iv. Other disbursements. These include outlays for property, plant, equipment, and other long-
term investments.
v. Income tax payments.
c. Financing effects. Short-term financing requirements depend on how the total cash available
for needs [keyed as (x) in Exhibit 6-6] compares with the total cash disbursements [keyed as (y)],
plus the minimum ending cash balance desired. The financing plans will depend on the
relationship between total cash available for needs and total cash needed. If there is a deficiency
of cash, loans will be obtained. If there is excess cash, any outstanding loans will be repaid.
d. Ending cash balance. The cash budget in Exhibit 6-6 shows the pattern of short-term “self-
liquidating” cash loans.

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Cash collections and payments depend on revenues and expenses, which appear in the operating
budget. This is why you cannot prepare the cash budget until you have finished the operating
budget.
Beginning cash balance ------------------------------- XXX
Add: cash collection from customers ---------------- XXX
Total cash available for needs(X) ------------------------------------------ XXX
Disbursements:
Direct material ------------------------------------------ XXX
Payroll --------------------------------------------------- XXX
Interest expense ----------------------------------------- XXX
Plant Asset ----------------------------------------------- XXX
Income tax ----------------------------------------------- XXX
Others ---------------------------------------------------- XXX
Total disbursements (Y) ---------------------------------------------------- XXX
Add: minimum cash balance ----------------------------------------------- XXX
Total Cash needed (P) ------------------------------------------------------ XXX
Cash excess (deficiency) (X – P) ---------------------------------------- XXX
Financing (if there is deficiency) or investment (if there is excess):
Borrowing ----------------------------------------------- XXX
Repayment ---------------------------------------------- (XXX)
Interest --------------------------------------------------- (XXX)
Net effect of financing (Z) -------------------------------------------------- XXX
Ending Cash balance (X –Y + Z) ------------------------------------------ XXX

Budgeted Balance Sheet

Determine the balance of each account by analyzing the policy of the organization and all other
related data.

Cash – refer to cash budget (the budgeted ending balance of cash)

AR – Beg AR + Total sales –Cash collection from customer
INV – refer to ending inventory budget under operational budget
Acct Pay – Beg AP + total material purchase- cash paid to supplier
Plant asset – refer to capital budget
3.6 Responsibility accounting
3.6.1 Organizational structure and responsibility accounting
Organizational structure is an arrangement of lines of responsibility within the entity. To attain
the goals described in the master budget, an organization must coordinate the efforts of all its
employees – from the top executive through all levels of management to every supervised
worker. Coordinating the organization efforts means assigning responsibility to managers who
are accountable for their actions in planning and controlling human and physical resources.

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Management is in essence a human activity. Budgets exist not for their own sake, but to help
managers achieve their own pursuits and thereby contribute to meeting those of the organization.
Each manager, regardless of level, is in charge of a responsibility center. A responsibility center
is a part, segment or subunit of an organization whose manager is accountable for a specified set
of activities. The higher the manager’s level, the broader the responsibility center he or she
manages and, generally, the larger the number of subordinates who report to him or her.
Responsibility accounting is a system that measures the plans (by budgets) and actions (by
actual results) of each responsibility center.
Four major types of responsibility center are:
1 Cost center – manager accountable for costs only.
2 Revenue center – manager accountable for revenues only.
3 Profit center – manager accountable for revenues and costs.
4 Investment center – manager accountable for investments, revenues and costs.

Feedback:
Budgets coupled with responsibility accounting provide systematic help for managers,
particularly if managers interpret the feedback carefully. Managers, accountants and students of
management accounting sometimes use variances (the difference between the actual results and
the budgeted results) appearing in the responsibility accounting system to pinpoint fault for
operating problems. In looking at variances, managers should focus on whom they should ask
and not on whom they should blame. Variances only suggest questions or direct attention to
persons who should have the relevant information. Nevertheless, variances, properly used, can be
helpful in four ways:
 Early warning. Variances alert managers early to events not easily or immediately
evident. Managers can then take corrective actions or exploit available opportunities.
 Performance valuation. Variances inform managers about how well the company has
performed in implementing its strategies.
 Evaluating strategy. Variances sometimes signal to managers that their strategies are
ineffective.
 Communicating the goals of the organization. The budget-making exercise and budgeting
information are useful in conveying to managers across the organization the goals of
subunits and the wider corporate goals.

3.6.2 Responsibility and controllability

Controllability is the degree of influence that a specific manager has over costs, revenues or
other items in question. A controllable cost is any cost that is primarily subject to the influence
of a given manager of a given responsibility centre for a given time span. A responsibility
accounting system could either exclude all uncontrollable costs from a manager’s performance
report or segregate such costs from the controllable costs. For example, a machining supervisor’s
performance report might be confined to quantities (not costs) of direct materials, direct
manufacturing labor, power and supplies.

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In practice, controllability is difficult to pinpoint:
1 Few costs are clearly under the sole influence of one manager. For example, costs of
direct materials may be influenced by a purchasing manager, but such costs also depend
on market conditions beyond the manager’s control. Quantities used may be influenced
by a production manager, but quantities used also depend on the quality of materials
purchased. Moreover, managers often work in teams. How can individual responsibility
be evaluated in a team decision?
2 With a long enough time span, all costs will come under somebody’s control. However,
most performance reports focus on periods of a year or less. A current manager may have
inherited problems and inefficiencies from his or her predecessor. For example, present
managers may have to work under undesirable contracts with suppliers or trade unions
that were negotiated by their predecessors. How can we separate what the current
manager actually controls from the results of decisions made by others? Exactly what is
the current manager accountable for? Answers to such questions may not be clear cut.
Budgeting slack: Padding the budget

Budget padding means underestimating revenue or overestimating costs during the time of
budget preparation. The difference between the revenue or cost projection that a person provides
and a realistic estimate of revenue or cost is called budgetary slack. Therefore budgets
formulated with the active participation of all affected employees are generally more effective
than budgets imposed on subordinates – participative budgeting.

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