Management Accounting and Costing 341 December 30, 1899

MANAGEMENT ACCOUNTING AND COSTING 341

(MAC 341)

221
MODULE 9
Budgeting Process

READING REFERENCES:

Fundamentals of Cost and Management Chapter 13

PLAN: Theory
Complete review problem 13:1 – Cash Budget
Class questions 13:2 – Flexible Budget

Complete exercise 13.1 – Operational Budget

Tutorial questions 13.2 – Budgeted Statement of Financial Position

OBJECTIVES:

At the end of this module you should be able to:

 Define the concept of a budget and budget control

 Explain the function of budgets and budget control
 Explain the broad aims of budgets and budget control
 Discuss the advantages and disadvantages of budgets and budget control
 Identify important aspects of the preparation of budgets
 List the types of budgets of a manufacturing enterprise
 Explain how zero based budgets work
 Explain three types of responsibility centres
 Differentiate between fixed and flexible budgets
 Compile the master budget from operating and financial budgets

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Management Accounting and Costing 341 December 30, 1899

The various activities within a company should be coordinated by the preparation of plans of
actions for future periods.

These detailed plans are usually referred to as BUDGETS

The strategic planning, budgeting and control process:

1. Strategic planning process:

 An organisation should have prepared a long-term plan or strategy.
 A vision statement clarifies beliefs and governing principles whilst a mission statement is
more action oriented.
 Managers must know where their organisation is going and how they’ll achieve their
objectives.
o Objectives are more specific, measurable and expressed in financial terms such as
desired profits, sales levels, return on capital employed, rates of growth and market
share.

2. Creation of a long-term plan:

 Strategy is used to describe the courses of action that need to be taken to achieve the
objective.
 A long-term plan is a statement of targets and activities required.
o Plans are generally long term and tend to be uncertain, general, imprecise and subject
to change.

3. Preparation of the annual budget within the context of the long-term plan:
 Budgeting is concerned with the implementation of the long-term plan for the year ahead.
o The long-term plans represent the broad directions that top management intend to
follow, whereas budgets have a more short-term focus and are more precise and
detailed.
o Budgets originates from previous decisions that have been taken within the long-term
planning process.
o Decisions are reviewed and incorporated into the annual budgeting process; therefore,
budgeting is an essential part of long-term planning.
 A budget gives a clear indication of what is expected during the budget period.

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 Budgeting is part of the long-term planning process.

4. Monitor actual outcomes and respond to deviations from planned outcomes (and
5 combined)
 Compare the actual and the planned outcomes, this is budgetary control.
 Control involves looking back to ascertain what actually happened.
 Effective control requires corrective action to be taken.

PLANNING involves looking AHEAD

CONTROL involves looking BACK to ascertain what actually happened and comparing it with
the planned outcomes. (refer to standard costing and variances)

The process is dynamic and stress the interdependencies between the various steps in the
process. If needed, corrective action must be taken if plans are no longer attainable.

Multiple functions of budgets:

 Planning annual operations (ensure the planning is done, refinement of plans, anticipate future
problems and manage them)
 Coordinating the activities of various parts of the business (different parts of business are
brought together and are reconciled in a common plan, relationships between divisions are
encouraged, conflicts are identified and resolved)
 Communicating plans to the various responsibility centres (each one understands the
expectations of lower and senior management)
 Motivation of managers to achieve goals (it should motivate managers to perform within their
objectives, it can also encourage inefficiency and conflict between managers)
 Controlling activities via variances (managers are responsible for certain activities and this
helps management to operate a system of management by exception)
 Evaluating the performance of managers (bonuses can be awarded to managers in terms of
achieving their targets.)

Basis for determining the numbers:

There are three different approaches to determining the numbers to be reflected in the budget:
Incremental, Activity Based Budgeting (ABB) and Zero-Based Budgeting (ZBB).

Incremental budgeting:

 Incremental budgeting involves using the previous year’s budget and adjusting it on an
incremental basis to arrive at the new budget.
 In this method, inefficiencies may be carried forward as opposed to considering whether the
expenditure is value added or wasteful.

Activity based budgeting (ABB):

 Conventional budgeting is inappropriate for those activities where the consumption of

resources does not vary proportionately with the volume of the final output of products or
services.
o Existing operations and the current budget are used as the starting point for the next annual
budget. The main disadvantage is that most spending stays the same, meaning past
inefficiencies and waste are carried forward.
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 For support activities conventional incremental budgets merely serve as authorisation levels for
certain levels of spending.
 Incremental budgeting results in the cost of non-unit level activities becoming fixed.
 ABB aims to authorise only the supply of those resources that are needed to perform activities
required to meet budgeted production and sales volumes.

ABB involves the following stages:

i. Estimate the production and sales volume by individual products and customers.
ii. Estimate the demand for organisational activities.
iii. Determine the resources that are required to perform organisational activities.
iv. Estimate for each resource the quantity that must be supplied to meet the demand.
v. Take action to adjust the capacity of resources to match the projected supply.

Zero Based Budgeting (ZBB):

 Attempt to overcome limitations of incremental budgeting.

 All expenditure should start from base zero.
 Requires managers to justify expenditure.
 Best suited to discretionary costs and support activities.
o ZBB is best suited to discretionary costs and support activities. With discretionary costs,
management has some discretion as to the amount it will budget for the particular activity in
question. Examples are advertising, research and training costs.
 Three stages:
i. a description of each organisational activity in a decision package;
ii. the evaluation and ranking of decision packages;
iii. allocation of resources based on order of priority.

ZBB is mostly applied in municipal and government organizations where the predominant costs are
of a discretionary nature.

Advantages of ZBB over traditional budgeting:

 ZBB avoids deficiencies of incremental budgeting and represent a move towards the allocation
of resources by need of benefit.
 ZBB creates a questioning attitude rather than to assume that the current practice represents
value for money.
 ZBB focuses attention on outputs in relation to value for money.

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Conflicting roles of budgets:

Budgets serve several purposes, planning and motivation roles may be in conflict.

Budgets should rather be set based on easier and more realistic targets that are expected to be
met.

The planning and performance roles can also be in conflict. Planning a budget is done on
anticipated circumstances but performance evaluation is done under actual circumstances and this
can be different from the anticipated circumstances. Flexed budget where the budget is adjusted to
the actual level of activity can help with this conflict situation.

The budget period:

Conventional approach is to prepare a budget for one year. This can be risky because it can be too
rigid and uncertain (given circumstances change rapidly).

Budgets should be broken down for the first three months and by quarters for the remaining time.
During the first quarter, the monthly budgets for the second quarter will be prepared and during the
second quarter the monthly budgets for the third quarter will be prepared.

This is known as a ROLLING BUDGET and ensures that a 12-month is always available by adding
a quartering future as the quarter just ended is dropped. Managers are encouraged to plan
continuously and actual performance will be compared with a more realistic budget. A possible
negative of rolling budgets are that managers can become uncertain given that the budget
changes every 3 months.

Administration of the budgeting process:

 The budget committee has high level executives who represents the major segments of
the business. This committee is to ensure that the budgets are realistic and coordinated.
Managers present their budget to this committee and the decision is made as to whether
the budget is reasonable. If not, the budget must be adjusted and re-submitted.
 Accounting staff provide valuable advice for line managers and they will also coordinate
the individual budgets into a budget for the whole organization.

A detailed illustration starts from page 378

Sales budget is the starting point, then production budget, the direct materials, direct labour,
production overhead budget and lastly the selling and admin budget.

All these budgets are combined into separate departmental budgets known as responsibility
centres. When all the budgets have been prepared, a master budget is prepared where the profit
and loss account and the balance sheet provide the overall picture for the budgeted period.

Cash Budgets:

This is to ensure that sufficient cash is available at all times to meet the level of operations that are
outlined in the various budgets. Monthly or weekly cash budgets are necessary. Cash budgets help
to avoid surplus cash to meet requirements and also to invest in short-term investments. Cash
deficiencies can also be identified in advanced and steps can be taken to ensure that bank loans
will be available to meet any temporary shortfalls.

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The budgeted profit statement, balance sheet and cash budget will be submitted by the accountant
to the budget committee, together with budgeted financial ratios, such as liquidity, gearing, return
on capital employed and working capital. IF these ratios are acceptable, the budgets will be
approved.

Computerized budgeting:

Computerized budgets enable accounting staff to become more involved in real planning instead of
using their time to do numerical manipulations. Financial models enable management to evaluate
different options before the budget is finally agreed.

Budgets in non-profit making organizations:

Objectives are difficult to define in a quantifiable way and accomplishments are difficult to
measure. The concern is mainly with input of resources. There is not the same emphasis on what
was intended to be achieved for a given input of resources. Little emphasis on measures of
managerial performance in terms of the results achieved. There is no clear relationship between
resource inputs and the benefits flowing from the use of these resources. Incremental budgeting
approach is normally used.

Criticisms of budgeting:

 Encouraging rigid planning and incremental thinking

 Very time consuming (30% of management time) – is the benefits worth the cost and time
going into budget processes?
 Ignoring key drivers of shareholder value (innovation, new products etc) and focus too much on
short-term financial numbers
 Being a yearly rigid ritual that impedes firms from being flexible and adaptive in the increasingly
unpredictable environment.
 Tying the company to a 12-month commitment which is risky based on uncertain forecasts
derived from a fast-changing environment.
o Focus on achieving the budget even if this results in undesirable actions.
 Meeting the lowest/easiest targets and not attempting to beat targets.
 Spending what is in the budget even if this is not necessary in order to guard against next
year’s budget being reduced.
 Being disconnected from strategy whereby budgets are typically prepared in isolation from, and
not aligned with, the strategic objectives of the organization.

Beyond budgeting:
Alternative approaches that should be used instead of annual budgeting.

Resources are allocated in advance on an annual basis. Instead, rolling forecasts, ambitious
target setting, more decentralized decision behaviour and relative external performance evaluation
are advocated. It supports decentralization and employee empowerment initiative that are required
for firms to compete in today’s fast changing environment. Great emphasis on team-based
rewards rather than individual reward because of the difficulty in identifying the incremental
contribution of individuals and the need to demonstrate that everyone is pulling together in the
same direction, each dependent on the other.

More information on the functions of budgets:

Communication

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Management Accounting and Costing 341 December 30, 1899
Both the preparation of the budget, and the budget itself, facilitate knowledge sharing within an
organization. The budget is a formal communication/expression of the financial role that each
responsibility centre has, in supporting the organization to achieve its strategic, financial and
operational targets.

Motivation

Motivation can be affected by various factors, financial reward being one such consideration. In
this regard the motivation and performance evaluation aspects of budgeting overlap.

Targets

Can either be easy, ideal or tough but attainable. The latter is usually found to be the most
effective in terms of motivating managers to achieve the targets set.

Style

The manner in which the budget is communicated and implemented has motivational
consequences – managers are more motivated to meet targets that they have “bought into” than
targets which they consider to be imposed. Two opposing implementation styles are:
 Top-Down/Imposed where the budget originates from and is handed down by top
management
 Bottom-Up/Negotiated emphasizes participation and acceptance. The budget originates
from those who will be responsible for ensuring the budget is achieved. The budget is
escalated up for approval and feedback. Co-ordination of budgets are considered at
budget committee level.

Performance evaluation

Key principle is that managers should only be evaluated on items that they can control.

Management should not be evaluated on uncontrollable line items such as allocated administrative
costs.

Flexible performance standards should be applied by adjusting targets to reflect variations in

uncontrollable factors arising from circumstances not envisaged when targets were set.
Uncontrollable volume effects on cost behaviour are removed from the manager’s performance
report be restating the original budget at the actual level of activity (volumes) experienced. This
technique is termed “Flexible Budgeting” and you can refer to the notes on the Standard Costing
module.

Qualitative considerations should also be considered when interpreting the numerical results,
especially the interrelationship of variances (the possibility that another centre has the ability to
affect the results of the responsibility centre under evaluation), and the performance of the
division/centre relative to that of other similar divisions or companies.

Control

Controllable and non-controllable items

One of the purposes of budgeting is to achieve control over revenue and costs, and often control of
costs in particular. Departmental managers are usually held responsible for ensuring that the
budget for their department is achieve. Which raises the questions: Can a manager control all the
costs on their department’s budget? And should budgets comprise either controllable income and
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Management Accounting and Costing 341 December 30, 1899
expenses only, or both controllable and non-controllable items? By including non-controllable
expenditure in budgets, management is made aware of the greater operating and administrative
cost base that they need to contribute to. However, the inclusion of non-controllable items in the
budget complicates performance evaluation.

Overheads

One category of costs that are particularly difficult to control is overheads, as overheads are
indirect, rather than direct, costs. ABB has been developed as a tool to improve an organisation’s
control over overhead costs, by effectively turning indirect costs into direct.

ABC and ABB: The conventional approach to budgeting works fine where the consumption of
resources varies proportionately with the volume of final output of products or services. However,
for those indirect costs and support activities where there are no clearly defined input-output
relationships and the consumption of resources does not vary with the final output of products or
services, conventional budgets only serve to authorise certain levels of spending for each
budgeted item of expense. Budgets that are not based on well-understood relationships between
activities and costs, are poor indicators of performance and performance reporting normally implies
little more than checking whether the budget has been exceeded. Conventional budgets therefore
provide little relevant information for managing costs of support activities. To manage costs more
effectively ABC and ABB can be employed, whereby overhead costs are related to activities, rather
than volumes.

Article extract: ABB focuses on work, not costs (Raiborn 1999 adapted)
A budget should be based on knowledge of how good the organization can be and should be.
Developing an achievable budget is often difficult because most managers develop a budget what
they spend, not on what they do (activities) that consumes the budgeted costs. Many
organisations (in the US), such as Johnson & Johnson and Chrysler Corporation, are looking to
their existing activity-based cost systems as the basis for re-engineering their budgeting process.
Unlike conventional budgeting that focuses on resource cost, the re-engineered budget process
should assume that the focus will centre on activities and business processes. ABB is a process of
planning and controlling the expected activities of an organization. ABB links work (activity) with
the strategic cost, time and quality objectives of the organization. ACC focuses on activities.
Costs are determined after the activity workload is defined.

ABB require an analysis of cost drivers and the relating of budget line items to activities performed.

Tutorials: In the prescribed textbook

Complete Review Problem 13:1 – Cash Budget

13:2 – Flexible Budget
Complete Exercise 13.1 – Operational Budget
13.2 – Budgeted Statement of Financial Position