CONTROLLABLE VS NONCONTROLLABLE
REVENUES AND COSTS

Can control all costs and revenues at some level of responsibility within the company

Critical issue under responsibility accounting:
Whether the cost or revenue is controllable at the level of responsibility with which it is associated

CONTROLLABLE VS NONCONTROLLABLE
REVENUES AND COSTS

All costs controllable by top management

Fewer costs controllable as one moves down to lower levels of management

Controllable costs - costs incurred directly by a level of responsibility that are controllable at that level

Noncontrollable costs – costs incurred indirectly which are allocated to a responsibility level


Involves preparation of a report for each level of
responsibility in the company's organization chart

Begins with the lowest level of responsibility and moves
upward to higher levels

Permits management by exception at each level of responsibility

RESPONSIBILITY REPORTING SYSTEM
Example – Francis Chair Co.


Also permits comparative evaluations

Plant manager can rank the department manager’s effectiveness in controlling manufacturing costs

Comparative ranking provides incentive for a manager to control costs

RESPONSIBILITY REPORTING SYSTEM


Three basic types:

Cost centers

Profit centers

Investment centers

Indicates degree of responsibility that managers have for the performance of the center

TYPES OF
RESPONSIBILITY CENTERS

 Based on a manager’s ability to meet budgeted goals for controllable costs

Results in responsibility reports which compare actual controllable costs with flexible budget data

Include only controllable costs in reports

No distinction between variable and fixed costs

RESPONSIBILITY ACCOUNTING FOR
COST CENTERS
Example – Fox Manufacturing Co.
 Assumes department manager can control all manufacturing overhead costs except depreciation, property taxes, and his own monthly salary of $4,000


Based on detailed information about both controllable revenues and controllable costs

Manager controls operating revenues earned, such as sales,

Manager controls all variable costs (and expenses) incurred by the center because they vary with sales

Direct and Indirect Fixed Costs

May have both direct and indirect fixed costs

Direct fixed costs
 Relate specifically to a responsibility center

Incurred for the sole benefit of the center

Most controllable by the profit center manager

Indirect fixed costs

Pertain to a company's overall operating activities
 Incurred for the benefit of more than one profit center

Most not controllable by the profit center manager

Responsibility Reports

Shows budgeted and actual controllable revenues and costs

Prepared using the cost-volume-profit income statement format:

Deduct controllable fixed costs from the contribution margin

Controllable margin excess of contribution margin over controllable fixed costs – best measure of manager’s performance in controlling revenues and costs

Do not report noncontrollable fixed costs

PROFIT CENTER -RESPONSIBILITY REPORTS
Example – Marine Division
$60,000 of indirect fixed costs are not controllable by manager not shown


Controls or significantly influences investment funds available for use

ROI (return on investment) primary basis for evaluating manager performance in an investment center

ROI shows the effectiveness of the manager in utilizing the assets at his or her disposal


ROI is computed as follows:

Operating assets include current assets and plant assets used in operations by the center.
• Exclude nonoperating assets such as idle plant assets and land held for future use

Base average operating assets on the beginning and ending cost or book values of the assets

INVESTMENT CENTERS Responsibility Report
Example – Marine Division
All fixed costs are controllable by manager


Valuation of operating assets

May be valued at acquisition cost, book value, appraised value, or market value

Margin (income) measure

May be controllable margin, income from operations, or net income

IMPROVING ROI

ROI can be improved by

Increasing controllable margin or

Reducing average operating assets

Assume the following data for Laser Division of
Berra Manufacturing:

IMPROVING ROI

Increased by increasing sales or by reducing variable and controllable fixed costs

Increase sales by 10%
•
Sales increase $200,000 and contribution margin increases $90,000 ($200,000 X 45%)
•
Thus, controllable margin increases to $690,000
($600,000 + $90,000)
• New ROI is 13.8%

IMPROVING ROI

Decrease variable and fixed costs 10%
• Total costs decrease $140,000 [($1,100,000 + $300,000) X
10%]
• Controllable margin becomes $740,000 ($600,000 +
$140,000 )
• New ROI becomes 14.8%

IMPROVING ROI

Reduce average operating assets by 10% or
$500,000
 Average operating assets become $4,500,000
($5,000,000 X 10%)
 Controllable margin remains unchanged at
$600,000

New ROI becomes 13.3%


Management function that compares actual results with budget goals

At center of responsibility accounting

Includes both behavioral and reporting principles

Behavioral Principles

Human factor – critical in performance evaluation

Behavioral principles:

Managers of responsibility centers should have direct input into the process of establishing budget goals for their area of responsibility
 The evaluation of performance should be based entirely on matters that are controllable by the manager being evaluated
 Top management should support the evaluation process

The evaluation process must allow managers to respond to their evaluations

The evaluation should identify both good and poor performance

Reporting Principles

Reporting principles for performance reports include reports which

Contain only data that are controllable by the manager of the responsibility center

Provide accurate and reliable budget data to measure performance
 Highlight significant differences between actual results and budget goals
 Are tailor-made for the intended evaluation
 Are prepared at reasonable intervals

Summary of Study Objectives

Describe the concept of budgetary control.
 Preparing periodic budget reports to compare actual results with planned objectives
 Analyzing the differences to determine causes

Taking appropriate corrective action

Modifying future plans, if necessary

Evaluate the usefulness of static budget reports

Useful in evaluating the progress toward planned sales and profit goals
 Also appropriate in assessing manager’s effectiveness in controlling cost when
•
Actual activity approximates budget activity level and/or
•
Costs are fixed

Summary of Study Objectives

Explain the development of flexible budgets and the usefulness of flexible budget reports.

Identify the activity index and the relevant range
 Identify variable costs and determine the budgeted variable cost per unit

Identify fixed costs and the budgeted amount for each cost
 Prepare budget for selected increments of activity within relevant range

Flexible budget reports permit evaluation of manager’s performance

Summary of Study Objectives

Describe the concept of responsibility accounting.
 Accumulating and reporting revenues and costs on the basis of the individual who has the authority to make the decisions
 Manager’s performance judged on matters directly under manager’s control
 Necessary to distinguish between controllable and noncontrollable fixed costs

Must identify three types of responsibility centers
• Cost centers
• Profit centers
•
Investment centers

Summary of Study Objectives
 Indicate the features of responsibility reports for cost centers.
 Compare actual costs with flexible budget data

Reports show only controllable costs

No distinction is made between variable and fixed costs
 Identify the content of responsibility reports for profit centers.
 For each profit center show
 Contribution margin
 Controllable fixed costs

Controllable margin

Summary of Study Objectives

Explain the basis and formula used in evaluating performance in investment centers.
 Primary basis for evaluating performance : return on investment
(ROI)

Formula for ROI:
Controllable margin ÷ average operating assets

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

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

APPENDIX: RESIDUAL INCOME –
ANOTHER PERFORMANCE
MEASUREMENT

Most companies use ROI to evaluate investment performance

Significant disadvantage - ignores the minimum rate of return on operating assets

Rate at which cost are covered and a profit earned

APPENDIX: RESIDUAL INCOME – ANOTHER
PERFORMANCE MEASUREMENT
Example – Electronics Division of Pujols Manufacturing Co.

Electronics Division has the following ROI:

Considering producing a new product – Tracker

To produce the product, operating assets increase $2,000,000

Tracker expected to generate an additional $260,000 of controllable margin

APPENDIX: RESIDUAL INCOME – ANOTHER
PERFORMANCE MEASUREMENT
Example – Electronics Division

Making Tracking reduces ROI from 20% to 18%:

If only use ROI, would not produce Tracker

However, if Electronics has a minimum rate of return of 10%,
Tracker would be produced because its ROI, 13%, is greater


Use the residual income approach to evaluate performance using the minimum rate of return

Residual Income:
The income that remains after subtracting from controllable margin the minimum rate of return on average operating assets

APPENDIX: RESIDUAL INCOME
COMPARED TO ROI
Example – Electronics Division

The residual income for Tracking:
 With Tracker, Electronics’ residual income increases:
Thus, ROI can be misleading by rejecting a project that actually increases income


Attempting to evaluate a company only on maximizing residual income ignores the fact that one division might use substantially fewer assets to attain the same level of residual income

Electronics Division used $2,000,000 of average operating assets to generate $260,000 of residual income
Can a different division use fewer operating assets to generate a greater amount of residual income?

Example – Electronics Division vs. Seadog Division
 Seadog used $4,000,000 to generate $460,000 of controllable margin

Using the residual income approach, both investments are equal
 However, this ignores the fact that Seadog
Required twice as many operating assets to achieve the same level of residual income


Explain the difference between ROI and residual income.
 ROI is controllable income divided by average operating assets
 Residual income is the income remaining after subtracting the minimum rate of return on average operating assets
 ROI can provide misleading results because
Profitable investments can be rejected when the investment reduces ROI but increases overall profitability

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