Section C Performance management

Variance analysis
Compares actual expenses and revenue to budgeted (planned) amounts of same
period
Standard cost
A standard cost is a predetermined or estimated cost of producing a product or
performing an activity, set before the period begins.

Standard cost = Planned cost used to compare with actual cost.

Standard Cost vs. Standard Cost System:

Standard cost

Expected cost of a product or activity.

Standard cost system

Formal accounting system which used standard costs and tracking variances.

Using a Standard Cost System

Process costing system

A process costing system is an accounting method used to assign costs to products

that are mass-produced and nearly identical

Job costing system

A job costing system is an accounting method used to track and assign costs to
specific, individual jobs or projects. Separately

So we can used standard cost with either with process costing system or with job
costing system

Reasons for using standard cost system:

Simpler in process costing due to repetitive production.

Easier to find cost per equivalent unit for materials, labor, and overhead.

Simplifies record-keeping – just track quantity and multiply by standard cost

Also best used with flexible budget

A flexible budget changes based on how much you actually produce or sell.

It will give us more accurate and meaning full variances

Cost

Cost come from activities(cost drivers) which we do when creating new product or
providing new services

Activities or cost driver

Machine hrs , labour hrs and materials etc

So standard cost is based on correct level activities

Choosing the right activity level is important:

If set too high, workers feel discouraged.

If set too low, it’s too easy and not motivating.

Types of activity levels:

Ideal (Theoretical)

No breaks, waste, or downtime (not realistic long-term).

Practical (Currently Attainable)

Allows for normal delays, some waste, and learning time (motivating and realistic).

Normal level of output

Average expected output over a few years.

Master Budget level of output

Planned output for the upcoming budget period.

Point

In practices we will used normal or master budget level of activities to set standard

Standard costs must be updated regularly

Because prices, materials, and processes can change over time.

Sources of Standards

Several sources can be used to set appropriate standards for usage and prices.

Activity Analysis
Activity analysis is the process of identifying and evaluating all the steps (activities)
needed to complete a job, project, or operation.

Most accurate, but time-consuming and costly.

Historical Data

Uses past performance data.

Low cost and easy to get.

May carry old inefficiencies, not good for continuous improvement.

Bench-marking

Compares with best practices in other companies.

Helps stay competitive.

May not always fit your company exactly.

Target Costing

Starts with market price and desired profit → then works back to find target cost.

Uses kaizen (continuous improvement) to reduce costs.

Focused on efficiency and staying within target profit margins.

Strategic Decisions

Big changes (e.g., new equipment or kai-zen commitment) can affect standard costs.

Standards need to reflect those strategic updates.

Variance analysis

Compares actual results to budgeted (standard) results.

To find differences between cost or usage

Variance Levels

Amount of detail that variance contain

Static vs. Flexible Budget Variances

Static Budget or fixed budget

Budget prepared for one specific planed level activity.

Doesn’t adjust if actual output changes.

Level 1 variances.

Easy to make, but less useful for analysis.

Flexible Budget

Budget adjusts for actual activity level.

Fixed costs stay the same unless outside relevant range.

Level 2 variances.

More accurate and useful for evaluating performance.

Level 3 Variances

Calculated for individual inputs (like direct materials, labor, or variable overhead).

More detailed and specific information.

Identify exact causes of cost differences.

Level 1 Variances – Static Budget Variances

Most general type of variance

Compare actual results vs. static (master) budget.

Focus only on sold units (not all produced).

Show if results were better or worse than planned, but not why.

Benefits:

Helps spot unexpected differences in revenue/cost.

Highlights what needs to be investigated.

Part of the control loop in budgeting.

Limitations:

Doesn’t separate causes (like more/less sales vs. cost issues).

Focuses on short-term results, not long-term goals.

May ignore non-financial performance.

Managers should be judged on total contribution, not just hitting budget.

Control loop

The process by which the activities of the company are controlled.

Point

When calculating variances for incomes or costs/expenses

Always subtract the Budget amount from the Actual Amount ( Actual – Budget =
Variance)

Income

A positive variance for an income item is a Favorable variance

A negative variance for an income item is an Unfavorable variance 

Expenses

A positive variance for a cost or expense item is an Unfavorable variance 

A negative variance for a cost or expense item is a Favorable variance

Manufacturing Input Variances

Variances in direct materials, direct labor, and overhead.

Focus on units produced.

Includes:

Price variance – paid more/less than standard.

Quantity (efficiency) variance – used more/less than standard.

Used to control production costs.

Reported in Production Variance Report (Level 3).

Sales Variances

Focus on units sold.

Reported in Sales Variance Report (Level 2).

Shows total flexible budget variance (price + quantity combined).

Does not show detailed breakdown.

Key Differences

Feature Level 2 (Sales Variance) Level 3 (Production Variance)

Based on Units sold Units produced
Variance detail Combined (price + quantity) Separated (price and quantity)
Report type Sales variance report Production variance report
Reconciliation Tip

Only reconcile if:

Units produced = Units sold (e.g., new company, no inventory)

What Causes Manufacturing Input Variances?

Manufacturing input variances happen when:

Actual price ≠ Standard (budgeted) price

Actual quantity used ≠ Standard quantity allowed

Main Types of Input Variances:

Variance Type Cause Formula

Price Variance Paid more or less per unit (AP – SP) × AQ
Quantity (Efficiency) Variance Used more or less input than expected (AQ – SQ) × SP

AP = Actual Price
SP = Standard Price
AQ = Actual Quantity
SQ = Standard Quantity

Breakdown by Input Type:

Quantity/Efficiency
Input Price Variance
Variance
Materials Price Materials Quantity
Materials
Variance Variance
Labor Labor Rate Variance Labor Efficiency Variance
Variable
Spending Variance Efficiency Variance
OH
Production Volume
Fixed OH Spending Variance
Variance
Advanced (Multiple Inputs):

Variance Formula
Mix Variance (WASPActual Mix – WASPStandard Mix) × AQ
Yield Variance (AQ – SQ) × WASPStandard Mix

WASP = Weighted Average Standard Price

Purpose of Variance Analysis:

Helps management find why costs differ.

Focuses attention on inefficiencies or price issues.

Supports cost control and decision-making.

Direct Materials Variances – Definition

Difference between:

What was actually spent on materials

vs.

What should have been spent (based on standards)

Total Direct Materials Variance

= Flexible Budget Variance for Materials

= Actual Cost − Standard Cost for Actual Output

Two Components:

1. Materials Quantity Variance (Efficiency/Usage Variance)

Measures how much material was used vs. should have been used

Formula:

(AQ – SQ) × SP

AQ = Actual Quantity

SQ = Standard Quantity for actual output

SP = Standard Price

Positive = Unfavorable, Negative = Favorable

2. Materials Price Variance (Price Usage Variance)

Measures how much was paid vs. should have been paid per unit

Formula:

(AP – SP) × AQ
AP = Actual Price

SP = Standard Price

AQ = Actual Quantity

Positive = Unfavorable, Negative = Favorable

Total Variance = Price Variance + Quantity Variance

Management by Exception – Definition

Focus only on significant variances (positive or negative) to save time and effort.

Note:

Too many variances or ignoring favorable ones can lead to missed opportunities or
confusion

Accounting for Direct Materials Variances in a Standard Cost System

Definition

Standard Cost System records costs based on pre-set (standard) prices and quantities,
and tracks differences (variances) between standard and actual costs.

Types of Direct Material Variances

Materials Price Variance (MPV)

Difference between actual price paid and standard price.
Recorded when materials are purchased.

Dr. Materials Inventory (at standard cost)

Dr./Cr. Materials Price Variance (for price difference)

Cr. Accounts Payable (at actual cost)

Materials Quantity Variance (MQV)

Difference between actual quantity used and standard quantity allowed.
Recorded when materials are used in production

Dr. Work-in-Process (WIP) Inventory (standard quantity × standard price)

Dr./Cr. Materials Quantity Variance (for quantity difference)

Cr. Materials Inventory (actual quantity × standard price)

Accounting for Materials Price Usage Variances,

Definition

In this system, materials inventory is recorded at actual cost, and both price and
quantity variances are calculated when materials are used in production.

Key Points

At Purchase:

Record materials at actual cost

No variance recorded yet

Journal Entry:

Dr. Materials Inventory (actual cost)

Cr. Accounts Payable (actual cost)

At Use (Production):

Compare:

Standard cost allowed for actual output

Actual cost used

Record the difference as:

Materials Price Usage Variance

Materials Quantity Variance

Journal Entry:

Dr. Work-in-Process (WIP) Inventory (standard cost)

Dr./Cr. Materials Price Usage Variance
Dr./Cr. Materials Quantity Variance
Cr. Materials Inventory (actual cost)

End-of-Period Treatment

Variances are closed out to:

Cost of Goods Sold (COGS), or

Prorated across:

Direct Materials Inventory

Work-in-Process (WIP)

Finished Goods Inventory

COGS

If variances are material (large/important).

Long-Term Impact

Both standard and actual costing methods lead to the same total expenses and profit
over time.

The difference is when and how costs are allocated — not how much.

Direct Labor Variances

Definition:

Difference between standard labor cost and actual labor cost for actual output.

1. Total Labor Variance

= Standard Cost – Actual Cost

Also called Flexible Budget Variance

2. Labor Rate Variance (Price Variance)

= (Actual Rate – Standard Rate) × Actual Hours

Shows if you paid workers more or less than expected.

3. Labor Efficiency Variance (Quantity Variance)

= (Actual Hours – Standard Hours) × Standard Rate

Shows if you used more or fewer labor hours than expected.

Accounting Treatment (Standard Cost System):

Dr. Work-in-Process Inventory (Standard Hours × Std. Rate)

Dr/Cr. Labor Rate Variance

Dr/Cr. Labor Efficiency Variance

Cr. Accrued Payroll (Actual Hours × Actual Rate)

Multiple Inputs (Materials or Labor Classes)

Definition:

When more than one material or labor type is used, quantity variance is split into:

Mix Variance

Mix variance is the portion of the total quantity variance that occurs because the
actual mix (proportion) of materials or labor used is different from the standard mix.

= (WASP of Actual Mix – WASP of Standard Mix) × Actual Quantity

Shows cost impact of mix ratio difference.

Yield Variance

Yield variance is the portion of the total quantity variance that arises when the total
actual input used (materials or labor) is more or less than the standard input allowed
for the actual output.

= (Actual Total Quantity – Standard Total Quantity) × WASP of Standard Mix

Shows cost impact of total input difference.

Total Variance in Weighted Mix

Total Price Variance = Sum of each input’s price variance

Total Quantity Variance = Sum of each input’s quantity variance

Quantity Variance = Mix Variance + Yield Variance

Factory Overhead Variances

Definition:

Factory overhead includes indirect production costs (not directly traceable to a

product), such as:

 Utilities
 Indirect labour
 Maintenance
 Depreciation

Overhead Allocation Is Important:

 Accurate product costs

 Absorption costing (GAAP)
 Prevents under-pricing and losses
 Applied to products using standard/predetermined rates

Types of Overhead:
Variable Overhead

Changes with production level (e.g., electricity)

Fixed Overhead

Remains constant within a certain production range (e.g., rent)

Overhead Allocation Basics:

Overhead is applied to products using a predetermined rate:

Predetermined Rate = Budgeted Overhead / Budgeted Base (e.g., labour or machine

hours)

Cost Allocation Base:

Activity used to assign overhead (e.g., direct labour hours, machine hours)

Overhead is applied during production. Actual cost is known later.

Factory Overhead Variance:

Shows the difference between:

Actual overhead incurred

vs
Overhead applied to production

Four Overhead Variances:

1. Variable Overhead Spending Variance

Difference in cost per unit of allocation base

Focuses on rate/price of variable overhead

2. Variable Overhead Efficiency Variance

Difference in actual vs. standard usage of allocation base

Measures efficiency in using hours/resources

3. Fixed Overhead Spending Variance

Difference between actual fixed overhead and budgeted fixed overhead

Shows if company overspent on fixed costs

4. Fixed Overhead Production Volume Variance

Arises from difference between actual production and expected production

Measures how well capacity was used

Total Overhead Variance Formula:

Actual Total Overhead Incurred

– Total Overhead Applied (at standard rates)
= Total Overhead Variance

Variable Overhead (VOH) Variances

Definition:

Variable overheads are indirect costs that change with production volume (e.g.,
electricity, maintenance, utilities).

Key Points:

VOH costs can’t be traced to specific units, but increase/decrease with production.

Applied to production using a standard (pre-set) rate.

VOH variances help compare what was actually spent vs. what should have been
spent.

Total Variable Overhead Variance

Definition: Difference between actual VOH incurred and standard VOH applied
to actual production.

Formula:

(AP × AQ) − (SP × SQ)

Where:
• AP = Actual rate per unit of base
• AQ = Actual quantity of allocation base used
• SP = Standard rate per unit
• SQ = Standard quantity allowed for actual output

Favourable = actual < standard

Unfavourable = actual > standard

Types of variable overhead

There are two types

1) Variable Overhead Spending Variance

Definition: Shows if VOH was paid at a higher or lower rate than expected.
Formula:

(AP × AQ) − (SP × AQ)

OR
(AP − SP) × AQ

Favourable = paid less per unit

Unfavourable = paid more per unit

2) Variable Overhead Efficiency Variance

Definition:

Measures the effect of using more or fewer hours (or other allocation base) than
expected for the actual output.
It shows how efficiently the allocation base (like labour or machine hours) was used.

Formula:

(AQ − SQ) × SP

Where:

 AQ = Actual quantity of allocation base used

 SQ = Standard quantity allowed for actual output
 SP = Standard variable overhead rate per unit of base

Interpretation:

 Favourable (−): Used less than expected → saved cost

 Unfavourable (+): Used more than expected → extra cost

Fixed Overhead (FOH) Variances

Definition:

Fixed Overheads are costs that do not change with production volume (within a
certain range).
E.g., factory rent, salaries, depreciation.

1. Total Fixed Overhead Variance

Formula:

Actual FOH Incurred − Applied FOH

= Total Fixed Overhead Variance

 Applied FOH = Standard rate × Standard hours for actual output

 Favourable (−): Actual < Applied
 Unfavourable (+): Actual > Applied
2. Fixed Overhead Spending (Flexible Budget) Variance

Definition: Difference between actual FOH incurred and budgeted FOH.

Formula:

Actual FOH Incurred − Budgeted FOH

= FOH Spending Variance

 Related to over- or under-spending of fixed costs.

 Fixed costs are the same in static and flexible budgets.

Favourable: Actual < Budgeted

Unfavourable: Actual > Budgeted

3. Fixed Overhead Production-Volume Variance

Definition: Difference between budgeted FOH and applied FOH.

Measures capacity utilization, not spending.

Formula:

Budgeted FOH − Applied FOH

= FOH Production-Volume Variance

Favourable: Applied > Budgeted (high output)

Unfavourable: Applied < Budgeted (low output)

Not a cost variance — doesn't compare actual cost.

No FOH Efficiency Variance

 Fixed costs don’t vary with production.

 Can’t be used efficiently or inefficiently.

Total Overhead Flexible Budget Variances

Formula:

Actual Total OH Incurred − Total OH per Flexible Budget

= Total Overhead Flexible Budget Variance

Includes:

 Variable Overhead Spending Variance

 Variable Overhead Efficiency Variance
 Fixed Overhead Spending Variance

Way of Overhead Variance Analysis

1. Four-Way Overhead Variance Analysis

Breaks down total overhead variance into four separate variances:

 Variable Overhead Spending Variance = (AP − SP) × AQ

 Variable Overhead Efficiency Variance = (AQ − SQ) × SP
 Fixed Overhead Spending Variance = Actual Fixed − Budgeted Fixed
 Fixed Overhead Volume Variance = Budgeted Fixed − Applied Fixed

2. Three-Way Overhead Variance Analysis

Combines some four-way variances into 3 totals:

1. Volume Variance
= Same as Fixed Overhead Volume Variance
2. Efficiency Variance
= Same as Variable Overhead Efficiency Variance
3. Spending Variance
= Variable Overhead Spending Variance + Fixed Overhead Spending
Variance

3. Two-Way Overhead Variance Analysis

Combines into only 2 variances:

1. Volume Variance
= Same as Fixed Overhead Volume Variance
2. Controllable Variance (aka Flexible Budget Variance)
= Variable Spending + Variable Efficiency + Fixed Spending

Sales Variances

1. Definitions

 Sales Variances: Differences between actual and budgeted revenues, variable

costs, and contribution margin based on units sold.
 Selling Price Variance (aka Sales Price Variance):
Difference between actual and budgeted selling price per unit.
Formula: (AP – SP) × AQ
 Sales Volume Variance:
Difference caused by units sold being more or less than budgeted.
Formula: (AQ – SQ) × SP

2. Types of Budgets

Budget Type Based On

Static Budget Planned (budgeted) units
Flexible Budget Adjusted to actual units sold

Flexible Budget Variances on a Sales Variance Report

Flexible Budget Variance (FBV):
The difference between actual results and the flexible budget (which adjusts budgeted
amounts based on actual units sold).
Formula:

FBV=(AP−SP) × AQ

Where:

 AP = Actual price or cost per unit

 SP = Standard (budgeted) price or cost per unit
 AQ = Actual quantity sold

Key Points

FBV for sales revenue is also called the Selling Price Variance.

FBV shows how much of the difference is due to a price/cost difference (per unit), not
volume.

FBV on Sales Reports ≠ Manufacturing Price Variance interpretation:

 In manufacturing, the FBV is split into:

o Price Variance (AP − SP)
o Quantity Variance (AQ − SQ)
 In sales reports, this formula shows the entire variance, not split.

Sales Volume Variances on a Sales Variance Report:

Definition

Sales Volume Variance (SVV):

Measures the effect on budgeted results caused by selling more or fewer units than
planned.

Formula:

SVV=(AQ−SQ) × SP

Where:

 AQ = Actual quantity sold

 SQ = Static budget quantity
 SP = Standard (budgeted) selling price (for revenue) or variable cost (for
costs)

Key Points

SVV is caused by volume difference only (not price or cost per unit).
Positive SVV:

 Favourable (F) for revenue

 Unfavourable (U) for costs

Negative SVV:

 Unfavourable (U) for revenue

 Favourable (F) for costs

SVV Applies To:

 Revenue line (using budgeted selling price)

 Variable costs (using budgeted cost per unit)
 Contribution margin (using budgeted CM per unit)

No SVV for fixed costs, as they don’t change with sales volume.

Sales Variance Report

Sales Variances (Definition)

All variances reported on a Sales Variance Report, based on comparing actual vs.
budgeted income statement items (revenues, costs, contribution margin, etc.).

Selling Price Variance (aka Sales Price Variance)

Definition:
The difference caused by selling products at a price different from budgeted.

Formula:

Selling Price Variance=(AP–SP)×AQ

Where:

 AP = Actual selling price per unit

 SP = Budgeted (standard) selling price per unit
 AQ = Actual quantity sold

Applies to revenue line only

It’s the same as the Flexible Budget Variance for revenue

3. Flexible Budget Variance

Definition:
The difference between actual results and the Flexible Budget (adjusted to actual units
sold).

Formula:
(AP–SP) × AQ

Used for both revenues and variable costs.

Positive variance is:

 Favourable for revenue

 Unfavourable for cost

Sales Volume Variance (SVV)

Definition:
The effect of selling a different number of units than budgeted (volume difference
only).

Formula:

(AQ–SQ) × SP

Where:

 AQ = Actual quantity sold

 SQ = Static budget quantity
 SP = Budgeted selling price (for revenue) or cost (for costs)

Sales Volume Variance = Static Budget – Flexible Budget

Static Budget Variance

Definition:
The difference between actual results and the Static Budget (based on original
forecasted units).

Formula:

Static Budget Variance=Actual–Static Budget

Includes both price and volume effects.

Contribution Margin Variance

Use same formulas above, but:

CM per unit=Selling Price–Variable Costs per unit

SVV for Contribution Margin:

(AQ–SQ) × CM/unit

Fixed Costs
  No Selling Price Variance
 No Sales Volume Variance
 Always same in Static and Flexible budgets

Quick Recap Table

Variance Type Formula Applies to Meaning of (+) Variance

Selling Price
(AP – SP) × AQ Revenue only Favourable (Revenue ↑)
Variance
Flexible Budget
(AP – SP) × AQ Revenues, costs Revenue = F, Cost = U
Variance
Sales Volume All variable
(AQ – SQ) × SP Revenue = U, Cost = F
Variance items
Static Budget Actual – Static Net of price and volume
All items
Variance Budget effects

Single-Product Firm Summary

 Uses Flexible Budget Variance and Sales Volume Variance only.

 Selling Price Variance is same as Flexible Budget Variance for revenue.
 Variance formulas:
o Flexible Budget Variance = (Actual Price – Budgeted Price) × Actual
Quantity
o Sales Volume Variance = (Actual Quantity – Budgeted Quantity) ×
Budgeted Price

Flexible Budget and Sales Variances for a Multiple-Product Firm:

Flexible Budget Variance (Selling Price Variance)

 Measures the impact of actual selling prices or costs differing from budgeted
amounts for each product.
 For revenue (Selling Price Variance):

Selling Price Variance=∑(AP−SP) × AQ

APAP = Actual Price

o SPSP = Standard (Budgeted) Price

o AQAQ = Actual Quantity sold
 Calculated for each product and then summed.
 Positive variance (Favourable) means actual prices were higher than budgeted.
 This variance is unrelated to sales volume.

Sales Volume Variance

 Measures the effect of actual sales quantities differing from budgeted sales
quantities.
 Calculated as:
∑(AQ−SQ)×SP

o SQSQ = Standard (Budgeted) Quantity

 Shows impact of selling more or fewer units than expected.
 Negative variance (Unfavourable) means fewer units sold than budgeted.
 This variance + Flexible Budget Variance = Static Budget Variance.

Sales Volume Variance Sub-Components for Multiple Products

 Sales Quantity Variance: Impact of total units sold being different from total
budgeted units, regardless of product mix.

(AQ−SQ) × wasp SM

o Wasp SM= Weighted Average Standard Price for the Standard Mix
 Sales Mix Variance: Impact of the difference between the actual sales mix and
the budgeted sales mix.

(wasp AM−wasp SM)×AQ= Weighted Average Standard Price for the Actual Mix

o Wasp SM = Weighted Average Standard Price for the Standard Mix

 Sales Volume Variance = Sales Quantity Variance + Sales Mix Variance

Key Points

 The Selling Price Variance (Flexible Budget Variance) is strictly due to price
differences, not quantity.
 The Sales Volume Variance is split into:
o Sales Quantity Variance (effect of total units sold differing from
budget)
o Sales Mix Variance (effect of mix of products sold differing from
budget)
 The sum of Selling Price Variance and Sales Volume Variance equals the total
Static Budget Variance for revenue.
 The same approach applies to variable cost and contribution margin lines,
adjusting the price and cost inputs accordingly.
 Variance signs interpretation differs between revenue and cost lines:
o For revenue: positive = favourable, negative = unfavourable
o For variable costs: negative = favourable, positive = unfavourable

Market Variances Analysis

1. Sales Quantity Variance (SQV)

 Definition: Measures the impact of selling more or fewer total units (all
products combined) than budgeted.
 Cause: Due to market size or market share changes.
2. Market Size Variance (MSV)

 Definition: Measures effect on contribution margin due to actual market size

being different from expected.
 Formula:

(Actual Market Size−Expected Market Size)×Expected Market Share×waspSM

3. Market Share Variance (MSHV)

 Definition: Measures effect on contribution margin due to actual market share

being different from expected.
 Formula:

(Actual Market Share−Expected Market Share) × Actual Market Size × wasp SM

4. wasp SM

 Definition: Weighted Average Standard Contribution Margin per Unit (used

for multiple-product firms).

Note for Single-Product Firms

 Use same formulas, but no need to calculate a weighted average contribution

margin—just use the standard per-unit margin.

Variance Analysis for a Service Company

Service = Product

 Service companies sell services, not physical goods.

 Example: Public accounting firm.

Types of Variances (for services)

 Price Variance – Difference between actual and expected price charged for
service.
 Quantity (Volume) Variance – Difference in number of services provided.
 Mix Variance – Change in proportion of different services offered.
 Overhead Variance – Differences in actual vs. expected overhead costs.

Mixed Companies (Service + Product)

 Separate service revenue and product (parts) revenue.

 Analyse:
o Service: Only revenue variances.
o Products: Revenue, cost, and contribution margin variances (like
resellers).

Overhead Cost Management

  Variable Overhead – Important for pricing/service mix decisions.
 Fixed Overhead – Risky if revenue drops (cost stays the same).
o Fixed overhead variance can help spot trouble early.

Importance of Variance Analysis

 Helps in pricing, cost control, and service mix decisions.

 Applies to all companies (even manufacturers) for non-manufacturing
overhead (e.g., distribution).

Responsibility Centres & Reporting Segments

Responsibility Centre

 Definition: A unit (e.g., department, location, product line) within an

organization evaluated for performance.
 Purpose: To assess both unit and manager performance.

Responsibility Accounting

 Definition: Accounting system measuring results by each responsibility

centre.
 Use: Supports planning, control, and manager evaluation.

Budgeting

 Each centre creates its own budget, approved by top management.

 All budgets form the Master Budget.
 Actual results vs. budgeted results are compared to provide feedback.

Types of Responsibility Centres

Cost Centre

o Focus: Costs only

o Example: HR, maintenance, internal accounting
o Evaluation: Efficiency & cost control

Revenue Centre

o Focus: Revenue only

o Example: Sales department
o Evaluation: Effectiveness (revenue generation)

Profit centre

o Focus: Revenues & costs (profit)

o Example: Store department (e.g., hardware)
o Evaluation: Profit (effectiveness & efficiency)
Investment Centre

o Focus: Profit + return on investment (ROI)

o Example: Branch office
o Evaluation: ROI (most comprehensive)

Key Concepts

 Feedback: Main link between planning and control

 Timely Reports: Needed for relevant decision-making
 Variance Reports: Show actual vs. budget differences; help improve, not
blame
 Manager Control: Managers should be evaluated only on factors they can
influence
 Strategic Use: Helps in decisions like expansion, promotion, or cost reduction

Evaluating the Manager vs. Business Unit

🔹 Key Idea

 Manager performance ≠ Business unit performance

 Evaluate managers only on what they can control

Manager Evaluation

 Should be based on controllable factors only (e.g., costs, decisions they can
influence)
 Unit performance info may support the evaluation but should not be the only
basis
 Use variance reports that separate controllable from non-controllable costs

Common Costs

Common Costs – Definition

 Costs not directly traceable to any one department or product.

 Examples: CEO salary, financial reporting, budgeting functions.
 Key Trait: These costs remain even if a segment is discontinued.

Shared Services vs. Common Costs

Shared Services Common Costs

Can be allocated by usage Cannot be allocated by usage
Based on a cost driver No clear cost driver
Example: IT, Payroll Example: CEO Salary, Budget Dept.

Why Allocate Common Costs?

 Helps calculate accurate product costs

  Ensures all costs are covered
 Supports better decision-making

Manager Evaluation

 Do NOT include common costs in manager performance evaluation

 Managers should only be judged on controllable costs

Key Points

 Common costs are not controllable by segment managers.

 Must be allocated internally, but separated in reports used for evaluating
managers.
 Allocation should balance accuracy vs. cost/effort (training, data gathering).

Common Cost Allocation Methods

Stand-Alone Allocation Method

 Definition: Allocates common costs proportionally based on each unit’s share

(e.g., sales, costs).
 Key Point: Treats each department as independent.
 Seen As: Fairer since each unit pays its proportional share.

Incremental Allocation Method

 Definition: Allocates costs based on priority ranking (usually size).

 Primary Party: Bears all fixed + some variable common costs.
 Incremental Parties: Bear only variable costs.
 Advantage: Helps new/small units by reducing their cost burden.
 Disadvantage: Can cause conflict over who is "primary."

Alternative Method: Contribution Percentage

 Definition: Assign a % of each department’s contribution to cover common

costs.
 Goal: Encourage shared responsibility across all departments.
 Benefit: Reinforces that all departments support the overall business.

Key Reminders

 Stand-Alone = Proportional & Fair

 Incremental = Priority-based & Supportive of new units
 Contribution % Method = Encourages teamwork without direct cost allocation

Contribution Income Statement – Summary Notes

🔹 Definition

 Separates variable costs and fixed costs

  Highlights contribution margin = Revenue – Variable Costs
 Helps evaluate manager and segment performance

4 Levels of Contribution Income Statement

Level 1: Manufacturing Contribution Margin

 = Sales – Variable Manufacturing Costs

 Shows profit after production costs

Level 2: Contribution Margin

 = Manufacturing Contribution – Variable Non-manufacturing Costs

 Covers all variable costs (e.g., marketing, admin)
 Amount left to cover fixed costs and profit

Level 3: Controllable Margin

 = Contribution Margin – Controllable Fixed Costs

 Fixed costs the manager can control
 Used to evaluate short-term manager performance

Level 4: Segment Margin

 = Controllable Margin – Non-controllable Traceable Fixed Costs

 Includes segment-related fixed costs (e.g., depreciation, taxes)
 Used to evaluate the segment, not the manager
 Excludes untraceable common costs

Untraceable Common Costs

 Definition: Company-wide costs that cannot be assigned to segments

 Examples: CEO salary, company-wide sponsorship
 Not included in segment or manager evaluations

Use of Contribution Income Statement

 Evaluate:
o Manager: Use Controllable Margin
o Business Unit: Use Segment Margin
 Helps decide: Keep, drop, or expand a segment or product

Profit Margin Ratio

 Formula: Net Income ÷ Sales

 Measures: % of sales that become profit
 Improve by:
o Increasing sales
o Cutting costs
o Growing sales faster than costs
Transfer Pricing

Definition:
Transfer pricing is the price charged when one division of a company sells goods or
services to another division within the same company.

Key Points:

 The item sold is called an intermediate product.

 Common in vertically integrated companies (e.g., one division makes parts,
another assembles the product).
 Transfer pricing does not affect total company profit, because internal
transactions are removed in consolidated financials.
 It does affect individual division profits (important for performance
evaluation).
 If set incorrectly, it can distort divisional performance and lead to poor
decisions.
 Should be set to benefit both divisions:
o Selling division earns a fair profit.
o Buying division pays less than external price.
 Should promote goal congruence

Purpose of Transfer Pricing:

1. Evaluate performance of divisions.

2. Encourage divisions to act in the company's best interest.
3. Share internal cost savings fairly.
4. Motivate managers through fair profit recognition.

Multinational Transfer Pricing & Taxes

 Tax Impact: Different countries have different tax rates, so transfer prices can
affect where profits are reported.
 Companies must follow the “arm’s-length” principle — internal prices should
be the same as if selling to an unrelated party.
 Using unfair transfer prices to shift profits to low-tax countries is not allowed
and attracts regulatory attention.

Tariffs, Customs & Transfer Pricing

 Lower transfer prices can reduce import tariffs/customs duties.

 But if transfer prices are too low, customs authorities may reject them.
 Must comply with local laws and fair value standards.

Exchange Rates & Other Factors

 Currency rates, local labor/material costs, and laws can impact subsidiary
performance.
 Companies must adjust evaluations to account for these differences.
Objectives of a Good Transfer Pricing System

A proper system should:

1. Promote goal congruence (align division & company goals)

2. Motivate managers to improve efficiency
3. Enable fair performance evaluation
4. Maintain managerial autonomy
5. Be equitable
6. Comply with legal & tax rules
7. Be simple to apply

Methods of Setting Transfer Prices

Method Description Pros Cons

Not always available,
Uses external market Fair, objective, meets
1. Market Price may complicate cost
price tax laws
tracking
2. Cost + Production cost + lost
Fair to seller when Complex, not arm’s-
Opportunity profit from not selling
capacity is limited length
Cost externally
Bad for evaluating
3. Variable Only includes variable Good if seller has
profit centers, no
Cost production costs excess capacity
profit for seller
Includes all production Can be misleading,
Easy to calculate,
4. Full Cost costs (materials, labor, not good for
commonly used
overhead) decision-making
Allows for profit, May encourage
Cost + markup (fixed
5. Cost Plus simple if no market inefficiency, costs
amount or %)
price can be inflated
Time-consuming,
6. Negotiated Price agreed between Flexible, encourages
depends on
Price divisions collaboration
negotiation skill
Undermines
7. Arbitrary Set by central Meets company
autonomy, unfair to
Price management objectives
divisions
Selling division records
Motivates both Complex to manage,
8. Dual-Rate market price, buying
divisions, better inconsistent profits
Pricing division records variable
internal cost analysis across divisions
cost

Choosing the Right Method

 Best method (in theory): Market Price

 If excess capacity: Use Variable Cost + small markup
 If no excess capacity: Use Market Price or Cost + Opportunity Cost
 Goal: Seller should cover cost + opportunity cost; buyer should not pay more
than external price.