Managerial Accounting

Weygandt, Kieso, & Kimmel

Prepared by
Karleen Nordquist..
The College of St. Benedict...
and St. John’s University...

with contributions by
Marianne Bradford..
The University of Tennessee...
Gregory K. Lowry….
Macon Technical Institute…..

John Wiley & Sons, Inc.

 Chapter 7

Budgetary Control and

Responsibility Accounting
 Chapter 7
Budgetary Control and Responsibility
Accounting
After studying this chapter, you should be able to:
1 Describe the concept of budgetary control.
2 Evaluate the usefulness of static budget reports.
3 Explain the development of flexible budgets and the
usefulness of flexible budget reports.
4 Describe the concept of responsibility accounting.
 Chapter 7
Budgetary Control and Responsibility
Accounting
After studying this chapter, you should be able to:
5 Indicate the features of responsibility reports for cost
centers.
6 Identify the content of responsibility reports for profit
centers.
7 Explain the basis and formula used in evaluating
performance in investment centers.
 Preview of Chapter 7

Concept of Budgetary Control

Static Budget Reports
• Illustrations
BUDGETARY • Uses and Limitations
CONTROL AND
RESPONSIBILITY Flexible Budgets
• Why Flexible Budgets?
ACCOUNTING
• Development
• Case Study
• Reports
• Management by Exception
 Preview of Chapter 7

Concept of Responsibility
Accounting
• Controllable vs. Noncontrollable
• Reporting System
BUDGETARY
CONTROL AND
Types of Responsibility
RESPONSIBILITY
ACCOUNTING
Centers
• Cost Centers
• Profit Centers
• Investment Centers
• Performance Evaluation
 Study Objective 1

Describe the concept of budgetary

control.
 Budgetary Control
 The use of budgets in controlling operations is
known as budgetary control.
 The centerpiece of budgetary control is the use of
budget reports that compare actual results with
planned objectives.
 The budget reports provide the feedback needed
by management to see whether actual operations
are on course.
 Budgetary Control
Budgetary control involves:
 Developing budgets.
 Analyzing the differences between actual and
budgeted results.
 Taking corrective action.
 Modifying future plans, if necessary.
 Repeating the cycle.
 Budgetary Control
Budgetary control works best when a company has a
formalized reporting system. The system should:
 Identify the name of the budget report, such as the
sales budget or the manufacturing overhead budget.
 State the frequency of the report, such as weekly or
monthly.
 Specify the purpose of the report.
 Indicate the primary recipient(s) of the report.
 Budgetary Control Reporting
System
The schedule below illustrates a partial budgetary control system for a
manufacturing company. Note the emphasis on control in the reports
and the frequency of the reports. Illustration 7-2
 Study Objective 2

Evaluate the usefulness of static

budget reports.
 Static Budget Reports
 A static budget is a projection of budget data
at one level of activity.
 In such a budget, data for different levels of
activity are ignored.
 As a result, actual results are always
compared with the budget data at the activity
level used in developing the master budget.
 Static Budget Reports:
Illustration
 To illustrate the role of a static budget in budgetary
control, we will use selected budget data for Hayes
Company prepared in Chapter 6.
 Budget and actual sales data for the Kitchen-mate
product in the first and second quarters of 1999 are as
follows:

Sales First Quarter Second Quarter Total

Budgeted $180,000 $210,000 $390,000
Actual 179,000 199,500 378,000
Difference $ 1,000 $ 10,500 $ 11,500

Illustration 7-3
 Static Budget Reports:
Illustration
 The sales budget report for Hayes Company’s 1st quarter is
shown below. Illustration 7-4
Hayes Company
Sales Budget Report
For the Quarter Ended March 31, 1999
Difference
Difference
Favorable
Favorable--FF
Product
ProductLine
Line Budget
Budget Actual
Actual Unfavorable
Unfavorable--UU
Kitchen-mate a
Kitchen-matea $180,000
$180,000 $179,000
$179,000 $1,000
$1,000UU
In
a practice, each product line would be included in the report.
a
In practice, each product line would be included in the report.
 The report shows that sales are $1,000 under budget – an
unfavorable result. Since the difference is less that 1% of
budgeted sales ($1,000/$180,000 =.0056), we will assume
that top management of Hayes Company will view the
difference as immaterial and take no specific action.
 Static Budget Reports:
Illustration
 The sales budget report for Hayes Company’s 2nd quarter
is shown below.
Hayes Company
Sales Budget Report
For the Quarter Ended March 31, 1999
Difference
Difference
Favorable
Favorable--FF
Product
ProductLine
Line Budget
Budget Actual
Actual Unfavorable
Unfavorable--UU
Kitchen-mate a
Kitchen-matea $210,000
$210,000 $199,500
$199,500 $10,500
$10,500UU
a
In
a practice, each product line would be included in the report.
In practice, each product line would be included in the report.
 The second quarter shows that sales were $10,500 below
budget, which is 5% of budgeted sales ($10,500/$210,000).
Top management may conclude that the difference between
budgeted and actual sales in the second quarter merits
investigation.
 Static Budget Reports:
Illustration
 Management’s analysis should start by asking the sales
manager the cause(s) of the shortfall. The need for
corrective action should be considered.
 For example, management may decide to spur sales by
offering sales incentives to customers or by increasing
advertising. On the other hand, if management
concludes that a downturn in the economy is
responsible for the lower sales, it may decide to modify
planned sales and profit goals for the remainder of the
year.
 Static Budget Reports
A static budget is appropriate in evaluating a
manager’s effectiveness in controlling costs
when:
 the actual level of activity closely approximates
the master budget activity level, and/or
 the behavior of the costs in response to changes
in activity is fixed.
 Study Objective 3

Explain the development of flexible

budgets and the usefulness of
flexible budget reports.
 Flexible Budgets
 A flexible budget projects budget data for various
levels of activity.
 In essence, the flexible budget is a series of static
budgets at different levels of activity.
 The flexible budget recognizes that the budgetary
process has greater usefulness if it is adaptable to
changed operating conditions.
 This type of budget permits a comparison of actual
and planned results at the level of activity actually
achieved.
 Why Flexible Budgets?
An Illustration
 Barton Steel prepares the following static budget for
manufacturing overhead based on a production
volume of 10,000 units of steel ingots.
Barton Steel (Forging Department)
Manufacturing Overhead Budget (Static)
For the Year Ended December 31, 1999
Budgeted
BudgetedProduction
Productionin
inunits
units(steel
(steelingots)
ingots) 10,000
10,000
Budgeted Costs
Budgeted Costs
Indirect
Indirectmaterials
materials $$250,000
250,000
Indirect labor
Indirect labor 260,000
260,000
Utilities
Utilities 190,000
190,000
Depreciation
Depreciation 280,000
280,000
Property
Propertytaxes
taxes 70,000
70,000
Supervision
Supervision 50,000
50,000
$1,100,000
$1,100,000

Illustration 7-6
 Why Flexible Budgets?
An Illustration
 If demand for steel ingots has increased and 12,000 units are
produced during the year, rather than 10,000, the budget
report will show very large variances. Illustration 7-6
 This is because the comparison is Barton Steel (Forging Department)
based on budget data based on Manufacturing Overhead Budget Report (Static)
the original activity level (10,000 For the Year Ended December 31, 1999
steel ingots). Variable budget Difference
Difference
allowances should increase with Favorable
FavorableFF
production. Budget
Budget Actual
Actual Unfavorable
UnfavorableUU
Production
Productionin inunits
units 10,000
10,000 12,000
12,000
Costs
Costs
Indirect
Indirectmaterials
materials $$250,000
250,000 $295,000
$295,000 $$45,000
45,000UU
Indirect
Indirectlabor
labor 260,000
260,000 312,000
312,000 53,000
53,000UU
Utilities
Utilities 190,000
190,000 225,000
225,000 35,000
35,000UU
Depreciation
Depreciation 280,000
280,000 280,000
280,000 -0-
-0-
Property
Propertytaxes
taxes 70,000
70,000 70,000
70,000 -0-
-0-
Supervision
Supervision 50,000
50,000 50,000
50,000 -0-
-0-
$1,100,000
$1,100,000 $1,232,000
$1,232,000 $132,000
$132,000UU
 Why Flexible Budgets?
An Illustration
 Since the comparison of actual variable costs with budgeted costs
is meaningless (due to different levels of activity), variable per unit
costs must be isolated so the budget can be adjusted. An analysis
of the budget data for these costs at 10,000 units produces the
following per unit results: Illustration 7-8
Item Total Cost Per Unit
Indirect materials $250,000 $25
Indirect labor 260,000 26
 The budgeted variable costs at 12,000 Utilities 190,000 19
units, therefore, are as shown on the $700,000 $70
right. Because fixed costs do not change
in total as activity changes, the budgeted Illustration 7-9
amounts for these costs remain the same.
Item Computation Total
Indirect materials $25 x 12,000 $300,000
Indirect labor 26 X 12,000 312,000
Utilities 19 x 12,000 228,000
$840,000
 Why Flexible Budgets?
An Illustration
 The budget report based on the flexible budget for 12,000 units is shown
below. Illustration 7-10
 This budget report shows that the Barton Steel (Forging Department)
Forging Department is below budget – Manufacturing Overhead Budget Report (Flexible)
a favorable difference. The only For the Year Ended December 31, 1999
appropriate comparison is between
actual and budgeted costs at the actual Difference
Difference
production level, which a flexible Favorable
FavorableFF
budget provides. Budget Actual
Budget Actual Unfavorable
UnfavorableUU
Production
Productionin inunits
units 12,000
12,000 12,000
12,000
Variable costs
Variable costs
Indirect
Indirectmaterials
materials $$ 300,000
300,000 $$ 295,000
295,000 $5,000
$5,000FF
Indirect labor
Indirect labor 312,000
312,000 312,000
312,000 -0-
-0-
Utilities
Utilities 228,000
228,000 225,000
225,000 3,000
3,000FF
Total
Totalvariable
variable 840,000
840,000 832,000
832,000 8,000
8,000FF
Fixed costs
Fixed costs
Depreciation
Depreciation 280,000
280,000 280,000
280,000 -0-
-0-
Property taxes
Property taxes 70,000
70,000 70,000
70,000 -0-
-0-
Supervision
Supervision 50,000
50,000 50,000
50,000 -0-
-0-
Total fixed
Total fixed 400,000
400,000 400,000
400,000 -0-
-0-
$1,100,000 $1,232,000
$1,100,000 $1,232,000 $8,000
$8,000FF
 Developing the Flexible
Budget
To develop the flexible budget, management should take the
following steps:
1 Identify the activity index and the relevant range of activity.
2 Identify the variable costs and determine the budgeted
variable cost per unit of activity for each cost.
3 Identify the fixed costs and determine the budgeted amount
for each cost.
4 Prepare the budget for selected increments of activity within
the relevant range.
 Flexible Budget – A Case Study
Master Budget Data
 Fox Company wants to use a flexible budget for monthly
comparisons of actual and budgeted manufacturing overhead
costs. The master budget for the year ended December 31,
1999 is prepared using 120,000 direct labor hours and the
following overhead costs.
Illustration 7-11
Variable Costs Fixed Costs
Indirect materials $180,000 Depreciation $180,000
Indirect labor 240,000 Supervision 120,000
Utilities 60,000 Property taxes 60,000
Total $480,000 Total $360,000

STEP 1: Identify the activity index and the relevant range of

activity:
 The activity index is direct labor hours and management concludes
that the relevant range is 8,000-12,000 direct labor hours.
 Flexible Budget – A Case Study
Variable Costs per Labor Hour
STEP 2: Identify the variable costs and determine the
budgeted variable cost per unit of activity for each cost.
 For Fox, there are 3 variable costs and the per unit variable
cost is found by dividing each total budgeted cost by the
direct labor hours used in preparing the master budget
(120,000 hours).
Variable Cost per
Variable Costs Computations Direct Labor Hour
Indirect materials $180,000  120,000 $1.50
Indirect labor 240,000  120,000 2.00
Utilities 60,000  120,000 .50
Total $4.00
Illustration 7-12
 Flexible Budget – A Case Study
Fixed Costs
Step 3: Identify the fixed costs and determine the
budgeted amount for each cost.
 There are three fixed costs and since Fox
Manufacturing desires monthly budget data, the
budgeted amount is found by dividing each annual
budgeted cost by 12.
 The monthly budgeted fixed costs are:
– Depreciation $15,000,
– Supervision $10,000, and
– Property taxes $5,000.
 Flexible Budget – A Case Study
The Flexible Budget
Step 4: Prepare the budget for selected increments
of activity within the relevant range. Illustration 7-13
Fox Manufacturing Company (Finishing Department)
Flexible Monthly Manufacturing Overhead Budget
For the Month Ended January 31, 1999

Activity
Activitylevel
level
Direct
Direct laborhours
labor hours 8,000
8,000 9,000
9,000 10,000
10,000 11,000
11,000 12,000
12,000
Variable
Variablecosts
costs
Indirect
Indirectmaterials
materials $12,000
$12,000 $13,500
$13,500 $15,000
$15,000 $16,500
$16,500 $18,000
$18,000
Indirect labor
Indirect labor 16,000
16,000 18,000
18,000 20,000
20,000 22,000
22,000 24,000
24,000
Utilities
Utilities 4,000
4,000 4,500
4,500 5,000
5,000 5,500
5,500 6,000
6,000
Total
Totalvariable
variable 32,000
32,000 36,000
36,000 40,000
40,000 44,000
44,000 48,000
48,000
Fixed
Fixedcosts
costs
Depreciation
Depreciation 15,000
15,000 15,000
15,000 15,000
15,000 15,000
15,000 15,000
15,000
Supervision
Supervision 10,000
10,000 10,000
10,000 10,000
10,000 10,000
10,000 10,000
10,000
Property
Propertytaxes
taxes 5,000
5,000 5,000
5,000 5,000
5,000 5,000
5,000 5,000
5,000
Total
Totalfixed
fixed 30,000
30,000 30,000
30,000 30,000
30,000 30,000
30,000 30,000
30,000
Total costs
Total costs $62,000
$62,000 $66,000
$66,000 $70,000
$70,000 $74,000
$74,000 $78,000
$78,000
 Flexible Budget – A Case Study
Formula for Total Budgeted
Costs
From the budget, the formula shown below may be used to
determine total budgeted costs at any level of activity.
 For Fox Manufacturing, fixed costs are $30,000, and
total variable costs per unit is $4.00.
 Thus, at 8,622 direct labor hours, total budgeted costs
are:
Illustration 7-14

Total Budgeted
Fixed Costs
+ Variable Costs* = Costs

$30,000 + ($4 x 8,622) = $64,488

*Total variable cost per unit times activity level.
 Flexible Budget Reports
 Flexible budget reports represent another type of
internal report produced by managerial accounting.
 The flexible budget report consists of two sections:

– Production data such as direct labor hours, and

– Cost data for variable and fixed costs.
 Flexible budgets are used to evaluate a manager’s
performance in production control and cost control.
 Flexible Budget – A Case Study
Flexible Budget Report
 In this budget report, 8,800 DLH were expected but 9,000 hours
were worked. Budget data are based on the flexible budget for
9,000 hours.
Fox Manufacturing Company (Finishing Department)
Manufacturing Overhead Budget Report (Flexible)
For the Month Ended January 31, 1999
Direct
Directlabor
laborhours
hours(DLH)
(DLH) Difference
Difference
Expected 8,800
Expected 8,800 Budget
Budgetatat Actual
ActualCosts
Costs Favorable
FavorableFF
Actual
Actual 9,000
9,000 9,000
9,000DLH
DLH 9,000
9,000DLH
DLH Unfavorable
UnfavorableUU
Variable costs
Variable costs
Indirect
Indirectmaterials
materials $13,500
$13,500 $14,000
$14,000 $$ 500
500UU
Indirect labor
Indirect labor 18,000
18,000 17,000
17,000 1,000
1,000FF
Utilities
Utilities 4,500
4,500 4,600
4,600 100
100UU
Total
Totalvariable
variable 36,000
36,000 35,600
35,600 400
400FF
Fixed costs
Fixed costs
Depreciation
Depreciation 15,000
15,000 15,000
15,000 -0-
-0-
Property taxes
Property taxes 10,000
10,000 10,000
10,000 -0-
-0-
Supervision
Supervision 5,000
5,000 5,000
5,000 -0-
-0-
Total fixed
Total fixed 30,000
30,000 40,000
40,000 -0-
-0-
Illustration 7-16 $66,000
$66,000 $65,600
$65,600 $$ 400
400FF
 Management by Exception
 Management by exception means that top management's
review of a budget report is directed entirely or primarily
to differences between actual results and planned
objectives.
 For management by exception to be effective, there must
be some guidelines for identifying an exception. The usual
criteria are:
– Materiality- usually expressed as a percentage difference
from budget.
– Controllability of the item- exception guidelines are more
restrictive for controllable items than for items that are not
controllable by the manager being evaluated.
Study Objective 4

Describe the concept of

responsibility accounting.
 The Concept of
Responsibility Accounting
 Responsibility accounting involves accumulating
and reporting costs (and revenues, where relevant)
on the basis of the individual manager who has the
authority to make the day-to-day decisions about the
items.
 The evaluation of a manager's performance is then
based on the costs directly under the manager's
control.
 Responsibility Accounting
Responsibility accounting can be used at every level of
management in which the following conditions exist:
1 Costs and revenues can be directly associated with the
specific level of management responsibility.
2 The costs and revenues are controllable at the level of
responsibility with which they are associated.
3 Budget data can be developed for evaluating the
manager's effectiveness in controlling the costs and
revenues.
 Responsibility Accounting
 Responsibility accounting personalizes the managerial
accounting systems. Under responsibility accounting, any
individual who has control and is accountable for a specified set
of activities can be recognized as a responsibility center.
 Responsibility accounting is especially valuable in a
decentralized company.
 Decentralization means that the control of operations is
delegated by top management to many individuals (managers)
throughout the organization.
 A segment is an identified area of responsibility in
decentralized operations.
 Responsibility Accounting
versus Budgetary Control
Responsibility accounting is essential to any effective
system of budgetary control. It differs from
budgeting in two respects:
 A distinction is made between controllable and
noncontrollable items.
 Performance reports either emphasize or include
only items controllable by the individual manager.
 Controllable versus
Noncontrollable Revenues and
Costs
 All costs and revenues are controllable at some level of
responsibility within the company. Under responsibility
accounting, the critical issue is whether the cost or revenue is
controllable at the level of responsibility with which it is
associated.
 A cost is considered controllable at a given level of managerial
responsibility if that manager has the power to incur it within a
given period of time. In general, costs incurred directly by a
level of responsibility are controllable at that level.
 Costs incurred indirectly and allocated to a responsibility level
are considered to be noncontrollable at that level.
 Responsibility Reporting
System
 A responsibility reporting system involves the
preparation of a report for each level of
responsibility shown in the company's organization
chart.
 A responsibility reporting system permits
management by exception at each level of
responsibility within the organization.
 Types of Responsibility
Centers
Responsibility centers may be classified into one of
three types:
 A cost center incurs costs (and expenses) but does
not directly generate revenues.
 A profit center incurs costs (and expenses) but
also generates revenues.
 An investment center incurs costs (and expenses),
generates revenues, and has control over investment
funds available for use.
Examples of Responsibility
Centers
Cost center: usually a
production center or service
department
Profit center: individual
departments of retail stores
and branch offices of banks
Investment center: subsidiary
companies
 Study Objective 5

Indicate the features of responsibility

reports for cost centers.
 Responsibility Accounting
for Cost Centers
 The evaluation of a manager’s performance for cost centers is based on the manager’s
ability to meet budgeted goals for controllable costs. Responsibility reports for cost
centers compare actual controllable costs with flexible budget data.
 Only controllable costs are included in the report, and fixed and variable costs are not
distinguished.

Illustration 7-21
Fox Manufacturing (Finishing Department)
Manufacturing Overhead Responsibility Report
 Assume that the For the Month Ended January 31, 1999
Difference
Difference
Finishing Department Budget Actual
Favorable
FavorableFF
Unfavorable
Budget Actual UnfavorableUU
manager is able to Controllable
ControllableCost
Indirect
Cost
Indirectmaterials
materials $13,500
$13,500 $14,000
$14,000 $$ 500
500UU
control the costs in the Indirect
Indirectlabor
labor 18,000
18,000 17,000
17,000 1,000
1,000FF
Utilities 4,500 4,600 100
100UU
report to the right. Utilities
Supervision
4,500
4,000
4,600
4,000 -0-
Supervision 4,000 4,000 -0-
$40,000
$40,000 $39,600
$39,600 $$ 400
400FF
 Study Objective 6

Identify the content of responsibility

reports for profit centers.
 Responsibility Accounting
for Profit Centers
 In a profit center, the operating revenues and variable
expenses are controllable by the manager of the profit center.
 To determine the controllability of fixed costs, however, it is
necessary to distinguish between direct and indirect fixed
costs.
– Direct fixed costs (traceable costs) are costs that relate
specifically to a responsibility center and are incurred for
the sole benefit of the center. Most direct fixed costs are
controllable by the profit center manager.
– Indirect fixed costs (common costs) pertain to a company's
overall operating activities and are incurred for the benefit
of more than one profit center. Thus, most indirect costs are
not controllable by the profit center manager.
 Responsibility Report for
Profit Centers
 A responsibility report for a profit center shows budgeted
and actual controllable revenues and costs.
 The report is prepared using the cost-volume-profit income
statement format. In the report:
– Controllable fixed costs are deducted from contribution
margin.
– The excess of contribution margin over controllable
fixed costs is identified as controllable margin.
– Noncontrollable fixed costs are not reported.
 Controllable margin is considered to be the best measure
of the manager’s performance in controlling revenues and
costs.
 Responsibility Report for a
Profit Center
Illustration 7-22
This manager was Mantel Manufacturing Company (Marine Division)
Responsibility Report
below budgeted For the Year Ended December 31, 1999
expectations by
Difference
approximately 10% Difference
Favorable
FavorableFF
($36,000/ Budget
Budget Actual
Actual Unfavorable
UnfavorableUU
Sales
Sales $1,200,000
$1,200,000 $1,150,000
$1,150,000 $50,000
$50,000UU
$360,000). Variable
VariableCosts
Costs
Cost
Cost of goodssold
of goods sold 500,000
500,000 490,000
490,000 10,000
10,000FF
Top management Selling & administrative
Selling & administrative 160,000
160,000 156,000
156,000 4,000
4,000FF
Total 660,000 646,000 14,000
14,000FF
would likely Total
Contribution
660,000 646,000
Contributionmargin
margin 540,000
540,000 504,000
504,000 36,000
36,000UU
investigate the Controllable fixed costs
Controllable fixed costs
Cost
Costofofgoods
goodssold 100,000 100,000 -0-
causes of this Selling &
sold
administrative
Selling & administrative
100,000
80,000
80,000
100,000
80,000
80,000
-0-
-0-
-0-
unfavorable result. Total
Total
Controllable
180,000
180,000 180,000
180,000 -0-
-0-
Controllablemargin
margin $$360,000
360,000 $$324,000
324,000 $36,000
$36,000UU
 Study Objective 7

Explain the basis and formula used

in evaluating performance in
investment centers.
 Responsibility Accounting
for Investment Centers
 An important characteristic of an investment center is
that the manager can control or significantly influence the
investment funds available for use.
 Thus, the primary basis for evaluating the performance of
a manger of an investment center is return on
investment (ROI).
 ROI is considered to be superior to any other performance
measurement because it shows the effectiveness of the
manager in utilizing the assets at the manager’s disposal.
 Return on Investment

 The formula for computing ROI for an investment center,

together with assumed illustrative data is shown below.
 Operating assets consist of current assets and plant assets
used in operations by the center. Average operating assets
are usually based on the beginning and ending cost or book
values of the assets.
Illustration 7-23

Investment Center Average Investment Return on

Controllable Margin
(in dollars)
 Center Operating
Assets
= Investment
(ROI)

$1,000,000  $5,000,000 = $20%

 Responsibility Report for a
Profit Center
Illustration 7-24
Mantel Manufacturing Company (Marine Division)
Responsibility Report
Since an investment For the Year Ended December 31, 1999
center is an Difference
independent entity for Favorable F
Budget Actual Unfavorable U
operating purposes, all Sales $1,200,000 $1,150,000 $50,000 U
fixed costs are Variable Costs
Cost of goods sold 500,000 490,000 10,000 F
controllable by the Selling & administrative 160,000 156,000 4,000 F
investment center Total 660,000 646,000 14,000 F
Contribution margin 540,000 504,000 36,000 U
manager. Controllable fixed costs
Notice the report Cost of goods sold 100,000 100,000 -0-
Selling & administrative 80,000 80,000 -0-
shows budgeted and Other fixed costs 60,000 60,000 -0-
actual ROI. Total 240,000 240,000 -0-
Controllable margin $ 300,000 $ 264,000 $36,000 U

Return on investment 15% 13.2% 1.8% U

 Improving ROI
A manager can improve ROI by:
– increasing controllable margin, and/or
– reducing average operating assets.
 Assume the following data for the Marine
Division of Mantle Manufacturing:
Sales $2,000,000
Variable costs 1,100,000
Contribution margin (45%) 900,000
Controllable fixed costs 300,000
Controllable margin (a) $ 600,000
Average operating assets (b) $5,000,000
Return on investment (a  b) 12%
Illustration 7-25
 Improving ROI: Increasing
Controllable Margin
 Controllable margin can be increased by increasing sales or by reducing
variable and controllable fixed costs.
 If sales increased by 10%, or $200,000 ($2,000,000 x .10) and there was
no change in the contribution margin percentage of 45%, contribution
margin will increase $90,000 ($200,000 x .45). Controllable margin will
increase by the same amount because controllable fixed costs will not
change. Thus, controllable margin becomes $690,000 ($600,000 +
$90,000), and the new ROI is 13.8%, computed as follows:

ROI = Controllable margin = $690,000 = 13.8%

Average operating assets $5,000,000
Illustration 7-26
 An increase in sales benefits both the investment center and the company
if it results in new business. It would not benefit the company if the
increase was achieved at the expense of other investment centers.
 Improving ROI: Increasing
Controllable Margin
 If variable and fixed costs were decreased by 10%, total costs
will decrease $140,000[($1,000,000 + $300,000) x .10]. This
reduction will result in a corresponding increase in controllable
margin. Thus, this margin becomes $740,000 ($600,000 +
$140,000), and the new ROI is 14.8%, computed as follows:

ROI = Controllable margin = $740,000 = 14.8%

Average operating assets $5,000,000
Illustration 7-27

 This course of action is clearly beneficial when waste and

inefficiencies are eliminated. However, a reduction in vital costs,
such as required maintenance and inspections, is not likely to be
acceptable to top management.
 Improving ROI: Reducing
Average Operating Assets
 Assume that average operating assets are reduced 10% or
$500,000 ($5,000,000 x .10). Average operating assets become
$4,500,000 ($5,000,000 - $500,000). Since controllable
margin remains unchanged at $600,000, the new ROI is 13.3%,
computed as follows:
ROI = Controllable margin = $600,000 = 13.3%
Average operating assets $4,500,000
Illustration 7-27
 Reductions in operating assets may or may not be prudent. It is
beneficial to eliminate overinvestment in inventories and to dispose
of excessive plant assets. However, it is unwise to reduce
inventories below expected needs or to dispose of essential plant
assets.
 Judgmental Factors in ROI
The return on investment approach includes two judgmental factors:
 Valuation of operating assets – Operating assets may be valued at
acquisition cost, book value, appraised value, or market value.
 Margin (income) measure – This measure may be controllable margin,
income from operations, or net income.
Each of the alternative values for operating assets can provide a reliable
basis for evaluating a manger’s performance as long as it is consistently
applied.
The use of income measures other than controllable margin will not result
in a valid basis for evaluating the performance of a manager because
they will include some noncontrollable revenues and costs.
 Principles of Performance
Evaluation
 Performance evaluation is at the center of
responsibility accounting. Performance
evaluation is a management function that
compares actual results with budget goals.
 Performance evaluation includes both
behavioral and reporting principles.
 Principles of Performance
Evaluation: Behavioral
The human factor is critical in evaluating performance.
Behavioral principles include the following:
 Managers of responsibility centers should have direct input into
the process of establishing budget goals for their area of
responsibility.
 The evaluation of performance should be based entirely on
matters that are controllable by the manager being evaluated.
 Top management should support the evaluation process.
 The evaluation process must allow managers to respond to their
evaluations.
 The evaluation should identify both good and poor
performance.
 Principles of Performance
Evaluation: Reporting
Performance reports (which are primarily internal)
should:
 Contain only data that are controllable by the manager of
the responsibility center.
 Provide accurate and reliable budget data to measure
performance.
 Highlight significant differences between actual results
and budget goals.
 Be tailor-made for the intended evaluation.
 Be prepared at reasonable intervals.
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 Chapter 7
Budgetary Control and Responsibility
Accounting