This chapter covers several topics including profit analysis related to cost variances, decentralization and responsibility
accounting, transfer pricing, evaluating investment centers with return on investment and residual income, and the efficacy of the financial control methodology.
2. Summary of Variances
Profit analysis includes both revenue and cost variances. Differences between the master budget and actual performance
are caused by two things:
1. differences between budgeted and actual sales volumes, and
2. price and cost differences, i.e., differences between budgeted and actual sales prices and differences between budgeted and actual unit cost.
Profit analysis separates the variances to isolate these effects.
Variance analysis can be viewed from several perspectives. The following table provides an equation
approach and shows the various levels of analysis and how each variance is calculated. An income statement approach is shown by ABKY on page 512 and in 3b.
below. ABKY do not include the sales revenue variances in their example. (See a simple example of profit analysis from MAAW's Chapter 13 that includes
Level Two Variances
Level Two Variances Separated for Sales
Price and Unit Cost Differences and Sales Volume Differences
Level Three Variances
Level Three Variances Separated for Price and Quantity Differences
Flexible budget or Price-Cost Variance (ACM-BCM)(AU)
Sales Price Variance (AP-BP)(AU)
Unit Cost Variance (AV-BV)(AU)
Direct Materials Variance
DM Price Variance (AMP-SMP)(AQp) or (AMP-SMP)(AQu)
DM Use or Quantity Variance (AQu-SQ)(SP)
Direct Labor Variance
DL Rate Variance (AR-SR)(AH)
DL Efficiency Variance (AH-SH)(SP)
Support Cost or Variable Overhead Variance
Planning or Sales Volume Variance (AU-BU)(BCM)
Revenue part of Sales Volume Variance (AU-BU)(BP)
Cost part of Sales Volume Variance (AU-BU)(BV)
AU = Actual units sold for individual products. BU = Budgeted units sold for individual products. AP = Actual average sales price for individual products.
BP = Budgeted sales price for individual products. AV = Actual unit variable cost for individual products. BV = Budgeted unit variable cost for individual products.
ACM = Actual contribution margin per unit for individual products. BCM = Budgeted contribution margin per unit for individual products. AMP = Actual Direct Materials price.
SMP = Standard Direct Materials price. AQp = Actual quantity purchased. AQu = Actual quantity used. AH = Actual hours used. SH = Standard hours allowed.
3A. Example - Data for Canning Cellular Services
Budgeted and actual unit sales (customers serviced) are indicated below along with aggregated variable (flexible) costs and level one variances.
AU = Actual units sold for individual products = 1,100,000. BU = Budgeted units sold for individual products = 1,000,000. AP = Actual average sales price for individual products = not available.
BP = Budgeted sales price for individual products = not available. AV = Actual unit variable cost for individual products = 93.00. BV = Budgeted unit variable cost for individual products = 95.50.
ACM = Actual contribution margin per unit for individual products = not available. BCM = Budgeted contribution margin per unit for individual products = not
available. AMP = Actual Direct Materials price = 27. SMP = Standard Direct Materials Price = 25. AQp = Actual quantity purchased = 1,1,00,000. AQu = Actual quantity used = 1,1,00,000.
AH = Actual hours used = 495,000 for Sales staff and 242,000 for Tech staff. SH = Standard hours allowed = 550,000 for Sales staff and 275,000 for Tech staff.
3b. Canning Cellular Services Aggregated Level Two variances
The income statement approach to profit analysis shown below, and in more detail on page 512 of ABKY, is a popular way to present variance
analysis. The master budget is presented on the left side and the actual results are shown on the right. To isolate the effects of sales volume and price and
costs, a flexible budget is placed between the budgeted and actual results (column 3). Then the sales volume, or planning variances are the differences
between columns 1 and 3, and the flexible budget or price and cost variances are the differences between columns 5 and 3.
Master Budget 1
Planning or Sales Volume
Variances 2 = 1 vs. 3
Flexible Budget* 3
Budget or Price-Cost Variances 4 = 5 vs. 3
Actual Results 5
Revenue part of Sales Volume
Sales Price Variance
Cost Part of Sales Volume
Unit Cost Variance 2,750,000F
* A flexible budget is a budget based on the actual level of activity, i.e., the actual sales level in this example. Column 3 represents a flexible budget.
The flexible budget amount for the cost row is (1,100,000)(95.50) = 105,050,000.
3c. Canning Cellular Services Summary of Variances
This example shows how the flexible budget variances for costs (or unit cost variances) can be decomposed into variances
for direct materials, direct labor and support costs. This level three, more detailed analysis is shown on the right side of the table.
Level Two Variances
Level Two Variances Separated for Sales Price and Unit
Cost Differences and Sales Volume Differences
Level Three Variances
Level Three Variances Separated for Price and
Flexible budget or Price-Cost Variance (ACM-BCM)(AU)
Sales Price Variance (AP-BP)(AU)
Unit Cost Variance (AV-BV)(AU)
Responsibility accounting is an underlying concept of accounting performance measurement systems. The basic idea is that
large diversified organizations are difficult, if not impossible to manage as a single segment, therefore they must be decentralized or separated into
manageable parts. These parts, or segments are referred to as responsibility centers and include:
This approach allows responsibility to be assigned (not delegated*)
to the segment managers that have the greatest amount of influence over the key elements to be managed. These elements include revenue for a revenue center (a
segment that mainly generates revenue with relatively little costs), costs for a cost center (a segment that generates costs, but no revenue), a measure of
profitability for a profit center (a segment that generates both revenue and costs) and return on investment (ROI) for an investment center (a segment such
as a division of a company where the manager controls the acquisition and utilization of assets, as well as revenue and costs). These concepts are
summarized by ABKY in Exhibit 12-15 and in a similar exhibit below.
Types of Responsibility Centers
Traditional Evaluation (Control) Methods
Centers - segments that mainly generate revenue with relatively little
Includes marketing functions only with very
little costs relative to the revenue produced.
Sales Variances Sale price variances Sales volume variances
2. Cost Centers - segments that
generate costs, but no revenue.
Includes production and service functions or departments.
Cost Variances: For purchasing & production departments Material price variances Material quantity variances Direct labor rate variances
Direct labor efficiency variances Variable overhead budget variances Fixed overhead budget variances Production volume variances
For service departments Spending variances
3. Profit Centers - segments that
generate both revenue and costs.
Includes both marketing, production and service
functions. Examples include a manufacturing
plant or product line.
Gross profit or contribution margin, operating
income and net income plus the variances for sales and cost such as the
Centers - segments such as divisions of a company where the managers control the acquisition and
utilization of assets, as well as revenue and costs.
Includes all the functions above plus the managers
control what to produce and how to produce, i.e., have autonomy or more autonomy than profit center managers.
Typically, investment centers are divisions of large companies.
Return on Investment:
= (Return on Sales)(Capital Turnover)
= (Net income ÷ Sales)(Sales ÷ Total assets)
= Net income ÷ Total assets
Also Residual Income. This is essentially the same as
economic value added (EVA).
Responsibility accounting is based on the controllability principle.The idea is that managers
should only be evaluated based on what they can control. One problem with this approach is that there is a great deal of interdependence within any organization. This
interdependence creates joint responsibility across segments that is difficult to separate. In addition, since the parts of an organization cannot be
entirely independent, they tend to affect each other in ways that influence the performance measurements in the exhibit above. Evaluating the various segments of an
organization separately tends to create competition between them and prevent the company from optimizing the performance of the whole. For example, the segment
reporting illustration in ABKY Exhibit 12-16 shows the allocation of some common, or joint costs to the segments of an automobile dealership. A problem
that frequently arises involves disputes between responsibility center managers related to how those costs are allocated. Another problem involves transfer
5. Transfer Pricing
A transfer price refers to the price used for intra-company transfers, i.e., transfers between segments of a company. The term transfer
pricing normally means pricing transfers between divisions, but could be used in any situation where the output of one segment (e.g., department, operation,
process) becomes the input for another segment within the same company. An example on page 536 of ABKY makes this point with an automobile dealership. A
transfer price, or value for a used car is needed when it is transferred from the new car department (as a trade-in) to the used car department. The new car
department would like for the value to be high, while the used car department would prefer a low value.
A transfer pricing situation usually involves three questions or decisions.
1. Should the transfer take place? This is essentially a (Make or Buy) question. Should the company make the item or purchase it on the
outside market? This is a relevant cost problem (also referred to as differential or incremental cost). The key is which costs will be different under the two
alternatives, i.e., make inside and transfer, or buy from outside the company?
2. If the answer to question one is yes, then what transfer price should be used?
3. Should the central office interfere in establishing the transfer price?
Objectives of Transfer Prices
The overall objective is to establish a transfer price that will motivate effort and goal congruence. There are at least three underlying
1. To aid in evaluating segment performance, i.e., investment centers or profit centers. If the divisions are treated as investment
centers, then Return on Investment (ROI) and Residual Income (RI) are the relevant measurements. For profit centers, contribution margin, segment margin,
or net income would be a more appropriate measurement.
2. To maintain division autonomy. Since autonomy means decentralization and freedom to make decisions, it is also an ingredient in
motivating effort. Remember, however, that effort and goal congruence are different. Managers may exert considerable effort in pursuing their own goals
that conflict with the goals of the firm. Central office interference in a transfer pricing dispute will affect autonomy and effort. The dilemma is that
goal congruent behavior may not be obtained with or without interference.
3. To provide the buying segment with needed economic information, i.e., the information necessary for the make or buy question.
Intra-company profits included in a transfer price make it impossible for the buying division to answer the make or buy question.
Possible Transfer Prices
1. Market prices. A market price is considered best if the market is perfectly competitive, i.e., if a single buyer or seller cannot
affect the price. Generally intra-company transfers at market prices accomplish objectives 1 and 2, but not 3. Unfortunately, several problems occur when trying
to use market prices:
a. Most markets are not perfectly competitive. The demand curve and price structure may shift if the firm buys outside.
b. Market prices may not exist for some products.
c. A market price may not be comparable because of differences in quality, credit terms, or extra services provided.
d. Price quotations may not be reliable because they are based on temporary distress or dumping conditions.
e. A market price may not be relevant because the selling division would not have the same transportation cost,
accounting cost for A/R, credit etc. as an outside supplier.
f. Information for the make or buy decision would not be available to the buying division.
2. Full cost. All manufacturing, selling and administrative cost are included. Problems that occur when full
cost is used as a transfer price:
a. Transfer prices based on full cost do not accomplish any of the objectives stated above. The selling division
could not be evaluated as a profit center or investment center since it is treated as a cost center.
b. The seller would be motivated to over allocate cost to the product transferred.
c. If actual cost are transferred, the cost of inefficiency will be passed along to the buying division. Thus, standard
cost make better transfer prices although standards may be rigged.
d. The buyer would not have the differential cost information needed for the overall firm make or buy decision.
The irrelevant common fixed cost of the seller become relevant cost to the buyer.
3. Full Cost Plus. All manufacturing, selling and administrative cost plus a markup for profit. Standard cost plus would be better than actual
cost plus to motivate the seller to be an efficient cost producer. The same problems in 2 are applicable here. Motivation for over allocation is still present.
Transfers at standard could motivate the seller to rig the standard.
4. Variable cost. All variable manufacturing, selling and administrative cost. This may come close to accomplishing objective 3, since
variable cost may approximate differential cost. Objectives 1 and 2 would not be obtained since the other problems listed under 2 and 3 are applicable
here, lack of motivation for profits, potential for cost over allocation etc.
5. Variable cost plus. This may be a little better than 4, but the plus should be kept separate to allow for a ball park make or buy decision.
Objectives 1 and 2 would not be fully obtained.
6. Negotiated price. Negotiated prices may be best if:
a.) An imperfect market exist for the product making it difficult, if not impossible, to determine the appropriate market price.
b.) The seller has excess capacity, thus the transfer becomes a relevant cost problem to the seller. Any
transfer price above the seller's differential cost would benefit the seller.
c.) There is no external market for the product, thus no market price.
In these cases the buyer and seller may negotiate a price that allows both parties to share in the benefits of the transfer. This may
accomplish objectives 1 and 2, but not 3. A problem with this approach is that managers may spend a substantial amount of time and effort negotiating transfer
7. Dual Price. Use two transfer prices. Give the seller credit for selling at market price or full cost plus a reasonable markup, but
charge the buyer with variable cost (i.e., approximate differential or additional outlay cost). Charge the difference to a central account. This
approach may not motivate either the seller or the buyer to be efficient.
8.Administered - Use an arbitrator to set the price based on a rule such as cost plus five percent. This is easy but accomplishes
none of the objectives stated above.
6. Evaluating Investment Centers
Investment centers are evaluated with Return on Investment (ROI) and Residual Income or Economic Value Added (EVA)
Return On Investment
To review the idea,
ROI = (Capital turnover ratio)(Profit Margin on Sales) = (Sales ÷ Investment)(Net Income ÷ Sales)
The Capital Turnover Ratio reflects management's ability to generate sales from a given investment base and reflects the overall
productivity of the segment. Note that the source of the investment (i.e., debt or stockholders equity) is usually considered irrelevant,
but see the alternatives below. Productivity is generally defined as some measure of output per input. In the ROI measurement, output is defined in terms
of sales dollars and inputs are typically represented by total assets.
The Profit Margin is the rate of return on sales (ROS) and measures management's ability to control the spread between prices and costs. Efficiency and cost control are reflected in this measure as well as other
factors such as productivity and the sales level. Productivity in this measurement refers to the quantity of products or services produced per input, such as per headcount.
ROI may be increased in various ways. Some possibilities include the following.
1. Increasing Capital Turnover. a. Increase sales with the same investment base. b. Decrease the investment base with the
same sales level.
2. Increasing Profit Margin or ROS. a. Increase prices with no unfavorable effects on sales. b. Decrease cost with no unfavorable
effects on quality or increase in assets employed. c. Increase sales with no changes in prices or costs.
Residual Income or Economic Value Added
Residual income or economic value added is calculated as follows:
RI or EVA = Income - the cost of capital, or minimum desired rate of return
The minimum desired rate of return used in the RI or EVA calculation is usually referred to as the cost of capital which is a weighted
average measure of the cost of long term debt and stockholders' equity.
Maximizing ROI and RI are different objectives.
Using ROI as a performance measurement may cause many managers to reject profitable projects if the projects would tend to lower the ROI. As a
result, a conflict arises between the goals of the manager and the goals of the organization, i.e., goal congruence is not obtained.
ABKY example on page 549. Assume that a division has a cost of capital, or minimum desired rate of return, of 10 percent, income of 13.5 million and 100 million in capital.
ROI = 13.5/100 = .135 or 13.5%
RI or EVA = 13.5 - .1(100) = 3.5 million
Would a manager evaluated on the basis of the ROI accept a new project with an expected return of 11, 12 or 13 percent? Probably not, since it
would reduce the division's overall ROI below the current 13.5%.
Would the manager accept the project if RI is used as the evaluation measurement. Yes, since the return is above 10%, it would increase
the division's residual income.
Separate problem for RI users
Using Residual Income avoids the problem stated above, but creates a different problem. Using RI makes it difficult to compare the performance of
different size divisions.
7. The Efficacy of Financial Control
Managing an organization with financial information has been criticized by many leading management researchers and
theorist. For example, Deming included placing emphasis on short term profits and running the company on visible figures alone
as deadly diseases. ABKY discuss three problems with financial control.
1. Financial control does not measure other important
attributes such as the quality of products and services, the time required to develop new products and services, the quality of the work
environment and many other critical non-financial factors.
2. Financial control measures the overall level of performance, but does not help the company improve. Johnson refers to this
as placing the cart in front of the horse. For improvement, the emphasis needs to be on the processes and work that people do (the horse), not the
financial results (the cart).
3. Since financial control is usually oriented towards short term profits, managers and workers are motivated to do things to
improve short term results that hurt the long run performance of the organization.
6. "If more experienced workers work on the job than planned in developing the labor standards, the labor efficiency
variance is likely to be favorable but the labor wage (rate) variance is likely to be
unfavorable." Do you agree with this statement? Explain. (See
item 3c above or MAAW's Chapter 10 exhibit related to labor).
7. What effect will the purchase and use of cheaper, lower-quality materials likely have on price and use components of both
materials and labor variances? (See
item 3c above or MAAW's Chapter 10 exhibit related to material).
27. What are three reasons financial control alone may provide an ineffective control scorecard? (See
item 7 above).
* One person can delegate authority to another to act on his or her behalf, but one person's
responsibility can not be delegated to another person. For example, an individual can hire a tax service to prepare the taxpayer's return, but the
taxpayer is still responsible.