MOD 6000: Managerial Accounting for Non-Accountants Budgeting & Budgetary Control Outcomes 1. Explain the nature and purpose of budgets 2. Appreciate the difficulties encountered in preparing budgets 3. Understand the concept of the master budget and the budget manuals 4. Appreciate the role of the budget holders in a business organization 5. Describe various types of budgets. 6. Explain the concept of Zero-Based and Activity Based Budgeting 2 Contents 1. Nature and Purpose of Budgets. 2. Challenges in Budgeting. 3. Master Budget. 4. Budget Manual. 5. Types of Budgets. 6. Zero-Base Budgeting. 7. Activity Based Budgeting. 3 What is a Budget? A statement, expressed in monetary terms indicating how the business resources are to be deployed. Business resources: human resources. finance, physical and Business plans are usually made in terms of physical units such as number of units to produce, number of hours to work amounts of materials to be consumed and so on. 4 Aspects of Budgeting 1. Involves future (forecasting). 2. Prepared for a specific period called the budget period. The budget period should be reasonable to allow budgetary control. 3. Prepared for departments or functions. 4. Are the basic financial plans. 5. Involves responsibility accounting. 6. Implemented by the departmental heads. Different budgets in the organization are interrelated. 7. Are often affected by “key” or limiting factors. 5 Reasons for Budgeting 1. Scheduling of resources. 2. Medium of communication for organizational plans and objectives. 3. Helps to achieve co-ordination departments and functions. between 4. Motivation element. 5. Helps in Management by Exception. 6. Enables budgetary control. 7. Leads to reduced costs and greater efficiency. 8. Performance evaluation. 6 Responsibility accounting - A system of accounting that separates revenues and costs in to areas of personal responsibility in order to monitor and assess the performance of each part of an organisation - A responsibility center is a function or department of an organisation that is headed by a manager who has direct responsibility for its performance - The manager must: (i) Know what his or her resources are (ii) The rate at which the resources are consumed in operations (iii) How well the resources are used 7 Responsibility Centers Cost centers, profit centers and investment centers. - Decisions need to be made on the level of details that is provided and the frequency of generation of information - Cost benefit of information must also be established - A control system is desirable to ensure that actual performance is checked against the budgets 8 Types of Responsibility Centers Responsibility centers 9 Revenue Centers Accountable for revenues only. To have validity in planning and control, the revenue center managers should have control over how revenues are raised. Managers are evaluated on the basis of actual sales or orders booked against budgets or quotas Example: a unit of a chain store in a mall. 10 Cost Center - A collecting place for certain costs before they are analyzed further - May include a department, machine, group of machines, project or product - Each cost center is assigned a cost code in which direct costs are charged and indirect costs apportioned to it - The idea behind cost centers is to hold managers accountable for the costs. - Eg R&D, Marketing. 11 Profit Center - A unit of an organisation to which both revenues and costs are assigned so that profitability of the unit may be measured. - Differs with a cost center in that it accounts for both costs and revenues - Managers must have control of both costs and revenues - It is possible to have several cost centers in one profit center 12 Profit Center….contd e.g. departmental stores of larger chains – Wal Mart, restaurants, corporate hotels such as Hilton). The store manager will have responsibility for pricing, product selection and promotion. 13 Investment Center This is a profit center whose performance is measured by its return on capital employed Investment center manager must have control over the investment policy of his department Several profit centers may share the same capital items and so investment centers are likely to include several profit centers Key ratios include; profit to sales ratio, asset turnover ratios, cost to sales ratios and cost variances 14 Wrap up on Responsibility Accounting All responsibility centers evolve from the concept of “controllability.” Controllability principle states a manager should be assigned responsibility for the revenue, costs, or investment that (s)he could control. Revenues, costs, or investments that do not fall under a manager’s control must be excluded when evaluating the manager or his/her center. Problem with this concept: In most organizations, many revenues and costs are jointly earned or incurred and differentiation the controllable from the uncontrollable is difficult. 15 An alternative to “Controllability” Some argue that performance measures should be chosen to influence decision-making behavior. For example, if market prices for raw material is increasing, what can a manager do? Perhaps, enter into long term contract for fixed prices for raw materials. If electricity consumption cost is going up, find out how consumption can be economized (better machines, lighting, reduce waste). 16 Challenges in Budgeting 1. Too much reliance on the technique as a substitute for good management. 2. Affected by factors beyond the control of the firm. 3. May cause antagonism and decrease motivation. 4. Budgetary variances may not necessarily relate to poor managerial performance. 5. Inflexibility of operations. 6. Top managements’ interference. 7. Expensive and time-consuming process. 8. Requires participation of all the concerned persons. 17 Conditions for Effective Budgeting 1. Top management involvement. 2. Clear-Cut objectives of budgeting. 3. Organization structure with clearly defined responsibilities. 4. Genuine and full involvement of the line managers. 5. Appropriate accounting information system, and 18 Conditions continued… 6. Revise budgets and targets to suit the changing conditions. 7. Administer budgets in a flexible manner. 8. Constant monitoring of the budget by comparing actual results and budget results. 9. Create Budget Centers. 10. Prepare and maintain budget manuals. 11. Make use of Budget Committees. 19 Budget Making Process 1. Budget Committee. 2. Derive the key forecasts. 3. Prepare quantity budgets. 4. Produce financial budgets. 5. Produce the master budget. 6. Submit budget for approval. 7. Publish the budget. 8. Implement. 9. Budgetary control. 20 Types of Budgets 1. Sales (Revenue) Material Budgets (Quantity & Cost) 2. Production 3. Labour 4. Capital Expenditure 5. Cash 6. Service (utility) 21 Zero Base Budgeting (ZBB) A method of budgeting whereby all activities are re-evaluated each time a budget is formulated. Each functional budget starts with the assumption that the function does not exist and is at zero cost. Increments of cost are compared with increments of benefit, culminating in the planning maximum benefit for a given budgeted cost. Can be applied in the manufacturing firms, profit making as well as non-profit making organizations to control service expenditure. 22 Why ZBB? 1. Results to more efficient allocation of resources. 2. Focuses attention on value for money by relating inputs with outputs. 3. Develops a questioning attitude and makes it easier to identify inefficient, obsolete or less cost effective operations. 4. Leads to greater staff and management knowledge of the operations and activities of the organizations and can increase motivation. 5. It is a systematic way of challenging the status quo and obliges the organization to examine alternative activities and existing cost behavior patterns and expenditure levels. 6. It can be used where no past cost data exists. 23 ZBB Limitations 1. Time consuming process. 2. Generates a lot of paperwork especially for the decision packages. 3. There is considerable management skill required in both drawing up the decision packages and for the ranking process. 4. ZBB is not always acceptable to staff or management or trade unions who may prefer the status quo. 5. Political pressures within organizations also contribute to the problem of ranking. 6. It may emphasize short-term benefits to the detriment of longer term ones, which in the end may be more important. 24 Activity Based Budgeting A method of budgeting in which the activities that incur costs in every functional area of an organization are recorded and their relationships are defined and analyzed. Activities are then tied to strategic goals, after which the costs of the activities needed are used to create the budget. ABB begins by looking at results and the activities that created them, as opposed to cost-based budgeting, which often begins with raw input and material and works outward. ABB can also help firms create more accurate financial forecasts. 25 Approaches to budgeting Two approaches to budgeting – Top-down (imposed) and Bottom up (participatory) Top down – A budget allowance that is set without permitting the ultimate budget holder to have the opportunity to participate in the budgeting process 26 Top Down Effective? 1. Newly formed organisations 2. Very small organisations 3. During periods of economic hardships 4. When operational managers lack budget skills 5. When the organisation’s different units require precise coordination 27 Top Down Approach - Merits 1. Strategic plans are likely to be incorporated in to the planned activities 2. They enhance coordination between the plans and objectives of the departments 3. They use senior managers awareness of total resource availability 4. They decrease the input from inexperienced or uninformed lower level employees 5. They decrease the time required to prepare budgets 28 Disadvantages 1. Dissatisfaction, defensiveness and low morale amongst the employees 2. Feeling of team spirit is eroded 3. The acceptance of organizational goals and objectives could be limited 4. Feeling of the budget as a punitive device could arise 5. Heightens political “tensions” in the organisation 6. Does not provide opportunity for lower managers to learn 29 Participative budgeting – bottom up - Also referred to as self imposed budgeting. - A budgeting system in which all budget holders are given the opportunity to participate in setting their own budgets - Budgets are developed by low level managers who then submit to top management for approval 30 Advantages of participative budgets 1. Based on information from employees who are familiar with the operations on ground 2. Knowledge spread amongst the people 3. Morale and motivation is improved 4. They increase operational managers commitment to organisation objectives 5. Are more realistic 6. Coordination between units is improved 7. Specific resource requirements are included 8. Senior manager overview is combined with operational level details 9. Individual manager’s aspiration levels are taken in to account 31 Disadvantages – participative budgets 1. They consume more time 2. Changes implemented by senior management may cause dissatisfaction 3. Not effective if managers are not competent to make the budgets 4. Can support empire building by subordinates 5. May have slacks 32 Negotiated Style of Budgeting A budget in which allowances are set largely on the basis of negotiations between budget holders and those to whom they report - A compromise between the imposed and participative approaches 33 Summary 1. Budgets are the basic financial plans. 2. Budgets show how financial resources will be deployed in the future. 3. The budget making process should be orderly and participative. 4. Budgets are affected by limiting factors (constraints). Appropriate research should be done to reveal the extent and impact of these factors. 34 Summary 5. Different organizational budgets are integrated into the master budget. 6. Activity based budgeting involves paying attention to the cost and revenue drivers. 7. Zero Based Budgeting does not make use of past cost information. Rather every items’ inclusion in the budget is justified by the manager concerned. 35