Responsibility Accounting Thesis

Submitted to Dr. Ahmed El-Zayaty

In partial fulfilment of course requirement for MBA: 670 (01)
Accounting for Managers

The University of Findlay

12-14-2014

Abstract
Responsibility Accounting is an accounting system which collects, summarizes and reports the
accounting data relating to individual manager responsibilities. We in this paper we will go
through the following subjects in brief: Profit Planning, Flexible Budgets and Performance
Analysis, Standard Costs and Variances and Performance Measurement in Decentralized
Organizations. For each subject we learn various learning objectives. In this paper we will
discuss briefly all the learning objectives along with computation performed at each level. The
paper is concluded by explaining how responsibility accounting is effectively used highly
decentralized organization. We also discussed the advantages & disadvantages and limitations of
responsibility accounting as a manager tool.

1.0 Profit Planning: the following objectives were learned from the following subject: why do
the companies do budgeting and what are the processes used to create those budgets. How the
sales budget is created which include a schedule of expected cash collections. How the
production budget is prepared. How the direct materials budget is prepared which includes a
schedule of cash disbursements for materials purchase. How to create a direct labor budget. How
to create a manufacturing overhead budget. How to create administrative and selling expense
budget. How the cash budget is prepared. How to create a budgeted income statement and a
budgeted balance sheet. In overall in profit planning subject matter we concentrate on what is the
importance of budgets and types of budgets used for various purposes and finally create income
and balance sheet.

The above picture represents a master budget. The master budget consists of number of separate
budgets but interdependent budgets that formally layout the company sales, production and

financial goals. A cash budget, budgeted income statement and budgeted balance sheet is
culminated from master budget. For the profit planning the sales budget is the foundation. Once
the sales budget was established the production budget and the selling and administrative
expenses budget will be prepared. The selling and administrative expenses will depend on the
number of units sold. The budget for production will determine how many units have to be
produced to meet the sales figures from the sales budget. The various manufacturing cost
budgets can be prepared. All these budgets were feed into cash budget and the budgeted income
statement and the balance sheet.

2.0 Flexible Budgets and Performance Analysis: the following objectives were learned from
the following subject: how to create a flexible budget. How the activity variances were showed
in a report. How revenue and spending variances were prepared in a report. How the
performance report is prepared which combines both the activity variances & revenue and
spending variances. How to create a flexible budget with more than one cost driver. Understand
common errors in creating performance reports which are based on actual and budgeted results.
2.1 Flexible Budgets: the flexible budgets are different from the planning budget. The planning
budget is actually a static planning budget and is ineffective for evaluating how well the costs
were controlled. The flexile budgets will come in to existence when the actual level of
activity differs from what was planned. Two situations comes in to light when the activity
were changed apart from the planned. If activity is higher than the costs related to this change
also have to be higher or if the activity is lower than the costs associated to be decreased.

Activity Variances: When the flexible budget is compared to the budget from beginning
period the result were the activity variances. Activity variances shows how the costs or

revenues were changed in response to the difference between the actual and budgeted
activity.

Spending Variances: when the flexible budget is compared to actual results, revenue
and spending variances are the result. A favorable revenue variance indicates that
revenue were larger than expected than the given level of activity. And in the other way
the unfavorable spending variance indicates that low revenue that it was supposed to.

2.2 Combined Activity and Spending Variances: A report flexible budget performance
combines the activity variances and the spending & revenue variances on one report.
2.3 Common Errors: Common errors in comparing actual to the budgeted costs are to assume
all costs are fixed or to assume all costs are variable. If the costs of all assumed to be fixed, the
variances for variable and mixed costs will be incorrect. If the costs of all assumed to be
variable, the variances for fixed and mixed costs will be incorrect. The cost of the variance will
be correct only when the cost actual behavior is used to develop the benchmark of flexible
budget.

3.0 Standard Costs and Variances: the following objectives were learned from the following
subject: computing the price and material variances and explaining their significance. Computing
the rate and direct labor efficiencies and explaining their significance. Computing the rate and
variable manufacturing overhead variances and explaining their significance. Computing budget
and fixed volume overhead variances and interpreting them. How to create journal entries in
order to record standard costs and variances.

3.1 Standard costs Setting the stage: a standard is a word used as a norm or benchmark for
performance measurement. And the standards were been in all types of industries across the
world for many centuries. In the manufacturing industry the stands were used for various entities,
as price and quantity standards were set for each major input such as labor time and raw
materials. These standards of quantity describe how much amount of input is required to produce
or to make one unit or service. Price standards specify how much price have to be paid for each
unit of input. If for any reason either the quantity or costs of inputs deviates from the standards
significantly then managers will investigate the discrepancy to find the cause of the problem and
eliminate it. And this process of elimination of problems which occurred because of deviation
from standards is called management by exception.

Setting Direct Materials Standards: the standard quantity per unit of direct materials
reflect the amount of material is required to produce or make for each unit of finished
product as well as an allowance for unavoidable waste.

Setting Direct Labor Standards: the standards for direct labor quantity and price are
expressed usually in terms of labor rate and labor hours. The standard rate per hour for
direct labor include wages on hourly basis, employment taxes and fringe benefits.

Setting Variable Manufacturing Overhead Standards: as the same way we set

standards for direct labor the quantity and price standards for variable manufacturing
overhead are usually expressed in terms of hours and rates. The hours here relate to the
activity based that is used to apply overhead to units of product (usually direct labor or
machine hours).

3.2 A General Model for Standard Cost Variance Analysis: to distinguish from the flexible

budget of spending variances the standard cost variance analysis is used. In to two elements the

spending variances were decomposed from flexible budget. One is the quantity variance and
other is the price variance. In quantity variance the difference between how much the quantity
have to be used to the actual quantity used at a standard price of input. A price variance is the
difference between how much of price was actual to the standard price keeping quantity as a
standard. The formula were shown below and was taken from the text book accounting for
managers.

Direct Material Variances:

Direct Labor Variances: we have decomposed into labor efficiency variance and labor
rate variance. The formula is show below for both the elements.
Labor Efficiency Variance = (AH x SR) (SH x SR)
= SR (AH SH)
Labor Rate Variance = (AH x AR) (AH x SR)
= AH (AR SR)

Variable Manufacturing Overhead Variances:

Variable Overhead Efficiency Variance = (AH x SR) (SH x SR)
= SR (AH SH)
Variable Rate Overhead Variance = (AH x AR) (AH x SR)
= AH (AR SR)

4.0 Performance Measurement in Decentralized Organizations: the following objectives

were learned from the following subject: computing return on investment and show the changes
in assets, sales and expenses affect ROI (Return on Investment). Computing the residual income
and explain its strengths and weaknesses. Computing delivery cycle time, throughput time &
manufacturing cycle efficiency (MCE). How the balance card is constructed and used.

In a decentralized organization, the authority of decision making is not confined to few top level
executives but was spread throughout. The major advantage is the low level managers have the
freedom to take necessary actions according to the situation.

4.1 Evaluating Investment Center Performance: An investment center is responsible for

adequate ROI earning. So the performance of the investment center is crucial for knowing the
earning of ROI. So two methods determine the evaluating aspect of an investment center
performance. The two methods are: Return on Investment (ROI) and the second one is called
Residual Income.

Return on Investment: ROI (Return on Investment): is defined as net operating income

divided by average operating assets.
ROI = (Net operating income/ Average operating assets)
The direct equation of ROI doesnt help managers in improving the ROI. So the equation
can be stated in the following way:
ROI = Margin x Turn Over
= (Net operating Income/ Sales) x (Sales/ Average operating assets)

In this way the managers were able to either influence margin or turnover in order to
improve ROI.

Residual Income: Residual Income is the second method of measuring the investment
center performance. The residual income is the net operating income that the investment
center earns above the minimum required return on operating assets. The following
equation displays the equation form.
Residual Income = Net operating Income {Average operating assets x
Minimum

required

rate

of

return}

4.2 Operating Performance Measures: In additional to focus on improving or measuring the

financial performance many organizations also evaluate non-financial performance measures.
Financial performance measures the results while non-financial performance measures what
driving the organizational performance. Here we would describe three examples of measures that
are critical to many organizations i.e. delivery cycle time, throughput time and manufacturing
cycle efficiency. The following figure taken from text book accounting for managers illustrates
the three examples.

Manufacturing Cycle Efficiency (MCE): The companies wanted to eliminate the nonvalue added activities in the manufacturing chain. Such as eliminating inspection, moving
and queuing activities to a considerable time so that the order time from customer
delivery of to customer is reduced from months to even days or hours. The manufacturing
cycle efficiency was computed by the following equation.
MCE = {Value added time (process time) / Throughput time (manufacturing cycle)}

4.3 Balanced Scorecard: the balanced score card system is an integrated system of performance
measures which are designed to support a strategy of an organization. As per balance score card
it is linked with the plausible cause and effects basis from the lowest level up through
organization ultimate objectives. The balanced scorecard is essentially a theory which showcase
what actions undertook by various individuals will further the objectives of the organization. If
the theory of the score card changes then the performance measures on the balance card also
changes. This is considered as a dynamic measurement system that evolves as an organization
learns more about what works best and what will not and refines strategy accordingly.

Responsibility Accounting Advantages and Disadvantages

Advantages of Responsibility Accounting: the following points were showed to explain the
advantages of responsibility accounting.

The Responsibility Accounting helps in managing a highly decentralized or diversified

organization. With the help responsibility accounting tool better decisions were taken at
each level in the organization.

Responsibility Accounting will develop incentive system to department managers and

other individuals to optimize their performance towards the organization.

Responsibility Accounting establishes freedom for the managers at each level in the
organization to make decisions.

Responsibility Accounting provides top management have ample time to make new
policy decisions and engage in strategic planning.

Responsibility Accounting allows the top management in avoiding the system

understanding using top down remote control based on measurements of accounting.

Responsibility Accounting supports individual specialization & management based on

comparative advantage.

Responsibility Accounting supports individualistic capitalism.

Disadvantages of Responsibility Accounting: the following points were showed to explain the
disadvantages of Responsibility Accounting:

The Responsibility Accounting is good at divisional level but in order to be effective the
entire system as to be managed as a system but not a group of subsystems. Some
organizations faces conflicts with in their segments such as: problems at transfer pricing,
buying on the basis of price by purchasing department, to maximize the labor efficiency
and measurements of production volume the defective products were pushed downstream
by production departments and so on etc.

Responsibility Accounting develops incentive system but in causes fierce competition

between individuals and segments rather than teamwork and co-operation. Prevents from
goal orientation. Develops excess and slack, e.g., inventory buffers, excess capacity,

vendors and people. It promotes ranking the people at which ignores statistical variation.
As per Deming, the incentive based on performance destroys morality, intrinsic
motivation and teamwork.

With the system managers were given freedom to make decisions which are fruitful for
the system but mostly the managers ignore many. Managers will deviate from most
interdependencies within the system. Most decisions made by managers are on their selfinterest but not at the best interest of the system.

Responsibility Accounting avoids the top down remote control based on accounting
measurements in the organization. Many scholars believe that this were the point the
managerial accounting lose its significance. Through this approach two important
concepts i.e. concept of continuous improvement and concept of leadership. At both of
these concepts the managers will stop acting like leaders where leaders understand the
system so that they can help facilitate improvements for the organization.

The Responsibility Accounting conflicts with communitarian capitalism.

Limitations of Responsibility Accounting:

A built in means in a system provides inside a responsibility accounting evaluates a managers
performance. Timely reports were to be developed or prepared in order to take necessary steps to
prevent the deviations from budgeted performance. But in spite of above mentioned positive
effect on the system as a whole responsibility accounting suffers from following limitations:

The conflict might rise between the individual interest and with the interest of the
organization.

It is very difficult to create a fully established responsibility accounting in the

organization. Which mean it is very difficult to establish sound organization structure
with clearly defined responsibilities and authorities at every level in the organization.

It is difficult to match the responsibility centers and accounts which showing collective
costs of these centers.

The relations of who involved in the system was not taken into consideration.

The system will emerge successfully only with the help of people who are operating the
system. Since the system is encouraged by individuals they create a report of costs and he
is the one responsible for the deviations.

The system needs constant feed of considerations of reactions from segmental managers.

References:
Ray H., Eric W. & Peter C., G. N. &. B. (2012).Accounting for managers 14e. NY: McGraw Hill Publishing.