CHAPTER
7
Flexible Budgets and
Performance Analysis
Managerial
Accounting
10e
Crosson
Needles
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Concepts Underlying Performance Analysis
 A performance management and evaluation system is a
set of procedures that account for and report on both
financial and nonfinancial performance so that a company
can understand how well it is doing, where it is going, and
what improvements will make it more profitable.
 Performance measures are quantitative tools that gauge
and compare an organization’s performance in relation to
a specific goal or an expected outcome.
– Performance measurement is the use of quantitative tools to
understand an organization’s performance in relation to a specific
goal or an expected outcome.
 Organizations assign resources to specific areas of responsibility and
track how the managers of those areas use those resources.
©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
What to Measure, How to Measure
 To assist in performance management and evaluation,
many organizations use responsibility accounting—an
information system that classifies data according to areas
of responsibility and reports each area’s activities by
including only the revenues, costs, and resources that the
assigned manager can control.
– A responsibility center is an organizational unit whose manager
has been assigned the responsibility of managing a portion of the
organization’s resources.
– A report for a responsibility center should contain only the costs,
revenues, and resources that the manager of that center can
control. Such costs and revenues are called controllable costs and
revenues, because they are the result of a manager’s actions,
influence, or decisions.
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Cost Center and Discretionary Cost Center
 A responsibility center whose manager is accountable only
for controllable costs that have well-defined relationships
between the center’s resources and certain products or
services is called a cost center.
– The performance of a cost center is usually evaluated by
comparing an activity’s actual cost with its budgeted cost and
analyzing the resulting variances.
 A responsibility center whose manager is accountable for
costs only and in which the relationship between resources
and the products or services produced is not well defined
is called a discretionary cost center.
– Cost-based measures usually cannot be used to evaluate the
performance of a discretionary cost center.
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Revenue Center and Profit Center
 A responsibility center whose manager is accountable
primarily for revenue and whose success is based on its
ability to generate revenue is called a revenue center.
– A revenue center’s performance is usually evaluated by comparing
its actual revenue with its budgeted revenue and analyzing the
resulting variances.
 A responsibility center whose manager is accountable for
both revenue and costs and for the resulting operating
income is called a profit center.
 The performance of a profit center is usually evaluated by
comparing the figures on its actual income statement with the
figures on its master or flexible budget income statement.
©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Investment Center
 A responsibility center whose manager is
accountable for profit generation and who can
also make significant decisions about the resources
that the center uses is called an investment
center.
– Presidents of companies, who can control revenues,
costs, and the investment of assets, are examples of
investment center managers.
– The performance of these centers is evaluated using
such measures as return on investment, residual income,
and economic value added.
©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Organizational Structure and
Performance Reports
 An organization chart is a visual representation of
an organization’s hierarchy of responsibility for
the purposes of management control.
– Within an organization chart, the five types of
responsibility centers are arranged by level of
management authority and control.
©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Organizational Structure and
Performance Reports
 Performance reporting by responsibility level enables an
organization to trace a cost, revenue, or resource to the
manager who controls it and to evaluate that manager’s
performance accordingly.
 Performance reports have some common themes:
– All responsibility center reports compare actual results to budgeted
figures and focus on the differences.
– Often, comparisons are made to a flexible budget as well as to
the master budget.
– Only the items that the manager can control are included in the
performance report.
– Nonfinancial measures are also examined to achieve a more
balanced view of the manager’s responsibilities.
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Performance Evaluation of Cost Centers and
Profit Centers
 The accuracy of performance analysis depends to a large
extent on the type of budget that managers use when
comparing actual results to a budget.
– Static, or fixed, budgets forecast revenues and expenses for just
one level of sales and just one level of output.
– To judge a product or division’s performance accurately, the
company’s managers can use a flexible budget (or variable
budget), which is a summary of expected costs for a range of
activity levels.
 Unlike a static budget, a flexible budget provides forecasted data
that can be adjusted for changes in the level of output.
 Flexible budgets allow managers to compare budgeted and actual
costs at any level of output.
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Flexible Budgets and Performance Analysis
 An important element in preparing a flexible
budget is the flexible budget formula, an
equation that determines the expected, or
budgeted, cost for any level of output.
– The flexible budget formula is computed as
follows:
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Evaluating Profit Center Performance Using
Variable Costing
 One method of preparing profit center
performance reports is variable costing, which
classifies a manager’s controllable costs as either
variable or fixed.
– Variable costing produces a variable costing income
statement instead of a traditional income statement.
The variable costing income statement is an internally
prepared income statement that is useful in
performance management because it focuses on cost
variability and the profit center’s contribution to
operating income.
©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Performance Evaluation of Investment Centers
 Because the managers of investment centers also control
resources and invest in assets, other performance measures
must be used to hold them accountable for revenues, costs,
and the capital investments that they control.
– Traditionally, the most common performance measure
that takes into account both operating income and the
assets invested to earn that income is return on
investment (ROI), which is computed as follows.
 In this formula, assets invested is the average of the beginning
and ending asset balances for the period.
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Return on Investment
 The basic ROI equation (Operating Income ÷ Assets
Invested) can be rewritten to show the elements within the
aggregate ROI number that a manager can influence.
– Two important indicators of performance are:
 Profit margin—the ratio of operating income to sales. It represents
the percentage of each sales dollar that results in profit.
 Asset turnover—the ratio of sales to average assets invested. It
indicates the productivity of assets, or the number of sales dollars
generated by each dollar invested in assets.
– The following formula recognizes the many interrelationships that affect
ROI:
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Residual Income
 Residual income (RI) is another approach to
evaluating investment centers. It is the operating
income that an investment center earns above a
minimum desired return on invested assets.
– Residual income is not a ratio but a dollar amount—the
amount of profit left after subtracting a predetermined
desired income target for an investment center.
– It is computed as follows:
 Assets invested is the average of the center’s beginning and
ending asset balances for the period.
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Economic Value Added
 More and more businesses are using the
shareholder wealth created by an investment
center, or the economic value added (EVA™), as
an indicator of performance.
– EVA is computed as follows:
 The cost of capital is the minimum desired rate of
return on an investment, such as the assets invested
in an investment center.
©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Performance Measurement
 To be effective, a performance management system must
consider both operating results and multiple performance
measures, such ROI, RI, and EVA.
– However, all three measures are limited by their focus on shortterm financial performance.
 To ensure a more balanced view of a business’s wellbeing, managers must collaborate to develop a group of
measures, such as the balanced scorecard.
– The balanced scorecard links the perspectives of an organization’s
four basic stakeholder groups—financial (investor), learning and
growth (employee), internal business processes, and customer—
with the organization’s mission and vision, performance measures,
strategic and tactical plans, and resources.
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Planning
 During the planning stage, the balanced scorecard
provides a framework that enables managers to
translate their organization’s vision and strategy
into operational terms.
– Managers evaluate the company’s vision from the
perspective of each stakeholder group.
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Performing
 Managers use the mutually agreed-upon strategic
and tactical objectives for the entire organization
as the basis for decision making within their
individual areas of responsibility.
– This practice ensures that they consider the needs of all
stakeholder groups.
– Improving the performance of leading indicators like
internal business processes and learning and growth
will create improvements for customers, which in turn
will result in improved financial performance (a lagging
indicator).
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Evaluating and Communicatig
 Managers compare performance objectives and targets
with actual results to determine if the targets were met,
what measures need to be changed, and what objectives
need revision.
 A company will also compare its performance with that of
similar companies in the same industry.
– Benchmarking determines a company’s competitive advantage by
comparing its performance with that of its closest competitors.
 Benchmarks are measures of the best practices in an industry.
 A variety of reports enable managers to monitor and
evaluate performance measures that add value for
stakeholder groups.
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Performance Evaluation and the
Management Process
 The ways in which performance measures and
evaluation support and inform the management
process are:




Plan
Perform
Evaluate
Communicate
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Performance Incentives and Goals
 The effectiveness of a performance management and
evaluation system depends on how well it coordinates the
goals of responsibility centers, managers, and the entire
company.
– Two factors are key to the successful coordination of goals:
 The logical linking of goals to measurable objectives and
targets.
 The tying of appropriate compensation incentives to the
achievement of the targets—that is, performance-based pay.
– Cash bonuses, awards, profit-sharing plans, and stock
options are common types of incentive compensation.
– Using stock as a reward encourages employees to think
and act as both investors and employees.
©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.