Budgetary System

8/8/2019 Budgetary System

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Budgetary controlBudgetary control

Chapter objectivesChapter objectivesStructure of the chapterStructure of the chapter

Budgetary control methodsBudgetary control methods

Management action and cost controlManagement action and cost controlZero base budgeting (ZBB)Zero base budgeting (ZBB)

Key termsKey terms


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There are two types of control, namely budgetary andThere are two types of control, namely budgetary andfinancial.This chapter concentrates on budgetaryfinancial.This chapter concentrates on budgetarycontrol only. This is because financial control would becontrol only. This is because financial control would becovered in detail in financial management.covered in detail in financial management.

Budgetary control is defined by the Institute of CostBudgetary control is defined by the Institute of Costand Management Accountants (CIMA) as:and Management Accountants (CIMA) as:

"The establishment of budgets relating the"The establishment of budgets relating theresponsibilities of executives to the requirements of aresponsibilities of executives to the requirements of a

policy, and the continuous comparison of actual withpolicy, and the continuous comparison of actual withbudgeted results, either to secure by individual actionbudgeted results, either to secure by individual actionthe objective of that policy, or to provide a basis for itsthe objective of that policy, or to provide a basis for itsrevision".revision".


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This chapter is intended to provide:This chapter is intended to provide:

An indication and explanation of the An indication and explanation of theimportance of budgetary control in marketing asimportance of budgetary control in marketing asa key marketing control techniquea key marketing control technique

An overview of the advantages and An overview of the advantages anddisadvantages of budgetingdisadvantages of budgeting

An introduction to the methods for preparing An introduction to the methods for preparingbudgetsbudgets

An appreciation of the uses of budgets. An appreciation of the uses of budgets.


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Of all business activities, budgeting is one of theOf all business activities, budgeting is one of themost important and, therefore, requires detailedmost important and, therefore, requires detailedattention. The chapter looks at the concept ofattention. The chapter looks at the concept of

responsibility centres, and the advantages andresponsibility centres, and the advantages anddisadvantages of budgetary control. It then goesdisadvantages of budgetary control. It then goeson to look at the detail of budget constructionon to look at the detail of budget constructionand the use to which budgets can be put. Like alland the use to which budgets can be put. Like allmanagement tools, the chapter highlights themanagement tools, the chapter highlights theneed for detailed information, if the technique isneed for detailed information, if the technique isto be used to its fullest advantage.to be used to its fullest advantage.


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Budgetary control methodsBudgetary control methods

a)a) Budget:Budget:

A formal statement of the financial resources set aside for A formal statement of the financial resources set aside forcarrying out specific activities in a given period of time.carrying out specific activities in a given period of time.

It helps to co

It helps to co--ordinate the activities of the organisation.ordinate the activities of the organisation. An example would be an advertising budget or sales forceAn example would be an advertising budget or sales force

budget.budget.

b) Budgetary control:b) Budgetary control:

A control technique whereby actual results are compared with A control technique whereby actual results are compared with

budgets.budgets. Any differences (variances) are made the responsibility of key Any differences (variances) are made the responsibility of key

individuals who can either exercise control action or revise theindividuals who can either exercise control action or revise theoriginal budgets.original budgets.


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Budgetary control and responsibilityBudgetary control and responsibility

centres;centres; These enable managers to monitor organisationalThese enable managers to monitor organisational

functions.functions.

A responsibility centreA responsibility centre can be defined as anycan be defined as any

functional unit headed by a manager who is responsiblefunctional unit headed by a manager who is responsiblefor the activities of that unit.for the activities of that unit.

There are four types of responsibility centres:There are four types of responsibility centres:

a)a) Revenue centresRevenue centres

Organisational units in which outputs are measured inOrganisational units in which outputs are measured inmonetary terms but are not directly compared to inputmonetary terms but are not directly compared to inputcosts.costs.


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b)b) Expense centresExpense centres Units where inputs are measured in monetary terms butUnits where inputs are measured in monetary terms but

outputs are not.outputs are not. c)c) Profit centresProfit centres

Where performance is measured by the differenceWhere performance is measured by the differencebetween revenues (outputs) and expenditure (inputs).between revenues (outputs) and expenditure (inputs).InterInter--departmental sales are often made using"transferdepartmental sales are often made using"transferprices".prices".

d)d) Investment centresInvestment centres Where outputs are compared with the assets employedWhere outputs are compared with the assets employed

in producing them, i.e. ROI.in producing them, i.e. ROI.


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Advantages of budgeting andAdvantages of budgeting and

budgetary controlbudgetary control There are a number of advantages to budgeting and budgetaryThere are a number of advantages to budgeting and budgetary

control:control:

Compels management to think about the future, which is Compels management to think about the future, which isprobably the most important feature of a budgetary planning andprobably the most important feature of a budgetary planning andcontrol system. Forces management to look ahead, to set outcontrol system. Forces management to look ahead, to set outdetailed plans for achieving the targets for each department,detailed plans for achieving the targets for each department,operation and (ideally) each manager, to anticipate and give theoperation and (ideally) each manager, to anticipate and give theorganisation purpose and direction.organisation purpose and direction.

Promotes coordination and communication. Promotes coordination and communication.

Clearly defines areas of responsibility. Requires managers of Clearly defines areas of responsibility. Requires managers ofbudget centres to be made responsible for the achievement ofbudget centres to be made responsible for the achievement ofbudget targets for the operations under their personal control.budget targets for the operations under their personal control.


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Provides a basis for performance appraisal (variance analysis). Provides a basis for performance appraisal (variance analysis).A budget is basically a yardstick against which actualA budget is basically a yardstick against which actualperformance is measured and assessed. Control is provided byperformance is measured and assessed. Control is provided bycomparisons of actual results against budget plan. Departurescomparisons of actual results against budget plan. Departures

from budget can then be investigated and the reasons for thefrom budget can then be investigated and the reasons for thedifferences can be divided into controllable and nondifferences can be divided into controllable and non--controllablecontrollablefactors.factors.

Enables remedial action to be taken as variances emerge. Enables remedial action to be taken as variances emerge.

Motivates employees by participating in the setting of budgets. Motivates employees by participating in the setting of budgets.

Improves the allocation of scarce resources. Improves the allocation of scarce resources.

Economises management time by using the management by Economises management time by using the management byexception principle.exception principle.


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Problems in budgetingProblems in budgeting

Whilst budgets may be an essential part of anyWhilst budgets may be an essential part of anymarketing activity they do have a number ofmarketing activity they do have a number ofdisadvantages, particularly in perception terms.disadvantages, particularly in perception terms.

Budgets can be seen as pressure devices imposed by Budgets can be seen as pressure devices imposed bymanagement, thus resulting in:management, thus resulting in:

a) bad labour relationsa) bad labour relationsb) inaccurate recordb) inaccurate record--keeping.keeping.

Departmental conflict arises due to: Departmental conflict arises due to:

a) disputes over resource allocationa) disputes over resource allocationb) departments blaming each other if targets are notb) departments blaming each other if targets are notattained.attained.


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It is difficult to reconcile personal/individual and It is difficult to reconcile personal/individual andcorporate goals.corporate goals.

Waste may arise as managers adopt the view, "we hadWaste may arise as managers adopt the view, "we hadbetter spend it or we will lose it". This is often coupledbetter spend it or we will lose it". This is often coupledwith "empire building" in order to enhance the prestigewith "empire building" in order to enhance the prestigeof a department.of a department.

Responsibility versus controlling, i.e. some costs areResponsibility versus controlling, i.e. some costs areunder the influence of more than one person, e.g.under the influence of more than one person, e.g.

power costs.power costs. Managers may overestimate costs so that they will not Managers may overestimate costs so that they will not

be blamed in the future should they overspend.be blamed in the future should they overspend.


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Characteristics of a budgetCharacteristics of a budget

A good budget is characterised by the following:A good budget is characterised by the following:

Participation: involve as many people as possible in Participation: involve as many people as possible indrawing up a budget.drawing up a budget.

Comprehensiveness: embrace the whole organisation. Comprehensiveness: embrace the whole organisation. Standards: base it on established standards of Standards: base it on established standards ofperformance.performance. Flexibility: allow for changing circumstances. Flexibility: allow for changing circumstances. Feedback: constantly monitor performance. Feedback: constantly monitor performance. Analysis of costs and revenues: this can be done on Analysis of costs and revenues: this can be done onthe basis of product lines, departments or cost centres.the basis of product lines, departments or cost centres.


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Budget organisation andBudget organisation and

administration:administration: In organising and administering a budget system the followingIn organising and administering a budget system the followingcharacteristics may apply:characteristics may apply:

a)a) Budget centres:Budget centres:Units responsible for the preparation of budgets.Units responsible for the preparation of budgets.A budget centre may encompass several cost centres.A budget centre may encompass several cost centres.

b)b)B

udget committee:B

udget committee:This may consist of senior members of theThis may consist of senior members of theorganisation, e.g. departmental heads and executives (with theorganisation, e.g. departmental heads and executives (with themanaging director as chairman). Every part of the organisationmanaging director as chairman). Every part of the organisationshould be represented on the committee, so there should be ashould be represented on the committee, so there should be arepresentative from sales, production, marketing and so on.representative from sales, production, marketing and so on.Functions of the budget committee include:Functions of the budget committee include:

Coordination of the preparation of budgets, including the issue Coordination of the preparation of budgets, including the issueof a manualof a manual Issuing of timetables for preparation of budgets Issuing of timetables for preparation of budgets Provision of information to assist budget preparations Provision of information to assist budget preparations Comparison of actual results with budget and investigation of Comparison of actual results with budget and investigation of

variances.variances.


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Budget Officer:Budget Officer:Controls the budget administrationControls the budget administrationThe job involves:The job involves:

liaising between the budget committee and liaising between the budget committee andmanagers responsible for budget preparationmanagers responsible for budget preparation dealing with budgetary control problems dealing with budgetary control problems

ensuring that deadlines are met ensuring that deadlines are met

educating people about budgetary control. educating people about budgetary control.


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Budget manual:Budget manual:

This document:This document:

charts the organisation

charts the organisation details the budget procedures details the budget procedures

contains account codes for items of contains account codes for items ofexpenditure and revenueexpenditure and revenue

timetables the process timetables the process clearly defines the responsibility of persons clearly defines the responsibility of personsinvolved in the budgeting system.involved in the budgeting system.


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Budget preparationBudget preparation

Firstly, determine the principal budget factor. This is also knownFirstly, determine the principal budget factor. This is also knownas the key budget factor or limiting budget factor and is theas the key budget factor or limiting budget factor and is thefactor which will limit the activities of an undertaking. This limitsfactor which will limit the activities of an undertaking. This limitsoutput, e.g. sales, material or labour.output, e.g. sales, material or labour.

a)a) Sales budgetSales budget: this involves a realistic sales forecast. This: this involves a realistic sales forecast. Thisis prepared in units of each product and also in sales value.is prepared in units of each product and also in sales value.Methods of sales forecasting include:Methods of sales forecasting include:

sales force opinions sales force opinions

market research market research statistical methods (correlation analysis and examination of statistical methods (correlation analysis and examination oftrends)trends) mathematical models. mathematical models.


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In using these techniques consider:In using these techniques consider:

company's pricing policy company's pricing policy general economic and political conditions general economic and political conditions

changes in the population changes in the population competition competition consumers' income and tastes consumers' income and tastes advertising and other sales promotion techniques advertising and other sales promotion techniques after sales service after sales service credit terms offered. credit terms offered.


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b) Production budget:b) Production budget:

expressed in quantitative terms only and is geared to theexpressed in quantitative terms only and is geared to thesales budget. The production manager's duties include:sales budget. The production manager's duties include:

analysis of plant utilisation analysis of plant utilisation work work--inin--progress budgets.progress budgets.

If requirements exceed capacity he may:If requirements exceed capacity he may: subcontract subcontract plan for overtime plan for overtime introduce shift work introduce shift work

hire or buy additional machinery hire or buy additional machineryThe materials purchases budget's both quantitativeThe materials purchases budget's both quantitativeand financial.and financial.


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) Raw materials and purchasing) Raw materials and purchasing

budget:budget:

The materials usage budget is in quantities.The materials usage budget is in quantities.The materials purchases budget is bothThe materials purchases budget is bothquantitative and financial.quantitative and financial.

Factors influencing a) and b) include:Factors influencing a) and b) include:

production requirements production requirements planning stock levels planning stock levels storage space storage space trends of material prices. trends of material prices.


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d) Labour budgetd) Labour budget

is both quantitative and financial. This isis both quantitative and financial. This is

influenced by:influenced by:

production requirements production requirements man man--hours availablehours available grades of labour required grades of labour required

wage rates (union agreements) wage rates (union agreements)

the need for incentives. the need for incentives.


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e) Cash budgete) Cash budget a cash plan for a defined period of time. It summarises monthlya cash plan for a defined period of time. It summarises monthly

receipts and payments. Hence, it highlights monthly surplusesreceipts and payments. Hence, it highlights monthly surplusesand deficits of actual cash. Its main uses are:and deficits of actual cash. Its main uses are:

to maintain control over a firm's cash requirements, e.g. stock to maintain control over a firm's cash requirements, e.g. stock

and debtorsand debtors to enable a firm to take precautionary measures and arrange in to enable a firm to take precautionary measures and arrange in

advance for investment and loan facilities whenever cashadvance for investment and loan facilities whenever cashsurpluses or deficits arisessurpluses or deficits arises

to show the feasibility of management's plans in cash terms

to show the feasibility of management's plans in cash terms

to illustrate the financial impact of changes in management to illustrate the financial impact of changes in managementpolicy, e.g. change of credit terms offered to customers.policy, e.g. change of credit terms offered to customers.


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Receipts of cash may come from one of theReceipts of cash may come from one of the

following:following:

cash sales cash sales payments by debtors payments by debtors the sale of fixed assets the sale of fixed assets

the issue of new shares the issue of new shares

the receipt of interest and dividends from the receipt of interest and dividends frominvestments.investments.


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Payments of cash may be for one or more of thePayments of cash may be for one or more of the

following:following:

purchase of stocks purchase of stocks payments of wages or other expenses payments of wages or other expenses purchase of capital items purchase of capital items

payment of interest, dividends or taxation. payment of interest, dividends or taxation.


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Steps in preparing a cash budgetSteps in preparing a cash budget

Step 1: set out a pro forma cash budget month byStep 1: set out a pro forma cash budget month bymonth. Below is a suggested layout.month. Below is a suggested layout.

Month 1Month 1 Month 2Month 2 Month 3Month 3

$$ $$ $$ Cash receiptsCash receipts Receipts from debtorsReceipts from debtors Sales of capital itemsSales of capital items

Loans receivedLoans received Proceeds from share issuesProceeds from share issues Any other cash receiptsAny other cash receipts


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Cash paymentsCash payments

Payments to creditorsPayments to creditors

Wages and salaries

Wages and salaries Loan repaymentsLoan repayments

Capital expenditureCapital expenditure

TaxationTaxation

DividendsDividends

Any other cash expenditureAny other cash expenditure


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Receipts less paymentsReceipts less payments

Opening cash balance b/fOpening cash balance b/fWW XX YY

Closing cash balance c/fClosing cash balance c/f XX YY ZZ


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Step 2: sort out cash receipts from debtorsStep 2: sort out cash receipts from debtors

iii) Step 3: other incomeiii) Step 3: other income

iv) Step 4: sort out cash payments to suppliersiv) Step 4: sort out cash payments to suppliers v) Step 5: establish other cash payments in thev) Step 5: establish other cash payments in the

monthmonth


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the composition of a master budgetthe composition of a master budget

analysisanalysis

OPERATING BUDGETOPERATING BUDGET FINANCIAL BUDGETFINANCIAL BUDGET

consists of:consists of:-- consists of consists of

Budget P/L acc: get:Budget P/L acc: get: Cash budgetCash budget

Production budgetProduction budget Balance sheetBalance sheet

Materials budgetMaterials budget Funds statementFunds statement

Labour budgetLabour budget

Admin. budgetAdmin. budget

Stocks budgetStocks budget


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O

ther budgets:O

ther budgets: These include budgets for:These include budgets for: administration administration

research and development

research and development selling and distribution expenses selling and distribution expenses capital expenditures capital expenditures

working capital (debtors and creditors). working capital (debtors and creditors).


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Management action and cost controlManagement action and cost control

Producing information in management accounting form is expensive in terms of theProducing information in management accounting form is expensive in terms of thetime and effort involved. It will be very wasteful if the information once produced istime and effort involved. It will be very wasteful if the information once produced isnot put into effective use.not put into effective use.

There are five parts to an effective cost control system.These are:There are five parts to an effective cost control system.These are:

a) preparation of budgetsa) preparation of budgets b) communicating and agreeing budgets with all concernedb) communicating and agreeing budgets with all concerned

c) having an accounting system that will record all actual costsc) having an accounting system that will record all actual costs d) preparing statements that will compare actual costs with budgets, showing anyd) preparing statements that will compare actual costs with budgets, showing any

variances and disclosing the reasons for them, andvariances and disclosing the reasons for them, and

e) taking any appropriate action based on the analysis of the variances in d) above.e) taking any appropriate action based on the analysis of the variances in d) above. Action(s) that can be taken when a significant variance has been revealed will dependAction(s) that can be taken when a significant variance has been revealed will depend

on the nature of the variance itself. Some variances can be identified to a specificon the nature of the variance itself. Some variances can be identified to a specific

department and it is within that department's control to take corrective action. Otherdepartment and it is within that department's control to take corrective action. Othervariances might prove to be much more difficult, and sometimes impossible, tovariances might prove to be much more difficult, and sometimes impossible, tocontrol.control.

Variances revealed are historic. They show what happened last month or last quarterVariances revealed are historic. They show what happened last month or last quarterand no amount of analysis and discussion can alter that. However, they can be used toand no amount of analysis and discussion can alter that. However, they can be used toinfluence managerial action in future periods.influence managerial action in future periods.


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Zero base budgeting (ZBB)Zero base budgeting (ZBB)

After a budgeting system has been in operation for some time,After a budgeting system has been in operation for some time,there is a tendency for next year's budget to be justified bythere is a tendency for next year's budget to be justified byreference to the actual levels being achieved at present. In factreference to the actual levels being achieved at present. In factthis is part of the financial analysis discussed so far, but thethis is part of the financial analysis discussed so far, but theproper analysis process takes into account all the changes whichproper analysis process takes into account all the changes whichshould affect the future activities of the company. Even usingshould affect the future activities of the company. Even usingsuch an analytical base, some businesses find that historicalsuch an analytical base, some businesses find that historicalcomparisons, and particularly the current level of constraints oncomparisons, and particularly the current level of constraints onresources, can inhibit really innovative changes in budgets. Thisresources, can inhibit really innovative changes in budgets. Thiscan cause a severe handicap for the business because the budgetcan cause a severe handicap for the business because the budget

should be the first year of the long range plan.T

hus, if changesshould be the first year of the long range plan.T

hus, if changesare not started in the budget period, it will be difficult for theare not started in the budget period, it will be difficult for thebusiness to make the progress necessary to achieve longer termbusiness to make the progress necessary to achieve longer termobjectives.objectives.


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One way of breaking out of this cyclical budgeting problem is toOne way of breaking out of this cyclical budgeting problem is togo back to basics and develop the budget from an assumption ofgo back to basics and develop the budget from an assumption ofno existing resources (that is, a zero base). This means allno existing resources (that is, a zero base). This means allresources will have to be justified and the chosen way ofresources will have to be justified and the chosen way of

achieving any specified objectives will have to be compared withachieving any specified objectives will have to be compared withthe alternatives. For example, in the sales area, the currentthe alternatives. For example, in the sales area, the currentexisting field sales force will be ignored, and the optimum way ofexisting field sales force will be ignored, and the optimum way ofachieving the sales objectives in that particular market for theachieving the sales objectives in that particular market for theparticular goods or services should be developed. This might notparticular goods or services should be developed. This might not

include any field sales force, or a differentinclude any field sales force, or a different--sized team, and thesized team, and thecompany then has to plan how to implement this new strategy.company then has to plan how to implement this new strategy.


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The obvious problem of this zeroThe obvious problem of this zero--basebasebudgeting process is the massive amount ofbudgeting process is the massive amount ofmanagerial time needed to carry out the exercise.managerial time needed to carry out the exercise.

Hence, some companies carry out the fullHence, some companies carry out the fullprocess every five years, but in that year theprocess every five years, but in that year thebusiness can almost grind to a halt. Thus, anbusiness can almost grind to a halt. Thus, analternative way is to look in depth at one area ofalternative way is to look in depth at one area of

the business each year on a rolling basis, so thatthe business each year on a rolling basis, so thateach sector does a zero base budget every fiveeach sector does a zero base budget every fiveyears or so.years or so.


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Key termsKey terms

BudgetingBudgetingBudgetary controlBudgetary control

Budget preparationBudget preparationManagement action and cost controlManagement action and cost controlMaster budgetMaster budgetPrice and quantity variancePrice and quantity varianceResponsibility centresResponsibility centresZero based budgetingZero based budgeting

Documents

Budgetary System