5. Budgetary Control as Control Tool

8/3/2019 5. Budgetary Control as Control Tool

1/45

5. Budgetary Control as a ControlTool

1

5. Budgetary Control as a

control tool


2/45


2

Budgetary Control

One of three main functions ofmanagement is control. The other two areplanning and directing & motivating

Budgets are the main tools for controlling:

Compare actual results with plannedobjectives


3/45


3

Budgetary Control


4/45


4

Budgetary Control

A formalized reporting system should : Identify the name of the budget report:

such as the sales budget or the manufacturing

overhead budget Frequency of the report

weekly or monthly

Purpose of the report

Recipient(s) of the report


5/45


5

Name ofReport

Frequency Purpose Primary Recipient(s)

Sales Weekly Determine whether salesgoals are being met

Top management and salesmanager

Labor Weekly Control direct and indirectlabor costs

Vice president of productionand production departmentmanagers

Scrap Daily Determine efficient use of

materials

Production manager

DepartmentOverhead costs

Monthly Control overhead costs Department manager

Selling expenses Monthly Control selling expenses Sales manager

IncomeStatement

Monthlyand

quarterly

Determine whetherincome objectives are

being met

Top manager

Budgetary Control Reporting System

The schedule above illustrates a partial budgetary controlsystem for a manufacturing company. Note the frequency of

reports and their emphasis on control


6/45


6

Benefits of budgets

1. Forces managers to do planning.

2. Realistic performance targets.

3. Basis for controllingwhat happens within theorganisation.

4. Helps coordinate the activities of the variouscentres that make up the business.

5. Communication managers exchangeinformation on ideas, etc.

6. Motivating tool if the process involves

staff.


7/45


7

Budget classification

Static (fixed) budgets: prepared for onelevel of activity, usually around theforecasts made for sales.

Flexible budgets: a series of fixedbudgets set to different levels of salesactivity (or any other activity) within which

the organization may operate.


8/45


8

Cost/volume relationships

Fixed costs: in total remain the same fora period of time and over a particularrange of activity.

Variable costs: in total tend to changeas the level of activity changes.


9/45


9

Cost/volume relationships

Fixed costs: in total remain the samefor a period of time and over a particularrange of activity.

Variable costs: in total tend to changeas the level of activity changes.


10/45


10

Budget processes

Zero-based budgeting: sets the initial

figures for each activity to zero.

Period budgets: developed for a specific

period of time, e.g. a month.

Rolling (continuous) budgets: arecontinually updated by periodically

adding a new incremental time periodand dropping the period just completed.


11/45


11

Types of budgets

Revenue budgets: estimates of the income of anorganization from the sale of goods and/or provision ofservices for a specific period.

Operating budgets: estimate activities that will affect profit. From Wikipedia:An operating budgetis the annualbudgetof

an activity stated in terms of Budget Classification Code,functional/subfunctional categories and cost accounts. It contains

estimates of the total value ofresourcesrequired for theperformanceof the operation including reimbursable work orservices for others. It also includes estimates ofworkloadinterms of total work units identified by cost accounts.

Budgeted financial statements: show the estimated results

and projected financial position of a business. That isbudgeted revenue, balance sheet and statement of cashflows.
http://en.wikipedia.org/wiki/Budgethttp://en.wikipedia.org/wiki/Factors_of_productionhttp://en.wikipedia.org/wiki/Performancehttp://en.wikipedia.org/wiki/Workloadhttp://en.wikipedia.org/wiki/Workloadhttp://en.wikipedia.org/wiki/Performancehttp://en.wikipedia.org/wiki/Factors_of_productionhttp://en.wikipedia.org/wiki/Budget


12/45


12

Types Of Budgets Sales budget: The sales budget is an estimate of future sales, often broken

down into both units and dollars. It is used to create company sales goals. Production budget: Product oriented companies create a production

budget which estimates the number of units that must be manufactured tomeet the sales goals. The production budget also estimates the variouscosts involved with manufacturing those units, including labor and material.

Cash Flow/Cash budget: The cash flow budget is a prediction of futurecash receipts and expenditures for a particular time period. It usually coversa period in the short term future. The cash flow budget helps the businessdetermine when income will be sufficient to cover expenses and when thecompany will need to seek outside financing.

Marketing budget: The marketing budget is an estimate of the fundsneeded for promotion, advertising, and public relations in order to marketthe product or service.

Project budget: The project budget is a prediction of the costs associatedwith a particular company project. These costs include labor, materials, andother related expenses. The project budget is often broken down intospecific tasks, with task budgets assigned to each.

Revenue budget: The Revenue Budget consists of revenue receipts ofgovernment and the expenditure met from these revenues. Tax revenuesare made up of taxes and other duties that the government levies.

Expenditure budget: A budget type which include of spending data items.
http://en.wikipedia.org/wiki/Production_budgethttp://en.wikipedia.org/wiki/Production_budgethttp://en.wikipedia.org/wiki/Cash_flowhttp://en.wikipedia.org/wiki/Cash_flowhttp://en.wikipedia.org/wiki/Production_budgethttp://en.wikipedia.org/wiki/Production_budget


13/45


13

Master budget

A combination of all the budgets of an organization.

Merchandising firm Professionalservices

Manufacturing firm

Sales budget Fees or fees & salesbudget

Sales budget

Purchases budget Professional &support labor budget Cost of productionbudget

Cost of goods soldbudget

Cost of supplies used Cost of goods soldbudget

Other operatingexpense budgets




14/45


14

The Master Budget - Schematic


15/45


15

Master budget

Irrespective of the type of organization, thefollowing budgets will be part of the masterbudget:

Statement of financial performance[revenue budget]

Statement of financial position [balance

sheet] Statement of cash flow


16/45


16

Static Budget Reports

Projection of budget data at one level ofactivity.

Data for different levels of activity are

ignored. Actual results are always compared with the

budget data at the activity level in the masterbudget.


17/45


17

Budget and Actual Sales Data

To illustrate the role of a static budget in budgetarycontrol, we will use selected data for Hayes Company.Budget and actual sales data for the Kitchen-mateproduct in the first and second quarters of 2005 are as

follows:

Sales First Quarter Second Quarter Total

Budgeted $180,000 $210,000 $390,000Actual 179,000 199,500 378,500Difference $1,000 $10,500 $11,500


18/45


18

The report shows that sales are $1,000 under budget - an

unfavorable result. This difference is less that 1% of budgetedsales ($1,000/$180,000 =.0056), we will assume that topmanagement of Hayes Company will view the difference asimmaterial and take no specific action.

Sales Budget Report:First Quarter

HAYES COMPANYSales Budget Report

For the Quarter Ended March 31, 2005Difference

Favorable F

roduct Line Budget Actual Unfavorable Uitchen-mate $180,000 $179,000

The sales budget report for Hayes Companys 1st quarter is

shown below.

$1,000 U


19/45


19

Sales Budget Report:Second Quarter

HAYES COMPANYSales Budget

For the Quarter Ended June 30, 2005Second Quarter

DifferenceFavorable F

Product Line Budget Actual Unfavorable UKitchen-mate $210,000 $199,500 $10,500 U

The second quarter shows that sales were $10,500below budget, which is 5% of budgeted sales($10,500/$210,000). Top management may conclude

that the difference between budgeted and actual salesin the second quarter merits investigation and willbegin by asking the sales manager the cause(s).


20/45


20

Uses and Limitations

A static budgetevaluates a managerseffectiveness in controlling costs when:

Actual level of activity closely approximates themaster budget activity level, and/or

Behavior of the costs in response to changes inactivity is fixed, i.e. costs do not change say if salesis more than budgeted


21/45

5. Budgetary Control as a ControlTool 21

Flexible Budgets

A flexible budget projects budget datafor various levels of activity.

The flexible budget recognizes that the

budgetary process is more useful if it isadaptable to changed operatingconditions.


22/45


Static Overhead BudgetBARTON STEEL

Manufacturing Overhead Budget (Static)Forging Department

For the Year Ended December 31, 2005Budgeted production in units(steel ingots) 10,000

Budget costs

Indirect material $ 250,000

Indirect labor 260,000

Utilities 190,000Depreciation 280,000

Property taxes 70,000

Supervision 50,000

$1,100,000

Barton Steel prepares the above static budget for manufacturing overheadbased on a production volume of 10,000 units of steel ingots.

(Budget based on 10,000units of production)


23/45


If demand for steelingots has increased

and 12,000 units are

produced during the

year, rather than

10,000, the budget

report will show

very large variances.This is because the

comparison is based

on budget data based

on the original

activity level (10,000

steel ingots). Variablebudget allowances

have increased with

production.

BARTON STEEL

Manufacturing Overhead Budget Report (Static)Forging department

For the Year Ended December 31,2005

Difference

Favorable F

Budget Actual Unfavorable U

Production in units 10,000 12,000Costs

Indirect materials $ 250,000 $ 295,000

Indirect labor 260,000 312,000

Utilities 190,000 225,000

Depreciation 280,000 280,000

Property taxes 70,000 70,000

Supervision 50,000 50,000

$1,100,000 $1,232,000

Static Overhead Budget Report

$ 45,000 U

52,000 U

35,000 U

-0-

-0--0-

$132,000 ?


24/45


Item Total Cost Production Per Unit

Indirect material $250,000

Indirect labor 260,000

Utilities 190,000

$700,000

Variable Costs per Unit

/10,000 units $25

/10,000 units 26

/10,000 units 19

$70

Comparing actual variable costs with budgeted costs

is meaningless (due to different levels of activity),variable per unit costs must be isolated, so the budgetcan be adjusted. An analysis of the budget data forthese costs at 10,000 units produces the aboveper unit results:

Ill i B d d V i bl


25/45


The budgeted variable costs at 12,000units, therefore, are shown above.Because FIXEDcosts do not change intotal as activity changes, the budgetedamounts for these costs remain the same.

Illustration Budgeted VariableCosts

(12,000 units)Item Computation Total

Indirect material $25 X 12,000

Indirect labor 26 X 12,000

Utilities 19 X 12,000

$300,000

312,000

228,000$840,000


26/45


BARTON STEELForging DepartmentManufacturing Overhead Budget Report (Flexible)

For the Year Ended December 31,2005

Difference

Favorable F

Budget Actual Unfavorable U

Production in units 12,000 12,000Variable Costs

Indirect materials $300,000 $ 295,000

Indirect labor 312,000 312,000

Utilities 228,000 225,000

Total variable 840,000 832,000

Fixed Costs

Depreciation 280,000 280,000

Property taxes 70,000 70,000

Supervision 50,000 50,000

Total fixed 400,000 400,000

Total costs $1,240,000 $1,232,000

Flexible Overhead BudgetReport

This budgetreport basedon the flexiblebudget for

12,000 unitsof productionshows thatthe Forging

Departmentis belowbudget-a favorabledifference.

$ 5,000 F

-0-

3,000 F

8,000 F

-0-

-0-

-0-

-0-

$8,000 F


27/45


Developing the FlexibleBudget

Identify the activity index and the relevantrange of activity.

Identify the variable costs, and determine the

budgeted variable cost per unit of activity foreach cost.

Identify the fixed costs, and determine thebudgeted amount for each cost.

Prepare the budget for selected increments ofactivity within the relevant range.


28/45


Flexible Budget -A Case StudyMaster Budget Data

Variable Costs Fixed Costs

Indirect material $180,000 Depreciation $180,00Indirect labor 240,000 Supervision 120,00

Utilities 60,000 Property Taxes 60,00

Total $480,000 Total $360,00

Fox Company wants to use a flexible budget for monthlycomparisons of actual and budgeted manufacturing

overhead costs. The master budget for the year endedDecember 31, 2005 is prepared using 120,000 directlabor hours and the following overhead costs.

STEP 1: Identify the activity index and the relevant range of activity:The activity index is direct labor hours and management concludes that therelevant range is 8,000-12,000 direct labor hours.

Flexible Budget A Case Study


29/45


Flexible Budget-A Case StudyComputation of variable costs per direct labor hour

Variable Cost per

Variable Cost Computation Direct Labor HourIndirect material $180,000/120,000 $1.5

Indirect labor 240,000/120,000 2.0

Utilities 60,000/120,000 .5

Total $4.0

STEP 2: Identify the variable costs and determine the budgeted variable

cost per unit of activity for each cost.There are 3 variable costs and the per unit variable cost is found bydividing each total budgeted cost by the direct labor hours used inpreparing the master budget (120,000 hours).

Fl ibl B d t A C St d


30/45


Flexible Budget - A Case Study Step 3: Identify the fixed costs and determine the budgeted amount for

each cost.

There are three fixed costs and since Fox desires monthly budget data,

the budgeted amount is found by dividing each annual budgeted costby 12 ($180,000/12 =$15,000).

Variable Fixed

Indirect material $180,000 Depreciation $15,000

Indirect labor 240,000 Supervision 10,000

Utilities 60,000 Property Taxes 5,000$480,000


31/45


FOX MANUFACTURING COMPANYFlexible Monthly Manufacturing Overhead Budget

Finishing DepartmentFor the Year 2005

Activity Level 8,000 9,000 10,000 11,000 12,000

Variable Costs

Indirect materials $12,000 $13,500 $15,000 $16,500 $18,000

Indirect labor 16,000 18,000 20,000 22,000 24,000Utilities 4,000 4,500 5,000 5,500 6,000

Total variable 32,000 36,000 40,000 44,000 48,000

Fixed Costs

Depreciation 15,000 15,000 15,000 15,000 15,000

Property taxes 5,000 5,000 5,000 5,000 5,000

Supervision 10,000 10,000 10,000 10,000 10,000Total fixed 30,000 30,000 30,000 30,000 30,000

Total costs $62,000 $66,000 $70,000 $74,000 $78,000

Flexible Budget - A Case StudyFlexible Monthly Overhead Budget

Step 4: Prepare the budget for selected increments of activity within therelevant range.


32/45


Flexible Budget - A Case StudyFormula for Total Budgeted Costs

VariableCosts

TotalBudgeted

Costs

FixedCosts +

From the budget, the following formula may beused to determine total budgeted costs at anylevel of activity.

For Fox Manufacturing, fixed costs are $30,000,

and total variable costs per unit is $4.00. Thus, at 8,622 direct labor hours, total budgeted

costs are:

$30,000 $4.00 x 8,622 $64,488


33/45


Flexible Budget Reports

Another type of internal report

produced by managerial accounting.Two sections:

Production data such as direct labor hours

Cost data for variable and fixed costs

Flexible budgets are used to evaluate a

managers performance in productioncontrol and cost control.


34/45


Graphic Flexible Budget Data


35/45


Flexible Overhead Budget Report

$ 13,50018,000

4,50036,000

15,00010,0005,000

30,000$66,000

FOX MANUFACTURING COMPANYFlexible Manufacturing O verhead Budget Report

Finishing Department

For the Month Ended January 31, 2005Direct labor hours (DLH) Difference

Expected 8,800Actual 9,000

Budget at9,000 DLH

Actual Costs9,000 DLH

Favorable FUnfavorable U

Variable costs

Indirect materials $14,000 $500 UIndirect labor 17,000 1,000FUtilities 4,600 100 U

Total variable 35,600 400 FFixed costs

Depreciation 15,000 -0-Supervision 10,000 -0-Proper ty taxes 5,000 -0-

Total fixed 30,000 -0-Total costs $65,600 $ 400 F

In this budget report, 8,800 DLH were expected but 9,000 hours were worked.Budget data are based on the flexible budget for 9,000 hours.


36/45


Management by Exception

Review of a budget report

Focus on differences between actual resultsand planned objectives

Guidelines for identifying an exception.

Materiality expressed as a percentage difference from

budget

Controllability

more restrictive for controllable items thanfor items that are not controllable by themanager

General Control Characteristics for Expense Centers


37/45


General Control Characteristics for Expense Centers

BudgetPreparation

FOR ENGINEERED COST CENTER:

Unit costs (of activity) provide basis for operating budget. The volume isdetermined by another dept. e.g. Sales (a Revenue center) is responsible for

volume. The Expense center is responsible for cost/unit of item soldFOR DISCRETIONARY COST CENTER:

The magnitude of the job to be done, determines the cost budget. Work is oftwo types - CONTINUING WORK: & SPECIAL WORK.

Management Objectives budgetee proposes to accomplish pre-definedobjectives, and expects to measured on those objectives..

Generally, personnel costs are the most significant cost item.

IncrementalBudgeting

Applies only to DISCRETIONARY COST CENTER. Current expense level isthe starting point. Adjustments made for inflation & changes in workload.

DRAWBACKS: ( 1.) No re-examination of current exp. Level. ( 2.)Foradditional services, additional budget. OVERHEADS INCREASE, PERIOD!

Zero-basedreview

From scratch, i.e. De Novo, certain resources required for each activity.Questions asked (a) should the activity be performed at all? (b) At whatquality level? ( c) Is the current way, the right way? ( d) How much should itcost?

Improvement tools - Benchmarking & Re-engineering. May be downsizing

General Control Characteristics for


38/45


General Control Characteristics forExpense Centerscontd

Cost Variability In ENGINEERED : costs proportional to short-term changes in

volume (for e.g. of sales). In DISCRETIONARY: Insulated from short-term fluctuations.Driven mainly by the annual budget.

Type of Financial

Control

In ENGINEERED : set standards & measure actuals against

them. Variances are dependent on volume. In DISCRETIONARY: comparision made with planned costs, inthe annual budget.

Measurement ofPerformance

In ENGINEERED : Cost/ unit, required level/ volume of delivery

In DISCRETIONARY: The stated level of activity must performed,at budget cost. Less than budget expenditure, could actually be abad sign! Performance is measured non-financial terms goodjob, on-time ERP implemented,

Expense centers (continued)


39/45


Expense centers (continued)Comparing Budgeted and Actual Costs

Budgeted costs are target estimates.

It points to a goal to be achieved.

But, it is not written in concrete.

Actual costs are that were incurred during a given period.

The difference between the two could be either positive or negativevariances.

However, making conclusions on the basis of positive or negativevariances must be done carefully.

C t/E t i


40/45


Cost/Expense center variances A few pointers

Dont rush to conclusions based on positive or negative variances.

Find the cause behind the variances.

Decompose the flexible budget variances for unit-related costs intoprice and quantity components.

Since analysis of variances for batch-related, product-sustaining,and facility-sustaining costs is not formalized and proceeds on an adhoc basis,

Use your common sense and rationale as a neutral evaluator.

Administrati e Centers & S pport centers


41/45


Administrative Centers & Support centers

EXAMPLES: ADMINISTRATIVE CENTERS: Senior Corporate Management, SBU Management SUPPORT CENTERS: Provide services to other responsibility centers

CONTROL PROBLEMS: Difficult to measure output. Attempt to tangibalize, routinize. Possible for standard

services such as payroll, i.e. x hours for one persons processing. But most often, it isnot so easy to measure.

Lack of Goal Congruence: The support centers desire to give perfect services(likely be at increased input costs) may mitigate against the profitability of the

organization. However, it is difficult define the optimum level of service. In tough times, discretionary expenses are under the tightest control.

BUDGET PREPARATION: Normally an Expense Center budget contains the list of expense items with their

proposed budget & current years expense. Sometimes, when large budgets are involved different levels of discretion must

available to top management The minimum required for being in business Discretionary activities (with objectives & estimated costs) Proposed increases, other than due to inflation

R h & D l t C t


42/45


Research & Development Centers CONTROL PROBLEMS

Difficulty in relating results to Inputs Better than Administrative centers, because often semi-tangible output can be

seen e.g. patents, new products, new processes.

An R&D project may be on for many years, before the company can seebenefits:

E.g. a new drug could take 10 years, before launch. NOW IT HAS COMEDOWN (say 3-5 years).

The importance of PLM solutions : It is difficult to establish the value of theoutput.

Not all products succeed in the market. Issues of timing, changing tastes,

LUCK MATTERS! It is difficult to even decide which area in research will even be useful

LACK OF GOAL CONGRUENCE The technical perspective is to develop the best, maximum features, .THIS

COSTS MONEY. But how much money to sink in , must be balanced properly The value R&D sees in its own baby, is not what customer sees! Here good

selling skills can make a big difference DISCUSSION : CISCO small / incremental projects. Continue if customer

confirms value. AGILE PRODUCT DEVELOPMENT METHODS- show value on day one, if

possible. Co-create along with customer. The concept of alpha & beta customers

Research & Development Centerscontd.


43/45


43

p The R&D continuum:

Basic research, applied research, development to Product Testing. Basic research unplanned, only broad area of research is known (what we will

discover is completely unknown). As we move towards Product Testing activities and outcomes become more

measurable & predictable. Significant time between basic research & successful product.

XEROX started research in photo-optics. Took 24 years before the photo-copyingmachine was launched!

> 90% research efforts fail to generate profitable outcomes. A possible MCS solution: 15% of an engineers time can be spent on

innovation in any topic of personal interest.

The need to establish an innovation culture maximum new value uncovered

at minimum cost & risk . IBM, Microsoft, Apple, Google, .. Tatas are the only company in the league world class innovators

R&D Program Management What should be the optimum R&D budget

% of revenue (is typically industry specific i.e. pharmaceutical 19%, computers 10%,Mfg 3-5% )

The budget is modified only annually. Many projects have to be planned over thelong term. Expenses are calendarized.

Performance Measurement Compare actual expenses, with budgeted The concept of earned value. To measure the effectiveness of the project


44/45


44

Marketing Centers Marketing involves two very different types of activities i.e. order-getting &

order fulfillment.

Order Getting Marketing: Include test marketing, sales force activity, advertising & sales promotion The sales target is critical control point. Expenses are less important. Order Book

is the most important number for a sales person. There is (should be) a good co-relation between expenses in sales promotion &

advertising. Expense budgets tend to be short-term / flexible. Costs tend to discretionary costs

Order Fulfilling Logistics: All activities after an order is received. Similar to an expense center like

manufacturing. The expenses are proportional to sales volume / number of transactions (i.e.

tend to be engineered costs)

OVERALL RESPONSIBILITY OF MARKETING : Generate Revenue

Revenue = no of units sold X price / unit >> both must be optimised. Measure of performance : Actual Revenue vs Budgeted, on an ongoing basis


45/45

5. Budgetary Control as a Control 45

University Questions

1. Compare (any three) :

a. Rolling budget and zero based budget. ch 4 pg 155-6

b. Engineered cost and budget" and "Discritionery cost and budget". Ch4 pgs 154-157

c. ZBB vs. Traditional Budget ch 4 pg 155-6

2. What are the differences between Engineered Expense Center andDiscretionary Expense Center? Give your answer with respect tofollowing control characteristics. [18]

a) Budget Preparation.

b) Cost variability.c) Type of Financial Control.

d) Measurement of Performance.

Give examples to support your answer. {ch 4 pg 151-7}

Documents

5. Budgetary Control as Control Tool