A manager of an investment center can improve roi by

22

Budgetary Control and Responsibility Accounting

 CHAPTER PREVIEW 

In Chapter 21 , we discussed the use of budgets for planning. We now consider how budgets are used by management to control operations. In the Feature Story on the Tribeca Grand Hotel, we see that management uses the budget to adapt to the business environment. This chapter focuses on two aspects of management control: (1) budgetary control and (2) responsibility accounting.

Pumpkin Madeleines and a Movie

Perhaps no place in the world has a wider variety of distinctive, high‐end accommodations than New York City. It's tough to set yourself apart in the Big Apple, but unique is what the Tribeca Grand Hotel is all about.

When you walk through the doors of this triangular‐shaped building, nestled in one of Manhattan's most affluent neighborhoods, you immediately encounter a striking eight‐story atrium. Although the hotel was completely renovated, it still maintains its funky mid‐century charm. Just consider the always hip Church Bar. Besides serving up cocktails until 2 A.M., Church's also provides food. These are not the run‐of‐the‐mill, chain hotel, borderline edibles. Church's chef is famous for tantalizing delectables such as duck rillettes, sea salt baked branzino, housemade pappardelle, and pumpkin madeleines.

Another thing that really sets the Tribeca Grand apart is its private screening room. As a guest, you can enjoy plush leather seating, state‐of‐the‐art projection, and digital surround sound, all while viewing a cult classic from the hotel's film series. In fact, on Sundays, free screenings are available to guests and non‐guests alike on a first‐come‐first‐served basis.

To attract and satisfy a discerning clientele, the Tribeca Grand's management incurs higher and more unpredictable costs than those of your standard hotel. As fun as it might be to run a high‐end hotel, management can't be cavalier about spending money. To maintain profitability, management closely monitors costs and revenues to make sure that they track with budgeted amounts. Further, because of unexpected fluctuations (think Hurricane Sandy or a bitterly cold stretch of winter weather), management must sometimes revise forecasts and budgets and adapt quickly. To evaluate performance when things happen that are beyond management's control, the budget needs to be flexible.

LEARNING OBJECTIVE 1

Describe budgetary control and static budget reports.

BUDGETARY CONTROL

One of management's functions is to control company operations. Control consists of the steps taken by management to see that planned objectives are met. We now ask: How do budgets contribute to control of operations?

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 use of budget reports is based on the belief that planned objectives lose much of their potential value without some monitoring of progress along the way. Just as your professors give midterm exams to evaluate your progress, top management requires periodic reports on the progress of department managers toward their planned objectives.

Budget reports provide management with feedback on operations. The feedback for a crucial objective, such as having enough cash on hand to pay bills, may be made daily. For other objectives, such as meeting budgeted annual sales and operating expenses, monthly budget reports may suffice. Budget reports are prepared as frequently as needed. From these reports, management analyzes any differences between actual and planned results and determines their causes. Management then takes corrective action, or it decides to modify future plans. Budgetary control involves the activities shown in Illustration 22-1 .

ILLUSTRATION 22-1 Budgetary control activities

Budgetary control works best when a company has a formalized reporting system. The system does the following:

1. Identifies the name of the budget report, such as the sales budget or the manufacturing overhead budget.

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

3. Specifies the purpose of the report.

4. Indicates the primary recipient(s) of the report.

Illustration 22-2 provides a partial budgetary control system for a manufacturing company. Note the frequency of the reports and their emphasis on control. For example, there is a daily report on scrap and a weekly report on labor.

Name of Report

Frequency

Purpose

Primary Recipient(s)

Sales

Weekly

Determine whether sales goals are met

Top management and sales manager

Labor

Weekly

Control direct and indirect labor costs

Vice president of production and production department managers

Scrap

Daily

Determine efficient use of materials

Production manager

Departmental overhead costs

Monthly

Control overhead costs

Department manager

Selling expenses

Monthly

Control selling expenses

Sales manager

Income statement

Monthly and quarterly

Determine whether income goals are met

Top management

ILLUSTRATION 22-2 Budgetary control reporting system

STATIC BUDGET REPORTS

You learned in Chapter 21 that the master budget formalizes management's planned objectives for the coming year. When used in budgetary control, each budget included in the master budget is considered to be static. A static budget is a projection of budget data at one level of activity. These budgets do 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.

Examples

To illustrate the role of a static budget in budgetary control, we will use selected data prepared for Hayes Company in Chapter 21 . Budget and actual sales data for the Rightride product in the first and second quarters of 2017 are as follows.

Sales

First Quarter

Second Quarter

Total

Budgeted

$180,000

$210,000

$390,000

Actual

 179,000

 199,500

 378,500

Difference

$  1,000

$ 10,500

$ 11,500

ILLUSTRATION 22-3 Budget and actual sales data

The sales budget report for Hayes' first quarter is shown below. The right‐most column reports the difference between the budgeted and actual amounts.

ILLUSTRATION 22-4 Sales budget report—first quarter

The report shows that sales are $1,000 under budget—an unfavorable result. This difference is less than 1% of budgeted sales ($1,000÷$180,000=.0056)($1,000÷$180,000=.0056). Top management's reaction to unfavorable differences is often influenced by the materiality (significance) of the difference. Since the difference of $1,000 is immaterial in this case, we assume that Hayes management takes no specific corrective action.

Illustration 22-5 shows the budget report for the second quarter. It contains one new feature: cumulative year‐to‐date information. This report indicates that sales for the second quarter are $10,500 below budget. This is 5% of budgeted sales ($10,500÷$210,000)($10,500÷$210,000). Top management may now conclude that the difference between budgeted and actual sales requires investigation.

ILLUSTRATION 22-5 Sales budget report—second quarter

Management's analysis should start by asking the sales manager the cause(s) of the shortfall. Managers should consider the need for corrective action. For example, management may decide to spur sales by offering sales incentives to customers or by increasing the advertising of the product line. Or, if management concludes that a downturn in the economy is responsible for the lower sales, it may modify planned sales and profit goals for the remainder of the year.

ALTERNATIVE TERMINOLOGY

The difference between budget and actual is sometimes called a budget variance.

Uses and Limitations

From these examples, you can see that a master sales budget is useful in evaluating the performance of a sales manager. It is now necessary to ask: Is the master budget appropriate for evaluating a manager's performance in controlling costs? Recall that in a static budget, data are not modified or adjusted, regardless of changes in activity. It follows, then, that a static budget is appropriate in evaluating a manager's effectiveness in controlling costs when:

1. The actual level of activity closely approximates the master budget activity level, and/or

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

A static budget report is, therefore, appropriate for fixed manufacturing costs and for fixed selling and administrative expenses. But, as you will see shortly, static budget reports may not be a proper basis for evaluating a manager's performance in controlling variable costs.

DO IT! 1

Static Budget Reports

Lawler Company expects to produce 5,000 units of product CV93 during the current month. Budgeted variable manufacturing costs per unit are direct materials $6, direct labor $15, and overhead $24. Monthly budgeted fixed manufacturing overhead costs are $10,000 for depreciation and $5,000 for supervision.

In the current month, Lawler actually produced 5,500 units and incurred the following costs: direct materials $33,900, direct labor $74,200, variable overhead $120,500, depreciation $10,000, and supervision $5,000.

Prepare a static budget report. (Hint: The Budget column is based on estimated production of 5,000 units while the Actual column is the actual costs incurred during the period.) Were costs controlled? Discuss limitations of this budget.

Action Plan

✓ Classify each cost as variable or fixed.

✓ Determine the difference as favorable or unfavorable.

✓ Determine the difference in total variable costs, total fixed costs, and total costs.

SOLUTION

The static budget indicates that actual variable costs exceeded budgeted amounts by $3,600. Fixed costs were exactly as budgeted. The static budget gives the impression that the company did not control its variable costs. However, the static budget does not give consideration to the fact that the company produced 500 more units than planned. As a result, the static budget is not a good tool to evaluate variable costs. It is, however, a good tool to evaluate fixed costs as those should not vary with changes in production volume.

Related exercise material: BE22-1, BE22-2, E22-1, E22-2, and DO IT! 22-1.

LEARNING OBJECTIVE 2

Prepare flexible budget reports.

In contrast to a static budget, which is based on one level of activity, 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 is more useful if it is adaptable to changed operating conditions.

Flexible budgets can be prepared for each of the types of budgets included in the master budget. For example, Marriott Hotels can budget revenues and net income on the basis of 60%, 80%, and 100% of room occupancy. Similarly, American Van Lines can budget its operating expenses on the basis of various levels of truck‐miles driven. Duke Energycan budget revenue and net income on the basis of estimated billions of kwh (kilowatt hours) of residential, commercial, and industrial electricity generated. In the following pages, we will illustrate a flexible budget for manufacturing overhead.

WHY FLEXIBLE BUDGETS?

Assume that you are the manager in charge of manufacturing overhead in the Assembly Department of Barton Robotics. In preparing the manufacturing overhead budget for 2017, you prepare the following static budget based on a production volume of 10,000 units of robotic controls.

ILLUSTRATION 22-6 Static overhead budget

Fortunately for the company, the demand for robotic controls has increased, and Barton produces and sells 12,000 units during the year rather than 10,000. You are elated! Increased sales means increased profitability, which should mean a bonus or a raise for you and the employees in your department. Unfortunately, a comparison of Assembly Department actual and budgeted costs has put you on the spot. The budget report is shown below.

ILLUSTRATION 22-7 Overhead static budget report

This comparison uses budget data based on the original activity level (10,000 robotic controls). It indicates that the Assembly Department is significantly over budget for three of the six overhead costs. There is a total unfavorable difference of $132,000, which is 12% over budget ($132,000÷$1,100,000)($132,000÷$1,100,000). Your supervisor is very unhappy. Instead of sharing in the company's success, you may find yourself looking for another job. What went wrong?

When you calm down and carefully examine the manufacturing overhead budget, you identify the problem: The budget data are not relevant! At the time the budget was developed, the company anticipated that only 10,000 units would be produced, not 12,000. Comparing actual with budgeted variable costs is meaningless. As production increases, the budget allowances for variable costs should increase proportionately. The variable costs in this example are indirect materials, indirect labor, and utilities.

Analyzing the budget data for these costs at 10,000 units, you arrive at the following per unit results.

Item

Total Cost

Per Unit

Indirect materials

$250,000

$25

Indirect labor

260,000

26

Utilities

190,000

19

$700,000

$70

ILLUSTRATION 22-8 Variable costs per unit

Illustration 22-9 calculates the budgeted variable costs at 12,000 units.

Item

Computation

Total

Indirect materials

$25 × 12,000

$300,000

Indirect labor

 26 × 12,000

 312,000

Utilities

 19 × 12,000

 228,000

$840,000

ILLUSTRATION 22-9 Budgeted variable costs, 12,000 units

Because fixed costs do not change in total as activity changes, the budgeted amounts for these costs remain the same. Illustration 22-10 shows the budget report based on the flexible budget for 12,000 units of production. (Compare this with Illustration 22-7 .)

ILLUSTRATION 22-10 Overhead flexible budget report

This report indicates that the Assembly Department's costs are under budget—a favorable difference. Instead of worrying about being fired, you may be in line for a bonus or a raise after all! As this analysis shows, the only appropriate comparison is between actual costs at 12,000 units of production and budgeted costs at 12,000 units. Flexible budget reports provide this comparison.

▼ HELPFUL HINT

The master budget described in Chapter 21 is based on a static budget.

▼ HELPFUL HINT

A static budget is not useful for performance evaluation if a company has substantial variable costs.

DECISION TOOLS

The flexible budget indicates whether cost changes resulting from different production volumes are reasonable.

DEVELOPING THE FLEXIBLE BUDGET

The flexible budget uses the master budget as its basis. To develop the flexible budget, management uses 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.

The activity index chosen should significantly influence the costs being budgeted. For manufacturing overhead costs, for example, 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.

The choice of the increment of activity is largely a matter of judgment. For example, if the relevant range is 8,000 to 12,000 direct labor hours, increments of 1,000 hours may be selected. The flexible budget is then prepared for each increment within the relevant range.

SERVICE COMPANY INSIGHT

NBCUniversal

Just What the Doctor Ordered?

Nobody is immune from the effects of declining revenues—not even movie stars. 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%. What would NBCUniversal do in response? It might cut the size of the show's cast, which would reduce the payroll costs associated with the show. Or, it could reduce the number of episodes that take advantage of the full cast. Alternatively, it might threaten to quit providing the show to Fox altogether and instead present the show on its own NBC‐affiliated channels.

Source: Sam Schechner, “Media Business Shorts: NBCU, Fox Taking Scalpel to ‘House’,” Wall Street Journal Online (April 17, 2011).

Explain how the use of flexible budgets might help to identify the best solution to this problem. (Go to WileyPLUS for this answer and additional questions.)

FLEXIBLE BUDGET—A CASE STUDY

To illustrate the flexible budget, we use Fox Company. Fox's management uses a flexible budget for monthly comparisons of actual and budgeted manufacturing overhead costs of the Finishing Department. The master budget for the year ending December 31, 2017, shows expected annual operating capacity of 120,000 direct labor hours and the following overhead costs.

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

ILLUSTRATION 22-11 Master budget data

The four steps for developing the flexible budget are applied as follows.

STEP 1. Identify the activity index and the relevant range of activity. The activity index is direct labor hours. The relevant range is 8,000–12,000 direct labor hours per month.

STEP 2. Identify the variable costs, and determine the budgeted variable cost per unit of activity for each cost. There are three variable costs. The variable cost per unit is found by dividing each total budgeted cost by the direct labor hours used in preparing the annual master budget (120,000 hours). Illustration 22-12 shows the computations for Fox Company.

Variable Costs

Computation

Variable Cost per Direct Labor Hour

Indirect materials

$180,000 ÷ 120,000

$1.50

Indirect labor

 240,000 ÷ 120,000

 2.00

Utilities

  60,000 ÷ 120,000

 0.50

Total

$4.00

ILLUSTRATION 22-12 Computation of variable cost per direct labor hour

STEP 3. Identify the fixed costs, and determine the budgeted amount for each cost. There are three fixed costs. Since Fox desires monthly budget data, it divides each annual budgeted cost by 12 to find the monthly amounts. Therefore, the monthly budgeted fixed costs are depreciation $15,000, supervision $10,000, and property taxes $5,000.

STEP 4. Prepare the budget for selected increments of activity within the relevant range. Management prepares the budget in increments of 1,000 direct labor hours.

Illustration 22-13 shows Fox's flexible budget.

ILLUSTRATION 22-13 Monthly overhead flexible budget

Fox uses the formula below to determine total budgeted costs at any level of activity.

Fixed Costs

+

Variable Costs*

=

Total Budgeted Costs

* Total variable cost per unit of activity × Activity level.

ILLUSTRATION 22-14 Formula for total budgeted costs

For Fox, fixed costs are $30,000, and total variable cost per direct labor hour is $4 ($1.50+$2.00+$0.50)$4 ($1.50+$2.00+$0.50). At 9,000 direct labor hours, total budgeted costs are $66,000 [$30,000+($4×9,000)]$66,000 [$30,000+($4×9,000)]. At 8,622 direct labor hours, total budgeted costs are $64,488 [$30,000+($4×8,622)]$64,488 [$30,000+($4×8,622)].

Total budgeted costs can also be shown graphically, as in Illustration 22-15 . In the graph, the horizontal axis represents the activity index, and costs are indicated on the vertical axis. The graph highlights two activity levels (10,000 and 12,000). As shown, total budgeted costs at these activity levels are $70,000 [$30,000+($4×10,000)]$70,000 [$30,000+($4×10,000)] and $78,000 [$30,000+($4×12,000)]$78,000 [$30,000+($4×12,000)], respectively.

ILLUSTRATION 22-15 Graphic flexible budget data highlighting 10,000 and 12,000 activity levels

▼ HELPFUL HINT

Using the data given for Fox, the amount of total costs to be budgeted for 10,600 direct labor hours would be $30,000 fixed+$42,400 variable (10,600×$4)=$72,400 total$30,000 fixed+$42,400 variable (10,600×$4)=$72,400 total.

FLEXIBLE BUDGET REPORTS

Flexible budget reports are another type of internal report. The flexible budget report consists of two sections: (1) production data for a selected activity index, such as direct labor hours, and (2) cost data for variable and fixed costs. The report provides a basis for evaluating a manager's performance in two areas: production control and cost control. Flexible budget reports are widely used in production and service departments.

Illustration 22-16 shows a budget report for the Finishing Department of Fox Company for the month of January. In this month, 9,000 hours are worked. The budget data are therefore based on the flexible budget for 9,000 hours in Illustration 22-13 . The actual cost data are assumed.

ILLUSTRATION 22-16 Overhead flexible budget report

How appropriate is this report in evaluating the Finishing Department manager's performance in controlling overhead costs? The report clearly provides a reliable basis. Both actual and budget costs are based on the activity level worked during January. Since variable costs generally are incurred directly by the department, the difference between the budget allowance for those hours and the actual costs is the responsibility of the department manager.

In subsequent months, Fox Company will prepare other flexible budget reports. For each month, the budget data are based on the actual activity level attained. In February that level may be 11,000 direct labor hours, in July 10,000, and so on.

Note that this flexible budget is based on a single cost driver. A more accurate budget often can be developed using the activity‐based costing concepts explained in Chapter 17 .

SERVICE COMPANY INSIGHT

San Diego Zoo

Budgets and the Exotic Newcastle Disease

Exotic Newcastle Disease, one of the most infectious bird diseases in the world, kills so swiftly that many victims die before any symptoms appear. When it broke out in Southern California, it could have spelled disaster for the San Diego Zoo. “We have one of the most valuable collections of birds in the world, if not the most valuable,” says Paula Brock, CFO of the Zoological Society of San Diego, which operates the zoo.

Bird exhibits were closed to the public for several months (the disease, which is harmless to humans, can be carried on clothes and shoes). The tires of arriving delivery trucks were sanitized, as were the shoes of anyone visiting the zoo's nonpublic areas. Zookeeper uniforms had to be changed and cleaned daily. And ultimately, the zoo, with $150 million in revenues, spent almost half a million dollars on quarantine measures.

It worked: No birds got sick. Better yet, the damage to the rest of the zoo's budget was minimized by another protective measure: the monthly budget reforecast. “When we get a hit like this, we still have to find a way to make our bottom line,” says Brock. Thanks to a new planning process Brock had introduced a year earlier, the zoo's scientists were able to raise the financial alarm as they redirected resources to ward off the disease. “Because we had timely awareness,” she says, “we were able to make adjustments to weather the storm.”

Source: Tim Reason, “Budgeting in the Real World,” CFO Magazine (July 12, 2005), www.cfodirect.com/cfopublic.nsf/vContentPrint/649A82C8FF8AB06B85257037004 (accessed July 2005).

What is the major benefit of tying a budget to the overall goals of the company? (Go to WileyPLUS for this answer and additional questions.)

DO IT! 2

Flexible Budgets

In Strassel Company's flexible budget graph, the fixed cost line and the total budgeted cost line intersect the vertical axis at $36,000. The total budgeted cost line is $186,000 at an activity level of 50,000 direct labor hours. Compute total budgeted costs at 30,000 direct labor hours.

Action Plan

✓ Apply the formula: Fixed costs+Variable costs (Total variable cost per unit×Activity level)=Total budgeted costsFixed costs+Variable costs (Total variable cost per unit×Activity level)=Total budgeted costs.

SOLUTION

Using the graph, fixed costs are $36,000, and variable costs are $3 per direct labor hour [($186,000−$36,000)÷50,000][($186,000−$36,000)÷50,000]. Thus, at 30,000 direct labor hours, total budgeted costs are $126,000 [$36,000+($3×30,000)]$126,000 [$36,000+($3×30,000)].

Related exercise material: BE22-4, E22-3, E22-5, and DO IT! 22-2.

LEARNING OBJECTIVE 3

Apply responsibility accounting to cost and profit centers.

Like budgeting, responsibility accounting is an important part of management accounting. 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. Under responsibility accounting, a manager's performance is evaluated on matters directly under that manager's control. 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 can be controlled by employees 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.

Illustration 22-17 depicts levels of responsibility for controlling costs.

ILLUSTRATION 22-17 Responsibility for controllable costs at varying levels of management

Under responsibility accounting, any individual who controls a specified set of activities can be a responsibility center. Thus, responsibility accounting may extend from the lowest level of control to the top strata of management. Once responsibility is established, the company first measures and reports the effectiveness of the individual's performance for the specified activity. It then reports that measure upward throughout the organization.

Responsibility accounting is especially valuable in a decentralized company. Decentralization means that the control of operations is delegated to many managers throughout the organization. The term segment is sometimes used to identify an area of responsibility in decentralized operations. Under responsibility accounting, companies prepare segment reports periodically, such as monthly, quarterly, and annually, to evaluate managers' performance.

Responsibility accounting is an essential part of any effective system of budgetary control. The reporting of costs and revenues under responsibility accounting differs from budgeting in two respects:

1. A distinction is made between controllable and noncontrollable items.

2. Performance reports either emphasize or include only items controllable by the individual manager.

Responsibility accounting applies to both profit and not‐for‐profit entities. For‐profit entities seek to maximize net income. Not‐for‐profit entities wish to provide services as efficiently as possible.

MANAGEMENT INSIGHT

Procter & Gamble

Competition versus Collaboration

Many compensation and promotion programs encourage competition among employees for pay raises. To get ahead, you have to perform better than your fellow employees. While this may encourage hard work, it does not foster collaboration, and it can lead to distrust and disloyalty. Such negative effects have led some companies to believe that cooperation and collaboration, not competition, are essential in order to succeed in today's work environment.

As a consequence, many companies now explicitly include measures of collaboration in their performance measures. For example, Procter & Gamble measures collaboration in employees' annual performance reviews. At Cisco Systems, the assessment of an employee's teamwork can affect the annual bonus by as much as 20%.

Source: Carol Hymowitz, “Rewarding Competitors Over Collaboration No Longer Makes Sense,” Wall Street Journal (February 13, 2006).

How might managers of separate divisions be able to reduce division costs through collaboration? (Go to WileyPLUS for this answer and additional questions.)

▼ HELPFUL HINT

All companies use responsibility accounting. Without some form of responsibility accounting, there would be chaos in discharging management's control function.

CONTROLLABLE VERSUS NONCONTROLLABLE REVENUES AND COSTS

All costs and revenues are controllable at some level of responsibility within a company. This truth underscores the adage by the CEO of any organization that “the buck stops here.” 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 over which a manager has control is called a controllable cost . From this definition, it follows that:

1. All costs are controllable by top management because of the broad range of its authority.

2. Fewer costs are controllable as one moves down to each lower level of managerial responsibility because of the manager's decreasing authority.

In general, costs incurred directly by a level of responsibility are controllable at that level. In contrast, costs incurred indirectly and allocated to a responsibility level are noncontrollable costs at that level.

▼ HELPFUL HINT

There are more, not fewer, controllable costs as you move to higher levels of management.

▼ HELPFUL HINT

The longer the time span, the more likely that the cost becomes controllable.

PRINCIPLES OF PERFORMANCE EVALUATION

Performance evaluation is at the center of responsibility accounting. It is a management function that compares actual results with budget goals. It involves both behavioral and reporting principles.

Management by Exception

Management by exception means that top management's review of a budget report is focused either entirely or primarily on differences between actual results and planned objectives. This approach enables top management to focus on problem areas. For example, many companies now use online reporting systems for employees to file their travel and entertainment expense reports. In addition to cutting reporting time in half, the online system enables managers to quickly analyze variances from travel budgets. This cuts down on expense account “padding” such as spending too much on meals or falsifying documents for costs that were never actually incurred.

Management by exception does not mean that top management will investigate every difference. For this approach to be effective, there must be guidelines for identifying an exception. The usual criteria are materiality and controllability.

MATERIALITY Without quantitative guidelines, management would have to investigate every budget difference regardless of the amount. Materiality is usually expressed as a percentage difference from budget. For example, management may set the percentage difference at 5% for important items and 10% for other items. Managers will investigate all differences either over or under budget by the specified percentage. Costs over budget warrant investigation to determine why they were not controlled. Likewise, costs under budget merit investigation to determine whether costs critical to profitability are being curtailed. For example, if maintenance costs are budgeted at $80,000 but only $40,000 is spent, major unexpected breakdowns in productive facilities may occur in the future. Alternatively, as discussed earlier, cost might be under budget due to budgetary slack.

Alternatively, a company may specify a single percentage difference from budget for all items and supplement this guideline with a minimum dollar limit. For example, the exception criteria may be stated at 5% of budget or more than $10,000.

CONTROLLABILITY OF THE ITEM Exception guidelines are more restrictive for controllable items than for items the manager cannot control. In fact, there may be no guidelines for noncontrollable items. For example, a large unfavorable difference between actual and budgeted property tax expense may not be flagged for investigation because the only possible causes are an unexpected increase in the tax rate or in the assessed value of the property. An investigation into the difference would be useless: The manager cannot control either cause.

Behavioral Principles

The human factor is critical in evaluating performance. Behavioral principles include the following.

1. Managers of responsibility centers should have direct input into the process of establishing budget goals of their area of responsibility. Without such input, managers may view the goals as unrealistic or arbitrarily set by top management. Such views adversely affect the managers' motivation to meet the targeted objectives.

2. The evaluation of performance should be based entirely on matters that are controllable by the manager being evaluated. Criticism of a manager on matters outside his or her control reduces the effectiveness of the evaluation process. It leads to negative reactions by a manager and to doubts about the fairness of the company's evaluation policies.

3. Top management should support the evaluation process. As explained earlier, the evaluation process begins at the lowest level of responsibility and extends upward to the highest level of management. Managers quickly lose faith in the process when top management ignores, overrules, or bypasses established procedures for evaluating a manager's performance.

4. The evaluation process must allow managers to respond to their evaluations. Evaluation is not a one‐way street. Managers should have the opportunity to defend their performance. Evaluation without feedback is both impersonal and ineffective.

5. The evaluation should identify both good and poor performance. Praise for good performance is a powerful motivating factor for a manager. This is especially true when a manager's compensation includes rewards for meeting budget goals.

Reporting Principles

Performance evaluation under responsibility accounting should be based on certain reporting principles. These principles pertain primarily to the internal reports that provide the basis for evaluating performance. Performance reports should:

1. Contain only data that are controllable by the manager of the responsibility center.

2. Provide accurate and reliable budget data to measure performance.

3. Highlight significant differences between actual results and budget goals.

4. Be tailor‐made for the intended evaluation.

5. Be prepared at reasonable time intervals.

In recent years, companies have come under increasing pressure from influential shareholder groups to do a better job of linking executive pay to corporate performance. For example, software maker Siebel Systems unveiled a new incentive plan after lengthy discussions with the California Public Employees' Retirement System. One unique feature of the plan is that managers' targets will be publicly disclosed at the beginning of each year for investors to evaluate.

MANAGEMENT INSIGHT

Honda

Flexible Manufacturing Requires Flexible Accounting

Flexible budgeting is useful because it enables managers to evaluate performance in light of changing conditions. But the ability to react quickly to changing conditions is even more important. Among automobile manufacturing facilities in the U.S., few plants are more flexible than Honda.

The manufacturing facilities of some auto companies can make slight alterations to the features of a vehicle in response to changes in demand for particular features. But for most plants, to switch from production of one type of vehicle to a completely different one typically takes months and costs hundreds of millions of dollars. At the Honda plant, however, the switch takes minutes. For example, it takes about five minutes to install different hand‐like parts on the robots so they can switch from making Civic compacts to the longer, taller CR‐V crossover. This ability to adjust quickly to changing demand gave Honda a huge advantage when gas prices surged and demand for more fuel‐efficient cars increased quickly.

Source: Kate Linebaugh, “Honda's Flexible Plants Provide Edge,” Wall Street Journal Online (September 23, 2008).

What implications do these improvements in production capabilities have for management accounting information and performance evaluation within the organization? (Go to WileyPLUS for this answer and additional questions.)

RESPONSIBILITY REPORTING SYSTEM

A responsibility reporting system involves the preparation of a report for each level of responsibility in the company's organization chart. To illustrate such a system, we use the partial organization chart and production departments of Francis Chair Company in Illustration 22-18 .

DECISION TOOLS

Responsibility reports help to hold individual managers accountable for the costs and revenues under their control.

ILLUSTRATION 22-18 Partial organization chart

The responsibility reporting system begins with the lowest level of responsibility for controlling costs and moves upward to each higher level. Illustration 22-19 details the connections between levels.

ILLUSTRATION 22-19 Responsibility reporting system

A brief description of the four reports for Francis Chair is as follows.

1. Report D is typical of reports that go to department managers. Similar reports are prepared for the managers of the Assembly and Enameling Departments.

2. Report C is an example of reports that are sent to plant managers. It shows the costs of the Chicago plant that are controllable at the second level of responsibility. In addition, Report C shows summary data for each department that is controlled by the plant manager. Similar reports are prepared for the Detroit and St. Louis plant managers.

3. Report B illustrates the reports at the third level of responsibility. It shows the controllable costs of the vice president of production and summary data on the three assembly plants for which this officer is responsible. Similar reports are prepared for the vice presidents of sales and finance.

4. Report A is typical of reports that go to the top level of responsibility—the president. It shows the controllable costs and expenses of this office and summary data on the vice presidents that are accountable to the president.

A responsibility reporting system 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. For example, the vice president of production in Francis Chair may request the Chicago plant manager's report because this plant is $5,300 over budget.

This type of reporting system also permits comparative evaluations. In Illustration 22-19 , the Chicago plant manager can easily rank the department managers' effectiveness in controlling manufacturing costs. Comparative rankings provide further incentive for a manager to control costs.

TYPES OF RESPONSIBILITY CENTERS

There are three basic types of responsibility centers: cost centers, profit centers, and investment centers. These classifications indicate the degree of responsibility the manager has for the performance of the center.

A cost center incurs costs (and expenses) but does not directly generate revenues. Managers of cost centers have the authority to incur costs. They are evaluated on their ability to control costs. Cost centers are usually either production departments or service departments. Production departments participate directly in making the product. Service departments provide only support services. In a Ford Motor Company automobile plant, the welding, painting, and assembling departments are production departments. Ford's maintenance, cafeteria, and human resources departments are service departments. All of them are cost centers.

A profit center incurs costs (and expenses) and also generates revenues. Managers of profit centers are judged on the profitability of their centers. Examples of profit centers include the individual departments of a retail store, such as clothing, furniture, and automotive products, and branch offices of banks.

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. Investment center managers are evaluated on both the profitability of the center and the rate of return earned on the funds invested. Investment centers are often associated with subsidiary companies. Utility Duke Energy has operating divisions such as electric utility, energy trading, and natural gas. Investment center managers control or significantly influence investment decisions related to such matters as plant expansion and entry into new market areas. Illustration 22-20 depicts the three types of responsibility centers.

ILLUSTRATION 22-20 Types of responsibility centers

▼ HELPFUL HINT

The jewelry department of Macy's department store is a profit center, while the props department of a movie studio is a cost center.

Responsibility Accounting for Cost Centers

The evaluation of a manager's performance for cost centers is based on his or her ability to meet budgeted goals for controllable costs. Responsibility reports for cost centers compare actual controllable costs with flexible budget data.

Illustration 22-21 shows a responsibility report. The report is adapted from the flexible budget report for Fox Company in Illustration 22-16 . It assumes that the Finishing Department manager is able to control all manufacturing overhead costs except depreciation, property taxes, and his own monthly salary of $6,000. The remaining $4,000 ($10,000−$6,000)$4,000 ($10,000−$6,000) of supervision costs are assumed to apply to other supervisory personnel within the Finishing Department, whose salaries are controllable by the manager.

ILLUSTRATION 22-21 Responsibility report for a cost center

The report in Illustration 22-21 includes only controllable costs, and no distinction is made between variable and fixed costs. The responsibility report continues the concept of management by exception. In this case, top management may request an explanation of the $1,000 favorable difference in indirect labor and/or the $500 unfavorable difference in indirect materials.

Responsibility Accounting for Profit Centers

To evaluate the performance of a profit center manager, upper management needs detailed information about both controllable revenues and controllable costs. The operating revenues earned by a profit center, such as sales, are controllable by the manager. All variable costs (and expenses) incurred by the center are also controllable by the manager because they vary with sales. However, to determine the controllability of fixed costs, it is necessary to distinguish between direct and indirect fixed costs.

DIRECT AND INDIRECT FIXED COSTS A profit center may have both direct and indirect fixed costs. Direct fixed costs relate specifically to one center and are incurred for the sole benefit of that center. Examples of such costs include the salaries established by the profit center manager for supervisory personnel and the cost of a timekeeping department for the center's employees. Since these fixed costs can be traced directly to a center, they are also called traceable costs. Most direct fixed costs are controllable by the profit center manager.

In contrast, indirect fixed costs pertain to a company's overall operating activities and are incurred for the benefit of more than one profit center. Management allocates indirect fixed costs to profit centers on some type of equitable basis. For example, property taxes on a building occupied by more than one center may be allocated on the basis of square feet of floor space used by each center. Or, the costs of a company's human resources department may be allocated to profit centers on the basis of the number of employees in each center. Because these fixed costs apply to more than one center, they are also called common costs. Most indirect fixed costs are not controllable by the profit center manager.

RESPONSIBILITY REPORT The 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 explained in Chapter 18 . 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.

Illustration 22-22 shows the responsibility report for the manager of the Marine Division, a profit center of Mantle Company. For the year, the Marine Division also had $60,000 of indirect fixed costs that were not controllable by the profit center manager.

ILLUSTRATION 22-22 Responsibility report for profit center

Controllable margin is considered to be the best measure of the manager's performance in controlling revenues and costs. The report in Illustration 22-22 shows that the manager's performance was below budgeted expectations by 10%($36,000÷$360,000)10%($36,000÷$360,000). Top management would likely investigate the causes of this unfavorable result. Note that the report does not show the Marine Division's noncontrollable fixed costs of $60,000. These costs would be included in a report on the profitability of the profit center.

Management also may choose to see monthly responsibility reports for profit centers. In addition, responsibility reports may include cumulative year‐to‐date results.

DO IT! 3

Profit Center Responsibility Report

Midwest Division operates as a profit center. It reports the following for the year:

Budget

Actual

Sales

$1,500,000

$1,700,000

Variable costs

700,000

800,000

Controllable fixed costs

400,000

400,000

Noncontrollable fixed costs

200,000

200,000

Prepare a responsibility report for the Midwest Division for December 31, 2017.

Action Plan

✓ Deduct variable costs from sales to show contribution margin.

✓ Deduct controllable fixed costs from the contribution margin to show controllable margin.

✓ Do not report noncontrollable fixed costs.

SOLUTION

Related exercise material: BE22-7, E22-15, and DO IT! 22-3.

▼ HELPFUL HINT

Recognize that we are emphasizing financial measures of performance. Companies are now making an effort to also stress nonfinancial performance measures such as product quality, labor productivity, market growth, materials' yield, manufacturing flexibility, and technological capability.

LEARNING OBJECTIVE 4

Evaluate performance in investment centers.

As explained earlier, an investment center manager can control or significantly influence the investment funds available for use. Thus, the primary basis for evaluating the performance of a manager of an investment center is return on investment (ROI) . The return on investment is considered to be a useful performance measurement because it shows the effectiveness of the manager in utilizing the assets at his or her disposal.

RETURN ON INVESTMENT (ROI)

The formula for computing ROI for an investment center, together with assumed illustrative data, is shown in Illustration 22-23 .

ControllableMargin÷Average OperatingAssets=Return onInvestment(ROI)$1,000,000÷$5,000,000=20%ControllableMargin÷Average OperatingAssets=Return onInvestment(ROI)$1,000,000÷$5,000,000=20%

ILLUSTRATION 22-23 ROI formula

Both factors in the formula are controllable by the investment center manager. Operating assets consist of current assets and plant assets used in operations by the center and controlled by the manager. Nonoperating assets such as idle plant assets and land held for future use are excluded. Average operating assets are usually based on the cost or book value of the assets at the beginning and end of the year.

DECISION TOOLS

The ROI formula helps managers determine if the investment center has used its assets effectively.

RESPONSIBILITY REPORT

The scope of the investment center manager's responsibility significantly affects the content of the performance report. Since an investment center is an independent entity for operating purposes, all fixed costs are controllable by its manager. For example, the manager is responsible for depreciation on investment center assets. Therefore, more fixed costs are identified as controllable in the performance report for an investment center manager than in a performance report for a profit center manager. The report also shows budgeted and actual ROI below controllable margin.

To illustrate this responsibility report, we will now assume that the Marine Division of Mantle Company is an investment center. It has budgeted and actual average operating assets of $2,000,000. The manager can control $60,000 of fixed costs that were not controllable when the division was a profit center. Illustration 22-24 shows the division's responsibility report.

ILLUSTRATION 22-24 Responsibility report for investment center

The report shows that the manager's performance based on ROI was below budget expectations by 1.8% (15.0% versus 13.2%). Top management would likely want explanations for this unfavorable result.

JUDGMENTAL FACTORS IN ROI

The return on investment approach includes two judgmental factors:

1. Valuation of operating assets. Operating assets may be valued at acquisition cost, book value, appraised value, or fair value. The first two bases are readily available from the accounting records.

2. 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 manager's performance as long as it is consistently applied between reporting periods. However, the use of income measures other than controllable margin will not result in a valid basis for evaluating the performance of an investment center manager.

IMPROVING ROI

The manager of an investment center can improve ROI by increasing controllable margin, and/or reducing average operating assets. To illustrate, we will use the following assumed data for the Laser Division of Berra Company.

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 22-25 Assumed data for Laser Division

Increasing Controllable Margin

Controllable margin can be increased by increasing sales or by reducing variable and controllable fixed costs as follows.

1. Increase sales 10%. Sales will increase $200,000 ($2,000,000×.10)$200,000 ($2,000,000×.10). Assuming no change in the contribution margin percentage of 45%, contribution margin will increase $90,000 ($200,000×.45)$90,000 ($200,000×.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)$690,000 ($600,000+$90,000). The new ROI is 13.8%, computed as follows.

ROI=Controllable marginAverage operating assets=$690,000$5,000,000=13.8%ROI=Controllable marginAverage operating assets=$690,000$5,000,000=13.8%

ILLUSTRATION 22-26 ROI computation—increase in sales

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.

2. Decrease variable and fixed costs 10%. Total costs decrease $140,000 [($1,100,000+$300,000)×.10]$140,000 [($1,100,000+$300,000)×.10]. This reduction results in a corresponding increase in controllable margin. Thus, controllable margin becomes $740,000 ($600,000+$140,000)$740,000 ($600,000+$140,000). The new ROI is 14.8%, computed as follows.

ROI=Controllable marginAverage operating assets=$740,000$5,000,000=14.8%ROI=Controllable marginAverage operating assets=$740,000$5,000,000=14.8%

ILLUSTRATION 22-27 ROI computation—decrease in costs

This course of action is clearly beneficial when the reduction in costs is the result of eliminating waste and inefficiency. But, a reduction in costs that results from cutting expenditures on vital activities, such as required maintenance and inspections, is not likely to be acceptable to top management.

Reducing Average Operating Assets

Assume that average operating assets are reduced 10% or $500,000 ($5,000,000×.10)$500,000 ($5,000,000×.10). Average operating assets become $4,500,000 ($5,000,000−$500,000)$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 marginAverage operating assets=$600,000$4,500,000=13.3%ROI=Controllable marginAverage operating assets=$600,000$4,500,000=13.3%

ILLUSTRATION 22-28 ROI computation—decrease in operating assets

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.

 ACCOUNTING ACROSS THE ORGANIZATION 

Hollywood

Does Hollywood Look at ROI?

If Hollywood were run like a real business, where things like return on investment mattered, there would be one unchallenged, sacred principle that studio chieftains would never violate: Make lots of G‐rated movies.

No matter how you slice the movie business—by star vehicles, by budget levels, or by sequels or franchises—by far the best return on investment comes from the not‐so‐glamorous world of G‐rated films. The problem is, these movies represent only 3% of the total films made in a typical year.

On the flip side are the R‐rated films, which dominate the total releases and yet yield the worst return on investment. A whopping 646 R‐rated films were released in a recent year—69% of the total output—but only four of the top‐20 grossing movies of the year were R‐rated films.

This trend—G‐rated movies are good for business but underproduced, R‐rated movies are bad for business and yet overdone—is something that has been driving economists batty for the past several years.

Source: David Grainger, “The Dysfunctional Family‐Film Business,” Fortune (January 10, 2005), pp. 20–21.

What might be the reason that movie studios do not produce G‐rated movies as much as R‐rated ones? (Go to WileyPLUS for this answer and additional questions.)

DO IT! 4

Performance Evaluation

The service division of Metro Industries reported the following results for 2017.

Sales

$400,000

Variable costs

320,000

Controllable fixed costs

40,800

Average operating assets

280,000

Management is considering the following independent courses of action in 2018 in order to maximize the return on investment for this division.

1. Reduce average operating assets by $80,000, with no change in controllable margin.

2. Increase sales $80,000, with no change in the contribution margin percentage.

(a) Compute the controllable margin and the return on investment for 2017.

(b) Compute the controllable margin and the expected return on investment for each proposed alternative.

Action Plan

✓ Recall key formulas: Sales−Variable costs=Contribution margin.Recall key formulas: Sales−Variable costs=Contribution margin.

✓ Contribution margin÷Sales=Contribution margin percentage.Contribution margin÷Sales=Contribution margin percentage.

✓ Contribution margin−Controllable fixed costs=Controllable margin.Contribution margin−Controllable fixed costs=Controllable margin.

✓ Return on investment=Controllable margin÷Average operating assets.Return on investment=Controllable margin÷Average operating assets.

SOLUTION

(a) Return on investment for 2017:

Sales

$400,000  

Variable costs

 320,000  

Contribution margin

80,000  

Controllable fixed costs

  40,800  

Controllable margin

$ 39,200  

  Return on investment

$39,200$280,000$39,200$280,000

=

14%

(b) Expected return on investment for alternative 1:

$39,200$280,000‒$80,000=19.6%$39,200$280,000‒$80,000=19.6%

Expected return on investment for alternative 2:

Sales($400,000+$80,000)Sales ($400,000+$80,000)

$480,000  

Variable costs($320,000/$400,000×$480,000)Variable costs ($320,000/$400,000×$480,000)

 384,000  

Contribution margin

96,000  

Controllable fixed costs

  40,800  

Controllable margin

$ 55,200  

    Return on investment

$55,200$280,000$55,200$280,000

=

19.7%

Related exercise material: BE22-8, BE22-9, BE22-10, E22-16, E22-17, and DO IT! 22-4.

USING DECISION TOOLS—TRIBECA GRAND HOTEL

The Tribeca Grand Hotel, which was discussed in the Feature Story, faces many situations where it needs to apply the decision tools learned in this chapter. For example, assume that the hotel's housekeeping budget contains the following items.

Variable costs

 Direct labor

$37,000

 Laundry service

10,000

 Supplies

  6,000

 Total variable

$53,000

Fixed costs

 Supervision

$17,000

 Inspection costs

1,000

 Insurance expenses

2,000

 Depreciation

 15,000

 Total fixed

$35,000

The budget was based on an estimated 4,000‐room rental for the month. During November, 3,000 rooms were actually rented, with the following costs incurred.

Variable costs

 Direct labor

$38,700

 Laundry service

8,200

 Supplies

  5,100

 Total variable

$52,000

Fixed costs

 Supervision

$19,300

 Inspection costs

1,200

 Insurance expenses

2,200

 Depreciation

 14,700

 Total fixed

$37,400

INSTRUCTIONS

(a) Determine which items would be controllable by the housekeeping manager. (Assume “supervision” excludes the housekeeping manager's own salary.)

(b) How much should have been spent during the month for providing rental of 3,000 rooms?

(c) Prepare a flexible housekeeping budget report for the housekeeping manager.

(d) Prepare a responsibility report. Include only the costs that would have been controllable by the housekeeping manager.

SOLUTION

(a) The housekeeping manager should be able to control all the variable costs and the fixed costs of supervision and inspection. Insurance and depreciation ordinarily are not the responsibility of the housekeeping manager.

(b) The total variable cost per unit is $13.25 ($53,000÷4,000)$13.25 ($53,000÷4,000). The total budgeted cost during the month to provide 3,000 room rentals is variable costs $39,750 (3,000×$13.25)$39,750 (3,000×$13.25) plus fixed costs ($35,000), for a total of $74,750 ($39,750+$35,000)$74,750 ($39,750+$35,000).

(c)

TRIBECA GRAND HOTEL

Housekeeping Department

Housekeeping Budget Report (Flexible)

For the Month Ended November 30, 2017

Difference

Budget at 3,000 Rooms

Actual at 3,000 Rooms

Favorable F Unfavorable U

Variable costs

  Direct labor ($9.25)*

$27,750

$38,700

$10,950 U

  Laundry service ($2.50)

  7,500

  8,200

    700 U

  Supplies ($1.50)

  4,500

  5,100

    600 U

  Total variable ($13.25)

 39,750

 52,000

 12,250 U

Fixed costs

  Supervision

 17,000

 19,300

  2,300 U

  Inspection

  1,000

  1,200

    200 U

  Insurance

  2,000

  2,200

    200 U

  Depreciation

 15,000

 14,700

    300 F

  Total fixed

 35,000

 37,400

  2,400 U

Total costs

$74,750

$89,400

$14,650 U

*$37,000 ÷ 4,000

(d) Because a housekeeping department is a cost center, the responsibility report should include only the costs that are controllable by the housekeeping manager. In this type of report, no distinction is made between variable and fixed costs. Budget data in the report should be based on the rooms actually rented.

TRIBECA GRAND HOTEL

Housekeeping Department

Housekeeping Responsibility Report

For the Month Ended November 30, 2017

Difference

Controllable Costs

Budget

Actual

Favorable F Unfavorable U

Direct labor

$27,750

$38,700

$10,950 U

Laundry service

  7,500

  8,200

    700 U

Supplies

  4,500

  5,100

    600 U

Supervision

 17,000

 19,300

  2,300 U

Inspection

  1,000

  1,200

    200 U

Total

$57,750

$72,500

$14,750 U

LEARNING OBJECTIVE *5

APPENDIX 22A: Explain the difference between ROI and residual income.

Although most companies use ROI to evaluate investment performance, ROI has a significant disadvantage. To illustrate, let's look at the Electronics Division of Pujols Company. It has an ROI of 20%, computed as follows.

ControllableMargin÷Average OperatingAssets=Return onInvestment(ROI)$1,000,000÷$5,000,000=$20%ControllableMargin÷Average OperatingAssets=Return onInvestment(ROI)$1,000,000÷$5,000,000=$20%

ILLUSTRATION 22A‐1 ROI formula

The Electronics Division is considering producing a new product, a GPS device (hereafter referred to as Tracker) for its boats. To produce Tracker, operating assets will have to increase $2,000,000. Tracker is expected to generate an additional $260,000 of controllable margin. Illustration 22A-2 shows how Tracker will effect ROI.

Without Tracker

Tracker

With Tracker

Controllable margin (a)

$1,000,000

$  260,000

$1,260,000

Average operating assets (b)

$5,000,000

$2,000,000

$7,000,000

Return on investment [(a) ÷ (b)]

20%

13%

18%

ILLUSTRATION 22A-2 ROI comparison

The investment in Tracker reduces ROI from 20% to 18%.

Let's suppose that you are the manager of the Electronics Division and must make the decision to produce or not produce Tracker. If you were evaluated using ROI, you probably would not produce Tracker because your ROI would drop from 20% to 18%. The problem with this ROI analysis is that it ignores an important variable: the minimum rate of return on a company's operating assets. The minimum rate of return is the rate at which the Electronics Division can cover its costs and earn a profit. Assuming that the Electronics Division has a minimum rate of return of 10%, it should invest in Tracker because its ROI of 13% is greater than 10%.

RESIDUAL INCOME COMPARED TO ROI

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 company's average operating assets. The residual income for Tracker would be computed as follows.

ControllableMargin‒Minimum Rate of Return×Average Operating Assets=ResidualIncome$260,000‒10%×$2,000,000=$60,000ControllableMargin‒Minimum Rate of Return×Average Operating Assets=ResidualIncome$260,000‒10%×$2,000,000=$60,000

ILLUSTRATION 22A‐3 Residual income formula

As shown, the residual income related to the Tracker investment is $60,000. Illustration 22A-4 (page 1092) indicates how residual income changes as the additional investment is made.

Without Tracker

Tracker

With Tracker

Controllable margin (a)

$1,000,000

$260,000

$1,260,000

Average operating assets × 10% (b)

  500,000

  200,000

  700,000

Residual income [(a) ‒ (b)]

$  500,000

$ 60,000

$ 560,000

ILLUSTRATION 22A‐4 Residual income comparison

This example illustrates how performance evaluation based on ROI can be misleading and can even cause managers to reject projects that would actually increase income for the company. As a result, many companies such as Coca‐Cola, Briggs and Stratton, Eli Lilly, and Siemens AG use residual income (or a variant often referred to as economic value added) to evaluate investment alternatives and measure company performance.

RESIDUAL INCOME WEAKNESS

It might appear from the above discussion that the goal of any company should be to maximize the total amount of residual income in each division. This goal, however, ignores the fact that one division might use substantially fewer assets to attain the same level of residual income as another division. For example, we know that to produce Tracker, the Electronics Division of Pujols Company used $2,000,000 of average operating assets to generate $260,000 of controllable margin. Now let's say a different division produced a product called SeaDog, which used $4,000,000 to generate $460,000 of controllable margin, as shown in Illustration 22A-5 .

Tracker

SeaDog

Controllable margin (a)

$260,000

$460,000

Average operating assets × 10% (b)

 200,000

 400,000

Residual income [(a) ‒ (b)]

$ 60,000

$ 60,000

ILLUSTRATION 22A‐5 Comparison of two products

If the performance of these two investments were evaluated using residual income, they would be considered equal: Both products have the same total residual income. This ignores, however, the fact that SeaDog required twice as many operating assets to achieve the same level of residual income.

REVIEW AND PRACTICE

LEARNING OBJECTIVES REVIEW

1 Describe budgetary control and static budget reports. 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, and (d) modifying future plans, if necessary.

Static budget reports are useful in evaluating the progress toward planned sales and profit goals. They are also appropriate in assessing a manager's effectiveness in controlling costs when (a) actual activity closely approximates the master budget activity level, and/or (b) the behavior of the costs in response to changes in activity is fixed.

2 Prepare flexible budget reports. To develop the flexible budget it is necessary to: (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. Flexible budget reports permit an evaluation of a manager's performance in controlling production and costs.

3 Apply responsibility accounting to cost and profit centers. Responsibility accounting involves accumulating and reporting revenues and costs 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 based on the matters directly under the manager's control. In responsibility accounting, it is necessary to distinguish between controllable and noncontrollable fixed costs and to identify three types of responsibility centers: cost, profit, and investment.

Responsibility reports for cost centers compare actual costs with flexible budget data. The reports show only controllable costs, and no distinction is made between variable and fixed costs. Responsibility reports show contribution margin, controllable fixed costs, and controllable margin for each profit center.

4 Evaluate performance in investment centers. The primary basis for evaluating performance in investment centers is return on investment (ROI). The formula for computing ROI for investment centers is Controllable margin ÷ Average operating assets.

*5 Explain the difference between ROI and residual income. ROI is controllable margin divided by average operating assets. Residual income is the income that remains after subtracting the minimum rate of return on a company's average operating assets. ROI sometimes provides misleading results because profitable investments are often rejected when the investment reduces ROI but increases overall profitability.

DECISION TOOLS REVIEW

DECISION CHECKPOINTS

INFO NEEDED FOR DECISION

TOOL TO USE FOR DECISION

HOW TO EVALUATE RESULTS

Are the increased costs resulting from increased production reasonable?

Variable costs projected at different levels of production

Flexible budget

After taking into account different production levels, results are favorable if expenses are less than budgeted amounts.

Have the individual managers been held accountable for the costs and revenues under their control?

Relevant costs and revenues, where the individual manager has authority to make day‐to‐day decisions about the items

Responsibility reports focused on cost centers, profit centers, and investment centers as appropriate

Compare budget to actual costs and revenues for controllable items.

Has the investment center performed up to expectations?

Controllable margin (contribution margin minus controllable fixed costs), and average investment center operating assets

Return on investment

Compare actual ROI to expected ROI.

GLOSSARY REVIEW

· Budgetary control  The use of budgets to control operations.

· Controllable cost  A cost over which a manager has control.

· Controllable margin  Contribution margin less controllable fixed costs.

· Cost center  A responsibility center that incurs costs but does not directly generate revenues.

· Decentralization  Control of operations is delegated to many managers throughout the organization.

· Direct fixed costs  Costs that relate specifically to a responsibility center and are incurred for the sole benefit of the center.

· Flexible budget  A projection of budget data for various levels of activity.

· Indirect fixed costs  Costs that are incurred for the benefit of more than one profit center.

· Investment center  A responsibility center that incurs costs, generates revenues, and has control over decisions regarding the assets available for use.

· Management by exception  The review of budget reports by top management focused entirely or primarily on differences between actual results and planned objectives.

· Noncontrollable costs  Costs incurred indirectly and allocated to a responsibility center that are not controllable at that level.

· Profit center  A responsibility center that incurs costs and also generates revenues.

· * Residual income  The income that remains after subtracting from the controllable margin the minimum rate of return on a company's average operating assets.

· Responsibility accounting  A part of management accounting that involves accumulating and reporting revenues and costs on the basis of the manager who has the authority to make the day‐to‐day decisions about the items.

· Responsibility reporting system  The preparation of reports for each level of responsibility in the company's organization chart.

· Return on investment (ROI)  A measure of management's effectiveness in utilizing assets at its disposal in an investment center.

· Segment  An area of responsibility in decentralized operations.

· Static budget  A projection of budget data at one level of activity.

PRACTICE MULTIPLE-CHOICE QUESTIONS

(LO 1)

1. Budgetary control involves all but one of the following:

(a) modifying future plans.

(b) analyzing differences.

(c) using static budgets but not flexible budgets.

(d) determining differences between actual and planned results.

(LO 1)

2. Budget reports are prepared:

(a) daily.

(b) weekly.

(c) monthly.

(d) All of the above.

(LO 1)

3. A production manager in a manufacturing company would most likely receive a:

(a) sales report.

(b) income statement.

(c) scrap report.

(d) shipping department overhead report.

(LO 1)

4. A static budget is:

(a) a projection of budget data at several levels of activity within the relevant range of activity.

(b) a projection of budget data at a single level of activity.

(c) compared to a flexible budget in a budget report.

(d) never appropriate in evaluating a manager's effectiveness in controlling costs.

(LO 1)

5. A static budget is useful in controlling costs when cost behavior is:

(a) mixed.

(b) fixed.

(c) variable.

(d) linear.

(LO 1)

6. At zero direct labor hours in a flexible budget graph, the total budgeted cost line intersects the vertical axis at $30,000. At 10,000 direct labor hours, a horizontal line drawn from the total budgeted cost line intersects the vertical axis at $90,000. Fixed and variable costs may be expressed as:

(a) $30,000 fixed plus $6 per direct labor hour variable.

(b) $30,000 fixed plus $9 per direct labor hour variable.

(c) $60,000 fixed plus $3 per direct labor hour variable.

(d) $60,000 fixed plus $6 per direct labor hour variable.

(LO 2)

7. At 9,000 direct labor hours, the flexible budget for indirect materials is $27,000. If $28,000 of indirect materials costs are incurred at 9,200 direct labor hours, the flexible budget report should show the following difference for indirect materials:

(a) $1,000 unfavorable.

(b) $1,000 favorable.

(c) $400 favorable.

(d) $400 unfavorable.

(LO 3)

8. Under responsibility accounting, the evaluation of a manager's performance is based on matters that the manager:

(a) directly controls.

(b) directly and indirectly controls.

(c) indirectly controls.

(d) has shared responsibility for with another manager.

(LO 3)

9. Responsibility centers include:

(a) cost centers.

(b) profit centers.

(c) investment centers.

(d) All of the above.

(LO 3)

10. Responsibility reports for cost centers:

(a) distinguish between fixed and variable costs.

(b) use static budget data.

(c) include both controllable and noncontrollable costs.

(d) include only controllable costs.

(LO 3)

11. The accounting department of a manufacturing company is an example of:

(a) a cost center.

(b) a profit center.

(c) an investment center.

(d) a contribution center.

(LO 3)

12. To evaluate the performance of a profit center manager, upper management needs detailed information about:

(a) controllable costs.

(b) controllable revenues.

(c) controllable costs and revenues.

(d) controllable costs and revenues and average operating assets.

(LO 3)

13. In a responsibility report for a profit center, controllable fixed costs are deducted from contribution margin to show:

(a) profit center margin.

(b) controllable margin.

(c) net income.

(d) income from operations.

(LO 4)

14. In the formula for return on investment (ROI), the factors for controllable margin and operating assets are, respectively:

(a) controllable margin percentage and total operating assets.

(b) controllable margin dollars and average operating assets.

(c) controllable margin dollars and total assets.

(d) controllable margin percentage and average operating assets.

(LO 4)

15. A manager of an investment center can improve ROI by:

(a) increasing average operating assets.

(b) reducing sales.

(c) increasing variable costs.

(d) reducing variable and/or controllable fixed costs.

SOLUTIONS

1. (c) Budgetary control involves using flexible budgets and sometimes static budgets. The other choices are all part of budgetary control.

2. (d) Budget reports are prepared daily, weekly, or monthly. The other choices are correct, but choice (d) is the better answer.

3. (c) A production manager in a manufacturing company would most likely receive a scrap report. The other choices are incorrect because (a) top management or a sales manager would most likely receive a sales report, (b) top management would most likely receive an income statement, and (d) a department manager would most likely receive a shipping department overhead report.

4. (b) A static budget is a projection of budget data at a single level of activity. The other choices are incorrect because a static budget (a) is a projection of budget data at a single level of activity, not at several levels of activity within the relevant range of activity; (c) is not compared to a flexible budget in a budget report; and (d) is appropriate in evaluating a manager's effectiveness in controlling fixed costs.

5. (b) A static budget is useful for controlling fixed costs. The other choices are incorrect because a static budget is not useful for controlling (a) mixed costs, (c) variable costs, or (d) linear costs.

6. (a) The intersection point of $90,000 is total budgeted costs, or budgeted fixed costs plus budgeted variable costs. Fixed costs are $30,000 (amount at zero direct labor hours), so budgeted variable costs are $60,000 [$90,000 (Total costs)−$30,000 (Fixed costs)]$60,000 [$90,000 (Total costs)−$30,000 (Fixed costs)]. Budgeted variable costs ($60,000) divided by total activity level (10,000 direct labor hours) gives the variable cost per unit of $6 per direct labor hour. The other choices are therefore incorrect.

7. (d) Budgeted indirect materials per direct labor hour (DLH) is $3 ($27,000/9,000). At an activity level of 9,200 direct labor hours, budgeted indirect materials are $27,600 (9,200×$3 per DLH)$27,600 (9,200×$3 per DLH) but actual indirect materials costs are $28,000, resulting in a $400 unfavorable difference. The other choices are therefore incorrect.

8. (a) The evaluation of a manager's performance is based only on matters that the manager directly controls. The other choices are therefore incorrect as they include indirect controls and shared responsibility.

9. (d) Cost centers, profit centers, and investment centers are all responsibility centers. The other choices are correct, but choice (d) is the better answer.

10. (d) Responsibility reports for cost centers report only controllable costs; they (a) do not distinguish between fixed and variable costs; (b) use flexible budget data, not static budget data; and (c) do not include noncontrollable costs.

11. (a) The accounting department of a manufacturing company is an example of a cost center, not (b) a profit center, (c) an investment center, or (d) contribution center.

12. (c) To evaluate the performance of a profit center manager, upper management needs detailed information about controllable costs and revenues, not just (a) controllable costs or (b) controllable revenues. Choice (d) is incorrect because upper management does not need information about average operating assets.

13. (b) Contribution margin less controllable fixed costs is the controllable margin, not (a) the profit center margin, (c) net income, or (d) income from operations.

14. (b) The factors in the formula for ROI are controllable margin dollars and average operating assets. The other choices are therefore incorrect.

15. (d) Reducing variable or controllable fixed costs will cause the controllable margin to increase, which is one way a manager of an investment center can improve ROI. The other choices are incorrect because (a) increasing average operating assets will lower ROI; (b) reducing sales will cause contribution margin to go down, thereby decreasing controllable margin since there will be less contribution margin to cover controllable fixed costs and resulting in lower ROI; and (c) increasing variable costs will cause the contribution margin to be lower, thereby decreasing controllable margin and resulting in lower ROI.

PRACTICE EXERCISES

Prepare flexible manufacturing overhead budget.

(LO 2)

1. Felix Company uses a flexible budget for manufacturing overhead based on direct labor hours. Variable manufacturing overhead costs per direct labor hour are as follows.

Indirect labor

$0.70

Indirect materials

0.50

Utilities

0.40

Fixed overhead costs per month are supervision $4,000, depreciation $3,000, and property taxes $800. The company believes it will normally operate in a range of 7,000–10,000 direct labor hours per month.

INSTRUCTIONS

Prepare a monthly flexible manufacturing overhead budget for 2017 for the expected range of activity, using increments of 1,000 direct labor hours.

SOLUTION

1.

FELIX COMPANY

Monthly Flexible Manufacturing Overhead Budget

For the Year 2017

Activity level

  Direct labor hours

  7,000

  8,000

  9,000

  10,000

Variable costs

  Indirect labor ($.70)

$ 4,900

$ 5,600

$ 6,300

$ 7,000

  Indirect materials ($.50)

3,500

4,000

4,500

5,000

  Utilities ($.40)

  2,800

  3,200

  3,600

  4,000

    Total variable costs ($1.60)

 11,200

 12,800

 14,400

 16,000

Fixed costs

  Supervision

4,000

4,000

4,000

4,000

  Depreciation

3,000

3,000

3,000

3,000

  Property taxes

   800

   800

   800

   800

    Total fixed costs

  7,800

  7,800

  7,800

  7,800

Total costs

$19,000

$20,600

$22,200

$23,800

Compute ROI for current year and for possible future changes.

(LO 4)

2. The White Division of Mesin Company reported the following data for the current year.

Sales

$3,000,000

Variable costs

2,400,000

Controllable fixed costs

400,000

Average operating assets

5,000,000

Top management is unhappy with the investment center's return on investment (ROI). It asks the manager of the White Division to submit plans to improve ROI in the next year. The manager believes it is feasible to consider the following independent courses of action.

1. Increase sales by $300,000 with no change in the contribution margin percentage.

2. Reduce variable costs by $100,000.

3. Reduce average operating assets by 4%.

INSTRUCTIONS

(a) Compute the return on investment (ROI) for the current year.

(b) Using the ROI formula, compute the ROI under each of the proposed courses of action. (Round to one decimal.)

SOLUTION

1. 2. (a) Controllable margin=($3,000,000 ‒$2,400,000 ‒$400,000)=$200,000ROI=$200,000÷$5,000,000=4%2. (a) Controllable margin=($3,000,000 ‒$2,400,000 ‒$400,000)=$200,000   ROI=$200,000÷$5,000,000=4%

1. (b) (1) Contribution margin percentage is20%,or($600,000÷$3,000,000)Increase in controllable margin=$300,000×20%=$60,000ROI=($200,000+$60,000)÷$5,000,000=5.2% (b) (1) Contribution margin percentage is 20%,or ($600,000÷$3,000,000)    Increase in controllable margin=$300,000×20%=$60,000    ROI=($200,000+$60,000)÷$5,000,000=5.2%

2. (2) ($200,000+$100,000)÷$5,000,000=6%   (2) ($200,000+$100,000)÷$5,000,000=6%

3. (3) $200,000÷[$5,000,000‒($5,000,000×.04)]=4.2%   (3) $200,000÷[$5,000,000‒($5,000,000×.04)]=4.2%

PRACTICE PROBLEM

Prepare flexible budget report.

(LO 2)

Glenda Company uses a flexible budget for manufacturing overhead based on direct labor hours. For 2017, the master overhead budget for the Packaging Department based on 300,000 direct labor hours was as follows.

Variable Costs

Fixed Costs

Indirect labor

$360,000

Supervision

$ 60,000

Supplies and lubricants

150,000

Depreciation

24,000

Maintenance

210,000

Property taxes

18,000

Utilities

  120,000

Insurance

  12,000

$840,000

$114,000

During July, 24,000 direct labor hours were worked. The company incurred the following variable costs in July: indirect labor $30,200, supplies and lubricants $11,600, maintenance $17,500, and utilities $9,200. Actual fixed overhead costs were the same as monthly budgeted fixed costs.

INSTRUCTIONS

Prepare a flexible budget report for the Packaging Department for July.

SOLUTION

GLENDA COMPANY

Manufacturing Overhead Budget Report (Flexible)

Packaging Department

For the Month Ended July 31, 2017

Difference

Direct labor hours (DLH)

Budget 24,000 DLH

Actual Costs 24,000 DLH

Favorable F Unfavorable U

Variable costs

  Indirect labor ($1.20a)

$28,800

$30,200

$1,400 U

  Supplies and lubricants ($0.50a)

12,000

 11,600

  400 F

  Maintenance ($0.70a)

16,800

 17,500

  700 U

  Utilities ($0.40a)

  9,600 

  9,200

  400 F

  Total variable

 67,200 

 68,500

 1,300 U

Fixed costs

  Supervision

$ 5,000b

$ 5,000

–0–  

  Depreciation

2,000b

  2,000

–0–  

  Property taxes

1,500b

  1,500

–0–  

  Insurance

  1,000b

  1,000

–0– 

  Total fixed

  9,500 

  9,500

  –0–  

Total costs

$76,700 

$78,000

$1,300 U

a$360,000 ÷ 300,000; $150,000 ÷ 300,000; $210,000 ÷ 300,000; $120,000 ÷ 300,000.

bAnnual cost divided by 12.

WileyPLUS

Brief Exercises, DO IT! Exercises, Exercises, Problems, and many additional resources are available for practice in WileyPLUS

NOTE: All asterisked Questions, Exercises, and Problems relate to material in the appendix to the chapter.

QUESTIONS

1. (a) What is budgetary control?

(b) Fred Barone is describing budgetary control. What steps should be included in Fred's description?

2. The following purposes are part of a budgetary reporting system:(a) Determine efficient use of materials. (b) Control overhead costs. (c) Determine whether income objectives are being met. For each purpose, indicate the name of the report, the frequency of the report, and the primary recipient(s) of the report.

3. How may a budget report for the second quarter differ from a budget report for the first quarter?

4. Ken Bay questions the usefulness of a master sales budget in evaluating sales performance. Is there justification for Ken's concern? Explain.

5. Under what circumstances may a static budget be an appropriate basis for evaluating a manager's effectiveness in controlling costs?

6. “A flexible budget is really a series of static budgets.” Is this true? Why?

7. The static manufacturing overhead budget based on 40,000 direct labor hours shows budgeted indirect labor costs of $54,000. During March, the department incurs $64,000 of indirect labor while working 45,000 direct labor hours. Is this a favorable or unfavorable performance? Why?

8. A static overhead budget based on 40,000 direct labor hours shows Factory Insurance $6,500 as a fixed cost. At the 50,000 direct labor hours worked in March, factory insurance costs were $6,300. Is this a favorable or unfavorable performance? Why?

9. Megan Pedigo is confused about how a flexible budget is prepared. Identify the steps for Megan.

10. Cali Company has prepared a graph of flexible budget data. At zero direct labor hours, the total budgeted cost line intersects the vertical axis at $20,000. At 10,000 direct labor hours, the line drawn from the total budgeted cost line intersects the vertical axis at $85,000. How may the fixed and variable costs be expressed?

11. The flexible budget formula is fixed costs $50,000 plus variable costs of $4 per direct labor hour. What is the total budgeted cost at (a) 9,000 hours and (b) 12,345 hours?

12. What is management by exception? What criteria may be used in identifying exceptions?

13. What is responsibility accounting? Explain the purpose of responsibility accounting.

14. Eve Rooney is studying for an accounting examination. Describe for Eve what conditions are necessary for responsibility accounting to be used effectively.

15. Distinguish between controllable and noncontrollable costs.

16. How do responsibility reports differ from budget reports?

17. What is the relationship, if any, between a responsibility reporting system and a company's organization chart?

18. Distinguish among the three types of responsibility centers.

19. (a) What costs are included in a performance report for a cost center? (b) In the report, are variable and fixed costs identified?

20. How do direct fixed costs differ from indirect fixed costs? Are both types of fixed costs controllable?

21. Jane Nott is confused about controllable margin reported in an income statement for a profit center. How is this margin computed, and what is its primary purpose?

22. What is the primary basis for evaluating the performance of the manager of an investment center? Indicate the formula for this basis.

23. Explain the ways that ROI can be improved.

24. Indicate two behavioral principles that pertain to (a) the manager being evaluated and (b) top management.

*25. What is a major disadvantage of using ROI to evaluate investment and company performance?

*26. What is residual income, and what is one of its major weaknesses?

BRIEF EXERCISES

Prepare static budget report.

(LO 1), AP

BE22-1 For the quarter ended March 31, 2017, Croix Company accumulates the following sales data for its newest guitar, The Edge: $315,000 budget; $305,000 actual. Prepare a static budget report for the quarter.

Prepare static budget report for 2 quarters.

(LO 1), AP

BE22-2 Data for Croix Company are given in BE22-1. In the second quarter, budgeted sales were $380,000, and actual sales were $384,000. Prepare a static budget report for the second quarter and for the year to date.

Show usefulness of flexible budgets in evaluating performance.

(LO 2), E

BE22-3 In Rooney Company, direct labor is $20 per hour. The company expects to operate at 10,000 direct labor hours each month. In January 2017, direct labor totaling $206,000 is incurred in working 10,400 hours. Prepare (a) a static budget report and (b) a flexible budget report. Evaluate the usefulness of each report.

Prepare a flexible budget for variable costs.

(LO 2), AP

BE22-4 Gundy Company expects to produce 1,200,000 units of Product XX in 2017. Monthly production is expected to range from 80,000 to 120,000 units. Budgeted variable manufacturing costs per unit are direct materials $5, direct labor $6, and overhead $8. Budgeted fixed manufacturing costs per unit for depreciation are $2 and for supervision are $1. Prepare a flexible manufacturing budget for the relevant range value using 20,000 unit increments.

Prepare flexible budget report.

(LO 2), AN

BE22-5 Data for Gundy Company are given in BE22-4. In March 2017, the company incurs the following costs in producing 100,000 units: direct materials $520,000, direct labor $596,000, and variable overhead $805,000. Actual fixed costs were equal to budgeted fixed costs. Prepare a flexible budget report for March. Were costs controlled?

Prepare a responsibility report for a cost center.

(LO 3), AP

BE22-6 In the Assembly Department of Hannon Company, budgeted and actual manufacturing overhead costs for the month of April 2017 were as follows.

Budget

Actual

Indirect materials

$16,000

$14,300

Indirect labor

20,000

20,600

Utilities

10,000

10,850

Supervision

5,000

5,000

All costs are controllable by the department manager. Prepare a responsibility report for April for the cost center.

Prepare a responsibility report for a profit center.

(LO 3), AP

BE22-7 Torres Company accumulates the following summary data for the year ending December 31, 2017, for its Water Division, which it operates as a profit center: sales—$2,000,000 budget, $2,080,000 actual; variable costs—$1,000,000 budget, $1,050,000 actual; and controllable fixed costs—$300,000 budget, $305,000 actual. Prepare a responsibility report for the Water Division.

Prepare a responsibility report for an investment center.

(LO 4), AP

BE22-8 For the year ending December 31, 2017, Cobb Company accumulates the following data for the Plastics Division which it operates as an investment center: contribution margin—$700,000 budget, $710,000 actual; controllable fixed costs—$300,000 budget, $302,000 actual. Average operating assets for the year were $2,000,000. Prepare a responsibility report for the Plastics Division beginning with contribution margin.

Compute return on investment using the ROI formula.

(LO 4), AP

BE22-9 For its three investment centers, Gerrard Company accumulates the following data:

I

II

III

Sales

$2,000,000

$4,000,000

$ 4,000,000

Controllable margin

1,400,000

2,000,000

3,600,000

Average operating assets

5,000,000

8,000,000

10,000,000

Compute the return on investment (ROI) for each center.

Compute return on investment under changed conditions.

(LO 4), AP

BE22-10 Data for the investment centers for Gerrard Company are given in BE22-9. The centers expect the following changes in the next year: (I) increase sales 15%, (II) decrease costs $400,000, and (III) decrease average operating assets $500,000. Compute the expected return on investment (ROI) for each center. Assume center I has a controllable margin percentage of 70%.

Compute ROI and residual income.

(LO 5), AP

*BE22-11 Sterling, Inc. reports the following financial information.

Average operating assets

$3,000,000

Controllable margin

$  630,000

Minimum rate of return

10%

Compute the return on investment and the residual income.

Compute ROI and residual income.

(LO 5), AP

*BE22-12 Presented below is information related to the Southern Division of Lumber, Inc.

Contribution margin

$1,200,000

Controllable margin

$  800,000

Average operating assets

$4,000,000

Minimum rate of return

15%

Compute the Southern Division's return on investment and residual income.

DO IT!

EXERCISES

Prepare and evaluate a static budget report.

(LO 1), AP

DO IT! 22-1 Wade Company estimates that it will produce 6,000 units of product IOA during the current month. Budgeted variable manufacturing costs per unit are direct materials $7, direct labor $13, and overhead $18. Monthly budgeted fixed manufacturing overhead costs are $8,000 for depreciation and $3,800 for supervision.

In the current month, Wade actually produced 6,500 units and incurred the following costs: direct materials $38,850, direct labor $76,440, variable overhead $116,640, depreciation $8,000, and supervision $4,000.

Prepare a static budget report. Hint: The Budget column is based on estimated production while the Actual column is the actual cost incurred during the period. (Note: You do not need to prepare the heading.) Were costs controlled? Discuss limitations of the budget.

Compute total budgeted costs in flexible budget.

(LO 2), AP

DO IT! 22-2 In Pargo Company's flexible budget graph, the fixed cost line and the total budgeted cost line intersect the vertical axis at $90,000. The total budgeted cost line is $350,000 at an activity level of 50,000 direct labor hours. Compute total budgeted costs at 65,000 direct labor hours.

Prepare a responsibility report.

(LO 3), AP

DO IT! 22-3 The Rockies Division operates as a profit center. It reports the following for the year:

Budget

Actual

Sales

$2,000,000

$1,890,000

Variable costs

800,000

760,000

Controllable fixed costs

550,000

550,000

Noncontrollable fixed costs

250,000

250,000

Prepare a responsibility report for the Rockies Division at December 31, 2017.

Compute ROI and expected return on investments.

(LO 4), AP

DO IT! 22-4 The service division of Raney Industries reported the following results for 2017.

Sales

$500,000

Variable costs

300,000

Controllable fixed costs

75,000

Average operating assets

625,000

Management is considering the following independent courses of action in 2018 in order to maximize the return on investment for this division.

1. Reduce average operating assets by $125,000, with no change in controllable margin.

2. Increase sales $100,000, with no change in the contribution margin percentage.

(a) Compute the controllable margin and the return on investment for 2017. (b) Compute the controllable margin and the expected return on investment for each proposed alternative.

EXERCISES

Understand the concept of budgetary control.

(LO 1, 2), K

E22-1 Connie Rice has prepared the following list of statements about budgetary control.

1. Budget reports compare actual results with planned objectives.

2. All budget reports are prepared on a weekly basis.

3. Management uses budget reports to analyze differences between actual and planned results and determine their causes.

4. As a result of analyzing budget reports, management may either take corrective action or modify future plans.

5. Budgetary control works best when a company has an informal reporting system.

6. The primary recipients of the sales report are the sales manager and the production supervisor.

7. The primary recipient of the scrap report is the production manager.

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

9. Top management's reaction to unfavorable differences is not influenced by the materiality of the difference.

10. A static budget is not appropriate in evaluating a manager's effectiveness in controlling costs unless the actual activity level approximates the static budget activity level or the behavior of the costs is fixed.

Instructions

Identify each statement as true or false. If false, indicate how to correct the statement.

Prepare and evaluate static budget report.

(LO 1), AN

E22-2 Crede Company budgeted selling expenses of $30,000 in January, $35,000 in February, and $40,000 in March. Actual selling expenses were $31,200 in January, $34,525 in February, and $46,000 in March.

Instructions

(a) Prepare a selling expense report that compares budgeted and actual amounts by month and for the year to date.

(b) What is the purpose of the report prepared in (a), and who would be the primary recipient?

(c) What would be the likely result of management's analysis of the report?

Prepare flexible manufacturing overhead budget.

(LO 2), AP

E22-3 Myers Company uses a flexible budget for manufacturing overhead based on direct labor hours. Variable manufacturing overhead costs per direct labor hour are as follows.

Indirect labor

$1.00

Indirect materials

0.70

Utilities

0.40

Fixed overhead costs per month are supervision $4,000, depreciation $1,200, and property taxes $800. The company believes it will normally operate in a range of 7,000–10,000 direct labor hours per month.

Instructions

Prepare a monthly manufacturing overhead flexible budget for 2017 for the expected range of activity, using increments of 1,000 direct labor hours.

Prepare flexible budget reports for manufacturing overhead costs, and comment on findings.

(LO 2), AN

E22-4 Using the information in E22-3, assume that in July 2017, Myers Company incurs the following manufacturing overhead costs.

Variable Costs

Fixed Costs

Indirect labor

$8,800

Supervision

$4,000

Indirect materials

5,800

Depreciation

1,200

Utilities

3,200

Property taxes

800

Instructions

(a) Prepare a flexible budget performance report, assuming that the company worked 9,000 direct labor hours during the month.

(b) Prepare a flexible budget performance report, assuming that the company worked 8,500 direct labor hours during the month.

(c) Comment on your findings.

Prepare flexible selling expense budget.

(LO 2), AP

E22-5 Fallon Company uses flexible budgets to control its selling expenses. Monthly sales are expected to range from $170,000 to $200,000. Variable costs and their percentage relationship to sales are sales commissions 6%, advertising 4%, traveling 3%, and delivery 2%. Fixed selling expenses will consist of sales salaries $35,000, depreciation on delivery equipment $7,000, and insurance on delivery equipment $1,000.

Instructions

Prepare a monthly flexible budget for each $10,000 increment of sales within the relevant range for the year ending December 31, 2017.

Prepare flexible budget reports for selling expenses.

(LO 2), AN

E22-6 The actual selling expenses incurred in March 2017 by Fallon Company are as follows.

Variable Expenses

Fixed Expenses

Sales commissions

$11,000

Sales salaries

$35,000

Advertising

6,900

Depreciation

7,000

Travel

5,100

Insurance

1,000

Delivery

3,450

Instructions

(a) Prepare a flexible budget performance report for March using the budget data in E22-5, assuming that March sales were $170,000.

(b) Prepare a flexible budget performance report, assuming that March sales were $180,000.

(c) Comment on the importance of using flexible budgets in evaluating the performance of the sales manager.

Prepare flexible budget report.

(LO 2), AP

E22-7 Appliance Possible Inc. (AP) is a manufacturer of toaster ovens. To improve control over operations, the president of AP wants to begin using a flexible budgeting system, rather than use only the current master budget. The following data are available for AP's expected costs at production levels of 90,000, 100,000, and 110,000 units.

Variable costs

Manufacturing

$6 per unit

Administrative

$4 per unit

Selling

$3 per unit

Fixed costs

Manufacturing

$160,000

Administrative

$ 80,000

Instructions

(a) Prepare a flexible budget for each of the possible production levels: 90,000, 100,000, and 110,000 units.

(b) If AP sells the toaster ovens for $16 each, how many units will it have to sell to make a profit of $60,000 before taxes?

(CGA adapted)

Prepare flexible budget report; compare flexible and static budgets.

(LO 1, 2), E

E22-8 Rensing Groomers is in the dog‐grooming business. Its operating costs are described by the following formulas:

Grooming supplies (variable)

y = $0 + $5x

Direct labor (variable)

y = $0 + $14x

Overhead (mixed)

y = $10,000 + $1x

Milo, the owner, has determined that direct labor is the cost driver for all three categories of costs.

Instructions

(a) Prepare a flexible budget for activity levels of 550, 600, and 700 direct labor hours.

(b) Explain why the flexible budget is more informative than the static budget.

(c) Calculate the total cost per direct labor hour at each of the activity levels specified in part (a).

(d) The groomers at Rensing normally work a total of 650 direct labor hours during each month. Each grooming job normally takes a groomer 1.3 hours. Milo wants to earn a profit equal to 40% of the costs incurred. Determine what he should charge each pet owner for grooming.

(CGA adapted)

Prepare flexible budget report, and answer question.

(LO 1, 2), E

E22-9 As sales manager, Joe Batista was given the following static budget report for selling expenses in the Clothing Department of Soria Company for the month of October.

SORIA COMPANY

Clothing Department

Budget Report

For the Month Ended October 31, 2017

Difference

Budget

Actual

Favorable F Unfavorable U

Sales in units

8,000

10,000

2,000 F

Variable expenses

Sales commissions

$2,400

$2,600

$200 U

Advertising expense

720

850

130 U

Travel expense

3,600

4,100

500 U

Free samples given out

1,600

1,400

200 F

Total variable

8,320

8,950

630 U

Fixed expenses

Rent

1,500

1,500

–0–

Sales salaries

1,200

1,200

–0–

Office salaries

800

800

–0–

Depreciation—autos (sales staff)

500

500

–0–

Total fixed

4,000

4,000

–0–

Total expenses

$12,320

$12,950

$630 U

As a result of this budget report, Joe was called into the president's office and congratulated on his fine sales performance. He was reprimanded, however, for allowing his costs to get out of control. Joe knew something was wrong with the performance report that he had been given. However, he was not sure what to do, and comes to you for advice.

Instructions

(a) Prepare a budget report based on flexible budget data to help Joe.

(b) Should Joe have been reprimanded? Explain.

Prepare flexible budget and responsibility report for manufacturing overhead.

(LO 2, 3), AP

E22-10 Chubbs Inc.'s manufacturing overhead budget for the first quarter of 2017 contained the following data.

Variable Costs

Fixed Costs

Indirect materials

$12,000

Supervisory salaries

$36,000

Indirect labor

10,000

Depreciation

7,000

Utilities

8,000

Property taxes and insurance

8,000

Maintenance

6,000

Maintenance

5,000

Actual variable costs were indirect materials $13,500, indirect labor $9,500, utilities $8,700, and maintenance $5,000. Actual fixed costs equaled budgeted costs except for property taxes and insurance, which were $8,300. The actual activity level equaled the budgeted level.

All costs are considered controllable by the production department manager except for depreciation, and property taxes and insurance.

Instructions

(a) Prepare a manufacturing overhead flexible budget report for the first quarter.

(b) Prepare a responsibility report for the first quarter.

Prepare and discuss a responsibility report.

(LO 2, 3), AP

E22-11 UrLink Company is a newly formed company specializing in high‐speed Internet service for home and business. The owner, Lenny Kirkland, had divided the company into two segments: Home Internet Service and Business Internet Service. Each segment is run by its own supervisor, while basic selling and administrative services are shared by both segments.

Lenny has asked you to help him create a performance reporting system that will allow him to measure each segment's performance in terms of its profitability. To that end, the following information has been collected on the Home Internet Service segment for the first quarter of 2017.

Budget

Actual

Service revenue

$25,000

$26,200

Allocated portion of:

Building depreciation

11,000

11,000

Advertising

5,000

4,200

Billing

3,500

3,000

Property taxes

1,200

1,000

Material and supplies

1,600

1,200

Supervisory salaries

9,000

9,500

Insurance

4,000

3,900

Wages

3,000

3,250

Gas and oil

2,800

3,400

Equipment depreciation

1,500

1,300

Instructions

(a) Prepare a responsibility report for the first quarter of 2017 for the Home Internet Service segment.

(b) Write a memo to Lenny Kirkland discussing the principles that should be used when preparing performance reports.

State total budgeted cost formulas, and prepare flexible budget graph.

(LO 2), AP

E22-12 Venetian Company has two production departments, Fabricating and Assembling. At a department managers' meeting, the controller uses flexible budget graphs to explain total budgeted costs. Separate graphs based on direct labor hours are used for each department. The graphs show the following.

1. At zero direct labor hours, the total budgeted cost line and the fixed cost line intersect the vertical axis at $50,000 in the Fabricating Department and $40,000 in the Assembling Department.

2. At normal capacity of 50,000 direct labor hours, the line drawn from the total budgeted cost line intersects the vertical axis at $150,000 in the Fabricating Department, and $120,000 in the Assembling Department.

Instructions

(a) State the total budgeted cost formula for each department.

(b) Compute the total budgeted cost for each department, assuming actual direct labor hours worked were 53,000 and 47,000, in the Fabricating and Assembling Departments, respectively.

(c) Prepare the flexible budget graph for the Fabricating Department, assuming the maximum direct labor hours in the relevant range is 100,000. Use increments of 10,000 direct labor hours on the horizontal axis and increments of $50,000 on the vertical axis.

Prepare reports in a responsibility reporting system.

(LO 3), AP

E22-13 Fey Company's organization chart includes the president; the vice president of production; three assembly plants—Dallas, Atlanta, and Tucson; and two departments within each plant—Machining and Finishing. Budget and actual manufacturing cost data for July 2017 are as follows.

1. Finishing Department—Dallas: direct materials $42,500 actual, $44,000 budget; direct labor $83,400 actual, $82,000 budget; manufacturing overhead $51,000 actual, $49,200 budget.

2. Machining Department—Dallas: total manufacturing costs $220,000 actual, $219,000 budget.

3. Atlanta Plant: total manufacturing costs $424,000 actual, $420,000 budget.

4. Tucson Plant: total manufacturing costs $494,200 actual, $496,500 budget.

The Dallas plant manager's office costs were $95,000 actual and $92,000 budget. The vice president of production's office costs were $132,000 actual and $130,000 budget. Office costs are not allocated to departments and plants.

Instructions

Using the format shown in Illustration 22-19 , prepare the reports in a responsibility system for:

(a) The Finishing Department—Dallas.

(b) The plant manager—Dallas.

(c) The vice president of production.

Prepare a responsibility report for a cost center.

(LO 3), AN

E22-14 The Mixing Department manager of Malone Company is able to control all overhead costs except rent, property taxes, and salaries. Budgeted monthly overhead costs for the Mixing Department, in alphabetical order, are:

Indirect labor

$12,000

Property taxes

$ 1,000

Indirect materials

7,700

Rent

1,800

Lubricants

1,675

Salaries

10,000

Maintenance

3,500

Utilities

5,000

Actual costs incurred for January 2017 are indirect labor $12,250; indirect materials $10,200; lubricants $1,650; maintenance $3,500; property taxes $1,100; rent $1,800; salaries $10,000; and utilities $6,400.

Instructions

(a) Prepare a responsibility report for January 2017.

(b) What would be the likely result of management's analysis of the report?

Compute missing amounts in responsibility reports for three profit centers, and prepare a report.

(LO 3), AN

E22-15 Horatio Inc. has three divisions which are operated as profit centers. Actual operating data for the divisions listed alphabetically are as follows.

Operating Data

Women's Shoes

Men's Shoes

Children's Shoes

Contribution margin

$270,000

(3)

$180,000

Controllable fixed costs

 100,000

(4)

(5)

Controllable margin

(1)

$ 90,000

  95,000

Sales

 600,000

 450,000

(6)

Variable costs

(2)

 320,000

 250,000

Instructions

(a) Compute the missing amounts. Show computations.

(b) Prepare a responsibility report for the Women's Shoes Division assuming (1) the data are for the month ended June 30, 2017, and (2) all data equal budget except variable costs which are $5,000 over budget.

Prepare a responsibility report for a profit center, and compute ROI.

(LO 3, 4), AP

E22-16 The Sports Equipment Division of Harrington Company is operated as a profit center. Sales for the division were budgeted for 2017 at $900,000. The only variable costs budgeted for the division were cost of goods sold ($440,000) and selling and administrative ($60,000). Fixed costs were budgeted at $100,000 for cost of goods sold, $90,000 for selling and administrative, and $70,000 for noncontrollable fixed costs. Actual results for these items were:

Sales

$880,000

Cost of goods sold

 Variable

408,000

 Fixed

105,000

Selling and administrative

 Variable

61,000

 Fixed

66,000

Noncontrollable fixed

90,000

Instructions

(a) Prepare a responsibility report for the Sports Equipment Division for 2017.

(b) Assume the division is an investment center, and average operating assets were $1,000,000. The noncontrollable fixed costs are controllable at the investment center level. Compute ROI.

Compute ROI for current year and for possible future changes.

(LO 4), AP

E22-17 The South Division of Wiig Company reported the following data for the current year.

Sales

$3,000,000

Variable costs

1,950,000

Controllable fixed costs

600,000

Average operating assets

5,000,000

Top management is unhappy with the investment center's return on investment (ROI). It asks the manager of the South Division to submit plans to improve ROI in the next year. The manager believes it is feasible to consider the following independent courses of action.

1. Increase sales by $300,000 with no change in the contribution margin percentage.

2. Reduce variable costs by $150,000.

3. Reduce average operating assets by 4%.

Instructions

(a) Compute the return on investment (ROI) for the current year.

(b) Using the ROI formula, compute the ROI under each of the proposed courses of action. (Round to one decimal.)

Prepare a responsibility report for an investment center.

(LO 4), AP

E22-18 The Dinkle and Frizell Dental Clinic provides both preventive and orthodontic dental services. The two owners, Reese Dinkle and Anita Frizell, operate the clinic as two separate investment centers: Preventive Services and Orthodontic Services. Each of them is in charge of one of the centers: Reese for Preventive Services and Anita for Orthodontic Services. Each month, they prepare an income statement for the two centers to evaluate performance and make decisions about how to improve the operational efficiency and profitability of the clinic.

Recently, they have been concerned about the profitability of the Preventive Services operations. For several months, it has been reporting a loss. The responsibility report for the month of May 2017 is shown below.

Actual

Difference from Budget

Service revenue

$ 40,000

$1,000 F

Variable costs

Filling materials

5,000

100 U

Novocain

3,900

100 U

Supplies

1,900

350 F

Dental assistant wages

2,500

–0–

Utilities

500

110 U

Total variable costs

13,800

40 F

Fixed costs

Allocated portion of receptionist's salary

3,000

200 U

Dentist salary

9,800

400 U

Equipment depreciation

6,000

–0–

Allocated portion of building depreciation

15,000

1,000 U

Total fixed costs

33,800

1,600 U

Operating income (loss)

$ (7,600)

$ 560 U

In addition, the owners know that the investment in operating assets at the beginning of the month was $82,400, and it was $77,600 at the end of the month. They have asked for your assistance in evaluating their current performance reporting system.

Instructions

(a) Prepare a responsibility report for an investment center as illustrated in the chapter.

(b) Write a memo to the owners discussing the deficiencies of their current reporting system.

Prepare missing amounts in responsibility reports for three investment centers.

(LO 4), AN

E22-19 The Ferrell Transportation Company uses a responsibility reporting system to measure the performance of its three investment centers: Planes, Taxis, and Limos. Segment performance is measured using a system of responsibility reports and return on investment calculations. The allocation of resources within the company and the segment managers' bonuses are based in part on the results shown in these reports.

Recently, the company was the victim of a computer virus that deleted portions of the company's accounting records. This was discovered when the current period's responsibility reports were being prepared. The printout of the actual operating results appeared as follows.

Planes

Taxis

Limos

Service revenue

$    ?      

$500,000

$    ?     

Variable costs

5,500,000

?     

300,000

Contribution margin

?      

250,000

480,000

Controllable fixed costs

1,500,000

?     

?     

Controllable margin

?      

80,000

210,000

Average operating assets

25,000,000

?     

1,500,000

Return on investment

12%

10%

?     

Instructions

Determine the missing pieces of information above.

Compare ROI and residual income.

(LO 5), AN

*E22-20 Presented below is selected information for three regional divisions of Medina Company.

Divisions

North

West

South

Contribution margin

$  300,000  

$  500,000  

$  400,000  

Controllable margin

$  140,000  

$  360,000  

$  210,000  

Average operating assets

$1,000,000  

$2,000,000  

$1,500,000  

Minimum rate of return

13%

16%

10%

Instructions

(a) Compute the return on investment for each division.

(b) Compute the residual income for each division.

(c) Assume that each division has an investment opportunity that would provide a rate of return of 16%.

1. If ROI is used to measure performance, which division or divisions will probably make the additional investment?

2. If residual income is used to measure performance, which division or divisions will probably make the additional investment?

Fill in information related to ROI and residual income.

(LO 5), AN

*E22-21 Presented below is selected financial information for two divisions of Samberg Brewing.

Lager

Lite Lager

Contribution margin

$500,000

$  300,000

Controllable margin

200,000

    (c)   

Average operating assets

  (a)   

$1,200,000

Minimum rate of return

  (b)   

11%

Return on investment

16%

    (d)   

Residual income

$100,000

$ 204,000

Instructions

Supply the missing information for the lettered items.

EXERCISES: SET B AND CHALLENGE EXERCISES

Visit the book's companion website, at www.wiley.com/college/kimmel , and choose the Student Companion site to access Exercises: Set B and Challenge Exercises.

PROBLEMS: SET A

Prepare flexible budget and budget report for manufacturing overhead.

(LO 2), AN

P22-1A Bumblebee Company estimates that 300,000 direct labor hours will be worked during the coming year, 2017, in the Packaging Department. On this basis, the following budgeted manufacturing overhead cost data are computed for the year.

Fixed Overhead Costs

Variable Overhead Costs

Supervision

$ 96,000

Indirect labor

$126,000

Depreciation

72,000

Indirect materials

90,000

Insurance

30,000

Repairs

69,000

Rent

24,000

Utilities

72,000

Property taxes

  18,000

Lubricants

  18,000

$240,000

$375,000

It is estimated that direct labor hours worked each month will range from 27,000 to 36,000 hours.

During October, 27,000 direct labor hours were worked and the following overhead costs were incurred.

1. Fixed overhead costs: supervision $8,000, depreciation $6,000, insurance $2,460, rent $2,000, and property taxes $1,500.

2. Variable overhead costs: indirect labor $12,432, indirect materials $7,680, repairs $6,100, utilities $6,840, and lubricants $1,920.

Instructions

(a) Prepare a monthly manufacturing overhead flexible budget for each increment of 3,000 direct labor hours over the relevant range for the year ending December 31, 2017.

(a) Total costs: DLH 27,000, $53,750; DLH 36,000, $65,000

(b) Prepare a flexible budget report for October.

(b) Total $1,182 U

(c) Comment on management's efficiency in controlling manufacturing overhead costs in October.

Prepare flexible budget, budget report, and graph for manufacturing overhead.

(LO 2), E

P22-2A Zelmer Company manufactures tablecloths. Sales have grown rapidly over the past 2 years. As a result, the president has installed a budgetary control system for 2017. The following data were used in developing the master manufacturing overhead budget for the Ironing Department, which is based on an activity index of direct labor hours.

Variable Costs

Rate per Direct Labor Hour

Annual Fixed Costs

Indirect labor

$0.40

Supervision

$48,000

Indirect materials

 0.50

Depreciation

18,000

Factory utilities

 0.30

Insurance

12,000

Factory repairs

 0.20

Rent

30,000

The master overhead budget was prepared on the expectation that 480,000 direct labor hours will be worked during the year. In June, 41,000 direct labor hours were worked. At that level of activity, actual costs were as shown below.

1. Variable—per direct labor hour: indirect labor $0.44, indirect materials $0.48, factory utilities $0.32, and factory repairs $0.25.

2. Fixed: same as budgeted.

Instructions

(a) Prepare a monthly manufacturing overhead flexible budget for the year ending December 31, 2017, assuming production levels range from 35,000 to 50,000 direct labor hours. Use increments of 5,000 direct labor hours.

(a) Total costs: 35,000 DLH, $58,000; 50,000 DLH, $79,000

(b) Prepare a budget report for June comparing actual results with budget data based on the flexible budget.

(b) Budget $66,400 Actual $70,090

(c) Were costs effectively controlled? Explain.

(d) State the formula for computing the total budgeted costs for the Ironing Department.

(e) Prepare the flexible budget graph, showing total budgeted costs at 35,000 and 45,000 direct labor hours. Use increments of 5,000 direct labor hours on the horizontal axis and increments of $10,000 on the vertical axis.

State total budgeted cost formula, and prepare flexible budget reports for 2 time periods.

(LO 1, 2), AN

P22-3A Ratchet Company uses budgets in controlling costs. The August 2017 budget report for the company's Assembling Department is as follows.

RATCHET COMPANY

Budget Report

Assembling Department

For the Month Ended August 31, 2017

Difference

Manufacturing Costs

Budget

Actual

Favorable F Unfavorable U

Variable costs

  Direct materials

$ 48,000

$ 47,000

$1,000 F

  Direct labor

54,000

51,200

 2,800 F

  Indirect materials

24,000

24,200

  200 U

  Indirect labor

18,000

17,500

  500 F

  Utilities

15,000

14,900

  100 F

  Maintenance

  12,000

  12,400

  400 U

    Total variable

  171,000

  167,200

  3,800 F

Fixed costs

  Rent

12,000

12,000

–0–

  Supervision

17,000

17,000

–0–

  Depreciation

  6,000

  6,000

  –0– 

    Total fixed

  35,000

  35,000

  –0– 

Total costs

$206,000

$202,200

$3,800 F

The monthly budget amounts in the report were based on an expected production of 60,000 units per month or 720,000 units per year. The Assembling Department manager is pleased with the report and expects a raise, or at least praise for a job well done. The company president, however, is unhappy with the results for August because only 58,000 units were produced.

Instructions

(a) State the total monthly budgeted cost formula.

(b) Prepare a budget report for August using flexible budget data. Why does this report provide a better basis for evaluating performance than the report based on static budget data?

(b) Budget $200,300

(c) In September, 64,000 units were produced. Prepare the budget report using flexible budget data, assuming (1) each variable cost was 10% higher than its actual cost in August, and (2) fixed costs were the same in September as in August.

(c) Budget $217,400 Actual $218,920

Prepare responsibility report for a profit center.

(LO 3), AN

P22-4A Clarke Inc. operates the Patio Furniture Division as a profit center. Operating data for this division for the year ended December 31, 2017, are as shown below.

Budget

Difference from Budget

Sales

$2,500,000

$50,000 F    

Cost of goods sold

Variable

 1,300,000

 41,000 F    

Controllable fixed

   200,000

  3,000 U    

Selling and administrative

Variable

   220,000

  6,000 U    

Controllable fixed

    50,000

  2,000 U    

Noncontrollable fixed costs

    70,000

  4,000 U    

In addition, Clarke incurs $180,000 of indirect fixed costs that were budgeted at $175,000. Twenty percent (20%) of these costs are allocated to the Patio Furniture Division.

Instructions

(a) Prepare a responsibility report for the Patio Furniture Division for the year.

(a) Contribution margin $85,000 F Controllable margin $80,000 F

(b) Comment on the manager's performance in controlling revenues and costs.

(c) Identify any costs excluded from the responsibility report and explain why they were excluded.

Prepare responsibility report for an investment center, and compute ROI.

(LO 4), E

P22-5A Optimus Company manufactures a variety of tools and industrial equipment. The company operates through three divisions. Each division is an investment center. Operating data for the Home Division for the year ended December 31, 2017, and relevant budget data are as follows.

Actual

Comparison with Budget

Sales

$1,400,000

$100,000 favorable

Variable cost of goods sold

665,000

  45,000 unfavorable

Variable selling and administrative expenses

125,000

  25,000 unfavorable

Controllable fixed cost of goods sold

170,000

On target

Controllable fixed selling and administrative expenses

80,000

On target

Average operating assets for the year for the Home Division were $2,000,000 which was also the budgeted amount.

Instructions

(a) Prepare a responsibility report (in thousands of dollars) for the Home Division.

(a) Controllable margin: Budget $330; Actual $360

(b) Evaluate the manager's performance. Which items will likely be investigated by top management?

(c) Compute the expected ROI in 2017 for the Home Division, assuming the following independent changes to actual data.

(1) Variable cost of goods sold is decreased by 5%.

(2) Average operating assets are decreased by 10%.

(3) Sales are increased by $200,000, and this increase is expected to increase contribution margin by $80,000.

Prepare reports for cost centers under responsibility accounting, and comment on performance of managers.

(LO 3), AN

P22-6A Durham Company uses a responsibility reporting system. It has divisions in Denver, Seattle, and San Diego. Each division has three production departments: Cutting, Shaping, and Finishing. The responsibility for each department rests with a manager who reports to the division production manager. Each division manager reports to the vice president of production. There are also vice presidents for marketing and finance. All vice presidents report to the president.

In January 2017, controllable actual and budget manufacturing overhead cost data for the departments and divisions were as shown below.

Manufacturing Overhead

Actual

Budget

Individual costs—Cutting Department—Seattle

  Indirect labor

$ 73,000

$ 70,000

  Indirect materials

47,900

46,000

  Maintenance

20,500

18,000

  Utilities

20,100

17,000

  Supervision

  22,000

  20,000

$183,500

$171,000

Total costs

  Shaping Department—Seattle

$158,000

$148,000

  Finishing Department—Seattle

210,000

205,000

  Denver division

678,000

673,000

  San Diego division

722,000

715,000

Additional overhead costs were incurred as follows: Seattle division production manager—actual costs $52,500, budget $51,000; vice president of production—actual costs $65,000, budget $64,000; president—actual costs $76,400, budget $74,200. These expenses are not allocated.

The vice presidents who report to the president, other than the vice president of production, had the following expenses.

Vice President

Actual

Budget

Marketing

$133,600

$130,000

Finance

109,000

104,000

Instructions

(a) Using the format on page 1081, prepare the following responsibility reports.

(1) Manufacturing overhead—Cutting Department manager—Seattle division.

(2) Manufacturing overhead—Seattle division manager.

(3) Manufacturing overhead—vice president of production.

(4) Manufacturing overhead and expenses—president.

(a) (1) $12,500 U

(2) $29,000 U

(3) $42,000 U

(4) $52,800 U

(b) Comment on the comparative performances of:

(1) Department managers in the Seattle division.

(2) Division managers.

(3) Vice presidents.

Compare ROI and residual income.

(LO 5), AN

*P22-7A Sentinel Industries has manufactured prefabricated houses for over 20 years. The houses are constructed in sections to be assembled on customers' lots. Sentinel expanded into the precut housing market when it acquired Jensen Company, one of its suppliers. In this market, various types of lumber are precut into the appropriate lengths, banded into packages, and shipped to customers' lots for assembly. Sentinel designated the Jensen Division as an investment center.

Sentinel uses return on investment (ROI) as a performance measure with investment defined as average operating assets. Management bonuses are based in part on ROI. All investments are expected to earn a minimum rate of return of 18%. Jensen's ROI has ranged from 20.1% to 23.5% since it was acquired. Jensen had an investment opportunity in 2017 that had an estimated ROI of 19%. Jensen management decided against the investment because it believed the investment would decrease the division's overall ROI.

Selected financial information for Jensen are presented below. The division's average operating assets were $12,300,000 for the year 2017.

SENTINEL INDUSTRIES

Jensen Division

Selected Financial Information

For the Year Ended December 31, 2017

Sales

$24,000,000

Contribution margin

9,100,000

Controllable margin

2,460,000

Instructions

(a) Calculate the following performance measures for 2017 for the Jensen Division.

(1) Return on investment (ROI).

(2) Residual income.

(b) Would the management of Jensen Division have been more likely to accept the investment opportunity it had in 2017 if residual income were used as a performance measure instead of ROI? Explain your answer.

(CMA adapted)

PROBLEMS: SET B AND SET C

Visit the book's companion website, at www.wiley.com/college/kimmel , and choose the Student Companion site to access Problems: Set B and Set C.

CONTINUING PROBLEMS

CURRENT DESIGNS

CD22 The Current Designs staff has prepared the annual manufacturing budget for the rotomolded line based on an estimated annual production of 4,000 kayaks during 2017. Each kayak will require 54 pounds of polyethylene powder and a finishing kit (rope, seat, hardware, etc.). The polyethylene powder used in these kayaks costs $1.50 per pound, and the finishing kits cost $170 each. Each kayak will use two kinds of labor—2 hours of type I labor from people who run the oven and trim the plastic, and 3 hours of work from type II workers who attach the hatches and seat and other hardware. The type I employees are paid $15 per hour, and the type II are paid $12 per hour.

EXCEL TUTORIAL

Manufacturing overhead is budgeted at $396,000 for 2017, broken down as follows.

Variable costs

Indirect materials

$ 40,000

Manufacturing supplies

53,800

Maintenance and utilities

  88,000

  181,800

Fixed costs

Supervision

90,000

Insurance

14,400

Depreciation

  109,800

  214,200

Total

$396,000

During the first quarter, ended March 31, 2017, 1,050 units were actually produced with the following costs.

Polyethylene powder

$ 87,000

Finishing kits

178,840

Type I labor

31,500

Type II labor

39,060

Indirect materials

10,500

Manufacturing supplies

14,150

Maintenance and utilities

26,000

Supervision

20,000

Insurance

3,600

Depreciation

27,450

Total

$438,100

Instructions

(a) Prepare the annual manufacturing budget for 2017, assuming that 4,000 kayaks will be produced.

(b) Prepare the flexible budget for manufacturing for the quarter ended March 31, 2017. Assume activity levels of 900, 1,000, and 1,050 units.

(c) Assuming the rotomolded line is treated as a profit center, prepare a flexible budget report for manufacturing for the quarter ended March 31, 2017, when 1,050 units were produced.

WATERWAYS

(Note: This is a continuation of the Waterways problem from Chapters 14 – 21 .)

WP22 Waterways Corporation is continuing its budget preparations. This problem gives you static budget information as well as actual overhead costs, and asks you to calculate amounts related to budgetary control and responsibility accounting.

Go to the book's companion website, at www.wiley.com/college/kimmel , to find the completion of this problem.

  EXPAND YOUR | CRITICAL THINKING

DECISION‐MAKING ACROSS THE ORGANIZATION

CT22-1 Green Pastures is a 400‐acre farm on the outskirts of the Kentucky Bluegrass, specializing in the boarding of broodmares and their foals. A recent economic downturn in the thoroughbred industry has led to a decline in breeding activities, and it has made the boarding business extremely competitive. To meet the competition, Green Pastures planned in 2017 to entertain clients, advertise more extensively, and absorb expenses formerly paid by clients such as veterinary and blacksmith fees.

The budget report for 2017 is presented below. As shown, the static income statement budget for the year is based on an expected 21,900 boarding days at $25 per mare. The variable expenses per mare per day were budgeted: feed $5, veterinary fees $3, blacksmith fees $0.25, and supplies $0.55. All other budgeted expenses were either semifixed or fixed.

During the year, management decided not to replace a worker who quit in March, but it did issue a new advertising brochure and did more entertaining of clients. 1

GREEN PASTURES

Static Budget Income Statement

For the Year Ended December 31, 2017

Actual

Master Budget

Difference

Number of mares

      52

      60

      8 U

Number of boarding days

  19,000

  21,900

  2,900 U

Sales

$380,000

$547,500

$167,500 U

Less: Variable expenses

  Feed

104,390

109,500

5,110 F

  Veterinary fees

58,838

65,700

6,862 F

  Blacksmith fees

4,984

5,475

491 F

  Supplies

  10,178

  12,045

  1,867 F

Total variable expenses

 178,390

 192,720

  14,330 F

Contribution margin

 201,610

 354,780

 153,170 U

Less: Fixed expenses

  Depreciation

40,000

40,000

–0– 

  Insurance

11,000

11,000

–0– 

  Utilities

12,000

14,000

2,000 F

  Repairs and maintenance

10,000

11,000

1,000 F

  Labor

88,000

95,000

7,000 F

  Advertisement

12,000

8,000

4,000 U

  Entertainment

   7,000

   5,000

   2,000 U

Total fixed expenses

 180,000

 184,000

 4,000 F

Net income

$ 21,610

$170,780

$149,170 U

Instructions

With the class divided into groups, answer the following.

(a) Based on the static budget report:

(1) What was the primary cause(s) of the loss in net income?

(2) Did management do a good, average, or poor job of controlling expenses?

(3) Were management's decisions to stay competitive sound?

(b) Prepare a flexible budget report for the year.

(c) Based on the flexible budget report, answer the three questions in part (a) above.

(d) What course of action do you recommend for the management of Green Pastures?

AN

MANAGERIAL ANALYSIS

CT22-2 Lanier Company manufactures expensive watch cases sold as souvenirs. Three of its sales departments are Retail Sales, Wholesale Sales, and Outlet Sales. The Retail Sales Department is a profit center. The Wholesale Sales Department is a cost center. Its managers merely take orders from customers who purchase through the company's wholesale catalog. The Outlet Sales Department is an investment center because each manager is given full responsibility for an outlet store location. The manager can hire and discharge employees, purchase, maintain, and sell equipment, and in general is fairly independent of company control.

Mary Gammel is a manager in the Retail Sales Department. Stephen Flott manages the Wholesale Sales Department. Jose Gomez manages the Golden Gate Club outlet store in San Francisco. The following are the budget responsibility reports for each of the three departments.

Budget

Retail Sales

Wholesale Sales

Outlet Sales

Sales

$  750,000

$  400,000

$200,000

Variable costs

  Cost of goods sold

150,000

100,000

25,000

  Advertising

100,000

30,000

5,000

  Sales salaries

75,000

15,000

3,000

  Printing

10,000

20,000

5,000

  Travel

20,000

30,000

2,000

Fixed costs

  Rent

50,000

30,000

10,000

  Insurance

5,000

2,000

1,000

  Depreciation

75,000

100,000

40,000

Investment in assets

1,000,000

1,200,000

800,000

Actual Results

Retail Sales

Wholesale Sales

Outlet Sales

Sales

$  750,000

$  400,000

$200,000

Variable costs

  Cost of goods sold

192,000

122,000

26,500

  Advertising

100,000

30,000

5,000

  Sales salaries

75,000

15,000

3,000

  Printing

10,000

20,000

5,000

  Travel

14,000

21,000

1,500

Fixed costs

  Rent

40,000

50,000

12,300

  Insurance

5,000

2,000

1,000

  Depreciation

80,000

90,000

56,000

Investment in assets

1,000,000

1,200,000

800,000

Instructions

(a) Determine which of the items should be included in the responsibility report for each of the three managers.

(b) Compare the budgeted measures with the actual results. Decide which results should be called to the attention of each manager.

AP

REAL‐WORLD FOCUS

CT22-3 Computer Associates International, Inc., the world's leading business software company, delivers the end‐to‐end infrastructure to enable e‐business through innovative technology, services, and education. Recently, Computer Associates had 19,000 employees worldwide and revenue of over $6 billion.

The following information is from the company's annual report.

COMPUTER ASSOCIATES INTERNATIONAL, INC. Management Discussion

The Company has experienced a pattern of business whereby revenue for its third and fourth fiscal quarters reflects an increase over first‐ and second‐quarter revenue. The Company attributes this increase to clients' increased spending at the end of their calendar year budgetary periods and the culmination of its annual sales plan. Since the Company's costs do not increase proportionately with the third‐ and fourth‐quarters' increase in revenue, the higher revenue in these quarters results in greater profit margins and income. Fourth‐quarter profitability is traditionally affected by significant new hirings, training, and education expenditures for the succeeding year.

Instructions

(a) Why don't the company's costs increase proportionately as the revenues increase in the third and fourth quarters?

(b) What type of budgeting seems appropriate for the Computer Associates situation?

C  CT22-4 There are many useful resources regarding budgeting available on websites. The following activity investigates the results of a comprehensive budgeting study.

Address: http://www.accountingweb.com/whitepapers/centage_ioma.pdf, or go to www.wiley.com/college/kimmel

Instructions

Go to the address above and then answer the following questions.

(a) What are cited as the two most common “pain points” of budgeting?

(b) What percentage of companies that participated in the survey said that they prepare annual budgets? Of those that prepare budgets, what percentage say that they start the budgeting process by first generating sales projections?

(c) What is the most common amount of time for the annual budgeting process?

(d) When evaluating variances from budgeted amounts, what was the most commonly defined range of acceptable tolerance levels?

(e) The study defines three types of consequences for varying from budgeted amounts. How does it describe “severe” consequences?

COMMUNICATION ACTIVITY

CT22-5 The manufacturing overhead budget for Fleming Company contains the following items.

Variable costs

Fixed costs

Indirect materials

$22,000

Supervision

$17,000

Indirect labor

12,000

Inspection costs

1,000

Maintenance expense

10,000

Insurance expense

2,000

Manufacturing supplies

  6,000

Depreciation

  15,000

Total variable

$50,000

Total fixed

$35,000

The budget was based on an estimated 2,000 units being produced. During the past month, 1,500 units were produced, and the following costs incurred.

Variable costs

Fixed costs

Indirect materials

$22,500

Supervision

$18,400

Indirect labor

13,500

Inspection costs

1,200

Maintenance expense

8,200

Insurance expense

2,200

Manufacturing supplies

  5,000

Depreciation

  14,700

Total variable

$49,200

Total fixed

$36,500

Instructions

(a) Determine which items would be controllable by Fred Bedner, the production manager.

(b) How much should have been spent during the month for the manufacture of the 1,500 units?

(c) Prepare a flexible manufacturing overhead budget report for Mr. Bedner.

(d) Prepare a responsibility report. Include only the costs that would have been controllable by Mr. Bedner. Assume that the supervision cost above includes Mr. Bedner's salary of $10,000, both at budget and actual. In an attached memo, describe clearly for Mr. Bedner the areas in which his performance needs to be improved.

E

ETHICS CASE

CT22-6 American Products Corporation participates in a highly competitive industry. In order to meet this competition and achieve profit goals, the company has chosen the decentralized form of organization. Each manager of a decentralized investment center is measured on the basis of profit contribution, market penetration, and return on investment. Failure to meet the objectives established by corporate management for these measures has not been acceptable and usually has resulted in demotion or dismissal of an investment center manager.

An anonymous survey of managers in the company revealed that the managers feel the pressure to compromise their personal ethical standards to achieve the corporate objectives. For example, at certain plant locations there was pressure to reduce quality control to a level which could not assure that all unsafe products would be rejected. Also, sales personnel were encouraged to use questionable sales tactics to obtain orders, including gifts and other incentives to purchasing agents.

The chief executive officer is disturbed by the survey findings. In his opinion, such behavior cannot be condoned by the company. He concludes that the company should do something about this problem.

Instructions

(a) Who are the stakeholders (the affected parties) in this situation?

(b) Identify the ethical implications, conflicts, or dilemmas in the above described situation.

(c) What might the company do to reduce the pressures on managers and decrease the ethical conflicts?

(CMA adapted)

E

ALL ABOUT YOU

CT22-7 It is one thing to prepare a personal budget; it is another thing to stick to it. Financial planners have suggested various mechanisms to provide support for enforcing personal budgets. One approach is called “envelope budgeting.”

Instructions

Read the article provided at http://en.wikipedia.org/wiki/Envelope_budgeting, and answer the following questions.

(a) Summarize the process of envelope budgeting.

(b) Evaluate whether you think you would benefit from envelope budgeting. What do you think are its strengths and weaknesses relative to your situation?

E

CONSIDERING YOUR COSTS AND BENEFITS

CT22-8 Preparing a personal budget is a great first step toward control over your personal finances. It is especially useful to prepare a budget when you face a big decision. For most people, the biggest decision they will ever make is whether to purchase a house. The percentage of people in the United States who own a home is high compared to many other countries. This is partially the result of U.S. government programs and incentives that encourage home ownership. For example, the interest on a home mortgage is tax‐deductible.

Before purchasing a house, you should first consider whether buying it is the best choice for you. Suppose you just graduated from college and are moving to a new community. Should you immediately buy a new home?

1. YES: If I purchase a home, I am making my housing cost more like a “fixed cost,” thus minimizing increases in my future housing costs. Also, I benefit from the appreciation in my home's value. Although recent turbulence in the economy has caused home prices in many communities to decline, I know that over the long term, home prices have increased across the country.

2. NO: I just moved to a new town, so I don't know the housing market. I am new to my job, so I don't know whether I will like it or my new community. Also, if my job does go well, it is likely that my income will increase in the next few years, so I will able to afford a better house if I wait. Therefore, the flexibility provided by renting is very valuable to me at this point in my life.

Instructions

Write a response indicating your position regarding this situation. Provide support for your view.

1 Data for this case are based on Hans Sprohge and Joh