Financial and Managerial Accounting, 9th Edition

CHAPTER 22
PERFORMANCE MEASUREMENT AND
RESPONSIBILITY ACCOUNTING

Chapter Outline
I. Responsibility Accounting
A. Performance Evaluation
1. Large companies are easier to manage if divided into smaller units called divisions, segments, or
departments.
2. In decentralized organizations, unit managers make decisions and top management evaluates
their performance.
3. Responsibility accounting evaluates unit managers only on activities they can control.
4. The methods of performance evaluation vary for cost centers, profit centers and investment
centers.
a. Cost centerincurs costs without generating revenues (e.g. manufacturing departments and
service departments).
b. Profit centerincurs costs and generates revenues (e.g. product lines).
c. Investment centerincurs costs, generates revenues and its managers is responsible for
major investing decisions.
5. Basis for evaluating performance:
a. Cost center managers are evaluated on their success in controlling actual costs compared to
budgeted costs.
b. Profit center managers are evaluated on their success in generating income.
c. Investment center managers are evaluated on their use of assets to generate income.
II. Controllable versus Uncontrollable Costs
A. Controllable Costs -
1. Costs a manager can determine or influence.
B. Uncontrollable costs –
1. Costs not within the manager’s control or influence.
2. A manager’s performance is evaluated using responsibility accounting performance reports that
list actual costs that a manager is responsible for and their budgeted amounts.
3. Distinguishing between controllable and uncontrollable costs depends on the particular manager
and the time period under analysis.
4. All costs are controllable at some level of management if the time period is sufficiently long.
C. Responsibility Accounting Performance Report
1. Reports actual costs that a manager is responsible for and their budgeted amounts.
a. Analysis of differences between actual and budgeted amounts often results in corrective or
strategic managerial actions.
b. Recognizes that control over costs and expenses belongs to several layers of management.
c. Provides relevant information for each management level.
d. Lower-level managers have responsibility for more detailed costs.

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 Financial and Managerial Accounting, 9th Edition

e. Higher-level managers are responsible for larger and broader costs.

f. Reports to higher-level managers usually are less detailed because lower-level managers are
responsible for detailed costs and detailed reports can distract from key issues facing top
managers.

III. Profit Centers

A. The responsibility accounting focuses on how well each department-controlled costs and generated
revenues.
B. Departmental income statements are used to report profit center performance.
C. When computing department income, we make two decisions for allocating expenses:
1. How to allocate indirect expenses, such as rent and utilities which benefit several departments.
2. How to allocate service department expenses, such as payroll and purchasing, that benefit several
departments.
D. Expenses
1. Direct expenses are readily traced to a department.
a. Incurred for sole benefit of that one department; no allocation required.
b. Often, but not always, controllable costs.
2. Indirect expenses are incurred for joint benefit of more than one department; can’t be readily
traced to just one department.
a. Allocated across departments benefiting from them.
b. Ideally allocated to departments that benefit from them.
E. Expense Allocations – indirect expenses and service department expenses are allocated to
departments that benefit from them.
1. Allocated Cost = Total cost to allocate x Percentage of allocation base used.
F. Allocating Indirect Expenses – no standard rule for “best” allocation bases exists. Commonly used
allocation bases for allocating indirect expenses include:
1. Wages and salaries –hours worked in each department.
2. Rent and utilitiesfloor space occupied.
3. Advertising –percentage of total sales.
4. Depreciation –hours of depreciable asset used.
G. Service Department expenses –operating departments use services such as personnel, payroll and
purchasing. Commonly used allocation bases for service expenses:
1. Office -- number of employees or sales in each department.
2. Personnel and payroll -- number of employees in each department.
3. Purchasing– dollars of purchases or number of purchase orders processed.
4. Maintenance– square feet of space occupied.
H. Departmental Income Statements
1. Departmental income is computed using the following formula: Departmental income = Dept.
sales – Dept. direct expenses – Allocated indirect expenses – Allocated service dept. expenses.
2. Three steps for allocating costs and preparing departmental income statements:
a. Step 1: accumulate sales, direct and indirect expenses by department. List sales and amounts
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 Financial and Managerial Accounting, 9th Edition

for each department followed by the same for direct expenses and indirect expenses. Total
for each expense is in the Expense Balance column. Exhibit 22.9 shows these data.
i. Direct and indirect expenses include salaries, depreciation and supplies expenses.
b. Step 2 – allocate indirect expenses to both service and operating departments.
i. Uses a departmental expense allocation spreadsheet shown in Exhibit 22.10.
ii. Calculations are shown for the allocation of Rent and Advertising.
c. Step 3—allocate service department expenses to operating departments. After service
department costs are allocated, no expenses remain in service departments.
3. Prepare departmental income statements using the departmental expense allocation spreadsheet.
i. Actual service department expenses are compared with budgeted amounts to help assess
cost center performance.
ii. Amounts in the operating department columns are used to prepare departmental income
statements. (Exhibit 22.11).
I. Departmental Contribution to Overhead (see Exhibit 22.12)
1. Departmental income statements not always best for evaluating each profit center’s performance
especially when indirect expenses are a large portion of total expenses.
2. Evaluate using departmental contributions to overheada report of the amount of sales minus
cost of goods sold and direct expenses.
IV. Investment Centers
A. Financial Performance Evaluation Measures include:
1. Return-on-investment (return on assets), computed as income divided by average assets.
2. Residual income – Expressed in dollars. Encourages division managers to accept opportunities
that return more than target income. Computed as income minus target income.
3. Profit margin and investment turnover – split return on investment into two measures – profit
margin and investment turnover.
a. Profit margin measures income per dollar of sales computed as income divided by sales.
Shown as a percent.
b. Investment turnover measures how efficiently an investment center generates sales from its
assets. Calculated as sales divided by average assets. Expressed as the number of times assets
were converted into sales.
4. Evaluating performance solely on financial measures has limitations. Companies can also use
nonfinancial measures.
5. Balanced scorecard: system of performance measures, including nonfinancial measures used to
assess company and division manager performance. Requires managers to think of their
company from four perspectives:
1. Customer: What do customers think of us?
2. Internal Processes: Which operations are crucial to customers?
3.Innovation/Learning: How can we improve?
4.Financial: What do our owners think of us?
V. Transfer Pricing
The price used to record transfers across divisions within a company is called a transfer price. Can be
used in cost, profit and investment centers.
A. Low transfer price – transfer price cannot be less than variable manufacturing cost.
B. High transfer price – transfer price cannot be more than the market price.
C. The transfer price should be between the low and high transfer price.
D. If there is no excess capacity, the internal supplier will not accept a transfer price less than the market
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 Financial and Managerial Accounting, 9th Edition

price. This is called the market-based transfer price.

E. If there is excess capacity, the internal supplier should accept a price between the variable cost and
the market price. This is called the cost-based transfer price.
F. If there is excess capacity, division managers often negotiate a transfer price between the variable
cost per unit and market price per unit. This is called the negotiated transfer price.
VI. Decision Analysis Cash Conversion Cycle
A. Effectively managing working capital is important for survival and profit.
1. Accounts receivable, accounts payable, and inventory ratios are used to evaluate performance on
working capital dimensions.
a. Combining these ratios summarize how a company manages its working capital.
2. The cash conversion (or cash-to-cash) cycle measures the average time it takes to convert cash
outflows into cash inflows.

Cycle conversion cycle =

Days’ sales in accounts receivable plus Days’ sales in inventory minus Days’sales in accounts
payable.

a. If a company’s conversion cycle is too long, companies do not have use of that money and
risks missing investment opportunities.
b. Companies can speed up the cash conversion cycle by:
i. Offering customers fewer days to pay
ii. Offering customers discounts for prompt payment
iii. Adopting lean principles to reduce inventory
iv. Negotiating longer times to pay suppliers
VII. Appendix 22A – Joint Costs
A. Joint Coststhe costs incurred to produce or purchase two or more products at the same time.
1. When management wishes to estimate the costs of individual products, joint costs must be
allocated to joint products.
2. Financial statements prepared according to GAAP also must assign joint costs to products.
3. Popular approach is the value basis which allocates joint cost in proportion to the sales value of
the output produced by the process at the split-off point.
4. Split-off point is the point at which separate products can be identified.
5. Value basis of allocation of joint costs:
A. Shown in Exhibit 22A.2.
B. Determine the percents of the total costs allocated to each product by the ratio of each
product’s sales value at the split-off point to the total sales value.
C. Allocation basis is a close matching of costs and revenues.

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 Financial and Managerial Accounting, 9th Edition

i.

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 Financial and Managerial Accounting, 9th Edition

Chapter 22 Alternate Demo Problem

Jack and Susan Roberts own a farm that produces potatoes. Based on a review of the
income statement shown below, Jack remarked that they should have fed the No. 3
potatoes to the pigs; then they would have avoided the loss from the sale of the those
potatoes.

JACK AND SUSAN ROBERTS

Income from the Production and Sale of Potatoes
For Year Ended December 31, 20xx

Results by Grade
No. 1 No. 2 No. 3 Combined
Sales by grades:
No. 1, 300,000 lbs. $0.045 per lb. $13,500
No. 2, 500,000 lbs. $0.04 per lb. $20,000
No. 3, 200,000 lbs. $0.03 per lb. $6,000
Combined sales: $39,500
Costs:
Land preparation, seed,
planting, cultivating @ $0.01422/lb. 4,266 7,110 2,844 14,220
Harvesting, sorting, grading
@ $0.01185 per lb. 3,555 5,925 2,370 11,850
Marketing @ $0.00415 per lb. 1,245 2,075 830 4,150
Total costs 9,066 15,110 6,044 30,220
Income (or loss) $4,434 $4,890 ($44) $9,280

Jack and Susan divided their costs among the grades on a per pound basis, because
their records do not show cost per grade. However, their records did show that $4,020
of the $4,150 of marketing costs represented the cost of placing the No. 1 and No. 2
potatoes in bags and hauling them to the warehouse of the produce buyer. Bagging
and hauling costs were the same for both grades. The remaining $130 represented the
cost of loading the No. 3 potatoes into the trucks of the potato starch factory that
bought these potatoes in bulk and picked them up at the farm.

Required:
Prepare a departmental income statement to show the results of producing and
marketing each of the potatoe grades.

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 Financial and Managerial Accounting, 9th Edition

Chapter 22 Alternate Demo Problem: Solution

JACK AND SUSAN ROBERTS
Income from the Production and Sale of Potatoes
For Year Ended December 31, 20xx

Results by Grade
No. 1 No. 2 No. 3 Combined
Revenue from sales: $13,500 $20,000 $6,00 $39,500
0
Costs:
Land preparation, seed,
planting, cultivating 4,860 7,200 2,160 14,220
Harvesting, sorting, grading 4,050 6,000 1,800 11,850
Marketing 1,620 2,400 130 4,150
Total costs 10,530 15,600 4,090 30,220
Income $2,970 $4,400 $1,91 $9,280
0

COST ALLOCATIONS

Land preparation, seed, planting, and cultivating:

No. 1: $13,500 / $39,500 x $14,220 = $ 4,860
No. 2: $20,000 / $39,500 x $14,220 = 7,200
No. 3: $ 6,000 / $39,500 x $14,220 = 2,160
$14,220
Harvesting, sorting, and grading:
No. 1: $13,500 / $39,500 x $11,850 = $ 4,050
No. 2: $20,000 / $39,500 x $11,850 = 6,000
No. 3: $ 6,000 / $39,500 x $11,850 = 1,800
$11,850
Marketing:
No. 1: $13,500 / $33,500 x $4,020 = $1,620
No. 2: $20,000 / $33,500 x $4,020 = 2,400
Subtotal bagging and hauling costs 4,020
No. 3: Loading costs 130
$4,150

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