Managing Finance and Budgets
Lecture 10
Budgetary Control
Session 10 – Budgetary Control
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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
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Incremental budgeting
Zero base budgeting
Activity Based Budgeting
Standard costing
Incremental Budgeting
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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)
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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)
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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
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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 zerobased budgeting? How might any disadvantages be
overcome?
Activity One- Solution
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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
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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
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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
Value of Sales
Direct Costs
Materials
Labour
Budget
100
40
20
Total Direct Costs
Gross Profit
Overheads
Admin Salaries
Travel
Other costs
Total Overheads
60
40
Net Profit
(5)
20
5
20
45
Comparison of Actual Performance (1)
£ 000
Value of Sales
Direct Costs
Materials
Labour
Total Direct Costs
Gross Profit
Overheads
Admin Salaries
Travel
Other costs
Total Overheads
Net Profit
Original Budget
Sales 1000 Units
Original
Budget
100
30
25
55
45
20
5
17
42
3
Actual Figures
Sales 1040 Units
Actual
Figures
Here we can see what
104
has happened at the
end of the period:
37
Although we have
24
produced and sold
61
slightly over target,
43
the sharp rise in the
cost of materials
19
means that we have
8
made an overall loss.
17
44
(1)
Comparison of Actual Performance (2)
Original Budget Sales (Units): 1000
Original
£ 000
Budget
Value of Sales
100
Direct Costs
Materials
30
Labour
25
Total Direct Costs
55
Gross Profit
45
Overheads
Admin Salaries
20
Travel
5
Other costs
17
Total Overheads
42
Net Profit
3
Actual Sales (Units): 1500
Actual
Figures
150
Here the original
sales targets have
been well
47
exceeded, and we
25
have increased our
72
profits
78
considerably
27
10
23
60
18
However all is not
as well as it
seems!
Flexible Budgets
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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
Original
£ 000
Budget
Value of Sales
100
Direct Costs
Materials
30
Labour
25
Total Direct Costs
55
Gross Profit
45
Overheads
Admin Salaries
20
Travel
5
Other costs
17
Total Overheads
42
Net Profit
3
Actual Sales (Units): 1500
Flexed
Actual
Budget
Figures
150
150 Here we have
45
30
75
75
47
25
72
78
20
8
17
45
30
27
10
23
60
18
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
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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
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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:
Actual Figures
Profit :
Profit:
Sales Volume Variance:
£30,000
£12,000
£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
Relationship between the total, usage and price
variances of direct materials
Total direct materials variance
Direct
materials
usage
variance
Direct
materials
price
variance
Relationship between the budgeted and actual profit
Budgeted profit
plus
All favourable variances
minus
All adverse variances
equals
Actual profit
Key elements for budgetary control
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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
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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 budgetsetting 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.
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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?
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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
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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)
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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)
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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
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KEY CONCEPTS:
Forms of budget-setting
Financial control structures and techniques
Behavioural Issues
Non-financial measures