12 - 1 2001 prentice hall business publishing management accounting, 3/e, atkinson, banker, kaplan,...

12 - 1 2001 Prentice Hall Business Publishing Management Accounting, 3/E, Atkinson, Banker, Kaplan, and Young

Responsibility Centers and Financial Control

Chapter 12


Introduction

Georgia Tech University developed and maintained athletic programs to generate revenue, to attract top students, and to support alumni fund raising.


Introduction

The early 1990s saw the costs of athletic programs at many universities spiraling out of control.

The tightening cost environment created a situation of desperation that called for the development and implementation of a system of financial control for varsity sports.


Learning Objectives

1 Describe the form and nature of variance analysis and apply its basic insights.

2 Show why organizations use responsibility centers.

3 Recognize the common forms of responsibility centers.

4 Identify the issues to consider and basic tools to use in assessing the performance of a responsibility center.


Learning Objectives

5 Assess the issues and problems created by revenue and cost interactions in evaluating the performance of an organization unit.

6 Identify the transfer-pricing alternatives available to organizations and the criteria for choosing a transfer pricing alternative.

7 Use return on investment and economic value added as financial control tools.

8 Identify the limitations of financial controls.


Learning Objective 1

Describe the form and nature of variance analysis and apply its basic insights.


Variances What are variances? Variances are differences between actual

and estimated costs. Variance analysis is a necessary step to

understand why a difference occurred.


First-Level Variances

The first-level variance for a cost item is the difference between the actual and master budget costs.

Variances are “favorable” if the actual costs are less than estimated costs.

Variances are “unfavorable” if the actual costs exceeds estimated costs.


First-Level VariancesCanning Cellular Services (000)

Master ActualBudget Costs Difference

Direct Material – Welcome Package 25,000 29,700 4,700

Direct Labor – Sales Staff 12,500 14,850 2,350 – Technical Staff 10,000 10,890 890

Support Cost – Data Processing 3,000 3,960 960 – System Activation 45,000 42,900 – 2,100

Total Customer-Related Costs 95,500 102,300 6,800


Decomposing Variances

What are flexible budgets? Flexible budgets recast cost targets in the

planned or master budget to reflect the actual level of production.

This allows comparisons of actual results to targets based on the achieved level of production.



What are planning variances? They reflect the effect of the volume

change between the master budget and actual activity level achieved.

What are flexible budget variances? They show the differences between the

flexible budget and the actual results.



Master Budget– Flexible Budget

= Planning Variance

Flexible Budget– Actual Results

= Flexible Budget Variance

Planning variances and flexible budgetvariances are called secondary variances.



What is the direct material efficiency or usage variance?

It is actual quantity used at target or standard price less the flexible budget allowance at the planned or target price.

Usage Variance = (AQ – SQ) × SP What is the direct material price variance? Price Variance = (AP – SP) × AQ



What is the efficiency or usage variance for direct labor costs?

Efficiency Variance = (AH – SH) × SR What is the rate variance for direct labor

costs? Rate Variance = (AR – SR) × AH Support costs can also be analyzed in detail.



Support costs can reflect flexible or capacity-related costs.

The quantity of capacity-related costs may not change from period to period, but the spending on them may fluctuate.

What are flexible support costs? They reflect operations that are proportional

to the volume of activity.



Master Planning FlexibleBudget Variance Budget

Direct Material – Welcome Package 25,000 2,500 27,500

Direct Labor – Sales Staff 12,500 1,250 13,750 – Technical Staff 10,000 1,000 11,000

Support Cost – Data Processing 3,000 300 3,300 – System Activation 45,000 4,500 49,500

Total Customer-Related Costs 95,500 9,550 105,050

Canning Cellular Services (000)



Flexible Actual Budget Variance Results

Direct Material – Welcome Package 2,200 29,700

Direct Labor – Sales Staff 1,100 14,850 – Technical Staff – 110 10,890

Support Cost – Data Processing 660 3,960 – System Activation – 6,600 42,900

Total Customer-Related Costs – 2,750 102,300

Canning Cellular Services (000)



The following information relates to Canning Cellular Service:

The actual number of new customers were 1,100,000.

Direct MaterialsSQ: 1 AQ: 1

SP: $25 AP: $27

Direct LaborSales Staff

SH: .50 AH: .45SR: $25 AR: $30



Direct LaborTechnical Staff

SH: .25 AH: .22SR: $40 AR: $45

Support CostData ProcessingSH: .20 AH: .24SR: $15 AR: $15

Support CostSystem ActivationSH: .15 AH: .12

SR: $300 AR: $325



Materials efficiency variance = 0 Materials price variance:

($25 SP – $27 AP) × 1,100,000 = $2,200,000 U

Flexible budget variance = $2,200,000 U Sales staff efficiency variance:

(550,000 SH – 495,000 AH) × $25 = $1,375,000 F



Sales staff rate variance: ($25 SR – $30 AR) × 495,000 = $2,475,000 U

Flexible budget variance = $1,100,000 U Technical staff efficiency variance:

(275,000 SH – 242,000 AH ) × $40 = $1,320,000 F



Technical staff rate variance: ($40 SR – $4 AR) × 242,000 = $1,210,000 U

Flexible budget variance = $110,000 F

Support cost data processing efficiency: variance (220,000 SH – 264,000 AH) × $15 = $660,000 U

Rate variance = 0 Flexible budget variance = $660,000 U



Support cost system activation efficiency variance: (165,000 SH – 132,000 AH) × $300 = $9,900,000 F

Support cost system activation rate variance ($300 SR – $325 AR) × 132,000 = $3,300,000 U

Flexible budget variance = $6,600,000 F



MasterBudget

FlexibleBudget

ActualResults

Planning Variance Flexible Budget Variance

Total Variance



Usage Variance

Flexible Budget Variance

Actual Quantity× Standard Price

Standard Quantity× Standard Price

Actual Quantity× Actual Price

Price Variance



Second Level VariancesPlanning variances

Flexible budget variances

First Level VariancesDifference between the actual

and master budget costs

Third Level VariancesUse and price variances



Show why organizations use responsibility centers.


Decentralization

What are centralized organizations? Organizations which reserve most of the

decision-making power for senior executives.

Centralization works effectively in organizations with stable environments.


Decentralization

What are decentralized organizations? Organizations which delegate a good deal

of the decision-making authority to lower-level managers.

Decentralized organizations are effective in environments requiring quick responses to change.


Decentralization

Three conditions are necessary for effective decentralization:

1 Employees must be given, and accept, the authority and responsibility to make decisions.


Decentralization

2 Employees must have the training and skills they need to accept the decision making responsibility.

3 The organization must have a system in place that guides and coordinates the activities of decentralized decision makers.


Controlling Operations

The major purpose of decentralization is to give decision makers the responsibility to make operating decisions.

This creates a need for operations control. What is the focus of operations control? It focuses on finding the best operating

decisions.


Controlling Operations

What is the focus of financial control? It focuses on an overall assessment of how

well operations control is working to improve financial performance.



Recognize the common forms of responsibility centers.


Responsibility Centers

What is a responsibility center? It is an organization unit for which a

manager is made responsible. The center’s manager and supervisor

establish specific and measurable goals for the responsibility center.

The goals should promote the long-term interest of the organization.



Responsibility centers are classified into four types:

1 Cost centers2 Revenue centers3 Profit centers4 Investment centers



What is a cost center? It is a responsibility center whose

employees control costs but do not control its revenues or investment level.



What is a revenue center? It is a responsibility center whose members

control revenues but do not control the cost of the product or service they sell or the level of investment in the responsibility center.



What is a profit center? It is a responsibility center whose manager

and other employees control both the revenues and the costs of the product or service they sell or deliver.



What is an investment center? It is a responsibility center whose manager

and other employees control the revenues, costs, and the level of investment in the responsibility center.



Identify the issues to consider and basic tools to use in

assessing the performance of a responsibility center.


Evaluating Responsibility Centers

Underlying the accounting classifications of responsibility centers is the concept of controllability.

The controllability principle asserts that people should only be held accountable for results that they can control.

It is often difficult to apply the controllability principle.


Evaluating Responsibility Centers

What are some problems associated with controllability?

– jointly earned revenues and/or jointly incurred costs

– intricate, and often arbitrary, accounting procedures



Assess the issues and problems created by revenue

and cost interactions in evaluating the performance

of an organization unit.


Using Segment Margin Reports

What is a segment margin? It is the level of controllable profit reported

by an organizational unit or product line.



Revenue $950,000 $1,250,000 $2,200,000Variable Costs 750,000 950,000 1,700,000Contribution Margin $200,000 $ 300,000 $ 500,000Other Costs 75,000 60,000 135,000Segment Margin $125,000 $ 240,000 $ 365,000Allocated Costs 70,000 80,000 150,000Income $ 55,000 $ 160,000 $ 215,000Unallocated Costs 300,000Organization Profit ($85,000)

New Car Sales

Used Car Sales Total



What type of problem can occur when organizations evaluate responsibility centers as profit centers?

– identifying responsibility for the control of sales and costs



Organizations use two different approaches to evaluate segment margin numbers:

1 Past performance Is performance this period reasonable, given

past experience?2 Comparable organizations How does performance compare to similar

organizations?



What are some limitations of segment margin reporting?

1 Margins can be highly aggregated summaries.

2 Some segment reports contain arbitrary, or soft, numbers.

3 Revenue figures often reflect assumptions and allocations that can be misleading.



Because of these limitations, interpreting segment margins should be done carefully.

Other critical success factors should be used as well to assess performance.



Identify the transfer-pricing alternatives available to

organizations and the criteria for choosing a transfer

pricing alternative.


Transfer Pricing

What is transfer pricing? It is a set of tools and methods used to

attribute revenues earned by the organization to organization sub-units.


Transfer Pricing

Transfer pricing can be very arbitrary, especially if there is a high degree of interaction among the responsibility centers.


Transfer Pricing Interrelationships

Body Shop Department

Service Department

Leasing Department

Used Car Department New Car Department

New Car PreparationRepairs

RepairsNew Car

Preparation

Used Cars

Used Cars

Used Cars


Approaches to Transfer Pricing

There are four approaches to transfer pricing:

– Market-Based– Cost-Based– Negotiated– Administered



Market-Based Transfer Pricing

If a good external market existsfor the transferred product or service,

then market prices are the mostappropriate basis for pricing.

Unfortunately, these marketswith well-defined prices seldom exist.



Cost-BasedTransfer Prices

Variable cost plus a markup

Full cost

Full cost plus a markup



What are some concerns about cost-based transfer prices?

– Cost-based transfer prices do not provide the appropriate economic guidance when operations are capacity constrained.

– They do not focus on the intent of the system, which is to allow calculation of unit incomes.



Economists argue that only marginal cost transfer prices are optimal.

If the transfer price is higher than the marginal cost…

– the supplying unit wants to sell more than the optimal quantity, and

– the purchasing unit wants to buy fewer than the optimal quantity.



NegotiatedTransfer Prices

Supplying and receiving responsibilitycenters negotiate prices.

Prices reflect both negotiating skillsand economic considerations.Optimal transfer price is the

the net realizable value of the last unitsupplied for all units supplied.



NegotiatedTransfer Prices

Reflect the accountability and controllabilityprinciples underlying responsibility centers

Can easily lead to decisions thatdo not provide the greatest economic benefits



AdministeredTransfer Prices

Prices set by a rule, policy, or an arbitrator

Easy to administer

Arbitrary

Tend to violate the spirit ofthe responsibility approach



Use return on investment and economic value added

as financial control tools.


Efficiency and Productivity Elements of ROI

ROI = Operating Income ÷ Investment

ROI = Operating Income × Sales Sales Investment

ROI = Return on Sales × Asset Turnover = Efficiency × Productivity



What is efficiency? It is a measure of an organization’s ability

to control costs.

Operations Efficiency = Standard Cost Actual Cost



What is productivity? It is a ratio of output to input. In financial control, this is the ratio of sales

to investment.


Assessing Return on Investment

Analyze trends. Compare to competitors. Decompose and compare to competitors. Look for signals suggesting where there

might be problems.


Using Economic Value Added

What is economic value added? It is an investment criterion, previously

called residual income.

Economic Value Added = Income – Cost of Capital


Using Economic Value Added

EVA evaluates income relative to the level of investment required to earn that income.

It motivates managers to do what they think is necessary to make economic value added as large as possible.



Identify the limitations of financial controls.


The Efficacy of Financial Control

What are some criticisms of financial control?

Information is delayed. Information is highly aggregated. Its measures are narrow and do not evaluate

how well the organization is doing in meeting stakeholders’ requirements.

It is too focused on short-term results.


The Efficacy of Financial Control

How should we interpret these facets of financial control?

Financial control is an important tool in the process of control.

Used properly, it provides crucial help in assessing the organization’s long-term viability and identifying processes that need improvement.


Conclusion

Georgia Tech implemented a Responsibility Approach Center (RAC), which focuses on computing a cost per sport.

The analysis revealed that all sports, with the exception of basketball, were a net drain on the University’s resources.


End of Chapter 12

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