Class Notes CH22

CHAPTER 22
Budgetary Control and Responsibility Accounting

LEARNING OBJECTIVES
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.
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.
*8.
EXPLAIN THE DIFFERENCE BETWEEN ROI AND RESIDUAL

INCOME.
Copyright 2013 John Wiley & Sons, Inc.Kimmel, Accounting, 5/e, Instructors Manual(For Instructor Use Only)
22-1
CHAPTER REVIEW
Budgetary Control
1.
(L.O. 1) The use of budgets in controlling operations is known as budgetary control. Such
control takes place by means of budget reports that compare actual results with planned
objectives. The budget reports provide management with feedback on operations.
2.
Budgetary control involves:

a. Developing budgets.
b. Analyzing the differences between actual and budgeted results.
c. Taking corrective action.
d. Modifying future plans, if necessary.
3.
Budgetary control works best when a company has a formalized reporting system. The system
should
a. Identify the name of the budget report such as the sales budget or the manufacturing overhead
budget.
b. State the frequency of the report such as weekly, or monthly.
c. Specify the purpose of the report.
d. Indicate the primary recipient(s) of the report.
Static Budget Reports

4.
(L.O. 2) A static budget does not modify or adjust data regardless of changes in activity during
the year. As a result, actual results are always compared with the budget data at the activity level
used in developing the master budget.
5.
A static budget is appropriate in evaluating a managers effectiveness in controlling costs when (a)
the actual level of activity closely approximates the master budget activity level, and/or (b) the
behavior of the costs in response to changes in activity is fixed.
Flexible Budgets
6.
(L.O. 3) A flexible budget projects budget data for various levels of activity. The flexible budget
recognizes that the budgetary process is more useful 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.
7.
To develop the flexible budget, the following steps are taken:

a. Identify the activity index and the relevant range of activity.
22-2 Copyright 2013 John Wiley & Sons, Inc.Kimmel, Accounting, 5/e, Instructors Manual(For Instructor Use Only)
b.
c.
d.
8.
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.
For manufacturing overhead costs, the activity index is usually the same as the index used in
developing the predetermined overhead rate; that is, direct labor hours or machine hours. For
selling and administrative expenses, the activity index usually is sales or net sales.
22-3
9.
The following formula may be used to determine total budgeted costs at any level of activity:
Total budgeted costs = Fixed costs + (Total variable cost per unit X Activity level)
10.
Total budgeted costs at each level of activity can be shown graphically.

a. In a graph, the activity index is shown on the horizontal axis and costs are shown on the
vertical axis.
b. The total budgeted costs for each level of activity are then identified from the total budgeted
cost line.
11.
Flexible budget reports are another type of internal report produced by managerial accounting.
The flexible budget report consists of two sections: (a) production data such as direct labor hours
and (b) cost data for variable and fixed costs. It also shows differences between budget and actual
results.
Responsibility Accounting
12.
(L.O. 4) Responsibility accounting involves accumulating and reporting costs (and revenues,
where relevant) on the basis of the manager who has the authority to make the day-to-day
decisions about the items. A managers performance is evaluated on matters directly under that
managers control.
13.
Responsibility accounting can be used at every level of management in which the following
conditions exist:
a. Costs and revenues can be directly associated with the specific level of management
responsibility.
b. The costs and revenues are controllable at the level of responsibility with which they are
associated.
c. Budget data can be developed for evaluating the managers effectiveness in controlling the
costs and revenues.
14.
Responsibility accounting is especially valuable in a decentralized company. Decentralization

means that the control of operations is delegated to many managers throughout the organization.
A segment is an identified area of responsibility in decentralized operations.
15.
Responsibility accounting is an essential part of any effective system of budgetary control. It

differs from budgeting in two respects:
a. A distinction is made between controllable and noncontrollable items.
b. Performance reports either emphasize or include only items controllable by the individual
manager.
16.
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. Costs incurred indirectly and allocated to a
responsibility level are considered to be noncontrollable at that level.
17.
Management by exception means that top managements review of a budget report is focused
either entirely or primarily on differences between actual results and planned objectives. The
guidelines for identifying an exception are based on materiality and controllability.
18.
A responsibility reporting system involves the preparation of a report for each level of
responsibility shown in the companys organization chart. A responsibility reporting system
permits management by exception at each level of responsibility within the organization.
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.
19.
Cost Centers
20.
(L.O. 5) A responsibility report for cost centers compares actual controllable costs with
flexible budget data. Only controllable costs are included in the report, and no distinction is made
between variable and fixed costs.
Profit Centers
21.
(L.O. 6) 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.
22.
Direct fixed costs or traceable costs are costs that relate specifically to a responsibility center
and are incurred for the sole benefit of the center. Indirect fixed costs or common costs pertain
to a companys overall operating activities and are incurred for the benefit of more than one profit
center.
23.
In the responsibility report for a profit center:

a. Controllable fixed costs are deducted from contribution margin.
b. The excess of contribution margin over controllable fixed costs is identified as controllable
margin.
c. Noncontrollable fixed costs are not reported.
24.
Controllable margin is considered to be the best measure of the managers performance in

controlling revenues and costs.
Investment Centers
22-5
25.
(L.O. 7) The primary basis for evaluating the performance of a manger of an investment center is
return on investment (ROI). The formula for computing return on investment is: Investment
Center Controllable Margin (in dollars) Average Investment Center Operating Assets = Return
on Investment.
a. Operating assets consist of current assets and plant assets used in operations by the
center. Nonoperating assets such as idle plant assets and land held for future use are
excluded.
b. Average operating assets are usually based on the beginning and ending cost or book
values of the assets.
26.
A manager can improve ROI by (a) increasing controllable margin or (b) reducing average
operating assets.
27.
The return on investment approach includes two judgmental factors:

a. Valuation of operating assetscost, book value, appraised value, or market value.
b Margin (income) measurecontrollable margin, income from operations, or net income.
28.
Performance evaluation is a management function that compares actual results with budget goals.
Performance evaluation includes both behavioral and reporting principles.
*Residual Income
*29. (L.O. 8) To evaluate performance using the minimum rate of return, companies use the residual
income approach. Residual income is the income that remains after subtracting from the
controllable margin the minimum rate of return on a companys average operating assets.
The residual income would be computed as follows:
Controllable
Margin
Minimum Rate of Return
X
=
Average Operating Assets
Residual
Income
22-7
LECTURE OUTLINE
A.
The Concept of Budgetary Control.

1. The use of budgets in controlling operations is known as budgetary control.
Such control takes place by means of budget reports that compare actual
results with planned objectives.
2. Budgetary control consists of:
a.
Preparing periodic budget reports that compare actual results with

planned objectives.
b.
Analyzing the differences to determine their causes.
c.
Taking appropriate corrective action.
d.
Modifying future plans, if necessary.
3. Budgetary control works best when a company has a formalized reporting

system. This system does the following:
a.
Identifies the name of the budget report (i.e. sales budget).
b.
States the frequency of the report, such as weekly or monthly.
c.
Specifies the purpose of the report.
d.
Indicates the primary recipient(s) of the report.
4. A static budget is a projection of budget data at one level of activity. This

budget does not consider data for different levels of activity. As a result,
companies always compare actual results with budget data at the
activity level that was used in developing the master budget.
5. A static budget is appropriate in evaluating a managers effectiveness in
controlling costs when:
a.
The actual level of activity closely approximates the master budget

activity level, and/or
b.
The behavior of the costs in response to changes in activity is fixed.
6. A static budget report is appropriate for fixed manufacturing costs and

for fixed selling and administrative expenses.
B.
The Flexible Budget.

1. 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.
2. To develop the flexible budget, management should:
a.
Identify the activity index and the relevant range of activity.
b.
Identify the variable costs, and determine the budgeted variable cost
per unit of activity for each cost.
c.
Identify the fixed costs, and determine the budgeted amount for
each cost.
d.
Prepare the budget for selected increments of activity within the

relevant range.
SERVICE COMPANY INSIGHT

When the number of viewers of the television show House, a medical drama,
declined by almost 20%, Fox Broadcasting said it wanted to cut the license fee
that it paid to NBCUniversal by 20%. How could NBCUniversal deal with the
20% cut in revenue? Choices include cutting the size of the cast or reducing the
number of episodes, among other choices.
22-9
Explain how the use of flexible budgets might help to identify the best solution to
this problem.
Answer: A fixed budget assumes a particular level of activity. In the case of
television shows, the number of viewers can impact revenues and
costs. NBCUniversal could prepare alternative budgets at varying
levels of activities and assume various cost structures depending on
the number of cast members and other factors. Experimenting with
different scenarios could help the network identify an approach that
maintains an acceptable level of income as revenues decline.
3. Flexible budget reports are another type of internal report. The flexible
budget report consists of two sections:
a.
Production data for a selected activity index, such as direct labor

hours.
b.
Cost data for variable and fixed costs.
4. The flexible budget report provides a basis for evaluating a managers

performance in two areas:
a.
Production control.
b.
Cost control.
5. Flexible budget reports are appropriate for evaluating performance since

both actual and budgeted costs are based on the actual activity level
achieved.
SERVICE COMPANY INSIGHT
When the Exotic Newcastle Disease (an infectious bird disease) broke out in
Southern California in 2003, it could have spelled disaster for the San Diego Zoo.
The zoo spent almost half a million dollars on quarantine measures in 2003. It
worked: no birds got sick and the damage to the zoos budget was minimized by
a monthly budget reforecast.
The new planning process, introduced a year earlier, allowed the zoo to redirect
resources to ward off the disease.
The San Diego Zoos annual static budget was behind the times before Paula
Brock took over as CFO in 2001. Brocks first efforts were to link strategy to the
process. Consultants believe its a key way to improve peoples involvement in
budgeting.
What is the major benefit of tying a budget to the overall goals of the company?
Answer: People working on a budgeting process that is clearly guided and
focused by strategic goals spend less time arguing about irrelevant
details and more time focusing on the items that matter.
C.
Responsibility Accounting.
1. Responsibility accounting involves accumulating and reporting costs
(and revenues) on the basis of the manager who has the authority to
make the day-to-day decisions about the items.
2. Under responsibility accounting, a managers performance is evaluated
on matters directly under that managers control.
3. Responsibility accounting can be used at every level of management in
which the following conditions exist:
a.
Costs and revenues can be directly associated with the specific

level of management responsibility.
b.
The costs and revenues can be controlled by employees at the level

of responsibility with which they are associated.
c.
Budget data can be developed for evaluating the managers effectiveness in controlling the costs and revenues.
22-11
4. The reporting of costs and revenues under responsibility accounting

differs from budgeting in two respects:
a.
A distinction is made between controllable and noncontrollable

items.
b.
Performance reports either emphasize or include only items controllable by the individual manager.
MANAGEMENT INSIGHT
While many compensation and promotion programs encourage competition and
hard work, it does not foster collaboration, and can lead to distrust and disloyalty.
As a consequence, many companies now explicitly include measures of collaboration in their performance measures.
How might managers of separate divisions be able to reduce division costs
through collaboration?
Answer: Division managers might reduce costs by sharing design and marketing
resources or by jointly negotiating with suppliers. In addition, they can
reduce the need to hire and lay off employees by sharing staff across
divisions as human resource needs change.
5. A cost over which a manager has control is called a controllable cost. It
follows that:
a.
All costs are controllable by top management because of the broad

range of its activity.
b.
Fewer costs are controllable as one moves down to each lower level
of managerial responsibility because of the managers decreasing
authority.
6. Noncontrollable costs are costs incurred indirectly and allocated to a

responsibility level.
7. A responsibility reporting system involves the preparation of a report for

each level of responsibility in the companys organization chart.
D.
Principles of Performance Evaluation.

1. Management by exception means that top managements review of
a budget report is focused either entirely or primarily on differences
between actual results and planned objectives.
2. For management by exception to be effective, there must be guidelines
for identifying an exception. The usual criteria are:
a.
Materialityusually expressed as a percentage difference from

budget.
b.
Controllability of the itemexception guidelines are more restrictive

for controllable items than for items the manager cannot control.
3. The human factor is critical in evaluating performance. Behavioral

principles include:
a.
Managers of responsibility centers should have direct input into the

process of establishing budget goals of their area of responsibility.
b.
The evaluation of performance should be based entirely on matters

that are controllable by the manager being evaluated.
c.
Top management should support the evaluation process.
d.
The evaluation process must allow managers to respond to their

evaluations.
e.
The evaluation should identify both good and poor performance.
4. Performance evaluation under responsibility accounting should be based

on certain reporting principles. Performance reports should:
a.
Contain only data that are controllable by the manager of the

responsibility center.
22-13
b.
Provide accurate and reliable budget data to measure performance.
c.
Highlight significant differences between actual results and budget

goals.
d.
Be tailor-made for the intended evaluation.
e.
Be prepared at reasonable intervals.
MANAGEMENT INSIGHT
Among automobile manufacturing facilities in the U.S., nobody has more flexible
plants than Honda. At the Honda plant, the switch from the production of one
type of vehicle to a different type of vehicle takes only minutes instead of months
like for most plants. This ability to adjust quickly to changing demand gave Honda
a huge advantage when demand for more fuel-efficient cars increased quickly.
What implications do these improvements in production capabilities have for
management accounting information and performance evaluation within the
organization?
Answer: In order to maximize the potential of flexible manufacturing facilities
managers need to be supplied with information on a more frequent
basis. In turn, the tools used to evaluate performance need to take into
account what information management had at its disposal, and what
decisions were made in response to this information.
5. A responsibility reporting system involves the preparation of a report for
each level of responsibility in the companys organization chart. It also
permits management by exception at each level of responsibility. And,
each higher level of responsibility can obtain the detailed report for each
lower level of responsibility.
E.
Types of Responsibility Centers.

1. There are three basic types of responsibility centers: cost centers, profit
centers, and investment centers.
a.
A cost center incurs costs (and expenses) but does not directly
generate revenues.
b.
A profit center incurs costs (and expenses) and also generates

revenues.
c.
Like a profit center, an investment center incurs costs (and expenses)

and generates revenues. In addition, an investment center has control
over decisions regarding the assets available for use.
2. Responsibility Reports.
a.
The evaluation of a managers performance for cost centers is based

on his or her ability to meet budgeted goals for controllable costs.
b.
To evaluate the performance of a profit center manager, upper

management needs detailed information about both controllable
revenues and controllable costs. The report is prepared using the
cost-volume-profit income statement. In the report:
(1) Controllable fixed costs are deducted from contribution margin.
(2) The excess of contribution margin over controllable fixed costs
is identified as controllable margin.
(3) Noncontrollable fixed costs are not reported.
c.
The primary basis for evaluating the performance of a manager of

an investment center is return on investment (ROI).
d.
Return on investment is computed by dividing controllable margin

by average operating assets.
22-15
e.
Judgmental factors in ROI are (1) valuation of operating assets and

(2) margin (income) measure.
ACCOUNTING ACROSS THE ORGANIZATION

No matter how you slice the movie business, by far the best return on investment
comes from the not-so-glamorous world of G-rated films. However, these movies
represent only 3% of the total films made in a typical year.
What might be the reason that movie studios do not produce G-rated movies as
often as R-rated ones?
Answer: Perhaps Hollywood believes that big-name stars or large budgets, both
of which are typical of R-rated movies, sell movies. However, one study
recently concluded, We cant find evidence that stars help movies,
and we cant find evidence that bigger budgets increase return on investment. Some film companies are going out of their way to achieve at
least a PG rating.
*F. Residual Income Compared To ROI.
1. Residual income is the income that remains after subtracting from the
controllable margin the minimum rate of return on a companys average
operating assets.
2. Residual income is computed as follows: Controllable Margin
(Minimum Rate of Return X Average Operating Assets).
3. ROI sometimes provides misleading results because profitable investments are often rejected when the investment reduces ROI but increases
overall profitability.
20 MINUTE QUIZ
Circle the correct answer.
True/False
1.
In a static budget, the data may be modified or adjusted if activity changes more than a
specified amount during the year.
True
2.
Flexible budgets can be prepared for each of the types of budgets included in the master
budget.
True
3.
False
There are three types of responsibility centers: cost, segment, and investment.
True
10.
False
A responsibility reporting system begins with the lowest level of responsibility in an

organization and moves upward to each higher level.
True
9.
False
Only controllable costs are included in a responsibility performance report, and there is
no distinction made between variable and fixed costs.
True
8.
False
The terms controllable costs and noncontrollable costs are synonymous with variable
costs and fixed costs, respectively.
True
7.
False
Under responsibility accounting, the evaluation of a managers performance is based on

the matters directly under that managers control.
True
6.
False
Flexible budget reports consist of two sections: production data and cost data.
True
5.
False
With a flexible budget, if production increases, budget allowances for variable costs
should increase both directly and proportionately.
True
4.
False
False
The primary basis for evaluating the performance of a manager of an investment center
is return on investment.
True
False
22-17
Multiple Choice
1.
A static budget report is appropriate for

a. evaluating a managers performance in controlling variable costs.
b. fixed manufacturing costs and fixed selling and administrative expenses.
c. variable costs and fixed costs.
d. none of the above.
2.
The flexible budget report includes all of the following sections except
a. cost data for variable and fixed costs .
b. data for excess of contribution margin over controllable fixed costs (controllable
margin).
c. production data for a selected activity index.
d. All of the choices are included in a flexible budget report.
3.
At 40,000 direct labor hours, the flexible budget for indirect labor is $160,000. If $172,000
of indirect labor costs are incurred at 44,000 direct labor hours, the flexible budget report
should show the following difference for indirect labor.
a. $12,000 favorable.
b. $4,000 unfavorable.
c. $4,000 favorable.
d. $12,000 unfavorable.
4.
Controllable fixed costs are deducted from the contribution margin to arrive at
a. income from operations.
b. net income.
c. controllable margin.
d. realized income.
5.
The numerator in computing return on investment is

a. controllable margin.
b. average operating assets.
c. contribution margin.
d. net assets.
ANSWERS TO QUIZ
True/False
1.
2.
3.
4.
5.
False
True
True
True
True
6.
7.
8.
9.
10.
False
True
True
False
True
Multiple Choice
1.
2.
3.
4.
5.
b.
b.
c.
c.
a.
22-19

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CHAPTER 22

Budgetary Control and Responsibility Accounting

EXPLAIN THE DIFFERENCE BETWEEN ROI AND RESIDUAL

Budgetary control involves:

Static Budget Reports

To develop the flexible budget, the following steps are taken:

Total budgeted costs at each level of activity can be shown graphically.

Responsibility accounting is especially valuable in a decentralized company. Decentralization

Responsibility accounting is an essential part of any effective system of budgetary control. It

In the responsibility report for a profit center:

Controllable margin is considered to be the best measure of the managers performance in

The return on investment approach includes two judgmental factors:

Minimum Rate of Return

The Concept of Budgetary Control.

Preparing periodic budget reports that compare actual results with

Analyzing the differences to determine their causes.

Taking appropriate corrective action.

Modifying future plans, if necessary.

3. Budgetary control works best when a company has a formalized reporting

Identifies the name of the budget report (i.e. sales budget).

States the frequency of the report, such as weekly or monthly.

Specifies the purpose of the report.

Indicates the primary recipient(s) of the report.

4. A static budget is a projection of budget data at one level of activity. This

The actual level of activity closely approximates the master budget

The behavior of the costs in response to changes in activity is fixed.

6. A static budget report is appropriate for fixed manufacturing costs and

The Flexible Budget.

Identify the activity index and the relevant range of activity.

Prepare the budget for selected increments of activity within the

SERVICE COMPANY INSIGHT

Production data for a selected activity index, such as direct labor

Cost data for variable and fixed costs.

4. The flexible budget report provides a basis for evaluating a managers

5. Flexible budget reports are appropriate for evaluating performance since

Costs and revenues can be directly associated with the specific

The costs and revenues can be controlled by employees at the level

4. The reporting of costs and revenues under responsibility accounting

A distinction is made between controllable and noncontrollable

All costs are controllable by top management because of the broad

6. Noncontrollable costs are costs incurred indirectly and allocated to a

7. A responsibility reporting system involves the preparation of a report for

Principles of Performance Evaluation.

Materialityusually expressed as a percentage difference from

Controllability of the itemexception guidelines are more restrictive

3. The human factor is critical in evaluating performance. Behavioral

Managers of responsibility centers should have direct input into the

The evaluation of performance should be based entirely on matters

Top management should support the evaluation process.

The evaluation process must allow managers to respond to their

The evaluation should identify both good and poor performance.

4. Performance evaluation under responsibility accounting should be based

Contain only data that are controllable by the manager of the

Provide accurate and reliable budget data to measure performance.

Highlight significant differences between actual results and budget

Be tailor-made for the intended evaluation.

Be prepared at reasonable intervals.

Types of Responsibility Centers.

A profit center incurs costs (and expenses) and also generates

Like a profit center, an investment center incurs costs (and expenses)

The evaluation of a managers performance for cost centers is based

To evaluate the performance of a profit center manager, upper

The primary basis for evaluating the performance of a manager of

Return on investment is computed by dividing controllable margin