Managing Finance and Budgets

Lecture 11

Budgetary Control

Session 10 – Budgetary Control

ObjectivesBy the end of this week, you will: Be able to discuss how a budget is constructed. Be able to state different budgeting principles, and how

these might be used in different situations. Know how budgetary targets might be used as controls. Be able to discuss some of the ways in which managers

react to budgetary targets Know some of the non-financial measures used in

budgeting.

Steps in the budget setting and control process

1. Establish responsibility for the budget-setting process

4. Prepare the budget for the area of the limiting factor

5. Prepare draft budgets for all other areas

8. Communicate the budgets to all interested parties

2. Communicate budget guidelines to relevant managers

3. Identify the key or limiting factor

6. Review and co-ordinate budgets

7. Prepare the master budgets

9. Monitor actual performance relative to the budget

10. Act to ensure performance conforms to the budget

Budgets – Time horizons

Periodic budget This is a one-off budget set for a year (e.g.) It is normally broken down into monthly or weekly

amounts

Continual Budget This will be updated continually (still for one year, but a

new month will be added to replace the one which has passed.)

Methods used in budget-setting

Incremental Budgeting:

- same as last year with a bit added

Zero Base Budgeting

- budget holders required to justify why any money is needed

Activity Based Budgeting

- those responsible for activities which incur costs hold the budgets

Standard costing- standard quantities & costs used to generate targets.

Sensitivity Analysis- computer software used to answer ‘what-if’ questions.

The budgetary control process

Prepare budgets

Perform and collect information on actual performance

Respond to variances between planned and actual

performance and exercise control

Simple 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 Budgeting

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.

Variance Analysis

Used to analyse performance and promote management action

Variance - the difference between the budgeted amount and the actual amount; this can be

adverse : the difference will ultimately lead to a reduction in the budgeted profitfavourable: the difference will ultimately lead to an increase in the budgeted profit.

Variances might cover: Sales Volume, Pricing, Direct Materials Usage, Direct Materials Price, Direct Labour Efficiency, Direct Labour rate, Fixed Overheads

equals

minus

Actual profit

plus

All adverse variances

All favourable variances

Budgeted profit

Relationship between the budgeted and actual profit

Types of Control

There are essentially two types of control used in budget management:

Feedback Control: where the information from actual performance is used to cause actions to be taken to rectify an unfavourable situation.

Feedforward control: where action is taken in advance to anticipate what might occur, and therefore avoid an unfavourable outcome.

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 of the budget holder Records of action taken to control operations Flexibility provided where appropriate Serious attitude from higher management towards

importance, relevance and accuracy of budgets

The use of Targets for Control

Targets in themselves are a useful means of control. These are devolved down to junior managers who are able to monitor & self-correct.

Regular upwards reporting of performance to targets means that problems which occur will be relatively minor and easier to deal with.

It is only when large variances occur between targets and actual performance that further investigation & intervention is required.

Investigating Variances

This can be expensive in terms of time and money. Knowing the reason for a variance is only useful if an

investigation into its cause can yield a method for rectifying it. To decide whether this should be done, we can use the statistical

notion of significance. In this case, we would regard variance to be significant if it was greater than 5%. In this case:Significant adverse variances will need to be acted upon.Significant favourable variances should be investigated.Insignificant variances should simply be kept under review.

We can only act on variances if the cause of them is known, and there are clear courses of action to be taken

Acting on Variances 1

Example 1: In a large retailing company, variance in budgeted Profit & Loss half way through the year shows a projected shortfall in budgeted profit of 15% at year end. This is traced back to a reduction in turnover; sales targets are not being met in the being met in stores in the South West of England.

Action TakenArea Sales Manager to meet with Marketing Team; members of the team to focus on particular stores, examining sales records; team to visit & advise, and devise a strategy unique to that store. Targets to be kept under weekly review, Area Sales Manager reporting directly to Financial Director.

This is an example of a feedback control, as the unfavourable situation has already occurred.

This is an example of a feedback control, as the unfavourable situation has already occurred.

Acting on Variances 2

Example 2:

In a small engineering company, variance in budgeted Cash Flow predicts a potential cash-flow crisis in two week’s time, on further investigation this appears to be due to late payment by a valued customer.

Action Taken

Credit control to contact customer and negotiate payment; however, the payment will arrive too late to avert the cash flow crisis. Bank contacted and alerted to potential problem,. Temporary overdraft facility negotiated.

This is an example of a feedforward control, as the unfavourable situation has not yet occurred.

This is an example of a feedforward control, as the unfavourable situation has not yet occurred.

Management by Exception

• The use of budgetary targets is an important way in which decision-making and responsibility can be delegated to junior management.

• Control is retained by senior management, since they can use the variances to determine which junior managers are meeting or exceeding their targets.

• This means that energy can be concentrated on those areas which are under-performing – the exceptions.

• This process is called Management by Exception.

Positive Reactions to Budgets

Budgets can be: Motivating - Targets become clear, and if the goals are

attainable, this provides a sense of fulfilment in achieving them. Empowering - budgets set boundaries within which to work;

each manager knows their resources, and is able to work autonomously within the limits set to achieve their targets.

Inclusive - where the budget-setting process is dynamic, iterative and based on true negotiation, this can help form a sense of community in which all managers feel that they have a contribution to make, and understand their role within the organisation more fully.

Negative Reactions to Budgets

Budgets are often seen as: 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.

Limiting: targets are seen as a maximum instead of a threshold.

Self-defeating: prone to end-of-year expenditure ‘binges’ Confrontational: - they become catalysts for organisational

conflict

Budgets as 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

Management Styles

When confronted by budgets, managers appear to adopt one of three styles:

Budget-constrained styleManagers focus only on the targets, and on performance of subordinates in that context; all other issues are deemed irrelevant.

Profit-conscious styleManagers use budget information in a flexible way, and in conjunction with other data. Emphasis is on overall improvement; budget data is just one piece in the jigsaw.

Non-accounting styleManagers ignore the budget & targets are not seen as relevant.

Keys to Successful Budgeting (1)

Information is the key: Aims of budgets must be understood. This means

communicating as much of the background ( corporate strategy, short-term objectives, limiting factors) as possible.

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, as well as the consequences of targets not being met.

Keys to Successful Budgeting (2)

Participation is the key: It is crucial in the budget-setting process to

acceptance, job satisfaction and motivation It is also likely to increase accuracy It should decrease distortion and manipulation...

However: Managers may deliberately introduce ‘slack’ (I.e.

deliberately over-or under estimate items during the budget-setting negotiations)

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.

Where these relate to ‘hard data’, based on measurable objectives, targets can be incorporated into the budgeting process

Examples of Non Financial measures

General examples of these include:

• Product quality• Delivery efficiency• Supplier quality• Supplier delivery• Set-up times• Throughput times• Wastage• Customer satisfaction• 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.

Follow-up to Lecture 10 - Activities

Reading All of chapters 12 and 13 of M & A, except the details of

material on variances pp pp 395-404.

Activity. Attempted the test material on budgets on the M & A

website, sections 12 & 13. There will be no questions in the examination which ask you to calculate budgets, so any of these questions which require calculation (e.g. calculation of specific variances) can be omitted.

The seminar this week will focus purely on the examination.