NATURE & PURPOSES OF BUDGETING

NATURE & PURPOSES OF BUDGETING FM A – M ANAG EM ENT AC C OUNTI NG

LEARNING OUTCOMES 1. Explain why organizations use budgets 2. Describe the planning and control cycle in an organization 3. Define the concept of responsibility accounting and its significance in control 4. Explain the importance of flexible budgets in control

5. Identify situations where fixed or flexible budgetary control would be appropriate 6. Flex a budget to a given volume

THE PLANNING & CONTROL CYCLE There are 7 seven steps in the planning & control cycle (1) Identify objectives (2) Identify alternative courses of action (strategies) which might contribute towards achieving the objectives (3) Evaluate each strategy (4) Choose alternative courses of action

(5) Implement the long-term plan in the form of the annual budget (6) Measure actual results and compare with plan (7) Respond to divergences from the plan

BUDGETING • Budgeting is an essential tool for management accounting for both planning and controlling future activity Objectives of a budgetary planning and control system • Ensure the organisation's objectives are achieved • Compel planning • Communicate ideas and plans • Coordinate activities • Provide a framework for responsibility accounting • Establish a system of control • Motivate employees to improve their performance

OBJECTIVES OF BUDGETING SYSTEMS OBJECTIVE

COMMENT

Ensure the achievement of the organisation's objectives

Objectives are set for the organisation as a whole, and for individual departments and operations within the organisation.

Quantified expressions of these objectives are then drawn up as targets to be achieved within the timescale of the budget plan.

Compel planning

This is probably the most important feature of a budgetary planning and control system. Planning forces management to look ahead, to set out detailed plans for achieving the targets for each department, operation and (ideally) each manager and to anticipate problems. It thus prevents management from relying on ad hoc or uncoordinated planning which may be detrimental to the performance of the organisation.

OBJECTIVES OF BUDGETING SYSTEMS OBJECTIVE

COMMENT

Communicate ideas and plans

A formal system is necessary to ensure that each person affected by the plans is aware of what he or she is supposed to be doing.

Communication might be one-way, with managers giving orders to subordinates, or there might be a two-way dialogue and exchange of ideas.

Provide a framework for responsibility accounting

Budgetary planning and control systems require that managers of budget centres are made responsible for the achievement of budget targets for the operations under their personal control.

Motivate employees to improve their performance

The interest and commitment of employees can be retained via a system of feedback of actual results, which lets them know how well or badly they are performing. The identification of controllable reasons for departures from budget with managers responsible provides an incentive for improving future performance.

RESPONSIBILITY ACCOUNTING & BUDGET CENTRE Responsibility Accounting A form of reporting which identifies costs & revenues with departments, or with individuals who are most concerned with managing them

Budget Centre Each section of an organisation for which a budget is prepared

CATEGORIES OF RESPONSIBILITY CENTERS Type

Manager has control over

Principal performance measurement

Revenue centre

Sales revenue, selling expenses

Sales revenue

Cost centre

Controllable costs

Variance analysis, efficiency

Profit centre

Controllable costs, SP (including transfer prices), output volumes

Profit

Investment centre

Controllable costs, SP (including transfer prices), output volumes, investment in assets

ROI, residual income, other financial ratios

CONTROLLABLE COST • Controllable costs are items of expenditure which can be directly influenced by a manager within a given time span • Managers of responsibility centres should only be held accountable for costs over which they have some influence  This is important for motivation because it is demoralising for managers who feel that their performance is being judged on basis of something over which they have no influence  It is important for control in that control reports should ensure that information on costs is reported to manager who is able to take action to control them

CONTROLLABLE COST • Responsibility accounting attempts to associate costs, revenues, assets & liabilities with the managers most capable of controlling them ďƒźAs a system of accounting, it therefore distinguishes between controllable & uncontrollable costs.

MASTER BUDGET • Summary of all the financial projections in the organisation’s individual budgets for a set time period.

• Comprises budgeted income statement, B/S & capital expenditure budget and cash budget

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FLEXIBLE BUDGETS Before introducing the concept of flexible budgeting it is important to understand the following terms:

• Fixed budget: this is prepared before the beginning of a budget period for a single level of activity.

• Flexible budget: this is also prepared before the beginning of a budget period. It is prepared for a number of levels of activity and requires the analysis of costs between fixed and variable elements.

• Flexed budget: this is prepared at the end of the budget period. It provides a more meaningful estimate of costs and revenues and is based on the actual level of output.

FLEXIBLE BUDGET • Budgetary control compares actual results against expected results.

The difference between the two is called a variance.

• The actual results may be better (favourable variance) or worse (adverse variance) than expected.

• It can be useful to present these figures in a flexible budget statement. (Note: This is not the same as a flexible budget).

FLEXIBLE BUDGETS Procedure • Decide whether costs are fixed, variable or semi-variable • Split semi-variable costs into their fixed and variable components using the high-low method • Flex the budget to the required activity level

• Many cost items in modern industry are fixed costs so the value of flexible budgets is dwindling

FLEXIBLE / FLEXED BUDGET For example, suppose that a company expects to sell 10,000 units of output during the next year. A master budget (the fixed budget) would be prepared on the basis of these expected volumes.

However, if the company thinks that output and sales might be as low as 8,000 units or as high as 12,000 units, it may prepare contingency flexible budgets, at volumes of, say 8,000, 9,000, 11,000 and 12,000 units and then assess the possible outcomes.

ANSWER Tianjin Beer has a bottling plant for its beer and has prepared flexible budgets:

Required If actual production was 12,350 bottles and the production costs incurred totalled $90,000, what is the meaningful total variance for performance evaluation purposes?

ANSWER Materials: Variable cost = $3/unit

Overhead: Fixed cost = $20,000 Labour: (High-low method)

∴VC/unit = $2

Output 14,000 10,000 4,000

Cost 35,000 27,000 8,000

ANSWER By substitution into high output: Total VC = $28,000 ∴ Total FC

= $35,000 – $28,000 = $7,000

∴ Flexed budgeted cost: Materials (12,350  3) Labour (7,000 + 2  12,350) Overhead Actual costs – Flexed budgeted cost

$ 37,050 31,700 20,000 88,750 ∴ $1,250 (A)