Managing Finance and Budgets

Lecture 10

Budgetary Control

Session 10 – Budgetary Control

KEY CONCEPTS Forms of budget-setting Financial control structures and techniques Behavioural Issues Non-financial measures

Section A:

Forms of Budget-setting

Forms of budget-setting

Incremental budgeting Zero base budgeting Activity Based Budgeting Standard costing

Incremental Budgeting

Traditional form of Budgeting, Common in local & central government

Costs and Allocations of monies tend to be on the basis of what happened in previous years

Adjustment (increments) are made on the basis of changes (e.g. inflation, increases in productivity, workforce etc.) that happen from year to year.

Often used for ‘discretionary’ budgets (i.e. where budget holder is responsible for allocating a sum of money within a department)

No clear relationship between the input or output (e.g the raw materials required or the level of sales produced)

Zero-Base Budgeting (ZBB)

Draws on the philosophy that ALL spending needs to be justified.

All budgets are allocated a zero base, and will be increased from this only if a good case can be made out for the money

Senior management will be using the criterion of ‘value for money’ to allocate scarce resources.

ZBB encourages managers to adopt a questioning approach; this leads to more strategic thinking and allocation of resources to enable this strategy to happen

Clear links required between input/output and the resourcing

Activity-Based Budgeting (ABB)

Applies the philosophy of Activity-Based Costing to the Budget process, recognising that activities ‘drive’ costs

If ‘cost-driving’ activities can be identified, then the cost of the output can be achieved more accurately)

Central feature: budget holders (those who are responsible for meeting a particular budget) have control over the events that affect performance in their area.

ABB tries to generate budgets in such a way that the manager who has control over the cost drivers is accountable for those costs.

Typical problems: increased levels of activity generated from outside the manager’s control, e.g. Manufacturing Budget thrown into disarray by a new sales contract

Standard Costing

Embodies the idea that standard quantities and costs can be planned for individual units such as sales items, labour rates, raw materials etc.

The standards are targets, and become benchmarks by which actual performance s measured.

The targets are derived from experience, market assessments, current rates (e.g. labour, fees etc.)

The targets should be realistic. Variances (differences between the budgeted amounts

and the actual amounts) are always based on standards.

Activity One

What are the advantages and disadvantages of zero-based budgeting? How might any disadvantages be overcome?

Activity One- Solution

Advantages• Little Wastage of

Resources• Strategic use of

resources, enable plans to be fulfilled more easily

Disadvantages• Time Consuming• Managers can often feel

threatened by ZBB

The disadvantages can be countered by using the approach selectively, for example on every third year, or on particular budgets which tend to require strategic input, e.g. training, advertising, research & development.

Section B:

Financial Control Techniques

Financial Control Techniques

Flexing (but not ignoring) budgets Management by exception Variance Analysis

The budgetary control process

Prepare budgets

Perform and collect information on actual performance

Respond to variances between planned and actual

performance and exercise control

Budgetary Control Structures

Budgets provide a useful mechanism for control. This starts with the detailed planning within the budget,

which forms the basis for exercising control In addition we need a basis for measuring actual

performance against planned performance Finally in exercising control, we need a means of finding

out where and why events deviated from the plan, and ways of rectifying these.

Performance Comparison

This Budget is part of the Profit and Loss budget for a manufacturing company

The amounts shown represent targets to be achieved for a particular product line during the next 12 months.

This allows us to compare our prediction with what actually happens.

Budget Sales (Units): 1000

£ 000 BudgetValue of Sales 100

Direct CostsMaterials 40 Labour 20

Total Direct Costs 60Gross Profit 40Overheads Admin Salaries 20 Travel 5 Other costs 20 Total Overheads 45

Net Profit (5)

Comparison of Actual Performance (1)

Original Budget Actual Figures Sales 1000 Units Sales 1040 Units

Original Actual £ 000 Budget FiguresValue of Sales 100 104Direct Costs Materials 30 37 Labour 25 24Total Direct Costs 55 61 Gross Profit 45 43Overheads Admin Salaries 20 19 Travel 5 8 Other costs 17 17Total Overheads 42 44Net Profit 3 (1)

Here we can see what has happened at the end of the period:

Although we have produced and sold slightly over target,

the sharp rise in the cost of materials

means that we have made an overall loss.

Here we can see what has happened at the end of the period:

Although we have produced and sold slightly over target,

the sharp rise in the cost of materials

means that we have made an overall loss.

Comparison of Actual Performance (2)

Original Budget Sales (Units): 1000 Actual Sales (Units): 1500Original Actual

£ 000 Budget FiguresValue of Sales 100 150Direct Costs Materials 30 47 Labour 25 25Total Direct Costs 55 72 Gross Profit 45 78Overheads Admin Salaries 20 27 Travel 5 10 Other costs 17 23Total Overheads 42 60Net Profit 3 18

Here the original sales targets have been well exceeded, and we have increased our profits considerably

However all is not as well as it seems!

Here the original sales targets have been well exceeded, and we have increased our profits considerably

However all is not as well as it seems!

Flexible Budgets

If it becomes apparent before the end of the year that there is a huge discrepancy between the actual performance and the budget, it may be necessary to revise targets.

This might happen if there are unexpected surges or slumps in demand, or the economic situation changes.

This does not mean that we dispense with the budget altogether, and write a new one.

Flexible budgeting allows selected targets to be revised. The revised budget is said to be ‘flexed’.

Comparison with Flexed Budget

Original Budget Sales (Units): 1000 Actual Sales (Units): 1500Original Flexed Actual

£ 000 Budget BudgetFiguresValue of Sales 100 150 150Direct Costs Materials 30 45 47 Labour 25 30 25Total Direct Costs 55 75 72 Gross Profit 45 75 78Overheads Admin Salaries 20 20 27 Travel 5 8 10 Other costs 17 17 23Total Overheads 42 45 60Net Profit 3 30 18

Here we have written in new targets on the basis of the new sales figures. We can now see that despite the fact that we have increased our profits, this is well below what we should have achieved.

Here we have written in new targets on the basis of the new sales figures. We can now see that despite the fact that we have increased our profits, this is well below what we should have achieved.

Management by Exception

• By using flexible budgets, decision-making and responsibility can be delegated to junior management.

• Control is retained by senior management, since they can use the budgetary targets to determine which junior managers are meeting targets.

• This means that energy can be concentrated on those areas which are under-performing – the exceptions.

• This process is called Management by Exception.

Variance Analysis

Used to analyse performance and promote management action

Variance = difference between the Budgeted amount and the actual amount; this can be adverse or favourable.

Variances might cover: Sales Volume, Pricing, Direct Materials Usage, Direct Materials Price, Direct Labour Efficiency, Direct Labour rate, Fixed Overheads

They can be calculated using absorption costing or marginal costing

Limitations include out-of-date standards; inappropriate absorption of fixed overheads into cost units; and focus on price at expense of other more important issues (j-i-t)

Sample Variance Analyses

Sales Volume Variance

The difference between the profit as shown in the flexed budget and the actual profit

Flexed Budget: Profit : £30,000

Actual Figures Profit: £12,000

Sales Volume Variance: £18,000 Adverse

Sample Variance Analyses

Direct Material PRICE variance

(Actual material purchased x standard price) less Actual cost of material purchased

Direct Material USAGE variance

(Standard quantity of material required for actual production x standard price) less (Actual material x standard price

Total Direct Material variance

Standard direct material cost less Actual direct material cost

Direct materials

usage variance

Direct materials

price variance

Total direct materials variance

Relationship between the total, usage and price variances of direct materials

equals

minus

Actual profit

plus

All adverse variances

All favourable variances

Budgeted profit

Relationship between the budgeted and actual profit

Key elements for budgetary control

Achievable yet rigorous targets Accurate, relevant, customised and timely reporting Short reporting periods (e.g. one month) Clear lines of responsibility Accountability Action taken to control operations Flexibility where appropriate Serious attitude from higher management towards

importance, relevance and accuracy of budgets

Section C:

Behavioural Issues

Budgets – Behavioural issues

Budgets are often: Restrictive; it becomes more difficult to take advantage of

opportunities since the expenditure has already been allocated.

Inflexible; money often needs to be spent within a particular time-frame. It discourages managers from thinking strategically.

Seen as a maximum instead of a target Prone to end-of-year expenditure ‘binges’ Catalysts for organisational conflict

Budgets - Behavioural issues

Budgets must be seen as attainable. Highest performance is achieved by setting the most difficult specific goals which are acceptable to manager

Control information must be understood Aims of budgets must be understood Participation in setting processes is crucial to acceptance,

job satisfaction and motivation Participation is also likely to increase accuracy Participation should decrease distortion and manipulation...

but may not as managers may deliberately introduce ‘slack’ (I.e. deliberately over-or under estimate items during the budget-setting negotiations)

Budgets for performance evaluation

Where evaluation of performance is based on the ability of the manager to meet the budget a range of factors occurs:• Rigidity – the manager feels straitjacketed by the budget,

and restrained from taking risks, as this might create adverse variances.

• Fixation- There is a focus on budget at expense of other criteria

• Manipulation: Figures are often ‘massaged’ or distorted in order to present the department in the best light.

• Exaggeration: Introduction of slack during budget-setting processes

Activity Two

A Sales Manager believes that she could reach her overall sales budget target by reducing prices and selling a higher volume of units.

Why might it not be sensible for her to do so?

What overall issues does this raise about budget monitoring and control?

Activity Two Solution 1

A Sales Manager reaches her overall sales budget target by reducing prices and selling a higher volume.

This is not sensible because:• Production targets will have been set in the production budget;

this will involve budgeting for raw materials and labour etc. Suddenly selling more will cause problems elsewhere; this will mean that higher stock levels will be required, and may cause problems with debtors.

• Similarly, reducing prices will reduce profitability. This will have an effect on the company’s balance sheet, and may ultimately reduce dividends to shareholders.

Activity Two Solution 2

What overall issues does this raise about budget monitoring and control?

• Budgets are interrelated, and targets are set to dovetail; individual managers need to know how their targets match with those of others. One way to do this is through a budgetary committee, and participation in the budgetary process.

• Managers not only need targets, they need to know to what extent under ‘normal conditions’ those targets can be flexed, that is, by how much can we exceed or fall short without a new budget needing to be set?

Section D:

Non-Financial Measures in Budgets

Non financial measures in budgeting

The budget itself tends to be a document which apportions money according to a strategic plan

In manufacturing, the money sets numerical targets for input, throughput and output.

However, in service industries and in other areas such as Education and the National Health Service it is difficult to measure ‘output’ using conventional financial means.

It is increasingly the case that other, non-financial measures are used as a basis for reporting.

These measures are incorporated into budgeting process

Examples of Non financial measures

General Examples of these include:• Customer satisfaction• Product quality• Delivery efficiency• Supplier quality• Supplier delivery• Set-up times• Throughput times• Wastage• Employee satisfaction

Specific Non financial measures

There are two specific examples : Patient Waiting Times in the NHS Pupil Performance Indicators for Schools

In both cases: These are Non-financial Measures which appear as

targets for specific institutions. These are treated in the same way as other budgetary

measures, i.e. institutions are compared with one another (league tables) and their past performance (looking for year-on-year improvement)

These are elements of control; resources follow the successful achievement of targets.

Activity Three

What particular problems might be caused in a hospital by the incorporation of non-financial targets such as “Average patient waiting time” in an A & E Department as part of their budgetary considerations?

Activity Three – Solution (1)

The problems are exactly the same as those outlined for financial targets:

Rigidity – managers may feel straitjacketed by the targets and manage purely to meet rather than exceed them; this means that ‘natural grass-roots development’ tends to be stifled. (e.g. new types of procedure which might ultimately lead (in the long run) to improved patient care will not be implemented, as in the short run this might result in failure to meet targets.)

• Fixation- There is a focus on the target at expense of other criteria.In the example given, it could lead to undifferentiated patient care (e.g. a patient with a cut finger becomes as important as road traffic accident victim)

Activity Three – Solution (2)

Manipulation: The department is reorganised in such a way as to present figures which meet the target, but do not necessarily result in improvements. (e.g. All patients are met at the door by a doctor, and then asked to wait – this technically reduces the waiting time to zero, but does not improve the service)

• Exaggeration: Accounting procedures are put in place which locally redefine what the target means. (e.g. Average patient waiting time redefined as: the time before first treatment divided by the total number of separate visits by a doctor or nurse subsequently.)

Follow-up to Lecture Ten - Activities

KEY CONCEPTS:

Forms of budget-setting

Financial control structures and techniques

Behavioural Issues

Non-financial measures