Performance Measurement and

Responsibility Accounting
Chapter 22

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 Performance Evaluation
Large companies are easier to manage if divided into smaller
units, called divisions, segments, or departments.
In decentralized organizations, decisions are made by unit
managers instead of by top management.
1. Cost center:
Evaluated on their success in controlling costs.
2. Revenues center:
Evaluated on their success in controlling revenues.
3. Profit center:
Evaluated on their success in generating income.
4. Investment center:
Evaluated on use of investment center assets to generate income.
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 Controllable versus Uncontrollable Costs
A cost is controllable if a manager has the power to
determine or at least significantly affect the amount
incurred.
Supplies used in the manager’s department.

Uncontrollable costs are not within the manager’s

control or influence.
The department manager’s own salary.

Learning Objective P1: Prepare a responsibility accounting report using controllable costs. ©McGraw-Hill Education. 3
 Responsibility Accounting System 1

An accounting system that

provides information . . .

Relating to the To evaluate

responsibilities of managers on
individual managers. controllable items.

Learning Objective P1: Prepare a responsibility accounting report using controllable costs. ©McGraw-Hill Education. 4
 Responsibility Accounting System 2

Responsibility accounting recognizes that control over costs and

expenses belongs to several levels of management.

Exhibit 22.1

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Learning Objective P1: Prepare a responsibility accounting report using controllable costs. ©McGraw-Hill Education. 5
 Responsibility Accounting Performance
Report
Amount of detail varies according to the level
in the organization.
A department manager receives detailed reports.
A store manager receives summarized information from each
department.

Learning Objective P1: Prepare a responsibility accounting report using controllable costs. ©McGraw-Hill Education. 6
 Responsibility Accounting Performance Reports
Exhibit 22.2

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Learning Objective P1: Prepare a responsibility accounting report using controllable costs. ©McGraw-Hill Education. 7
 Profit centers
Ø How to allocate indirect expenses such as rent and utilities,
which benefit several department?

Ø How to allocate service departments expenses (e.g. payroll or

purchasing), which perform services that benefit several
departments?

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 Direct and Indirect Expenses
Direct expenses are costs Indirect expenses
traced directly to a are costs incurred for
department and incurred the joint benefit; they
for that department’s cannot be traced to
sole benefit. only one department.
Exhibit 22.4 Indirect Expense Common Allocation Bases
Wages and salaries Relative amount of hours worked
in each department
Rent Square feet of space occupied
Utilities Square feet of space occupied
Advertising Percentage of total sales
Depreciation Hours of depreciable asset used
Learning Objective C1: Distinguish between direct and indirect expenses and identify bases for allocating
indirect expenses to departments. ©McGraw-Hill Education. 9
 Expense Allocations: General Model
• Indirect and service department expenses are
allocated across departments that benefit from them.
• Try to use a cause-effect relation to allocate
expenses.
• If no cause-effect, we allocate based on
approximating the relative benefit each department
receives.
Exhibit 22.3
Allocated cost = Total cost to allocate × Percentage of allocation base used

Learning Objective C1: Distinguish between direct and indirect expenses and identify bases for
allocating indirect expenses to departments. ©McGraw-Hill Education. 10
Allocate indirect expenses to
departments.

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 Allocating Indirect and Service Department
Expenses
Service department costs are shared, indirect expenses that support the
activities of two or more production departments.
Indirect Expense Common Allocation Bases
Exhibit 22.4 Wages and salaries Relative amount of hours worked in each department
Rent Square feet of space occupied
Utilities Square feet of space occupied
Advertising Percentage of total sales
Exhibit 22.5 Depreciation Hours of depreciable asset used

Service Department Common Allocation Bases

Office expenses Number of employees or sales in each department
Personnel expenses Number of employees in each department
Payroll expenses Number of employees in each department
Purchasing costs Dollar amounts of purchases or number of purchase orders processed
Maintenance expenses Square feet of floor space occupied
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Learning Objective P2: Allocate indirect expenses to departments.
 Illustration of Cost Allocation
Classic Jewelry pays its janitorial service $800 per
month to clean its store. Management allocates this
cost to its three departments according to the floor
space each occupies.
Exhibit 22.6

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Learning Objective P2: Allocate indirect expenses to departments.
 Departmental Income Statements
Let’s prepare departmental income statements using the
following steps:
1. Accumulating revenues and direct expenses by department,
and total indirect expenses.
2. Allocating indirect expenses across both service and
operating departments.
3. Allocating service department expenses to operating
departments.
4. Preparing departmental income statements.

Learning Objective P3: Prepare departmental income statements and contribution reports. ©McGraw-Hill Education. 14
 Apply Step 1:
Departmental Expense Allocation Spreadsheet
Exhibit 22.9

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Learning Objective P3: Prepare departmental income statements and contribution reports. ©McGraw-Hill Education. 15
 Apply Steps 2 and 3:
Departmental Expense Allocation Spreadsheet
Exhibit 22.10

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Learning Objective P3: Prepare departmental income statements and contribution reports. ©McGraw-Hill Education. 16
 Apply Step 4:
Departmental Income Statements
Exhibit 22.11

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Learning Objective P3: Prepare departmental income statements and contribution reports. ©McGraw-Hill Education. 17
 Departmental Contribution to Overhead
Departmental revenue − Direct expenses
= Departmental contribution to overhead

Departmental contribution . . .
• Is used to evaluate departmental performance.
• Is not a function of arbitrary allocations of indirect
expenses.
A department may be a candidate for elimination
when its departmental contribution is negative.

Learning Objective P3: Prepare departmental income statements and contribution reports. ©McGraw-Hill Education. 18
 Departmental Contribution to Overhead
Exhibit 22.12

Departmental contributions to indirect expenses (overhead) are emphasized.

Departmental contributions are positive so neither department is a candidate for
elimination.
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Learning Objective P3: Prepare departmental income statements and contribution reports. ©McGraw-Hill Education. 19
 Investment Centers
Investment center managers are evaluated using
performance measures that combine income and
assets.

Performance measures are:

1. Return on investment
2. Residual income
3. Profit margin
4. Investment turnover

Learning Objective A1: Analyze investment centers using return on investment and residual income. ©McGraw-Hill Education. 20
 1. Investment Center Return
on Investment (ROI)
Exhibit 22.13
Investment center income
ROl =
Investment center average invested assets

LCD Division earned more dollars of income, but it was less

efficient in using its assets to generate income compared
to the S-Phone Division.
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Learning Objective A1: Analyze investment centers using return on investment and residual income.
 2. Investment Center Residual Income
Exhibit 22.14

Residual income = Investment center net income − Target

investment center net income
Assume the target net income is 8% of divisional assets.

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Learning Objective A1: Analyze investment centers using return on investment and residual income.
 ¾.Investment Center Profit Margin and
Investment Turnover

Exhibit 22.15

Exhibit 22.16

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Learning Objective A2: Analyze investment centers using profit margin and investment turnover.
 Non-financial performance
evaluation measures:
Analyzing investment centers using
balanced scorecard.

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 Balanced Scorecard
Collects information on several key performance indicators
within each of the four perspectives.
Exhibit 22.17

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Learning Objective A3: Analyze investment centers using balanced scorecard.
 Performance measurement
vs. Performance management
Performance measurement system encompasses the processes for
setting goals and collecting, analyzing and interpreting performance
data.

Performance management system encompasses the process of

assessing the difference between actual and desired outcomes,
identifying and flagging those differences that are critical,
understanding if and why the deficiencies have taken place, and
when necessary, introducing corrective actions aimed at closing the
significant performance gaps.

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The balanced scorecard

• Traditionally MA focused mainly on financial performance

measures.

• Greater emphasis now being given to incorporating non-

financial measures into the formal reporting system.

• Result was a proliferation of performance measures.

• To integrate financial and non-financial measures the
Balanced Scorecard (BSC) emerged.

• BSC seeks to link performance measures to an

organization’s strategy — Should be used to clarify,
communicate and manage strategy.
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• BSC Advocates looking at the business from four different perspectives by
seeking to provide answers to the following four basic questions:

1. How do customers see us? (customer perspective)

2. What must we excel at? (internal business process perspective)
3. Can we continue to improve and create value? (learning and growth
perspective)
4. How do we look to shareholders? (financial perspective)

• To implement the BSC the major objectives for each of the 4 perspectives
should be articulated and these objectives should be translated into
specific performance measures.

• A critical assumption of BSC is that each performance measure is part of a

cause-and-effect relationship.

• The BSC consists of two types of performance measures:

1. Lagging measures
2. Leading measures

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The Balanced Scorecard

(Source: Kaplan and Norton, 1996b)

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Financial perspective objectives and measures

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Customer perspective objectives and measures

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Internal business perspective objectives and measures

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Learning and growth perspective objectives and measures

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STRATEGIC PERFORMANCE MANAGEMENT
Cause-and-effect relationships
•BSC requires that each performance measure is a part of a cause-and-
effect relationship involving a link from strategy formulation to financial
outcomes.
•Every measure selected for a BSC should be an element of a chain of
cause-and-effect relationship that communicates the business unit’s
strategy.
•The cause-and-effect relationships are illustrated by the following strategy
map:

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Benefits of the balanced scorecard:
• Brings together in a single report four different perspectives
on a company’s performance that relate to many of the
disparate elements of a company’s competitive agenda.
• Provides a comprehensive framework for translating
company’s strategic goals into a coherent set of performance
measures.
• Helps managers to consider all important operational
measures together – enables managers to see whether
improvement in one area may have been at the expense of the
other.
• Promotes the active formulation of organizational strategy by
making it highly visible through the linkage of performance
measures to business unit strategy.
©McGraw-Hill Education.
Criticisms of the balanced scorecard:
• The cause-and-effect relationships are too ambiguous and
lack theoretical underpinning or empirical support.
• Omission of other important perspectives (e.g.
environmental impact on society and employee perspectives).

TOWARDS SUSTAINABILITY BSC

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Another approach

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 Appendix 22A: Cost Allocations
Cost allocations in Exhibits 22.10 and 22.11.
• Allocated cost = Total cost to allocate × % of allocation base used.

Company will allocate four indirect costs:

• Rent expense: $12,000
• Utilities expense: $2,400
• Advertising expense: $1,000
• Insurance expense: $2,500

©McGraw-Hill Education. 38
 Department Allocation Bases
A-1 Hardware uses the following allocation bases:
• Square feet of floor space.
• Dollar value of insured assets.
• Sales dollars.
• Number of purchase orders.
Exhibit 22A.1

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 Allocation of Rent
• Two service departments occupy 25% of total space, but value
of space is $1,200 ($12,000 × 10%).
• Operating departments are allocated remainder of rent cost
$10,800 ($12,000 − $1,200) based on each department’s
percent of total.
Exhibit 22A.2

See now 13 of departmental expense allocation spreadsheet (Exhibit 22.10).

Exhibit 22A.3

See now 13 of departmental expense allocation spreadsheet (Exhibit 22.10).

©McGraw-Hill Education. 40
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 Allocation of Utilities
$2,400 utilities expense is allocated based on square footage
occupied.
Exhibit 22A.4

*See row 14 of departmental expense allocation spreadsheet (Exhibit 22.10).

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 Allocation of Advertising
$1,000 advertising expense is allocated based on sales dollars.

Exhibit 22A.5

*See row 15 of departmental expense allocation spreadsheet (Exhibit 22.10).

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 Allocation of Insurance
$2,500 insurance expense is allocated based on value of insured
assets.
Exhibit 22A.6

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 Allocation of Service Department
Expenses 1

$15,300 of General office service department is allocated to

operating departments based on sales.
Exhibit 22A.7

*See row 19 of departmental expense allocation spreadsheet (Exhibit 22.10).

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 Allocation of Service Department
Expenses 2

$9,700 of purchasing service department is allocated to

operating departments based on number of purchase orders.
Exhibit 22A.8

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Allocation of joint costs across
products.

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 Joint Costs and Their Allocation 1

Joint costs are costs incurred to produce or purchase two or

more products at the same time. Consider a sawmill company:
Exhibit 22C.1

How should the joint costs be allocated to the different products?

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Learning Objective C3: Describe allocation of joint costs across products.
 Joint Costs and Their Allocation 2

Physical Basis Allocation

In this sawmill, joint costs include the logs and their being cut into boards. This joint
cost will need to be allocated to the different products resulting from it. We will
focus on board feet produced.

Exhibit 22C.2

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Learning Objective C3: Describe allocation of joint costs across products.
 Joint Costs and Their Allocation 3

Value Basis Allocation

In this sawmill, joint costs include the logs and their being cut into boards. This joint
cost will need to be allocated to the different products resulting from it. We will
focus on sales value.

Exhibit 22C.3

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Learning Objective C3: Describe allocation of joint costs across products.
 Join costs allocation: Integration
(to put it simple)

The two-stage allocation process

• To establish departmental or cost centre overhead rates a

two-stage allocation procedure is required:

Stage 1 – Assign overheads initially to cost centres.

Stage 2 – Allocate cost centre overheads to cost objects (e.g.
products) using second stage allocation bases/cost drivers.

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An illustration of the two-stage allocation process for traditional costing systems

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Applying the two-stage allocation process requires the following 4
steps:

1. Assigning all manufacturing overheads to production and service

cost centres.
2. Reallocating the costs assigned to service cost centres to
production cost centres.
3. Computing separate overhead rates for each production cost
centre.
4. Assigning cost centre overheads to products or other chosen cost
objects.

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• Steps 1 and 2 comprise stage one and steps 3 and 4 relate to the
second stage of the two-stage allocation process.

• Note that in the third step above traditional costing systems

mostly use either direct labour hours or machine hours as the
allocation bases.

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The annual overhead costs for a company which has three production centres
and two service centres (Materials procurement and General factory support)
are as follows:

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The following information is also available

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©McGraw-Hill Education.
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