Ch. 10 Flexible Budgets & Performance Evaluation

what are the different performance evaluation tools?

performance report/budget vs. actual/variance analysis

segmented income statement

return on investment (ROI)

residual income

decentralized operations

companies can split their operations into diff. op. segments (“decentralize”)

what do companies typically decentralize based on?

geographic lines

product lines

responsibility centers

can a busn. be classified as several responsibility centers?

no, designations are mutually exclusive

what are the responsibility centers?

cost center

revenue center

profit center

investment center

cost center

manager is responsible for controlling costs

• actual costs are compared to budgeted costs using performance reports

revenue center

manager is responsible for generating revenue

• actual revenues are compared to budgeted revenues using performance reports

profit center

manager is responsible for generating revenue AND controlling costs

• actual revenues, expenses, and profits compared to budgeted revenues, expenses, and profits using performance reports and segmented income statements

investment center

manager is responsible for generating revenue, controlling costs, and investing in assets

• can use performance reports & segmented income statements to assess revenue, costs, & profits

• determine if assets were used efficiently to generate profit using ROI & residual income

how can you determine if assets were used efficiently to generate profit (investment center)?

using ROI & residual income

which responsibility centers are assessed using performance reports?

cost center

revenue center

profit center

investment center

which responsibility centers are assessed using segmented income statements?

profit center

investment center

static budgets

prepared with a set activity level in mind

(ch 9 budgets)

flexible budgets

represents the budget the managers would have prepared had they anticipated the exact sales volume for the period

flexible budgets are prepared in the planning phase to plan for…

“best case” & “worst case” scenarios

what changes/doesn’t change in the flexible budget?

changes: sales volume (x)

doesn’t change: cost formula (y = mx + b)

performance report

compares actual revenues and expenses against budgeted revenues & expenses to calculate a variance

variance

the difference

what 3 differences do we calculate using the flexible budget?

master budget variance

flexible budget variance

volume variance

master budget variance

comparison of the master budget (static budget) against actual results

“apples to oranges” comparison due to difference in sales volume (x)

what variances can the master budget variance be broken down into?

flexible budget variance

volume variance

the flexible budget is between…

the actual results & master budget

difference between actual results & flexible budget

flexible budget variance

difference between master budget & flexible budget

volume variance

(volume of units sold)

most → least useful variance

flexible budget variance → volume variance → master budget variance

flexible budget variance

shows us the variance due to changes in prices or costs (NOT units sold; volume)

we “flex” our budgeted volume to match actual volume

most meaningful

“apples to apples” comparison

volume variance

results solely from the diff. in budgeted & actual volume

never FC

can fixed costs ever have a volume variance?

no.. NEVER

breaking out the master budget variance into flexible budget variance & volume variance allows us to isolate differences in…

sales volume

actual operational differences (sales price per unit, cost per units, total fixed costs)

variances are labeled as…

favorable (F) or unfavorable (U)

variance is favorable if…

op. income > budget

variance is unfavorable if…

op. income < budget

mgmt. must determine if identified variances are…

material

if an amt is big enough to care abt, it’s considered

material

material vs. immaterial helps mgmt. focus on…

what’s most important to the busn.

if a variance falls within/below the materiality threshold…

it’s immaterial & doesn’t require explanation

if a variance falls outside/above the materiality threshold…

it’s material & does require explanation

is the materiality threshold the same for every company?

no, it varies

performance reports are prepared to easily see variances btwn…

master budget

flexible budget

actual results

for the flexible budget, everything stays the same from the ____ except…

master budget

volume

the master budget includes __ values while actual results include _ values

budgeted

actual

master budget variance

actual - master

flex the __ budget and use the _ budget to prepare it (flexible budget)

actual

master

order of preparing the different budgets

master → actual → flexible

why is the master budget variance not very helpful?

b/c of potential changes due to volume & sales price

for FC in the flexible budget, do you use actual results or values from the master budget?

values from the master budget

segmented income statement

Sales

(VC)

= CM

(TFC)

= SM

how are we using the segmented income statement in performance evaluation?

comparing the actual results of the statements against the expectations for each segment

(instead of just seeing whether SM is just pos/neg)

“calculate the margin on which the performance of each segment should be judged.” what are you being asked to calculate?

segment margin

traceable costs include..

TFC

TVC

all VC are…

traceable

CM calculation

sales price - VC per unit

sales - total VC

CM % calculation

CM / sales rev.

CM per unit / sales price

what does CM % tell us?

what % of each dollar made is available to cover FC & generate op. income

what if a segment has a higher SM than expected?

it outperformed

what if a segment has a lower SM than expected?

it underperformed

can a SM be negative and still outperform?

yes.. like if you expected to lose more than you did that’s outperforming.

return on investment (ROI)

measures the amt. of income an investment center earns relative to the size of its assets

what is ROI used to do?

determine how to invest excess funds

to compare a division’s performance across periods

ROI calculation

op income / capital

alternative ROI calculation

sales margin * capital turnover

ROI is expressed as…

a percentage

sales margin is expressed as…

a percntage

capital turnover is expressed as…

a ratio

ROI interpretation

for every dollar invested, how much income is generated?

sales margin interpretation

for every dollar of revenue, how much income is generated?

capital turnover interpretation

for every dollar invested, how much sales revenue is generated?

residual income (RI)

determines whether the division has created excess income beyond the expectations of management

what does residual income help do?

align goals across all investment centers b/c it factors in the expectations of mgmt.

expectations of mgmt. are seen in…

the target rate of return specified by the company

residual income (RI) calculation

op. income - ((target rate) * (target assets))

target rate of return can also be called…

hurdle rate

min. acceptable rate of return

cost of capital

total assets can also be called…

total capital

total investment

(residual income formula) op. income is AKA…

expected income from project/investment opp./actuals

(residual income formula) target rate * total assets is AKA…

return required by mgmt./mgmt’s expectation

if RI is positive, the proposed project yields a __ ROI than required by mgmt (ex. target rate of return). what should you do?

greater

take the project!!

if RI is negative, the proposed project yields a __ ROI than required by mgmt (ex. target rate of return). what should you do?

lesser

don’t take the project!!

is RI based on something that’s already happened?

no, you haven’t invested anything yet (proposed project). calculations based on what you’re expecting.

if we see that RI is positive for each division, what does that tell us abt the ROI in relation to the target rate of return?

ROI is larger than the target rate of return

sales margin formula

op. income / sales

capital turnover formula

sales revenue / capital

capital/assets is the same as…

investment

what tools do investment centers use?

performance report, seg. IS, ROI, & RI