3.11.

The (Master) Budget and Responsibility Accounting

- Integration: The master budget is closely linked to responsibility
accounting. Each responsibility center within the organization is responsible
for achieving specific budget targets.
- Performance Evaluation: The master budget provides the benchmarks
against which the performance of each responsibility center is evaluated.
- Control: Responsibility accounting helps in controlling the financial
performance of the organization by holding managers accountable for their
budget targets.
- Example: If the sales department is responsible for achieving a certain
level of sales revenue, the sales budget will reflect this target. The
performance of the sales department will be evaluated based on its ability to
meet or exceed this target.

- Conclusion:
The master budget is a critical tool for financial planning and control in
organizations. It integrates various individual budgets and provides a
comprehensive financial plan for the organization. Responsibility accounting
complements the master budget by assigning responsibility for financial
performance to specific managers and evaluating their performance based
on budget targets. Together, the master budget and responsibility accounting
help organizations achieve their financial and operational goals.

Additional Notes on Responsibility Center:

a. What is a Responsibility Center?
A responsibility center is a segment or unit within an organization where a
manager is responsible for specific activities and outcomes. It is a way to
decentralize decision-making and hold managers accountable for their areas
of control. Responsibility centers are classified based on the type of
responsibility assigned to them, such as costs, revenues, profits, or
investments.

b. Types of Responsibility Centers:

There are four main types of responsibility centers:
1. Cost Center: A cost center is a responsibility center where the manager is
responsible for controlling costs but not for generating revenue.
- Example: The production department in a manufacturing company. The
manager is responsible for minimizing production costs while meeting output
targets.
- Key Focus: Cost control and efficiency.
2. Revenue Center: A revenue center is a responsibility center where the
manager is responsible for generating revenue but not for controlling costs.
- Example: The sales department in a company. The manager is
responsible for maximizing sales revenue but does not control production or
manufacturing costs.
- Key Focus: Revenue generation and sales performance.
3. Profit Center: A profit center is a responsibility center where the manager
is responsible for both generating revenue and controlling costs, effectively
managing the profitability of the unit.
- Example: A division of a company that operates like a standalone
business. The manager is responsible for both sales and costs, and the
division’s performance is measured by its profit.
- Key Focus: Profitability (revenue - costs).
4. Investment Center: An investment center is a responsibility center where
the manager is responsible for generating profits and managing the assets
invested in the unit. The manager is evaluated based on the return on
investment (ROI) or other financial metrics.
- Example: A subsidiary of a company. The manager is responsible for
profits and the efficient use of capital invested in the subsidiary.
- Key Focus: Return on investment (ROI) and efficient use of assets.

c. What Does It Mean to "Identify Responsibility Centers"?

- In the context of responsibility accounting, "identifying responsibility
centers" means:
1. Defining Units: Breaking down the organization into smaller units (e.g.,
departments, divisions, or teams) where managers can be held accountable
for specific activities.
2. Assigning Responsibility: Clearly defining what each manager is
responsible for (e.g., costs, revenues, profits, or investments).
3. Setting Goals: Establishing performance targets for each responsibility
center (e.g., cost reduction, revenue growth, profit margins, or ROI).
4. Monitoring Performance: Tracking and evaluating the performance of each
responsibility center against its goals.

For example:
- If the production department is identified as a cost center, the manager will
be responsible for controlling production costs.
- If the sales department is identified as a revenue center, the manager will
be responsible for maximizing sales revenue.
- If a division is identified as a profit center, the manager will be responsible
for both revenue and costs, with a focus on profitability.

d. Why Identify Responsibility Centers?

1. Accountability: Managers are held accountable for their specific areas of
responsibility.
2. Performance Evaluation: It provides a clear basis for evaluating the
performance of managers and units.
3. Decision-Making: Decentralizes decision-making, allowing managers to
make decisions that align with their responsibilities.
4. Goal Alignment: Ensures that the goals of individual units align with the
overall objectives of the organization.

- Examples of Responsibility Centers in Practice

1. Cost Center: The IT department in a company. The IT manager is

responsible for controlling IT-related costs (e.g., software, hardware, and
maintenance) but does not generate revenue.
2. Revenue Center: The marketing department. The marketing manager is
responsible for generating sales through campaigns but does not control
production costs.
3. Profit Center: A regional branch of a retail chain. The branch manager is
responsible for both sales and costs, and the branch’s performance is
measured by its profit.
4. Investment Center: A subsidiary of a multinational corporation. The
subsidiary manager is responsible for profits and the efficient use of capital
invested in the subsidiary.

e. How Responsibility Centers Fit into Responsibility Accounting:

- Responsibility accounting is a system that tracks and reports financial
information by responsibility centers. Here’s how it works:
1. Identify Responsibility Centers: Define the units and assign responsibilities
(e.g., cost center, revenue center, profit center, or investment center).
2. Set Budgets and Targets: Establish budgets and performance targets for
each responsibility center.
3. Track Performance: Monitor actual performance against the budget and
targets.
4. Evaluate and Reward: Evaluate the performance of each responsibility
center and reward or take corrective actions as needed.

- Summary:
- Responsibility Center: A unit within an organization where a manager is
responsible for specific activities. Example: Production department, sales
department.
- Cost Center: A unit where the manager is responsible for controlling
costs. Example: IT department, production department.
- Revenue Center: A unit where the manager is responsible for generating
revenue.
Example: Sales department, marketing department.
- Profit Center: A unit where the manager is responsible for both revenue and
costs. Example: Regional branch, product line.
- Investment Center: A unit where the manager is responsible for profits and
managing investments.
Example: Subsidiary, division.

Study Notes on Flexible Budgets, Fixed Budgets, Standard Costing, and

Variance Analysis

1. Static Budget
- Definition: A static budget is a fixed budget prepared for a specific level of
activity. It does not change regardless of changes in actual activity levels.
- Characteristics:
- Prepared for a single level of activity.
- Remains unchanged even if actual activity differs.
- Useful for planning but less effective for control and performance
evaluation.
- Often used in stable environments with predictable activity levels.

2. Flexible Budget
- Definition: A flexible budget adjusts to different levels of activity. It is
prepared for a range of activities rather than a single level.
- Characteristics:
- Adjusts based on actual activity levels.
- Provides more accurate performance evaluation.
- Useful for control purposes.
- Reflects variable costs and revenues that change with activity levels.

3. Static Budget vs. Flexible Budget

~ Activity Level
- Static Budget: Fixed at one level
- Flexible Budget: Adjusts to multiple activity levels
~ Flexibility
- Static Budget: Inflexible
- Flexible Budget: Flexible
~ Usefulness
- Static Budget: Planning
- Flexible Budget: Control and performance evaluation
~ Accuracy
- Static Budget: Less accurate if activity levels change
- Flexible Budget: More accurate

4. Constructing Flexible Budgets:

- Steps:
1. Identify the relevant range of activity levels.
2. Separate costs into fixed and variable components.
3. Calculate variable costs per unit.
4. Prepare the budget for different activity levels.
Example:
- Fixed Costs: $10,000
- Variable Costs: $5 per unit
- Activity Levels: 1,000 units, 1,500 units, 2,000 units
- Flexible Budget:
- At 1,000 units: $10,000 + ($5 × 1,000) = $15,000
- At 1,500 units: $10,000 + ($5 × 1,500) = $17,500
- At 2,000 units: $10,000 + ($5 × 2,000) = $20,000

5. Variance Analysis:
- Definition: Variance analysis compares actual results to budgeted or
standard costs to identify differences.
- Importance:
- Helps in cost control.
- Identifies areas needing improvement.
- Aids in performance evaluation.
- Process:
1. Compute actual results.
2. Compare actual results to budgeted or standard costs.
3. Analyze variances (favorable or unfavorable).
4. Take corrective actions.

6. Favorable Variance and Unfavorable Variance:

- Favorable Variance: Actual costs are lower than budgeted, or revenues are
higher than budgeted.
- Unfavorable Variance: Actual costs are higher than budgeted, or revenues
are lower than budgeted.
Example:
- Budgeted Cost: $10,000
- Actual Cost: $9,500
- Variance: $500 (Favorable)

7. Master Budget Variance:

- Definition: The difference between the master budget and actual results.
- Analysis: Compare master budget figures to actual results.
- Importance: Helps in overall performance evaluation.
- Application: Used for strategic planning and control.
Example:
- Master Budget Revenue: $100,000
- Actual Revenue: $95,000
- Variance: $5,000 (Unfavorable)

8. Flexible Budget Variance:

- Definition: The difference between the flexible budget and actual results.
- Analysis: Compare flexible budget figures to actual results.
- Importance: Provides insights into cost control and efficiency.
- Application: Used for operational control.
-Example:
- Flexible Budget Cost: $15,000
- Actual Cost: $16,000
- Variance: $1,000 (Unfavorable)

9. Master Budget Variance Analysis vs. Flexible Budget Variance Analysis

~ Basis
- Master Budget Variance Analysis: Master Budget

- Flexible Budget Variance Analysis: Flexible Budget

~ Focus
- Master Budget Variance Analysis: Overall performance
- Flexible Budget Variance Analysis: Operational efficiency
~ Use
- Master Budget Variance Analysis: Strategic planning
- Flexible Budget Variance Analysis: Cost control
10. Flexible Budget for Various Levels of Activities
- Flexible Budget Formula:
Total Cost = Fixed Costs + (Variable Cost per Unit × Activity Level)
- Activity Level Variances: Differences due to changes in activity levels.
Example:
- Fixed Costs: $10,000
- Variable Costs: $5 per unit
- Activity Levels: 1,000 units, 1,500 units, 2,000 units
- Flexible Budgets:
- At 1,000 units: $15,000
- At 1,500 units: $17,500
- At 2,000 units: $20,000

11. Evaluation of Performance Using Flexible Budget Variance

- Applications: Used to evaluate cost control and operational efficiency.
- Steps:
1. Prepare flexible budget.
2. Compare actual results to flexible budget.
3. Analyze variances.
- Example:
- Flexible Budget Cost: $15,000
- Actual Cost: $16,000
- Variance: $1,000 (Unfavorable)

12. Sales Activity Variance

- Definition: The difference between actual sales and budgeted sales.
Formula:
Sales Activity Variance = (Actual Units Sold - Budgeted Units Sold) ×
Budgeted Selling Price
Example:
- Budgeted Units: 1,000
- Actual Units: 1,200
- Budgeted Selling Price: $10
- Variance: (1,200 - 1,000) × $10 = $2,000 (Favorable)

13. Standard Costing and Standard Costs

- Standard costing involves setting predetermined costs for products or
services.
- Importance:
- Helps in cost control.
 - Facilitates performance evaluation.
- Aids in budgeting and planning.
- Application: Used in manufacturing and service industries.
- Standard Cost refers to the predetermined cost of producing a single unit of
a product or service under normal conditions. It is based on historical data,
industry benchmarks, and expected efficiency levels. Standard costs are
established for direct materials, direct labor, and manufacturing overhead.
- Direct Materials: The expected cost of raw materials required to produce
one unit.
- Direct Labor: The expected labor hours and rate required to produce one
unit.
- Manufacturing Overhead: The expected indirect costs (e.g., utilities,
depreciation) allocated to one unit.
- Importance of Standard Cost: Standard cost(ing) is a critical tool in
managerial accounting and offers several benefits:
a. Cost Control: Standard costs provide a benchmark against which actual
costs can be compared. This helps in identifying variances and taking
corrective actions to control costs.
b. Performance Evaluation: By comparing actual costs to standard costs,
management can evaluate the efficiency of production processes and
employee performance.
c. Budgeting and Planning: Standard costs serve as the foundation for
preparing budgets and forecasts. They help in estimating future costs and
revenues accurately.
d. Pricing Decisions: Standard costs provide a basis for setting selling prices.
By knowing the expected cost of production, businesses can determine
profitable pricing strategies.
d. Inventory Valuation: Standard costs simplify the process of valuing
inventory by assigning a consistent cost to each unit of product.
f. Motivation and Accountability: Standard costs set clear expectations for
employees and departments, encouraging them to work efficiently to meet
or exceed the standards.
g. Simplification of Accounting: Standard costing reduces the complexity of
accounting by using predetermined costs instead of tracking actual costs for
every transaction.

h. Variance Analysis: Standard costs enable variance analysis, which helps in

identifying the causes of differences between actual and expected
performance. This analysis is crucial for continuous improvement.
i. Decision-Making: Standard costs provide reliable data for making strategic
decisions, such as whether to outsource production, invest in new
equipment, or discontinue a product line.
j. Benchmarking: Standard costs allow businesses to compare their
performance with industry standards or competitors, helping them identify
areas for improvement.
- Example of Standard Cost:
- Product: Mallet
- Direct Materials: 2 kg at $3/kg = $6
- Direct Labor: 1.5 hours at $10/hour = $15
- Manufacturing Overhead: 1.5 hours at $4/hour = $6
- Standard Unit Cost: $6 + $15 + $6 = $27
Therefore, this standard cost of $27 per unit serves as a benchmark for
evaluating actual production costs of a mallet.

NB: Standard costing is a powerful tool that helps businesses plan, control,
and evaluate their operations. By setting predetermined costs and
comparing them to actual results, organizations can identify inefficiencies,
improve performance, and make informed decisions. Its importance lies in its
ability to simplify accounting processes, enhance cost control, and support
strategic decision-making.

14. Computing Standard Costs:

- General Guidelines:
- Use historical data and industry benchmarks.
- Consider expected efficiency levels.
- Adjust for expected changes in costs.

15. Standard Unit Cost

- Definition: The predetermined cost of producing one unit of product.
- Components:
- Direct Materials
- Direct Labor
- Manufacturing Overhead
- Process:
1. Determine standard quantities and prices for each component.
2. Calculate standard unit cost.
Example:
- Direct Materials: $5
- Direct Labor: $3
- Overhead: $2
 - Standard Unit Cost: $10

16. Computing Standard Direct Material Cost

- Formula:
Standard Direct Material Cost = Standard Quantity × Standard Price
Example:
- Standard Quantity: 2 kg
- Standard Price: $3/kg
- Standard Direct Material Cost: 2 × 3 = $6

17. Computing Standard Direct Labor Cost

- Formula:
Standard Direct Labor Cost = Standard Hours × Standard Rate
Example:
- Standard Hours: 1.5 hours
- Standard Rate: $10/hour
- Standard Direct Labor Cost: 1.5 × 10 = $15

18. Computing Standard Overhead Cost

- Formula:
Standard Overhead Cost = Standard Hours × Overhead Rate
Example:
- Standard Hours: 1.5 hours
- Overhead Rate: $4/hour
- Standard Overhead Cost: 1.5 × 4 = $6

19. Controllability and Variance Analysis

- Controllability: Variances are analyzed based on whether they are
controllable or uncontrollable.
- Controllable Variances: Can be influenced by management (e.g., material
usage variance).
- Uncontrollable Variances: Cannot be influenced by management (e.g.,
market price changes).
- Application: Helps in assigning responsibility and taking corrective actions.

6. Flexible Budget Variance Analysis: Breaks down the flexible budget

variance into:
- Price Variance (e.g., sales price, material price)
- Efficiency Variance (e.g., labor efficiency, material usage)
Example:
- Sales Price Variance = (Actual Price - Budgeted Price) × Actual Units
= ($52 - $50) × 8,000 = +$16,000 (Favorable)
- Variable Cost Variance = (Actual Cost - Budgeted Cost) × Actual Units
= ($22 - $20) × 8,000 = -$16,000 (Unfavorable)
- Fixed Cost Variance = Actual Fixed Costs - Budgeted Fixed Costs
= $105,000 - $100,000 = -$5,000 (Unfavorable)

7. Sales Volume Variance: Measures the impact of selling a different quantity

than budgeted, holding price and costs constant.
Formula: Sales Volume Variance =
(Actual Units Sold - Budgeted Units)× (Budgeted CM per Unit)
Example: From earlier: Sales Volume Variance
= (8,000 - 10,000) × ($50 - $20)
= -$60,000 (Unfavorable)
(Because fewer units were sold than planned.)

8. Sales Volume Variance Analysis: Explains why sales volume differed from
expectations (e.g., market conditions, competition, pricing strategy).
Possible Causes:
- Lower demand due to economic downturn.
- Higher competition leading to lost sales.
- Ineffective marketing reducing customer reach.
Example: If the company expected to sell 10,000 units but only sold 8,000,
possible reasons include:
- A new competitor entered the market.
- The product price was perceived as too high.
- Advertising campaigns were less effective than expected.

Summary:
- Static Budget Variance = Actual - Static Budget
- Flexible Budget Variance = Actual - Flexible Budget
- Sales Volume Variance = (Actual Qty - Budgeted Qty) × Budgeted CM
- Sales Price Variance = (Actual Price - Budgeted Price) × Actual Qty
- Variable Cost Variance = (Actual Cost - Budgeted Cost) × Actual Qty

Conclusion:
- Static Budget → Fixed plan, no adjustments.
- Static Budget Variance → Overall performance gap.
- Flexible Budget → Adjusts for actual activity.
- Flexible Budget Variance → Price & efficiency effects.
- Sales Volume Variance → Impact of selling more/less.

As a whole, this structured approach helps businesses identify 'where' and

'why' deviations occurred, aiding in better decision-making.

Part 1: ADDITIONAL LECTURE NOTES ON VARIANCE ANALYSIS

1. Static Budget is a fixed financial plan prepared for a specific level of
activity (e.g., production or sales volume) before a period begins. It does not
adjust for actual activity levels.
Key Points:
- Prepared in advance based on expected output.
- Remains unchanged regardless of actual performance.
- Used for planning and benchmarking.
Example:
A company budgets to produce and sell 10,000 units at $50 each, with total
variable costs of $20 per unit and fixed costs of $100,000.
- Static Budget (for 10,000 units)
Sales Revenue (10,000 × $50) .. 500,000
Variable Costs (10,000 × $20) .. (200,000)
Contribution Margin ....................300,000
Fixed Costs .................................(100,000)
Net Income ..................................200,000

2. Static Budget Variance is the difference between actual results and the
static budget. It helps to assess the overall performance but does not
separate volume and efficiency effects.

Formula: Static Budget Variance =

(Actual Results - Static Budget)

Example: Suppose the company actually sells 8,000 units at $52 each, with
variable costs of $22 per unit and fixed costs of $105,000.
- Actual Results (for 8,000 units)
Sales Revenue (8,000 × $52) .... 416,000 Variable Costs (8,000 ×
$22) .... (176,000) Contribution Margin ................... 240,000
Fixed Costs ................................. (105,000) Net
Income .................................. 135,000
- Static Budget Variance = Actual Net Income - Static Budget Net Income
= $135,000 - $200,000 = -$65,000 (Unfavorable)
3. Static Budget Based Variance Analysis:
This analysis breaks down the static budget variance into:
1. Sales Volume Variance (due to changes in quantity sold)
2. Flexible Budget Variance (due to price and cost differences)
Example (Continuing from above):
- Sales Volume Variance:
= (Actual Units Sold - Budgeted Units) × Budgeted CM per Unit
= (8,000 - 10,000) × ($50 - $20)
= -$60,000 (Unfavorable)
- Flexible Budget Variance:
= Actual Net Income - Flexible Budget Net Income
(Flexible Budget adjusts for actual sales volume of 8,000 units.)
- Flexible Budget (for 8,000 units)
Sales Revenue (8,000 × $50)..... 400,000 Variable Costs (8,000 ×
$20)......(160,000) Contribution Margin ................... 240,000 Fixed
Costs ................................. (100,000) Net
Income ...................................140,000
- Flexible Budget Variance = $135,000 - $140,000 = -$5,000 (Unfavorable)
(Due to higher variable costs and fixed costs than budgeted.)

4. Flexible Budget: A flexible budget adjusts for actual activity levels (e.g.,
actual units sold). It provides a more accurate benchmark than a static
budget.
Key Points:
- Adjusts revenues and variable costs based on actual volume.
- Fixed costs remain unchanged (unless they are step-fixed).
Example: Using the same case, if actual sales = 8,000 units, the flexible
budget adjusts the static budget for this new volume.
- Flexible Budget (for 8,000 units)
Sales Revenue (8,000 × $50).......400,000 Variable Costs (8,000 ×
$20).......(160,000) Contribution Margin .....................240,000 Fixed
Costs ................................. (100,000) Net
Income ...................................140,000

5. Flexible Budget Variance: The difference between actual results and the
flexible budget. It isolates price and efficiency variances (not volume).
- Formula: Flexible Budget Variance = Actual Results - Flexible Budget
Example: From earlier,
Actual Net Income = $135,000,
Flexible Budget Net Income = $140,000.
Variance = -$5,000 (Unfavorable)
(Due to higher costs: $22 vs. $20 variable cost, $105k vs. $100k fixed costs.)

Part 2: NOTES ON CONTROLABILITY AND VARIANCE ANALYSIS

1. Total Material Variance: measures the total difference between the actual
cost of materials and the standard cost for actual production.
Formula: Total Material Variance
= Actual Cost - Standard Cost
Where:
- Actual Cost = Actual Quantity (AQ) × Actual Price (AP)
- Standard Cost = Standard Quantity (SQ) × Standard Price (SP)
Example:
- Standard: 2 kg per unit at $5/kg
- Actual: Produced 1,000 units, used 2,200 kg at $4.80/kg
- Standard Cost = (1,000 × 2 kg) × $5 = $10,000
- Actual Cost = 2,200 kg × $4.80 = $10,560
- Total Material Variance = $10,560 - $10,000 = $560 (Unfavorable)

2. Material Price Variance (MPV): Measures the difference due to paying more
or less per unit than budgeted.
Formula: MPV = (AP - SP) × (AQ Purchased)
Example:
- AP = $4.80/kg, SP = $5/kg, AQ = 2,200 kg
- MPV = ($4.80 - $5) × 2,200 = -$440 (Favorable)
- (Saved $0.20 per kg.)

3. Material Quantity Variance (MQV): Measures the difference due to using

more or fewer materials than budgeted.

Formula: MQV = (AQ Used - SQ Allowed) × (SP)

Example:
- AQ Used = 2,200 kg, SQ = 2,000 kg (1,000 units × 2 kg)
- MQV = (2,200 - 2,000) × $5 = +$1,000 (Unfavorable)
- (Wasted 200 kg of material.)

4. Total Labor Variance: Measures the total difference between actual labor
costs and standard labor costs for actual production.
Formula: Total Labor Variance = (Actual Cost - Standard Cost)
Where:
- Actual Cost = Actual Hours (AH) × Actual Rate (AR)
- Standard Cost = Standard Hours (SH) × Standard Rate (SR)
Example:
- Standard: 3 hours/unit at $12/hour
- Actual: Produced 2,000 units, worked 6,500 hours at $11.80/hour
- Standard Cost = (2,000 × 3) × $12 = $72,000
- Actual Cost = 6,500 × $11.80 = $76,700
- Total Labor Variance = $76,700 - $72,000 = $4,700 (Unfavorable)

5. Labor Rate Variance (LRV): Measures the difference due to paying more or
less per labor hour than budgeted.
Formula: LRV} = (AR - SR) × AH Worked
Example:
- AR = $11.80/hour, SR = $12/hour, AH = 6,500
- LRV = ($11.80 - $12) × 6,500 = -$1,300 (Favorable)
- (Saved $0.20 per hour.)

6. Labor Efficiency Variance (LEV): Measures the difference due to using

more or fewer labor hours than budgeted.
Formula:
LEV = (AH Worked - SH Allowed) × SR
Example:
- AH Worked = 6,500, SH = 6,000 (2,000 units × 3 hours)
- LEV = (6,500 - 6,000) × $12 = +$6,000 (Unfavorable)
- (Worked 500 extra hours.)

7. Total Overhead Variance: Measures the total difference between actual

overhead costs and standard overhead applied to production.
Formula: Total Overhead Variance = (Actual Overhead - Applied Overhead)
Where:
- Applied Overhead = Predetermined Overhead Rate (POHR) × Standard
Hours Allowed
Example:
- Budgeted Overhead = $50,000 for 10,000 hours → POHR = $5/hour
- Actual Overhead = $52,000
- Standard Hours Allowed = 9,000 hours (for actual production)
- Applied Overhead = $5 × 9,000 = $45,000
- Total Overhead Variance = $52,000 - $45,000 = $7,000 (Unfavorable)

Summary:
- Total Material Variance = (AQ × AP) - (SQ × SP)
- Material Price Variance = (AP - SP) × AQ
- Material Quantity Variance = (AQ - SQ) × SP
- Total Labor Variance = AH × AR - SH × SR
- Labor Rate Variance = (AR - SR) × AH
- Labor Efficiency Variance = (AH - SH) × SR
- Total Overhead Variance = Actual OH - Applied OH

Why These Variances Matter:

- Material Variances: Identify wastage or cost savings in raw materials.
- Labor Variances: Highlight inefficiencies in workforce productivity.
- Overhead Variances: Show if overhead costs are under/over-absorbed.