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Managing Finance and Budgets
Lecture 10
Budgetary Control
Session 10 – Budgetary Control
KEY CONCEPTS Forms of budget-setting Financial control structures and techniques Behavioural Issues Non-financial measures
Section A:
Forms of Budget-setting
Forms of budget-setting
Incremental budgeting Zero base budgeting Activity Based Budgeting Standard costing
Incremental Budgeting
Traditional form of Budgeting, Common in local & central government
Costs and Allocations of monies tend to be on the basis of what happened in previous years
Adjustment (increments) are made on the basis of changes (e.g. inflation, increases in productivity, workforce etc.) that happen from year to year.
Often used for ‘discretionary’ budgets (i.e. where budget holder is responsible for allocating a sum of money within a department)
No clear relationship between the input or output (e.g the raw materials required or the level of sales produced)
Zero-Base Budgeting (ZBB)
Draws on the philosophy that ALL spending needs to be justified.
All budgets are allocated a zero base, and will be increased from this only if a good case can be made out for the money
Senior management will be using the criterion of ‘value for money’ to allocate scarce resources.
ZBB encourages managers to adopt a questioning approach; this leads to more strategic thinking and allocation of resources to enable this strategy to happen
Clear links required between input/output and the resourcing
Activity-Based Budgeting (ABB)
Applies the philosophy of Activity-Based Costing to the Budget process, recognising that activities ‘drive’ costs
If ‘cost-driving’ activities can be identified, then the cost of the output can be achieved more accurately)
Central feature: budget holders (those who are responsible for meeting a particular budget) have control over the events that affect performance in their area.
ABB tries to generate budgets in such a way that the manager who has control over the cost drivers is accountable for those costs.
Typical problems: increased levels of activity generated from outside the manager’s control, e.g. Manufacturing Budget thrown into disarray by a new sales contract
Standard Costing
Embodies the idea that standard quantities and costs can be planned for individual units such as sales items, labour rates, raw materials etc.
The standards are targets, and become benchmarks by which actual performance s measured.
The targets are derived from experience, market assessments, current rates (e.g. labour, fees etc.)
The targets should be realistic. Variances (differences between the budgeted amounts
and the actual amounts) are always based on standards.
Activity One
What are the advantages and disadvantages of zero-based budgeting? How might any disadvantages be overcome?
Activity One- Solution
Advantages• Little Wastage of
Resources• Strategic use of
resources, enable plans to be fulfilled more easily
Disadvantages• Time Consuming• Managers can often feel
threatened by ZBB
The disadvantages can be countered by using the approach selectively, for example on every third year, or on particular budgets which tend to require strategic input, e.g. training, advertising, research & development.
Section B:
Financial Control Techniques
Financial Control Techniques
Flexing (but not ignoring) budgets Management by exception Variance Analysis
The budgetary control process
Prepare budgets
Perform and collect information on actual performance
Respond to variances between planned and actual
performance and exercise control
Budgetary Control Structures
Budgets provide a useful mechanism for control. This starts with the detailed planning within the budget,
which forms the basis for exercising control In addition we need a basis for measuring actual
performance against planned performance Finally in exercising control, we need a means of finding
out where and why events deviated from the plan, and ways of rectifying these.
Performance Comparison
This Budget is part of the Profit and Loss budget for a manufacturing company
The amounts shown represent targets to be achieved for a particular product line during the next 12 months.
This allows us to compare our prediction with what actually happens.
Budget Sales (Units): 1000
£ 000 BudgetValue of Sales 100
Direct CostsMaterials 40 Labour 20
Total Direct Costs 60Gross Profit 40Overheads Admin Salaries 20 Travel 5 Other costs 20 Total Overheads 45
Net Profit (5)
Comparison of Actual Performance (1)
Original Budget Actual Figures Sales 1000 Units Sales 1040 Units
Original Actual £ 000 Budget FiguresValue of Sales 100 104Direct Costs Materials 30 37 Labour 25 24Total Direct Costs 55 61 Gross Profit 45 43Overheads Admin Salaries 20 19 Travel 5 8 Other costs 17 17Total Overheads 42 44Net Profit 3 (1)
Here we can see what has happened at the end of the period:
Although we have produced and sold slightly over target,
the sharp rise in the cost of materials
means that we have made an overall loss.
Here we can see what has happened at the end of the period:
Although we have produced and sold slightly over target,
the sharp rise in the cost of materials
means that we have made an overall loss.
Comparison of Actual Performance (2)
Original Budget Sales (Units): 1000 Actual Sales (Units): 1500Original Actual
£ 000 Budget FiguresValue of Sales 100 150Direct Costs Materials 30 47 Labour 25 25Total Direct Costs 55 72 Gross Profit 45 78Overheads Admin Salaries 20 27 Travel 5 10 Other costs 17 23Total Overheads 42 60Net Profit 3 18
Here the original sales targets have been well exceeded, and we have increased our profits considerably
However all is not as well as it seems!
Here the original sales targets have been well exceeded, and we have increased our profits considerably
However all is not as well as it seems!
Flexible Budgets
If it becomes apparent before the end of the year that there is a huge discrepancy between the actual performance and the budget, it may be necessary to revise targets.
This might happen if there are unexpected surges or slumps in demand, or the economic situation changes.
This does not mean that we dispense with the budget altogether, and write a new one.
Flexible budgeting allows selected targets to be revised. The revised budget is said to be ‘flexed’.
Comparison with Flexed Budget
Original Budget Sales (Units): 1000 Actual Sales (Units): 1500Original Flexed Actual
£ 000 Budget BudgetFiguresValue of Sales 100 150 150Direct Costs Materials 30 45 47 Labour 25 30 25Total Direct Costs 55 75 72 Gross Profit 45 75 78Overheads Admin Salaries 20 20 27 Travel 5 8 10 Other costs 17 17 23Total Overheads 42 45 60Net Profit 3 30 18
Here we have written in new targets on the basis of the new sales figures. We can now see that despite the fact that we have increased our profits, this is well below what we should have achieved.
Here we have written in new targets on the basis of the new sales figures. We can now see that despite the fact that we have increased our profits, this is well below what we should have achieved.
Management by Exception
• By using flexible budgets, decision-making and responsibility can be delegated to junior management.
• Control is retained by senior management, since they can use the budgetary targets to determine which junior managers are meeting targets.
• This means that energy can be concentrated on those areas which are under-performing – the exceptions.
• This process is called Management by Exception.
Variance Analysis
Used to analyse performance and promote management action
Variance = difference between the Budgeted amount and the actual amount; this can be adverse or favourable.
Variances might cover: Sales Volume, Pricing, Direct Materials Usage, Direct Materials Price, Direct Labour Efficiency, Direct Labour rate, Fixed Overheads
They can be calculated using absorption costing or marginal costing
Limitations include out-of-date standards; inappropriate absorption of fixed overheads into cost units; and focus on price at expense of other more important issues (j-i-t)
Sample Variance Analyses
Sales Volume Variance
The difference between the profit as shown in the flexed budget and the actual profit
Flexed Budget: Profit : £30,000
Actual Figures Profit: £12,000
Sales Volume Variance: £18,000 Adverse
Sample Variance Analyses
Direct Material PRICE variance
(Actual material purchased x standard price) less Actual cost of material purchased
Direct Material USAGE variance
(Standard quantity of material required for actual production x standard price) less (Actual material x standard price
Total Direct Material variance
Standard direct material cost less Actual direct material cost
Direct materials
usage variance
Direct materials
price variance
Total direct materials variance
Relationship between the total, usage and price variances of direct materials
equals
minus
Actual profit
plus
All adverse variances
All favourable variances
Budgeted profit
Relationship between the budgeted and actual profit
Key elements for budgetary control
Achievable yet rigorous targets Accurate, relevant, customised and timely reporting Short reporting periods (e.g. one month) Clear lines of responsibility Accountability Action taken to control operations Flexibility where appropriate Serious attitude from higher management towards
importance, relevance and accuracy of budgets
Section C:
Behavioural Issues
Budgets – Behavioural issues
Budgets are often: Restrictive; it becomes more difficult to take advantage of
opportunities since the expenditure has already been allocated.
Inflexible; money often needs to be spent within a particular time-frame. It discourages managers from thinking strategically.
Seen as a maximum instead of a target Prone to end-of-year expenditure ‘binges’ Catalysts for organisational conflict
Budgets - Behavioural issues
Budgets must be seen as attainable. Highest performance is achieved by setting the most difficult specific goals which are acceptable to manager
Control information must be understood Aims of budgets must be understood Participation in setting processes is crucial to acceptance,
job satisfaction and motivation Participation is also likely to increase accuracy Participation should decrease distortion and manipulation...
but may not as managers may deliberately introduce ‘slack’ (I.e. deliberately over-or under estimate items during the budget-setting negotiations)
Budgets for performance evaluation
Where evaluation of performance is based on the ability of the manager to meet the budget a range of factors occurs:• Rigidity – the manager feels straitjacketed by the budget,
and restrained from taking risks, as this might create adverse variances.
• Fixation- There is a focus on budget at expense of other criteria
• Manipulation: Figures are often ‘massaged’ or distorted in order to present the department in the best light.
• Exaggeration: Introduction of slack during budget-setting processes
Activity Two
A Sales Manager believes that she could reach her overall sales budget target by reducing prices and selling a higher volume of units.
Why might it not be sensible for her to do so?
What overall issues does this raise about budget monitoring and control?
Activity Two Solution 1
A Sales Manager reaches her overall sales budget target by reducing prices and selling a higher volume.
This is not sensible because:• Production targets will have been set in the production budget;
this will involve budgeting for raw materials and labour etc. Suddenly selling more will cause problems elsewhere; this will mean that higher stock levels will be required, and may cause problems with debtors.
• Similarly, reducing prices will reduce profitability. This will have an effect on the company’s balance sheet, and may ultimately reduce dividends to shareholders.
Activity Two Solution 2
What overall issues does this raise about budget monitoring and control?
• Budgets are interrelated, and targets are set to dovetail; individual managers need to know how their targets match with those of others. One way to do this is through a budgetary committee, and participation in the budgetary process.
• Managers not only need targets, they need to know to what extent under ‘normal conditions’ those targets can be flexed, that is, by how much can we exceed or fall short without a new budget needing to be set?
Section D:
Non-Financial Measures in Budgets
Non financial measures in budgeting
The budget itself tends to be a document which apportions money according to a strategic plan
In manufacturing, the money sets numerical targets for input, throughput and output.
However, in service industries and in other areas such as Education and the National Health Service it is difficult to measure ‘output’ using conventional financial means.
It is increasingly the case that other, non-financial measures are used as a basis for reporting.
These measures are incorporated into budgeting process
Examples of Non financial measures
General Examples of these include:• Customer satisfaction• Product quality• Delivery efficiency• Supplier quality• Supplier delivery• Set-up times• Throughput times• Wastage• Employee satisfaction
Specific Non financial measures
There are two specific examples : Patient Waiting Times in the NHS Pupil Performance Indicators for Schools
In both cases: These are Non-financial Measures which appear as
targets for specific institutions. These are treated in the same way as other budgetary
measures, i.e. institutions are compared with one another (league tables) and their past performance (looking for year-on-year improvement)
These are elements of control; resources follow the successful achievement of targets.
Activity Three
What particular problems might be caused in a hospital by the incorporation of non-financial targets such as “Average patient waiting time” in an A & E Department as part of their budgetary considerations?
Activity Three – Solution (1)
The problems are exactly the same as those outlined for financial targets:
Rigidity – managers may feel straitjacketed by the targets and manage purely to meet rather than exceed them; this means that ‘natural grass-roots development’ tends to be stifled. (e.g. new types of procedure which might ultimately lead (in the long run) to improved patient care will not be implemented, as in the short run this might result in failure to meet targets.)
• Fixation- There is a focus on the target at expense of other criteria.In the example given, it could lead to undifferentiated patient care (e.g. a patient with a cut finger becomes as important as road traffic accident victim)
Activity Three – Solution (2)
Manipulation: The department is reorganised in such a way as to present figures which meet the target, but do not necessarily result in improvements. (e.g. All patients are met at the door by a doctor, and then asked to wait – this technically reduces the waiting time to zero, but does not improve the service)
• Exaggeration: Accounting procedures are put in place which locally redefine what the target means. (e.g. Average patient waiting time redefined as: the time before first treatment divided by the total number of separate visits by a doctor or nurse subsequently.)
Follow-up to Lecture Ten - Activities
KEY CONCEPTS:
Forms of budget-setting
Financial control structures and techniques
Behavioural Issues
Non-financial measures