RESPONSIBILITY ACCOUNTING

LECTURE OUTLINE
Lesson Objectives:
1. Discuss the role of a management control system.
2. List the advantages and disadvantages of decentralization.
3. Enumerate the three types of responsibility centers.
4. Understand how managers evaluate performance of responsibility centers

A. The Concept of Budgetary Control.

1. The use of budgets in controlling operations is known as budgetary control. Such
control takes place by means of budget reports that compare actual results with planned
objectives.
2. Budgetary control consists of:
a. Preparing periodic budget reports that compare actual results with planned
objectives.
b. Analyzing the differences to determine their causes.
c. Taking appropriate corrective action.
d. Modifying future plans, if necessary.

3. Budgetary control works best when a company has a formalized reporting system. This
system should do the following:
a. Identify the name of the budget report.
b. State the frequency of the report, such as weekly or monthly.
c. Specify the purpose of the report.
d. Indicate the primary recipient(s) of the report.

B. Static Budget Reports.

1. A static budget is a projection of budget data at one level of activity; data for different
levels of activity are ignored. As a result, actual results are always compared with
budget data at the activity level that was used in developing the master budget.
2. The static budget is appropriate in evaluating a manager’s effectiveness in controlling
costs when:
a. The actual level of activity closely approximates the master budget activity level,
and/or
b. The behavior of the costs in response to changes in activity is fixed.

3. A static budget report is appropriate for fixed manufacturing costs and fixed selling and
administrative expenses.

C. Flexible Budgets.
1. A flexible budget projects budget data for various levels of activity. In essence, the
flexible budget is a series of static budgets at different levels of activity.
2. To develop the flexible budget, it is necessary to:
a. Identify the activity index and the relevant range of activity.
b. Identify the variable costs, and determine the budgeted variable cost per unit of
activity for each cost.
 c. Identify the fixed costs, and determine the budgeted amount for each cost.
d. Prepare the budget for selected increments of activity within the relevant range.
3. Flexible budget reports are another type of internal report. The flexible budget report
consists of two sections:
a. Production data for a selected activity index, such as direct labor hours.
b. Cost data for variable and fixed costs.
4. The flexible budget report provides a basis for evaluating a manager’s performance in
two areas:
a. Production control.
b. Cost control.
5. Flexible budget reports are appropriate for evaluating performance since both actual
and budgeted costs are based on the actual activity level achieved.

D. Management by Exception.
1. Management by exception means that top management’s review of a budget report is
focused either entirely or primarily on differences between actual results and planned
objectives.
2. For management by exception to be effective, there must be guidelines for identifying
an exception. The usual criteria are:
a. Materiality—usually expressed as a percentage difference from budget.
b. Controllability of the item—exception guidelines are more restrictive for
controllable items than for items that are not controllable by the manager.

E. The Concept of Responsibility Accounting.

1. Responsibility accounting involves accumulating and reporting costs (and revenues)
on the basis of the manager who has the authority to make the day-to-day decisions
about the items.
2. Under responsibility accounting, a manager’s performance is evaluated on matters
directly under that manager’s control.
3. Responsibility accounting can be used at every level of management in which the
following conditions exist:
a. Costs and revenues can be directly associated with the specific level of
management responsibility.
b. The costs and revenues are controllable at the level of responsibility with which
they are associated.
c. Budget data can be developed for evaluating the manager’s effectiveness in
controlling the costs and revenues.
4. The reporting of costs and revenues under responsibility accounting differs from
budgeting in two respects:
a. A distinction is made between controllable and noncontrollable costs.
b. Performance reports either emphasize or include only items controllable by the
individual manager.
5. A cost is considered to be controllable at a given level of managerial responsibility if
the manager has the power to incur it within a given period of time. It follows that:
a. All costs are controllable by top management because of the broad range of its
activity.
 b. Fewer costs are controllable as one moves down to each lower level of
managerial responsibility because of the manager’s decreasing authority.
6. Noncontrollable costs are costs incurred indirectly and allocated to a responsibility
level.
7. A responsibility reporting system involves the preparation of a report for each level of
responsibility in the company’s organization chart.
8. Responsibility reports usually compare actual costs with flexible budget data. The
reports show only controllable costs and no distinction is made between variable and
fixed costs.
9. There are three basic types of responsibility centers: cost centers, profit centers, and
investment centers.
a. A cost center incurs costs (and expenses) but does not directly generate revenues.
b. A profit center incurs costs (and expenses) and also generates revenues.
c. Like a profit center, an investment center incurs costs (and expenses) and
generates revenues. In addition, an investment center has control over the
investment funds available for use.

10. Responsibility Reports.

a. The evaluation of a manager’s performance for cost centers is based on his or
her ability to meet budgeted goals for controllable costs.
b. To evaluate the performance of a manager of a profit center, detailed information
is needed about both controllable revenues and controllable costs. The report is
prepared using the cost-volume-profit income statement. In the report:
(1) Controllable fixed costs are deducted from contribution margin.
(2) The excess of contribution margin over controllable fixed costs is
identified as controllable margin.
(3) Noncontrollable fixed costs are not reported.
c. The primary basis for evaluating the performance of a manager of an investment
center is return on investment (ROI).

d. Return on investment is computed by dividing controllable margin by average

operating assets.
e. Judgmental factors in the ROI approach are (1) valuation of operating assets and
(2) margin (income) measure.

F. Principles of Performance Evaluation.

1. The human factor is critical in evaluating performance. Behavioral principles should
include:
a. Managers of responsibility centers should have direct input into the process of
establishing budget goals of their area of responsibility.
b. The evaluation of performance should be based entirely on matters that are
controllable by the manager being evaluated.
c. Top management should support the evaluation process.
d. The evaluation process must allow managers to respond to their evaluations.
e. The evaluation should identify both good and poor performance.
 2. Performance evaluation under responsibility accounting should be based on certain
reporting principles. Performance reports should:
a. Contain only data that are controllable by the manager of the responsibility
center.
b. Provide accurate and reliable budget data to measure performance.
c. Highlight significant differences between actual results and budget goals.
d. Be tailor-made for the intended evaluation.
e. Be prepared at reasonable intervals.

G. Residual Income Compared To ROI.

1. Residual income is the income that remains after subtracting from the controllable
margin the minimum rate of return on a company’s average operating assets.
2. Residual income is computed as follows: Controllable Margin – (Minimum Rate of
Return X Average Operating Assets).
3. ROI sometimes provides misleading results because profitable investments are often
rejected when the investment reduces ROI but increases overall profitability.

Types of Responsibility Centers

 1. Cost Center – is any responsibility center that has control over the incurrence of cost.

Evaluation of Cost Center: (Pro-Forma Responsibility Cost Report)

Variance*
Unfavorable
Cost Items Actual Budget (Favorable) Remarks
Direct Costs P xxx P xxx P xxx U/F
Controllable Costs
________ xxx xxx xxx
________ xxx xxx xxx
________ xxx xxx xxx
Total xxx xxx xxx
Non-Controllable Costs
________ xxx xxx xxx
________ xxx xxx xxx
________ xxx xxx xxx
TotalTotal Direct Costs xxx xxx xxx

Indirect Costs
_______ xxx xxx xxx
_______ xxx xxx xxx
Total Indirect Costs xxx xxx xxx
Total Costs P xxx P xxx P xxx
=== === ===

Note: Material variance, favourable or unfavourable, are analyzed to determine their causes and
why they are controllable or not. Efficiency of the manager is evaluated on the basis of the results
of the analysis.

2. Profit Center – is any responsibility center that has control over both revenues and costs

Evaluation of a Profit Center

Revenue P xxx
Less: Direct Variable Costs xxx
Contribution Margin xxx
Less: Direct Fixed Costs xxx
Segment Margin P xxx
=====

Note: If segment margin is positive, performance is generally considered

satisfactory
3. Investment Center – is any responsibility center that has control over costs, and revenue
and also control over investment funds

Evaluation of an Investment Center:

A. Return on Investment (ROI) = Operating Income

Average Operating Assets

Note: Compare with minimum desired return on investment

ROI – measures the turnover of assets as well as the margin earned on sales

Three Approaches to Improve Overall Profitability or ROI

a. Increase Sales – increase in sales will increase margin and turnover
because of the presence of fixed costs
b. Reduce Expenses – a decrease in expenses will increase margin through
an increase in net operating income
c. Reduce operating assets – focus of JIT

Criticisms of ROI
1. ROI tends to emphasize short-run rather than long-term performance.
Managers can often improve short-term profitability by taking actions that
hurt the company in the long-term
2. A manager who takes over an investment center typically inherits many
committed costs over which the manager has little control
3. A division whose ROI is larger than the ROI for the entire company may
reject an alternative that would lower its own ROI even though it would
increase the ROI for the entire company.

B. Residual Income

Operating Income P xxx

Less: Minimum Desired ROI
(Ave. Operating Asset x ROI) xxx
Residual Income P xxx
=====

Residual Income – is the net operating income which an investment center is able
to earn above some minimum rate of return on operating assets. Ideally, the
minimum required rate of return should be the firm’s cost of capital or opportunity
cost of funds. When residual income is used to measure performance, the goal is to
maximize the total amount of residual income generated for a period.
 1. Motivation for the residual income approach. Profitable investments may
be rejected if a segment is evaluated based on the ROI
2. Divisional Comparison and Residual Income. A major disadvantage of
residual income approach is that it cannot be easily used to compare the
performance of divisions of different sizes. Residual income can be used to
track the performance of a division over time and actual residual income
can be compared to target residual income.

C. Economic Value Added

Economic Value Added (EVA) – this calculates the excess of after tax operating profit
over the total annual cost of capital; if EVA is positive, wealth is created

Earnings before interest but after tax P xxx (EBIT – Tax)

Less: Minimum return on long-term equity
(Total assets – current liabilities) x WACOC xxx
Economic Value Added P xxx
====

WACOC = weighted average cost of capital

D. Equity Spread – calculates equity value creation of shareholder value

ES = Beginning equity capital x (Return on equity – Percentage cost of equity)

ROE = net income/ average stockholders’ equity

E. Total Shareholder Return (TSR) = Change in the Stock Price plus Dividend per Share
Initial Stock Price

F. Market Value Added (MVA)

Market value of equity (shares outstanding x market price) P xx
Less: Equity supplied by shareholders’ xx
Market value added P xx

Q. Explain how to get positive behavioral effects from responsibility accounting

system?
A. Attention to the following two factors may yield positive behavioral effects from
a responsibility accounting system.
(1) When properly used, a responsibility accounting system does not
emphasize blame. The emphasis should be on providing the individual who
is in the best position to explain a particular event or financial result with
information to help in understanding reasons behind the event or financial
result.
(2) Distinguishing between controllable and non-controllable costs or revenues
helps the individual who are evaluated under a responsibility accounting
 system to feel as though they are evaluated on the basis of events and results
over which they have some control or influence.

Non-Financial and Other Performance Measures

1. Number of frequency of rework 6. on-time delivery
2. Returned merchandise 7. Competitive rank
3. Quality level of output 8. Product development time
4. Total set-up time
5. Customers’ comments/complaints

• Break-even Time – the time when the cumulative value of the cash inflows is equal
to the cumulative present value of the cash outflow
• Customer-Response-Time (Delivery Cycle Time) – the time period from the
placement of an order to the delivery of the goods or services, composed of
1. Order-Receipt time – period of time between placement of an order to its
readiness for set-up
2. Manufacturing Cycle time(Manufacturing Lead time or Throughput time)
– period of time from the moment the order is ready for set-up to its
completion
3. Order-Delivery time
• Manufacturing Cycle Efficiency = Value-added Production time
Manufacturing Cycle time

TRANSFER PRICE
The term transfer price means the price exchanged for a transfer or goods or services
between units of the same organization, such as two departments or divisions. Transfer prices are
needed for performance evaluation purposes.

Factors Considered in Selecting a Transfer Pricing Policy

a. Goal Congruence – a transfer price should permit a segment to operate as an independent
entity and achieve its goals while functioning in the best interest of the organization as a
whole
b. Segmental performance – the selling segment should not lose income by selling within the
company
c. Negotiation – the buying segment should not incur greater costs by buying within the
company. Hence, if the product or service could be purchased outside the company, the
buying segment should be allowed to negotiate the transfer price.
d. Capacity – if the selling segment has excess capacity, it should be used to produce goods
for transfer within the company. If there is no excess capacity, the selling segment should
not incur loss by selling to another segment within the same organization
e. Cost Structure – costs to be considered in a transfer price should be analyzed and broken
down into variable and fixed components so that it would be easier to identify relevant cost
items.
Bases in Setting Transfer Prices
1. Minimum Transfer Price – transfer price that would leave the selling division no worse off
if the good is sold to an internal division:

Formula: Transfer Price = Variable cost per unit + Lost contribution margin per unit on
outside sales

2. Maximum Transfer Price – transfer price that would leave the buying division no worse
off if an input is purchased from an internal division (Purchase price from outside supplier)

3. Market-based Price – Transfer price is the selling price of the product to outside market.

4. Cost-based Price – Transfer price is based either on variable cost, full cost, price cost or
other basis chosen by management

5. Negotiated Price or Cost Plus Transfer Price – transfer price is the sum of costs incurred
by the producing division plus an agreed-on-profit percentage

Suboptimization
Suboptimization results if transfer prices are set in a way that benefits a particular division,
but works to the disadvantage of the company as a whole. Suboptimization can also result, if
transfer pricing is so inflexible that one division buys from the outside when there is substantial
idle capacity to produce the item internally. If divisional managers are given full autonomy in
setting, accepting and rejecting transfer prices, then either of these situations can be created,
through selfishness, desire to look good, pettiness or bickering.

Management by Objective
Under the management-by-objective (MBO) philosophy, managers participate in setting
goals that they strive to achieve. These goals may be achieved in financial or other qualitative
terms, and the responsibility accounting system is used to evaluate performance in achieving them.
The MBO approach is consistent with an emphasis on obtaining goal congruence throughout an
organization.

Balanced Scorecard
The balanced scorecard is an accounting report that includes the firm’s critical success
factors in four areas: customer satisfaction, financial performance, internal business processes and
innovation and learning (human resources). The primary objective of the balanced scorecard is to
serve as an action plan, a basis for implementing the strategy expressed in the critical success
factors.
The balanced scorecard is constructed to support the company’s strategy which is a theory
about what actions will further the company’s goals. Assuming that the company has financial
goals, measures of financial performance must be included in the balanced scorecard as a check
on the reality of the theory. If the internal business processes improve but the financial outcomes
do not improve, the theory may be flawed and the strategy should be changed.
 It is an approach to performance measurement that combines traditional financial measures
with non-financial measures.

FOUR PERSPECTIVES OF THE BALANCED SCORECARD

• FINANCIAL Perspective – measures reflecting financial performance
(Example: profit, return on investment (ROI), cash flow, revenue growth, economic value
added (EVA)
• CUSTOMER Perspective – measures having a direct impact on customers
(Examples: customer satisfaction, customer retention, market share, customer complaints)
• LEARNING AND GROWTH Perspective – measures describing the company employees’
learning curve.
(Examples: employee satisfaction, employee turnover, training and recreation
• INTERNAL BUSINESS PROCESS Perspective – measures showing key business
processes performance.
(Examples: quality costs, rejects and defects, productivity measures, manufacturing cycle
efficiency)

COMPONENTS OF THE BALANCED SCORECARD

• STRATEGIC OBJECTIVES – a statement of what the strategy must achieve and what is
critical to its success. (WHAT is to be achieved)
• PERFORMANCE MEASURES – describe how success in achieving the strategy will be
measured. (Relates to how objectives will be measured)
• BASELINE PERFORMANCE – the current level of performance for the performance
measure (relates to how objectives will be measured)
• TARGETS – the level of performance or rate of improvement needed in the performance
measure
• STRATEGIC INITIATIVES – key action programs required to achieve strategic
objectives. (HOW objectives will be achieved)
Exercises:

Problem 1
The supervisor of Department X purchases supplies, authorizes repairs and maintenance
service, and hires labor for the department. Various costs for the month of March 2021 are given
below:
Sales salaries and commission P 9,850
Salary, supervisor of Department X 1,800
Factory, heat and light 650
General office salaries 14,200
Depreciation, factory 750
Supplies, Department X 1,430
Repairs and maintenance 820
Factory insurance 460
Labor cost, Department X 17,220
Salary of factory superintendent 2,400
Total P 49,850

Required:
1. List the costs that can be controlled by the supervisor of Dept. X
2. List the costs that can be directly identified with Department X
3. List the costs that will have to be allocated to the factory departments
4. List the costs that do not pertain to factory operations.

Problem 2
Francesca Company has three divisions – marketing, production, and personnel. There is
a manager in charge of each division. The flexible budget for each division follows:
Marketing Production Personnel
Controllable Costs
Direct materials - P 20,000 -
Direct labor - 50,000 -
Salaries P 80,000 - P 70,000
Supplies 20,000 6,000 4,000
Maintenance 2,000 4,000 2,000
Total P102,000 P 80,000 P 76,000

Actual Costs of the Departments:

Direct Materials - P 24,000 -
Direct labor - 48,000 -
Salaries 102,000 - 68,000
Supplies 1,600 4,000 3,000
Maintenance 400 3,000 1,000
Required:
1. Prepare and evaluate a performance report for the production manager.
2. Prepare and evaluate a performance report for the vice president. Other costs for the vice
president are assumed to be: Budgeted P 70,000 and actual, P 68,800

Problem 3
Gaylan Company has two investment centers and has developed the following information:
Head Division Foot Division
Departmental controllable margin P90,000 ?
Average operating assets ? P400,000
Sales 1,000,000 1,250,000
ROI 12% 8%

Instructions
Answer the following questions about the two divisions:
a. What was the amount of the Head Division's average operating assets?
b. What was the amount of Foot Division’s controllable margin?
c. If the Foot Division is able to reduce its operating assets by P100,000, how much would its
new ROI be?
d. If the Head Division is able to increase its controllable margin by P20,000 as a result of
reducing variable costs, how much would its new ROI be?

Problem 4
The Candle Division of Dax Wax Company reported the following results for 2020:
Sales P800,000
Variable costs 420,000
Controllable fixed costs 100,000
Average operating assets 4,000,000
Management is considering the following independent alternative courses of action in 2021 in
order to maximize the return on investment for the division.
1. Reduce controllable fixed costs by 50% with no change in sales or variable costs
2. Reduce average operating assets by 30% with no change in controllable margin
3. Increase sales P200,000 with no change in the contribution margin percentage

Instructions
a. Compute the return on investment for 2021.
b. Compute the expected return on investment for each of the alternative courses of action.