STRATEGIC MANAGEMENT ACCOUNTING

Module 3
PLANNING, BUDGETING AND FORECASTING
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Contents
Preview 185
Introduction
Objectives

Part A: Introduction to plans, budgets and forecasts 187

Relationship between budgets and strategic planning 187
Roles of operational plans, budgets and forecasts 189
Purposes of a budget 190
Relationship with responsibility accounting 192
Revenue centres
Cost centres
Profit centres
Investment centres
Responsibility accounting
Planning and control 195

Part B: Developing master budgets 196

Impact of external and internal factors on budgets 196
Preparing operational budgets in manufacturing organisations 198
Step 1: Sales budget
Step 2: Production budget
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Step 3: Direct materials cost budget

Step 4: Direct manufacturing labour costs budget
Step 5: Manufacturing overhead costs budget
Step 6: Finished goods inventory budget
Step 7: Cost of goods sold budget
Step 8: Period costs budgets
Preparing budgets in non-manufacturing organisations 204
Preparing financial budgets 204
Budgeted income statement
Cash budget
Budgeted balance sheet
Capital expenditure budget
Preparing budgets for various departments 206
Preparing flexible budgets 206

Part C: Variance analyses and control 209

Static versus flexible budgets 209
Profit- and revenue-related variances 212
Direct material analysis 215
Direct labour analysis 217
Variable manufacturing overhead analysis 218
Fixed manufacturing overhead analysis 221

Part D: Behavioural aspects of budgets 232

Participative budgeting 232
The top-down approach
The bottom-up approach
Setting realistic and achievable targets 236
Monetary and non-monetary incentive schemes 237

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Part E: Alternative approaches to budgeting 240

Shortcomings of traditional budgets 240
Incremental budgeting 241
Zero-based budgeting 241
Activity-based budgeting 242
Beyond Budgeting: Managing without budgets 245

Review 247

Suggested answers 249

References 257

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Module 3:
Planning, budgeting
and forecasting
Study guide

MODULE 3
Preview
Introduction
The business environment is constantly changing, resulting in many challenges. One such
challenge is how an organisation can sustain itself in an uncertain future. The governing board
of organisations typically considers the organisation’s sustainability in their strategic plan and
managers implement the strategic plan through operational plans. Budgets form a part of the
operational plan.

Budgets are an accounting tool that helps managers plan to meet the organisation’s goals.
During this planning, they anticipate and consider the challenges posed by an uncertain future
and predict the possible effects of these challenges and uncertainties on their organisation’s
limited resources. This culminates in setting targets that make best use of the organisation’s
limited resources and that would achieve the organisation’s goals. Once targets are set in the
budgets, they are used to gauge the performance of the organisation and the managers.

This module focuses on budgeting as a planning and control mechanism. The role of budgets
and their relationship to the organisation’s strategy is discussed. The module also describes
the various components of budgets and demonstrates how financial forecasts addressing
uncertainties are developed.

Variance analyses are then considered as a means to monitor and evaluate the organisation’s
and managers’ performance compared with targets set in the budgets.

The module then discusses the human behavioural issues that typically result when using
budgets as a control mechanism. Finally, the module concludes with a discussion of proposed
alternative approaches to alleviate the limitations of traditional annual budgets.

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The highlighted sections in Figure 3.1 provide an overview of the important concepts in this
subject and how they link with this module. This module discusses how the management
accountant works to provide management with information for budgets and operational
decision-making that, in turn, informs and is informed by strategy.

Figure 3.1: Subject map highlighting Module 3

rnal environment
Exte

VISION

VALUE INFORMATION
STRATEGY

STRATEGY
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MANAGEMENT ACCOUNTANT

VALUE INFORMATION

OPERATIONS

Exte
rnal environment

Source: CPA Australia 2019.

Objectives
After completing this module, you should be able to:
• Identify the roles of operational plans, budgets and forecasts and the relationship between
these elements and strategy.
• Develop a master budget based on operational plans, previous financial results, and forecasts.
• Perform variance analysis to monitor and evaluate performance.
• Prepare a financial forecast that addresses uncertainty.
• Analyse the behavioural impacts that may result from budgeting
• Discuss the usage of alternative approaches to budgeting.

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Part A: Introduction to plans, budgets

and forecasts
Organisations are continually confronted with making decisions about how to be sustainable
in the long and short term. In making these decisions, they have to decide which market to
compete in, which products or services to offer, and how to allocate resources. When evaluating
alternative courses of action, they also have to consider the likely financial and non-financial
effects of each alternative.

Note: This links with the financial analysis and performance measures discussed later in
Modules 4 and 5.

The choice the organisation makes about which course of action to pursue, and the direction
for their future activities over the long term, are set out in broad terms in their strategic plan.
Strategic plans normally cover three or more years, with most being for at least five years.
A budget is a means to operationalise strategic plans, create value and shape the future of
an organisation (Eldenburg et al. 2017).

Once the strategic plan is in place, organisations focus on short-term decisions that shape their
day-to-day activities for the chosen course of action. These are set out in the operational plan,
which is normally for a one-year period—corresponding to the financial year of the organisation.

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Although budgets are plans of how the organisation is going to achieve its goals for the next
year only, they are set within the context of the organisation’s strategic plan, and are therefore
linked with how the organisation is going to achieve its long-term goals.

Since the future is unknown and uncertain, organisations make predictions about the financial
outcomes of their planned activities. Forecasts in the strategic plan are set out in broad terms,
while estimates in the operational plan are done in much greater detail. A budget is therefore an
outcome of the planning process.

Relationship between budgets and

strategic planning
Strategic planning focuses on long-term planning and involves senior managers planning and
setting the direction for future activities to meet the organisation’s goals as set out in its strategy.
A strategic plan is typically divided into long-term and short-term objectives. Although numerous
definitions of strategy exist, in this module, strategy means future direction (Eldenburg et al.
2011). A strategy helps organisations to think about where they are now, where they want to
go, and how they are going to get there. Operational planning on the other hand focuses on
short-term planning. Operational plans are the mechanism that an organisation uses to address
the short-term objectives of the strategic plan. Table 3.1 provides a summary of the differences
between strategic and operational planning.

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Table 3.1: Differences between strategic and operational planning

Strategic planning Operational planning

Time period involved Long-term, at least five years Short-term, usually one year

Emphasis Identifies long-term goals, selects Focuses on achieving short-term

strategies to achieve those goals, goals
and develops policies and plans
to implement the strategies

Amount of detail presented Broad plan, much less detail Very detailed

Source: CPA Australia 2019.

‘Budgeting is used to assist in strategic planning’ (Kleiner & Wilhelmi 1995, p. 78). Budgets are
most useful when they are integrated with an organisation’s strategy (Horngren et al., 2011).
Ideally, the development of a budget should begin with the organisation’s strategy. Budgets set
benchmarks for how an organisation is going to achieve its goals over the short term, so they
are useful tools to gauge if an organisation is on target in meeting its operational plan and
hence its strategic plan. If used properly, budgets can signal if managers need to revise their
plans and possibly even the organisation’s strategy. Consequently, budgets are used as a
control mechanism to evaluate managers’ and the organisation’s performance.
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In summary, budgets represent short-term expressions of the long-term horizon of an

organisation’s strategic plan, as illustrated in Figure 3.2.

Figure 3.2: Relationship between budgets and strategy

Strategic plan
(long-term plan)

Operational plan
Long-term objectives
(short-term plan)

Master budget

Operational budget

Financial budget

Source: CPA Australia 2019.

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Roles of operational plans, budgets

and forecasts
Budgeting is a cross-functional activity. There are many types of budgets and different time
periods for which a budget can be prepared. For example, a budget may be prepared for a
specific event (e.g. the budget for the 2018 Commonwealth Games). A budget may also be
prepared for a specific project or task (e.g. planning an overseas family holiday). This module
focuses on budgets where managers and management accountants work together to plan the
performance of an organisation as a whole as well as the performance of sub-units (i.e. divisions
or departments). The most common period for this type of budget is one year broken down into
months. They are often supplemented by quarterly budgets. These budgets are an organisation’s
financial roadmap—demonstrating the financial consequences of an organisation’s detailed plan
of their operating activities.

Budgets are financial plans, setting out managers’ and owners’ expectations about financial
aspects such as sales prices and operational costs for the next year. However, budgets also
include non-financial aspects of the organisation’s proposed plan. These include, for example,
the quantities of units that need to be manufactured and sold, and the number of labour hours
and number of employees. The management accountant is uniquely placed to add value to an
organisation’s budgeting process by analysing and including non-financial information in the
budgets. Budgets are a useful means to monitor and control the organisation’s performance
when they are used to compare what actually happened with initial expectations.

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A master budget is a comprehensive initial plan of what the whole organisation intends to
accomplish in the budget period. In preparing a master budget, managers make decisions about:
• how best to use the limited financial and non-financial resources in the operating activities
• how to obtain funds to acquire those resources.

These decisions are formalised in the operating budget and the financial budget.

The operating budget is associated with the operating activities or income-producing activities
of an organisation and always precedes the financial budget. In the operating budget,
an organisation’s sales, cost of goods sold (COGS), and selling and administration expenses
are forecast. Thus, the end result (outcome) of the operating budget is a budgeted income
statement, although the latter is part of the financial budget. To derive the budgeted income
statement, the operating budget consists of numerous budgets prepared in a specific sequence
(discussed later in the module). Developing budgets for the coming year usually starts a few
months before the end of the current financial year.

The financial budget is a set of budgeted financial statements, providing forecasts about the
organisation’s income statement, balance sheet and cash budget for the next financial year.
In addition, the financial budget also contains a plan for acquiring assets beyond the next
12 months, namely the capital expenditure budget. This budget shows the purchase of assets
in the next operating period and beyond.

Operating budgets are developed within the constraints of limiting factors such as demand or
capacity, and therefore based on a limited level of activity. If market demand is the limiting factor,
then the defined level of activity will be expected sales revenue. In a manufacturing organisation,
if production capacity is the limiting factor, then the defined level of activity will be production
capacity, as shown in Example 3.1.

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Example 3.1: Limiting factors for budgets

Alco Ltd (Alco) has a production capacity level of 10 000 units for a given period. Even though there
might be a demand for 30 000 units of Alco’s products, the budget will be based on the limited
production capacity of 10 000 units.

SprocketCo Ltd (SprocketCo), on the other hand, has a production capacity of 30 000 units but their
forecast sales is only 10 000 units, so their budget will based on the 10 000 units demand level. There is
no point in developing a budget for what SprocketCo can supply if there is no demand for the products.

It is often useful to have either a moving 12-month or quarterly budget, or use a combination
of both. This is made possible by continually adding a month or a quarter to the period that
just ended so that the business always has a 12-month period budget. This budget is referred
to as a rolling or continuous budget. For example, the global appliance company, Electrolux,
has a three- to five-year strategic plan and a four-quarter rolling budget (Horngren et al. 2011).
The purpose of a rolling budget is to allow managers to plan a full year ahead constantly,
and not only once a year when budgets are prepared. Constant future planning is important
to all organisations, but more so when organisations operate in rapidly changing environments.

Purposes of a budget
According to Roosli and Kaduthanam (2018, p. 21), ‘a budget represents a financial plan and
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a financial target at the same time’. Budgets are used to:

• implement strategy by allocating limited resources among competing uses
• coordinate activities
• assist in communication between sub-units of the organisation
• motivate managers and employees with bonuses based on meeting or exceeding
planned objectives
• provide definite objectives for judging and evaluating managers’ performance at each
level of responsibility
• facilitate learning
• raise management awareness on the organisation’s overall operations
• guide decentralised decision-making
• anticipate potential problems
• show early warning signs to enable management to prepare solutions
• assess performance, goal achievement and hence a basis for rewards (Collier 2015;
Covaleski et al. 2003; Weygandt et al. 2012a; Eldenburg et al. 2017).

Traditionally, budgets are used to help managers and owners plan for the future and to formalise
goals. To do this they need to think about what courses of action to take to create value, to achieve
their goals, satisfy their customers and succeed in the marketplace. Further, they need to make
decisions about what courses of action to take in allocating scarce resources. When managers
make decisions about allocating scarce resources, they will typically rank competing projects or
programs or products. The ranking of these is done in Module 4. The emphasis in Module 3 is to
illustrate how budgets help managers in making decisions about scarce resources.

In essence, a budget is a planning instrument for resource allocation and a yardstick for
performance evaluation (Roosli & Kaduthanam 2018). Example 3.2 illustrates how budgets can
assist with allocating scarce resources.

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Example 3.2: Using budgets to allocate scarce resources

A university has a scarce resource of capital expenditure in its 2019 budget of $2 million to invest in
one of its regional campuses. Three competing projects have been submitted and a decision has to
be made as to which projects will be funded. The following three business cases were submitted:

Business case A
Currently the academic staff in the nursing department have an open plan office structure. Due to
overall noise, it is very difficult for these academics to do their jobs to the best of their ability. Further,
they experience ongoing challenges due to privacy issues and the nature of discussing learning and
teaching issues with students. The Dean of the nursing department submitted a plan to renovate
this space so that staff can have their own offices. The estimated cost for this project is $1.2 million.

Business case B
Due to the success of the nursing department, there was a huge increase in the student numbers.
However, the university’s carpark is too small to provide off-road parking for these students.
They protested and threatened to study at other universities in a nearby metropolitan area. The Deputy
Vice-Chancellor of the campus submitted a business plan to extend the carpark. The estimated cost
for this project is $1 million.

Business case C
The Student Social Network Association has seen that there are not a lot of activities and social events
that attract students on campus. They argue better student life will result in satisfied students and attract
more students in the future. They propose to build a theatre in which art and music performances and
exhibitions can be held. The projected cost for this theatre is $750 000.

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To fund all three business cases, $2.95 million is required, but the budget is limited to $2 million.
The Campus Growth Committee has to make decisions about what causes of action to take to create
value, satisfy staff and students, and succeed in the marketplace. After deliberating the three cases,
the Committee decided to allocate the limited resource of funds as follows.

Note: As the decision-making process that the Committee followed is outside the scope of Module 3,
you may assume that the Campus Growth Committee has validated these three business cases against
the University’s key performance indicators (KPIs), perceived risk tolerance and stakeholder importance.
The latter is discussed in Module 2: Information for decision-making).

Business case Funds applied for Funds awarded

A $1 200 000 $1 200 000

B $1 000 000 $800 000

C $750 000 zero

Total $2 950 000 $2 000 000

Justification:

Business case A
The growth in the nursing students will result in an increase in the university’s revenue and perhaps
also enhance the university’s reputation, which may ensure ongoing growth. Such growth depends
on satisfied staff and students. Although there are many factors contributing to their satisfaction,
having their own offices will certainly impact staff job satisfaction. Students may also feel more
comfortable to consult their lecturers when they have the own offices in which private and sensitive
issues related to the teaching can be discussed. The Committee therefore decided to fully fund
this project.

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Business case B
Providing off-road parking to students is important as this will enable students to attend lectures and
study on the premises of the university without worrying about their cars. It may also encourage students
to attend lectures. Further, students already threatened to leave the university due to not having off‑road
parking. Not only is it important to retain these students, but providing off-road parking may also result
in satisfied students in the future which should enhance the credibility of the university and may result
in growth of student numbers and ultimately increased revenue. Although these benefits were pointed
out in the business plan, the Committee proposed that the Campus Coordinator meet with Council and
to negotiate better public transport facilities. Consequently, the Committee decided to partly fund this
business case with the remaining $800 000.

Business case C
The Committee decided not to fund this project because, compared to the other two projects that will
affect the revenue of the university directly, this project is the least critical at this moment—although
it is an important issue for the future.

The procedures and activities that are undertaken to develop the budget are referred to
as the budgeting process. The budgeting process provides a formal mechanism to ensure
organisational objectives and activities are planned effectively. During the execution period,
budgets can serve as a benchmark and provide guidelines for operations. As mentioned earlier,
it also allows comparison against actual financial results at all levels of a business, enabling
managers to measure and evaluate the performance of individuals, departments, divisions or
the entire organisation. Care should be taken to not make the budget the target that needs
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to be met, because ‘when a measure becomes a target, it ceases to be a good measure’

(Strathern 1997). Setting and using budgets as targets will defeat the purpose of budgets and
may result in dysfunctional behaviour (which is discussed in Part D of this module). To discourage
dysfunctional behaviour and encourage individuals to set realistic budgets and strive to
achieve them, organisations often link budgets to incentives for achieving and exceeding both
short- and long-term goals. During the budgeting process, communication and coordination
between the budget holders is important, because they have the responsibility and authority
to implement the budget. Consequently, an essential part of an effective system of budgetary
control is responsibility accounting, where budgets are usually developed using a framework
of responsibility centres.

Relationship with responsibility accounting

Any unit with an ‘individual who controls a specified set of activities can be a responsibility center’
(Weygandt et al. 2012b, pp. 1109–10). Responsibility accounting and centres are particularly
valuable, for example, in decentralised organisations, where decision-making power is transferred
and accountability and responsibility of results are assigned to individuals or units at all levels of
an organisation, and not only top management. Delegating control throughout the organisation
reduces the burden on top management, promotes motivation and enables better supervision
and quick decision-making. Responsibility centres extend the responsibility from the ‘lowest level
of control to the top’ level of management (Weygandt et al. 2012b, pp. 1109–10). A responsibility
centre is a unit in an organisation (e.g. a department or a division) where the manager ‘has the
authority to make the day-to-day decisions’ (Weygandt et al. 2012b, pp. 1109–10) about their
unit’s activities and performance. The manager is accountable for matters in their unit only—
that is, ones that are directly under their control within their respective units. The four common
types of responsibility centre are shown in Figure 3.3.

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Figure 3.3: Four common types of responsibility centre

Revenue

Responsibility
Investment Cost
centres

Profit

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Source: CPA Australia 2019.

‘These classifications indicate the degree of responsibility the manager has for the performance
of the centre’ (Weygandt et al. 2012b, pp. 1109–10).

Revenue centres
For a revenue centre, the manager is only responsible for activities generating revenue (e.g. sales).
The sales department is therefore a revenue centre and the sales manager is responsible for
preparing the sales budget.

Cost centres
In a cost centre, costs and expenses are incurred but the centre does not directly generate
revenues. Since managers in cost centres have the ‘authority to incur costs’, they are responsible
and accountable for meeting the budget targets. Consequently, they are ‘evaluated on their ability
to control’ these costs (Weygandt et al. 2012b, pp. 1109–10). Typical examples of cost centres
are support departments such as accounting, research and development, human resources (HR)
and maintenance departments. For example, the maintenance department of a hotel is a cost
centre as the maintenance manager is accountable for the costs of maintenance. Production
departments are also cost centres. For example, in an automobile plant, the production
departments such as welding, painting, and assembling are separate cost centres.

Profit centres
In addition to incurring costs and expenses, a profit centre generates revenues. Here managers
are judged on the profitability of their centres. For example, the hotel manager is in charge of
the profit for the specific hotel and is therefore accountable for both revenues and costs. In a
retail store, for example a hardware store, each department (e.g. building materials, gardening,
and tools) might be cost centres. Although the sales, operating expenses and costs budgets may
be developed by other managers within the unit, ultimately, the manager of the profit centre is
responsible for the profit centre’s budget.

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Investment centres
In addition to being responsible for generating revenues and incurring costs and expenses,
the manager of an investment centre has the responsibility and control over the centre’s available
assets. Managers in investment centres significantly influence decisions related to investments
(e.g. expansion of a manufacturing plant or entry into new markets). They are therefore
‘evaluated on both the profitability of the centre and on the rate of return’ (Weygandt et al.
2012b, p. 1112) (using return on investment (ROI)) earned on invested funds. The ROI shows
the manager’s effectiveness in utilising the assets at their disposal. To use a hotel example,
investment centres in this case would be subsidiary companies and the regional manager of
hotels within a region.

Responsibility accounting
‘Responsibility accounting can be used at every level of management’ (Weygandt et al. 2012b,
p. 1109). However, it is important that when responsibility accounting is used in performance
evaluation, that only revenue and costs that meet the following conditions are included:
• those that can be directly associated with the specific level of management responsibility
• those that can be controlled by management at the level of responsibility with which
they are associated.

To ensure this, costs are split between controllable and non-controllable, separating direct cost
from indirect cost in budgets. This is important due to the potential impact on the behaviour
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of managers during both the preparation of and assessment against budgets. For example,
being held accountable for costs they cannot control could be perceived as unfair and may
demotivate managers. Behavioural aspects are discussed further in Part D of this module.

An example of a controllable cost of a profit centre is the supervisor’s salary. This direct fixed cost
‘relates specifically to one centre and is incurred for the sole benefit of that centre’ (Weygandt et
al. 2012b, p. 1115). Further, this cost is directly associated as the manager of that responsibility
centre can control this cost because they can influence the costs and these costs can be traced
directly to a centre. On the other hand, indirect fixed costs are common corporate-level costs
pertaining to the organisation’s ‘overall operating activities and are incurred for the benefit of
more than one’ (Weygandt et al. 2012b, p. 1115) centre. Such costs are non-controllable by
divisional managers and are allocated to responsibility centres on some sort of equitable basis.
Examples of indirect fixed cost is property taxes on a building, research and development costs,
and salaries of top management. These costs can be allocated to various centres, for example
based on the square metres of floor space each centre uses. These costs are neither associated
nor can be controlled by revenue and by cost responsibility centre managers and therefore
need to be separated from controllable cost in budgets.

Applying responsibility accounting, first the effectiveness of the individual’s performance for the
specified activity is measured, followed upward throughout the organisation to top management.
Since top management has a broad range of authority, all costs are controllable by them.
However, as one moves down to each lower level of responsibility, fewer costs are directly
associated with the specified level, and due to the individual’s decreasing authority, fewer costs
are controllable at each lower level (Weygandt et al. 2012b).

‘Budgets, coupled with responsibility accounting, provide feedback to top management about
the performance relative to the budget of different responsibility centre managers’ (Horngren
2011, p. 435).

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Planning and control

Budgets are a useful tool helping managers and owners to plan for the organisation’s future.
Although managers make predictions about the future and try to anticipate future problems,
it is impossible to make these accurately. The only certainties about the future is that it is
uncertain, change is inevitable, and it is risky. To plan for the future as best as possible,
managers may test alternative courses of action before they formalise the budget. Consequently,
multiple budgets are sometimes prepared that identify best, worst and most likely scenarios.
Once the optimal course of action is selected, the final budget is adopted which will guide the
organisation’s activities.

‘Budgeting is the cornerstone of the management control process’ (Hansen et al. 2003, p. 95).
Since budgets set standards and benchmarks, it is common practice to use budgets as a
means to monitor and to control the use of an organisation’s use of resources and to evaluate
its performance (Mowen et al. 2016). This is done by frequent and timely (usually monthly)
comparison of actual results with budgeted forecasts—referred to as variance analyses.
The purpose of variance analyses is to understand the magnitude of the differences between
planned (budgeted) and realised (actual) performance, for both the monetary values and the
quantities of related costs and revenues. Once these are known, the causes of the differences
can be investigated.

Variance analyses show how successful managers have been in their execution of the operational

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plan, and as a consequence the implementation of the organisation’s strategies. It may also
provide warning signs of potential problems or events that may otherwise not be easily or
immediately evident and may also signal that strategies are ineffective. Variance analyses enable
managers to learn, evaluate the organisation’s strategies, take corrective actions and change
operational plans accordingly.

The financial budgets help management to ensure the organisation remains solvent and
sustainable. For example, it helps to ensure enough cash is available to pay creditors, normal
operating expenses and taxes. It also helps ensure ‘sufficient raw materials are available to
meet production requirements’, and that ‘adequate finished goods will be available to meet
expected sales’ (Weygandt et al. 2012b, p. 1054) and ultimately satisfy customers.

Using budgets as a means to control the performance of managers and employees can be
challenging. Ideally, budgets should neither be too rigid nor too slack. For example, if top
management sets budgets that are too difficult to achieve, employees will be discouraged.
Budgets should also not be too rigidly administered—not meeting the set budget does not
necessarily mean the employees did not perform optimally. Budgets are prepared based on
predicted information about an uncertain future—in the intervening period, conditions and
markets may have changed. Consequently, to best assess the performance of individuals and
the organisation, budgets are ‘updated’ during the year. This is referred to as a flexed budget
(discussed later in this module).

Now that the relationship between strategic and operational planning, the role and purposes
of budgets, and their relationship with responsibility accounting have been discussed, the next
section elaborates on developing master budgets.

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Part B: Developing master budgets

A master budget is a comprehensive set of interrelated budgets for an upcoming financial
period. Master budgets reflect an organisation’s plan for its future operating activities (in the
operating budgets) and financing actions (in the financial budgets) resulting from management’s
predictions and decisions about the future. Ideally, these plans should be the result of careful
consideration of the following:
• operational plan derived from the strategic plan
• actual results from the past (the past is often a good indication of what may happen
in the future)
• predictions about the future.

Many organisations use financial planning models to reduce the computational burden and
time required in preparing budgets. These models ‘are mathematical representations of the
relationships among operating activities, financing activities and other factors that affect the
master budget’ (Horngren 2011, p. 432). Computer-based systems, such as enterprise resource
planning (ERP) systems, store a huge amount of data required for preparing budgets. An ERP
system therefore allows quick calculation of budgeted costs, for example to manufacture
products. This includes, for example, information about manufacturing different products
such as:
• the direct manufacturing costs—for example, materials and labour
• the indirect manufacturing overhead costs—for example, power and machine maintenance
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• the machinery and equipment required

• information about different activities in the manufacturing process—for example, the number
of set‑ups required.

Further, most financial planning model software packages have a module on sensitivity analysis
to test alternative ‘what-if’ scenarios. For example, what will be the impact on the budget if the
assumptions change, or what will be the outcome for the organisation’s worst-case, best-case
and most likely-case scenario?

In developing plans about the organisation’s future activities, managers use estimates to
determine the resources the organisation is going to need, including the number of employees
and specific skill sets required, the quantities of raw materials and supplies, cash and anything
else necessary to the future operations. To make these decisions, managers consider many
internal and external factors that may impact the organisation’s future. This is discussed in the
next section. Later in this part, the development of operational budgets is discussed, separating
those of manufacturing organisations from non-manufacturing organisations. This is followed by
a discussion of the development of financial budgets, budgeting for various departments and
flexible budgets.

Impact of external and internal factors

on budgets
The first budget developed in the operational budget is the sales budget, because all the
other budgets in the operating budget depend on the sales budget. It is important to get the
sales budget as accurate as possible, because an inaccurate sales budget may affect the entire
business adversely. ‘An overly optimistic sales budget may result in excessive inventories that
which may have to be sold at reduced prices (Weygandt et al. 2012b, p. 1060) and even at a loss,
while an unduly pessimistic sales budget may result in inventory shortages, which may result in
loss of sales revenue and perhaps loss of customers.

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Just as important is getting the forecasts of the raw materials and finished goods inventories
as accurate as possible:
• Inadequate raw material inventories ‘could result in temporary shutdowns of production’
while inadequate inventories of finished goods inventories may result either in ‘added costs
for overtime work’ to produce more goods or ‘in lost sales’ (Weygandt et al. 2012b, p. 1061).
• Stockpiling of both raw material and finished goods may result in additional costs such as
storage, insurance, and handling costs, increase the risk that the inventory may become
obsolete, and if the prices of the raw materials drop, the organisation may be stuck with
overpriced raw material. If the economy slows down, excessive finished goods in one period
‘may lead to cutbacks in production and even employee layoffs’ (Weygandt et al. 2012b,
p. 1061) in subsequent periods.

To mitigate this, careful consideration of internal and external factors is extremely important
when planning and developing budgets.

Table 3.2 provides a summary of the internal and external factors that affect business
environments that should be considered in both strategic and operational plans and budgets.

Table 3.2: Internal and external factors that affect business environments

External factors Internal factors

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Demand for the goods or services Supply and capacity constraints

Market research studies Political issues in setting budgets, such as game

playing and empire building of budget holders

Suppliers of resources such as raw materials, labour, Anticipated advertising and sales promotions
supplies, and everything that impacts them and their
existence—e.g. a short supply of raw materials may
result in increased prices

General economic climate and past trends of a Policies of organisation (e.g. sales prices,
country—e.g. is it growing, is there an economic inventory levels)
slowdown, or a recession?

General economic climate worldwide New products and services planned by the
organisation, which may be the outcome
of research and development

Industry trends Improvements and changes in products

and services

Rivalry among existing competitors Change in operations and improvements

in operations

Competition in the market Change in management and leaders

Change in political situation in a country Changes in sales and product mixes

New or changing legislation and regulations

such as taxes on certain industries or products
(e.g. sugar and wine)

Environmental issues such as water supply

infrastructure

Trends and fads—e.g. healthy lifestyles may affect

the sugar industry

Changes in prices both in sales and purchases

Technological developments

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External factors Internal factors

Reaction of customers to improved products,

changes in products and services

Risk of potential entrants to the market

Risk of substitute products and services

Risk of changing needs and choices of customers

Natural disasters—e.g. cyclones, bushfires and

drought in Australia

Source: Based on Eldenburg, L. G., Brooks, A., Oliver, J., Vesty, G., Dormer, R. & Murthy, V. 2017,
Management Accounting, 3rd edn, Wiley, Milton; Mowen, M., Hansen, D., Heitger, D., Sands, J.,
Winata, L. & Su, S. 2016, Managerial Accounting, Asia-Pacific edn, Cengage Learning, Australia, p. 328;
Horngren, C. T., Wynder, M., Maguire, W., Tan, R., Datar, S. M., Foster, G., Rajan, M. V. & Ittner, C.
2011, Cost Accounting: A Managerial Emphasis, rev. edn, Pearson, French Forest, p. 422; Langfield-
Smith, K., Smith, D., Andon, P., Hilton, R. & Thorne, H. 2018, Management Accounting: Information for
Creating and Managing Value, 8th edn, McGrawHill Education, Sydney; Weygandt, J. J., Kimmel, P. D.
& Kieso, D. E. 2012a, Managerial Accounting: Tools for Business Decision Making,
6th edn, Wiley, USA, p. 385.

Although the information in Table 3.2 is not exhaustive, it clearly indicates that setting budgets
requires elaborate information gathering, and a considerable amount of discussion among
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managers. It also demonstrates that developing budgets can be time consuming. Managers
setting budgets must have detailed knowledge, understanding and appreciation of the
organisation, its products and services, the markets it operates in and its competitors.

In addition, the size of an organisation and whether it is a national or international organisation

affects the budgeting process. The larger the organisation, the more complex it is to set budgets.
Setting budgets for international organisations is often even more complex due to cultural and
legal differences in different countries, escalated by communication barriers. Further, since
the economies of different countries rarely move in tandem, forecasting sales for international
organisations is more difficult than those of national organisations (Eldenburg 2017). Other issues
that make the budgeting process of international organisations more challenging are currency
translations and differences in inflation and deflation rates.

Preparing operational budgets in manufacturing

organisations
Operating budgets for manufacturing organisations are prepared in a specific order, because
some figures in budgets are based on figures calculated in previous budgets. As discussed
earlier, the usual starting point for the operating budget is the sales budget, because production
levels depend on the level of units sold. Further, the costs of production such as direct material,
direct labour and manufacturing overhead costs, depend on production levels. Therefore,
the forecast level of sales units generally drives the operating budget. The steps in this
process are summarised in Figure 3.4.

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Figure 3.4: Preparing an operational budget in a manufacturing organisation

Step 1
Sales budget

Step 2
Production budget

Step 3
Direct materials cost budget

Step 4
Direct manufacturing labour costs budget

Step 5
Manufacturing overhead costs budget

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Step 6
Finished goods inventory budget

Step 7
COGS budget

Step 8
Period costs budgets

Source: CPA Australia 2019.

In the following discussion, the links between the various operating budgets are highlighted to
explain the sequence in which operating budgets are prepared.

Step 1: Sales budget

Since the sales forecast is the foundation of operational budgets, a great deal of effort generally
goes into developing the sales budget. Generally, sales representatives and managers have
detailed understanding and knowledge of the markets the organisation operates in and their
customers’ demands and needs. They are therefore best placed to develop the sales forecasts.
Organisations may also:
• gather information about the market, competitors and customers through a customer
relationship management (CRM) or sales management system
• use statistical methods, such as regression and trend analysis, and probability distributions,
to forecast future sales
• engage market research firms to forecast sales levels.

In some organisations, production managers may participate in the forecasting of sales. This is
because both supply and demand influence the sales budget. A sales budget set at demand levels
that an organisation cannot supply will be unrealistic and useless, as explained in Example 3.3.

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Example 3.3: S
 upply and demand influence on the
sales budget
Assume that the expected demand for the organisation’s products is 30 000 units. Usually, forecast sales
will be based on the 30 000 units. However, assume that the organisation has constraints such as
production capacity or short supply of inputs—for example, materials and labour. These constraints
in supply limit the demand level. Consequently, the sales budget will be set on 10 000 units.

Regardless of how organisations forecast sales, ultimately it should represent managers’

collective experience and judgment.

➤➤Question 3.1
Kabuki Ltd imports electrical equipment used in the mining industry from Japan and converts the
equipment so that it is suitable for the Australian environment. Kabuki has been very successful
and operated at full capacity and sold all the products in the past. The organisation has a capacity
to convert 15 000 pieces of the imported electrical equipment per year.
The success of Kabuki Ltd attracted competitors to the market. One competitor also imports the
product from Japan, does the conversion in India, and then imports the final product to Australia.
Consequently, they are able to sell the final product at a significantly reduced price. Another
competitor manufactures the entire product in Australia. It is expected that this organisation
may dominate the market in future as they meet the recent changes in the Australian regulation
of imported electrical equipment. Further, there has been an outcry to buy locally manufactured
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goods, which may boost their sales.

The sales representatives of Kabuki Ltd are sceptical about the demand for Kabuki’s product for
the next financial period and believe they will only be able to sell 5000 pieces.
Discuss the factors that should be considered in making the decision about the forecast sales
for the next financial period.

Check your work against the suggested answer at the end of the module.

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Step 2: Production budget

Preparing the production budget is normally the responsibility of the manufacturing or production
manager. In this budget, the number of finished good units that need to be manufactured is
determined. This number is driven by the level of forecast sales unit and the organisation’s policy
regarding finished goods inventory. If the organisation does not require any finished goods
inventory (e.g. if they use a just in time (JIT) system) then the units it needs to manufacture will be
the same as the number of units it forecasts to sell. However, most organisations require ending
inventory of finished goods as a buffer against uncertainties in demand or production. Therefore,
the number of units to produce will be the estimated sales (linked to the sales budget) plus ending
finished goods inventory, minus opening finished goods inventory.

The next three budgets are prepared to estimate the cost of goods manufactured: direct
materials, direct labour, and manufacturing overhead costs budgets.

Step 3: Direct materials cost budget

In this budget, two sets of quantities and costs of raw materials used directly in the manufacturing
of the finished goods are determined:
1. for units used
2. for units purchased.

The purchasing manager has the responsibility to determine the costs of the direct materials

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purchased. The production manager is responsible for the effective use of raw materials, so also
participates in developing this budget.

If an organisation uses different components of raw material to manufacture the finished product,
separate budgets are prepared for each component for both cost of materials used and materials
purchased. For example, an organisation that manufactures running shoes will prepare separate
budgets for the materials used to manufacture the soles of the shoes and for materials used to
manufacture the upper part of the shoes. These separate budgets are then integrated into one
aggregated direct materials costs budget.

To determine the quantity of direct material that will be used in manufacturing the finished
goods, this budget is linked to the number of finished goods that need to be purchased,
forecast for each period in the production budget. These numbers are multiplied by the
quantities of each raw material component used in the finished product to determine the
direct materials that will be used. This is shown in Example 3.4.

Example 3.4: Determining the quantity of direct material

GadgetCo uses 1.5 kg of raw material to manufacture a finished product (the MegaGadget). Assume
that 5000 MegaGadgets will be produced. The quantity of raw material is then 1.5 kg × 5000 = 7500 kg.

To determine how much (quantity) raw materials to purchase, GadgetCo uses the number of finished
MegaGadgets to be produced (5000 units) plus the closing inventory of raw material minus the opening
raw material inventory.

To calculate the cost of raw materials to purchase, the quantity of each direct materials component
to be purchased is multiplied by the cost per unit of that specific component of direct material used
to manufacture the finished MegaGadget.

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Depending on the inventory levels, the figures of raw material purchased will not necessarily be
the same as the figures of raw material used for any period. Both figures are essential though.
The purchasing manager requires information about the quantity and costs of raw material to be
purchased. The cost of direct materials used for the period is required to calculate the COGS.
The reason why there is a difference between the cost of direct materials purchased and the cost
of direct materials used is because of direct material inventory. For example, if an organisation
uses the first in, first out (FIFO) method to value its raw material inventory, the goods that were
manufactured first will be sold first. If the costs of direct materials change (which is very likely),
then there will be a difference between the costs of direct materials used in different periods. It is
therefore important to pay attention to the period when the finished goods were manufactured
when valuing finished goods inventory.

It is important to distinguish between costs of direct materials purchased and used when using
budgets in performance evaluations. The purchasing manager must explain any difference
between budgeted and actual costs (AC) to purchase raw materials. The production manager is
responsible for the efficient use of raw material in manufacturing the finished product. However,
this can sometimes be tricky, as shown in Example 3.5.

Example 3.5: E
 xplaining variances in budgeted and actual
costs of raw materials
ManufacturingCo purchased a batch of raw material that was inferior in quality. This resulted in
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increased waste. This resulted in the inefficient use of raw material, for which the production manager
was held responsible. But the decision to purchase the inferior raw materials was actually made by the
purchasing department, so although the production manager should explain the inefficient use of raw
materials, they are not responsible for the purchase. This shows the importance of coordination and
communication during the budgeting process as well as the actual day-to-day operating activities.

Step 4: Direct manufacturing labour costs budget

The production manager normally prepares and is responsible for this budget. In this budget,
the total direct labour hours for all stages of the production phase and the direct labour costs
are calculated. Similar to the direct materials costs budget, the direct labour budget is linked to
the production budget. This is because the cost of labour to produce finished goods is directly
related to the number of units produced.

Step 5: Manufacturing overhead costs budget

The production manager is also responsible for preparing this budget. The manufacturing
overhead costs are separated based on their behaviour—namely if the costs are variable or fixed.
Separating these costs is important in analysing and explaining any differences between actual
and budgeted costs. To calculate the budgeted variable costs, predetermined departmental
overhead rates are used. For example, if the driver of the variable overhead costs is labour hours,
then this budget will be linked to the direct labour budget.

Step 6: Finished goods inventory budget

The management accountant prepares the finished goods inventory budget. To calculate the
cost of finished goods, the number of units in inventory at the end of a period is multiplied by
the cost of goods manufactured. Consequently, this budget is linked to a few budgets prepared
earlier in the sequence. The first link is to the production budget, where the quantities of finished
goods inventory figures are shown. Second, cost of goods manufactured per unit (direct material,
direct labour and manufacturing overhead costs) are obtained from the following three budgets:
direct materials, direct labour and manufacturing overhead costs.

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Since the opening finished goods inventory of one period is the closing finished goods inventory
of the previous period, both opening and closing finished goods inventory figures are available
automatically in this budget. However, the opening balance of finished goods inventory for the
start of the budgeted financial year needs to be estimated. This is because many organisations
prepare budgets a few months before the end of the financial year and therefore have to
estimate the cost of closing finished goods inventory for the current period.

➤➤Question 3.2
To which operating budgets are the finished goods inventory budget linked, directly and indirectly?

Check your work against the suggested answer at the end of the module.

Step 7: Cost of goods sold budget

The COGS budget is also linked to several budgets prepared earlier. To calculate the budgeted

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COGS, the budgeted costs of manufacturing need to be determined. This is the sum of the
total cost of direct materials used, plus the direct labour costs plus the total manufacturing
overhead costs. The budgeted opening finished goods inventory is added to the budgeted
cost of manufacturing to get the cost of goods available for sale. Then, the ending finished
goods inventory is subtracted to determine the budgeted COGS. This figure will appear in the
budgeted income statement, which is part of the financial budget.

The budgets prepared in Steps 2 to 7 cover budgeting for an organisation’s production function
of the value chain. Budgets for other parts of the value chain, for example product design,
research and development, marketing and distribution, and administration, are prepared in
the next step.

Step 8: Period costs budgets

Period costs budgets can either be prepared as separate budgets for each cost component such
as research and development, marketing, distribution, and administration costs. Alternatively,
this can be combined into one budget. The costs and expenses included in this budget are
all the non-manufacturing overhead costs or the costs of the non-manufacturing activities
of the organisation. Similar to the manufacturing overhead cost budget in Step 5, costs in
this budget can be separated between fixed and variable components, depending on their
behaviour. Consequently, the period costs budget will be linked with other operational budgets,
depending if the period costs are driven by any of the components or activities in these budgets.
For example, sales commission and freight costs normally vary with sales activity and are
therefore variable costs. To determine these costs, this budget will be linked to the sales budget.
In preparing the period costs budget, all non-cash expenditure, for example depreciation on
office furniture, are shown as separate line items. This is because non-cash items are excluded
from the cash flow budget that is prepared in the financial budgets.

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Preparing budgets in non-manufacturing

organisations
Retail and wholesale organisations do not manufacture goods, so do not prepare a production
budget or any budget that relates to cost of goods manufactured. Instead of preparing a
production budget, retail and wholesale organisations develop a purchases budget. In this
budget, they determine the quantity and the cost of goods they need to purchase for resale.
It is likely that retail and wholesale organisations will need to carry inventory, so planned levels of
inventory will be taken into account in the purchases budget. The budgets for period costs and
expenses for retail and wholesale businesses are similar to those of a manufacturing organisation.

Many service organisations, ‘such as a public accounting firm, a law office, or a medical practice’
(Weygandt et al. 2012b, p. 1073), provide only services. These organisations will only prepare
budgets to forecast the revenue, and the costs and expenses relevant to their activities in
rendering the services. An accounting firm would for example prepare the following budgets:
• a revenue budget of planned hours and rates that will be charged to clients
• labour costs budgets for staff—including hours of professional staff that will be charged
and the cost of administrative staff
• an overhead budget—including other costs and expenses related to the operations of
the organisation.

Service organisations normally have large labour cost budgets and extensive selling and
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administrative costs budgets. However, some service organisations also sell goods (e.g. a dentist
or a veterinary practice). Therefore, these organisations will also prepare a purchases budget
similar to those prepared by retail and wholesale organisations.

Preparing financial budgets

Preparing financial budgets for non-manufacturing organisations is similar to that of
manufacturing organisations. Annual financial budgets consist of a set of financial statements
plus the capital expenditure budget.

Budgeted income statement

The budgeted income statement is the outcome of the operational budgets. This budget sets
out the expected financial performance for the budgeted period. Expenses not budgeted for
in the operating budgets, such as income taxes, are forecast here, and the budgeted income
statement is presented in a format that shows the gross margin, operating income, and the
net income as separate line items.

In preparing the budgeted income statement though, no regard is given to when the money
will flow in and out of the organisation. For example, making a credit sale (and a profit for that
matter) in say February does not necessarily mean that the cash will flow into the business in
February. It is important to know when the cash for credit sales in February will be collected as an
ethical organisation always aims to pay its debts and expenses on time. The inflow and outflow
of money is considered in the cash budget.

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Cash budget
Cash management is essential for the success of any business, which makes the cash budget
the most important financial budget (Weygandt et al. 2012a) and one of the most important
budgets in the master budget. The cash budget also shows when there will be cash shortages
(deficiencies) and excess cash (surpluses). This will enable management to make plans about
when to borrow money and when to spend money (e.g. buying assets, repaying loans or even
making short-term investments).

Further, the principal source of revenue and cash inflow should be from the core business of an
organisation, namely its sales. However, for many organisations, a large proportion of sales is on
account. It is therefore important to prepare a schedule for cash sales and collections from credit
sales. This schedule is based on past experience of what percentage of credit sales are paid in
the month of and months following sales. Similarly, a schedule for cash purchases and payments
of credit purchases is prepared in developing the cash budget. In addition to preparing
schedules to indicate the periods in which cash will be collected from credit sales and when
cash will be paid for credit purchases, schedules are also prepared for other inflows and outflows
of cash (e.g. when cash will be received from sources such as interest and dividends (where these
are receivable), and proceeds from selling investments and assets). Examples of other payments
are income taxes, acquisition of assets and interest and dividends (where these are payable).
The latter will be identified from the capital expenditure budget.

At its simplest, a cash budget shows the cash balances at the beginning and at the end of

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the period, cash inflows, and cash outflows for the period. The cash budget shows how much
money will be available for each period (opening balance plus cash receipts) to finance the
cash disbursements for the period. In developing a cash budget, cash flows from all activities,
thus operating, investing and financing activities are considered.

➤➤Question 3.3
How and in which budget is the figure ‘cash in bank’ in the budgeted balance sheet determined?

Check your work against the suggested answer at the end of the module.

Budgeted balance sheet

The budgeted balance sheet sets out the expected financial position at the end of the budget
period. This budget is linked to a few other budgets:
• the projected profit (or loss) for the budgeted financial year as projected in the budgeted
income statement
• the ending inventory figures for raw material, work in progress and finished goods in the
operating budget
• the cash balance projected in the cash budget.

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Capital expenditure budget

The capital expenditure budget is the organisation’s plan for the acquisition of long-term assets
such as property, plant and equipment. Acquisitions for the next financial year are considered
as well as acquisitions beyond 12 months.

Preparing budgets for various departments

The process of preparing master budgets for decentralised organisations is the same as preparing
a master budget for an organisation that is centralised. Preparing budgets for decentralised
organisations is simply a bigger and more time-consuming process.

Normally, in preparing budgets for decentralised organisations, the sales managers and
representatives of a specific unit or region or town (in short referred to as a department) prepare
the sales budget. Thus the bottom-up approach is applied. The department for which a budget
is prepared may be for example within a large retail hardware store chain (e.g. gardening
supplies) or one of the stores in the chain in a town or region. Senior management will then
aggregate these departmental budgets, which will form the sales budget for the organisation
as a whole. In responsibility accounting, the individual sales representatives and sales managers
are accountable for their centre’s revenue budget only. This is shown in Example 3.6.
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Example 3.6: P
 reparing budgets for decentralised
organisations
RunGear manufactures running gear (e.g. shoes, clothes and accessories) and has developed a sales
budget. RunGear has sales representatives in each state in Australia, and each state is divided into a
north, south, east and west region.

The sales representatives responsible for the sales in the north Queensland region will prepare a sales
budget for north Queensland. The sales representatives responsible for the south, east and west
Queensland regions will do the same.

The sales manager for Queensland will then aggregate these budgets for the four regions and be held
responsible for the sales budget for Queensland. A similar process will be followed in the other states.

Ultimately, in developing the sales budget for RunGear as a whole, the sales budgets for all the states
will be aggregated and sales forecasts through other means, such as the internet, will be added.

Preparing flexible budgets

The term ‘flexible budgets’ is often used with two meanings.
1. In the planning phase, the term is used to reflect a range of activity levels (discussed in the
next section).
2. In the controlling phase, the term is used to describe the flexing of the static budget as a
means to evaluate the variance between actual results and budgeted forecasts (discussed in
Part C of this module).

For planning purposes, flexible budgets are used to study the sensitivity of budgeted revenues
and costs for various activity levels. Large organisations typically use software packages to develop
flexible budgets, while spreadsheets are sufficient for small organisations. ‘Flexible budgets can be
prepared for each … of the budgets … in the master budget’ (Weygandt et al. 2012b, p. 1101).

Example 3.7 provides an illustration of a flexible sales budget, using sales volume ranging from
24 000 units to 32 000 units and a selling price of $50 per unit.

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Example 3.7: Flexible sales budget

ExampleCo has the following sales volume and budgeted sales revenue figures.

Sales volume 24 000 26 000 28 000 30 000 32 000

Budgeted sales revenue $1 200 000 $1 300 000 $1 400 000 $1 600 000 $1 800 000

The relevant range for fixed costs is 8000 to 12 000 units. ExampleCo uses labour hours as the cost
driver for variable costs. ExampleCo’s production budget indicated that 8000, 9000, 10 000, 11 000,
and 12 000 labour hours will be required to manufacture the finished goods required to meet the sales
volume (including the required inventory levels).

Using the information in the following table to prepare a flexible manufacturing overhead cost budget
in the planning phase illustrates the sensitivity of the budgeted costs.

Variable cost rates per direct labour hour Fixed costs

$ $

Indirect material 1.50 Depreciation 180 000

Indirect labour 2.00 Supervisor salary 120 000

Utilities 0.50 Property taxes 60 000

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Manufacturing overhead cost budget for various levels of activity

$ $ $ $ $

Activity level: 8 000 9 000 10 000 11 000 12 000

Direct labour hours

Variable costs

Indirect material 12 000† 13 500 15 000 16 500 18 000

Indirect labour 16 000 ‡

18 000 20 000 22 000 24 000

Utilities 4 000§ 4 500 5 000 5 500 6 000

Total variable costs 32 000 36 000 40 000 44 000 48 000

Fixed costs

Depreciation 15 000 15 000 15 000 15 000 15 000

Supervision salary 10 000 10 000 10 000 10 000 10 000

Property taxes 5 000 5 000 5 000 5 000 5 000

Total fixed costs 30 000 30 000 30 000 30 000 30 000

Total manufacturing 62 000 66 000 70 000 74 000 78 000

overhead costs

Calculations:
†
8000 × $1.50
‡
8000 × $2.00
§
8000 × $0.50

The complete master budget will be prepared for various activity levels as shown in the two tables.

Source: Adapted from Weygandt, J. J., Kimmel, P. D. & Kieso, D. E. 2012a,

Managerial Accounting: Tools for Business Decision Making, 6th edn, Wiley, USA, p. 443.

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Using flexible budgets in the planning phase is a useful means to determine a worst case, a best
case, a most likely case and a few alternatives in between, of expected results for the next
financial year. Having budgets for different scenarios provides valuable information for making
decisions about the allocation of resources and also about the most realistic budget.

Although one budget will be approved and adapted, flexible budgets may be useful in the
coming year, because they indicate the outcome of various activity levels that may be a useful
reference of probable outcomes if the planned activity levels are not achieved. When the master
budget is formalised, approved and accepted, it is then used to monitor and evaluate the
organisation’s and individuals’ performances. One way of doing this is comparing the budget
forecasts with the actual results, referred to as variance analysis. This is discussed in the next part
of this module.
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Part C: Variance analyses and control

As discussed earlier, to evaluate if expectations set out in strategic and operational plans are
met, actual results are compared with budget forecasts or planned objectives. Differences
between budget forecasts and actual results are called budget variances. Because budgets
are based on forecasts about the future, variances are inevitable. Analysing variances is an
important mechanism to monitor operations and to evaluate managers’ performance.

A variance is categorised as unfavourable when AC are greater than budgeted or actual

revenues are less than budgeted. A variance is favourable if actual revenues are larger than
the budget or AC are lower than the budget. The question arises: which variances should be
investigated? Normally, organisations set a materiality level as a percentage difference from the
budget, regardless of whether this is over or under the budget. For example, AC over budget
exceeding the materiality threshold need to be investigated to determine whether they were
not properly controlled

It is sometimes complicated to determine the underlying causes of a variance. This may be due
to the flow-on effects of decisions made and actions taken in other departments or functional
units of the value chain. For example, sales staff may promise a rush delivery to a customer,
forcing employees to work overtime and increasing the labour costs—which will probably result
in an unfavourable variance. Consequently, in analysing variances, the management accountant
must have a thorough understanding of and insight into the connections, interdependencies

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and interrelatedness of activities in the organisation, and the effect of one decision and action
on other aspects. Management accountants have to ensure that the managers of responsibility
centres provide sensible explanations for actual results deviating from forecast budgets.

The static budget is only used as a starting point in doing variance analysis. Due to the limitations
of the static budget, flexible budgets are developed to perform variance analyses (discussed in
the next section). Later in this part, the usefulness of variance analyses of revenue and several
cost components is discussed.

Static versus flexible budgets

The approved and adopted master budget is based on forecasts of planned sales and production
volumes determined on one level of activity. ‘When used in budgetary control, each budget
in the master budget is static’ (Weygandt et al. 2012b, p. 1099), hence being referred to as a
static budget. In a complex business environment, it is almost unheard of that the planned
levels of activity will be the same as the actual levels. Many manufacturing costs are variable and
therefore the total cost changes proportionately with changes in production levels. Consequently,
comparing actual results with the static budget forecast will not give a clear picture of the
underlying causes of the variance, and the variance may be incorrectly interpreted.

When using variance analysis to monitor and control the organisation’s and managers’
performance, two aspects are analysed to investigate the underlying causes:
1. quantities—both sales and production
2. prices—both selling prices and costs.

The difference between actual and budgeted prices is known as the price variance, and the
difference between actual and budgeted quantities (volumes) as the efficiency variance.
However, comparing actual results with the static budget will not show either of these variances.
Consequently, to interpret variances appropriately, a flexible budget is developed, as illustrated
in Examples 3.8 to 3.13.

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Example 3.8: C
 omparing actual results with the static
budget forecast—budgeted quantities
exceed actual quantities
StarCo has a budget production level of 5000 units (finished goods) and an actual production level of
4500 units for flagship product ‘Starz’. The raw material required (budget and actual) to manufacture
one unit of Starz is 1.5 kg. Both budgeted and actual cost of the raw material is $2 per kg.

Using a static budget to determine the variance of direct material will result in a favourable variance,
calculated as follows:

Actual results – Budgeted forecasts

(Actual quantity × actual price) – (Budget quantity × budget price)
= (4500 × 1.5 × $2) – (5000 × 1.5 × $2)
= $13 500 – $15 000
= $1500 favourable

Should the production manager receive a bonus for this favourable variance? The answer is
no, because the reason for the favourable variance is simply because they produced less units.
The operations were not more efficient, because the production manager budgeted to use 1.5 kg of
raw material per unit and the actual usage was 1.5 kg per unit. Further, the purchasing manager did not
deviate from the budgeted cost of $2 per kg of raw material. So there are no favourable performances
that warrant any awards. Although simplistic, this example illustrates that the difference between the
static budget and actual results is purely because of the difference in volume.
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Care should be taken in analysing and interpreting variances between a static budget and actual
results. It only indicates if more or less units have been sold or more or less units have been
produced. To understand the underlying causes of variances between actual results and budgeted
forecasts, the static budgets are therefore flexed and described as flexible budgets. In developing
a flexible budget, the actual quantities are used instead of the budgeted quantities.

Example 3.9: D
 eveloping a flexible budget—actual and
budgeted prices are equal
Using the figures in Example 3.8, the flexible budget is determined as follows:

(Actual quantity × actual price) – (Actual quantity × budget price)

= (4500 × 1.5 × $2) – (4500 × 1.5 × $2)
= $13 500 – $13 500
= zero variance

Flexing the static budget clearly shows that the only reason why the difference between the actual
result and the static budget showed a favourable variance is because fewer units were produced.
The production manager certainly should not be rewarded with a bonus. On the other hand,
an unfavourable variance will result if more units have been produced than budgeted. This would
not mean that the production manager underperformed and should be reprimanded, as illustrated
in Example 3.10.

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Example 3.10: C
 omparing actual results with the static
budget—actual quantities exceed
budgeted quantities
Assume now that 5500 units of Starz were produced (everything else remain the same). Logically,
comparing the actual results with the static budget will result in an unfavourable variance, calculated
as follows:

(Actual quantity × actual price) – (Budget quantity × budget price)

Abbreviated from here onwards as: [(AQ × AP) – (BQ × BP)]
= (5500 × 1.5 × $2) – (5000 × 1.5 × $2)
= $16 500 – $15 000
= $1500 unfavourable

Example 3.11: D
 eveloping a flexible budget—actual and
budgeted prices are different
Using the information in Example 3.8, assume that the actual cost per kg of raw material is $2.10. Using a
static budget, the variance is calculated as follows:

(AQ × AP) – (BQ × BP)

= (4500 × 1.5 × $2.10) – (5000 × 1.5 × $2)
= $14 175 – $15 000

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= $825 favourable.

Again, this does not make sense as the actual cost (price) is higher than the budget so one would
have expected that the variance would be unfavourable. In fact, the purchasing manager should be
asked to explain why the price increased.

Example 3.12: D
 eveloping a flexible budget—actual
and budgeted quantities used per unit
are different
Assume that the actual cost is the same as the budgeted cost but that the actual quantity of raw
material used per unit is 1.6 kg. Using the static budget, the variance is calculated as follows:

(AQ × AP) – (BQ × BP)

= (4500 × 1.6 × $2) – (5000 × 1.5 × $2)
= $14 400 – $15 000
= $600 favourable.

Again, this does not look correct because Steve, the production manager, was less efficient in using
1.6 kg as opposed to the budgeted 1.5 kg per unit. Steve should explain why more materials were
used than planned.

Examples 3.8 to 3.12 illustrate that the causes of variances between actual results and flexible
budgets relate to differences in price as well as differences in quantities used (both number
of units produced and input per unit). Therefore, flexible budgets are developed so that two
variances can be determined: price variance and efficiency variance. Example 3.13 illustrates
how an efficiency variance is determined.

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Example 3.13: D
 eveloping a flexible budget—budgeted
and actual quantity per unit are different
To determine the efficiency of Steve, the quantities that should have been consumed (based on
the budgeted consumption) for the actual activity level is determined in the flexible budget. In this
example, the budgeted quantity per output unit was 1.5 kg of the raw material. To determine the
figure for raw material that should have been used to produce the 4500 units in the flexible budget,
the following formula is applied:

Budgeted quantity allowed for Actual quantity × Budget price

This formula is abbreviated in the remainder of this module as:

(BQ allowed for AQ × BP).

Applying this formula, an efficiency variance is calculated as follows:

(AQ × AP) – (BQ allowed for AQ × BP)

= (4500 × 1.6 × $2) – (4500 × 1.5 × $2)
= $14 400 – $13 500
= $900 unfavourable

This formula will be further expanded later in the discussion, as in this example, the actual and
budgeted prices are the same ($2). Examples 3.8 to 3.13 illustrate why using a static budget in
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performance evaluation to analyse and interpret variances is not useful. Static budgets hide
variances due to efficiencies and inefficiencies, and also due to changes in prices and costs.
To expose these hidden variances, the static budget is flexed. In a flexible budget, the data is
based on the actual activity levels such as sales and production attained.

The usefulness of flexible budgets as a control mechanism in performance evaluation is

illustrated in the remainder of this module.

Profit- and revenue-related variances

When analysing profit and revenue variances, both the static and the flexible budgets are used.
Here the differences between the static and the flexible budget are due to variances in sales
and production volumes. In preparing the master budget, the budgeted sales volumes drive
the production volumes. Hence, the difference in the bottom lines (operating profit) of the
static and the flexible budgets is because of the difference between the budgeted sales volume
(used in the static budget) and the actual sales volume (used in the flexible budget), referred to
as the sales-volume variance. But remember: the operating profit is sales minus all the costs,
both variable and fixed, and that fixed costs is not driven by activity levels (sales and production).
Consequently, in performing variance analyses, the static budget is the same as the flexible
budget for fixed costs. Therefore, to determine the profit-related variance (known as the sales
volume variance), the contribution margin is used (and not the bottom-line, i.e. profit), as shown
in the following formula and Example 3.14.

Sales-volume variance for operating profit = (Actual quantity sold – budgeted quantity sold)
× budgeted contribution margin per unit sold

This formula is abbreviated as follows:

Sales volume variance = (AQ – BQ) × Bcm†

†
cm = contribution margin

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Example 3.14: Calculating the sales volume variance

StarCo made and sold 4500 units of Starz, while the budgeted figure was 5000 units. The budgeted
selling price and variable cost per unit was $120 and $70 per unit respectively and the actual selling
price and variable cost per unit was $110 and $75 respectively. The sales volume variance is calculated
as follows:

(AQ × BQ) × Bcm

= (4500 – 5000) × ($120 – $70)
= 500 × $50
= $25 000 unfavourable

The sales volume variance indicates that the variance in the profit (or contribution margin) of the
organisation is solely because of the decrease in the number of units sold.

Applying responsibility accounting, the sales volume variance is useful to evaluate the
performance of the manager of a profit or investment centre. Although the variance is referred
to as the sales volume variance, the sales manager is not entirely responsible to explain this
variance as it is based on the contribution margin. The sales manager is only responsible for
the performance of the revenue responsibility centre.

To understand the causes of the sales volume variance and to evaluate the performance of the
appropriate responsible managers in the revenue and costs responsibility centres, the sales
volume variance is separated between sales and various costs components. This is normally done

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by analysing each line item in the income statement and calculating a variance. It is important to
remember though that the sales volume variance is calculated using only budgeted prices and
costs and budgeted quantities. The reality is that actual prices and costs, and actual quantities
used are seldom the same as budgeted. Consequently, flexible budgets are developed as
explained in the previous section.

To evaluate the performance of the sales manager, the variation in revenue (sales) is determined,
referred to as the selling-price variance. This variance is the difference between actual and
budgeted selling prices, calculated in the following formula and applied in Example 3.15:

Selling-price variance = (Actual selling price – Budgeted selling price) × Actual units sold

This formula is abbreviated as follows:

Selling-price variance = (AP – BP) × AQ

Example 3.15: Calculating the selling-price variance

Using the information from Example 3.14, StarCo has an unfavourable selling-price variance, calculated
as follows:

(AP – BP) × AQ
= ($110 – $120) × 4500
= $45 000 unfavourable

Selling prices are likely to affect the sales demand. Consequently, in evaluating the performance
of the revenue centre, the selling-price variance should be considered in conjunction with the
sales volume variance. The sales manager is responsible for both the price and volume of sales
and hence the revenue centre’s performance and will therefore be responsible for providing
explanations for these two variances.

Figure 3.5 outlines possible explanations for increases and decreases in selling prices.

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Figure 3.5: Possible explanations for increases and decreases in selling prices

Possible explanations
• Shortage of supply in the market
• Increase in market demand
Increased • Increase in competitors’ prices
selling • Organisation may use a superior quality
prices of raw material
• Improved quality of the product
• Added features to the product

Possible explanations
Decreased • Decreased selling prices in the
selling industry/market/competitors
prices • Decrease in the demand for the product
• New competitors may have entered
the market
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Source: CPA Australia 2019.

However, the sales managers’ decisions to increase or decrease the selling prices will have flow-
on effects on other functional units in the value chain, particularly the production department.
For example, a decrease in the selling price may force the purchasing manager to buy cheaper
raw material and probably of an inferior quality. Further, using raw material of an inferior quality
may affect the efficiency of the production operations and may also result in an inferior quality
product being produced, which may ultimately result in a decrease in the demand for the
product. This illustrates the connectivity and interdependence of various managers’ decisions
and the consequential impact these decisions may have on other managers’ performance
evaluation. Therefore, understanding the connectivity between variances and their causes
is essential when using variance analysis to evaluate the performance of departments and
managers. This also emphasises the importance of open communication and coordination
between managers of various departments.

Variable direct manufacturing costs, such as direct material, direct labour and manufacturing
overhead costs, are generally incurred directly by production departments. Consequently,
in responsibility accounting, analysing variances of these costs is useful to evaluate the
performance of managers of cost centres. The production and purchasing managers will be
held accountable for variances between the actual results and the budgeted allowance for
variable costs. The next three sections illustrate how variances of direct material, direct labour
and variable manufacturing overhead costs are calculated and used as mechanisms to evaluate
the performance of relevant managers.

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Direct material analysis

Example 3.16: C
 alculating the direct material flexible
budget variance
Using the information in Example 3.8, the flexible budget for direct (raw) material is determined
as follows:

BQ allowed for AQ × BP
= 4500 × 1.5 × $2
= $13 500

Using the actual quantity direct material used per unit of Example 3.12, and actual cost of Example 3.11,
the actual results of direct material is calculated as follows:

AQ × AP
= 4500 × 1.6 × $2.10
= $15 120

The flexible budget variance is:

Actual results – flexible budget

= $15 120 – $13 500

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= $1620 unfavourable

The deviation is caused by two factors:

1. the inefficient consumption (1.6 kg as opposed to 1.5 kg)
2. the higher purchase price ($2.10 compared to a budget of $2) of the raw material.

However, it is not always obvious in the flexible variance how much of the variance relates to inefficient
consumption of the raw material and how much is related to the increased price.

To address the situation outlined in Example 3.16, flexible budgets are further subdivided to
show the price variance separate to the efficiency variance. Figure 3.6 illustrates how the price
and the efficiency variances are determined—for all variable cost components: direct material,
direct labour, and variable manufacturing overhead costs.

Figure 3.6: Calculations of price and efficiency variance

Actual results Flexed budget Flexible budget

AQ × AP AQ × BP BQ allowed for AQ × BP

Price variance Efficiency variance

Source: CPA Australia 2019.

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As shown in Figure 3.6, the term ‘flexed’ budget is used to determine the price variance—
the difference between actual results and flexed budget. Further, to determine the efficiency
variance—the difference between flexed budget and flexible budget. The formulas for calculating
the price and efficiency variances are illustrated in Examples 3.17 and 3.18 respectively.

Example 3.17: Calculating the direct material price variance

The formula for determining price variances of direct material, direct labour and variable manufacturing
overhead (although this is referred to as a spending variance) is as follows:

Price variance = (Actual Quantity of input × Actual price) – (Actual Quantity of input × Budgeted price)

This is abbreviated to:

(AQ × AP) – (AQ × BP)

Applying this formula, and using the information provided in Examples 3.8, 11 and 12, the price variance
of direct material can be determined as follows:

Difference between actual results and flexed budget

= (AQ × AP) – (AQ × BP)
= (4500 × 1.6 × $2.10) – (4500 × 1.6 × $2)
= $15 120 – $14 400
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= $720 unfavourable

Example 3.18: C
 alculating the direct material efficiency
variance
The formula for determining efficiency variances of direct material, direct labour and variable
manufacturing overhead is as follows:

Efficiency variance = (Actual quantity of input × Budgeted price) – (Budgeted quantity allowed
for actual quantity of input × Budgeted price)

This is abbreviated to:

(AQ × BP) – (BQ allowed for AQ × BP)

Using this formula and the information provided in Examples 3.8 and 12, the efficiency variance for
direct material can be determined as follows:

Difference between flexed budget and flexible budget

= (AQ × BP) – (BQ allowed for AQ × BP)
= (4500 × 1.6 × $2) – (4500 × 1.5 × $2)
= $14 400 – $13 500
= $900 unfavourable

Adding the price and efficiency variances shows the flexible budget variance as determined in
Example 3.16: $720 + $900 = $1620 unfavourable.

Separating the flexible budget into a price and an efficiency variance enables effective analyses
and interpretation of variance analysis, to evaluate the performance of appropriate managers.
The purchasing manager is responsible for the price variance of direct material and the
production manager is responsible for the efficiency variance of direct material.

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Direct labour analysis

Similar to analysing the price and efficiency variances of direct material, the price and efficiency
variances of direct labour are useful in evaluating the performance of the production manager.
Examples 3.19 to 3.21 illustrate how to calculate the price and the efficiency variances of direct
labour respectively.

Example 3.19: C
 alculating the direct labour flexible
budget variance
Use the information provided in Example 3.8 and assume the following direct labour information:

Budgeted labour hours to manufacture one unit: 15 minutes

Actual labour hours to manufacture one unit: 10 minutes
Budgeted cost per labour hour: $25
Actual cost per direct labour hour: $30

The flexible budget variance for direct labour costs will be determined as follows:

Actual results – Flexible budget

= (AQ × AP) – (BQ allowed for AQ × BP)
= (4500 × 10 / 60 × $30) – (4500 × 15 / 60 × $25)
= $22 500 – $28 125

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= $5625 favourable (F)

To understand the causes of the variance in Example 3.19, it is subdivided into the price and the
efficiency variances, calculated as shown in Examples 3.20 and 3.21.

Example 3.20: Calculating the direct labour price variance

Price variance = Difference between actual results and flexed budget
= (AQ × AP) – (AQ × BP)
= (4500 × 10 / 60 × $30) – (4500 × 10 / 60 × $25)
= $22 500 – $18 750
= $3750 unfavourable (U)

Example 3.21: Calculating the direct labour efficiency variance

Efficiency variance = Difference between flexed budget and flexible budget
= (AQ × BP) – (BQ allowed for AQ × BP)
= (4500 × 10 / 60 × $25) – (4500 × 15 / 60 × $25)
= $18 750 – $28 125
= $9375 favourable (F)

The total of the direct labour price and efficiency variances equals the flexible budget variance as
determined in Example 3.19: $3750 (U) + $9375 (F) = $5625 favourable.

Since the production manager is responsible for monitoring and controlling the labour rate and
efficiency of workers, the direct labour price and efficiency variances are used to evaluate the
performance of the production manager.

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Variable manufacturing overhead analysis

Although variable manufacturing costs is part of the costs to manufacture goods, variable
manufacturing costs are often not within the direct control of the line manager. Variable
manufacturing overhead cost is an indirect cost that cannot be traced directly but is allocated
to the products and departments instead. Consequently, care should be taken when analysing
the variances of variable manufacturing overhead costs as a means to evaluate the performance
of the line managers.

Examples of variable overhead costs are:

• indirect material
• indirect labour
• utilities—for example, energy and water consumption
• engineering support
• machine maintenance.

Further, to simplify record keeping, many organisations use standard costing to allocate
overhead costs to the various manufacturing departments. These standards may be derived
from either actual or budgeted costs. To calculate these standards, variable manufacturing
overhead costs may be grouped into one cost pool or a few appropriate cost pools, depending
on the complexity of the organisation. For example, the AC of all variable overhead costs may
be accumulated in one cost pool. In determining how to allocate these costs, managers make
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decisions about which factor drives these costs. Cost drivers can be for example:
• labour hours
• machine hours
• floor space
• kilometres driven
• number of employees.

The standard overhead-cost allocation rate is determined as follows: total costs for the cost pool
/ the driver (also known as the cost-allocation base) of the cost.

These standards are typically calculated at the start of the budget period and used when setting
the budgets. Although line managers often do not have direct control over actual variable
overhead costs incurred (as it is allocated), they help the control of these costs by budgeting for
each variable overhead cost separately, deciding about the cost driver and hence determining
the standard allocation rate. Therefore, line managers have shared responsibility for variable
manufacturing overhead costs variances. To investigate possible causes for variable manufacturing
overhead costs variances, variance analyses can be done for each cost item or in total, depending
on the complexity of the organisation, and how standard costs are determined and allocated.
So, in responsibility accounting, variance analyses of variable manufacturing overhead costs are
useful to evaluate the performance of the profit and investment centres. Although these variances
are not directly related to the performance of line managers, they are responsible for monitoring
and controlling these costs and hence have a shared responsibility to explain the causes of
these variances.

Similar to direct material and direct labour costs, a price and an efficiency variance is calculated
for variable overhead costs. Here, the price variance is referred to as the spending variance.
Example 3.22 demonstrates how the flexible budget variance is calculated for variable
overhead costs.

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Example 3.22: C
 alculating the flexible budget variance
for variable overhead costs
Assume that the variable overhead cost driver is labour hours and the following standard rates are applied:

Budgeted labour hours to manufacture one unit: 15 minutes

Actual labour hours to manufacture one unit: 10 minutes
Standard variable overhead rate: $8
Actual variable overhead rate: $7

Using the actual quantity of 4500 from the Example 3.8, the flexible budget variance for variable
overhead costs will be determined as follows:

Actual results – Flexible budget

= (AQ × AP) – (BQ allowed for AQ × BP)
= (4500 × 10 / 60 × $7) – (4500 × 15 / 60 × $8)
= $5250 – $9000
= $3750 favourable

Subdividing the flexible variance into the spending and efficiency variance for the variable overhead
costs are calculated in Examples 3.23 and 3.24 respectively:

Example 3.23: C
 alculating the variable overhead costs

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spending variance
Spending variance = Difference between actual results and flexed budget
= (AQ × AP) – (AQ × BP)
= (4500 × 10 / 60 × $7) – (4500 × 10 / 60 × $8)
= $5250 – $6000
= $750 favourable

Example 3.24: C
 alculating the variable overhead costs
efficiency variance
Efficiency variance = Difference between flexed budget and flexible budget
= (AQ × BP) – (BQ allowed for AQ × BP)
= (4500 × 10 / 60 × $8) – (4500 × 15 / 60 × $8)
= $6000 – $9000
= $3000 favourable

The total of the spending and efficiency variances equals the flexible budget calculated in Example 3.22:

$750 (F) + $3000 (F) = $3750 favourable.

The aim of organisations should not necessarily be to achieve favourable variances. A favourable
variance in one cost component is not always desirable, as it may result in unfavourable variances
in other cost components. These are illustrated in Example 3.25.

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Example 3.25: Favourable and unfavourable variances

Sunil, the purchasing manager for Acropolis Pty Ltd (Acropolis) purchased a batch of lower priced
direct and indirect materials. Consequently, the price and spending variances of direct materials and
indirect materials was favourable. However, often, the quality and the price of materials are linked.
Normally, the lower the price, the lower the quality.

The decision of Sunil, however, affected the performance of Diego, the production manager of
Acropolis, adversely. Using lower quality material resulted in more materials being used and wasted,
which resulted in unfavourable efficiency variances of direct material and of variable overhead costs.

The lower priced materials also impacted the labour price and efficiency variances of Acropolis
unfavourably because more time was needed to work with the poor-quality material and to rework jobs.
As more time was required, the actual direct labour costs increased and compared to the budgets,
the labourers were less efficient. These unfavourable direct labour price and efficiency variances will
impact the performance evaluation of Diego negatively, although he is not entirely responsible for
these, as they are a direct consequence of the lower quality of materials purchased.

Further, assume that later in the year, Acropolis hired several less skilled workers at a lower pay rate
than usual. Although this resulted in a favourable labour price variance, these workers were slower to
complete tasks. This increased the total labour hours and resulted in an unfavourable direct labour
efficiency variance.

If Acropolis had hired more skilled workers later in the year, they might have been more efficient
and completed the tasks more quickly, using less total direct labour hours, and consequently would
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have had a favourable efficiency variance. However, as they are more skilled, hiring them would have
resulted in an unfavourable direct labour price variance. In making decisions about which workers to
employ, managers have to offset the price and efficiency variances.

Correct interpretation of variance analysis provides management with essential information to

make the best decisions so as to find a ‘happy balance’.

Knowledge of how to calculate these variable cost variances is important for management
accountants in analysing and interpreting how variances are derived. However, more important
is that the management accountant can apply this knowledge in analysing and interpreting the
possible causes of the variances. It is essential that management accountants understand the
correlations between possible causes of variances, the interrelatedness and interdependencies
within and across business functions in the value chain, and between activities, decisions and
actions, and their flow-on effects.

Figure 3.7 provides some possible causes of variances in variable cost. In addition, remember
that one possible reason why actual results will deviate from budgeted forecasts is because of an
‘incorrect’ budget, either being too high or too low. Although this is a plausible reason as to why
AC will deviate from the budgeted forecasts, be cautious in accepting an ‘incorrect’ budget as
a cause for variances year after year.

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Figure 3.7: Possible reasons for variances

Favourable price and spending variance

• Talented junior staff who can perform Favourable efficiency variance
the tasks just as well as higher paid
staff • Workers are more skilled than
• Skilful negotiations of the purchasing expected, thus use less labour hours
manager • Efficient scheduling if jobs resulting
• Oversupply of raw materials in the in less machine-hours used than
market resulting in a drop in the price budgeted
• Buying raw material in bulk at reduced • New and improved production
prices scheduling software has been
• Change to supplier with better prices installed
• Using cheaper substitute materials • Using higher quality raw material
• Better financing decisions in and indirect materials
purchasing (e.g. asking for a discount)

Reasons
for
variances

Unfavourable efficiency variance

Unfavourable spending variance • Workers are less skilled than expected
• More experienced workers were • Unskilled workers had to be used
employed with higher wages because of an unexpected event

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• Sales staff promised a rushed delivery, that prevented skilled workers doing
so overtime had to be worked, paid at the job
higher rates • Inefficient scheduling of jobs resulting
• Staff underwent training, obtained in more machine-hours used than
qualifications or got promoted, so had budgeted
an increase in their wages • Machines not maintained, so not in
• Short supply of raw materials in the good operating condition
market resulting in an increase in • Machine breakdown
the price • Using lower quality raw material and
indirect materials

Source: CPA Australia 2019.

Fixed manufacturing overhead analysis

The fixed manufacturing overhead costs variances are determined in ways slightly different as
to how the variable cost analyses are determined. This is because sales and production volumes
do not affect fixed manufacturing overhead costs within a relevant range, so no efficiency
variance is calculated. Instead, a production volume variance is calculated. Similar to variable
manufacturing overhead costs, many organisations use standard costing to allocate fixed
overhead costs to responsibility centres or departments.

Actual fixed overhead costs are also accumulated to cost pools with the same cost driver to
determine a predetermined allocation rate—Total fixed costs / cost driver. This rate is then used
in developing the master budget. Examples of fixed manufacturing overhead costs that will be
allocated are:
• depreciation on plant and equipment
• leasing cost on plant and equipment
• plant manager’s salary.

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Similar to the variable overhead costs, a spending variance is calculated, but not in the same
way. First, no flexible budget is calculated and second, the spending variance is the difference
between the AC and the static budget for fixed costs. In essence, the static budget becomes
the flexible budget for fixed costs. Examples 3.26 and 3.27 illustrate how the spending and
production volume variances for fixed manufacturing overhead costs are determined,

Example 3.26: C
 alculating the spending variance for fixed
manufacturing overhead costs
Continuing on from the previous example, assume the following additional information:

Actual fixed overhead costs $32 000

Budgeted fixed overhead costs $30 000

Fixed manufacturing overhead costs are allocated to finished products based on the labour hours used.

Budgeted labour hours per finished product: 15 minutes per unit

Standard fixed overhead cost rate for allocating fixed overhead costs to finished products:

Total costs / cost driver

= $30 000 / (15 / 60 × 5000)
= $30 000 / 1250
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= $24 per hour

Four units are made per hour, therefore the rate per unit is $6.

The formula for determining the spending variance of fixed manufacturing overhead is as follows:

Actual fixed cost – static budget for fixed overhead cost

= $32 000 – $30 000
= $2000 unfavourable

It is important to remember that the $30 000 budgeted fixed cost will only be fully allocated if all 5000
budgeted goods are produced. Therefore, this predetermined rate of $6 per unit will only be accurate
if 5000 units are produced. However, in this example, only 4500 units are produced. Therefore, not all
fixed costs will be allocated, which is the production volume variance.

The production volume variance is the difference between budgeted fixed overhead and fixed
overhead allocated on the basis of the actual number of finished goods produced. To determine
the fixed costs allocated, the following formula is used:

Budgeted quantity allowed for Actual quantity of input × Budgeted price

This is abbreviated to:

BQ allowed for AQ × BP

Example 3.27 shows how the production volume variance is determined.

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Example 3.27: C
 alculating the production volume variance
for fixed overhead costs
Static budget – (BQ allowed for AQ × BP)
= $30 000 – (15 / 60 × 4500 × $24) or (4500 × $6)
= $30 000 – $27 000
= $3000 unfavourable or under-allocated

This production-volume variance is the fixed costs of units that were not produced (i.e. 500 units
× $6 = $3000) and could not be allocated (i.e. under-allocated). If more goods are produced than
forecast then the production volume variance will be favourable, which means too much fixed costs
were allocated (i.e. over-allocated). Over-allocated fixed costs is also referred to as over-applied and
under-allocated as under-applied.

It is important to understand the production volume variance so that it can be accounted for in the
accounting records. In accordance with AASB 102 Inventories, manufacturing fixed overhead costs
is considered an inventoriable cost. Using standard costing, fixed costs are viewed as if they had a
variable cost behaviour and are consequently allocated to finished goods accordingly.

In this case, only the fixed overhead costs that are allocated to the actual number of finished goods
produced ($27 000) are recorded in the accounting records. The master budget forecast fixed costs
as $30 000 but only $27 000 will be allocated. This will result in $3000 not being allocated to finished
goods. But remember, the actual fixed costs will eventually have to be recorded in the accounting
records and presented in the income statement, so the unfavourable production volume variance

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calculation of $3000 will also have to be recorded in the accounting records.

However, be cautious and remember that there is a vast difference between the actual behaviour
of fixed overhead costs (not affected by level of activities) and how fixed overhead costs are
allocated to finished goods (applying a predetermined rate to level of activity). When forecasting
fixed overhead costs to develop a master budget, always use the total lump sum costs (which are
based on their behaviour) and never use the fixed costs per unit.

Although fixed overhead costs are part of the manufacturing costs, they are not under direct
control of the managers of cost centres. In responsibility accounting, managers of the profit and
investment centres are responsible for these costs, and analysing these variances is useful in their
performance evaluation.

Analysing the production volume variance is important in making decisions about resource
allocation. Fixed costs are only fixed within a relevant range. The relevant range typically
depends on the available resource capacity. For example, the size of the plant and the number
of machines it contains, dictates how many units will be produced and hence the number of
labourers required. Returning to the Acropolis example (see Example 3.25), assume the relevant
range is between 4000 and 6000 units. The budgeted fixed cost of $30 000 is only appropriate
if Acropolis manufactures between 4000 and 6000 units. Now, assume there is an indication
of a sustained increase in the demand of 2000 of Acropolis’s products over the long term.
The relevant range will then change to between 6000 and 8000 units. To enable Acropolis to
increase its production, they will have to review their strategic plan and make decisions about
expanding resources, such as:
• buying or leasing additional plant and machinery
• employing more workers, including an additional supervisor for the plant.

The production volume variance may also indicate that not all fixed costs are allocated—meaning
that there is idle capacity. This may be an early warning sign of a decrease in the demand of
the organisation’s products, and may signal that the resources need to be downsized and
capacity curtailed.

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Analysing the spending and the production volume variances of the fixed overhead costs is
therefore important for the profit and investment centres’ managers to monitor the resource
allocations. Further, the production volume variance may provide signals and warning signs that
may trigger a chain reaction of issues that require further investigation. Important questions to
ask when analysing fixed overhead costs variances are:
• Why did the organisation not produce at the capacity forecast in the budget?
• Was there a decrease in demand?
• Did the quality of the product deteriorate, which resulted in customers buying less or
from competitors?
• Are there gaps or weaknesses in the product and marketing strategies?
• Do competitors have aggressive product and marketing strategies?
• Were there new entrants to the market?
• Are the selling prices too high?
• Are competitors selling their goods at a lower price?

Answering these questions will help with understanding the organisation’s environment and may
help managers to make decisions about possible future courses of action.

Although variance analyses are useful in evaluating performance of appropriate managers,

due to the connectivity and interrelatedness of issues within an organisation, variance analyses
should not be used as evidence of good or bad performance. A favourable variance does not
necessarily indicate that the manager should be rewarded with a bonus for good performance.
Similarly, an unfavourable variance does not necessarily indicate that a manager should be
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reprimanded or punished for poor performance. Variance analyses should only be regarded
as a starting point to understand what really happened in the organisation, and to dig deeper
and behind the measured results in order to reveal the underlying performance. The purpose
of setting budgets and doing variance analyses is to improve performance, monitor the
implementation of the operational plan and provide information for management to change
the strategy if needed. So, variance analyses are best used to provide suggestions for further
investigation and future improvements.

Variance analyses are therefore a means that enable management to take appropriate actions
and make more precise predictions in order to achieve improved budgets as well as actual results
in future, as illustrated in Example 3.28.

Example 3.28: Implementing improvements informed

by variances
Based on the results of the variance analysis provided by their management accountant, Acropolis
made the following decisions:
1. put in place new and improved quality management systems
2. implement improved employee-hiring practices and training procedures
3. install software and systems to allow this task to be done automatically
4. ensure preventive maintenance is done regularly on all machinery and equipment
5. start a project to improve communication and coordination between staff in various functions in
the value chain and to improve processes and systems.

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➤➤Question 3.4
Leap Ltd (Leap) uses standard costing in planning and flexible budgets in controlling its
manufacturing. It has two direct-cost categories (direct material and direct labour) and two
overhead–cost categories (variable and fixed manufacturing overhead).
The cost driver for both overhead-cost categories is direct manufacturing labour hours. For the
previous period:
• total variable overhead costs $720 000
• total fixed costs $2 568 000.
The fixed costs are incurred equally per month and is for a factory large enough to meet Leap’s
capacity to supply the current demand.
The total direct labour hours forecast for the current year was 80 000 hours.
During May, 17 000 saleable units were produced. Of these, 14 000 units were sold. There was
no beginning inventory of direct materials and no beginning or ending work in process for May.
Due to a natural disaster, there was a short supply of raw material from its current supplier during
April. Consequently, Leap had not been able to meet the demands of customers in April, causing a
backlog of 5000 units in sales. To satisfy these customers, the sales manager promised that the
goods would be produced in May, and offered a discount of $20 per unit on the budgeted selling
price of $150 per unit.
For the May budget:

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• sales volume 10 000 units
• number of units to be manufactured 12 000 units
• standard usage of raw material 1.2 kg per unit
• standard labour hours per unit 30 minutes.
To meet the demand for both the backlog of April sales and the planned sales of May, Leap
appointed casual labourers at a pay rate of $20 per hour. The budgeted and actual pay rate for its
permanent labourers is $25 per hour. However, due to the inexperience of the casual labourers,
they had to redo 1000 jobs. It took them 30 minutes to make each of the 1000 units the first
time and another 30 minutes to redo each one. Fortunately, Leap ended their contracts within
two weeks to avoid any further waste.
However, to meet the sales demand, permanent labourers had to work overtime to manufacture
2000 units. It took them 30 minutes per unit to manufacture the units, for which they were
paid time and a half. The permanent labourers also manufactured 12 000 units that took them
20 minutes each to make.
Leap’s purchasing manager found and purchased a substitute raw material that was superior
compared to the raw material they purchased before, but it cost $44 per kilogram (compared to
the budgeted raw material of $40 per kilogram). Leap started to purchase the substitute material
on 1 May. Due to the superior quality, less raw materials were used in the manufacturing process.
In addition, the finished product was of a better quality, so the sales manager increased the
selling price to $160 per unit on 1 May. Unfortunately, some customers were not satisfied with
the increased price and bought from Leap’s competitors instead. Due to this, Leap lost 1000 of
the forecast sales volume for May, although these units were produced.
Due to the improved quality of the raw material purchased in May, the permanent labourers
only used 1.1 kg per unit manufactured. The actual variable manufacturing overhead cost was
$60 000 and fixed manufacturing overhead cost was $220 000 for May.
During the planning of the budget, management wanted to increase the finished goods inventory
levels. The budgeted inventory of finished goods as at 31 May was 2000 units.

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(a) Prepare a static income statement budget for Leap

Sales volume

Sales

Direct material costs

Direct labour costs

Variable manufacturing overhead costs

Fixed manufacturing overhead costs

Operating profit

(b) Calculate each of the following variances so that you can communicate effectively with the
appropriate managers and ask appropriate questions to investigate possible causes for
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each variance.

Sales price variance

Sales volume variance

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Direct material price variance

Direct material efficiency variance

Direct labour price variance

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Direct labour efficiency variance

Variable manufacturing overhead

spending variance

Variable manufacturing overhead

efficiency variance

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Fixed manufacturing overhead

spending variance

Fixed manufacturing overhead

production volume variance

(c) Analyse each of the variances you calculated in (b) and discuss sensible and plausible causes
to explain these variances.
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Causes for variances in sales

Causes for variances in direct

material

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Causes for variances in direct labour

Causes for variances in variable

manufacturing overhead

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Causes for variances in fixed
manufacturing overhead

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(d) Consider each of these variances as a control mechanism to evaluate the responsible managers’
performance. Discuss which variance relates to which manager and whether any of these
managers will be eligible for a bonus or whether anyone needs to be reprimanded.

Sales manager
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Production manager

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Purchasing manager

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Check your work against the suggested answer at the end of the module.

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Part D: Behavioural aspects of budgets

When designing and implementing budgets, human behaviour should always be considered,
because this can influence an organisation’s overall effectiveness.
A budget affects virtually everyone in an organisation: those who prepare the budget, those who
use the budget to facilitate decision making, and those whose performance is evaluated using the
budget (Langfield-Smith et al. 2018).

Budgets are often used to judge managers’ performance, so they can have a significant
behavioural effect. When setting budgets, it is best if there is ‘goal congruence’—when an
individual’s goals coincide with the organisation’s goals. Goal congruence motivates individuals
and drives each manager to achieve the set goals. However, this is one of the greatest challenges
in managing large organisations. Negative (or dysfunctional) behaviour may occur if budgets
are poorly administrated—resulting in a conflict between individual goals and those of
the organisation.

The next section discusses participative budgeting, including resulting behavioural aspects,
and how negative behaviour can be avoided when setting budgets.

Participative budgeting
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Depending on the culture and structure of the organisation, a top-down or a bottom-

up approach may be used to prepare budgets. The approach and degree of lower-level
management participation in setting budgets varies between organisations. Participative
budgeting is an iterative process, involving many lengthy and time-consuming repetitive
steps in negotiating and revising figures so as to eventually gain approval for the budgets.
Consequently, participative budgeting is expensive.

The top-down approach

In the top-down approach, senior managers impose budgets on junior or lower level managers
(who have very little say and participation in the budget-setting process). For example, ‘budgets
may be set at the corporate level and then cascaded down to the various responsibility centres’
(Langfield-Smith et al. 2018). Although this approach is less time consuming than the bottom-up
approach and may therefore be more cost effective, it has major disadvantages:
• ‘[S]enior managers may have less knowledge of the local business environment than do
those managers working directly in the particular responsibility centres’ (Langfield-Smith
et al. 2018, p. 437).
• Due to a lack of involvement in setting the budgets, middle and junior managers may not
be committed to achieve the budgets.
• Although top management may set the target high as a means to encourage improved
performance, it may discourage employees.

Research has shown that the top-down approach to planning and control is not the best way to
create order in complex adaptive systems (Roosli & Kaduthanam 2018). When top management
sets the budgets too tightly, using the top-down approach, it often frustrates and demotivates
the individuals who have to execute the budget. Not only may this result in poorer performance,
but managers may be inclined to manipulate data. Targets and budgets are more likely to
be accepted and achieved if they are considered to be achievable. Therefore, managers of
responsibility centres should have direct input into the process of establishing budget goals

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of their area of responsibility. If this is not the case, they may adopt an ‘it’s not my budget’ view
and consider the goals set by top management as unrealistic or arbitrary. For these reasons,
it is argued that budgets should be developed with the participation of lower-level management,
referred to as the bottom-up approach. The idea is that the bottom-up plan should inform the
top-down plan.

The bottom-up approach

In the bottom-up approach, lower-level managers and operational staff participate in the
budgeting process. The decision-making is delegated down to the front line much as is
practical. The theory is that people will be more committed to a budget and try harder to
achieve it when they have been consulted during the target-setting process. It is more likely
that targets will be achieved if employees are held responsible for activities that they believe are
within their control and this results in greater motivation to improve performance. In the bottom-
up approach, budgets are developed at the lowest responsibility centres and fed up to senior
managers to make the final decisions.

Advantages
The bottom-up approach encourages coordination and communication between managers by
allowing subordinate managers considerable say in setting budgets. Giving people individual
freedom to make decisions and team autonomy creates a sense of responsibility and fosters

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creativity. Further, budgets developed using the bottom-up approach may lead to increased
goal congruence because the budgets may then become the manager’s personal goal.

This approach may also provide greater understanding and appreciation of the organisation’s
objectives and wider strategy when top management communicates strategic goals and
targets to division and department managers, who then incorporate these into the budgeted
operating plans. Although top managers approve the final budget, they rely on the knowledge,
insight and expertise of lower-level management and operational staff to help establish realistic
departmental budgets.

Disadvantages
However, using the bottom-up approach can also result in dysfunctional behaviour, including
internal corporate political issues (e.g. power struggles and refusing to cooperate), protracted
negotiation games, ‘horse-trading’ tactics, empire building, and eventually blame shifting.
Managers associate resources under their control as power and status, which may lead to a ‘game’
between leaders and would-be leaders. To avoid these political struggles, top management
should foster a culture of cooperation rather than competition among employees and ensure
there is transparency and involvement in budget setting.

The bottom-up approach may also result in potential problems with setting targets and budgets,
such as ‘pseudo participation’ and ‘budgetary slack’ (referred to as padding the budget).

Pseudo participation occurs when top management only appears to seek input from lower-level
managers, but they really assume total control of the budgeting process and only seek superficial
participation from lower-level managers. In essence, top management only seeks lower-level
managers’ formal acceptance of the budget and not real input.
Budgetary slack (or padding the budget) exists when a manager deliberately underestimates
revenues or overestimates costs in an effort to make the future period budgets appear less
attractive in the budget than they think it will be in reality (Mowen et al. 2016, p. 352).

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Some managers may pad budgets because they know it will be easy to achieve and so they will
be entitled on incentives. In essence, they drain the budget in an attempt to ensure sufficient
funds are available in future budgets. In padding the budget, managers believe they build in
a buffer and therefore reduce the risk of receiving an unfavourable performance evaluation for
not meeting their goals. Budgetary slack is also used as a means to cope with uncertainties
and unforeseen or unanticipated events. It is also common for top management or the budget
committee to cut budgets, so managers pad budgets, and because budgets are likely to be
padded, they are cut.

Budgetary slack may be the result of poor budgeting administration, where budgets are used
as a control mechanism of performance. For example, if a regional sales manager received a
poor performance evaluation in the previous period, they may be inclined to set a conservative
budget. On the other hand, managers of cost centres may inflate the budget. When this budget
is used in their performance evaluation, comparing AC with the overestimated costs in the
budget will appear as if the manager managed the cost centre in a cost-effective way.

It is understandable and sensible to build in a buffer in a budget and to estimate some costs
slightly higher than what is really expected so as to factor in uncertainty. However, deliberate
excessive padding of costs and revenue is misrepresentation and is a questionable ethical
professional practice. Not only is this is a violation of credibility standards but it is doubtful if
managers applying such behaviour demonstrate integrity. The challenge is for top management
to carefully review participative budgets in an attempt to reduce the effects of budgetary slack,
and to set budgets that are realistic and achievable (this is discussed in the next section).
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➤➤Question 3.5
Ariel Ltd (Ariel) uses the bottom-up approach in developing budgets and uses standard costing.
It manufactures a variety of outdoor furniture and equipment in numerous departments. Ariel uses
variance analysis to evaluate the performance of each department and the responsible manager.
In the past, the production department of the Akimo dining chairs and tables has achieved mostly
favourable variances. Consequently, the manager of the Akimo production department has
received excellent performance evaluations and considerable bonuses. Managers receive a bonus
if they either meet the budget or do not deviate from the budget by 10 per cent. The bonus is
based on a fixed percentage of actual profits of the organisation. No bonus is awarded if Ariel’s
actual profit is less than the budgeted profit.
On average, 144 tables of the Akimo dining table and chairs set are produced per day.
The production manager, Martin Steen, provided the following monthly data to be used to
prepare the budget for the next financial year:

Input Budget quantity per table Total quantity

Direct material 20 kilograms 2880 kg

Direct manufacturing labour 25 minutes 60 hours

Machine time 45 minutes 108 hours

Actual results to manufacture 144 tables for April of the following year are:

Input Total quantity

Direct material 2736 kg

Direct manufacturing labour 52.5 hours

Machine time 110 hours

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There are seven labourers each working 7.5 hours per day.
Due to an economic slowdown, Ariel’s top management wants to tighten the budget for the
following year as a means to challenge and encourage employees to improve their performance,
and to reduce costs.
As Ariel’s management accountant, you ask Martin Steen to provide you with challenging yet
achievable data to be used to develop next years’ budget. In response, Martin provided you
with the following input quantities per table:

Input Quantity per table

Direct material 19.5 kilograms

Direct manufacturing labour 24 minutes

Machine time 44 minutes

Martin also informed you that the reductions in the input quantities will only be possible if the
labourers are more efficient. To become more efficient, they will have to receive training in how
to use less time and materials. This will make them more skilled, which will entitle them to a
pay increase.
(a) Why has Martin Steen chosen these figures for the new budget? Are they challenging
and realistic?

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(b) What aspects would you consider when communicating with Martin in challenging him about
the proposed figures?

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(c) What steps can top management take to encourage Martin to provide budgeted data that
will ensure goal congruence?

Check your work against the suggested answer at the end of the module.

Setting realistic and achievable targets

To mitigate the negative behaviour and practices of setting unrealistic budgets and to enhance
goal congruence, the challenge is to set realistic budgets. This can be achieved in a few ways.
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• One way is to avoid using the budget as a means to rigidly evaluate performance, but instead
to allow some discretion when comparing actual performance with the expectations set
out in the budget. For example, consider the situation when the actual maintenance costs
of machinery exceed the budget, but this is due to a breakdown that was not foreseen—
these mitigating circumstances should be taken into account.
• Since incentives for achieving the budget have the potential to lead to negative behaviour and
practice, another way is to give rewards for consistently providing accurate budget estimates.
• To ensure that everyone makes decisions in the interest of meeting organisation-wide targets,
align goals and incentives giving everyone who achieves their goals an incentive.

To achieve goal congruence, budgets should be based on realistic conditions and expectations.
Setting realistic budgets requires coordination, transparency, communication, cooperation and
commitment on all levels of management. It requires an attitude of ‘us’ and not one of ‘us and
them’ or ‘what’s in it for me’. This is closely related to human behaviour and psychological
issues—controlling issues such as greed, ego and fear is clearly outside the scope of the
accounting discipline. No budget will ever be able to completely prevent this negative behaviour.

According to Horngren et al., most employees will ‘work more intensely to avoid failure than to
achieve success’ (2011, p. 421). From this perspective, top management may set challenging
targets but targets that, in their view, are achievable. However, as discussed earlier, overly ambitious
targets and budgets may be viewed as unachievable and therefore discourage staff because they
see very little chance of avoiding failure. On the other hand, lowering standards and setting targets
and budgets that are too easy to achieve may result in employees not being challenged enough.
This may result in them becoming complacent. It is argued that having a challenging budget,
but one that employees believe they can achieve, will encourage and motivate them—so the
trick is to find the balance between a ‘too easy’ and a ‘too hard’ budget. This is referred to as a
realistic budget.

Setting realistic budgets is important when budgets are linked to incentive schemes to reward
managers’ performance. This is discussed in the next section.

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Monetary and non-monetary incentive schemes

The core of nearly every organisation’s management control system is budgetary control (Kleiner
& Wilhelmi 1995). Providing regular feedback to managers on their performance is essential to
exercise budgetary control. It is more likely that targets and budgets will be achieved if managers
receive frequent feedback and if the achievement of targets is accompanied by rewards that are
valued. Consequently, both monetary and non-monetary incentive schemes are used as a means
to encourage goal-congruent behaviour.

Monetary incentives are used to motivate managers to be productive, work efficiently and
reduce waste. Good performance is rewarded with, for example, salary increases, bonuses
and promotions. Poor performance on the other hand may lead to dismissal. While monetary
incentive schemes are important, linking individual bonuses to targets will only increase
dysfunctional behaviour (Bogsnes 2018), and overemphasising monetary incentives can
lead to a form of dysfunctional behaviour referred to as ‘myopia’ or ‘milking the firm’. In this
case, managers take action to improve short-term performance but at the expense of the
long-term performance of the organisation. They simply disregard or overlook the fact that
concentrating only on short-term goals may have a harmful effect on the organisation’s long-
term sustainability. Further, ‘money loses its motivating power to purpose, mastery, autonomy
and belonging’ especially ‘when we move to more complex and team-based “knowledge” work’
(Bogsnes 2018, p. 12)

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In addition to monetary incentives, most people are also motivated by intrinsic psychological and
social factors, including non-monetary incentives such as responsibility, challenges, the freedom
of not being micro-managed or the simple acknowledgement and recognition of a job well
done. As Bogsnes states, many people ‘are much more fired up by the right words, igniting our
hearts and minds in a very different way than those clinical and decimal-loaded numbers ever
could’ (Bogsnes 2018, p. 9). Intrinsic factors may boost people’s self-esteem and give them
a feeling of job satisfaction. Consequently, some organisations use non-monetary incentives
such as job enrichment, increased responsibility and autonomy, and recognition programs in
budgetary control.

Therefore, to avoid dysfunctional behaviour in the budgeting process, a holistic performance

evaluation should be done, analysing how results were achieved, how ambitious the targets
were, which risks were taken, and how sustainable the achieved results are. Also, a combination
of financial and non-financial incentive schemes that gauge both short-term and long-term
effects on the organisation’s performance can be used to reward managers’ performance.
Further, employees should not be rewarded for meeting targets, but rather, for achieving the
best possible outcome given the circumstances. Setting targets is only one way of trying to
achieve the best possible outcome ‘but not the only way and all too often, not the best way’
(Bogsnes 2018, p. 5).

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➤➤Question 3.6
Following on from the information provided in Question 3.5, the following standards were used
in developing the budget for the Akimo production department of the dining chairs and tables
for the following year:

Input Standard quantity per table

Direct material 15 kilograms

Direct manufacturing labour 20 minutes

Machine time 40 minutes

These standards were made possible due to careful negotiation and coordination. Top management
agreed to provide training so that the employees could improve their efficiency, but due to the
downturn in the economy, they did not agree on an increased pay rate. The employees were
happy with this decision because they retained their jobs and had an opportunity to upskill.
Due to a redesign in the table, a different type of material is now being used, which requires
less material and fewer machine hours. Further, a new supplier for the material has been found.
Due to the tighter budget, the Akimo production department received a few unfavourable
variances in the first month of the new year. Martin Steen is concerned about the effect this may
have on his performance evaluation and bonus this year. A few months later, Martin also begins
to doubt that Ariel will achieve its budgeted profit. Due to these concerns, he deliberately works
on a plan to prove that the standards were set too high.
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• He convinces the employees that the quality of the tables is not as good as previously and
this encourages them to work more slowly.
• He also convinces the purchasing manager that the quality of the tables is not as good as
previously and to purchase the material from the previous supplier—which is of inferior
quality compared to the material currently used.
Martin knows that these proposed changes will increase the quantities input per table and he
plans to use these more generous standards in setting the budget for the following year. He is
convinced that if this budget gets approved, he will be able to convince the purchasing manager
to purchase the better quality material again and also the labourers to be more efficient.
(a) Comment on Martin Steen’s behaviour and what the potential drivers behind this might be.

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(b) What actions can be taken to ensure goal congruence?

(c) Assume that Martin is successful in convincing the labourers and the purchasing manager
and that he develops a budget which is quite obviously padded.
Discuss how you will be able to point out budgetary slack to Martin by discussing which
variances you will analyse and what the expected outcomes of these variances will be.

MODULE 3
Check your work against the suggested answer at the end of the module.

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Part E: Alternative approaches to

budgeting
Due to the negative behavioural issues and the limitations of budgets discussed so far, traditional
budgeting practices have been criticised. The shortcomings of annual traditional budgeting
practices are discussed in the next section. Later in this part, three alternative approaches and
techniques that are proposed to aid improved budgeting and planning processes are discussed:
1. incremental budgeting
2. zero-based budgeting
3. activity-based budgeting.

Finally, the Beyond Budgeting (BB) approach is discussed.

Shortcomings of traditional budgets

Practitioners argue that budgets impede the allocation of an organisation’s resources to their
best uses (Hansen et al. 2003). Further, that it encourages myopic decision-making. ‘By the
time budgets are used, their assumptions are outdated’ (Hansen et al. 2003, p. 97). Criticism of
traditional budgets are that they impose centralised planning and decision-making that is a costly
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method, stifle initiative, impede empowered employees from making the best decisions for the
organisation, and restrict organisations’ ability to act and react. Due to digitalisation, globalisation
or mobility, the business environment is becoming more and more demanding, causing a VUCA
world: volatile, uncertain, complex and ambiguous (Roosli & Kaduthanam 2018). The unexpected
is becoming the norm and organisations need to cope with unforeseen events. Traditional
budgeting methods are too unresponsive in this VUCA environment (Neely et al. 2003).

Further, traditional budgets are not focused on value creation but merely on reducing costs.
Research has found that responsibility-centre-focused budgets are not compatible with value-
chain-based organisations. ‘Traditional budgeting is fundamentally mismatched to today’s
rapidly changing and uncertain environments’ (Hansen et al. 2003, p. 98). Another criticism is
that traditional budgeting creates budgets for silo functional units such as sales, production,
and administration departments, and then allocates (or pushes) these functional budgets
to products.

Hansen et al. list the following most cited weaknesses of budgetary control:
1. Budgets are time-consuming to put together;
2. Budgets constrain responsiveness and are often a barrier to change;
3. Budgets are rarely strategically focused and often contradictory;
4. Budgets add little value, especially given the time required to prepare them;
5. Budgets concentrate on cost reduction and not value creation;
6. Budgets strengthen vertical command-and-control;
7. Budgets do not reflect the merging network structures that organisations are adopting;
8. Budgets encourage gaming and perverse behaviour;
9. Budgets are developed and updated too infrequently, usually annually;
10. Budgets are based on unsupported assumptions and guesswork;
11. Budgets reinforce departmental barriers rather than encourage knowledge sharing; and
12. Budgets make people feel undervalued (Hansen et al. 2003, p. 96).

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Neely et al. (2003) also identify 12 significant weaknesses of traditional planning and budgeting
practices, which they categorise into three principal categories:
1. competitive strategy
2. business process
3. organisational capability.

Overall, they state, traditional planning and budgeting processes are failing to deliver results,
as ‘they tend to promote an inward-looking, short-termist culture that focuses on achieving a
budget figure rather than on implementing business strategy and creating shareholder value
over the medium to long term’ (Neely et al. 2003, p. 25).

Despite the shortcomings of traditional budgets, the vast majority of organisations around the
world are still using them in planning and control. Three principal approaches and techniques
that have been proposed to improve budgeting and planning processes are discussed next.

Incremental budgeting
Incremental budgeting involves the common practice of projecting next year’s budget by adding
an adjustment (e.g. a percentage increase due to inflation) to either the actual results or the
previous budget. This is a quick and easy way to develop a budget and may be useful in small
businesses—especially service organisations—with simple business models. However, using this

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approach to develop a budget for large organisations with complex business models may not
be appropriate.

This approach has a few disadvantages, whereby managers will not:

• plan appropriately for the future
• consider the strategic or operational plans of the organisation
• carefully consider the effects of internal and external factors (discussed earlier in this module).

This approach does not force managers to manage resources more efficiently and effectively.
Further, using the previous year’s budget only to plan the next year’s budget may result in
complacency and dysfunctional behaviour and waste of resources. For example, some managers
have the belief and attitude that they should spend the money in a budget even though there is
no real need to do so. This dysfunctional behaviour can be characterised as the ‘if you don’t use
it, you will lose it’ mentality—resulting in some managers spending money unnecessarily simply
to avoid cutbacks.

To make these budgets more useful, it is recommended that the organisation use an incremental
budget simply as the starting point and, in addition, consider the internal and external factors
that may affect the organisation in future.

Zero-based budgeting
Zero-based budgeting was developed and used widely in the 1970s and 1980s (Langfield-Smith
2018, p. 441). Zero-based budgeting is designed to reduce problems associated with incremental
budgeting. As the name indicates, using this approach, virtually every activity is set to zero. It is
argued that this forces managers to rethink each phase of the operations and to justify each
activity and budgeted figure in order for them to receive an allocation of resources. Under zero-
based budgeting, managers prepare a budget as if no information about revenue and costs from
previous budget cycles is available—the budgets are developed from scratch. It forces managers
to carefully consider the effects of internal and external factors (discussed earlier in this module).

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Although rethinking each phase of an organisation’s operations and developing a budget from
scratch has advantages, it is very time consuming and expensive—because it requires extensive
in-depth analysis of expenditures.

Zero-based budgeting is also criticised as being too introspective. It is argued that managers
can overlook the interactions with other departments and the relevance of their own part of
the operations to the overall business objectives and strategies. Consequently, this approach
may not be useful for managing costs or improving an organisation’s performance. Zero-based
budgeting has also been criticised as not being useful to identify ‘areas of waste, redundant
activities, communication barriers or opportunities for more effectively deploying resources to
support business needs’ (Langfield-Smith 2018 p. 441).

For a further explanation of zero-based budgeting, please access the ‘Zero-based budgeting’
Case study on My Online Learning.

Activity-based budgeting
Activity-based budgeting (ABB) was developed by consultants Coopers and Lybrand Deloitte
(Kleiner & Wilhelm 1995). This approach primarily focuses on the problems with using traditional
budgets as a planning tool. ABB is a participative management process for control and continuous
improvement (CI) of performance and costs, operating at the activity level. It focuses on developing
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a budget explicitly from activities and resources. In essence, ABB aims to make budgeting more
meaningful to operational managers.

In this approach, organisations apply the analytical operational model of activity-based costing
(discussed in Module 6) with a detailed financial model. Opposed to traditional budgeting that
is primarily based on outputs and only use a few cost drivers, ABB uses a considerable amount
of cost drivers. In essence, activity-based and capacity management concepts are expanded
into budgeting. In ABB, the traditional budgeting process is modified to better reflect the
operational processes in the organisation. Various activity cost pools and their related cost
drivers are used to forecast the costs for individual activities. This approach allows managers
to identify the resources consumption of each activity separately and to prepare a budget for
that activity accordingly.

Similar to traditional budgeting, the ABB process starts with forecasting future market demand
for the organisation’s products and services. The sales forecast drives the quantities of products
to be manufactured (and the product mix), which then drives the expected production activities.
Using a range of activity drivers (as opposed to the limited drivers of sales and production used
in traditional budgeting), ABB helps managers to estimate the resources that will be needed for
each activity. Managers then analyse the resource capacity of the organisation to conduct the
required activities and compare this with the resources necessary to produce the products. If the
activity plan is not feasible, they adjust the budget loop until they achieve a balance between
the required resources and available resource capacity.

In using this approach, a feasible operating budget is developed before generating the financial
budget. Doing this avoids unnecessary calculations of financial effects until the operational plan
is feasible. The financial plan is typically broken down into information by resources, activities,
products or other cost objects (Hansen et al. 2003). In ABB, the product decisions, activity costs
and resource costs are reviewed until the targeted financial results are met (for further details,
see Hansen et al. 2003).

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It is argued that ABB has several potential benefits. It:

• makes budgeting more relevant for managers as it combines a more complete operational
plan with a detailed financial plan
• crosses departmental borders, leading to a horizontal process-based view of the organisation
• incorporates cost drivers such as batches or a facility, so it identifies the sources of
imbalances, inefficiencies and bottlenecks. In turn, this allows better product, process or
activity costing
• allows better decision-making, resource allocation and capacity balancing
• communicates budgeting information to lower-level management in operational terms they
can understand more easily and not in financial terms
• strengthens the interface between planning and budgeting
• allows organisations to have feasible operational plans from the start
• provides a complete set of tools for balancing the financial budget—since ABB looks
simultaneously at sales forecasts, production efficiency, procurement prices, capacity
decisions and product price
• makes the financial plan more relevant to operational managers—with the increased
transparency reducing dysfunctional behaviour and resulting in better coordination.

Prominent organisations such as Boeing, Emerson Electric, IBM Business Consulting Services,
SAS Institute and the US Marine Corps support the ABB approach. However, at the time of
writing, it is still an open question whether the higher complexity costs of the ABB approach
can earn back the credibility of the budgeting process.

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The components of the master budget in ABB is illustrated in the Figure 3.8.

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Figure 3.8: Components of a master budget in activity-based budgeting

Strategic plan

Activities Resource capacity

Operational Capital investment

budgets budget

Sales forecast

Production activities

Activity budget
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Financial plan

Resources Activities Products

Income statement Cash budget Balance sheet

Source: Based on Groot, T. & Selto, F. 2013, ‘Figure 5.3 Master budget components’,
Advanced Management Accounting, Pearson, Harlow, UK, p. 151.

In ABB, the operating budget implements the organisation’s strategy by forecasting the expected
levels of activities, for example sales, production, purchasing, maintenance, marketing and
distribution (and other overhead activities).

However, according to Neely et al., none of these three alternative approaches and techniques to
planning and budgeting processes provides a complete solution. A criticism that ABB and zero-
based budgeting share ‘is that they tend to involve even more work than traditional budgets so
they are best used on a ‘one-off’ basis rather than a regular one’ (Neely et al. 2003, p. 25).

A radical re-engineering proposal to banish budgeting altogether, called Beyond Budgeting (BB),
is discussed next.

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Beyond Budgeting: Managing without budgets

The BB approach primarily focuses on the problems with using traditional budgets as a
performance evaluation tool. It was developed in the late 1990s (Heupel & Schmitz 2015).
This is a new approach towards holistic organisational goals and their implementation,
extending beyond financial planning concepts (Roosli & Kaduthanam 2018). This approach
connects the organisation’s strategy with managers’ decisions, and represents a management
philosophy consisting of 12 principles.

See [Link] for the 12 principles and Roosli and

Kaduthanam (2018) for some dos and don’ts of these 12 principles.

The purpose of these principles is to guide and inspire organisations in implementing a

BB approach.

It is argued that in planning and preparing an annual budget, there are too many uncertainties
that cannot be foreseen. Consequently, this makes annual budgets risky and even dangerous.
Advocates of the BB model argue that traditional ‘fixed’ contract budgets should be eliminated.

BB is a contemporary management model where organisations are managed without budgets.

This model introduces a system that has two interlinked key dimensions: decentralised leadership
and adaptive management processes (Roosli & Kaduthanam 2018). In the BB approach, decision-

MODULE 3
making is in the hands of empowered local managers, having responsibility for their units. It is
based on principles of employee empowerment, assuming that employees enjoy contributing
to the organisation they work for and they take pride in their work. This model therefore ‘relies
heavily on high levels of trust among employees with a strong commitment to customer focus’
(Eldenburg et al. 2017, p. 178). The core of this movement rests with extreme decentralisation
of decision-making, with minimal influence from centralised functions. Other important issues
of this model is its transparent accounting and reward systems with relative performance
evaluation. Further, this model uses rolling forecasts as a form of benchmarking, in which plans
are adapted and evolved over time, enabling managers to adapt quickly to changing conditions.
It is important to keep in mind that rolling forecasts are not equivalent to rolling budgets.
‘Rolling forecasts as the prediction of key values that may or may not be budget related for a
period of time into the future, while rolling budgets specifically link these updates to the budget’
(Bhimani et al. 2018, p. 308). It is argued that this approach to forecasting can be used as a means
to evaluate ‘relative performance assessment with hindsight’(Hansen et al. 2003) and motivates
employees towards CI.

To avoid the dysfunctional behaviour of traditional budgeting when used as a tool to evaluate
performance, BB uses ‘relative performance contracts with hindsight’ (Hansen et al. 2003, p. 101).
The relative component is because financial compensation is attached to the organisation’s
overall financial results and not relative to the unit’s performance. The hindsight component
means that the performance is evaluated against targets with hindsight. Thus, the performance
’level is not set inflexibly in advance, but will be established when the evaluation takes place and
is equal to the benchmarked performance’(Groot & Selto 2013, p. 147). BB therefore aims to
achieve goal congruence and ‘a philosophy of doing what is best for the firm in light of current
circumstances and to improve teamwork (Hansen et al. 2003, p. 102).

Although budgets are still developed in the BB approach, these budgets will not be used as
targets that must be achieved in performance evaluation. Thus, the planning and the performance
evaluation functions of budgets are separated. It is argued that, in future, less attention should
be given to managing performance through targets, budgets and bonuses, and more on creating
conditions to enable great performance (Bogsnes 2018). So the BB approach will encourage
cooperation, make local managers feel responsible for the performance of the entire organisation
and discourage internal rivalry among units.

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BB applies a more decentralised model of management control, which is consistent with strong
clan control (Groot & Selto 2013). BB relies on managers to make more strategy-focused planning
and control decisions, but without budgets. This ‘requires authority to be developed through
the hierarchical layers to lower level branches, teams and individual employees’ (Eldenburg
et al. 2017, p. 178), giving individuals autonomy and allowing them to quickly respond to,
for example, customers. BB focuses on radically decentralising organisations. It is argued that
radical decentralisation gives employees responsibilities and power to make decisions that
affect their activities and operations they are responsible for. For example, when decentralising
an organisation, the sales managers may have the authority to make decisions about the best
product or service for a local region, and local teams will have the authority to set prices,
offer discounts and make decisions about local marketing and advertising. This decentralisation
allows employees to be innovative and creative. Support units, such as accounting, HR and
information technology departments, will still be maintained as centralised functions.

While the BB approach sounds like a sensible approach for performance evaluation, not all
organisations will necessarily benefit from decentralisation. Further, the principles of the BB
approach have not been taken up widely across the globe. Only a cluster of Scandinavian
companies have taken up the principles of the BB approach and operate without targets and
budgets (Neely et al. 2003). The Swedish bank Svenska Handelsbanken prepared their last
budget in 1970. Skandia, a Swedish financial services organisation, uses a highly slimmed-
down budgeting process that only includes high-level budget figures. To manage their
business, they apply a ‘navigator’ scorecard framework. Another company, Borealis, prepared
their last budget in 1995. They use rolling forecasts to manage the future and a balanced
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scorecard to keep track of the organisation’s performance, and motivate staff through target
setting. Volvo abandoned budgets in 1994. They use quarterly forecast planning and monthly
reporting to manage their business.

Another organisation with a radical reengineering approach to improve the process of planning
and budgeting is Hilcorp Energy (Lalicker & Lambert 2018). McKinsey & Company undertook an
interview with the CEO of Hilcorp Energy, Greg Lalicker, about Hilcorp’s practices in planning
and control. Hilcorp has four practices:
1. Commitment to a flat organisation with no more than five layers above any employee.
2. Delegate decision-making, pushing decision-making as close to the front line as is practical.
3. Align goals and incentives. To ensure everyone makes decisions in the interests of meeting
company-wide targets, everyone gets the same amount, and all employees who achieve their
goals receive an incentive.
4. Have just enough process and control. Start the planning with a bottom-up plan that informs
the top-down plan.

A possible reason why the BB approach has not been widely implemented across the world is
because it lends itself towards a coaching management style, so requires a radical change in
mindset or a new management philosophy. Managing organisations without targets and budgets
requires trust, autonomy, transparency, helping each other, and accountability for creating value.
Managers and employees have to leave the safety of their comfort zones and move into a stretch
zone (Heupel & Schmitz 2015). In these stretch zones, ‘managers have to be ambitious, accept
risks and deal with uncertainty’ (Heupel & Schmitz 2015, p. 734). BB is an approach positioning
organisations to continuous development so that they can stay viable for the future (Roosli &
Kaduthanam 2018). Giving people the freedom to make their own decisions develops greater
coherence and strength.

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Review
This module provided an overview of budgets and how they are developed and used to evaluate
performance. It also discussed negative behavioural issues related to using budgets as a control
mechanism and alternative approaches that have been proposed consequently.

Part A discussed the roles and purposes of budgets and their relationship with an organisation’s
strategy and responsibility centres.

Part B detailed the various components of a master budget and developed operational budgets
for an example manufacturing organisation. It also described how financial and flexible budgets
are developed. Internal and external factors that should be considered in developing budgets
were provided.

Part C described why and how static budgets are flexed into flexible budgets. It then illuminated
how flexible budgets are used to analyse variances with actual results for manufacturing
organisations. Possible causes for variances are proposed.

Part D discussed participative budgeting and behavioural issues that result from budgetary control.
A discussion of monetary and non-monetary incentive schemes used to motivate performance
was provided.

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Part E detailed criticisms against traditional annual budgets and alternative approaches
proposed to alleviate these shortcomings.

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Suggested answers
Suggested answers

Question 3.1

MODULE 3
Although Kabuki Ltd has the capacity to convert 15 000 units per year, the forecast demand is
only 5000 units. Therefore, the forecast sales should be set at 5 000 units. In making this decision,
the following factors were considered:

It is not sensible to supply 15 000 units if there is only a demand for 5000. The market has
changed significantly and there is no guarantee that Kabuki will achieve its past success. If the
organisation produces 15 000 units and is not be able to sell them, this will result in significant
losses. They will incur unnecessary costs in producing the final product that they will not be able
to recoup from selling the products. If such products are produced, they will end up in inventory,
which will cost Kabuki Ltd more money as they will have to store the inventory and incur many
other costs related to inventory. Further, there is the risk that the inventory may be damaged or
become obsolete and has to be written off. Also, they may try to sell the products at a reduced
price, but that is also very risky.

Therefore, Kabuki should not budget to manufacture to full capacity but only to the sales
demand. Should it become apparent in the next year that they are able to sell more units than
budgeted for, they will be able to manufacture and sell it as they have the capacity.

Return to Question 3.1 to continue reading.

Question 3.2
The finished goods inventory budget will be linked directly to the direct materials, direct labour,
and the manufacturing overheads costs budgets and indirectly to the production and sales
budgets. These are linked because the direct materials costs budget is linked to the production
budget, which in turn is linked to the sales budget.

Return to Question 3.2 to continue reading.

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Question 3.3
The closing balance of cash at bank in the budgeted balance sheet is the closing cash figure
in the cash flow budget as at the end of the forecast period. This balance is determined by
adding the cash inflows for the period to the opening cash figure in the beginning of the
period, and subtracting the cash outflows for the period.

Return to Question 3.3 to continue reading.

Question 3.4
(a)
$

Sales volume 10 000

Sales—10 000 × $150 1 500 000

Direct material costs—12 000 × 1.2 × $40 576 000

Direct labour costs—12 000 × 30 / 60 × $25 150 000

Variable manufacturing overhead costs—12 000 × 30 / 60 × $9 54 000

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($9 = $720 000 / 80 000 hours)

Fixed manufacturing overhead costs—$2568 / 12 214

Operating profit 506 000

(b)
Sales price variance (AP – BP) × AQ
April sales: ($130 – $150) × 5000 = $100 000 U
May sales: ($160 – $150) × 9000 = $90 000 F
Total sales volume variance = $10 000 U

Sales volume variance Budgeted quantity is 5000 for April and 10 000 for May

Budgeted contribution margin per unit calculation:

Selling price $150

Direct material cost 1.2 kg × $40 $48
Direct labour cost 30 / 60 × $25 $12.50
Variable overhead cost 30 / 60 × $9 $4.50
Contribution margin $85

(AQ – BQ) × Bcm

(14 000 × 15 000) × $85
= $85 000 U

Direct material price variance Actual quantities of raw material used

Casual labourers: (2000 units × 1.2 kg) = 2400 kg

Permanent labourers: (14 000 × 1.1 kg) = 15 400 kg
Total actual quantities used = 17 800 kg
(AQ × AP) – (AQ × BP)
= (17 800 × $40) – (17 800 × $44)
= $71 200 U

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Direct material efficiency variance (AQ × BP) – [(BQ allowed AQ) × BP]
= (17 800 × $40) – [(1.2 × 16 000) × $40]
= $712 000 – $768 000
= $56 000 F

Direct labour price variance Actual quantities of labour hours used

Casual labourers: (2000 units × 30 / 60) = 1 000 hours

Permanent labourers: (12 000 units × 20 / 60) +
(2000 units × 30 / 60) = 4000 + 1000 hours
Total actual labour hours used = 6000 hours

(AQ × AP) – (AQ × BP)

= [(Casual: 1000 × $20) + Permanent: (4000 × $25 normal
hourly rate) + (1000 × $37.50 overtime rate)] – [6000 × $25]
= ($20 000 + $100 000 + $37 500) – $150 000
= $7500 U

Direct labour efficiency variance (AQ × BP) – [(BQ allowed AQ) × BP]
= (6000 × $25) × [(30 / 60 × 16 000 units manufactured) × $25]
= $150 000 – 8000 hours × $25
= $150 000 – $200 000
= $50 000 F

Variable manufacturing overhead Calculation of variable overhead allocation rate:

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spending variance
Cost driver is direct labour hours.
Total cost / cost driver
= $720 000 / 80 000 hours
= $9 per hour

Actual results – (AQ × BP)

Actual quantities of labour hours used was determined
above (6000 hours)
$60 000 – (6000 × $9)
= $60 000 – $54 000
= $6000 U

Variable manufacturing overhead (AQ × BP) – [(BQ allowed AQ) × BP]

efficiency variance = (6000 hours × $9) × [(30 / 60 × 16 000
units manufactured) × $9]
= $54 000 – 8000 hours × $9
= $54 000 – $72 000
= $18 000 F

Fixed manufacturing overhead Actual result – Static budget

spending variance = $220 000 – $214 000
= $6000 U

Fixed manufacturing overhead Calculation of fixed overhead allocation rate:

production volume variance
Cost driver is direct labour hours.
Total cost / cost driver
= $2 5680 000 / 80 000 hours
= $32.10 per hour

Static budget – Allocated: (BQ allowed AQ × BP)

= $214 000 – (30 / 60 × 16 000 units × $32.10)
= $214 000 – $256 800
= $42 800 F

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(c)
Causes for variances in sales The sales price variance will be negatively affected by
the $20 discount per unit for the 5000 backlogged April
units, thus there is an unfavourable variance of $100 000.
On the other hand, selling 9000 units at $10 per unit more
than budgeted will result in a favourable price variance
of $90 000. However, it is questionable whether the sales
manager should have increased the selling price due to
the increased price of the raw materials. The organisation
has a large enough contribution margin that it could be
argued that they should not pass the increased cost on
to the customers. Due to this, 1000 units have not been
sold, and are now part of the inventory, which may cost the
organisation additional costs to carry. Further, customers
were lost and it is uncertain whether the organisation will
be able to win them back.

The sales volume variance can be explained as 15 000

units that should have been sold according to the budgets
(5000 backlog of April and 10 000 units for May). However,
only 14 000 units were sold, resulting in a decrease in
revenue of $1 500 000 ($150 for 1000 units).

Causes for variances in direct material The purchasing and use of a superior quality of raw material
MODULE 3

will result in a favourable direct material efficiency variance.

However, because the purchase price of this material is
$4 per kilogram more expensive than the budget, the direct
material price variance will be unfavourable.

The permanent labourers were more efficient than forecast

and used 1.1 kg per unit instead of 1.2 kg per unit. This
contributed to a favourable direct material price variance.
However, although the casual labourers used the 1.2 kg
per unit forecast, they had to redo 1000 jobs, resulting in
a waste of 1200 kg (1000 units × 1.2 kg), contributing to an
unfavourable direct material efficiency variance.

Causes for variances in direct labour The direct labour price variance has a few explanations.
First, casual labourers were paid $5 per unit less than
the permanent labourers, resulting in a favourable price
variance. However, they had to redo all 1000 units they
made, and therefore $20 for 1000 cost was a waste,
contributing to an unfavourable price variance.

Second, due to the fact that permanent labourers had to

work overtime at time plus a half ($37.50) contributed
to an unfavourable price variance.

However, since a better quality of raw material was

purchased, the permanent labourers spent less time
manufacturing units, resulting in a favourable efficiency
variance. Having had to redo 1000 units, the casual labourers
contributed to waste and since double the amount of hours
were used to manufacture the 1000 units, an unfavourable
efficiency variance.

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Causes for variances in variable The actual variable overhead cost rate is $10 per labour hour
manufacturing overhead ($60 000 / 6000 hours). As this exceeds the budgeted rate by
$1, the spending variance is unfavourable. Variable overhead
costs consist of all the indirect overhead costs incurred
such as indirect material and labour, and any other
common variable manufacturing costs that are not directly
under the control of any particular production manager.
Consequently, these costs are allocated. To understand
the variable manufacturing overhead spending variance,
the management accountant could break these costs up
and investigate each line item. It is possible that some items
will exceed the budgeted costs while other will beat the
budgeted costs.

The favourable variable manufacturing overhead efficiency

variance is because of the cost driver used to determine
the overhead rate. The actual direct labour hours (6000) are
less than the budgeted direct labour hours (8000). Thus,
2000 hours × $9 = $18 000 favourable variance, which is
due to the permanent labourers spending 20 minutes per
unit for manufacturing 12 000 units instead of the budgeted
30 minutes per unit, saving 10 minutes, thus 2000 hours
in total.

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Causes for variances in fixed The fixed manufacturing overhead spending variance
manufacturing overhead could be due to renting or leasing storage for the
increase inventory.

(d)
Sales manager Sales price and sales volume variance.

As both are unfavourable, it would appear as if the sales manager should

not receive a bonus. The unfavourable sales volume variance can be
explained in part due to the reduced number of units sold. Including
the 5000 backlogged April units, 15 000 units should have been sold,
but only 14 000 units were sold. This is because customers bought their
products from the competitors, due to the increased sales price. Thus,
the organisation lost revenue of $1 500 000 (1000 units × $150). However,
the sales volume variance is determined using the contribution margin.
Therefore, when analysing this variance, the deviations in the variable
costs (both direct and indirect) should be considered as well. The latter
is not under the control of the sales manager.

The unfavourable sale price variance is due to the reduced price applied
to the 5000 units not able to be manufactured and sold in April. It is
understandable that the sales manager would have offered a reduced
price in order to retain the customers. However, the decrease is 13.333%
(20 / 150) and it could be argued that this is too high. Perhaps 5% would
have been sufficient. The sales manager should ‘know’ these customers
and in theory should be best to judge if this would have convinced
them to stay with the organisation.

In summary, the unfavourable variances are both due to the sales manager’s
decision to change the selling price per unit. Unless they can provide
plausible and sensible reasons to justify their decision, the sales manager
should not receive any bonus.

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 254 | PLANNING, BUDGETING AND FORECASTING

Production manager Direct material, direct labour efficiency and the direct labour price variance.

It appears the product plant operated efficiently as both direct material

and labour efficiency variances are favourable. The reasons they are relate
to the superior quality of the raw material, resulting in the permanent
labourers using less material and labour time to manufacture the
finished product.

In evaluating the performance of the production manager, these three

variances should be looked at simultaneously. In this example, when
offsetting the unfavourable direct labour price variance against the two
favourable efficiency variances, overall, the variances are favourable.
However, only looking at the final figures in these variances does not
expose the underlying causes of the variance and therefore a decision
to pay a bonus or not should not be made on the basis of these figures.
In this example, the unfavourable labour price variance is due to the fact
that the permanent labourers had to work overtime to ensure the finished
products were made on time, so that they could be sold on time and so
that having a backlog as happened in April could be avoided. However,
the question should be asked as to why they had to work overtime. Was it
to finish the goods on time or was it because of the inefficiencies of the
casual labourers?

The casual labourers caused the organisation to lose profit, as they had
MODULE 3

to redo 1000 jobs, wasting material and labour costs. Thus, the process
of their appointment needs to be investigated. Who was responsible
for their appointment—the production manager or the HR department?
Were they appointed due to poor or hasty decisions? The organisation
can learn from this to ensure better communication and coordination
in the future. Perhaps it would have been better to negotiate with the
customers—for example, by informing them that the products would
not be manufactured on time and offering them a reduced price.

In summary, it would appear that the production manager managed the

department well and therefore they should be awarded with a bonus.

Purchasing manager The direct material price variance.

This is unfavourable and it would appear that the purchasing manager

should not receive a bonus. However, the product purchases are of
superior quality than budgeted for, which resulted in both the direct
material and the direct labour variance being favourable, as less material
and fewer hours per unit were used. Further, this also resulted in a better
quality of product, which justifies the increase in the purchase price
of the raw material. In theory, an increase in the quality of the product
should justify an increase in the selling price. However, 10% of the
customers included in the budgeted sales for May (1000 / 10 000 units)
did not respond positively to the increase in the selling price. Therefore,
further analysis of the changes in manufacturing costs per unit and thus
the contribution margin should be done to determine how much of the
increased cost of direct material should be passed on to the customers
and what a reasonable increase in the selling price should be. In this
example, it would appear that although the variance is in costs that
the purchasing manager is responsible for, they still might be eligible
for a bonus because their decision had favourable consequences.

Return to Question 3.4 to continue reading.

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 Suggested answers | 255

Question 3.5
(a) The figures Martin provided are not challenging and realistic. The Akimo production
department has already achieved these levels, as demonstrated in the April actual results.

Total kilograms direct materials used: 2736 / 144 units = 19 kg per table
Total direct labour hours spent: 52.5 hours / 144 units = 21.875 minutes per table
Total machine hours used: 110 hours / 144 units = 45.83 minutes.

Martin probably chose these figures so that the Akimo department will be able to
achieve the budget easily, resulting in favourable variances, which will give him a positive
performance evaluation and ultimately a bonus.

(b) The following ways may be considered to illustrate to Martin that the budgeted figures he
provided are easy to achieve.
–– Since Akimo is only one department of Ariel’s operations, there might be other
departments that may be used as benchmarks.
–– If available, industry averages may be used.

Further, Martin needs to be made aware that his actions are not ethical.

If Martin does not respond well to these suggestions, the situation may be escalated up

MODULE 3
the hierarchy.

(c) Top management may appoint an independent person, such as a consultant, to conduct
studies on the efficiency of the Akimo department, so as to better understand the operations.
If it is found that the figures Martin provided are indeed too lenient, they could use these
studies to encourage him to improve his management of the Akimo department.

They could also reward the performance of the Akimo department (and consequently
Martin’s bonus) only if it increases productivity and not when it beats the budget.

Further, they could also find out what intrinsic factors motivate Martin so as to make decisions
whether to award Martin with monetary or non-monetary incentive schemes or both.
They could award Martin’s performance only if he sets accurate budgets.

Return to Question 3.5 to continue reading.

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Question 3.6
(a) The standards set for the following year’s budget are considerably higher than those used
in the previous year (in Question 3.5). Further, due to the changes in the design of the table,
use of different material and reduction of material quantities and machine hours, Martin may
feel unsure as to whether those standards will be met, even though employees will receive
training. This is further escalated by Martin’s belief that the company will not achieve the
budgeted profit. It is therefore likely that Martin may think it will be challenging to meet the
standards and he may be concerned that he will lose his bonus.

From this perspective, it appears that Martin’s behaviour could be viewed as deceptive—he
lowered the standard to meet the budget, have a favourable performance evaluation and
receive a bonus. He has misrepresented the Akimo department’s capabilities.

Potential drivers of Martin’s behaviour and decisions could include self-interest and fear of
losing his bonus. Martin’s goal (to lower the standards so that he can get a bonus) is not
aligned with that of the organisation (to have realistic standards to ensure the company
remains sustainable)—so there appears to be an absence of goal congruence.

(b) This is not an easy issue to deal with, because as it has potential to create a challenging
internal political situation of power and game playing. If the purchasing manager suspects
dysfunctional behaviour, he could refuse to change suppliers. If, however, the purchasing
MODULE 3

manager coheres with Martin, the management accountant may detect budgetary slack when
analysing the direct material price and efficiency variances. The labourers may report Martin’s
leadership. First, he instructed them to improve their efficiency, work harder and ensured they
received adequate training. They would have learned new skills that could have given them
intrinsic rewards such as job satisfaction and knowing that they are capable of performing
at a higher level. However, then Martin instructed them again to work slower. They may feel
undervalued and criticised, which may encourage them to report Martin’s expectations to
a higher hierarchy.

(c) Due to the redesign of the Akimo table, less raw material is required. This will be represented
in the standards set in the budget. However, the budget will be based on buying material
with a superior quality from the new supplier at an increased price. Therefore, if the cheaper
and inferior material is purchased, the direct material price variance will be favourable but
the direct material efficiency variance will be unfavourable. Further, the inferior quality of
raw material will result in an unfavourable efficiency variance. Since the labourers received
a pay increase, the direct labour price variance will be unfavourable, but it can be expected
that they will be more efficient and hence that the direct labour efficiency variance should
be favourable. But if they used the inferior material, there may be waste and hence an
unfavourable direct labour efficiency variance.

Return to Question 3.6 to continue reading.

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 References | 257

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