Designing operating control statements

							Designing operating control statements
R. Srinivasan


                                A Case Study
The monitoring of managers’ achievements against targets is vital to top
management’s assessment of their efficiency. To ensure that this is done
effectively and, on time, operating control statements should be so
designed as to reflect operational efficiency by highlighting variances
between the actual and the budgeted performances

THIS case looks at the role of control and audit in management accounting and analyses a
situation where there was an imperative need for establishing a system for purposes of monitoring
actual operational performance with the target. One of the most important elements in the control
function of management accounting is the attributing of performance to managers and, in order to
be able to do this effectively, the system should be geared up for it.

The monitoring of managers’ achievement is vital both to senior management’s assessment of
their efficiency and, as feedback to the particular manager, in its motivating function. Managers
respond to the knowledge of their success or failure in past periods and to anticipation of
receiving reports on current performance.

Crescent Bearings Limited is a listed company and is an associate of a large group of companies
having diversified interests. The group had strayed, through an earlier acquisition, into an
unfamiliar line of business involving the manufacturing of bearings for the automotive and textile
sectors. Although the operations are not unprofitable, the company feels that the operational
performance could be improved upon by a proper reporting system and measuring performance
through this system.

The group feels it worth its while to remain in this business and ride over the recession so that it
may be able to perform well once demand in its area of operation picks up.

The company has only recently been able to institute a system of budgetary control but is still not
able to take advantage of the system due to lack of adequate measures of assessing actual
performance as against the budget. It had recently recruited a full-time management accountant
whose work included the setting up of reporting systems, measuring actual performance and
reporting to top management on variances from budgets and the discussion of such reports with
the line managers at periodical intervals for introducing refinements in the system.

A a starting point, the management accountant chose the production plan for a typical four-week
operating period and had obtained from the factory manager the following details. The main
objective of the management accountant was to institute a control statement that would reflect the
budget versus actual comparisons during the period under review. The idea was that if the
reporting is meaningful to the senior management, the system could be developed further
depending upon the requirements of those receiving the reports.
The factory is planning to produce 8,000 units of Product A that the sales department is planning
to sell during the period. The standard product unit and total costs of Product A for the four-week
period is as shown in Table 1.

Table 1
                                                                 Cost per unit     Total costs
                                                                      Rs.                Rs.
Direct material 1.11 unit @ Rs.54.00\per hour                        60.0            480000
Direct labour 0.6 hour @ Rs.50.00\per hour                           30.0            240000
Variable overhead 0.6 hours @ Rs.5.00\per hour                        3.0             24000
Fixed overhead                                                       59.5            476000
The product sells for Rs.165.00
The following details relate to the actual results for the four-
week period:
Actual order received during the period                             8200 units
Actual sales                                                        7500 units
Actual production                                                   7500 units
Units of direct material purchased and issued to production         7750 units
Direct material price per unit                                     Rs.56.00
Direct labour hours                                                   4700
Direct labour hour rate (per hour)                                 Rs.52.50
The management accountant decided that for an effective monitoring of actual operational
performance over the budget, it would be necessary to identify the variances, classifying them
according to cause. The four types of cause that can be identified are operating efficiency:
planning errors or external change effects: measurement errors: and random effects.

Having decided on this objective, he designed the following operating control statement (Table
2), summarizing the actual performance over the budget over the four-week period commencing
January 1 and ending January 28.

Table 2
                                     Original        Flexed             Actual          Variance
                                     Budget          Budget
Direct material                        480000         450000           434000           16000(F)
Direct labour                          240000         225000           246750           21750(A)
Variable overhead                       24000          22500            21500             1000(F)
Total costs                          1220000         1173500          1170750             2750(F)
Sales                                1320000         1237500          1237500               ---
Profit                                 100000          64000            66750             2750(F)
The analysis of variances is presented in Table 3. In designing this control statement, the
management accountant sought to report to the management deviations in the actual performance
classified according to the cause of the deviation.
Table 3
Analysis of variances:                                                     Rs.              Rs.
Direct material                                      Usage            31500(F)
                                                     Price            15500(A)         16000(F)
Direct labour                                        Efficiency       10000(A)
                                                     Rate             11750(A)         21750(A)
Variable overhead                                    Efficiency        1000(A)
                                                     Spending          2000(F)          1000(F)
Fixed overhead                                       Spending                           7500(F)
                                                                                        2750(F)
Budget Volume Variances:
Fixed overhead                                                        29750(A)
Loss of contribution from sales                                        6250(A)         36000(A)
Total variance (Rs.100000-Rs.66750)                                                    33250(A)
Analysis of variances:
Efficiency of variances
Direct material usage                                                 31500(F)
Direct labour                                                         10000(A)
Variable overhead                                                      1000(A)         20500(F)
Overhead spending variances:
 Variable overhead                                                      2000(F)
 Fixed overhead                                                         7500(F)         9500(F)
Price variances:
 Direct material                                                      15500(A)
 Direct labour rate                                                   11750(A)         27205(A)
Volume variances:
 Fixed overhead recovered                                             29750(A)
 Loss of profit from sales                                             6250(A)        36000(A)
                                                                                      33250(A)
Thus, the management is in a position to revise the budget mid-term to more flexible levels based
on the performance of the various factors taken into consideration while formulating the original
budget. The final variances in the actual performance compared with the flexible budget give the
analysis a more meaningful purpose as the comparison enables management to focus its attention
to the areas which caused the deviations and resulted in the budget being revised. This is the
objective of achieving control, but a number of problems arise in establishing controllability.

Responsibility cannot always be uniquely assigned, but may be shared between different levels of
management or different managers at the same level. Costs may be joint, so that attributing them
to one manager can only be achieved by arbitrary apportionment. Results may be interdependent
in that action by one manager has an indirect impact on the activity of another making the tracing
of controllability very difficult. Similarly, changes external to the organization may be beyond
the control of a manager.

Traditionally, management accounting methods have adjusted for changes in volume of activity
by, for example, flexing budgets. However, classification of costs into fixed and variable
elements has many hazards, particularly if it results in the view that fixed implies unchangeable
and variable implies that costs inevitably increase in response to volume change. The time
horizon of such a classification is vital and it may be more useful to identify managed costs, that
 is, those which managers can change from avoidable costs to committed costs within their
decision horizon.

In designing any control statement, it must be borne in mind that there is always a difficulty in
assessing performance as a manager’s performance becomes inseparable from the potential of his
unit. A job well done in a unit with poor opportunities may be difficult to identify.

Conclusion
An operating control statement should seek to highlight:
*Operational efficiency resulting in favourable variances in direct material usage, direct
labour and variable overhead – those which are easily controllable and for which
managers could be held accountable if these variances are adverse.
*Volume variances caused by over and under-absorption of fixed overhead recovery.
*The statements could be further broken down to show the results of rejections,
downtime, scrap, and so on, all of which contribute to lower profitability. Also, a system
of differential selling price policy for different classes of customers and for different
geographical regions will also have a major influence in profitability depending on the
actual sales mix.

Any control statement should be constantly under review so as to assess its utility to the
top management insofar as the effectiveness and timeliness of information for decision-
making is concerned.
Published in the Business Line issue dated Monday, March1, 1999