1. 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
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2. LEARNING OBJECTIVES
LO1: Define a performance management and evaluation system and responsibility accounting, and describe the roles they play in performance analysis.
LO2: Use flexible budgets and variable costing to analyze cost center and profit center performance.
LO3: Analyze investment centers using return on investment, residual income, and economic value added.
LO4: Describe how the balanced scorecard aligns performance with organizational goals.
LO5: Explain how properly linked performance incentives and measures add value for all stakeholders in performance management and evaluation.
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3. SECTION 1: CONCEPTS
Comparability: the convention of presenting information in a way that enables decision makers to recognize similarities, differences, and trends over different periods in the same company and among different companies
Understandability: the qualitative characteristic of information that enables users to comprehend the meaning of the information they receive
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4. Concepts Underlying Performance Analysis (slide 1 of 2)
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.
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5. Concepts Underlying Performance Analysis (slide 2 of 2)
Financial performance measures use monetary information to measure and compare the performance of a profit-generating organization or its divisions, departments, product lines, sales territories, or operating activities.
Nonfinancial performance measures use statistics to understand how to reduce or eliminate waste and inefficiencies in operating activities.
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6. What to Measure, How to Measure (slide 1 of 2)
Performance measurement is the use of quantitative tools to understand an organization’s performance in relation to a specific goal or an expected outcome.
As part of their performance management systems, organizations assign resources to specific areas of responsibility and track how the managers of those areas use those resources.
All managers at all levels are then evaluated in terms of their ability to manage their areas of responsibility.
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7. What to Measure, How to Measure (slide 2 of 2)
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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8. Types of Responsibility Centers
There are five types of responsibility centers:
cost center
discretionary cost center
revenue center
profit center
investment center
The key characteristics of each type of responsibility center are summarized on the next screen.
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9. Types of Responsibility Centers
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10. 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.
Assembly plants are good examples of cost centers.
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.
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11. Discretionary Cost Center
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.
Departments that perform administrative activities are typical examples of discretionary cost centers.
Because the spending and use of resources in discretionary cost centers are not clearly linked to the production of a product or service, cost-based measures usually cannot be used to evaluate performance.
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12. Revenue 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.
Examples of revenue centers are national car reservation centers and ecommerce order departments.
A revenue center’s performance is usually evaluated by comparing its actual revenue with its budgeted revenue and analyzing the resulting variances.
Performance measures may include sales dollars, number of customer sales, or sales revenue per minute.
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13. Profit Center
A responsibility center whose manager is accountable for both revenue and costs and for the resulting operating income is called a profit center.
A good example is a local store of a national chain.
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.
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14. 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.
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15. Organizational Structure and Performance Reports
Much can be learned about an organization by examining how its managers organize activities and resources.
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.
The next slide shows a typical corporate organization chart.
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16. Partial Organization Chart of the Restaurant Division
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17. 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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18. ©2014 Cengage Learning. All Rights Reserved
©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.

19. SECTION 2: ACCOUNTING APPLICATIONS
Create a flexible budget
Create a variable costing income statement
Compute return on investment (ROI)
Compute residual income (RI)
Compute economic value added (EVA)
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20. 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.
The budgets that make up a master budget are usually based on a single level of output, but many things can cause actual output to differ from the estimated output.
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21. Flexible Budgets and Performance Analysis
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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22. 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:
The flexible budget formula for Winter Wonderland’s House Dressing would be computed as follows:
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23. Flexible Budget for House Dressing
A flexible budget for Winter Wonderland’s House Dressing is shown below for 1,000, 1,200, and 1,500 gallons of salad dressing output.
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24. Evaluating Cost Center Performance Using Flexible Budgeting
The performance report on House Dressing presented on the next slide compares data from Winter Wonderland’s master budget and flexible budget with the actual results of the period.
Although actual costs exceeded budgeted costs, the amounts budgeted in the master budget are based on an output of 1,000 units of dressing and the actual output was 1,200 units.
To judge performance accurately, the company needs to change the budgeted data to reflect an output of 1,200 units, as shown on the next slide.
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25. Central Kitchen’s Performance Report on House Dressing
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26. Evaluating Profit Center Performance Using Variable Costing (slide 1 of 2)
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 and evaluation because it focuses on cost variability and the profit center’s contribution to operating income.
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27. Evaluating Profit Center Performance Using Variable Costing (slide 2 of 2)
The format of a variable costing income statement follows:
As shown on the next slide, the variable costing income statement differs from the traditional income statement prepared for financial reporting.
Only the variable manufacturing costs are included in the variable cost of goods sold.
Fixed manufacturing costs are listed with fixed selling expenses after the contribution margin has been computed.
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28. Variable Costing Income Statement Versus Traditional Income Statement for Trenton Restaurant (Amounts in Thousands)
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29. Performance Report Based on Variable Costing and Flexible Budgeting for Trenton Restaurant (Amounts in Thousands)
A manager of a profit center may also want to measure and evaluate nonfinancial information, such as the number of food orders processed and the average amount of a sales order at Trenton Restaurant.
The resulting report, based on variable costing and flexible budgeting, is shown below.
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30. ©2014 Cengage Learning. All Rights Reserved
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31. Performance Evaluation of Investment Centers
The evaluation of an investment center’s performance requires more than a comparison of controllable revenues and costs with budgeted amounts.
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.
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32. Return on Investment (slide 1 of 2)
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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33. Return on Investment (slide 2 of 2)
Properly measuring the income and the assets specifically controlled by a manager is critical to the quality of this performance measure.
As shown on the next slide, Winter Wonderland’s Restaurant Division had actual operating income of $610, and the average assets invested were $800. The master budget called for $890 in operating income and $1,000 in invested assets.
The actual ROI was lower than the budgeted ROI because the actual operating income was lower than expected relative to the actual assets invested.
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34. Performance Report Based on Return on Investment for the Restaurant Division
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35. Return on Investment
The basic ROI equation (Operating Income ÷ Assets Invested) can be rewritten to show the many 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.
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36. Return on Investment
A single ROI number is a composite index of many cause-and-effect relationships and interdependent financial elements.
The following formula recognizes the many interrelationships that affect ROI:
A manager can improve ROI by increasing sales, decreasing costs, or decreasing assets.
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37. Residual Income (slide 1 of 3)
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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38. Residual Income (slide 2 of 3)
Winter Wonderland’s Restaurant Division’s performance report based on residual income is shown below.
The residual income performance target is to exceed a 20 percent return on assets invested in the division.
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39. Residual Income (slide 3 of 3)
Comparisons with other residual income figures will strengthen the analysis. To add context to the analysis of the division and its manager, questions such as the following need to be answered:
How did the division’s residual income this year compare with its residual income in previous years?
Did the actual residual income exceed the budgeted residual income?
How did this division’s residual income compare with the amounts generated by other investment centers of the company?
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40. Economic Value Added (slide 1 of 2)
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.
A manager can improve the economic value of an investment center by increasing sales, decreasing costs, decreasing assets, or lowering the cost of capital.
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41. Economic Value Added (slide 2 of 2)
A basic computation of EVA for Winter Wonderland’s Restaurant Division is shown below.
The report shows that the division has added $334 to its economic value after taxes and cost of capital. In other words, the division produced after-tax profits of $334 in excess of the cost of capital required to generate those profits.
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42. ©2014 Cengage Learning. All Rights Reserved
©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.

43. SECTION 3: BUSINESS APPLICATIONS
Balanced scorecard
Benchmarking
Planning
Performing
Evaluating
Communicating
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44. 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 and how to improve it, managers must collaborate to develop a group of measures, such as the balanced scorecard.
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45. Organizational Goals and the Balanced Scorecard
The balanced scorecard is a framework that 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.
To succeed, an organization must add value for all groups in both the short and the long term.
The next few slides illustrate how managers use the balanced scorecard.
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46. Planning (slide 1 of 3)
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 and seek to answer one key question for each group:
Financial (investor): To achieve our organization’s vision, how should we appear to our shareholders?
Learning and growth (employee): To achieve our organization’s vision, how should we sustain our ability to improve and change?
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47. Planning (slide 2 of 3)
Internal business processes: To succeed, in which business processes must our organization excel?
Customer: To achieve our organization’s vision, how should we appeal to our customers?
The answers to these questions result in performance objectives that are mutually beneficial to all stakeholders.
For example, if Winter Wonderland’s collective vision and strategy is to please guests, its managers might establish the overall objectives shown on the next slide.
These overall objectives are then translated into specific performance objectives and measures for specific managers.
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48. Planning (slide 3 of 3)
The next slide summarizes how Winter Wonderland’s managers might link their organization’s vision and strategy to objectives, then link the objectives to logical performance measures, and, finally, set performance targets for a ski lift manager.
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49. Sample Balanced Scorecard of Linked Objectives, Performance Measures, and Targets
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50. 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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51. Evaluating
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.
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52. Communicating
A variety of reports enable managers to monitor and evaluate performance measures that add value for stakeholder groups.
For example, a database makes it possible to prepare financial performance reports, customer statements, internal business process reports for targeted performance measures and results, and performance appraisals of individual employees.
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53. Performance Evaluation and the Management Process
The graphic below summarizes the ways in which performance measures and evaluation support and inform the management process.
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54. ©2014 Cengage Learning. All Rights Reserved
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55. 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.
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56. Linking Goals, Performance Objectives, Measures, and Performance Targets
The causal links among an organization’s goals, performance objectives, measures, and targets must be apparent.
For example, if a company seeks to be an environmental steward, as Winter Wonderland does, it may choose the following linked goal, objective, measure, and performance target.
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57. Performance-Based Pay
Tying appropriate compensation incentives to performance targets increases the likelihood that the goals of responsibility centers, managers, and the entire organization will be well coordinated.
Performance-based pay is the linking of employee compensation to the achievement of measurable business targets.
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.
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58. The Coordination of Goals
To determine the right performance incentives for their organization, employees and managers must answer several questions:
When should the reward be given—now or sometime in the future?
Whose performance should be rewarded—responsibility centers, individual managers, or the entire company?
How should the reward be computed?
On what should the reward be based?
What performance criteria should be used?
Does the performance incentive plan address the interests of all stakeholders?
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59. The Coordination of Goals
The effectiveness of a performance management and evaluation system relies on the coordination of responsibility center, managerial, and company goals.
Performance can be optimized by linking goals to measurable objectives and targets and by tying appropriate compensation incentives to the achievement of the targets.
If management values the perspectives of all of its stakeholder groups, its performance management and evaluation system will balance and benefit all interests.
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60. ©2014 Cengage Learning. All Rights Reserved
©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.