Chapter 18: Budgetary controlOn completion of this topic you should be able toDescribe the main stages in budgetary controlDifferentiate between fixed and flexible budgetsExplain the purpose of budgetary control and the requirements for an effective systemDescribe the advantages and disadvantages of budgetary controlIndependent studyStudy Chapter 18Progress test and practice questions(s) as set

Business Accounting

The story so far Unlike financial accounting, there are no statutory regulations governing the preparation of management accounting information, as it is intended for internal usersOne advantage is that information can be produced about future financial periodsWe have already seen that cost accounting techniques can use actual (past) costs or budgeted (future) costsThis is very important as planning and control are essential if a business is to make a profit

Business Accounting

Budgetary controlBudgetary control is the process by which financial control is exercised by managers preparing budgets for revenue and expenditure for each function of the organization in advance of an accounting period. It involves the continuous comparison of actual performance against the budget to ensure the plan is achieved or to provide a basis for its revision (Collis and Hussey, 2007, p. 309)

Business Accounting

Budgets and budget centresA budget is a quantitative or financial statement, that contains the detailed plans and policies to be pursued during a future accounting period (Collis and Hussey, 2007, p. 310)A budget centre is a designated part of an entity for which budgets are prepared and controlled by a manager (Collis and Hussey, 2007, p. 310)

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VariancesOnce the budget period begins, each manager compares the actual performance of his/her budget centre against the budget and takes action to remedy any controllable adverse variancesA variance is the difference between the predetermined cost and the actual cost, or the difference between the predetermine revenue and the actual revenue (Collis and Hussey, 2007, p. 311)An adverse variance is an unfavourable difference

Business Accounting

Main requirements for an effective system of budgetary controlA sound and clearly defined organization with managers responsibilities clearly definedEffective accounting records and procedures that are clearly understood and appliedSupport and commitment of top management for the system of budgetary controlEducation/training of managers in the development, interpretation and use of budgetsRevision of budgets where amendments are needed to make them appropriate and useful (continued)

Business Accounting

Main requirements for an effective system of budgetary control (continued)Recognition that budgetary control is a management activity and not an accounting exerciseParticipation of managers in the budgetary control systemAn information system that provides data for managers so they can make realistic predictionsCorrect integration of budgets and their effective communication to managersSetting of budgets that are reasonable and achievable

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Main stages in budgetary control

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Exercise 1Role of assumptions in business planningIn order to set realistic financial plans, there needs to be a consultation process, so that management can set out their assumptions about what is going to happen to the firms markets and the business environmentRequiredUsing knowledge you have gained from other modules, jot down the key factors that managers should consider before setting their financial plans for the forthcoming period

Business Accounting

Solution 1Role of assumptions in business planning Key factors include assumptions about Changes in the size of the market and their market shareCompetitors strategiesChanges in interest rates and sources of fundingIncreases in the cost and availability of energy, materials and labourChanges in legal, social or environmental factors that will affect the demand for the organisations products/servicesEffects of the activities of other related organisations (eg major customers or suppliers)

Business Accounting

Objectives, strategies and plansThe overall purpose of budgetary control is to help managers plan and control the use of resources in a systematic and logical manner to ensure that they achieve their financial objectivesProfit satisficing (making a satisfactory level of profit)Profit maximisation (making the maximum profit)Having made their assumptions about the forthcoming period, the next stage is to set out their financial strategies in detail by preparing financial and non-financial budgets that cover every aspect of the firms activities

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ExampleNon-financial and financial budgets

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Methods for setting budgetsIn incremental budgeting managers add a percentage to the previous periods budget to take account of expected changes in price levelsBut this is unlikely to create a budget that is relevant to the particular conditions expected and non-recurring revenue and/or non-recurring expenditure will be includedIn zero-base budgeting managers start from zero, building each figure into the budget where it can be justified from the expected conditions and policiesThis makes the budget more relevant than incremental budgeting

Business Accounting

Interrelationship of budgetsFunctional budgets are drawn up for each department or function in the business by the specific functional managerNon-functional budgets are also needed (eg capital expenditure budget; cash flow budget; budgeted profit and loss account; budgeted balance sheet) and these require contributions from various managers and the accountantThe master budget incorporates all the budgets and is the final coordinated budget for the period

Business Accounting

Types of budgetA fixed budget is one that is not changed if the activity level differs from the planned levelDisadvantage is that if the actual activity level is higher than planned, an adverse cost variance may be due simply to the increase in variable costs at this level, so the budget becomes irrelevantA flexible budget is designed to change with the level of activity to reflect the different behaviour of fixed and variable costsAdvantage is that any cost variance can only be due to an increase or decrease in fixed costs

Business Accounting

Exercise 2Variance analysisVariance analysis is the investigation of the factors that have caused the differences between the actual and budgeted figuresA favourable variance is where actual performance is better than plannedAn adverse variance is where actual performance is worse than planned (eg costs are higher or revenue is lower)RequiredComplete the June budget report for Jersey Flowers Ltd, indicating whether the variances are favourable or adverse

Business Accounting

Pro forma Jersey Flowers Ltd Budget report for June

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Budget

Actual

Variance

Revenue

Roses

28,000

27,750

?

Carnations

22,000

21,500

?

Lavender

18,000

18,500

?

68,000

67,750

?

Costs

Salaries

20,000

20,000

?

Expenses

16,000

17,000

?

Administration

10,000

9,500

?

46,000

46,500

?

Net profit

22,000

21,250

?

Solution 2 Jersey Flowers Ltd Budget report for June

Business Accounting

Budget

Actual

Variance

Revenue

Roses

28,000

27,750

(250)

A

Carnations

22,000

21,500

(500)

A

Lavender

18,000

18,500

500

F

68,000

67,750

(250)

A

Expenditure

Salaries

20,000

20,000

0

Expenses

16,000

17,000

(1,000)

A

Administration

10,000

9,500

500

F

46,000

46,500

(500)

A

Net profit

22,000

21,250

(750)

A

Note

An adverse variance is where actual revenue is lower than planned or where actual costs are higher than planned

Advantages of budgetary controlCo-ordination of all functions and activitiesResponsibility accounting - information is provided to managers responsible for revenue and expenditureUtilisation of resources - capital and effort are used to achieve the financial objectivesMotivation of managers through the use of clearly defined objectives and monitoring of achievementPlanning ahead gives time to take corrective actionEstablishes a system of control if plans are reviewed regularly against actualTransfer of authority to individual managers for decisions

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Disadvantages of budgetary controlSet in stone - managers may be constrained by the original budget (eg make no attempt to spend less than maximum or exceed target income)Time consuming process may deflect managers from their prime responsibilities of running the businessUnrealistic if fixed budgets are set and actual activity level is not as plannedDisillusioning for managers if fixed budgets are set and not achieved merely due to changes in activityDemotivating for managers if budgets are imposed by top management with no consultation

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ConclusionsAn effective system of budgetary control helps managers plan and control the use of resources in a systematic and logical mannerPlanning helps co-ordinate the activities of the businessControl is achieved through the frequent monitoring of progress against the plan by managers of budget centres, and taking corrective action where necessaryIt is a communication systemFinancial objectives and constraints are communicated to managers of budget centres and regular monitoring keeps management informed of progress towards objectives

Business Accounting

Budgetary controlBudgetary controlBudgetary controlBudgetary controlBudgetary control