1. 12 - 1  2001 Prentice Hall Business Publishing Management Accounting, 3/E, Atkinson, Banker, Kaplan, and Young Responsibility Centers and Financial Control Chapter 12

2. 12 - 2  2001 Prentice Hall Business Publishing Management Accounting, 3/E, Atkinson, Banker, Kaplan, and Young Introduction u Georgia Tech University developed and maintained athletic programs to generate revenue, to attract top students, and to support alumni fund raising.

3. 12 - 3  2001 Prentice Hall Business Publishing Management Accounting, 3/E, Atkinson, Banker, Kaplan, and Young Introduction u The early 1990s saw the costs of athletic programs at many universities spiraling out of control. u The tightening cost environment created a situation of desperation that called for the development and implementation of a system of financial control for varsity sports.

4. 12 - 4  2001 Prentice Hall Business Publishing Management Accounting, 3/E, Atkinson, Banker, Kaplan, and Young Learning Objectives 1 Describe the form and nature of variance analysis and apply its basic insights. 2 Show why organizations use responsibility centers. 3 Recognize the common forms of responsibility centers. 4 Identify the issues to consider and basic tools to use in assessing the performance of a responsibility center.

5. 12 - 5  2001 Prentice Hall Business Publishing Management Accounting, 3/E, Atkinson, Banker, Kaplan, and Young Learning Objectives 5 Assess the issues and problems created by revenue and cost interactions in evaluating the performance of an organization unit. 6 Identify the transfer-pricing alternatives available to organizations and the criteria for choosing a transfer pricing alternative. 7 Use return on investment and economic value added as financial control tools. 8 Identify the limitations of financial controls.

6. 12 - 6  2001 Prentice Hall Business Publishing Management Accounting, 3/E, Atkinson, Banker, Kaplan, and Young Learning Objective 1 Describe the form and nature of variance analysis and apply its basic insights.

7. 12 - 7  2001 Prentice Hall Business Publishing Management Accounting, 3/E, Atkinson, Banker, Kaplan, and Young Variances u What are variances? u Variances are differences between actual and estimated costs. u Variance analysis is a necessary step to understand why a difference occurred.

8. 12 - 8  2001 Prentice Hall Business Publishing Management Accounting, 3/E, Atkinson, Banker, Kaplan, and Young First-Level Variances u The first-level variance for a cost item is the difference between the actual and master budget costs. u Variances are “favorable” if the actual costs are less than estimated costs. u Variances are “unfavorable” if the actual costs exceeds estimated costs.

9. 12 - 9  2001 Prentice Hall Business Publishing Management Accounting, 3/E, Atkinson, Banker, Kaplan, and Young First-Level Variances Canning Cellular Services (000) Master Actual Budget Costs Difference Direct Material – Welcome Package25,000 29,7004,700 Direct Labor – Sales Staff12,500 14,8502,350 – Technical Staff10,000 10,890 890 Support Cost – Data Processing 3,000 3,960 960 – System Activation45,000 42,900 – 2,100 Total Customer-Related Costs95,500102,3006,800

10. 12 - 10  2001 Prentice Hall Business Publishing Management Accounting, 3/E, Atkinson, Banker, Kaplan, and Young Decomposing Variances u What are flexible budgets? u Flexible budgets recast cost targets in the planned or master budget to reflect the actual level of production. u This allows comparisons of actual results to targets based on the achieved level of production.

11. 12 - 11  2001 Prentice Hall Business Publishing Management Accounting, 3/E, Atkinson, Banker, Kaplan, and Young Decomposing Variances u What are planning variances? u They reflect the effect of the volume change between the master budget and actual activity level achieved. u What are flexible budget variances? u They show the differences between the flexible budget and the actual results.

12. 12 - 12  2001 Prentice Hall Business Publishing Management Accounting, 3/E, Atkinson, Banker, Kaplan, and Young Decomposing Variances Master Budget – Flexible Budget = Planning Variance Flexible Budget – Actual Results = Flexible Budget Variance Planning variances and flexible budget variances are called secondary variances.

13. 12 - 13  2001 Prentice Hall Business Publishing Management Accounting, 3/E, Atkinson, Banker, Kaplan, and Young Decomposing Variances u What is the direct material efficiency or usage variance? u It is actual quantity used at target or standard price less the flexible budget allowance at the planned or target price. u Usage Variance = (AQ – SQ) × SP u What is the direct material price variance? u Price Variance = (AP – SP) × AQ

14. 12 - 14  2001 Prentice Hall Business Publishing Management Accounting, 3/E, Atkinson, Banker, Kaplan, and Young Decomposing Variances u What is the efficiency or usage variance for direct labor costs? u Efficiency Variance = (AH – SH) × SR u What is the rate variance for direct labor costs? u Rate Variance = (AR – SR) × AH u Support costs can also be analyzed in detail.

15. 12 - 15  2001 Prentice Hall Business Publishing Management Accounting, 3/E, Atkinson, Banker, Kaplan, and Young Decomposing Variances u Support costs can reflect flexible or capacity-related costs. u The quantity of capacity-related costs may not change from period to period, but the spending on them may fluctuate. u What are flexible support costs? u They reflect operations that are proportional to the volume of activity.

16. 12 - 16  2001 Prentice Hall Business Publishing Management Accounting, 3/E, Atkinson, Banker, Kaplan, and Young Decomposing Variances Master Planning Flexible Budget Variance Budget Direct Material – Welcome Package25,000 2,500 27,500 Direct Labor – Sales Staff12,500 1,250 13,750 – Technical Staff10,000 1,000 11,000 Support Cost – Data Processing 3,000 300 3,300 – System Activation45,000 4,500 49,500 Total Customer-Related Costs95,500 9,550105,050 Canning Cellular Services (000)

17. 12 - 17  2001 Prentice Hall Business Publishing Management Accounting, 3/E, Atkinson, Banker, Kaplan, and Young Decomposing Variances Flexible Actual Budget Variance Results Direct Material – Welcome Package 2,200 29,700 Direct Labor – Sales Staff 1,100 14,850 – Technical Staff – 110 10,890 Support Cost – Data Processing 660 3,960 – System Activation– 6,600 42,900 Total Customer-Related Costs– 2,750102,300 Canning Cellular Services (000)

18. 12 - 18  2001 Prentice Hall Business Publishing Management Accounting, 3/E, Atkinson, Banker, Kaplan, and Young Decomposing Variances u The following information relates to Canning Cellular Service: u The actual number of new customers were 1,100,000. Direct Materials SQ: 1 AQ: 1 SP: $25 AP: $27 Direct Labor Sales Staff SH:.50 AH:.45 SR: $25 AR: $30

19. 12 - 19  2001 Prentice Hall Business Publishing Management Accounting, 3/E, Atkinson, Banker, Kaplan, and Young Decomposing Variances Direct Labor Technical Staff SH:.25 AH:.22 SR: $40 AR: $45 Support Cost Data Processing SH:.20 AH:.24 SR: $15 AR: $15 Support Cost System Activation SH:.15 AH:.12 SR: $300 AR: $325

20. 12 - 20  2001 Prentice Hall Business Publishing Management Accounting, 3/E, Atkinson, Banker, Kaplan, and Young Decomposing Variances u Materials efficiency variance = 0 u Materials price variance: ($25 SP – $27 AP) × 1,100,000 = $2,200,000 U u Flexible budget variance = $2,200,000 U u Sales staff efficiency variance: (550,000 SH – 495,000 AH) × $25 = $1,375,000 F

21. 12 - 21  2001 Prentice Hall Business Publishing Management Accounting, 3/E, Atkinson, Banker, Kaplan, and Young Decomposing Variances u Sales staff rate variance: ($25 SR – $30 AR) × 495,000 = $2,475,000 U u Flexible budget variance = $1,100,000 U u Technical staff efficiency variance: (275,000 SH – 242,000 AH ) × $40 = $1,320,000 F

22. 12 - 22  2001 Prentice Hall Business Publishing Management Accounting, 3/E, Atkinson, Banker, Kaplan, and Young Decomposing Variances u Technical staff rate variance: ($40 SR – $4 AR) × 242,000 = $1,210,000 U u Flexible budget variance = $110,000 F u Support cost data processing efficiency: variance (220,000 SH – 264,000 AH) × $15 = $660,000 U u Rate variance = 0 u Flexible budget variance = $660,000 U

23. 12 - 23  2001 Prentice Hall Business Publishing Management Accounting, 3/E, Atkinson, Banker, Kaplan, and Young Decomposing Variances u Support cost system activation efficiency variance: (165,000 SH – 132,000 AH) × $300 = $9,900,000 F u Support cost system activation rate variance ($300 SR – $325 AR) × 132,000 = $3,300,000 U u Flexible budget variance = $6,600,000 F

24. 12 - 24  2001 Prentice Hall Business Publishing Management Accounting, 3/E, Atkinson, Banker, Kaplan, and Young Decomposing Variances Master Budget Flexible Budget Actual Results Planning Variance Flexible Budget Variance Total Variance

25. 12 - 25  2001 Prentice Hall Business Publishing Management Accounting, 3/E, Atkinson, Banker, Kaplan, and Young Decomposing Variances Usage Variance Flexible Budget Variance Actual Quantity × Standard Price Standard Quantity × Standard Price Actual Quantity × Actual Price Price Variance

26. 12 - 26  2001 Prentice Hall Business Publishing Management Accounting, 3/E, Atkinson, Banker, Kaplan, and Young Decomposing Variances Second Level Variances Planning variances Flexible budget variances First Level Variances Difference between the actual and master budget costs Third Level Variances Use and price variances

27. 12 - 27  2001 Prentice Hall Business Publishing Management Accounting, 3/E, Atkinson, Banker, Kaplan, and Young Learning Objective 2 Show why organizations use responsibility centers.

28. 12 - 28  2001 Prentice Hall Business Publishing Management Accounting, 3/E, Atkinson, Banker, Kaplan, and Young Decentralization u What are centralized organizations? u Organizations which reserve most of the decision-making power for senior executives. u Centralization works effectively in organizations with stable environments.

29. 12 - 29  2001 Prentice Hall Business Publishing Management Accounting, 3/E, Atkinson, Banker, Kaplan, and Young Decentralization u What are decentralized organizations? u Organizations which delegate a good deal of the decision-making authority to lower- level managers. u Decentralized organizations are effective in environments requiring quick responses to change.

30. 12 - 30  2001 Prentice Hall Business Publishing Management Accounting, 3/E, Atkinson, Banker, Kaplan, and Young Decentralization u Three conditions are necessary for effective decentralization: 1 Employees must be given, and accept, the authority and responsibility to make decisions.

31. 12 - 31  2001 Prentice Hall Business Publishing Management Accounting, 3/E, Atkinson, Banker, Kaplan, and Young Decentralization 2 Employees must have the training and skills they need to accept the decision making responsibility. 3 The organization must have a system in place that guides and coordinates the activities of decentralized decision makers.

32. 12 - 32  2001 Prentice Hall Business Publishing Management Accounting, 3/E, Atkinson, Banker, Kaplan, and Young Controlling Operations u The major purpose of decentralization is to give decision makers the responsibility to make operating decisions. u This creates a need for operations control. u What is the focus of operations control? u It focuses on finding the best operating decisions.

33. 12 - 33  2001 Prentice Hall Business Publishing Management Accounting, 3/E, Atkinson, Banker, Kaplan, and Young Controlling Operations u What is the focus of financial control? u It focuses on an overall assessment of how well operations control is working to improve financial performance.

34. 12 - 34  2001 Prentice Hall Business Publishing Management Accounting, 3/E, Atkinson, Banker, Kaplan, and Young Learning Objective 3 Recognize the common forms of responsibility centers.

35. 12 - 35  2001 Prentice Hall Business Publishing Management Accounting, 3/E, Atkinson, Banker, Kaplan, and Young Responsibility Centers u What is a responsibility center? u It is an organization unit for which a manager is made responsible. u The center’s manager and supervisor establish specific and measurable goals for the responsibility center. u The goals should promote the long-term interest of the organization.

36. 12 - 36  2001 Prentice Hall Business Publishing Management Accounting, 3/E, Atkinson, Banker, Kaplan, and Young Responsibility Centers u Responsibility centers are classified into four types: 1 Cost centers 2 Revenue centers 3 Profit centers 4 Investment centers

37. 12 - 37  2001 Prentice Hall Business Publishing Management Accounting, 3/E, Atkinson, Banker, Kaplan, and Young Responsibility Centers u What is a cost center? u It is a responsibility center whose employees control costs but do not control its revenues or investment level.

38. 12 - 38  2001 Prentice Hall Business Publishing Management Accounting, 3/E, Atkinson, Banker, Kaplan, and Young Responsibility Centers u What is a revenue center? u It is a responsibility center whose members control revenues but do not control the cost of the product or service they sell or the level of investment in the responsibility center.

39. 12 - 39  2001 Prentice Hall Business Publishing Management Accounting, 3/E, Atkinson, Banker, Kaplan, and Young Responsibility Centers u What is a profit center? u It is a responsibility center whose manager and other employees control both the revenues and the costs of the product or service they sell or deliver.

40. 12 - 40  2001 Prentice Hall Business Publishing Management Accounting, 3/E, Atkinson, Banker, Kaplan, and Young Responsibility Centers u What is an investment center? u It is a responsibility center whose manager and other employees control the revenues, costs, and the level of investment in the responsibility center.

41. 12 - 41  2001 Prentice Hall Business Publishing Management Accounting, 3/E, Atkinson, Banker, Kaplan, and Young Learning Objective 4 Identify the issues to consider and basic tools to use in assessing the performance of a responsibility center.

42. 12 - 42  2001 Prentice Hall Business Publishing Management Accounting, 3/E, Atkinson, Banker, Kaplan, and Young Evaluating Responsibility Centers u Underlying the accounting classifications of responsibility centers is the concept of controllability. u The controllability principle asserts that people should only be held accountable for results that they can control. u It is often difficult to apply the controllability principle.

43. 12 - 43  2001 Prentice Hall Business Publishing Management Accounting, 3/E, Atkinson, Banker, Kaplan, and Young Evaluating Responsibility Centers u What are some problems associated with controllability? – jointly earned revenues and/or jointly incurred costs – intricate, and often arbitrary, accounting procedures

44. 12 - 44  2001 Prentice Hall Business Publishing Management Accounting, 3/E, Atkinson, Banker, Kaplan, and Young Learning Objective 5 Assess the issues and problems created by revenue and cost interactions in evaluating the performance of an organization unit.

45. 12 - 45  2001 Prentice Hall Business Publishing Management Accounting, 3/E, Atkinson, Banker, Kaplan, and Young Using Segment Margin Reports u What is a segment margin? u It is the level of controllable profit reported by an organizational unit or product line.

46. 12 - 46  2001 Prentice Hall Business Publishing Management Accounting, 3/E, Atkinson, Banker, Kaplan, and Young Using Segment Margin Reports Revenue$950,000$1,250,000$2,200,000 Variable Costs 750,000 950,000 1,700,000 Contribution Margin$200,000$ 300,000$ 500,000 Other Costs 75,000 60,000 135,000 Segment Margin$125,000$ 240,000$ 365,000 Allocated Costs 70,000 80,000 150,000 Income$ 55,000$ 160,000$ 215,000 Unallocated Costs 300,000 Organization Profit ($85,000) New Car Sales Used Car Sales Total

47. 12 - 47  2001 Prentice Hall Business Publishing Management Accounting, 3/E, Atkinson, Banker, Kaplan, and Young Using Segment Margin Reports u What type of problem can occur when organizations evaluate responsibility centers as profit centers? – identifying responsibility for the control of sales and costs

48. 12 - 48  2001 Prentice Hall Business Publishing Management Accounting, 3/E, Atkinson, Banker, Kaplan, and Young Using Segment Margin Reports u Organizations use two different approaches to evaluate segment margin numbers: 1 Past performance u Is performance this period reasonable, given past experience? 2 Comparable organizations u How does performance compare to similar organizations?

49. 12 - 49  2001 Prentice Hall Business Publishing Management Accounting, 3/E, Atkinson, Banker, Kaplan, and Young Using Segment Margin Reports u What are some limitations of segment margin reporting? 1 Margins can be highly aggregated summaries. 2 Some segment reports contain arbitrary, or soft, numbers. 3 Revenue figures often reflect assumptions and allocations that can be misleading.

50. 12 - 50  2001 Prentice Hall Business Publishing Management Accounting, 3/E, Atkinson, Banker, Kaplan, and Young Using Segment Margin Reports u Because of these limitations, interpreting segment margins should be done carefully. u Other critical success factors should be used as well to assess performance.

51. 12 - 51  2001 Prentice Hall Business Publishing Management Accounting, 3/E, Atkinson, Banker, Kaplan, and Young Learning Objective 6 Identify the transfer-pricing alternatives available to organizations and the criteria for choosing a transfer pricing alternative.

52. 12 - 52  2001 Prentice Hall Business Publishing Management Accounting, 3/E, Atkinson, Banker, Kaplan, and Young Transfer Pricing u What is transfer pricing? u It is a set of tools and methods used to attribute revenues earned by the organization to organization sub-units.

53. 12 - 53  2001 Prentice Hall Business Publishing Management Accounting, 3/E, Atkinson, Banker, Kaplan, and Young Transfer Pricing u Transfer pricing can be very arbitrary, especially if there is a high degree of interaction among the responsibility centers.

54. 12 - 54  2001 Prentice Hall Business Publishing Management Accounting, 3/E, Atkinson, Banker, Kaplan, and Young Transfer Pricing Interrelationships Body Shop Department Service Department Leasing Department Used Car DepartmentNew Car Department New Car Preparation Repairs New Car Preparation Used Cars

55. 12 - 55  2001 Prentice Hall Business Publishing Management Accounting, 3/E, Atkinson, Banker, Kaplan, and Young Approaches to Transfer Pricing u There are four approaches to transfer pricing: – Market-Based – Cost-Based – Negotiated – Administered

56. 12 - 56  2001 Prentice Hall Business Publishing Management Accounting, 3/E, Atkinson, Banker, Kaplan, and Young Approaches to Transfer Pricing Market-Based Transfer Pricing If a good external market exists for the transferred product or service, then market prices are the most appropriate basis for pricing. Unfortunately, these markets with well-defined prices seldom exist.

57. 12 - 57  2001 Prentice Hall Business Publishing Management Accounting, 3/E, Atkinson, Banker, Kaplan, and Young Approaches to Transfer Pricing Cost-Based Transfer Prices Variable cost plus a markup Full cost Full cost plus a markup

58. 12 - 58  2001 Prentice Hall Business Publishing Management Accounting, 3/E, Atkinson, Banker, Kaplan, and Young Approaches to Transfer Pricing u What are some concerns about cost-based transfer prices? – Cost-based transfer prices do not provide the appropriate economic guidance when operations are capacity constrained. – They do not focus on the intent of the system, which is to allow calculation of unit incomes.

59. 12 - 59  2001 Prentice Hall Business Publishing Management Accounting, 3/E, Atkinson, Banker, Kaplan, and Young Approaches to Transfer Pricing u Economists argue that only marginal cost transfer prices are optimal. u If the transfer price is higher than the marginal cost… – the supplying unit wants to sell more than the optimal quantity, and – the purchasing unit wants to buy fewer than the optimal quantity.

60. 12 - 60  2001 Prentice Hall Business Publishing Management Accounting, 3/E, Atkinson, Banker, Kaplan, and Young Approaches to Transfer Pricing Negotiated Transfer Prices Supplying and receiving responsibility centers negotiate prices. Prices reflect both negotiating skills and economic considerations. Optimal transfer price is the the net realizable value of the last unit supplied for all units supplied.

61. 12 - 61  2001 Prentice Hall Business Publishing Management Accounting, 3/E, Atkinson, Banker, Kaplan, and Young Approaches to Transfer Pricing Negotiated Transfer Prices Reflect the accountability and controllability principles underlying responsibility centers Can easily lead to decisions that do not provide the greatest economic benefits

62. 12 - 62  2001 Prentice Hall Business Publishing Management Accounting, 3/E, Atkinson, Banker, Kaplan, and Young Approaches to Transfer Pricing Administered Transfer Prices Prices set by a rule, policy, or an arbitrator Easy to administer Arbitrary Tend to violate the spirit of the responsibility approach

63. 12 - 63  2001 Prentice Hall Business Publishing Management Accounting, 3/E, Atkinson, Banker, Kaplan, and Young Learning Objective 7 Use return on investment and economic value added as financial control tools.

64. 12 - 64  2001 Prentice Hall Business Publishing Management Accounting, 3/E, Atkinson, Banker, Kaplan, and Young Efficiency and Productivity Elements of ROI ROI = Operating Income ÷ Investment ROI = Operating Income × Sales Sales Investment ROI = Return on Sales × Asset Turnover = Efficiency × Productivity

65. 12 - 65  2001 Prentice Hall Business Publishing Management Accounting, 3/E, Atkinson, Banker, Kaplan, and Young Efficiency and Productivity Elements of ROI u What is efficiency? u It is a measure of an organization’s ability to control costs. Operations Efficiency = Standard Cost Actual Cost

66. 12 - 66  2001 Prentice Hall Business Publishing Management Accounting, 3/E, Atkinson, Banker, Kaplan, and Young Efficiency and Productivity Elements of ROI u What is productivity? u It is a ratio of output to input. u In financial control, this is the ratio of sales to investment.

67. 12 - 67  2001 Prentice Hall Business Publishing Management Accounting, 3/E, Atkinson, Banker, Kaplan, and Young Assessing Return on Investment u Analyze trends. u Compare to competitors. u Decompose and compare to competitors. u Look for signals suggesting where there might be problems.

68. 12 - 68  2001 Prentice Hall Business Publishing Management Accounting, 3/E, Atkinson, Banker, Kaplan, and Young Using Economic Value Added u What is economic value added? u It is an investment criterion, previously called residual income. Economic Value Added = Income – Cost of Capital

69. 12 - 69  2001 Prentice Hall Business Publishing Management Accounting, 3/E, Atkinson, Banker, Kaplan, and Young Using Economic Value Added u EVA evaluates income relative to the level of investment required to earn that income. u It motivates managers to do what they think is necessary to make economic value added as large as possible.

70. 12 - 70  2001 Prentice Hall Business Publishing Management Accounting, 3/E, Atkinson, Banker, Kaplan, and Young Learning Objective 8 Identify the limitations of financial controls.

71. 12 - 71  2001 Prentice Hall Business Publishing Management Accounting, 3/E, Atkinson, Banker, Kaplan, and Young The Efficacy of Financial Control u What are some criticisms of financial control? u Information is delayed. u Information is highly aggregated. u Its measures are narrow and do not evaluate how well the organization is doing in meeting stakeholders’ requirements. u It is too focused on short-term results.

72. 12 - 72  2001 Prentice Hall Business Publishing Management Accounting, 3/E, Atkinson, Banker, Kaplan, and Young The Efficacy of Financial Control u How should we interpret these facets of financial control? u Financial control is an important tool in the process of control. u Used properly, it provides crucial help in assessing the organization’s long-term viability and identifying processes that need improvement.

73. 12 - 73  2001 Prentice Hall Business Publishing Management Accounting, 3/E, Atkinson, Banker, Kaplan, and Young Conclusion u Georgia Tech implemented a Responsibility Approach Center (RAC), which focuses on computing a cost per sport. u The analysis revealed that all sports, with the exception of basketball, were a net drain on the University’s resources.

74. 12 - 74  2001 Prentice Hall Business Publishing Management Accounting, 3/E, Atkinson, Banker, Kaplan, and Young End of Chapter 12