Chapter
Fifteen
Performance
Evaluation
© 2015 McGraw-Hill Education.
LO 1
LO 1
Describe the concept
of decentralization.
15-2
Responsibility Accounting
An accounting system that
provides information . . .
Relating to the
responsibilities of
individual managers.
To evaluate
managers on
controllable items.
15-3
Decentralization
Improves quality
of decisions.
Improves
productivity.
Improves
performance
evaluation.
Develops
lower-level
managers.
Advantages
Encourages upper-level management to
concentrate on strategic decisions.
15-4
Decentralization
Decentralization
often occurs as
organizations
continue to grow.
Top
Management
Middle
Management
Supervisor
Supervisor
Middle
Management
Supervisor
Supervisor
Decision-Making is Pushed Down
15-5
Organization Chart
Responsibility
Level
Corporate headquarters – Panther Holding Company
Lumber
manufacturing
division
Home
building
division
Furniture
manufacturing
division
Wilson Carpet
Company
Selma Sopha
Corporation
Tables
Incorporated
Sales
department
Production
department
Planning
department
Cutting
department
Assembly
department
Finishing
department
1
2
3
Accounting
department
4
5
15-6
Responsibility Centers
Investment
Center
Profit Center
Cost Center
15-7
Managerial Performance
Measurement
Evaluation Measures
Cost
Center
Cost control
Quantity and quality
of services
Profit
Center
Profitability
Investment
Center
Return on investment (ROI)
Residual income (RI)
15-8
Controllability Concept
Managers should
only be evaluated on
revenues or costs
they control.
I’m in
control
Since the exercise of control may be clouded,
managers are usually held responsible for items
over which they have predominant rather
than absolute control.
15-9
LO 2
LO 1
Distinguish between
flexible and static
budgets.
15-10
Preparing Flexible Budgets
The master budget, sometimes called a static
budget, is based solely on the planned volume
of activity. Flexible budgets differ from static
budgets in that they show expected revenues
and costs at a variety of volume levels.
15-11
Preparing Flexible Budgets
Melrose Manufacturing, a producer of small high-quality
trophies, plans to make and sell 18,000 trophies during 2014.
Melrose uses a standard cost system as outlined below:
15-12
Preparing Flexible Budgets
With very little effort, the accountant can
provide management with a flexible budget
for both budgeted and actual levels of activity.
The flexible budget is a critical tool in effective
performance evaluation.
15-13
Preparing Flexible Budgets
From the standard cost information, Melrose prepares
the following static and flexible budgets.
18,000 × $80 = $1,440,000
Exhibit 15.1
Static and Flexible Budgets in Excel Spreadsheet
$ 259,200
15-14
LO 3
LO 1
Classify variances as
being favorable or
unfavorable.
15-15
Determining Variances for
Performance Evaluation
The differences between standard and actual
amounts are called variances. A variance may be
favorable or unfavorable. When actual sales are
less than expected, an unfavorable sales
variance exists. When actual sales revenue is
greater than expected revenue, a company has a
favorable sales variance.
15-16
Determining Variances for
Performance Evaluation
Variances are not limited to the evaluation of
revenues. They can also be used to understand
the differences between standard and actual
amounts of costs. When actual costs are less
than standard costs, cost variances are favorable
because lower costs increase net income.
Unfavorable cost variances exist when actual
costs are more than standard costs.
15-17
LO 4
LO 1
Compute and
interpret sales and
variable cost volume
variances.
15-18
Sales Volume Variances
The difference between the static budget sales amount
and the flexible budget sales amount is a measure of
the sales volume variance.
Exhibit 15.2
Melrose Manufacturing Company’s Volume Variances
15-19
Interpreting the Volume Variances
In a standard cost system, marketing managers are
usually responsible for the volume variance. Because
sales volume drives production, production managers
have little control over volume variance.
In the case of Melrose, the marketing manager exceeded
planned sales volume by 1,000 units, resulting in an
$80,000 favorable revenue variance ($80 × 1,000). The
unfavorable cost variances are somewhat misleading.
Melrose incurred higher costs because it manufactured
and sold more units than planned.
15-20
Fixed Cost Considerations
The fixed costs are the same in both
the static and flexible budgets.
Spending
Variance
The difference
between the
budgeted fixed
costs and the actual
fixed costs
Fixed Cost
Volume Variance
The difference
between costs
at planned
volume versus
actual
volume
15-21
LO 5
LO 1
Compute and
interpret flexible
budget variances.
15-22
Flexible Budget Variances
For effective performance evaluation, management must
compare the actual results achieved to the flexible
budget based on the actual volume of activity. Here is a
comparison of the standard amount and actual amount
per unit for the current period for Melrose.
Sales price
Variable material cost
Variable labor cost
Variable overhead cost
Variable GS&A cost
Standard
$ 80.00
12.00
16.80
5.60
15.00
Actual
$ 78.00
11.78
17.25
5.75
14.90
15-23
Flexible Budget Variances
Now we are comparing actual results achieved with the
results that should have been achieved at the activity level.
$78 × 19,000 = $1,482,000
Exhibit 15.3
Flexible Budget Variances for Melrose Manufacturing Company
15-24
Calculating Sales Price Variance
Actual sales (19,000 × $78)
Expected sales (18,000 × $80)
Favorable total sales variance
$ 1,482,000
1,440,000
$
42,000
or
Activity variance (volume)
Sales price variance
Favorable total sales variance
$ 80,000 F
(38,000) U
$ 42,000 F
15-25
The Human Element Associated
with Flexible Budget Variances
•
The flexible budget cost variances offer
insight into management efficiency.
• As with sales variances, cost variances
require careful analysis.
• A favorable materials variance could mean
that purchasing agents are good
negotiators or it might be caused by paying
low prices for inferior goods.
15-26
Management by Exception
Standards are the building blocks of budgets.
Performance report detail varies according
to the level in an organization.
Department
manager receives
detailed reports.
Store manager receives
summarized information
from each department.
15-27
Management by Exception
Management focuses on areas not
performing as expected.
Management by exception
Upper-level management
does not receive operating
detail unless problems arise.
The vice president of operations
receives summarized information
from each unit.
Businesses cannot
afford to have
managers spend
large amounts of
time on operations
that function
normally.
15-28
LO 6
LO 1
Evaluate investment
opportunities using
return on
investment.
15-29
Return on Investment
Return on investment is the ratio of
income to the investment used to
generate the income.
ROI = Operating Income
Operating Assets
15-30
Return on Investment
Panther Holding Company provides the following
information for the company’s second level
investment centers.
Operating income
Operating assets
Lumber
Home
Furniture
Manufacturing
Building
Manufacturing
Division
Division
Division
$
60,000 $
46,080 $
81,940
300,000
256,000
482,000
Let’s calculate ROI.
15-31
Return on Investment
Lumber
=
Manufacturing
Home
Building
=
Furniture
=
Manufacturing
$60,000
$300,000
=
20%
$46,080
$256,000
=
18%
$81,940
$482,000
=
17%
All other things being equal,
higher ROIs indicate better performance.
15-32
Measuring Operating Assets
Using the book value of operating assets to
calculate ROI will result in a higher ROI.
Acquisition cost
Less: Accumulated depreciation
Book value
15-33
Factors Affecting ROI
Operating Income
ROI =
Operating Assets
Operating Income
ROI =
×
Sales
Margin
Sales
Operating Assets
Turnover
15-34
Factors Affecting ROI
The Lumber Manufacturing Division
reported the following information:
Operating Income
Sales
Operating Assets
$ 60,000
$ 600,000
$ 300,000
Let’s calculate ROI using
the expanded equation.
15-35
Factors Affecting ROI
ROI = Operating Income ×
Sales
ROI =
$60,000
$600,000
ROI = .10 × 2 =
Sales
Operating Assets
×
$600,000
$300,000
20%
15-36
Factors Affecting ROI
2 Reduce
Expenses
1 Increase
Sales
3 Reduce
Operating
Assets
(The investment base)
Three ways to improve ROI
15-37
Factors Affecting ROI
 The
Lumber Manufacturing Division was
able to increase sales to $660,000 which
increased operating income to $72,600.
 There was no change in operating assets.
Let’s calculate the new ROI.
15-38
Factors Affecting ROI
Operating Income
ROI =
×
Sales
ROI =
$72,600
$660,000
×
Sales
Operating Assets
$660,000
$300,000
ROI = .11 × 2.2 = 24.2%
The division’s ROI increased from 20% to 24.2%.
15-39
ROI - A Major Drawback
 As division manager in Lumber Manufacturing,
your compensation package includes
a salary plus bonus based on your division’s
ROI -- the higher your ROI, the bigger your bonus.
 The company requires an ROI of 20% on all new
investments -- your division has been producing an ROI
of 30%.
 You have an opportunity to invest in a new project
that will produce an ROI of 25%.
As division manager, would you
invest in this project?
15-40
ROI - A Major Drawback
Gee . . .
I thought we were
supposed to do what
was best for the
company!
As division manager,
I wouldn’t invest in
that project because
it would lower my pay!
15-41
LO 7
LO 1
Evaluate investment
opportunities using
residual income.
15-42
Residual Income
Operating Income
– Investment charge
= Residual income
Operating Assets
× Desired ROI
= Investment charge
Investment center’s
cost of acquiring
investment capital
15-43
Residual Income
The Lumber Manufacturing Division
currently earns $60,000 of operating
income with the $300,000 of operating
assets it controls.
Panther has a 18% desired ROI.
Let’s calculate residual income.
15-44
Residual Income
Operating income = $60,000
– Desired income
= 54,000
= Residual income = $ 6,000
Operating assets
× Desired ROI
= Desired income
= $300,000
=
18%
= $ 54,000
Panther’s desired
return on investment.
15-45
Residual Income
Residual income encourages managers to
make profitable investments that would
be rejected by managers using ROI.
Suboptimization
occurs with ROI
when managers
benefit
themselves at
the expense of
the company
15-46
Responsibility Accounting and
the Balanced Scorecard
The balanced scorecard is a holistic
approach to evaluating managers.
Balanced
Scorecard
Multiple
financial
measures
Multiple
non-financial
measures
15-47
End of Chapter Fifteen
15-48