When preparing a flexible budget the level of activity

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).