ACCA F5 Performance Management - 2010 - Study text - Emile Woolf Publishing
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Chapter 7: Budgeting
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They can be used to communicate the company’s plans to the managers and
other individuals who have to implement them
In principle, they can motivate managers and employees, by setting performance
targets for achievement. Many entities have incentive schemes, whereby
individuals are rewarded, for example with an annual cash bonus, for achieving
their performance targets.
When a budget is approved, it establishes authorised expenditure limits for
departments.
A budget provides a benchmark against which actual performance can be
measured, and so acts as an information system for management control
(through budgetary control).
Within a budgetary system, there is a close link between budgeting (preparing the
financial plan) and budgetary control (monitoring actual performance and possibly
taking control measures when actual performance differs from the budget).
1.2 Budgeting: co-ordination of corporate and divisional objectives
Budgets should be an effective method of co-ordinating activities throughout an
entity, and reconciling differences between corporate and divisional or
departmental objectives.
Many budgets are prepared on a functional basis, which means that budgets are
prepared for each department within the entity (budget for production, for
marketing, for the human resources department, for IT services and so on).
When companies are organised as divisions, each with its own functional
departments, there will be a budget for each division as well as for each
functional department within each division.
In principle, the objectives of each department or division should be consistent
with each other. In practice, however, this is not always the case and there may
be differences or conflicts between divisional objectives and the objectives of the
entity as a whole.
Corporate objectives may be longer-term in nature than divisional objectives. For
example, the board of directors of a company may have a five-year plan for profit
growth, but heads of divisions might be rewarded with annual cash bonuses based
on annual profit performance. In such a situation, the longer-term corporate
objectives may conflict with the objectives of divisional managers whose aim might
be to maximise profit in the current year in order to maximise their bonuses.
Differences in objectives may also occur when the priorities and concerns of the
directors of a company differ from those of the divisional managers. For example,
some companies have developed environmental strategies based on creating a
sustainable business: a sustainable business is one which operates within its
environment without depleting the earth’s natural resources or creating
irrecoverable damage to the environment through pollution. Although the board of
directors of a company may have a sustainable business strategy, divisional
managers may not share the same views and may think that the environmental
policies of the board are restricting.
Differences in objectives can also exist at departmental level. For example within a
manufacturing company:
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The production department managers might have an objective of reducing
average costs through longer production runs and greater standardisation of
products.
In contrast, sales managers might have an objective of greater diversity in
product design (and shorter production runs) in order to meeting the differing
needs of customers in different segments of the market. Greater diversity should
result in higher sales revenue.
Conflict can also arise when an entity has a limited budget for new expenditure, and
divisional managers might compete for the limited available funds. For example, if
there is only a small amount of money available for discretionary spending, it is
inevitable that disagreements will occur about how the money should be spent – on
research and development, marketing, new IT systems, training of staff, and so on.
The nature of conflicting objectives can vary widely. For the purpose of your
examination, you need to be aware that conflicts between corporate and divisional
objectives, or between departmental objectives, may exist. In dealing with an
examination question on budgeting, you may be required to identify a conflict
between objectives in the data or ‘case study’ in the question.
Resolution of conflicts
One of the benefits of budgeting is that a budget covers all the activities of an entity,
and sets performance targets for each department and division. In the process of
preparing the budget, any conflicts between objectives will become apparent. The
budgeting process provides an opportunity to:
identify conflicts between corporate and divisional interests
identify the conflicting objectives of different departments
establish ‘rules’ for resolving the differences and making planning choices.
Chapter 7: Budgeting
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Preparing a budget
Organising for budgeting
Stages in the budgeting process
Preparing a budget: example
Sources of information for budgeting
2 Preparing a budget
From your previous studies, you should already be familiar with the basic process
of preparing an annual budget. It is unlikely that an examination question will test
your arithmetical ability to construct a budget, but you should be able to do so if
required.
This section provides some revision material about budget preparation.
2.1 Organising for budgeting
Medium-sized and large companies should have a well-defined budget process,
because a large number of individuals have to co-ordinate their efforts to prepare
the budget plans. The budget process may take several months, from beginning to
eventual approval by the board of directors.
The budget process might be supervised and controlled by a special committee (the
budget committee), consisting of executive directors and senior managers from all
the main areas of the business. This committee will co-ordinate the various
functional budgets submitted to it for review, and give instructions for changes to
be made when the draft budgets are unsatisfactory or the functional budgets are not
consistent with each other.
Although the budget committee manages the budget process, the functional
budgets (departmental budgets) are usually prepared by the managers with
responsibility for the particular aspect of operations covered by that functional
budget.
Budget manual
To guide everyone involved in the budgeting process, there should be a budget
manual or budget handbook, setting out:
the key objectives that the budget should plan towards
the planning procedures and the timetables to follow when preparing the
budget
instructions about the budget details to be submitted to the budget committee in
the functional budgets
responsibilities for the functional budgets (sales budget, production budget,
purchases budget, direct labour budget, overhead expenditure budgets, etcetera)
details of the budget approval process.
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To co-ordinate different functional budgets, the budget committee may also specify
key assumptions on which the budgets should be prepared, such as assumptions
about price inflation or about any restrictions on recruitment of new staff that will
be imposed in the next financial year.
2.2 Stages in the budgeting process
The stages in preparing a budget within a manufacturing company might be as
follows:
Stage 1: Identify the key budget factor (or principal budget factor). This is the
factor that will set a limit on all other activities in the budget. The key budget
factor is normally sales volume. However, if there is a shortage of key skilled
staff, the availability of skilled labour could be the principal budget factor.
All the functional budgets should be prepared within the limitation of the key
budget factor. For example, even if the company has the capacity to produce
more output, it should not produce more than it can profitably sell. In such a
situation, the production budget will be limited by the sales budget.
Stage 2: Prepare the functional budget for the key budget factor. Usually, this
means that the first functional budget to prepare is the sales budget.
Stage 3: Prepare the other functional budgets, in logical sequence where
necessary. When the sales budget has been prepared, a manufacturing
organisation can then prepare budgets for inventories, a production budget,
direct labour budgets and materials purchasing budgets. Expenditure budgets
should also be prepared for overhead costs (production overheads,
administration overheads and sales and distribution overheads).
Stage 4: Submit the functional budgets to the budget committee for review and
approval. The functional budgets are co-ordinated by the budget committee,
which must make sure that they are both realistic and consistent with each other.
It is not unusual for functional budgets to be rejected by the budget committee
and sent back for revising. Several versions of a functional budget might be
needed before a version acceptable to the budget committee is eventually
produced.
Stage 5: Prepare the ‘master budget’. This is the budget statement that
summarises the plans for the budget period. The master budget might be
presented in the form of:
− a budgeted income statement for the next financial year
− a budgeted statement of financial position as at the end of the next financial
year
− a cash budget or cash flow forecast for the next financial year.
It should be possible to prepare the master budget statements from the
functional budgets.
Stage 6: The master budget and the supporting functional budgets should be
submitted to board of directors for approval. The board approves and authorises
the budget.
Stage 7: The detailed budgets are communicated to the managers responsible for
their implementation.
Chapter 7: Budgeting
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Stage 8: Control process. The annual budget should be divided into a number of
shorter control periods, such as 12 one-month control periods. Actual results for
each control period should be recorded and reported to management. Actual
results should be compared with the budget, and significant differences should
be investigated. The reasons for the differences or variances should be
discovered, and where appropriate, control measures should be taken.
Comparing actual results with the budget therefore provides a system of control.
The managers responsible for activities where actual results differ significantly
from the budget should be held responsible and accountable.
2.3 Preparing a budget: example
A ‘master budget’ is the budget for an entire organisation, and consists of functional
budgets, together with:
a budgeted income statement for the financial year
a cash budget
a budgeted statement of financial position as at the year end
possibly, a capital expenditure budget (covering more than one financial year,
but updated on a ‘rolling’ basis each year).
The following example illustrates the logical approach that can normally be used to
prepare functional budgets and a master budget for a manufacturing organisation.
(The mathematics of budgeting for service industry organisations are usually
easier).
It is assumed here that the key budget factor is sales demand, and the initial
functional budget to prepare is the sales budget.
In practice, budgets are usually much more complex, and are commonly prepared
with computer models, such as a spreadsheet model.
Example
Yellow Co makes and sells two products, Product P and Product Q. The direct
production costs of these products are as follows:
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Product P $
Product Q $
Direct materials
Material A (2 kg × $0.80) 1.60
(0.5 kg × $0.80) 0.40
Material B (0.5 kg × $2) 1.00
(3 kg × $2) 6.00
Material C (1 kg × $4) 4.00
-
6.60
6.40
Direct labour
Grade X (0.25 hrs × $10) 2.50
(0.5 hrs × $10) 5.00
Grade Y (0.25 hrs × $8) 2.00
(0.75 hrs × $8) 6.00
4.50
11.00
Total direct cost 11.10
17.40
The sales price and expected sales volume for each product next year are as follows:
Product P Product Q
Sales price per unit $20 $30
Budgeted sales volume 20,000 units 30,000 units
Budgeted overhead costs are as follows:
Production overheads $80,000
including depreciation charges of
$20,000
Administration overheads $120,000
including depreciation charges of
$10,000
Selling and distribution
overheads
$190,000
including depreciation charges of
$10,000
Bad debts are expected to be 2% of sales, and should be provided for. The costs of
bad debts and allowances for doubtful debts are not included in the overhead costs
above.
Inventories of raw materials at the beginning of January, and planned closing
inventories at the end of January, are as follows:
Direct material Inventory
At beginning of January At end of January
kilos kilos
Material A 5,000 6,000
Material B 5,500 4,000
Material C 1,000 2,500
No further changes in inventory levels are planned during the year.
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The sales budget
The sales budget is prepared for each product individually, and for sales revenue in
total.
Product Sales quantity
Sales price
Sales revenue
units
$
$
P 20,000
20
400,000
Q 30,000
30
900,000
Total
1,300,000
The production budget
The production budget is calculated initially in units, although a production cost
budget can be prepared later. The production budget in units is prepared for each
product, as follows:
Units
Sales budget in units S
Plus budgeted closing inventory C
Minus opening inventory (O)
Production budget (S+C-O)
The production budget for each product in units is the sales budget in units plus
any planned increase in finished goods inventories (and work-in-progress
inventories) minus the opening inventories of finished goods (and work in
progress).
In this example, there are no planned changes in finished goods inventories;
therefore the production budget in units is the same as the sales budget.
The direct materials usage budget
The direct materials usage budget is a statement of the quantities of direct materials
required for production, and their cost. The budget is prepared for each item of
material separately, but a total usage cost can also be shown.
Material A
Material B
Material C Total
kilos
kilos
kilos
To make 20,000 P 40,000
10,000
20,000
To make 30,000 Q 15,000
90,000
0
Total quantities 55,000
100,000
20,000
Price per kilo $0.80
$2
$4
Total cost $44,000
$200,000
$80,000 $324,000
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The direct labour budget
The direct labour budget is similar to the direct materials usage budget. It is a
statement of the quantities of direct labour required for production, and its cost. The
budget is prepared for each grade of labour separately, but a total direct labour cost
can also be shown.
Grade X
Grade Y
Total
hours
hours
To make 20,000 P 5,000
5,000
To make 30,000 Q 15,000
22,500
Total hours 20,000
27,500
Cost per hour $10
$8
Total cost $200,000
$220,000
$420,000
The material purchases budget
The purchases budget is the budget for materials purchases. The purchases budget
might be prepared for all materials, direct and indirect, or for direct materials only.
The purchases budget differs from the materials usage budget by the amount of the
planned increase or decrease in inventory levels of materials in the budget period.
The purchase quantities are calculated first, and these are converted into a
purchases cost at the budgeted price for each material item. Purchase quantities are
calculated as follows:
Units
Material usage budget in units S
Plus budgeted closing inventory C
Minus opening inventory (O)
Purchases budget, in units (S+C-O)
The purchases budget in our example is as follows:
Material A
Material B
Material C Total
kilos
kilos
kilos
Usage budget 55,000
100,000
20,000
Closing inventory 6,000
4,000
2,500
61,000
104,000
22,500
Opening inventory (5,000)
(5,500)
(1,000)
Budgeted purchases 56,000
98,500
21,500
Price per kilo $0.80
$2
$4
Purchases budget in $ $44,800
$197,000
$86,000 $327,800
Chapter 7: Budgeting
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Budgeted income statement
The functional budgets, together with budgets for the overhead costs and any other
items of cost, should be sufficient to prepare a budgeted income statement for the
period.
In our example, we need to remember that there should be bad and doubtful debt
provisions for the year of 2% × $1,300,000 = $26,000
The budgeted income statement below is presented in a marginal costing format.
Product P
Product Q Total
$ $ $
Sales 400,000
900,000 1,300,000
Variable cost of sales
Direct materials 132,000
192,000 324,000
Direct labour 90,000
330,000 420,000
Total variable costs 222,000
522,000 744,000
Contribution 178,000
378,000 556,000
$
Production overheads
80,000
Administration overheads
120,000
Sales and distribution overheads
190,000
Bad and doubtful debts
26,000
416,000
Budgeted profit
140,000
2.4 Sources of information for budgeting
Budgets are prepared from a large number of forecasts and estimates. Some of the
information comes from sources within the entity and other information is obtained
from external sources.
An important source of internal information is the entity’s cost and management
accounts. Results in the current financial year are often used as a basis for budgeting
costs and revenues in the next year.
Some information is also needed from external sources. For example:
Market research information, or information about competitors, will be useful
for preparing sales budgets for the next financial year. This information might be
gathered by the entity’s marketing department or sales team.
Economic information, such as government forecasts, might be useful for
estimating the probable rate of inflation in certain costs (such as wages and
salary increases), and the likely level of interest rates and foreign exchange rates.
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Budgetary systems
Top-down and bottom-up budgeting
Periodic budgets and rolling budgets (continuous budgets)
Incremental budgeting and zero based budgeting (ZBB)
Activity based budgeting
Budgeting: feed-forward control
Difficulties in changing a budgetary system
Budgetary systems and uncertainty in the environment
3 Budgetary systems
A budgetary system is a system for preparing budgets (and producing control
reports for the purpose of budgetary control). There are several budgetary systems,
and entities will choose a system that is appropriate for their needs and
circumstances.
3.1 Top-down budgeting and bottom-up budgeting
Top-down budgeting
In a system of top-down budgeting, the budget targets for the year are set at senior
management level, perhaps by the board of directors or by the budget committee.
Top-level decisions might be made, for example, about the amount of budgeted
profit that will be achieved, the growth in sales, reductions in production costs and
other functional department costs, and so on.
Divisions and departments are then required to prepare a budget for their own
operations that is consistent with the budget imposed on them from above.
For example, the board of directors might state that in the budget for the next
financial year, sales revenue will grow by 5% and profits by 8%. The sales director
would then be required to prepare a more detailed sales budget in which the end
result is a 5% growth in annual sales revenue. A production budget and other
functional budgets will then be prepared that is consistent with the sales budget.
The target for 8% growth in profits cannot be checked until all the functional
budgets have been prepared in draft form. If the initial draft budgets fail to achieve
8% growth in profits, some re-drafting of the budgets will be required.
This process is called top-down budgeting because it starts at the top with senior
management and works its way down to the most detailed level of budgeting
within the management hierarchy. This might be departmental level or possibly an
even smaller unit level, such as budgets for each work section within each
department. A system of top-down budgeting would normally be associated with
an entity where management control is highly centralised.