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Budgeting & Control

Week 8

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The nature of budgeting Budget is a detailed plan, expressed in

quantitative terms, that specifies how resources will be acquired and used during a specified period of time

Purposes: Planning Facilitating communication & coordination Allocating resources Controlling profit & operations Evaluating performance & providing

incentives

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Budget organisation Budgeting is a financial information

system which exists to: help managers reach their goals and

discharge their responsibilities make managers fairly accountable for

their performance Budgeting should be relevant,

accurate, and prompt in reporting any performance problems and assisting with explaining their cause

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Budget organisation

Budget centres can be defined in terms of cost and revenue responsibility

Budget centres may consist of Cost centres Revenue centres Profit centres Investment centres

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Budget CentresCost Centres

Cost centres are responsible for control of costs alone

eg Service departments provide services to other

departments do not produce final good or service

sold externally include maintenance, computer

services, R&D

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Budget CentresRevenue Centres

Revenue centres are responsible for revenues alone

eg Sales division However, there would usually be

some costs which must be included in how well or how poorly the segment is doing

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Budget CentresProfit Centres

Profit centres combine both revenues and costs Local managers assessed by both

revenues and costs Especially useful in people-

intensive service organisations

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Budget CentresInvestment Centres

Investment centres create revenue incur costs and use assets

eg manufacturing divisions also some service businesses (eg.

hospitals, computer service bureaux)

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Budget cycle and administration The budget cycle involves many factors:

objectives success factors sales/revenue budget operating activities’ budgets negotiation of budget targets coordination and review acceptance and communication continuous monitoring

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Flexible budgeting Static budgets are prepared for a

single, planned level of activity. Performance evaluation is difficult

when actual activity differs from the planned level of activity.

With a flexible budget you can Estimate costs at different activity levels Compare actual outcomes to expectations

when output levels are known

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Flexible budgeting

To “flex” a budget for different activity levels, we need to know how costs behave with changes in activity levels Total variable costs change in direct

proportion to changes in activity Total fixed costs remain unchanged

within the relevant range

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Flexible budgeting Advantages

Flexible budgets show revenues and expenses that should have occurred at theactual level of activity

Flexible budgets may be prepared for any activity level in the relevant range

Flexible budgets reveal variances due to good cost control or lack of cost control

Flexible budgets

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Budget techniquesFlexible budgets

A simple example.. Output (units) 90 120

£ £ Revenue 900 1,200

Variable costs 450 600 Variable overheads 90 120 Fixed overheads 300 300

Total costs 840 1,020

Profit 60 180

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Preparing the flexible budget

From this we can see that certain costs clearly vary with levels of output.

Obviously fixed costs don’t. By calculating the relationship

between variable costs and output (as output drives the budget)

We can calculate expected costs/revenues for any output level

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Preparing the flexible budget

Clearly the relationships are (at a given level)

Revenue £900/90 = £10 per unit Variable costs £450/90 = £5 per

unit Variable overheads £90/90 = £1

per unit

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Preparing the flexible budget

Output (units) 135

Revenue 135 X £10 = 1,350

Variable costs 135 X £5 = 675 Variable overheads135 X £1= 135 Fixed overheads £300 300

Total costs 1,110

Profit 240

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But what if there are semi-variable costs?

There may be instances when the relationship between outputs and inputs is not clear

Some costs may be part fixed and part variable

High-Low technique

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High-Low method difference Output 90 120

30 £ £ £

Revenue 900 1,200 300

Variable costs 450 600 150 Variable overheads 435 480 45

Total costs 885 1,080

Profit 15 120

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High-Low method Compare costs/revenues at 2 levels of

output Divide cost/revenue change by change in

output For Revenue and variable costs £10 & £5

relationship still holds Overheads are semi-variable Therefore change can only be attributed

to variable element

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High-Low method Therefore change = 45/30 = £1.50

per unit At output 90 units Variable element = 90 X £1.50 = 135 So Fixed element = 435 – 135 = 300 To confirm, at 120 units of output Variable element = 120 X £1.50 = 180 So Fixed element = 480 – 180 = 300

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Budget at different output level

At (say) 100 units of output budget =

Revenue (100 X £10) £1,000 Variable costs (100 X £5) £ 500 Overheads (£300 + 100 X £1.50) £ 450 Total costs £ 950 Profit £ 50

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Budgets and behaviour Authoritarian Approach

Worker is beast of burden Management role to instruct worker

exactly how to perform tasks Top-down authority Usually causes resistance to develop Top-down budgets (imposed) Budgets used to force employees to

meet expectations of top management Often causes dysfunctional behaviour

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Budgets and behaviour Budgetary Slack

Developed by subordinate managers and workers to provide protection

underestimate revenues overestimate expenses deceive management about task time

However.. slack budget may lead to better

performance that tight budget provides a hedge against uncertainty confidence in meeting budget

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Budgets and behaviour Participative Budgeting

Allows individuals responsible for performance under budget to participate in establishment of budget

Managers (all levels) and workers should be in accord with goals of firm

Goal congruence is key objective Humans are highly diverse Behaviour influenced by many factors

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Budgets and behaviour Advantages of Participative Budgeting

Motivates by providing challenge and sense of responsibility

Creates higher morale because of positive employee attitudes towards firm

Increases likelihood of goal congruence Brings greater satisfaction and self-esteem

through job enlargement Better plan: combined knowledge Awareness of how particular fn fits into total

operational picture Increases interdepartmental cooperation Junior management made more aware of the

future

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Budgets and behaviour Disadvantages of Participative

Budgeting Involves both process & content Process only benefits firm if content is in line

with goals Budgetary slack may be included

Interaction between aspiration levels and actual performance depends on

tightness of budget nature of task level of actual performance personality of individual involved