23 Flexible Budgets and Performance Analysis Principles of Accounting C H A P T E R Flexible Budgets and Performance Analysis Principles of Accounting 12e Needles Powers Crosson ©human/iStockphoto

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. ©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.

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. ©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.

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. ©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 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. ©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.

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: ©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.

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. ©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.

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: ©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.

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. ©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.

EVA is computed as follows: 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 short-term financial performance. To ensure a more balanced view of a business’s well-being, 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. ©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.

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. ©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.

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). ©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.

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. ©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 and the Management Process The ways in which performance measures and evaluation support and inform the management process are: Plan Perform Evaluate Communicate ©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 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.