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Budgeting and budgeting control

The document discusses key concepts related to budgetary control including: - Static and flexible budgets which are used to control operations by comparing actual results to planned objectives. - Responsibility accounting which involves accumulating and reporting revenues and costs based on the manager who has authority over decisions. - Types of responsibility centers like cost centers, profit centers, and investment centers. - Performance evaluation principles for responsibility centers and the use of budgets, reports, and metrics like residual income and return on investment to evaluate managers.

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Budgetary Control Static Budgets Budgeting and Budgetary Control Flexible Budgets Responsibility Accounting Responsibility Reports/Cost Responsibility Reports -Profit Investment Centers Previous Next Slide Slide S EL End Show 7-1
Budgetary Control and Budgetary Control Responsibility Accounting Static Budgets Flexible Budgets Responsibility Accounting Responsibility Reports/Cost Responsibility Reports -Profit Investment Centers Previous Next Slide Slide End Show 7-2
Budgetary Management Functions Control Static Budgets • Planning Flexible Budgets Responsibility Accounting • Directing and Motivating Responsibility Reports/Cost Responsibility • Controlling Reports -Profit Investment Centers Previous Next Slide Slide End Show 7-3
Budgetary Control Budgetary Control • One of the three main Static Budgets Flexible Budgets functions of management Responsibility Accounting is to control. Responsibility Reports/Cost • Budgets are useful in Responsibility Reports -Profit Investment controlling operations. Centers Previous Next Slide Slide End Show 7-4
Budgetary Control Budgetary Control Static Budgets The use of budgets to Flexible Budgets control operations. Responsibility Accounting Compare actual results Responsibility Reports/Cost with planned objectives. Responsibility TS Reports -Profit EN L EMCIA BU AT N ST INA DG Investment F TE Centers Previous Next Slide Slide End Show 7-5
Illustration 7-1 Budgetary Control Budgetary Control Static Budgets Flexible Budgets Responsibility Accounting Responsibility Reports/Cost Responsibility Reports -Profit Investment Centers Previous Next Slide Slide End Show 7-6
Illustration 7-2 Budgetary Control Reporting System
Illustration 7-6 Static Budget Budgetary Control Static Budgets A projection of budget data Flexible Budgets at one level of activity. Responsibility Accounting Barton Steel (Forging Department) Manufacturing Overhead Budget (Static) Responsibility For the Year Ended December 31, 2002 Reports/Cost Responsibility Budgeted Production in units (steel ingots) Budgeted Production in units (steel ingots) 10,000 10,000 Reports -Profit Budgeted Costs Budgeted Costs Indirect materials Indirect materials $$250,000 250,000 Investment Indirect labor 260,000 Indirect labor 260,000 Centers Utilities 190,000 Utilities 190,000 Depreciation Depreciation 280,000 280,000 Property taxes Property taxes 70,000 70,000 Supervision Supervision 50,000 50,000 Previous Next $1,100,000 $1,100,000 Slide Slide End Show 7-8
Static Budget Budgetary Control Static Budgets Flexible Budgets Responsibility Accounting Responsibility Reports/Cost Responsibility Reports -Profit Investment Centers Previous Next Slide Slide End Show 7-9
Flexible Budget Budgetary Control Static Budgets A projection Flexible Budgets of budget Responsibility Accounting data for Responsibility Reports/Cost various Responsibility Reports -Profit levels of Investment activity. Centers Previous Next Slide Slide End Show 7 - 10
Illustration 7-13 Flexible Budget Fox Manufacturing Company (Finishing Department) Flexible Monthly Manufacturing Overhead Budget For the Month Ended January 31, 2002 Activity level Activity level Direct labor hours Direct labor hours 8,000 8,000 9,000 9,000 10,000 10,000 11,000 11,000 12,000 12,000 Variable costs Variable costs Indirect materials ($1.50) Indirect materials ($1.50) $12,000 $12,000 $13,500 $13,500 $15,000 $15,000 $16,500 $16,500 $18,000 $18,000 Indirect labor ($2.00) Indirect labor ($2.00) 16,000 16,000 18,000 18,000 20,000 20,000 22,000 22,000 24,000 24,000 Utilities ($.50) Utilities ($.50) 4,000 4,000 4,500 4,500 5,000 5,000 5,500 5,500 6,000 6,000 Total variable Total variable 32,000 32,000 36,000 36,000 40,000 40,000 44,000 44,000 48,000 48,000 Fixed costs Fixed costs Depreciation Depreciation 15,000 15,000 15,000 15,000 15,000 15,000 15,000 15,000 15,000 15,000 Supervision Supervision 10,000 10,000 10,000 10,000 10,000 10,000 10,000 10,000 10,000 10,000 Property taxes Property taxes 5,000 5,000 5,000 5,000 5,000 5,000 5,000 5,000 5,000 5,000 Total fixed Total fixed 30,000 30,000 30,000 30,000 30,000 30,000 30,000 30,000 30,000 30,000 Total costs Total costs $62,000 $62,000 $66,000 $66,000 $70,000 $70,000 $74,000 $74,000 $78,000 $78,000
Illustration 7-15 Flexible Budget at 10,000 and 12,000 Levels
Management by Exception Budgetary Control Static Budgets The review of budget reports Flexible Budgets by management focused Responsibility Accounting entirely or primarily on Responsibility Reports/Cost differences between actual Responsibility Reports -Profit results and planned Investment Centers objectives. Previous Next Slide Slide End Show 7 - 13
Illustration 7-17 Responsibility Reporting System Budgetary Control The preparation of reports Static Budgets for each level of Flexible Budgets Responsibility responsibility in the Accounting company’s organization Responsibility Reports/Cost chart. Responsibility Reports -Profit Investment Centers Previous Next Slide Slide End Show 7 - 14
Controllable Costs Budgetary Control Static Budgets Costs that a manager has the Flexible Budgets authority to incur within a Responsibility Accounting given period of time. Responsibility Reports/Cost Responsibility Reports -Profit Investment Centers Previous Next Slide Slide End Show 7 - 15
Illustration 7-17 Responsibility for Controlling Costs Budgetary Control Static Budgets Flexible Budgets Responsibility Accounting Responsibility Reports/Cost Responsibility Reports -Profit Investment Centers Previous Next Slide Slide End Show 7 - 16
Decentralization Budgetary Control Static Budgets Control of operations is Flexible Budgets delegated to many managers Responsibility Accounting throughout the organization. Responsibility Reports/Cost Responsibility Reports -Profit Investment Centers Previous Next Slide Slide End Show 7 - 17
Segment Budgetary Control Static Budgets An area of responsibility in Flexible Budgets decentralized operations. Responsibility Accounting Responsibility Reports/Cost Responsibility Reports -Profit Investment Centers Previous Next Slide Slide End Show 7 - 18
Responsibility Accounting Budgetary Control Static Budgets A part of management Flexible Budgets accounting that involves Responsibility Accounting accumulating and reporting Responsibility Reports/Cost revenues and costs on the Responsibility Reports -Profit basis of the manager who Investment Centers has the authority to make the day-to-day decisions Previous Slide Next Slide about the items. End Show 7 - 19
Illustration 7-20
Direct Fixed Costs Budgetary Control Static Budgets Costs that relate specifically Flexible Budgets to a responsibility center Responsibility Accounting and are incurred for the Responsibility Reports/Cost sole benefit of the center. Responsibility Reports -Profit Investment Centers Previous Next Slide Slide End Show 7 - 21
Indirect Fixed Costs Budgetary Control Static Budgets Costs that are incurred for Flexible Budgets the benefit of more than one Responsibility Accounting profit center. Responsibility Reports/Cost Responsibility Reports -Profit Investment Centers Previous Next Slide Slide End Show 7 - 22
Cost Center Budgetary Control Static Budgets A responsibility center that Flexible Budgets incurs costs but does not Responsibility Accounting directly generate revenues. Responsibility Reports/Cost Responsibility Reports -Profit Investment Centers Previous Next Slide Slide End Show Warranty Dept 7 - 23
Profit Center Budgetary Control Static Budgets A responsibility center that Flexible Budgets incurs costs but also Responsibility Accounting generates revenue. Responsibility Reports/Cost Responsibility Reports -Profit Investment Centers Previous Next Slide Slide End Show 7 - 24
Investment Center Budgetary Control Static Budgets A responsibility center that Flexible Budgets incurs costs, generates Responsibility Accounting revenues, and has control Responsibility Reports/Cost over the investment funds Responsibility Reports -Profit available for use. Investment Centers Previous Next Slide Slide End Show 7 - 25
Illustration 7-18 Budgetary Control Static Budgets Flexible Budgets Responsibility Accounting Responsibility Reports/Cost Responsibility Reports -Profit Investment Centers Previous Next Slide Slide End Show 7 - 26
Illustration 7-22 Responsibility Report Budgetary Control Contribution margin less controllable Static Budgets fixed costs=Controllable Margin. Flexible Budgets Responsibility Mantel Manufacturing Company (Marine Division) Accounting Responsibility Report Responsibility For the Year Ended December 31, 2002 Reports/Cost Difference Difference Responsibility Favorable F Favorable F Reports -Profit Budget Actual Unfavorable U Budget Actual Unfavorable U Investment Sales Sales $1,200,000 $1,150,000 $1,200,000 $1,150,000 $50,000 U $50,000 U Centers Variable Costs Variable Costs Cost of goods sold Cost of goods sold 500,000 500,000 490,000 490,000 10,000 F 10,000 F Selling & administrative Selling & administrative 160,000 160,000 156,000 156,000 4,000 F 4,000 F Total Total 660,000 660,000 646,000 646,000 14,000 F 14,000 F Contribution margin Contribution margin 540,000 540,000 504,000 504,000 36,000 U 36,000 U Previous Next Controllable fixed costs Slide Slide Controllable fixed costs Cost of goods sold Cost of goods sold 100,000 100,000 100,000 100,000 -0- -0- End Selling & administrative Selling & administrative 80,000 80,000 80,000 80,000 -0- -0- Show Total Total 180,000 180,000 180,000 180,000 -0- -0- 7 - 27 Controllable margin Controllable margin $$360,000 $$324,000 360,000 324,000 $36,000 U $36,000 U
Residual Income Budgetary Control The income that remains after Static Budgets Flexible Budgets subtracting from the Responsibility controllable margin the Accounting Responsibility minimum rate of return on a Reports/Cost company’s operating assets. Responsibility Reports -Profit Investment Centers Previous Next Slide Slide End Show 7 - 28
Return on Investment (ROI) Budgetary Control A measure of management’s Static Budgets effectiveness in utilizing assets Flexible Budgets at its disposal in an investment Responsibility Accounting center. Responsibility Reports/Cost Responsibility Reports -Profit Investment Centers Previous Next Slide Slide End Show 7 - 29
Principles of Performance Evaluation Budgetary • Managers of responsibility centers Control should have direct input into the Static Budgets process of establishing budget goals of Flexible Budgets their area of responsibility. Responsibility Accounting • The evaluation of performance should Responsibility be based entirely on matters that are Reports/Cost controllable by the manager being Responsibility evaluated. Reports -Profit • Top management should support the Investment Centers evaluation process. • The evaluation process must allow managers to respond to their Previous Next evaluations. Slide Slide • The evaluation should identify both End Show good and poor performance. 7 - 30
Budgetary Control Static Budgets Flexible Budgets Responsibility • Capital Budgeting Analysis Accounting Responsibility Reports/Cost Responsibility Reports -Profit Investment Centers Previous Next Slide Slide End Show 7 - 31
• Outline Budgetary Control Static Budgets Flexible Budgets Responsibility • Traditional Capital Budgeting Techniques Accounting Responsibility Reports/Cost – Payback Period Approach Responsibility – Discounted Payback Period Approach Reports -Profit – Discounted Cash Flow Techniques Investment • Net Present Value Centers • Internal Rate of Return • Profitability Index • Net Present Value versus Internal Rate of Return Previous Next Slide Slide End Show 7 - 32
• Meaning of Capital Budgeting Budgetary Control Static Budgets • Capital budgeting addresses the issue of Flexible Budgets Responsibility strategic long-term investment decisions. Accounting • Capital budgeting can be defined as the Responsibility Reports/Cost process of analyzing, evaluating, and Responsibility deciding whether resources should be Reports -Profit allocated to a project or not. Investment • Process of capital budgeting ensure Centers optimal allocation of resources and helps management work towards the goal of Previous Next shareholder wealth maximization. Slide Slide End Show 7 - 33
• Significance of Capital Budgeting Budgetary Control Static Budgets Flexible Budgets • Considered to be the most important Responsibility decision that a corporate treasurer Accounting Responsibility has to make. Reports/Cost Responsibility • So much is the significance of capital Reports -Profit budgeting that many business Investment Centers schools offer a separate course on capital budgeting Previous Next Slide Slide End Show 7 - 34
• Why Capital Budgeting is so Budgetary Important? Control Static Budgets Flexible Budgets • Involve massive investment of Responsibility Accounting resources Responsibility • Are not easily reversible Reports/Cost Responsibility • Have long-term implications for Reports -Profit Investment the firm Centers • Involve uncertainty and risk for the firm Previous Next Slide Slide End Show 7 - 35
Why Capital Budgeting is so Important? Budgetary Control • Due to the above factors, capital budgeting decisions become critical and must be evaluated Static Budgets very carefully. Flexible Budgets Responsibility • Any firm that does not follow the capital Accounting budgeting process will not be maximizing Responsibility shareholder wealth and Reports/Cost Responsibility • Management will not be acting in the best Reports -Profit interests of shareholders. Investment Centers • RJR Nabisco’s smokeless cigarette project example – Project initiated in 1989 Previous Next – More than $300 million was invested Slide Slide – Had 2 flaws- required special lighter & was tasteless for smoker End Show – Within 2 years the project failed to deliver 7 - 36
Why Capital Budgeting is so Important? Budgetary • Similarly: Control • Euro-Disney, – Failed miserably because of following factors : Static Budgets – Cultural gap’s – French felt that their children might loose Flexible Budgets french culture as it had more of English culture – Europeans love travelling and not interested in 1 day Responsibility vaccation Accounting – All Investments were Bad (Lost everything) . 1st year $900m Responsibility loss. Reports/Cost • Concorde Plane, – Too noisy Responsibility – Too expensive Reports -Profit – Plane crash in 2000- killed 113 passengers Investment • Saturn of GM Centers – Best selling model to kill competition from Japan cars – For 5 years GM did not make any other model – After 5 years brought various models killing the Saturn model Previous Next Slide Slide All faced problems due to bad capital budgeting, while End Intel became global leader due to sound capital Show budgeting decisions in 1990s. 7 - 37
• Techniques of Capital Budgeting Budgetary Analysis Control Static Budgets • Payback Period Approach Flexible Budgets Responsibility • Discounted Payback Period Accounting Responsibility Approach Reports/Cost • Net Present Value Approach Responsibility Reports -Profit • Internal Rate of Return Investment Centers • Profitability Index Previous Next Slide Slide End Show 7 - 38
• Which Technique should we follow? Budgetary Control Static Budgets Flexible Budgets • A technique that helps us in selecting Responsibility projects that are consistent with the Accounting principle of shareholder wealth Responsibility Reports/Cost maximization. Responsibility • A technique is considered consistent with Reports -Profit Investment wealth maximization if Centers – It is based on cash flows – Considers all the cash flows Previous – Considers time value of money Next Slide Slide – Is unbiased in selecting projects End Show 7 - 39
• Payback Period Approach Budgetary Control Static Budgets Flexible Budgets • The amount of time needed to recover the Responsibility initial investment Accounting • The number of years it takes including a Responsibility Reports/Cost fraction of the year to recover initial investment is called payback period Responsibility Reports -Profit • To compute payback period, keep adding the Investment cash flows till the sum equals initial Centers investment • Simplicity is the main benefit, but suffers from drawbacks Previous Next • Technique is not consistent with wealth Slide Slide maximization—Why? End Show 7 - 40
• Discounted Payback Period Budgetary Control Static Budgets • Similar to payback period approach with Flexible Budgets Responsibility one difference that it considers time value Accounting of money Responsibility Reports/Cost • The amount of time needed to recover Responsibility initial investment given the present value of Reports -Profit cash inflows Investment Centers • Keep adding the discounted cash flows till the sum equals initial investment • All other drawbacks of the payback period Previous Next remains in this approach Slide Slide End • Not consistent with wealth maximization Show 7 - 41
• Net Present Value Approach Budgetary Control Static Budgets Flexible Budgets • Based on the Rupees amount of cash flows Responsibility • The Rupee amount of value added by a Accounting project Responsibility Reports/Cost • NPV equals the present value of cash Responsibility Reports -Profit inflows minus initial investment Investment • Technique is consistent with the principle Centers of wealth maximization—Why? • Accept a project if NPV ≥ 0 Previous Next Slide Slide End Show 7 - 42
• Internal Rate of Return Budgetary Control Static Budgets Flexible Budgets • The rate at which the net present Responsibility value of cash flows of a project is Accounting zero, I.e., the rate at which the Responsibility Reports/Cost present value of cash inflows equals Responsibility initial investment Reports -Profit Investment • Project’s promised rate of return Centers given initial investment and cash flows Previous Next • Consistent with wealth maximization Slide Slide End • Accept a project if IRR ≥ Cost of Show 7 - 43 Capital
• NPV versus IRR Budgetary Control Static Budgets • Usually, NPV and IRR are consistent with Flexible Budgets Responsibility each other. If IRR says accept the project, Accounting NPV will also say accept the project Responsibility • IRR can be in conflict with NPV if Reports/Cost Responsibility – Investing or Financing Decisions Reports -Profit – Projects are mutually exclusive Investment • Projects differ in scale of investment Centers • Cash flow patterns of projects is different – If cash flows alternate in sign—problem of multiple IRR Previous Next Slide Slide • If IRR and NPV conflict, use NPV End approach Show 7 - 44
• Profitability Index (PI) Budgetary Control Static Budgets • A part of discounted cash flow family Flexible Budgets Responsibility • PI = PV of Cash Inflows/initial investment Accounting • Accept a project if PI ≥ 1.0, which means Responsibility Reports/Cost positive NPV Responsibility • Usually, PI consistent with NPV Reports -Profit Investment • PI may be in conflict with NPV if Centers – Projects are mutually exclusive • Scale of projects differ • Pattern of cash flows of projects is different Previous Slide Next Slide • When in conflict with NPV, use NPV End Show 7 - 45
• Evaluating Projects with Unequal Budgetary Lives Control Static Budgets Flexible Budgets • Replacement Chain Analysis Responsibility Accounting • Equivalent Annual Cost Method Responsibility Reports/Cost • If two machines are unequal in life, Responsibility we need to make adjustment before Reports -Profit Investment computing NPV. Centers Previous Next Slide Slide End Show 7 - 46
• Which technique is superior? Budgetary Control Static Budgets • Although our decision should be based on Flexible Budgets NPV, but each technique contributes in Responsibility its own way. Accounting • Payback period is a rough measure of Responsibility riskiness. The longer the payback period, Reports/Cost more risky a project is Responsibility Reports -Profit • IRR is a measure of safety margin in a Investment project. Higher IRR means more safety Centers margin in the project’s estimated cash flows • PI is a measure of cost-benefit analysis. Previous Slide Next How much NPV for every dollar of initial Slide investment End Show 7 - 47

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Budgeting and budgeting control

  • 1.
    Budgetary Control Static Budgets Budgeting and Budgetary Control Flexible Budgets Responsibility Accounting Responsibility Reports/Cost Responsibility Reports -Profit Investment Centers Previous Next Slide Slide S EL End Show 7-1
  • 2.
    Budgetary Control and Budgetary Control Responsibility Accounting Static Budgets Flexible Budgets Responsibility Accounting Responsibility Reports/Cost Responsibility Reports -Profit Investment Centers Previous Next Slide Slide End Show 7-2
  • 3.
    Budgetary Management Functions Control Static Budgets • Planning Flexible Budgets Responsibility Accounting • Directing and Motivating Responsibility Reports/Cost Responsibility • Controlling Reports -Profit Investment Centers Previous Next Slide Slide End Show 7-3
  • 4.
    Budgetary Control Budgetary Control • One of the three main Static Budgets Flexible Budgets functions of management Responsibility Accounting is to control. Responsibility Reports/Cost • Budgets are useful in Responsibility Reports -Profit Investment controlling operations. Centers Previous Next Slide Slide End Show 7-4
  • 5.
    Budgetary Control Budgetary Control Static Budgets The use of budgets to Flexible Budgets control operations. Responsibility Accounting Compare actual results Responsibility Reports/Cost with planned objectives. Responsibility TS Reports -Profit EN L EMCIA BU AT N ST INA DG Investment F TE Centers Previous Next Slide Slide End Show 7-5
  • 6.
    Illustration 7-1 Budgetary Control Budgetary Control Static Budgets Flexible Budgets Responsibility Accounting Responsibility Reports/Cost Responsibility Reports -Profit Investment Centers Previous Next Slide Slide End Show 7-6
  • 7.
    Illustration 7-2 Budgetary Control Reporting System
  • 8.
    Illustration 7-6 Static Budget Budgetary Control Static Budgets A projection of budget data Flexible Budgets at one level of activity. Responsibility Accounting Barton Steel (Forging Department) Manufacturing Overhead Budget (Static) Responsibility For the Year Ended December 31, 2002 Reports/Cost Responsibility Budgeted Production in units (steel ingots) Budgeted Production in units (steel ingots) 10,000 10,000 Reports -Profit Budgeted Costs Budgeted Costs Indirect materials Indirect materials $$250,000 250,000 Investment Indirect labor 260,000 Indirect labor 260,000 Centers Utilities 190,000 Utilities 190,000 Depreciation Depreciation 280,000 280,000 Property taxes Property taxes 70,000 70,000 Supervision Supervision 50,000 50,000 Previous Next $1,100,000 $1,100,000 Slide Slide End Show 7-8
  • 9.
    Static Budget Budgetary Control Static Budgets FlexibleBudgets Responsibility Accounting Responsibility Reports/Cost Responsibility Reports -Profit Investment Centers Previous Next Slide Slide End Show 7-9
  • 10.
    Flexible Budget Budgetary Control Static Budgets A projection Flexible Budgets of budget Responsibility Accounting data for Responsibility Reports/Cost various Responsibility Reports -Profit levels of Investment activity. Centers Previous Next Slide Slide End Show 7 - 10
  • 11.
    Illustration 7-13 Flexible Budget Fox Manufacturing Company (Finishing Department) Flexible Monthly Manufacturing Overhead Budget For the Month Ended January 31, 2002 Activity level Activity level Direct labor hours Direct labor hours 8,000 8,000 9,000 9,000 10,000 10,000 11,000 11,000 12,000 12,000 Variable costs Variable costs Indirect materials ($1.50) Indirect materials ($1.50) $12,000 $12,000 $13,500 $13,500 $15,000 $15,000 $16,500 $16,500 $18,000 $18,000 Indirect labor ($2.00) Indirect labor ($2.00) 16,000 16,000 18,000 18,000 20,000 20,000 22,000 22,000 24,000 24,000 Utilities ($.50) Utilities ($.50) 4,000 4,000 4,500 4,500 5,000 5,000 5,500 5,500 6,000 6,000 Total variable Total variable 32,000 32,000 36,000 36,000 40,000 40,000 44,000 44,000 48,000 48,000 Fixed costs Fixed costs Depreciation Depreciation 15,000 15,000 15,000 15,000 15,000 15,000 15,000 15,000 15,000 15,000 Supervision Supervision 10,000 10,000 10,000 10,000 10,000 10,000 10,000 10,000 10,000 10,000 Property taxes Property taxes 5,000 5,000 5,000 5,000 5,000 5,000 5,000 5,000 5,000 5,000 Total fixed Total fixed 30,000 30,000 30,000 30,000 30,000 30,000 30,000 30,000 30,000 30,000 Total costs Total costs $62,000 $62,000 $66,000 $66,000 $70,000 $70,000 $74,000 $74,000 $78,000 $78,000
  • 12.
    Illustration 7-15 Flexible Budgetat 10,000 and 12,000 Levels
  • 13.
    Management by Exception Budgetary Control StaticBudgets The review of budget reports Flexible Budgets by management focused Responsibility Accounting entirely or primarily on Responsibility Reports/Cost differences between actual Responsibility Reports -Profit results and planned Investment Centers objectives. Previous Next Slide Slide End Show 7 - 13
  • 14.
    Illustration 7-17 Responsibility Reporting System Budgetary Control The preparation of reports Static Budgets for each level of Flexible Budgets Responsibility responsibility in the Accounting company’s organization Responsibility Reports/Cost chart. Responsibility Reports -Profit Investment Centers Previous Next Slide Slide End Show 7 - 14
  • 15.
    Controllable Costs Budgetary Control Static Budgets Costs that a manager has the Flexible Budgets authority to incur within a Responsibility Accounting given period of time. Responsibility Reports/Cost Responsibility Reports -Profit Investment Centers Previous Next Slide Slide End Show 7 - 15
  • 16.
    Illustration 7-17 Responsibility for Controlling Costs Budgetary Control Static Budgets Flexible Budgets Responsibility Accounting Responsibility Reports/Cost Responsibility Reports -Profit Investment Centers Previous Next Slide Slide End Show 7 - 16
  • 17.
    Decentralization Budgetary Control Static Budgets Control of operations is Flexible Budgets delegated to many managers Responsibility Accounting throughout the organization. Responsibility Reports/Cost Responsibility Reports -Profit Investment Centers Previous Next Slide Slide End Show 7 - 17
  • 18.
    Segment Budgetary Control Static Budgets An area of responsibility in Flexible Budgets decentralized operations. Responsibility Accounting Responsibility Reports/Cost Responsibility Reports -Profit Investment Centers Previous Next Slide Slide End Show 7 - 18
  • 19.
    Responsibility Accounting Budgetary Control Static Budgets A part of management Flexible Budgets accounting that involves Responsibility Accounting accumulating and reporting Responsibility Reports/Cost revenues and costs on the Responsibility Reports -Profit basis of the manager who Investment Centers has the authority to make the day-to-day decisions Previous Slide Next Slide about the items. End Show 7 - 19
  • 20.
  • 21.
    Direct Fixed Costs Budgetary Control StaticBudgets Costs that relate specifically Flexible Budgets to a responsibility center Responsibility Accounting and are incurred for the Responsibility Reports/Cost sole benefit of the center. Responsibility Reports -Profit Investment Centers Previous Next Slide Slide End Show 7 - 21
  • 22.
    Indirect Fixed Costs Budgetary Control StaticBudgets Costs that are incurred for Flexible Budgets the benefit of more than one Responsibility Accounting profit center. Responsibility Reports/Cost Responsibility Reports -Profit Investment Centers Previous Next Slide Slide End Show 7 - 22
  • 23.
    Cost Center Budgetary Control Static Budgets A responsibility center that Flexible Budgets incurs costs but does not Responsibility Accounting directly generate revenues. Responsibility Reports/Cost Responsibility Reports -Profit Investment Centers Previous Next Slide Slide End Show Warranty Dept 7 - 23
  • 24.
    Profit Center Budgetary Control Static Budgets A responsibility center that Flexible Budgets incurs costs but also Responsibility Accounting generates revenue. Responsibility Reports/Cost Responsibility Reports -Profit Investment Centers Previous Next Slide Slide End Show 7 - 24
  • 25.
    Investment Center Budgetary Control Static Budgets A responsibility center that Flexible Budgets incurs costs, generates Responsibility Accounting revenues, and has control Responsibility Reports/Cost over the investment funds Responsibility Reports -Profit available for use. Investment Centers Previous Next Slide Slide End Show 7 - 25
  • 26.
    Illustration 7-18 Budgetary Control Static Budgets FlexibleBudgets Responsibility Accounting Responsibility Reports/Cost Responsibility Reports -Profit Investment Centers Previous Next Slide Slide End Show 7 - 26
  • 27.
    Illustration 7-22 Responsibility Report Budgetary Control Contribution margin less controllable Static Budgets fixed costs=Controllable Margin. Flexible Budgets Responsibility Mantel Manufacturing Company (Marine Division) Accounting Responsibility Report Responsibility For the Year Ended December 31, 2002 Reports/Cost Difference Difference Responsibility Favorable F Favorable F Reports -Profit Budget Actual Unfavorable U Budget Actual Unfavorable U Investment Sales Sales $1,200,000 $1,150,000 $1,200,000 $1,150,000 $50,000 U $50,000 U Centers Variable Costs Variable Costs Cost of goods sold Cost of goods sold 500,000 500,000 490,000 490,000 10,000 F 10,000 F Selling & administrative Selling & administrative 160,000 160,000 156,000 156,000 4,000 F 4,000 F Total Total 660,000 660,000 646,000 646,000 14,000 F 14,000 F Contribution margin Contribution margin 540,000 540,000 504,000 504,000 36,000 U 36,000 U Previous Next Controllable fixed costs Slide Slide Controllable fixed costs Cost of goods sold Cost of goods sold 100,000 100,000 100,000 100,000 -0- -0- End Selling & administrative Selling & administrative 80,000 80,000 80,000 80,000 -0- -0- Show Total Total 180,000 180,000 180,000 180,000 -0- -0- 7 - 27 Controllable margin Controllable margin $$360,000 $$324,000 360,000 324,000 $36,000 U $36,000 U
  • 28.
    Residual Income Budgetary Control The income that remains after Static Budgets Flexible Budgets subtracting from the Responsibility controllable margin the Accounting Responsibility minimum rate of return on a Reports/Cost company’s operating assets. Responsibility Reports -Profit Investment Centers Previous Next Slide Slide End Show 7 - 28
  • 29.
    Return on Investment(ROI) Budgetary Control A measure of management’s Static Budgets effectiveness in utilizing assets Flexible Budgets at its disposal in an investment Responsibility Accounting center. Responsibility Reports/Cost Responsibility Reports -Profit Investment Centers Previous Next Slide Slide End Show 7 - 29
  • 30.
    Principles of PerformanceEvaluation Budgetary • Managers of responsibility centers Control should have direct input into the Static Budgets process of establishing budget goals of Flexible Budgets their area of responsibility. Responsibility Accounting • The evaluation of performance should Responsibility be based entirely on matters that are Reports/Cost controllable by the manager being Responsibility evaluated. Reports -Profit • Top management should support the Investment Centers evaluation process. • The evaluation process must allow managers to respond to their Previous Next evaluations. Slide Slide • The evaluation should identify both End Show good and poor performance. 7 - 30
  • 31.
    Budgetary Control Static Budgets Flexible Budgets Responsibility • Capital Budgeting Analysis Accounting Responsibility Reports/Cost Responsibility Reports -Profit Investment Centers Previous Next Slide Slide End Show 7 - 31
  • 32.
    • Outline Budgetary Control Static Budgets FlexibleBudgets Responsibility • Traditional Capital Budgeting Techniques Accounting Responsibility Reports/Cost – Payback Period Approach Responsibility – Discounted Payback Period Approach Reports -Profit – Discounted Cash Flow Techniques Investment • Net Present Value Centers • Internal Rate of Return • Profitability Index • Net Present Value versus Internal Rate of Return Previous Next Slide Slide End Show 7 - 32
  • 33.
    • Meaning ofCapital Budgeting Budgetary Control Static Budgets • Capital budgeting addresses the issue of Flexible Budgets Responsibility strategic long-term investment decisions. Accounting • Capital budgeting can be defined as the Responsibility Reports/Cost process of analyzing, evaluating, and Responsibility deciding whether resources should be Reports -Profit allocated to a project or not. Investment • Process of capital budgeting ensure Centers optimal allocation of resources and helps management work towards the goal of Previous Next shareholder wealth maximization. Slide Slide End Show 7 - 33
  • 34.
    • Significance ofCapital Budgeting Budgetary Control Static Budgets Flexible Budgets • Considered to be the most important Responsibility decision that a corporate treasurer Accounting Responsibility has to make. Reports/Cost Responsibility • So much is the significance of capital Reports -Profit budgeting that many business Investment Centers schools offer a separate course on capital budgeting Previous Next Slide Slide End Show 7 - 34
  • 35.
    • Why CapitalBudgeting is so Budgetary Important? Control Static Budgets Flexible Budgets • Involve massive investment of Responsibility Accounting resources Responsibility • Are not easily reversible Reports/Cost Responsibility • Have long-term implications for Reports -Profit Investment the firm Centers • Involve uncertainty and risk for the firm Previous Next Slide Slide End Show 7 - 35
  • 36.
    Why Capital Budgetingis so Important? Budgetary Control • Due to the above factors, capital budgeting decisions become critical and must be evaluated Static Budgets very carefully. Flexible Budgets Responsibility • Any firm that does not follow the capital Accounting budgeting process will not be maximizing Responsibility shareholder wealth and Reports/Cost Responsibility • Management will not be acting in the best Reports -Profit interests of shareholders. Investment Centers • RJR Nabisco’s smokeless cigarette project example – Project initiated in 1989 Previous Next – More than $300 million was invested Slide Slide – Had 2 flaws- required special lighter & was tasteless for smoker End Show – Within 2 years the project failed to deliver 7 - 36
  • 37.
    Why Capital Budgetingis so Important? Budgetary • Similarly: Control • Euro-Disney, – Failed miserably because of following factors : Static Budgets – Cultural gap’s – French felt that their children might loose Flexible Budgets french culture as it had more of English culture – Europeans love travelling and not interested in 1 day Responsibility vaccation Accounting – All Investments were Bad (Lost everything) . 1st year $900m Responsibility loss. Reports/Cost • Concorde Plane, – Too noisy Responsibility – Too expensive Reports -Profit – Plane crash in 2000- killed 113 passengers Investment • Saturn of GM Centers – Best selling model to kill competition from Japan cars – For 5 years GM did not make any other model – After 5 years brought various models killing the Saturn model Previous Next Slide Slide All faced problems due to bad capital budgeting, while End Intel became global leader due to sound capital Show budgeting decisions in 1990s. 7 - 37
  • 38.
    • Techniques ofCapital Budgeting Budgetary Analysis Control Static Budgets • Payback Period Approach Flexible Budgets Responsibility • Discounted Payback Period Accounting Responsibility Approach Reports/Cost • Net Present Value Approach Responsibility Reports -Profit • Internal Rate of Return Investment Centers • Profitability Index Previous Next Slide Slide End Show 7 - 38
  • 39.
    • Which Techniqueshould we follow? Budgetary Control Static Budgets Flexible Budgets • A technique that helps us in selecting Responsibility projects that are consistent with the Accounting principle of shareholder wealth Responsibility Reports/Cost maximization. Responsibility • A technique is considered consistent with Reports -Profit Investment wealth maximization if Centers – It is based on cash flows – Considers all the cash flows Previous – Considers time value of money Next Slide Slide – Is unbiased in selecting projects End Show 7 - 39
  • 40.
    • Payback PeriodApproach Budgetary Control Static Budgets Flexible Budgets • The amount of time needed to recover the Responsibility initial investment Accounting • The number of years it takes including a Responsibility Reports/Cost fraction of the year to recover initial investment is called payback period Responsibility Reports -Profit • To compute payback period, keep adding the Investment cash flows till the sum equals initial Centers investment • Simplicity is the main benefit, but suffers from drawbacks Previous Next • Technique is not consistent with wealth Slide Slide maximization—Why? End Show 7 - 40
  • 41.
    • Discounted PaybackPeriod Budgetary Control Static Budgets • Similar to payback period approach with Flexible Budgets Responsibility one difference that it considers time value Accounting of money Responsibility Reports/Cost • The amount of time needed to recover Responsibility initial investment given the present value of Reports -Profit cash inflows Investment Centers • Keep adding the discounted cash flows till the sum equals initial investment • All other drawbacks of the payback period Previous Next remains in this approach Slide Slide End • Not consistent with wealth maximization Show 7 - 41
  • 42.
    • Net PresentValue Approach Budgetary Control Static Budgets Flexible Budgets • Based on the Rupees amount of cash flows Responsibility • The Rupee amount of value added by a Accounting project Responsibility Reports/Cost • NPV equals the present value of cash Responsibility Reports -Profit inflows minus initial investment Investment • Technique is consistent with the principle Centers of wealth maximization—Why? • Accept a project if NPV ≥ 0 Previous Next Slide Slide End Show 7 - 42
  • 43.
    • Internal Rateof Return Budgetary Control Static Budgets Flexible Budgets • The rate at which the net present Responsibility value of cash flows of a project is Accounting zero, I.e., the rate at which the Responsibility Reports/Cost present value of cash inflows equals Responsibility initial investment Reports -Profit Investment • Project’s promised rate of return Centers given initial investment and cash flows Previous Next • Consistent with wealth maximization Slide Slide End • Accept a project if IRR ≥ Cost of Show 7 - 43 Capital
  • 44.
    • NPV versusIRR Budgetary Control Static Budgets • Usually, NPV and IRR are consistent with Flexible Budgets Responsibility each other. If IRR says accept the project, Accounting NPV will also say accept the project Responsibility • IRR can be in conflict with NPV if Reports/Cost Responsibility – Investing or Financing Decisions Reports -Profit – Projects are mutually exclusive Investment • Projects differ in scale of investment Centers • Cash flow patterns of projects is different – If cash flows alternate in sign—problem of multiple IRR Previous Next Slide Slide • If IRR and NPV conflict, use NPV End approach Show 7 - 44
  • 45.
    • Profitability Index(PI) Budgetary Control Static Budgets • A part of discounted cash flow family Flexible Budgets Responsibility • PI = PV of Cash Inflows/initial investment Accounting • Accept a project if PI ≥ 1.0, which means Responsibility Reports/Cost positive NPV Responsibility • Usually, PI consistent with NPV Reports -Profit Investment • PI may be in conflict with NPV if Centers – Projects are mutually exclusive • Scale of projects differ • Pattern of cash flows of projects is different Previous Slide Next Slide • When in conflict with NPV, use NPV End Show 7 - 45
  • 46.
    • Evaluating Projectswith Unequal Budgetary Lives Control Static Budgets Flexible Budgets • Replacement Chain Analysis Responsibility Accounting • Equivalent Annual Cost Method Responsibility Reports/Cost • If two machines are unequal in life, Responsibility we need to make adjustment before Reports -Profit Investment computing NPV. Centers Previous Next Slide Slide End Show 7 - 46
  • 47.
    • Which techniqueis superior? Budgetary Control Static Budgets • Although our decision should be based on Flexible Budgets NPV, but each technique contributes in Responsibility its own way. Accounting • Payback period is a rough measure of Responsibility riskiness. The longer the payback period, Reports/Cost more risky a project is Responsibility Reports -Profit • IRR is a measure of safety margin in a Investment project. Higher IRR means more safety Centers margin in the project’s estimated cash flows • PI is a measure of cost-benefit analysis. Previous Slide Next How much NPV for every dollar of initial Slide investment End Show 7 - 47