Pearson Education Management Accounting for Decision Makers_7 pdf

Inpractice, budgeting can be a lengthy process that may involve much negotiation,reworking and updating, and may add little to the achievement of business objectives; l are based around

Whether budgets seem to be effective and how they can be made more effective arecrucial issues for managers We shall examine this topic in detail in the next chapter,after we have seen how budgets can be used to help managers to exercise control.

Until recently it would have been a heresy to suggest that budgeting was not of centralimportance to any business The benefits of budgeting, mentioned earlier in this chapter, have been widely recognised and the vast majority of businesses prepareannual budgets However, there is increasing concern that, in today’s highly dynamicand competitive environment, budgets may actually be harmful to the achievement ofbusiness objectives This has led a small but growing number of businesses to abandontraditional budgets as a tool of planning and control

Various charges have been levelled against the conventional budgeting process It isclaimed that budgets

l cannot deal with a fast-changing environment, and are often out of date before thestart of the budget period;

l focus too much management attention on the achievement of short-term financialtargets Instead, managers should focus on the things that create value for the business (for example, innovation, building brand loyalty, responding quickly tocompetitive threats, and so on);

l reinforce a ‘command and control’ structure that concentrates power in the hands

of senior managers and prevents junior managers from exercising autonomy Thismay be particularly true where a top-down approach, that allocates budgets to managers, is being used Where managers feel constrained, attempts to retain andrecruit able managers can be difficult;

l take up an enormous amount of management time that could be better used Inpractice, budgeting can be a lengthy process that may involve much negotiation,reworking and updating, and may add little to the achievement of business objectives;

l are based around business functions (sales, marketing, production, and so on).However, to achieve the business’s objectives, the focus should be on business pro-cesses that cut across functional boundaries and reflect the needs of the customer;

l encourage incremental thinking by employing a ‘last year plus x per cent’ approach

to planning This can inhibit the development of ‘break-out’ strategies that may benecessary in a fast-changing environment;

l can protect costs rather than lower costs In some cases, a fixed budget for an activity, such as research and development, is allocated to a manager If the amount

is not spent, the budget may be taken away and, in future periods, the budget forthis activity may be either reduced or eliminated Such a response to unused budgetallocations can encourage managers to spend the whole of the budget, irrespective

of need, in order to protect the allocations they receive;

l promote ‘sharp’ practice among managers In order to meet budget targets, managersmay try to negotiate lower sales targets or higher cost allocations than they feel

is really necessary This helps them to build some ‘slack’ into the budgets and someeting the budget becomes easier (see reference 2 at the end of the chapter).Although some people believe that many of the problems identified can be solved bybetter budgeting systems such as activity-based budgeting and zero-base budgeting and bytaking a more flexible approach, others believe that a more radical solution is required

Who needs budgets?

In recent years, a few businesses have abandoned budgeting, although they still recognise the need for forward planning No one seriously doubts that there must beappropriate systems in place to steer a business towards its objectives It is claimed,however, that the systems adopted should reflect a broader, more integrated approach

to planning The new systems that have been implemented are often based around a

‘leaner’ financial planning process that is more closely linked to other measurementand reward systems Emphasis is placed on the use of rolling forecasts, key performanceindicators (such as market share, customer satisfaction and innovations) and/or ‘score-cards’ (like the balanced scorecard, which we shall meet in Chapter 9) that identifyboth monetary and non-monetary targets to be achieved over the long term and shortterm These are often very demanding (‘stretch’) targets, based on benchmarks thathave been set by world-class businesses

The new ‘beyond budgeting’ model promotes a more decentralised, participativeapproach to managing the business It is claimed that the traditional hierarchical man-agement structure, where decision making is concentrated at the higher levels of thehierarchy, encourages a culture of dependency where meeting the budget targets set bysenior managers is the key to managerial success This traditional structure is replaced

by a network structure where decision making is devolved to ‘front-line’ managers Inthe new structure a more open, questioning attitude among employees is encouraged.There is a sharing of knowledge and best practice, and protective behaviour by man-agers is discouraged In addition, rewards are linked to targets based on improvement

in relative performance rather than to meeting the budget It is claimed that this newapproach allows greater adaptability to changing conditions, improves performanceand increases motivation among staff

Figure 6.8 sets out the main differences between the traditional and ‘beyond budgeting’ planning models

Real World 6.8looks at the management planning systems at Toyota, the well-knownJapanese motor vehicle business, a business that does not use conventional budgets

Beyond conventional budgeting

BEYOND CONVENTIONAL BUDGETING 205

REAL WORLD 6.8 Steering Toyota

Peter Bunce is at the forefront of those who argue that budgeting systems have anadverse effect on the ability of businesses to compete effectively The following is an out-line of Toyota’s planning and control systems, written by him:

Toyota is a well-known example of a sense-and-respond organisation Instead of pushing ucts through rigid processes to meet sales targets, its operating systems start from the customer – it is the customer order that drives operating processes and the work that people do The point

prod-is that in sense-and-respond companies, predetermined plans and performance contracts are an anathema and represent insurmountable barriers; which is why adaptive organisations like Toyota don’t have them However, in industries such as manufacturing, planning has a vital role to play

as they have to ensure that they will have sufficient capacity for expected levels of customer orders and they have to manage and coordinate the supply chain Every year Toyota Motor Europe develops what it calls its Original Business Plan (OBP) The OBP is just a forecast (or financial plan) for the year and provides a baseline for understanding actuals and changes, for communicating, discussion and reaching consensus (a key element of Toyota’s way of working) and also for

‘

Real World 6.8 continued

management reviews The OBP doesn’t have any of the toxic elements of a traditional budget such

as agreeing and coordinating fixed targets, rewards and resources for the year ahead, and the measuring and controlling performance against such an agreement Nor is it a reference for bonuses as it doesn’t contain any targets or goals (aspirational goals are set separately by Toyota) Toyota Motors Europe also undertakes quarterly forecasts to update the OBP These are much lighter than the OBP and don’t go into much detail.

Source: Bunce, P., ‘Transforming financial planning’, www.bbrt.org, June 2007.

Traditional versus ‘beyond budgeting’ planning modelFigure 6.8

The traditional model is based on the use of fixed targets, which determine the future actions

of managers The ‘beyond budgeting’ model, on the other hand, is based on the use of stretch targets that can be adapted The traditional hierarchical management structure is replaced by

a network structure.

It is perhaps too early to predict whether or not the trickle of businesses that are nowseeking an alternative to budgets will turn into a flood However, it is clear that in today’shighly competitive environment a business must be flexible and responsive to changingconditions Management systems that in any way hinder these attributes will not survive.

It is worth remembering that, despite the criticisms, budgeting remains a very widelyused technique Real World 6.3 provides evidence for this Furthermore, a glancethrough the annual report of virtually any well-known business will reveal that budget-ing is used and is not, therefore, regarded as an impediment to success Real World 6.9

is an account of a round table discussion at a Better Budgeting forum held in 2004

Long live budgets!

It could be argued that Toyota’s ‘Original Business Plan’ (see Real World 6.8 ) is

really a budget by another name The definition of a budget is a business plan, as wesaw earlier in the chapter

Real World 6.10provides survey evidence of senior finance staff that reveals able support for budgets Nevertheless, many recognised that budgeting is not always wellmanaged and acknowledged some of the criticisms of budgets that were mentioned earlier

consider-LONG LIVE BUDGETS! 207

REAL WORLD 6.9 Alive and kicking

A round table discussion at a Better Budgeting Forum held in London in March 2004 wasattended by representatives of 32 large organisations, including BAA (the airport operator),the BBC, Ford Motors, Sainsbury (the supermarket business) and Unilever (the householdgoods group)

The report of the forum discussions said:

If you were to believe all that has been written in recent years, you’d be forgiven for thinking that budgeting is on its way to becoming extinct Various research reports allude to the widespread dissatisfaction with the bureaucratic exercise in cost cutting that budgeting is accused of having become Budgets are pilloried as being out of touch with the needs of modern business and accused of taking too long, costing too much and encouraging all sorts of perverse behaviour.

Yet if there was one conclusion to emerge from the day’s discussions it was that budgets are

in fact alive and well Not only did all the organisations present operate a formal budget but all bar two had no interest in getting rid of it Quite the opposite – although aware of the problems it can cause, the participants by and large regarded the budgeting system and the accompanying processes as indispensable.

and later, in what could have been a reference to the use of ‘rolling forecasts’ among businesses that claim to have abandoned budgeting, it said:

It quickly became obvious that, as one participant put it, ‘one man’s budget is another man’s rolling forecast’ What people refer to when they talk about budgeting could in reality be very different things.

This presumably meant that businesses that abandon ‘budgets’ reintroduce them underanother name

Source: The Chartered Institute of Management Accountants and The Faculty of Finance and Management of the Institute of Chartered Accountants in England and Wales, Better Budgeting, March 2004.

In the next chapter we shall look in some detail at how budgets can be adapted foruse as devices for exercising management control.

REAL WORLD 6.10 Problems with budgets

The survey of the opinions of senior finance staff at 340 businesses of various sizes andoperating in a wide range of industries in North America that was mentioned earliershowed that 86 per cent of those surveyed regarded the budget process as either ‘essential’

or ‘very important’ However,

l 66 per cent thought that budgeting in their business was not agile or flexible enough

l 59 per cent were not very confident that budget targets would be met in 2008

l 67 per cent felt that their business devoted inappropriate amounts of time to budgeting(51 per cent felt it was too much and 16 per cent too little)

l 76 per cent felt that their businesses used inappropriate software in the budgeting process (generally using a spreadsheet rather than custom-designed software)

Source: ‘Perfect how you project’, BPM Forum, 2008.

The main points of this chapter may be summarised as follows:

A budget is a short-term business plan, mainly expressed in financial terms.

l Budgets are the short-term means of working towards the business’s objectives

l They are usually prepared for a one-year period with sub-periods of a month

l There is usually a separate budget for each key area

Uses of budgets

l Promote forward thinking

l Help co-ordinate the various aspects of the business

l Motivate performance

l Provide the basis of a system of control

l Provide a system of authorisation

The budget-setting process

l Establish who will take responsibility

l Communicate guidelines

l Identify key factor

l Prepare budget for key factor area

l Prepare draft budgets for all other areas

l Review and co-ordinate

l Prepare master budgets (income statement and statement of financial position (balance sheet))

l Communicate the budgets to interested parties

l Monitor performance relative to budget

SUMMARY

Preparing budgets

l There is no standard style – practicality and usefulness are the key issues

l They are usually prepared in columnar form, with a column for each month (orother period)

l Each budget must link (co-ordinate) with others

Criticisms of budgets

l Cannot deal with rapid change

l Focus on short-term financial targets, rather than on value creation

l Encourage a ‘top-down’ management style

l Time-consuming

l Based around traditional business functions and do not cross boundaries

l Encourage incremental thinking (last year’s figure, plus x per cent).

l Protect rather than lower costs

l Promote ‘sharp’ practice among managers

Budgeting is very widely regarded as useful and is extensively practised despite the criticisms.

1 BPM Forum, ‘Perfect how you project’, BPM Forum, 2008.

2 ‘Beyond budgeting’, www.beyondbudgeting.plus.com.

If you would like to explore the topics covered in this chapter in more depth, we recommend the following books:

Atkinson, A., Banker, R., Kaplan, R and Young, S M., Management Accounting, 5th edn, Prentice

Hall, 2007, chapter 11.

Drury, C., Management and Cost Accounting, 7th edn, Cengage Learning, 2007, chapter 15.

Hilton, R., Managerial Accounting, 6th edn, McGraw-Hill Irwin, 2005, chapter 9.

Horngren, C., Foster, G., Datar, S., Rajan, M and Ittner, C., Cost Accounting: A Managerial

Emphasis, 13th edn, Prentice Hall International, 2008, chapter 6.

Further reading References

Answers to these questions can be found in Appendix C at the back of the book.

Define a budget How is a budget different from a forecast?

What were the five uses of budgets that were identified in the chapter?

What do budgets have to do with control?

What is a budget committee? What purpose does it serve?

6.4 6.3 6.2 6.1

Exercises 6.5 to 6.8 are more advanced than 6.1 to 6.4 Those with coloured numbers have answers in Appendix D at the back of the book If you wish to try more exercises, visit the students’ side of the Companion Website at www.pearsoned.co.uk/atrillmclaney

Daniel Chu Ltd, a new business, will start production on 1 April, but sales will not start until

1 May Planned sales for the next nine months are as follows:

be available at the end of the previous month.

Raw materials purchases will be such that there will be sufficient raw materials ories available at the end of each month precisely to meet the following month’s planned pro- duction This planned policy will operate from the end of April Purchases of raw materials will be on one month’s credit The cost of raw material is £40 a unit of finished product The direct labour cost, which is variable with the level of production, is planned to be £20

invent-a unit of finished production Production overheinvent-ads invent-are plinvent-anned to be £20,000 einvent-ach month, including £3,000 for depreciation Non-production overheads are planned to be £11,000 a month, of which £1,000 will be depreciation.

Various non-current (fixed) assets costing £250,000 will be bought and paid for during April Except where specified, assume that all payments take place in the same month as the cost is incurred.

The business will raise £300,000 in cash from a share issue in April.

6.1REVIEW QUESTIONS

EXERCISES

Draw up the following for the six months ending 30 September:

(a) A finished inventories budget, showing just physical quantities

(b) A raw materials inventories budget showing both physical quantities and financial values

(c) A trade payables budget

(d) A trade receivables budget

(e) A cash budget

You have overheard the following statements:

(a) ‘A budget is a forecast of what is expected to happen in a business during the next year.’

(b) ‘Monthly budgets must be prepared with a column for each month so that you can see thewhole year at a glance, month by month.’

(c) ‘Budgets are OK but they stifle all initiative No manager worth employing would work for abusiness that seeks to control through budgets.’

(d) ‘Activity-based budgeting is an approach that takes account of the planned volume of activity

in order to deduce the figures to go into the budget.’

(e) ‘Any sensible person would start with the sales budget and build up the other budgets fromthere.’

Required:

Critically discuss these statements, explaining any technical terms

A nursing home, which is linked to a large hospital, has been examining its budgetary controlprocedures, with particular reference to overhead costs

The level of activity in the facility is measured by the number of patients treated in the budget period For the current year, the budget stands at 6,000 patients and this is expected

(b) The home actually treated 3,800 patients during months 7 to 12, the actual variable heads were £203,300, and the fixed overheads were £190,000 In summary form, examinehow well the home exercised control over its overheads

over-(c) Interpret your analysis and point out any limitations or assumptions

6.3 6.2

EXERCISES 211

Linpet Ltd is to be incorporated on 1 June The opening statement of financial position (balancesheet) of the business will then be as follows:

Share capital

£1 ordinary shares 60,000During June, the business intends to make payments of £40,000 for a leasehold property,

£10,000 for equipment and £6,000 for a motor vehicle The business will also purchase initialtrading inventories costing £22,000 on credit

The business has produced the following estimates:

1 Sales revenue for June will be £8,000 and will increase at the rate of £3,000 a month untilSeptember In October, sales revenue will rise to £22,000 and in subsequent months will bemaintained at this figure

2 The gross profit percentage on goods sold will be 25 per cent

3 There is a risk that supplies of trading inventories will be interrupted towards the end of theaccounting year The business therefore intends to build up its initial level of inventories(£22,000) by purchasing £1,000 of inventories each month in addition to the monthly purchases necessary to satisfy monthly sales requirements All purchases of inventories(including the initial inventories) will be on one month’s credit

4 Sales revenue will be divided equally between cash and credit sales Credit customers areexpected to pay two months after the sale is agreed

5 Wages and salaries will be £900 a month Other overheads will be £500 a month for the firstfour months and £650 thereafter Both types of expense will be payable when incurred

6 80 per cent of sales revenue will be generated by salespeople who will receive 5 per centcommission on sales revenue The commission is payable one month after the sale is agreed

7 The business intends to purchase further equipment in November for £7,000 cash

8 Depreciation will be provided at the rate of 5 per cent a year on property and 20 per cent

a year on equipment (Depreciation has not been included in the overheads mentioned in

5 above.)

Required:

(a) State why a cash budget is required for a business

(b) Prepare a cash budget for Linpet Ltd for the six-month period to 30 November

Lewisham Ltd manufactures one product line – the Zenith Sales of Zeniths over the next fewmonths are planned to be as follows:

Each Zenith sells for £3

2 Receipts from sales Credit customers are expected to pay as follows:

l 70 per cent during the month of sale

l 28 per cent during the following month

The remaining trade receivables are expected to go bad (that is, to be uncollectable).Credit customers who pay in the month of sale are entitled to deduct a 2 per cent discountfrom the invoice price

6.5 6.4

3 Finished goods inventories Inventories of finished goods are expected to be 40,000 units at

1 July The business’s policy is that, in future, the inventories at the end of each month shouldequal 20 per cent of the following month’s planned sales requirements

4 Raw materials inventories Inventories of raw materials are expected to be 40,000 kg on

1 July The business’s policy is that, in future, the inventories at the end of each month shouldequal 50 per cent of the following month’s planned production requirements Each Zenithrequires 0.5 kg of the raw material, which costs £1.50/kg Raw materials purchases are paid

in the month after purchase

5 Labour and overheads The direct labour cost of each Zenith is £0.50 The variable overhead

element of each Zenith is £0.30 Fixed overheads, including depreciation of £25,000, total

£47,000 a month All labour and overheads are paid during the month in which they arise

6 Cash in hand At 1 August the business plans to have a bank balance (in funds) of £20,000.

Required:

Prepare the following budgets:

(a) Finished inventories budget (expressed in units of Zenith) for each of the three months July,August and September

(b) Raw materials inventories budget (expressed in kilograms of the raw material) for the two months July and August

(c) Cash budget for August and September

Newtake Records Ltd owns a chain of 14 shops selling compact discs At the beginning of Junethe business had an overdraft of £35,000 and the bank had asked for this to be eliminated

by the end of November As a result, the directors have recently decided to review their plansfor the next six months

The following plans were prepared for the business some months earlier:

May June July August Sept Oct Nov

con-3 The gross profit margin is 40 per cent

4 Cash from all sales is received in the month of sale However, 50 per cent of customers paywith a credit card The charge made by the credit card business to Newtake Records Ltd is

3 per cent of the sales revenue value These charges are in addition to the selling expensesidentified above The credit card business pays Newtake Records Ltd in the month of sale

5 The business has a bank loan, which it is paying off in monthly instalments of £5,000 Theinterest element represents 20 per cent of each instalment

6 Administration expenses are paid when incurred This item includes a charge of £15,000 eachmonth in respect of depreciation

7 Selling expenses are payable in the following month

6.6

EXERCISES 213

Required (working to the nearest £1,000):

(a) Prepare a cash budget for the six months ending 30 November which shows the cash balance at the end of each month

(b) Compute the inventories levels at the end of each month for the six months to

30 November

(c) Prepare a budgeted income statement for the whole of the six-month period ending

30 November (A monthly breakdown of profit is not required.)

(d) What problems is Newtake Records Ltd likely to face in the next six months? Can you suggest how the business might deal with these problems?

Prolog Ltd is a small wholesaler of high-specification personal computers It has in recent monthsbeen selling 50 machines a month at a price of £2,000 each These machines cost £1,600 each

A new model has just been launched and this is expected to offer greatly enhanced ance Its selling price and cost will be the same as for the old model From the beginning ofJanuary, sales are planned to increase at a rate of 20 machines each month until the end ofJune, when sales will amount to 170 units a month They are planned to continue at that levelthereafter Operating costs including depreciation of £2,000 a month are planned as follows:

perform-January February March April May June

Prolog expects to receive no credit for operating costs Additional shelving for storage will bebought, installed and paid for in April, costing £12,000 Corporation tax of £25,000 is due at theend of March Prolog anticipates that trade receivables will amount to two months’ sales rev-enue To give its customers a good level of service, Prolog plans to hold enough inventories atthe end of each month to fulfil anticipated demand from customers in the following month Thecomputer manufacturer, however, grants one month’s credit to Prolog Prolog Ltd’s statement

of financial position (balance sheet) appears below

Statement of financial position (balance sheet) at 31 December

£000 Non-current assets 80

Brown and Jeffreys, a West Midlands business, makes one standard product for use in the motortrade The product, known as the Fuel Miser, for which the business holds the patent, when fitted

to the fuel system of production model cars has the effect of reducing petrol consumption

Part of the production is sold direct to a local car manufacturer, which fits the Fuel Miser as

an optional extra to several of its models, and the rest of the production is sold through variousretail outlets, garages, and so on

Brown and Jeffreys assemble the Fuel Miser, but all three components are manufactured bylocal engineering businesses The three components are codenamed A, B and C One FuelMiser consists of one of each component

The planned sales for the first seven months of the forthcoming accounting period, by channels

of distribution and in terms of Fuel Miser units, are as follows:

Jan Feb Mar Apr May June July

Retail, and so on 2,000 2,700 3,200 3,000 2,700 2,500 2,400

The following further information is available:

1 There will be inventories of finished units at 1 January of 7,000 Fuel Misers

2 The inventories of raw materials at 1 January will be:

5 Assembly of each Fuel Miser will take 10 minutes of direct labour Direct labour is paid

at the rate of £7.20 an hour during the month of production

6 The components are each expected to cost the following:

A £2.50

B £1.30

C £0.80

7 Indirect costs are to be paid at a regular rate of £32,000 each month

8 The cash at the bank at 1 January will be £2,620

The planned sales volumes must be met and the business intends to pursue the following policies for as many months as possible, consistent with meeting the sales targets:

l Finished inventories at the end of each month are to equal the following month’s total sales

to retail outlets, and half the total of the following month’s sales to the motor manufacturer

l Raw materials at the end of each month are to be sufficient to cover production requirementsfor the following month The production for July will be 6,800 units

l Suppliers of raw materials are to be paid during the month following purchase The paymentfor January will be £21,250

l Customers will pay in the month of sale, in the case of sales to the motor manufacturer, andthe month after sale, in the case of retail sales Retail sales during December were 2,000 units

(a) Sales budget.*

(b) Finished inventories budget (valued at direct cost).†

(c) Raw materials inventories budget (one budget for each component).†

(d) Production budget (direct costs only).*

(e) Trade receivables budget.†

(f) Trade payables budget.†

Accounting for control

LEARNING OUTCOMES

This chapter deals with the role of budgets in management control We thereforecontinue some of the themes that we discussed in Chapter 6 We shall consider how a budget can be used to help control a business, and we shall see that, bycollecting information on actual performance and comparing it with a revised budget,

it is possible to identify those activities that are in control and those that are not.Budgets are designed to influence the behaviour of managers, and we shallexplore some of the issues relating to budgets and management behaviour We shallalso take a look at standard costing and its relationship with budgeting We shall seethat standards provide the building blocks for budgets

INTRODUCTION

7

When you have completed this chapter, you should be able to:

l Discuss the role and limitations of budgets for performance evaluation andcontrol

l Undertake variance analysis and discuss possible reasons for the variancescalculated

l Discuss the issues that should be taken into account when designing aneffective system of budgetary control

l Explain the nature, role and limitations of standard costing

In Chapter 6, we saw that budgets provide a useful basis for exercising control over abusiness Control involves making events conform to a plan and, since the budget is

a short-term plan, making events conform to it is an obvious way to try to control thebusiness We saw in Chapter 6 that, for most businesses, the routine is as shown inFigure 7.1

Budgeting for control

If plans are drawn up sensibly, we have a basis for exercising control over the ness We must, however, measure actual performance in the same terms as those inwhich the budget is stated If they are not in the same terms, proper comparison willnot be possible

busi-Exercising control involves finding out where and why things did not go according

to plan and then seeking ways to put them right for the future One reason why thingsmay not have gone according to plan is that the budget targets were unachievable Inthis case, it may be necessary to revise the budgets for future periods so that targetsbecome achievable

This last point should not be taken to mean that budget targets can simply beignored if the going gets tough, but rather that they should be adaptable Unrealisticbudgets cannot form a basis for exercising control, and little can be gained by stickingwith them Budgets may become unrealistic for a variety of reasons, including unex-pected changes in the commercial environment (for example, an unexpected collapse

in demand for services of the type that the business provides)

Real World 7.1 reveals how one important budget had to be dramatically revisedbecause it had become unrealistic

The budgetary control processFigure 7.1

Budgets, once set, provide the yardstick for assessing whether things are going to plan Variances between budgeted and actual performance can be identified and reacted to.

When there is system of budgetary control, decision making and responsibility can

be delegated to junior management, yet senior management can still retain control.This is because senior managers can use the budgetary control system to find out whichjunior managers are meeting targets and therefore working towards achieving theobjectives of the business (We should remember that budgets are the short-term plans

for achieving the business’s objectives.) This enables a management-by-exception

envir-onment to be created where senior management can focus on areas where things are

not going according to plan (the exceptions – it is to be hoped) Junior managers who

are performing to budget can be left to get on with their jobs

The control process just outlined is known as feedback control Its main feature is thatsteps are taken to get operations back on track as soon as there is a signal that they havegone wrong This is similar to the thermostatic control that is a feature of most centralheating systems The thermostat incorporates a thermometer that senses when thetemperature has fallen below a pre-set level (analogous to the budget) The thermostatthen takes action to correct matters by activating the heating device that restores therequired minimum temperature Figure 7.2 depicts the stages in a feedback control sys-tem using budgets

There is an alternative type of control, known as feedforward control Here dictions are made as to what can go wrong and steps taken to avoid any undesirableoutcome The preparation of budgets, which we discussed in Chapter 6, provides anexample of this type of control Preparing a particular budget may reveal a problem

No medals for budgeting

The government’s dramatic increase this spring in the budget for the 2012 Olympicgames, almost tripling the £3.3bn cost to the taxpayer estimated at the time of winning the

2005 bid, has put the event on a ‘firmer financial footing’, says a report by the NationalAudit Office (NAO)

Nevertheless, the revised £9.3bn London Olympics budget contains ‘significant areas

of uncertainty’ that could drive costs up, unless effective controls are exercised Sir JohnBourn, head of the NAO, warned the government it still had to ‘work to contain fundingand achieve value for money’ He highlighted areas of uncertainty affecting costs, includ-ing the design specifications and future use of the Olympic venues, the level of price infla-tion in the construction sector and the contracts negotiated by suppliers

The NAO, in effect, gives the revised budget its seal of approval, saying it ‘should besufficient’ to cover the estimated costs of the games, provided – a ‘most important proviso’ – the assumptions on which the budget is based hold good But its report callsfor action by the government to ensure proper controls over the huge project

Source: Adapted from Watchdog warns on Olympic costs by Jean Eaglesham, ft.com, © The Financial Times Limited, 20 July 2007.

FT

that will arise unless the business changes its plans For example, preparing the cashbudget may reveal that if the original plans are followed, there will be a negative cashbalance for part of the budget period Having identified the problem, the plans canthen be revised to deal with it.

We can see that feedforward controls try to anticipate future problems, whereasfeedback controls react to problems that have already occurred Budgeting embracesboth forms of control Preparing a budget is a form of feedforward control while com-paring the budget with actual results is a form of feedback control Generally speaking,feedforward controls are preferable: things are less likely to go wrong in the first place

if steps have been taken to anticipate problems and plan accordingly It is not alwayspossible, however, to establish effective feedforward control

We saw in Chapter 1 that the key financial objective of a business is to increase thewealth of its owners (shareholders) Since profit is the net increase in wealth from busi-ness operations, the most important budget target to meet is the profit target We shalltherefore take this as our starting point when comparing the budget with the actualresults Example 7.1 shows the budgeted and actual income statements for Baxter Ltdfor the month of May

Variances from budget

Feedback controlFigure 7.2

When a comparison of actual and budgeted performance shows a divergence, steps can be taken to get performance back to plan If the plan needs revising, this can be done.

From these figures, it is clear that the budgeted profit was not achieved As far as May

is concerned, this is a matter of history However, the business (or at least one aspect

of it) is out of control Senior management must discover where things went wrongduring May and try to ensure that these mistakes are not repeated in later months It

is not enough to know that things went wrong overall We need to know where andwhy The approach taken is to compare the budgeted and actual figures for the variousitems (sales revenue, raw materials and so on) in the above statement

Flexing the budget

One practical way to overcome our difficulty is to ‘flex’ the budget to what it wouldhave been had the planned level of output been 900 units rather than 1,000 units

Flexing the budgetsimply means revising it, assuming a different volume of output

To exercise control, the budget is usually flexed to reflect the volume that actuallyoccurred, where this is higher or lower than that originally planned This means that

we need to know which revenues and costs are fixed and which are variable relative

to the volume of output Once we know this, flexing is a simple operation We shallassume that sales revenue, material cost and labour cost vary strictly with volume.Fixed overheads, by definition, will not Whether, in real life, labour cost does varywith the volume of output is not so certain, but it will serve well enough as an assump-tion for our purposes Were labour actually fixed, we should simply take this intoaccount in the flexing process

VARIANCES FROM BUDGET 221

mater-to draw conclusions as mater-to which aspects were out of control?

The problem is that the actual level of output was not as budgeted The actual level of put was 10 per cent less than budget This means that we cannot, for example, say thatthere was a labour cost saving of £2,500 (that is, £20,000 − £17,500) and conclude that all

out-is well in that area

Activity 7.1

On the basis of our assumptions regarding the behaviour of revenues and costs, theflexed budget would be as follows:

of the budgeted one)

Putting the original budget, the flexed budget and the actual for May together, weobtain the following:

Original budget Flexed budget Actual

(production and sales)

Sales volume variance

Let us begin by dealing with the shortfall in sales volume It may seem as if we are ing that this does not matter, because we just revise the budget and carry on as if all iswell However, this is not the case, because losing sales volume generally means losingprofit The first point we must pick up, therefore, is the loss of profit arising from theloss of sales of 100 units of the product

£4,000 (that is, £20,000 − £16,000)

Activity 7.2