Graduate School of Business and Law

Accounting

Performance Reporting

RMIT University 2010

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Contents

ii

Accounting

Introduction...............................................................1
Learning Objectives............................................................1

Unit outline................................................................1 Student activity...........................................................3 Further reading .........................................................6

Performance Reporting

iii

Introduction
Planning, and thus budgeting, is a key part of the management process. But budgeting alone is not sufficient. As part of the planning and control cycle of management, the controlling function is also necessary. Performance analysis compares the plans (budgets) to actual results. The results of this analysis are provided in performance reports, which in turn are used by management to make corrections or, if corrections are not possible, to revisit the plans i.e. revise the budgets.

Learning Objectives

Explain how performance reporting facilitates the management-byexception process Describe what a flexible budget is and how it is used Understand issues associated with reporting for responsibility centres Use return on assets and residual profit to evaluate investment centre performance. Explain the usefulness of a balanced scorecard.

Unit outline
Management by exception
The usual approach to management of the budget is to concentrate on those areas where results are not performing to plan. The performance report provides the responsible manager with details of the budgeted amount, the actual result and the variance for each activity being managed. Where a variance positively impacts profit it is known as a favourable variance, and where its impact is negative with regards to profit it is considered an unfavourable variance. Once a materially unfavourable variance is observed it is necessary to investigate the underlying cause of the variance. In reporting to senior management the reasons for the exceptional variances under consideration will be provided.

The flexible budget

For performance analysis and performance reporting to be useful to managers it must be meaningful. The budget may have been prepared for a particular level of activity and there will be some items in the budget that depend on this level of activity. An example of this situation is that of a manufacturer of wooden furniture. The budget will be prepared with the expectation of a certain number of pieces of furniture being produced. An item that will be budgeted for is the cost of wood being used in the making of this furniture, and this amount will reflect the number of item expected to be produced. If the performance report shows an unfavourable variance for the cost of wood being used, management needs to know why this situation has occurred. The reason may be that the proce of wood has increased, or that there has been waste in the using of wood. Both situations need further investigation and corrective action. However if the reason for the unfavourable variance is that the number of pieces of furniture produces is more than that budgeted for, then the report is not meaningful. Management cannot know whether the costs reflect good practice for this level of activity unless the figures reflect the new situation. Adjusting the original budget so that it reflects the new level of activity is known as flexible budgeting.

Reporting for Segments

In large organisations budgets may be managed by segments. Segmentisation can take place in many ways e.g. by division, geographical area, or product line. An issue for performance measurement for segments is that of allocation of fixed costs. If fixed costs are allocated arbitrarily to segments, a false picture of the contribution of the segment may occur. In some organisations segments may be deemed responsibility centres. In this situation a manager has been assigned responsibility and authority for the centre and is thus evaluated on the centres performance. A responsibility centre may be a cost centre or a profit centre or an investment centre. For a cost centre, the manager will be evaluated by comparing actual costs to budgeted costs. For the profit centre the measure will be actual segment margin as opposed to budgeted segment margin i.e. the manager is responsible for both revenues and costs. For an investment centre it is return on assets (ROA) being managed, compared to the budgeted ROA that is the key result. Thus for an investment centre the manager is responsible for costs, revenues and investments. Where decision making happens at a segment or responsibility centre level a management control approach often used is that of transfer pricing. A transfer price is the amount one segment or centre charges another segment or centre for the product or service provided to that segment or centre. Transfer pricing creates both revenue and costs for the segment or responsibility centre and thus impacts on its operating income.

Performance reporting for investment centres

As mentioned earlier the manager of an investment centre has a high level

of responsibility, being accountable for costs, revenues and investment. The performance evaluation system used needs to be such that it does not lead to dysfunctional behaviour where the manager acts in self interest rather than the interests of the company as a whole. The use of ROA as the sole measure of performance for a manager of an investment centre can lead to such dysfunctional behaviour. For example, a manager may seek to maximise the ROA of the investment centre by rejecting an investment that would decrease the ROA for the investment centre but increase the ROA for the company. One measure that can be used in this situation to complement ROA is that of residual profit.

The balanced scorecard

Traditionally organisational performance has been measured by financial results. The balanced scorecard goes beyond just financial performance e and uses a set of integrated financial and operating performance measures chosen to reflect the organisations strategic goals. There are four perspectives to the balanced scorecard: financial performance customer satisfaction internal business perspective learning and growth perspective.

The purpose of balanced scorecard approach is not to just introduce more measures. Rather the balanced scorecard approach is to keep managers focused in an integrated manner on all the areas that matter in delivering the best result possible for the company overall

Student activity
Exercise 1 Review the slide set for Unit 11. These slides can be found on the Learning Hub on Blackboard in the Unit 11 section of Course Content

Exercise 2 Use the information provided in the Unit Outline, immediately above, and the detailed list of ideas and learnings (to be found on Blackboard in the Unit 11 section of Course Content) together with the material in Chapter 14 of your textbook to develop a summary set of notes for this Unit. The information in the slide set for this unit will also be relevant to this task.

Exercise 3 Develop answers to what does it mean questions 5, 6, 7, 8, 9, 10, 11, 12, 13 in Chapter 14 of your textbook. Suggested answers to these questions can be found on p. 625 of the textbook. Exercise 4 Work through exercises E14.11, E14.12, E14.16, E14.18, E14.19, P14.27, P14.30 on pp.514- 524 of the textbook. Suggested answers to these exercises are provided below.

Suggested answers to nominated exercises

E14.11 a The problem presentation shows allocated fixed expenses, which can cause an erroneous conclusion because these expenses apply to the company as a whole (not to the individual segments). The $10,000 of company fixed expenses is apparently being allocated based on the number of units of each model sold. A total of 9,000 units were sold, and 50% of these were Student models, 33.33% were Business models and 16.67% were Math models. To resolve this problem, a Total Company column should be added, and the $10,000 of common fixed expenses should be subtracted out of the total column, rather than being allocated. b If the Student model were discontinued, total company net profit would decrease by $2,900 (the segment margin of the Student model). The $5,000 of fixed expenses that were allocated to the Student model would not be eliminated. Contribution margin ratio = contribution margin / selling price Business: $4 / $10 = 40% Math: $6 / $20 = 30% Student: $2 / $10 = 20% To achieve the greatest increase in contribution margin from an increase in the quantity sold, the product with the greatest contribution margin per unit should be pushed, which is the Math model. To achieve the greatest increase in contribution margin from an increase in revenues, the product with the greatest contribution margin ratio should be pushed, which is the Business model.

c.

d.

e.

E14.12. a. Cost formula = $38 800 + $10.70 per machine hour Budget = $38 800 + ($10.70 x 15 700 machine hours) = $206 790 Original Budget (15 700 MH) $206 790 Flexed Budget (16 060 MH) $210 642 * Actual Cost $213 940

b. Total maintenance cost.

Variance $3 298 U

Flexed budget = $38 800 + ($10.70 x 16 060 machine hours) = $210 642

E14.16. Original Budget $1 875 Flexed Budget $2 145 *

Direct labour

2 860 books / 20 books per hour = 143 standard hours allowed * $ 15 per hour = $2 145 flexed budget.

E14.18. a. DuPont Performance Analysis: Margin (Operating profit / Sales)... Turnover (Sales / Operating assets)... ROA(Operating profit / Operating assets).. or (Margin x Turnover) b. Residual Profit Analysis: Operating profit.. Required ROA (Operating assets x 12%).. Residual Profit.... South Western Division 10% 2 times 20%

$21 000 12 600 $ 8 400

E14.19. a. DuPont Performance Analysis: Sales... Operating Profit.. Operating Assets Margin (Operating profit / Sales)... Turnover (Sales / Operating assets)... ROA (Operating profit / Operating asset) or (Margin x Turnover) Residual Profit Analysis: Operating profit.. Sydney $ 1 200 000 $ 144 000 $ 500 000 12% 2.4 turns 28.8% Melbourne $ 300 000 $ 36 000 $ 330 000 12% 0.9090 turn 10.9% Perth $ 1 500 000 $ 120 000 $ 750 000 8% 2 turns 16%

$ 144 000

$ 36 000

$ 120 000

Required ROA (Operating assets x 12%).. Residual Profit.... b.

60 000 $ 84 000

39 600 ($ 3 600)

90 000 $ 30 000

The DuPont model provides an excellent basis of comparison between the three divisions and illustrates the importance of managing both margin and turnover. Sydney combines the best margin and turnover to yield an ROA of 28.8%. Melbourne is generating the same margin as Sydney but falls short on the turnover measure. Perth achieves the same turnover but falls short on the margin measure. By looking at margin and turnover as components of ROA the managers of these divisions can focus their attention on improving their shortcomings. Also note that Melbourne is falling below the minimum required ROA as evidenced by its negative result for residual profit.

P14.27. The gifts and grants budget should be flexed. In other words, it should be increased in total to attract more students. The average aid award is a variable expense. Each student who receives financial aid from the college will pay tuition, and generate revenue in excess of the aid award. Most of the other expenses of the college are fixed, so the additional students will generate additional contribution margin to help cover the fixed expenses of the college.

P14.30. a. Supplies are a variable expense. The supplies budget should be flexed (i.e., it should be increased to provide funds for the additional 12 students above the number anticipated when the original budget was established). No. The budget should still be flexed, but in this case it would be reduced. Salary for the lab assistant is a fixed expense. The salary amount budgeted will not change as the number of students enrolled changes. At some point of activity (number of students) the need for a second lab assistant may be necessitated by significantly larger enrolments.

b. c.

Further reading
Hoque, Z 2006, 'The balanced scorecard', in Strategic management accounting : concepts, processes and issues 2nd edn, Pearson Education Australia, Frenchs Forest, N.S.W., pp. 167 - 82. Horngren, CT, Datar, SM, Foster, G, Rajan, M & Ittner, C 2008, 'Management control systems,transfer pricing, and multinational considerations', in

Cost accounting : a managerial emphasis, Thirteenth edn, Pearson Prentice Hall, Upper Saddle River, NJ, pp. 768 - 87.