BUDGETARY & CONTROL

Prepared by Jessy ChongURL: chongsk818.blogspot.com

OBJECTIVES

A budgetary planning and control system is a system to ensuring communication, coordination and control within an organization. Ensure the achievement of the organisation’s objectives Compel planning Communicate ideas and plans Coordinate activities Provide a framework for responsibility accounting Establish a system of control Motivate employees to improve their performance

THE PLANNING AND CONTROL CYCLE Step 1: Identify objectives Step 2: Identify potential strategies Step 3: Evaluate strategies Step 4: Choose alternative course of action Step 5: Implement the long-term plan Step 6: Measure actual results and compare with

the plan Step 7: Respond to divergences from the plan

PLANNING & CONTROL IN THE PERFORMANCE HIERARCHY

1) Corporate plans / Strategic planso Prepared at a strategic level by senior managemento Focus on overall corporate performanceo Environmental influenceo Set overall plans & targets for units and

departmentso Some times qualitative planning

TACTICAL PLANS (CONT’D)

2) Tactical planso Prepared at lower management level within guidelines set by senior

managemento Time horizon typically 12 monthso Plans for individual departments or activities, some budgets may be

prepared in non-financial terms, but all budgets are converted into money values.

o The overall budget is expressed in financial terms, with a budgeted financial statement.

o Provides a link between strategic plans at senior level and operational planning.

o Budget targets should be consistent with strategic objectiveso Approved by senior management (Board of directors)

OPERATIONAL PLANS (CONT’D)

3) Operational planso Prepared by managers at a fairly junior level, at a

practical operational level.o Based on objectives about ‘what’ to achieve in

operational termso Operational targets likely to be quantitativeo Detailed specifications of targets and standardso Based on ‘how’ something is achievedo Short time horizons

CONTROL

Control involves two main processes.i. Measure actual results against the plan.ii. Take action to adjust actual performance to achieve

the plan or to change the plan altogether.

FEEDBACK CONTROL

Feedback occurs when the results (outputs) of a system are used to control it, by adjusting the input or behavior of the system. Feedback is information produced as output from operations; it is used to compare actual results with planned results for control purposes.

Feedback can be 2 signals:o Negative feedback indicates that results or activities must be brought back on

course, as they are deviating from the plan.o Positive feedback results in control action continuing the current course. You

would normally assume that positive feedback means that results are going according to plan and that no corrective action is necessary: but it is best to be sure that the control system itself is not picking up the wrong information.

TYPES OF FEEDBACK

Single loop feedback is control, like a thermostat, which regulates the output of a system. For example, if sales targets are not reached soon. The plan or target itself is not changed, even though the resources needed to achieve it might have to be reviewed.

Double loop feedback s of a different order. It is information used to change the plan itself. For example, if sales targets are not reached, the company may need to change the plan.

FEEDFORWARD CONTROL

This is a control based on forecast results: in other words if the forecast is bad, control action is taken well in advance of actual results.

TOP-DOWN BUDGETING

Top-down budgeting, budget targets are set at senior management level for the organization as a whole and for each major department or activity within the organization.

The departmental budget targets are then given to the departmental managers, who are required to prepare a budget that conforms to the targets that have been imposed on them from above.

The targets are then given to managers lower down the organization hierarchy and they are required to prepare budgets that meet the targets for their area of operations.

BOTTOM-UP BUDGETING

Bottom-up budgeting, the budgeting process starts at a relatively low level of management (operations).

Draft budgets are submitted to their superior, who combines the lower-level budgets into a combined budget for the department as a whole.

Departmental budgets are then submitted to senior management, where they are combined into a co-ordinate budget for the organization as a whole.

Two potential advantages:i. It reflects the views and expectations of mangers who are closer to operations

and so who may have a better understanding of what and what is not achievable.ii. Bottom-up budgeting is a form of participative budgeting process, which can

have behavioural and motivational advantages.

FACTORS TO CONSIDER

i. The attitudes of junior managers to their work.ii. The skills of junior managers relating to

budgeting.iii. The amount of interdependence between

departments.iv. The amount of ‘local’ knowledge of senior

managers.v. Culture of the organisation

INCREMENTAL BUDGETING

Incremental budgeting is a method of budgeting in which next year’s budget is prepared by using the current’s year’s actual results as a starting point, and making adjustments for expected inflation, sales growth or decline and other known changes.

USEFUL OF INCREMENTAL BUDGETING

The budget is stable, and change is gradual. Managers can operate their departments on a

consistent basis. The system is relatively simple to operate and easy to

understand. Conflicts should be avoided if departments can be

seen to be treated similarly. Coordination between budgets is easier to achieve. The effect of change can be seen quickly.

PROBLEMS WITH INCREMENTAL BUDGETING

Assumes activities and methods of working will continue in the same way. No incentive for developing new ideas. No incentives to reduce costs. Encourages “spend it or lose” mentally so that the budget is maintained

next year. The budget may become out of date and no longer relate to the level of

activity or type of work being carried out. The priority for resources may have changed since the budgets were set

originally. Managers may have overestimated their requirements in the past to obtain a budget which is easier to work to, and which will allow them to achieve favourable results.

There may be budgetary “slack” built into the budget, which is never reviewed.

FIXED BUDGET

The master budget, which is prepared and approved before the beginning of the budget period, is normally a fixed budget. The term ‘fixed’ means the following.

The budget is prepared on the basis of an estimated volume of production and an estimated volume of sales, but no plans are made for the event that actual volume of production and sales may differ from budgeted volumes.

When actual volumes of production and sales during a control period (month or four weeks or quarter) are achieved, the budget is not adjusted or revised (in retrospect) to the new levels of activity.

The major purpose of a fixed budget is for planning. It is prepared at the planning stage, when it is used to define the objectives and targets of the organization for the budget period (financial year).

FLEXIBLE BUDGET

A flexible budget is a budget which, by recognizing different cost behavior patterns, is changed as the volume of output and sales changes. It recognizes cost behavior patterns, such as changes in sales revenue and variable costs as sales volumes change, and step changes in fixed costs as activity levels rise or fall by more than a certain amount.

ZERO BASED BUDGETING (ZBB)

Zero based budgeting or also called as priority based budgeting, involves preparing a budget for each cost centre from a zero base.

Every item of expenditure has then to be justified in its entirety in order to be included in the next year’s budget. It is a method of budgeting which requires each cost element to be specifically justified, as though the activities to which the budget relates were being undertaken for the first time. Without approval, the budget allowance is zero.

ZBB is the opposite of incremental budgeting. Instead of creating the budget based on last year, in ZBB they create a budget as if that is the first year every time. (ie. There is never a last year to be referred to!)

IMPLEMENTING ZERO BASED BUDGETING

There are several formal stages involved in implementing a ZBB system but of greater importance is the development of an appropriate questioning attitude by all concerned. There must be a ‘value for money’ approach which challenges existing practices and expenditures and searching questions must be asked at each stage; typical of which are the following:

a) Does the activity need to be carried out at all? What would be the effects, if any, if it ceased?

b) How does the activity - existing or proposed - contribute to the organisation's objectives?

c) What is the correct level of provision? Has too much or (too little been provided in the past?

d) What is the best way to provide the function? Have all alternative possibilities been considered?

e) How much should the activity cost? Is this expenditure worth the benefits achieved?f) Is the activity essential or one of the frills? Etc.

BASIC APPROACH OF ZBB

Step 1: Define Decision Packageso Decision packages are activities or items in the

budget about which a decision should be made. Should this activity be included in the budget or not? Decision packages are used to rank activities in order of priority or preference. This ranking can be used to allocate scarce resources in the budget. Decision packages must be thoroughly documented.

TWO TYPES OF DECISION PACKAGES

a) Mutually Exclusive Packages

These are alternative forms of activity, tasks and expenditure to carry out the same job. The best option among the mutually exclusive packages is selected by comparing costs and benefits, and the other packages are then discarded. If there are two mutually exclusive decision packages, the preferred package is selected and the other rejected for budgeting purposes.

Naturally, mutually-exclusive packages would only be prepared when there

are quite clearly different approaches for dealing with the same function. Example, an organisation with a distribution problem might consider two alternative decision packages: Package 1 might be an in-house fleet of lorries, whereas Package 2 could involve contracts with independent haulers.

CONT’D

b) Incremental Packages These packages reflect different levels of effort in dealing with a

particular activity. There will be what is known as the base package, which represents the minimum feasible level of activity, and other packages which describe higher activity levels at given costs and resulting benefits.

Example, a base package for Personal Department might provide for staff engagement and termination procedures and payroll administration. Incremental packages might include; education and training, welfare and social activities, pension administration, trade union liaison and negotiations etc. Each package would have its costs benefits clearly tabulated.

STEP 2: EVALUATE AND RANK EACH DECISION PACKAGE

When the decision packages have been prepared; management will then rank all the packages on the basis of their benefits to the organisation. This is a process of allocating scarce resources between different activities, some of which already exist and other that are new.

Minimum requirements which are essential to get the job done and activities necessary to meet legal or safety obligations will naturally receive high priority. It’s been found that the ranking process focuses management's attention on discretionary or optional activities.

Because of the large number of packages prepared throughout the organisation, the ranking process can become onerous and time consuming for senior management. One way of reducing this problem is for lower level managers to level up the hierarchy. Alternatively, there could be cut-off limit for expenditure so that packages for a lower amount, say less than $2,000, could be ranked within the department and need not be referred higher.

STEP 3: ALLOCATE RESOURCES

When the overall budgeted expenditure level is decided upon the packages would be accepted in the ranked priority sequence up to the agreed expenditure level. When the ranking of lower cost packages has been delegated to departments the proportion of the expenditure budget remaining after the more expensive packages have been ranked would be allocated to individual departments. The departments would then rank their own small packages up to their allocated expenditure level.

ADVANTAGES OF ZBB

a) Properly carried out, it should result in a more efficient allocation of resources to activities and departments and provides a framework to ensure the optimum utilisation of resources by establishing priorities in relation to operational activity.

b) ZBB focuses attention on value for money and makes explicit the relationship between the input of resources and the output of benefits.

c) It develops a questioning attitude and makes it easier to identify inefficient, obsolete or less cost-effective operations and it concentrates the attention of management on the future rather than on the past

d) The ZBB process leads to greater staff and management knowledge of the operations and activities of the organisations and increase motivation.

ADVANTAGES OF ZBB (CONT’D)

e) It is a systematic way of challenging the status quo and obliges the organisation to examine alternative activities and existing cost behaviour patterns and expenditure levels and can assist motivation of management at all levels

f) It helps to create an organisational environment where change is accepted;

g) It helps management to focus on company objectives and goals;h) It provides a plan to follow when more financial resources

become available;i) It establishes minimum requirements from departments;j) It can be done piecemeal.

DISADVANTAGES OF ZBB

a) It is a time consuming process which can generate volumes of paper work especially for the decision packages.

b) There is considerable management skill required in both drawing up decision packages and for the ranking process. These skills may not exist in the organisation.

c) It may encourage the wrong impression that all decisions have to be made in the budget. Circumstances change and new opportunities and threats can arise at any time and organisations must be flexible enough to deal rapidly with these circumstances when they occur.

d) ZBB is not always acceptable to staff or management or trade unions who may prefer the cosy status quo and who see the detailed examination of alternatives, cost and benefits as a threat not a challenge.

DISADVANTAGES OF ZBB (CONT’D)

e) There are considerable problems in ranking packages and there are inevitably many subjective judgements. Political pressures within organisations also contribute to the problem of ranking different types of activity, especially where there are qualitative rather than quantitative benefits.

f) It may emphasise short term benefits to the detriment of longer term ones which in the end may be more important.

g) It takes time to show the real benefits of implementing such a system.

ACTIVITY BASED BUDGETING

Activity based budgeting (ABB) follows principles of activity based costing (ABC) “in reverse”. Having decided how many units to produce and sell, then organization then needs to define the cost of the activities required to produce them. These depend on the drivers identified for each activity.

A typical ABB exercise may follow these steps:1) Estimate the expected output (units) for each product.2) Identify the number of units of each activity which will be required to produce the

output. This is based on knowledge of the relationships between the output and the activities required to be performed to produce the output.

3) Determine the resources needed to perform the activities required. This is based on knowledge of the drivers – the factors which influence the price of the activities.

4) If the current commitment of resources is such that too many or too few resources exist to perform the activities required in Step 3, and then adjust accordingly.

ADVANTAGES OF ABB

a) Management attention is focused on the activities of the organization. These are something which management can control more easily than focusing on total costs.

b) Better understanding of what causes costs to be incurred may provide opportunities for cost reductions.

c) May identify non-value added activities which can be estimated.

DISADVANTAGES OF ABB

a) Complicated and expensive to implement. More suited to large organizations with multiple products and many drivers.

b) Many fixed costs do not vary with changes in the volume of drivers in the short run – so ABB may provide misleading information.

ROLLING BUDGETS

Rolling budgets (also called continuous budgets) are budgets which are continuously updates by adding a further accounting period (a month or quarter) to the end of the budget when the corresponding period in the current budget has ended.

This approach to budgeting helps to eliminate the adverse impact of environmental uncertainties on setting goals by updating the budget in quick succession.

This budget encourages a forward-looking attitude.

ADVANTAGES OF ROLLING BUDGETS

a) They reduce the element of uncertainty in budgeting because they concentrate detailed planning and control on the near-term future, where the degree of uncertainty is much smaller.

b) They force managers to reassess the budget regularly, and to produce budgets which are up to date in the light of current events and expectations.

c) Planning and control will be based on a recent plan which is likely to be far more realistic than a fixed annual budget made many months ago.

d) Realistic budgets are likely to have a better motivational influence on managers.

e) There is always a budget which extends for several months ahead. For example, if rolling budgets are prepared quarterly there will always be a budget extending for the next 9 to 12 months. This is not the case when fixed annuals budgets are used.

DISADVANTAGES OF ROLLING BUDGETSa) They involve more time, effort and money in budget

preparation.b) Frequent budgeting might have an off-putting effect on

managers who doubt the value of preparing one budget after another at regular intervals.

c) Revisions to the budget might involve revisions to standard costs too, which in turn would involve revisions to stock valuations. This could replace a large administrative effort from the accounts department every time a rolling budget is prepared.

d) The benefits of rolling budgets are limited, and so not worth the extra cost, when the rate of charge in the business environment is not rapid and continual.

MASTER BUDGETS

Master budget is a consolidation of the various operational and financial budgets. It is a projected financial plan. Budgeted financial statements are prepared on the basis of the master budget.

ADVANTAGES OF MASTER BUDGETS

a) It helps to co-ordinate all the other budgets and to devise the short-term objectives of an organization. Any conflict between departments is resolved by the master budget as it is a consolidation of all the functional budgets.

b) It is a good medium of communication between the various departments as it consolidates the functional budgets.

c) It enables an overall plan for achieving the budget targets to be prepared. Budget income statements, budgeted cash flow statements and forecasted balance sheets are prepared using the master budget.

d) The master budget incorporates the targets of every department and therefore acts as a measure of performance evaluation.

DISADVANTAGES OF MASTER BUDGETS

a) Budgets are based on forecasting. This means they are vulnerable to uncertainty in the environment.

b) Master budget is based on certain assumptions that may not prove correct over the period.

FUNCTIONAL BUDGET

Functional budgets are prepared for an individual function. For each operation in the organization a budget is prepared.

Sales budget, Purchase budget, Production budget, Cash budget etc. are examples of a functional budget. These budgets are consolidated to arrive at a master budget.

ADVANTAGES OF FUNCTIONAL BUDGET

a) A functional budget gives targets to the individual functional manager.

b) Those who actually implement the budget prepare the functional budget. They are familiar with the problems at the grass-root level. Therefore the budgets are more realistic and motivating.

DISADVANTAGES OF FUNCTIONAL BUDGET

a) As the functional managers prepare the functional budgets, the targets may not be in line with the strategic objectives or may conflict either with the organizational objectives or inter-departmental objectives. This problem can be avoided by encouraging co-ordination between the functional managers.

b) Functional budgets are based on forecasts. There are many external as well as internal environmental factors (such as change in demand for a product, non-availability of a particular raw material, high attrition causing shortage of skilled labourers, etc) that affect the functional budgets. If these factors behave differently than predicted, this may render the budgetary system ineffective.

INFORMATION USED IN BUDGET SYSTEMS

Sales Budget Information Before the sales budget can be prepared a sales forecast has to be

made. Sales forecasting is complex and difficult and involves the use of information from a variety of sources.

Past sales patterns New legislation The economic environmentDistribution Results of market research Pricing policies and discounts

offered Anticipated advertising Legislation Competition Environmental factors Changing consumer taste

PRODUCTION BUDGET INFORMATION

Sources of information for the production budget will include:

a) Labour costs including idle time, overtime and standard output rates per hour.

b) Raw material costs including allowances for losses during production.

c) Machine hours including expected idle time and expected output rates per machine hour.

CHANGING BUDGETARY SYSTEMS An organization wishing to change its budgetary practices will face a number of difficulties.a) Resistance by employees. Employees will be familiar with the current system and may

have built in slack so will not easily accept new targets. New control systems that threaten to alter existing power relationships may be thwarted by those affected.

b) Loss of control. Senior management may take time to adapt to the new system and understand the implications of results.

c) Costs of implementation. Any new system or process requires careful implementation which will have cost implications. For example, the procedures for preparing budgets will have to be re-written in a new budget manual. Establishing a system of zero based budgeting, for example, will require the design and documentation of a large number of decision packages.

d) Training. In order to prepare and implement budgets under the new system, managers will need to be fully trained. This is time-consuming and expensive.

e) Lack of accounting information. The organization may not have the systems in place to obtain and anaylse the necessary information for preparing the new style budget. For example, an organization needs a system of activity-based costing if it is to implement ABB.

BUDGET SYSTEMS AND UNCERTAINTY

Uncertainty can be allowed for in budgeting by means of flexible budgeting, rolling budgets, probabilistic budgeting and sensitivity analysis.

Causes of uncertainty in the budgeting process include:a) Customers. They may decide to buy less than forecast, or they may buy more.b) Products/services. In the modern business environment, organizations need to

respond to customers’ rapidly changing requirements.c) Inflation and movements in interest and exchange rates.d) Volatility in the cost of materials.e) Competitors. They may steal some of an organization’s expected customers, or

some competitors’ customers may change their buying allegiance.f) Employees. They may not work as hard as was hoped, or they may work harder.g) Machines. They may break down unexpectedly.

h) There may be political unrest (terrorist activity), social unrest (public transport strikes) or minor or major natural disasters (storms, floods).

Rolling budgets are a way of trying to reduce the element of uncertainty in the plan. There are other planning methods which try to analyse the uncertainty such as probabilistic budgeting (where probabilities are assigned to different conditions) and sensitivity analysis. These methods are suitable when the degree of uncertainty is quantifiable from the start of the budget period and actual results are not expected to go outside the range of these expectations.