A manufacturing organisation budgeted to produce 16,000 units in the budget period. The budgeted variable cost per unit was $2.75. When output was 18,000 units, total expenditure was $98,000 and it was found that fixed overheads were $11,000 over budget, while variable costs were in line with budget.
What was the amount budgeted for fixed costs?
A $37 500
B $43 000
C $59 500
D $65 000
(The answer is at the end of the chapter)
7 Cost estimation
Section overview
• It should be obvious that the production of a budget calls for the preparation of cost estimates and sales forecasts. In fact, budgeting could be said to be as much a test of estimating and forecasting skills than anything else.
In this section we will consider various cost estimation techniques.
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7.1 Cost estimation methods
Cost estimation involves the measurement of historical costs to predict future costs. Some estimation techniques are more sophisticated than others and are therefore likely to be more reliable but, in practice, the simple techniques are more commonly found and should give estimates that are sufficiently accurate for their purpose. It is these simple techniques which we will be examining here.
7.2 Account-classification method
By this method, the manager responsible for estimating costs will go through a list of the individual expenditure items which make up the total costs. Each item will be classified as fixed, variable or semi- variable, and values will be assigned to these, probably by reference to the historical cost accounts with an adjustment for estimated cost inflation.
This, in rough terms, is how the direct cost items (materials and labour costs) might be built-up when a budgeted direct cost per unit of output is estimated. It is also commonly used by cost centre managers in budgeting overhead costs and is quick and inexpensive. The technique does, however, depend on the subjective judgment of each manager and his skill and realism in estimating costs, and so only an approximate accuracy can be expected from its use.
7.3 High/low method
This method was introduced in section 6 of this chapter. The major drawback to the high/low method is that only two historical cost records from previous periods are used in the cost estimation. Unless these two records are a reliable indicator of costs throughout the relevant range of levels of activity, which is unlikely, only a 'loose approximation' of fixed and variable costs will be obtained. The advantage of the method is its relative simplicity.
7.4 The scatter graph method
A graph can be plotted of the historical costs from previous periods, and from the resulting scatter diagram, a line-of-best-fit can be drawn by visual estimation.
The advantage of the scatter graph over the high/low method is that a greater quantity of historical data is used in the estimation, but its disadvantage is that the cost line is drawn by visual judgment and so is a subjective approximation.
A more accurate technique for plotting a line of best fit is to use regression analysis. This statistical technique uses data from past periods to establish the relationship between costs and level of activity as the equation of a straight line:
y = a + bx,
where a = fixed costs, b= variable cost per unit and x = volume of output.
The regression line can then be used to forecast costs for future periods.
8 Incremental and zero-based budgeting systems
Section overview
• Incremental budgeting is concerned mainly with the increments in costs and revenues which will occur in a coming period.
• Zero-based budgeting involves preparing a budget for each cost centre from a zero base.
8.1 Traditional (incremental) budgeting
The traditional approach to budgeting is to base next year's budget on the current year's results plus an extra amount for estimated growth or inflation next year. This approach is known as incremental budgeting since it is concerned mainly with the increments in costs and revenues which will occur in the coming period.
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Incremental budgeting is a reasonable procedure if current operations are as effective, efficient and economical as they can be, and the organisation and the environment are largely unchanged.
In general, however, it is an inefficient form of budgeting as it encourages slack and wasteful spending to creep into budgets: managers will spend to budget, even if the amount added for inflation proved not to be necessary, so that the level of next year's budget is maintained. The result is that past inefficiencies are perpetuated because cost levels are rarely subjected to close scrutiny.
To ensure that inefficiencies are not concealed, alternative approaches to budgeting have been developed.
One such approach is zero-based budgeting (ZBB).
8.2 The principles of zero-based budgeting
ZBB rejects the assumption inherent in incremental budgeting that next year's budget can be based on this year's costs. Existing practices and expenditures must be challenged. Every aspect of the budget is examined in terms of its cost and the benefits it provides and the selection of better alternatives is encouraged.
Definition
Zero-based budgeting involves preparing a budget for each cost centre from a zero base. Every item of expenditure has to be justified in its entirety in order to be included in the next year's budget.
The basic approach of ZBB has three steps.
Step 1 Define decision packages
A decision package is a comprehensive description of a specific organisational activity, its objectives, costs and benefits.
Step 2 Evaluate and rank packages
Using the decision packages, each activity is evaluated and ranked on the basis of its benefit to the organization, in order of priority against other activities.
The ranking process provides managers with a technique to allocate scarce resources between different activities. Minimum work requirements (those that are essential to get a job done) will be given high priority and so too will work which meets legal obligations. In the accounting department these would be minimum requirements to operate the payroll, accounts receivable and accounts payable systems, and to maintain and publish a set of accounts which satisfies the external auditors and regulatory authorities (e.g. tax returns).
Step 3 Allocate resources
Resources in the budget are then allocated according to the funds available and the evaluation and ranking of the competing packages.
8.3 The advantages of implementing ZBB
• It is possible to identify and remove inefficient or obsolete operations.
• Cost reductions are possible.
• It forces employees to avoid wasteful expenditure.
• It can increase motivation if, as a result of preparing the decision packages, staff become more involved in the budgeting process
• It provides a budgeting and planning tool for management which responds to changes in the business environment; 'obsolescent' items of expenditure are identified and dropped.
• The documentation required provides all management with a coordinated, in-depth appraisal of an organisation's operations.
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• It challenges the status quo and forces an organisation to examine alternative activities and existing expenditure levels.
• In summary, ZBB should result in a more efficient allocation and utilisation of resources to an organisation's activities and departments.
8.4 The disadvantages of ZBB
The major disadvantage of zero-based budgeting is the time and energy required. The assumptions about costs and benefits in each package must be continually updated and new packages developed as soon as new activities emerge. The following problems might also occur:
• Short-term benefits might be emphasised to the detriment of long-term benefits.
• The false idea that all decisions have to be made in the budget might be encouraged.
Management must be able to meet unforeseen opportunities and threats at all times, and must not feel restricted from carrying out new ideas simply because they were not approved by a decision package, cost benefit analysis and the ranking process.
• It may be a requirement for management skills both in constructing decision packages and in the ranking process which the organisation does not possess. Managers may therefore have to be trained in ZBB techniques so that they can apply them sensibly and properly.
• It may be difficult to 'sell' ZBB to managers as a useful technique for the following reasons:
– costs and benefits of alternative courses of action are hard to quantify accurately.
– Employees or trade union representatives may resist management ideas for changing the ways in which work is done.
• The organisation's information systems may not be capable of providing suitable cost and benefit analysis.
• The ranking process can be difficult. Managers face three common problems:
– A large number of packages may have to be ranked.
– There is often a conceptual difficulty in having to rank packages which managers regard as being equally vital, for legal or operational reasons.
– It is difficult to rank completely different types of activity, especially where activities have qualitative rather than quantitative benefits, such as spending on staff welfare and working conditions, where ranking must usually be entirely subjective.
In summary, perhaps the most serious drawback to ZBB is that it requires a lot of management time and effort. One way of obtaining the benefits of ZBB and overcoming the drawbacks, is to apply it selectively on a rolling basis throughout the organisation. For example, this year it applies to the finance department, next year marketing department, the year after personnel department and so on. In this way all activities will be thoroughly scrutinised over a period of time.
8.5 Using zero-based budgeting
ZBB can be used by both profit-making and non-profit-making organisations.
The procedures of ZBB do not lend themselves easily to direct manufacturing costs where standard costing, work study and the techniques of management planning and control have long been established as a means of budgeting expenditure.
In manufacturing organisations, ZBB is best applied to expenditure incurred in departments that support the essential production function. These include marketing, finance, quality control, repairs and maintenance, production planning, research and development, engineering design, personnel, data
processing, sales and distribution. In many organisations, these expenses make up a large proportion of the total expenditure. These activities are less easily quantifiable by conventional methods and are more discretionary in nature.
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ZBB can also be successfully applied to service industries and public sector organisations such as local and central government departments, educational establishments, hospitals and so on. This is because ZBB is a useful technique for identifying the cause of excess spending in administrative activities, and eliminating wasteful and non-value-adding activities.
ZBB can be applied in any organisation where alternative levels of provision for each activity are possible and where the costs and benefits are separately identifiable.
Some particular uses of ZBB are:
(a) Budgeting for discretionary cost items, such as advertising, R & D and training costs. The priorities for spending money could be established by ranking activities and alternative levels of spending or service can be evaluated on an incremental basis. For example, is it worth spending
$2,000 more to increase the number of employees to be trained on one type of training course by 10%? If so, what priority should this incremental spending on training be given, when compared with other potential training activities?
(b) Rationalisation measures. 'Rationalisation' means cutting back on production and activity levels, and cutting costs. ZBB can be used to make rationalisation decisions when an organisation is forced to make spending cuts. As indicated above, it is also a useful approach to eliminating unnecessary and wasteful spending.
8.6 Rolling budgets
A Rolling budget is a budget that always extends a set number of financial periods into the future, for example four quarters. As the current period ends, a new period is added to the budget.
The advantages of rolling budgets include:
• The forecast represented by the budget will be more accurate as managers are forced to reassess the budget regularly and adjust for current conditions
• Planning and control is based on a more recent, up-to-date plan
• The budget will prompt managers to look further into the future than the traditional annual budget
• The rolling budget can help to provide an early warning of whether the organisation is on track to meet its goals.
Disadvantages include:
• The budget preparation process may be more costly
• Managers may be de-motivated by the additional volume of work involved, for example if standard costs or stock valuations need to be revised.
9 Budgeting, performance and motivation
Section overview
• Human behaviour affects the budgeting process, the resulting budgets and the performance of managers and employees alike.
In this chapter we have concentrated on the importance of the budgeting process for planning and control by management. A further aspect of the budgeting process is the human behavioural aspect, the effect that the budgeting process and resulting budgets has on the performance of managers and other employees alike.
9.1 Budgets and motivation
The motivational effect of the budgeting process on managers in a business is much written-about and there are many conflicting views. It is well recognised that the budgetary process has the potential to be a
powerful motivating tool, but conversely it may also have a de-motivating effect.
The effect of the budget on the motivation of managers is largely due to the level of difficulty of the targets set, and the manner in which they are set. Are the budgets imposed or have the managers taken part in the budgeting process?
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9.2 Budgets and standards as targets
Once decided, budgets become targets. But how difficult should the targets be? And how might people react to targets which are easy to achieve, or difficult to achieve?
The quantity of material and labour time included in the budget will depend on the level of performance required by management. Four types of performance standard might be set:
• Ideal standards are based on perfect operating conditions: no wastage, no spoilage, no inefficiencies, no idle time, no breakdowns. Employees will often feel that the goals are unattainable, become de-motivated and not work so hard.
• Attainable standards are based on the hope that a standard amount of work will be carried out efficiently, machines properly operated or materials properly used. Some allowance is made for wastage and inefficiencies. If well-set they provide a useful psychological incentive by giving employees a realistic, but challenging target of efficiency.
• Current standards are based on current working conditions (current wastage, current inefficiencies). They do not attempt to improve on current levels of efficiency.
• Basic standards are kept unaltered over a long period of time, and may be out of date. They are used to show change in efficiency or performance over a long period of time. They are perhaps the least useful and least common type of standard in use.
Management must decide which of the four types of standard is most appropriate as a benchmark for measuring performance.
Standards can be used as aspirational targets to drive improvements in performance, but when benchmarking actual performance against such standards, management need to be aware that this may result in de-motivated employees:
The impact on employee behaviour of budgets based on these different standards is summarised in the table below:
Type of standard Impact
Ideal standards Some say that they provide employees with an incentive to be more efficient even though it is highly unlikely that the standard will be achieved. Others argue that they are likely to have an unfavourable effect on employee motivation because the differences between standards and actual results will always be adverse. The employees may feel that the goals are unattainable and so they will not work so hard.
Attainable standards
Might be an incentive to work harder as they provide a realistic but challenging target of efficiency.
Current standards Will not motivate employees to do anything more than they are currently doing.
Basic standards May have an unfavourable impact on the motivation of employees. Over time they will discover that they are easily able to achieve the standards. They may become bored and lose interest in what they are doing if they have nothing to aim for.
Similar comments apply to budgets.
Budgets and standards are more likely to motivate employees if employees accept that the budget or standard is achievable. If it can be achieved too easily, it will not provide sufficient motivation. If it is too difficult, employees will not accept it because they will believe it to be unachievable. In extreme
circumstances, if employees believe a budget is impossible to achieve, they might be so de-motivated that they attempt to prove that the budget is wrong. This is obviously the completely opposite effect to that intended.
The various research projects into the behavioural effects of budgeting have given conflicting views on certain points. However, there appears to be general agreement that a target must fulfil certain conditions if it is to motivate employees to work towards it:
• It must be sufficiently difficult to be a challenging target.
• It must not be so difficult that it is not achievable.
• It must be accepted by the employees as their personal goal.
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9.3 Participation
There are basically two ways in which a budget can be set: from the top down (imposed budget) or from the bottom up (participatory budget).
9.4 Top-down style of budgeting
In this approach to budgeting, top management prepare a budget with little or no input from operating personnel. This budget is then imposed upon the employees who have to work to the budgeted figures.
The times when imposed budgets are effective are as follows:
• In newly-formed organisations, because of employees' lack of knowledge.
• In very small businesses, because the owner/manager has a complete overview of the business.
• When operational managers lack budgeting skills.
• When the organisation's different units require precise co-ordination.
• When budgets need to be set quickly.
There are, of course, advantages and disadvantages to this style of setting budgets.
Advantages
• The aims of long-term plans are more likely to be incorporated into short-term plans.
• They improve the co-ordination between the plans and objectives.
• They use senior management's overall awareness of the organisation.
• There is less likelihood of input from inexperienced or uninformed lower-level employees.
• Budgets can be drawn up in a shorter period of time because a consultation process is not required.
Disadvantages
• Dissatisfaction, defensiveness and low morale amongst employees who have to work to meet the targets. It is hard for people to be motivated to achieve targets set by somebody else. Employees might put in only just enough effort to achieve targets, without trying to beat them.
• The feeling of team spirit may disappear.
• Organisational goals and objectives might not be accepted so readily and/or employees will not be aware of them.
• Employees might see the budget as part of a system of trying to find fault with their work: if they cannot achieve a target that has been imposed on them they may be punished.
• If consideration is not given to local operating and political environments, unachievable budgets for overseas divisions could be produced.
• Lower-level management initiative may be stifled if they are not invited to participate.
9.5 Bottom-up style of budgeting
In this approach to budgeting, budgets are developed by lower-level managers who then submit the budgets to their superiors. The budgets are based on the lower-level managers' perceptions of what is achievable and the associated necessary resources.
The advantages of participative budgets are as follows:
• They are based on information from employees most familiar with the department. Budgets should therefore be more realistic.
• Knowledge spread among several levels of management is pulled together, again producing more realistic budgets.
• Because employees are more aware of organisational goals, they should be more committed to achieving them.