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Cost Analysis for Control

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1 Cost Analysis for Control
CHAPTER 15 Cost Analysis for Control Chapter 15: Cost Analysis for Control McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.

2 Decision Making Planning and Control Cycle
L O 1 Strategic, Operational, and Financial (Planning) Implement Plans Revisit Plans Planning and Control Cycle Performance analysis: Plans vs. actual results (Controlling) Data collection and Performance Feedback The decision-making process begins with strategic, operational and financial planning. Implementing the plans and executing operational activities provide performance data. After the data are collected, performance is analyzed; and the feedback generated is used to refine the process. Executing operational activities (Managing)

3 Cost Classification According to a Time-Frame Perspective
L O 1 Degree of Control Costs that may not be controllable in the short run are controllable in the long run. Costs that may not be controllable in the short run are controllable in the long run. Time

4 Performance Report Characteristics
L O 2 Budget Amount Actual Amount Activity = Variance Explanation Favorable Actual revenues > Budgeted revenues Actual costs < Budgeted costs Unfavorable Actual revenues < Budgeted revenues Actual costs > Budgeted costs A variance for an activity equals the budgeted amount less the actual amount. Favorable variances occur when the actual revenues are greater than budgeted revenues, and actual costs are less than budgeted costs. Unfavorable variances occur when actual revenues are less than budgeted revenues and actual costs are greater than budgeted costs.

5 Performance Report Characteristics
L O 2 A cost variance is the amount by which an actual amount differs from the budgeted amount. Budgeted Amount This variance is unfavorable because the actual cost exceeds the budgeted cost. A cost variance is the amount by which an actual amount differs from the budgeted amount. In this example, the variance is unfavorable because the actual cost exceeds the budgeted cost. Product Cost

6 Performance Report Characteristics
L O 2 Responsibility Reporting Amount of detail varies according to level in organization. For responsibility reporting, the amount of detail varies according to level in organization. A department manager receives detailed reports, and a store manager receives summarized information from each department. A store manager receives summarized information from each department. A department manager receives detailed reports.

7 Performance Report Characteristics
L O 2 Responsibility Reporting Amount of detail varies according to level in organization. Management by exception: Upper-level management does not receive operating detail unless activities are not performing according to plan. With management by exception, upper-level management does not receive operating detail unless activities are not performing according to plan, and the vice president of operations receives summarized information from each store. The vice president of operations receives summarized information from each store.

8 The Flexible Budget L O 3 Show revenues and expenses that should have occurred at the actual activity. May be prepared for any activity level within the relevant range. Reveal variances due to effective cost control or lack of cost control. Flexible budgets show revenues and expenses that should have occurred at the actual activity. They may be prepared for any activity level within the relevant range. Flexible budgets reveal variances due to effective cost control or lack of cost control. They can also improve performance evaluation. Improve performance evaluation.

9 The Flexible Budget L O 3 To a budget for different activity levels, we must know how costs behave with changes in activity levels. Total variable costs change in direct proportion to changes in activity. Total fixed costs remain unchanged within the relevant range. Variable To flex a budget for different activity levels, we must know how costs behave with changes in activity levels. Total variable costs change in direct proportion to changes in activity. Total fixed costs remain unchanged within the relevant range. Fixed

10 First, let’s compare actual results with the original budget.
The Flexible Budget L O 3 First, let’s compare actual results with the original budget. First, let's compare actual results with the original budget.

11 The Flexible Budget L O 3 Cost variances have little meaning since actual costs are at a different activity than the budgeted activity. When the original budget is compared to actual results, the cost variances have little meaning since actual costs are at a different activity than the budgeted activity.

12 The Flexible Budget L O 3 Now, let’s compare actual results with a flexed budget prepared at the actual level of activity. Now, let's compare actual results with a flexed budget prepared at the actual level of activity.

13 The Flexible Budget L O 3 A flexible budget is prepared for the same activity level as actually achieved to compare the budgeted costs and actual results at the same level of activity. Favorable and unfavorable variances are calculated by subtracting actual results from flex budget amounts for each activity level. A favorable variance results when actual results are less than the flex budget. Unfavorable variances arise when actual results are greater than the flex budget.

14 The Flexible Budget L O 3 A flexible budget is prepared for the same activity level as actually achieved. Note: There is no flex in the fixed costs. A flexible budget is prepared for the same activity level as actually achieved to compare the budgeted costs and actual results at the same level of activity. Note there is no flex in the fixed costs.

15 The Flexible Budget L O 3 Variable costs have unfavorable variances because actual costs are more than the flexible budget costs. Notice the unfavorable variances because actual costs are more than the flexible budget costs.

16 Standard Cost Variance Analysis
L O 4 Based on carefully predetermined amounts. Used for planning material, labor, and overhead requirements. Standard Costs are The expected level of performance. Benchmarks for measuring performance. Standard costs are based on carefully predetermined amounts. They are used for planning material, labor, and overhead requirements. They are the expected level of performance and the benchmarks for measuring performance.

17 Standard Cost Variance Analysis
L O 4 Standard Cost Variances Price Variance Usage Variance The difference between the actual price and the standard price The difference between the actual quantity and the standard quantity A price variance is the difference between the actual price and the standard price. A usage variance is the difference between the actual quantity and the standard quantity used.

18 Standard Cost Variance Analysis
L O 4 Actual Quantity Actual Quantity Standard Quantity × × × Actual Price Standard Price Standard Price Price Variance Usage Variance Standard price is the amount that should have been paid for the resources acquired. For the price variance, the actual quantity times the actual price is compared to the actual quantity times the standard price. For the usage variance, the actual quantity times the standard price is compared to the standard quantity times the standard price. Standard price is the amount that should have been paid for the resources acquired.

19 Standard Cost Variance Analysis
L O 4 Price Variance Usage Variance Actual Quantity Actual Quantity Standard Quantity × × × Actual Price Standard Price Standard Price The standard quantity is the quantity that should have been used for the output achieved. Standard quantity is the quantity that should have been used for the output achieved.

20 Standard Cost Variance Analysis
L O 4 Actual Quantity Actual Quantity Standard Quantity × × × Actual Price Standard Price Standard Price Price Variance Usage Variance The price variance equation can be stated as AQ(AP minus SP), where: AQ = Actual Quantity SP = Standard Price AP = Actual Price SQ = Standard Quantity The usage variance equation can be stated as SP(AQ minus SQ), where: AQ(AP - SP) SP(AQ - SQ) AQ = Actual Quantity SP = Standard Price AP = Actual Price SQ = Standard Quantity

21 Calculating Materials Price and Usage Variances
L O 5 Let’s apply what we have learned about how to calculate standard cost variances, starting with materials. Let's apply what we have learned about how to calculate standard cost variances, starting with materials.

22 Calculating Materials Price and Usage Variances
L O 5 Cruisers, Inc. has the following materials standards for fiberglass cloth used to make 100 SeaCruiser boat hulls: 218 yards per hull at $2.10 per yard Last month, 22,500 yards of material were purchased and used to make 100 hulls. The total materials costs were $46,125. Cruisers, Inc. has the following materials standards for fiberglass cloth used to make 100 SeaCruiser boat hulls: 218 yards per hull at $2.10 per yard. Last month, 22,500 yards of material were purchased and used to make 100 hulls. The total materials costs were $46,126.

23 Calculating Materials Price and Usage Variances
L O 5 What is the actual price per yard paid for the materials? a. $2.00 per yard. b. $2.10 per yard. c. $2.05 per yard. d. $2.25 per yard. What is the actual price per yard paid for the materials? $2.00 per yard. $2.10 per yard. $2.05 per yard. $2.25 per yard.

24 Calculating Materials Price and Usage Variances
L O 5 What is the actual price per yard paid for the materials? a. $2.00 per yard. b. $2.10 per yard. c. $2.05 per yard. d. $2.25 per yard. AP = $46,125 ÷ 22,500 yds. AP = $2.05 per yd. The correct answer is c: $2.05 per yard ($46,125/22,500).

25 Calculating Materials Price and Usage Variances
L O 5 The materials price variance (MPV) for the month was: a. $1,125 unfavorable. b. $1,125 favorable. c. $1,255 unfavorable. d. $1,255 favorable. The materials price variance (MPV) for the month was: $1,125 unfavorable. $1,125 favorable. $1,255 unfavorable. $1,255 favorable.

26 Calculating Materials Price and Usage Variances
L O 5 The materials price variance (MPV) for the month was: a. $1,125 unfavorable. b. $1,125 favorable. c. $1,255 unfavorable. d. $1,255 favorable. MPV = AQ(AP - SP) MPV = 22,500 yds. × ($2.05 – $2.10) MPV = $1,125 favorable The correct answer is b: $1,125 favorable [22,500 x ($ $2.10)].

27 Calculating Materials Price and Usage Variances
L O 5 The standard quantity of materials that should have been used to produce 100 hulls is: a. 22,500 yards. b. 21,600 yards. c. 21,800 yards. d. 22,000 yards. The standard quantity of materials that should have been used to produce 100 hulls is: 22,500 yards. 21,600 yards. 21,800 yards. 22,000 yards.

28 Calculating Materials Price and Usage Variances
L O 5 The standard quantity of materials that should have been used to produce 100 hulls is: a. 22,500 yards. b. 21,600 yards. c. 21,800 yards. d. 22,000 yards. The correct answer is c: 21,800 yards (100 x 218). SQ = 100 hulls × 218 yds. per hull SQ = 21,800 yds.

29 Calculating Materials Price and Usage Variances
L O 5 The materials usage variance (MUV) for the month was: a. $1,250 unfavorable. b. $1,250 favorable. c. $1,470 unfavorable. d. $1,470 favorable. The materials usage variance (MUV) for the month was: $1,250 unfavorable. $1,250 favorable. $1,470 unfavorable. $1,470 favorable.

30 Calculating Materials Price and Usage Variances
L O 5 The materials usage variance (MUV) for the month was: a. $1,250 unfavorable. b. $1,250 favorable. c. $1,470 unfavorable. d. $1,470 favorable. The correct answer is c: $1,470 unfavorable [$2.10 (22,500 – 21,800)]. MUV = SP(AQ - SQ) MUV = $2.10(22,500 yds. – 21,800 yds.) MUV = $1,470 unfavorable

31 Materials Variances Summary
L O 5 22,500 yds ,500 yds ,800 yds × × × $2.05 per yd $2.10 per yd $2.10 per yd. = $46, = $ 47, = $45,780 Actual Quantity Actual Quantity Standard Quantity × × × Actual Price Standard Price Standard Price The material variances summary shows the price variance is $1,125 favorable and the usage variance is $1,470 unfavorable. Price variance $1,125 favorable Usage variance $1,470 unfavorable

32 Calculating Labor Rate and Efficiency Variances
L O 5 Now let’s calculate standard cost variances for labor. Now let's calculate standard cost variances for labor.

33 Calculating Labor Rate and Efficiency Variances
L O 5 Cruisers, Inc. has the following direct labor standard to manufacture one boat hull: 26 standard hours per hull at $12.80 per direct labor hour. Last month, 2,540 direct labor hours were worked at a total labor cost of $32,893 to make 100 hulls. Cruisers has the following direct labor standard to manufacture one boat hull: 26 standard hours per hull at $12.80 per direct labor hour. Last month, 2,540 direct labor hours were worked at a total labor cost of $32,893 to make 100 hulls.

34 Calculating Labor Rate and Efficiency Variances
L O 5 What was the actual rate (AR) for labor for the month? a. $12.95 per hour. b. $12.80 per hour. c. $12.50 per hour. d. $12.25 per hour. What was the actual rate (AR) for labor for the month? $12.95 per hour. $12.80 per hour. $12.50 per hour. $12.25 per hour.

35 Calculating Labor Rate and Efficiency Variances
L O 5 What was the actual rate (AR) for labor for the month? a. $12.95 per hour. b. $12.80 per hour. c. $12.50 per hour. d. $12.25 per hour. The correct answer is a: $12.95 per hour ($32,893/2,540). AP = $32,893 ÷ 2,540 hours AP = $12.95 per hour

36 Calculating Labor Rate and Efficiency Variances
L O 5 The labor rate variance (LRV) for the month was: a. $381 unfavorable. b. $381 favorable. c. $462 unfavorable. d. $462 favorable. The labor rate variance (LRV) for the month was: $381 unfavorable. $381 favorable. $462 unfavorable. $462 favorable.

37 Calculating Labor Rate and Efficiency Variances
L O 5 The labor rate variance (LRV) for the month was: a. $381 unfavorable. b. $381 favorable. c. $462 unfavorable. d. $462 favorable. The correct answer is a: $381 unfavorable [2,540 ($ $12.80)]. LRV = AH(AP - SP) LRV = 2,540 hrs($ $12.80) LRV = $381 unfavorable

38 Calculating Labor Rate and Efficiency Variances
L O 5 The standard hours (SH) of labor that should have been worked to produce 100 hulls is: a. 2,500 hours. b. 2,600 hours. c. 2,700 hours. d. 2,800 hours. The standard hours (SH) of labor that should have been worked to produce 100 hulls is: 2,500 hours. 2,600 hours. 2,700 hours. 2,800 hours.

39 Calculating Labor Rate and Efficiency Variances
L O 5 The standard hours (SH) of labor that should have been worked to produce 100 hulls is: a. 2,500 hours. b. 2,600 hours. c. 2,700 hours. d. 2,800 hours. The correct answer is b: 2,600 hours (100 x 26). SH = 100 hulls × 26 hours per hulls SH = 2,600 hours

40 Calculating Labor Rate and Efficiency Variances
L O 5 The labor efficiency variance (LEV) for the month was: a. $694 unfavorable. b. $694 favorable. c. $768 unfavorable. d. $768 favorable. The labor efficiency variance (LEV) for the month was: $694 unfavorable. $694 favorable. $768 unfavorable. $768 favorable.

41 Calculating Labor Rate and Efficiency Variances
L O 5 The labor efficiency variance (LEV) for the month was: a. $694 unfavorable. b. $694 favorable. c. $768 unfavorable. d. $768 favorable. The correct answer is c: $768 favorable [$12.80 (2,540 – 2,600)]. LEV = SR(AH - SH) LEV = $12.80(2,540 hrs. - 2,600 hrs.) LEV = $768 favorable

42 Labor Variances Summary
L O 5 Actual Hours Actual Hours Standard Hours × × × Actual Price Standard Price Standard Price 2,540 hours ,540 hours ,600 hours × × × $12.95 per hr $12.80 per hr $12.80 per hr. = $32, = $32, = $33,280 The labor variance summary shows the rate variance is $381 unfavorable and the efficiency variance is $768 favorable. Rate variance $381 unfavorable Efficiency variance $768 favorable

43 Calculating Variable Overhead Spending and Efficiency Variances
L O 5 Now let’s calculate standard cost variances for the last of the variable production costs – variable overhead. Now let's calculate standard cost variances for the last of the variable production costs: variable overhead.

44 Calculating Variable Overhead Spending and Efficiency Variances
L O 5 Cruisers, Inc. has the following variable overhead standard to manufacture one boat hull: 26 standard hours per hull at $3.20 per direct labor hour Last month, 2,540 hours were worked to make 100 hulls, and actual variable overhead was $8,128. Cruisers has the following variable overhead standard to manufacture one boat hull: 26 standard hours per hull at $3.20 per direct labor hour. Last month, 2,540 hours were worked to make 100 hulls, and actual variable overhead was $8,128.

45 Calculating Variable Overhead Spending and Efficiency Variances
L O 5 What was the actual rate (AR) for variable overhead rate for the month? a. $3.00 per hour. b. $3.11 per hour. c. $3.20 per hour. d. $4.30 per hour. What was the actual rate (AR) for variable overhead rate for the month? $3.00 per hour. $3.11 per hour. $3.20 per hour. $4.30 per hour.

46 Calculating Variable Overhead Spending and Efficiency Variances
L O 5 What was the actual rate (AR) for variable overhead rate for the month? a. $3.00 per hour. b. $3.11 per hour. c. $3.20 per hour. d. $4.30 per hour. AR = $8,128 ÷ 2,540 hours AR = $3.20 per hour The correct answer is c: $3.20 per hour ($8,128/2,540).

47 Calculating Variable Overhead Spending and Efficiency Variances
L O 5 The spending variance (SV) for variable overhead for the month was: a. $0. b. $400 favorable. c. $335 unfavorable. d. $300 favorable. The spending variance (SV) for variable overhead for the month was: $0. $400 favorable. $335 unfavorable. $300 favorable.

48 Calculating Variable Overhead Spending and Efficiency Variances
L O 5 The spending variance (SV) for variable overhead for the month was: a. $0. b. $400 favorable. c. $335 unfavorable. d. $300 favorable. SV = AH(AR - SR) SV = 2,540 hrs($ $3.20) SV = $0 The correct answer is a: $0 [2,540 ($ $3.20)].

49 Calculating Variable Overhead Spending and Efficiency Variances
L O 5 The efficiency variance (EV) for variable overhead for the month was: a. $438 unfavorable. b. $438 favorable. c. $192 unfavorable. d. $192 favorable. The efficiency variance (EV) for variable overhead for the month was: $438 unfavorable. $438 favorable. $192 unfavorable. $192 favorable.

50 Calculating Variable Overhead Spending and Efficiency Variances
L O 5 The efficiency variance (EV) for variable overhead for the month was: a. $438 unfavorable. b. $438 favorable. c. $192 unfavorable. d. $192 favorable. 100 hulls × 26 hrs. per hull The correct answer is d: $192 favorable [$3.20 (2,540 – 2,600)]. EV = SR(AH - SH) EV = $3.20(2,540 hrs. - 2,600 hrs.) EV = $192 favorable

51 Variable Overhead Variances Summary
L O 5 Actual Hours Actual Hours Standard Hours × × × Actual Rate Standard Rate Standard Rate 2,540 hours ,540 hours ,600 hours × × × $3.20 per hour $3.20 per hour $3.20 per hour = $8, = $8, = $8,320 The variable overhead variance summary shows a $0 spending variance and the efficiency variance is $192 favorable. Spending variance $0 Efficiency variance $192 favorable

52 Analysis of Fixed Overhead Variances
L O 6 Now let’s turn our attention to fixed overhead. Now let's turn our attention to fixed overhead.

53 Analysis of Fixed Overhead Variances
L O 6 Overhead costs are applied to products and services using a predetermined overhead application rate (POHAR): Applied Overhead = POHAR × Standard Activity Overhead costs are applied to products and services using a predetermined overhead application rate (POHAR). The applied overhead is computed as POHAR times the standard activity. Note that the POHAR is computed as the estimated fixed overhead divided by the estimated total direct labor hours. Estimated Fixed Overhead POHAR = Estimated Total Direct Labor Hours

54 Analysis of Fixed Overhead Variances
L O 6 Actual Fixed Fixed Fixed Overhead Overhead Overhead Incurred Budget Applied SH × POHAR Budget Variance Volume Variance To compute the budget variance, actual fixed overhead incurred is compared to the fixed overhead budget. The fixed overhead budget is compared to the fixed overhead applied (SH times POHAR) to compute the volume variance. Note that POHAR equals the fixed overhead application rate, while SH equals the standard hours allowed. POHAR = Fixed Overhead Application Rate SH = Standard Hours Allowed

55 Analysis of Fixed Overhead Variances
L O 6 Cruisers, Inc. has the following budgeted and actual fixed overhead information for the year: Cruisers has the following budget and actual fixed overhead information for the year: Planned production equals 300,000 hours (1,250 units x 240 hours per unit). Actual production equals 1,288 units. Estimated fixed overhead equals $3,240,000. Actual fixed overhead equals $3,327,500. Standard hours equals 309,120 hours (1,288 units x 240 hours per unit). Predetermined overhead rate equals $10.80 per hour ($3,240,000/300,000 hours). Calculate the fixed overhead budget and volume variances. Calculate the fixed overhead budget and volume variances.

56 Analysis of Fixed Overhead Variances
L O 6 Actual Fixed Fixed Fixed Overhead Overhead Overhead Incurred Budget Applied SH × POHAR 309,120 hours × $10.80 per hour $3,327,500 $3,240,000 $3,338,496 The budget variance is $87,500 unfavorable, and the volume variance is $98,496 unfavorable. Budget variance $87,500 unfavorable Volume variance $98,496 unfavorable

57 Analysis of Fixed Overhead Variances
L O 6 Budget Variance Volume Variance Results from paying more or less than expected for overhead items. Results from operating at an activity level different from the planned activity. A budget variance results from paying more or less than expected for overhead items. A volume variance results from operating at an activity level different from the planned activity.

58 Volume Variance – A Closer Look
Results when standard hours allowed for actual output differs from the planned activity. Unfavorable when standard hours < planned hours Favorable when standard hours > planned hours A volume variance results when standard hours allowed for actual output differs from the planned activity. The variance is unfavorable when standard hours are less than planned hours. The variance is favorable when standard hours are greater than planned hours.

59 Volume Variance – A Closer Look
Does not measure over- or under spending Results when standard hours allowed for actual output differs from the budgeted activity. Explainable by and controllable only through activity Unfavorable when standard hours < planned hours Favorable when standard hours > planned hours A volume variance does not measure over- or under-spending that is explainable by and controllable only through activity.

60 Volume Variance – A Closer Look
Let’s look at a graph showing the volume variance. We will use Cruisers’ annual numbers from the previous example. Let's look at a graph showing the volume variance. We will use Cruisers' annual numbers from the previous example.

61 Volume Variance – A Closer Look
Cost 309,120 hours × $10.80 fixed overhead rate $3,338,496 applied fixed OH Volume Variance { $3,240,000 budgeted fixed OH Fixed overhead applied to products Overhead is applied at $10.80 per hour. There is a volume variance of $98,496 [($3,338,496 - $3,240,000) or (9,120 hours x $10.80). Volume 300,000 Budgeted Hours 309,120 Standard Hours

62 Accounting for Variances
L O 7 Net Unfavorable Variance Insignificant Net Favorable Variance Significant Net Favorable Variance Production inefficiency costs included in Product cost included in Product cost allocated between With a net unfavorable variance, production inefficiency costs are included in current period cost. With an insignificant net favorable variance, the product cost is included in cost of goods sold. With a significant net favorable variance, product cost is allocated between cost of goods sold and inventory. Current Period Cost Cost of Goods Sold Inventory

63 Reporting for Segments of an Organization
L O 8 Cruisers, Inc. reports the following for a recent quarter: Cruisers reports the following sales, variable expenses, fixed expenses and operating income for a recent quarter. Operating income for the company is $38,000. Operating income for the divisions include: the sailboat division, $28,000: the motorboat division, $16,000; and the repair parts division, $(6,000). Should the repair parts division be discontinued? Let's take a closer look at fixed expenses before we decide. Should the Repair Parts Division be discontinued? Let’s take a closer look at fixed expenses before we decide.

64 Reporting for Segments of an Organization
L O 8 Analysis of fixed expenses shows: Direct fixed expenses are incurred within a division. Common fixed expenses are incurred elsewhere and would continue even if a division is discontinued. An analysis of fixed expenses shows the direct fixed expenses for the repair parts division are $30,000 and common fixed expenses are $16,000. Direct fixed expenses are incurred within a division. Common fixed expenses are incurred elsewhere and would continue even if a division is discontinued.

65 Reporting for Segments of an Organization
L O 8 Segment margin is the Repair Parts Division’s contribution to overall operations. The segment margin is a division's contribution to overall operations (sales minus variable costs minus direct fixed expenses). Common fixed expenses will be incurred whether or not the repair part division is discontinued. Segment margin, $10,000, is the repair parts division's contribution to overall operations. In other words, Cruisers net income will be $10,000 less if the repair parts division is discontinued. Cruisers, Inc.’s Net Income will be $10,000 less if the Repair Parts Division is discontinued.

66 Reporting for Segments of an Organization
L O 8 Cost Center A business section that has control over the incurrence of costs, but no control over revenues or investment funds. Cost A cost center is a business section that has control over the incurrence of costs, but no control over revenues or investment funds.

67 Reporting for Segments of an Organization
L O 8 Revenues Sales Interest Other Costs Mfg. costs Commissions Salaries Profit Center A part of the business that has control over both costs and revenues, but no control over investment funds. A profit center is a part of the business that has control over both costs and revenues, but no control over investment funds.

68 Reporting for Segments of an Organization
L O 8 Investment Center A profit center where management also makes capital investment decisions. An investment center is a profit center where management also makes capital investment decisions. Corporate Headquarters

69 Methods of Evaluating Segments
L O 8 Segment Evaluation Measures Cost Center Actual costs are compared to budgeted costs Actual segment margin is compared to budgeted segment margin Profit Center Evaluation measures for segments are: for a cost center, the actual costs are compared to budgeted costs; for a profit center, the actual segment margin is compared to the budgeted segment margin; and for an investment center, the actual return on investment is compared to the budgeted return on investment. Actual Return on investment is compared to budgeted return on investment Investment Center

70 Analysis of Investment Centers
L O 9 Return on investment (ROI) is the ratio of segment margin to the investment used to generate the segment margin. Segment margin Divisional operating assets ROI = Return on investment (ROI) is the ratio of segment margin to the investment used to generate the segment margin. ROI equals segment margin divided by divisional operating assets.

71 Analysis of Investment Centers
L O 9 Segment Margin Operating assets ROI = Segment margin Sales Sales Operating assets ROI = × ROI equals segment margin divided by operating assets. ROI equals margin (segment margin divided by sales) times turnover (sales divided by operating assets). Margin Turnover

72 Analysis of Investment Centers
L O 9 Cruisers, Inc. reports the following for a recent quarter: Let's compute the margin, turnover, and ROI for Cruisers' segments. Let’s compute the margin, turnover, and ROI for Cruisers.

73 Analysis of Investment Centers
L O 9 Cruisers, Inc. reports the following for a recent quarter: Margin is segment margin divided by sales. Turnover is operating assets divided by sales. ROI is margin times turnover. Cruisers’ statistics for margin, turnover, and ROI are illustrated on this slide.

74 Analysis of Investment Centers
L O 9 Decrease Expenses Increase Sales Prices Lower Invested Capital There are three ways to improve ROI: 1) Increase sales prices; 2) Decrease expenses; and 3) Lower invested capital. Three ways to improve ROI

75 ROI and Dysfunctional Behavior
L O 9 As Sailboat Division Manager at Cruisers, Inc., your compensation package includes a salary plus bonus based on your division’s ROI -- the higher your ROI, the bigger your bonus. The company ROI is 12.6%, but your division is producing an ROI of 15.3%. You have an opportunity to invest in a new project that will produce an ROI of 13.5%. As Sailboat division manager at Cruisers, your compensation package includes a salary plus bonus based on your division's ROI -- the higher your ROI, the bigger your bonus. The company’s ROI is 12.6 percent, but your division is producing an ROI of 15.3 percent. You have an opportunity to invest in a new project that will produce an ROI of 13.5 percent. As division manager, would you invest in this project? As division manager, would you invest in this project?

76 ROI and Dysfunctional Behavior
L O 9 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! A division manager would not want to invest in that project because it would lower his or her pay. Gee, aren't we supposed to do what is best for the company?

77 Residual Income – Another Measure
L O 9 Segment margin less required return on operating assets Residual income is another performance measure.

78 Residual Income Segment margin – Required return = Residual income
L O 9 Segment margin – Required return = Residual income Operating assets × Required ROI = Required return Segment margin less required return equals residual income. Required return is the operating assets times required ROI. Let's calculate the residual income for Cruisers, using the total company information. Let’s calculate the residual income for Cruisers, Inc. using total company information.

79 Residual Income Segment margin = $150,000 – Required return = 120,000
L O 9 Segment margin = $150,000 – Required return = 120,000 = Residual income = $ 30,000 Operating assets = $1,200,000 × Required ROI = × 10% = Required return = $ 120,000 Let’s calculate the residual income for Cruisers, using total company information. Residual income is $30,000 [$150,000 (segment margin) less the required return, $120,000 ($1,200,000 x 0.10)]. Let’s calculate the residual income for Cruisers, Inc. using total company information.

80 Now, let’s find residual income for each of the divisions.
L O 9 The residual income for the company equals $30,000. Now, let's find residual income for each of the divisions. Now, let’s find residual income for each of the divisions.

81 Residual Income L O 9 Residual income for each division is shown on this slide.

82 Residual Income Residual income encourages managers to
L O 9 Residual income encourages managers to make profitable investments that would be rejected by managers using ROI. Residual income encourages managers to make profitable investments that would be rejected by managers using ROI.

83 The Balanced Scorecard
An integrated set of performance measures that show an organization’s performance in meeting its responsibilities to various stakeholders. The balanced scorecard is an integrated set of performance measures that shows an organization's performance in meeting its responsibilities to various stakeholders such as the employee stakeholder group and the investor stakeholder group. Employee Stakeholder Group Investor Stakeholder Group 13

84 The Balanced Scorecard
Financial Perspective How do we look to the firm’s owners? Integrated measures Learning and Growth Perspective How can we continually improve and create value? Internal Business Process Perspective In which activities must we excel? The balanced scorecard financial perspective examines how we look to the firm's owners. The learning and growth perspective examines how we can continually improve and create value. The internal business process perspective identifies the activities in which we must excel. And the customer perspective examines how our customers see us. Customer Perspective How do our customers see us?

85 End of Chapter 15 End of Chapter 15


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