5.

Budgetary Control as a control tool

5. Budgetary Control as a Control Tool

Budgetary Control
One of three main functions of management is control. The other two are planning and directing & motivating Budgets are the main tools for controlling:
Compare actual results with planned objectives

5. Budgetary Control as a Control Tool

Budgetary Control

5. Budgetary Control as a Control Tool

Budgetary Control
A formalized reporting system should :
Identify the name of the budget report:
such as the sales budget or the manufacturing overhead budget weekly or monthly

Frequency of the report

Purpose of the report Recipient(s) of the report

5. Budgetary Control as a Control Tool

Budgetary Control Reporting System

Name of Report
Sales Labor

Frequency
Weekly Weekly

Purpose

Primary Recipient(s)

Scrap

Daily

Department Monthly Overhead costs Selling expenses Monthly Income Statement Monthly and quarterly

Determine whether sales Top management and sales goals are being met manager Control direct and indirect Vice president of production labor costs and production department managers Determine efficient use of Production manager materials Control overhead costs Department manager Control selling expenses Determine whether income objectives are being met Sales manager Top manager

The schedule above illustrates a partial budgetary control system for a manufacturing company. Note the frequency of reports and their emphasis on control
5. Budgetary Control as a Control Tool 5

Benefits of budgets
1. Forces managers to do planning. 2. Realistic performance targets. 3. Basis for controlling what happens within the organisation. 4. Helps coordinate the activities of the various centres that make up the business. 5. Communication managers exchange information on ideas, etc. 6. Motivating tool if the process involves staff.
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Budget classification
Static (fixed) budgets: prepared for one level of activity, usually around the forecasts made for sales. Flexible budgets: a series of fixed budgets set to different levels of sales activity (or any other activity) within which the organization may operate.

5. Budgetary Control as a Control Tool

Cost/volume relationships
Fixed costs: in total remain the same for a period of time and over a particular range of activity.

Variable costs: in total tend to change as the level of activity changes.

5. Budgetary Control as a Control Tool

Cost/volume relationships
Fixed costs: in total remain the same for a period of time and over a particular range of activity. Variable costs: in total tend to change as the level of activity changes.

5. Budgetary Control as a Control Tool

Budget processes
Zero-based budgeting: sets the initial figures for each activity to zero. Period budgets: developed for a specific period of time, e.g. a month. Rolling (continuous) budgets: are continually updated by periodically adding a new incremental time period and dropping the period just completed.
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Types of budgets
Revenue budgets: estimates of the income of an organization from the sale of goods and/or provision of services for a specific period. Operating budgets: estimate activities that will affect profit.
From Wikipedia: An operating budget is the annual budget of an activity stated in terms of Budget Classification Code, functional/subfunctional categories and cost accounts. It contains estimates of the total value of resources required for the performance of the operation including reimbursable work or services for others. It also includes estimates of workload in terms of total work units identified by cost accounts.

Budgeted financial statements: show the estimated results and projected financial position of a business. That is budgeted revenue, balance sheet and statement of cash flows.

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Types Of Budgets
Sales budget: The sales budget is an estimate of future sales, often broken down into both units and dollars. It is used to create company sales goals. Production budget: Product oriented companies create a production budget which estimates the number of units that must be manufactured to meet the sales goals. The production budget also estimates the various costs involved with manufacturing those units, including labor and material. Cash Flow/Cash budget: The cash flow budget is a prediction of future cash receipts and expenditures for a particular time period. It usually covers a period in the short term future. The cash flow budget helps the business determine when income will be sufficient to cover expenses and when the company will need to seek outside financing. Marketing budget: The marketing budget is an estimate of the funds needed for promotion, advertising, and public relations in order to market the product or service. Project budget: The project budget is a prediction of the costs associated with a particular company project. These costs include labor, materials, and other related expenses. The project budget is often broken down into specific tasks, with task budgets assigned to each. Revenue budget: The Revenue Budget consists of revenue receipts of government and the expenditure met from these revenues. Tax revenues are made up of taxes and other duties that the government levies. Expenditure budget: A budget type which include of spending data items.
5. Budgetary Control as a Control Tool 12

Master budget
A combination of all the budgets of an organization.
Merchandising firm Sales budget Purchases budget Professional services Fees or fees & sales budget Professional & support labor budget Manufacturing firm Sales budget Cost of production budget

Cost of goods sold budget Other operating expense budgets

Cost of supplies used Cost of goods sold budget Other operating expense budgets Other operating expense budgets

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The Master Budget - Schematic

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Master budget
Irrespective of the type of organization, the following budgets will be part of the master budget: Statement of financial performance [revenue budget] Statement of financial position [balance sheet] Statement of cash flow
5. Budgetary Control as a Control Tool 15

Static Budget Reports

Projection of budget data at one level of activity. Data for different levels of activity are ignored. Actual results are always compared with the budget data at the activity level in the master budget.

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Budget and Actual Sales Data

To illustrate the role of a static budget in budgetary control, we will use selected data for Hayes Company. Budget and actual sales data for the Kitchen-mate product in the first and second quarters of 2005 are as follows:

Sales Budgeted Actual Difference

First Quarter Second Quarter $180,000 179,000 $210,000 199,500

Total $390,000 378,500

$1,000

$10,500

$11,500

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Sales Budget Report: First Quarter

The sales budget report for Hayes Companys 1st quarter is shown below.
HAYES COMPANY Sales Budget Report For the Quarter Ended March 31, 2005 Difference Favorable F Budget Actual Unfavorable U $180,000 $179,000 $1,000 U

Product Line Kitchen-mate

The report shows that sales are $1,000 under budget - an unfavorable result. This difference is less that 1% of budgeted sales ($1,000/$180,000 =.0056), we will assume that top management of Hayes Company will view the difference as immaterial and take no specific action.
5. Budgetary Control as a Control Tool 18

Sales Budget Report: Second Quarter

HAYES COMPANY Sales Budget For the Quarter Ended June 30, 2005
Second Quarter Difference Favorable F Budget Actual Unfavorable U $210,000 $199,500 $10,500 U

Product Line Kitchen-mate

The second quarter shows that sales were $10,500 below budget, which is 5% of budgeted sales ($10,500/$210,000). Top management may conclude that the difference between budgeted and actual sales in the second quarter merits investigation and will begin by asking the sales manager the cause(s).

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Uses and Limitations

A static budget evaluates a managers effectiveness in controlling costs when:
Actual level of activity closely approximates the master budget activity level, and/or Behavior of the costs in response to changes in activity is fixed, i.e. costs do not change say if sales is more than budgeted

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Flexible Budgets
A flexible budget projects budget data for various levels of activity. The flexible budget recognizes that the budgetary process is more useful if it is adaptable to changed operating conditions.

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Static Overhead Budget

BARTON STEEL Manufacturing Overhead Budget (Static) Forging Department For the Year Ended December 31, 2005 Budgeted production in units(steel ingots) 10,000 Budget costs Indirect material $ 250,000 Indirect labor 260,000 Utilities 190,000 Depreciation 280,000 Property taxes 70,000 Supervision 50,000 $1,100,000
(Budget based on 10,000 units of production)
Barton Steel prepares the above static budget for manufacturing overhead based on a production volume of 10,000 units of steel ingots.
5. Budgetary Control as a Control Tool 22

Static Overhead Budget Report

If demand for steel ingots has increased and 12,000 units are produced during the year, rather than 10,000, the budget report will show very large variances. This is because the comparison is based on budget data based on the original activity level (10,000 steel ingots). Variable budget allowances have increased with production.

BARTON STEEL Manufacturing Overhead Budget Report (Static) Forging department For the Year Ended December 31,2005 Difference Budget 10,000 Actual 12,000 Favorable F Unfavorable U

Production in units Costs Indirect materials Indirect labor Utilities Depreciation Property taxes Supervision

$ 250,000 $ 295,000 $ 45,000 U 52,000 U 260,000 312,000 190,000 225,000 35,000 U 280,000 280,000 -0-070,000 70,000 -050,000 50,000 $132,000 ? $1,100,000 $1,232,000

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Variable Costs per Unit

Item
Indirect material Indirect labor Utilities

Total Cost Production Per Unit

$250,000 /10,000 units 260,000 /10,000 units 190,000 /10,000 units $700,000
$25 26 19 $70

Comparing actual variable costs with budgeted costs is meaningless (due to different levels of activity), variable per unit costs must be isolated, so the budget can be adjusted. An analysis of the budget data for these costs at 10,000 units produces the above per unit results:
5. Budgetary Control as a Control Tool 24

Illustration Budgeted Variable Costs (12,000 units)

Item
Indirect material Indirect labor Utilities

Computation
$25 X 12,000 26 X 12,000 19 X 12,000

Total
$300,000 312,000 228,000 $840,000

The budgeted variable costs at 12,000 units, therefore, are shown above. Because FIXED costs do not change in total as activity changes, the budgeted amounts for these costs remain the same.
5. Budgetary Control as a Control Tool 25

Flexible Overhead Budget Report

This budget report based on the flexible budget for 12,000 units of production shows that the Forging Department is below budgeta favorable difference.
BARTON STEEL Forging Department Manufacturing Overhead Budget Report (Flexible) For the Year Ended December 31,2005

Production in units Variable Costs Indirect materials $300,000 $ 295,000 Indirect labor 312,000 312,000 Utilities 228,000 225,000 Total variable 840,000 832,000 Fixed Costs Depreciation 280,000 280,000 Property taxes 70,000 70,000 Supervision 50,000 50,000 Total fixed 400,000 400,000 5. Total costs Budgetary Control as a Control $1,240,000 $1,232,000
Tool

Budget 12,000

Actual 12,000

Difference Favorable F Unfavorable U

$ 5,000 F -03,000 F 8,000 F -0-0-0-0$8,000 F

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Developing the Flexible Budget

Identify the activity index and the relevant range of activity. Identify the variable costs, and determine the budgeted variable cost per unit of activity for each cost. Identify the fixed costs, and determine the budgeted amount for each cost. Prepare the budget for selected increments of activity within the relevant range.

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Flexible Budget -A Case Study Master Budget Data

Fox Company wants to use a flexible budget for monthly comparisons of actual and budgeted manufacturing overhead costs. The master budget for the year ended December 31, 2005 is prepared using 120,000 direct labor hours and the following overhead costs.

Variable Costs
Indirect material Indirect labor Utilities Total

Fixed Costs
$180,000 Depreciation 240,000 Supervision 60,000 Property Taxes $480,000 Total $180,000 120,000 60,000 $360,000

STEP 1: Identify the activity index and the relevant range of activity: The activity index is direct labor hours and management concludes that the relevant range is 8,000-12,000 direct labor hours.

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Computation of variable costs per direct labor hour

STEP 2: Identify the variable costs and determine the budgeted variable cost per unit of activity for each cost. There are 3 variable costs and the per unit variable cost is found by dividing each total budgeted cost by the direct labor hours used in preparing the master budget (120,000 hours).

Flexible Budget-A Case Study

Variable Cost
Indirect material Indirect labor Utilities Total

Computation
$180,000/120,000 240,000/120,000 60,000/120,000

Variable Cost per Direct Labor Hour

$1.50 2.00 .50 $4.00

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Flexible Budget - A Case Study

Step 3: Identify the fixed costs and determine the budgeted amount for each cost. There are three fixed costs and since Fox desires monthly budget data, the budgeted amount is found by dividing each annual budgeted cost by 12 ($180,000/12 =$15,000).

Variable
Indirect material Indirect labor Utilities

Fixed
$180,000 Depreciation 240,000 Supervision 60,000 Property Taxes $480,000 $15,000 10,000 5,000

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Flexible Budget - A Case Study Flexible Monthly Overhead Budget

FOX MANUFACTURING COMPANY Flexible Monthly Manufacturing Overhead Budget Finishing Department For the Year 2005
Activity Level Variable Costs Indirect materials Indirect labor Utilities Total variable Fixed Costs Depreciation Property taxes Supervision Total fixed Total costs 8,000 $12,000 16,000 4,000 32,000 15,000 5,000 10,000 30,000 $62,000 9,000 $13,500 18,000 4,500 36,000 15,000 5,000 10,000 30,000 $66,000 10,000 $15,000 20,000 5,000 40,000 15,000 5,000 10,000 30,000 $70,000 11,000 $16,500 22,000 5,500 44,000 15,000 5,000 10,000 30,000 $74,000 12,000 $18,000 24,000 6,000 48,000 15,000 5,000 10,000 30,000 $78,000

Step 4: Prepare the budget for selected increments of activity within the relevant range.
5. Budgetary Control as a Control Tool 31

Flexible Budget - A Case Study Formula for Total Budgeted Costs

From the budget, the following formula may be used to determine total budgeted costs at any level of activity. For Fox Manufacturing, fixed costs are $30,000, and total variable costs per unit is $4.00. Thus, at 8,622 direct labor hours, total budgeted costs are:
Fixed Costs $30,000 Variable Costs $4.00 x 8,622
5. Budgetary Control as a Control Tool

Total Budgeted Costs $64,488

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Flexible Budget Reports

Another type of internal report produced by managerial accounting. Two sections:
Production data such as direct labor hours Cost data for variable and fixed costs

Flexible budgets are used to evaluate a managers performance in production control and cost control.

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Graphic Flexible Budget Data

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Flexible Overhead Budget Report

FOX MANUFACTURING COMPANY Flexible Manufacturing O verhead Budget Report Finishing Department For the Month Ended January 31, 2005
Direct labor hours (DLH) Expected 8,800 Actual 9,000 Variable costs Indirect materials Indirect labor Utilities Total variable Fixed costs Depreciation Supervision Proper ty taxes Total fixed Total costs Budget at 9,000 DLH Actual Costs 9,000 DLH Difference Favorable F Unfavorable U

$14,000 17,000 4,600 35,600 15,000 10,000 5,000 30,000 $65,600

$500$ U 1,000 F 100 U 400 F -0 -0 -0 -0 $ 400 F

13,500 18,000 4,500 36,000 15,000 10,000 5,000 30,000

$66,000

In this budget report, 8,800 DLH were expected but 9,000 hours were worked. Budget data are based on the flexible budget for 9,000 hours.

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Management by Exception
Review of a budget report
Focus on differences between actual results and planned objectives

Guidelines for identifying an exception.

Materiality expressed as a percentage difference from budget Controllability more restrictive for controllable items than for items that are not controllable by the manager
5. Budgetary Control as a Control Tool 36

General Control Characteristics for Expense Centers

Budget Preparation FOR ENGINEERED COST CENTER: Unit costs (of activity) provide basis for operating budget. The volume is determined by another dept. e.g. Sales (a Revenue center) is responsible for volume. The Expense center is responsible for cost/unit of item sold FOR DISCRETIONARY COST CENTER: The magnitude of the job to be done, determines the cost budget. Work is of two types - CONTINUING WORK: & SPECIAL WORK. Management Objectives budgetee proposes to accomplish pre-defined objectives, and expects to measured on those objectives.. Generally, personnel costs are the most significant cost item. Applies only to DISCRETIONARY COST CENTER. Current expense level is the starting point. Adjustments made for inflation & changes in workload. DRAWBACKS: ( 1.) No re-examination of current exp. Level. ( 2.)For additional services, additional budget. OVERHEADS INCREASE, PERIOD! From scratch, i.e. De Novo, certain resources required for each activity. Questions asked (a) should the activity be performed at all? (b) At what quality level? ( c) Is the current way, the right way? ( d) How much should it cost? Improvement tools - Benchmarking & Re-engineering. May be downsizing
5. Budgetary Control as a Control Tool 37

Incremental Budgeting

Zero-based review

General Control Characteristics for Expense Centers contd

Cost Variability In ENGINEERED : costs proportional to short-term changes in volume (for e.g. of sales). In DISCRETIONARY: Insulated from short-term fluctuations. Driven mainly by the annual budget. In ENGINEERED : set standards & measure actuals against them. Variances are dependent on volume. In DISCRETIONARY: comparision made with planned costs, in the annual budget. In ENGINEERED : Cost/ unit, required level/ volume of delivery In DISCRETIONARY: The stated level of activity must performed, at budget cost. Less than budget expenditure, could actually be a bad sign! Performance is measured non-financial terms good job, on-time ERP implemented,

Type of Financial Control

Measurement of Performance

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Expense centers (continued) Comparing Budgeted and Actual Costs

Budgeted costs are target estimates. It points to a goal to be achieved.

But, it is not written in concrete.

Actual costs are that were incurred during a given period.

The difference between the two could be either positive or negative variances.
However, making conclusions on the basis of positive or negative variances must be done carefully.

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Cost/Expense center variances A few pointers

Dont rush to conclusions based on positive or negative variances. Find the cause behind the variances. Decompose the flexible budget variances for unit-related costs into price and quantity components. Since analysis of variances for batch-related, product-sustaining, and facility-sustaining costs is not formalized and proceeds on an ad hoc basis, Use your common sense and rationale as a neutral evaluator.

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Administrative Centers & Support centers

EXAMPLES: ADMINISTRATIVE CENTERS: Senior Corporate Management, SBU Management SUPPORT CENTERS: Provide services to other responsibility centers CONTROL PROBLEMS: Difficult to measure output. Attempt to tangibalize, routinize. Possible for standard services such as payroll, i.e. x hours for one persons processing. But most often, it is not so easy to measure. Lack of Goal Congruence: The support centers desire to give perfect services (likely be at increased input costs) may mitigate against the profitability of the organization. However, it is difficult define the optimum level of service. In tough times, discretionary expenses are under the tightest control. BUDGET PREPARATION: Normally an Expense Center budget contains the list of expense items with their proposed budget & current years expense. Sometimes, when large budgets are involved different levels of discretion must available to top management The minimum required for being in business Discretionary activities (with objectives & estimated costs) Proposed increases, other than due to inflation

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Research & Development Centers

CONTROL PROBLEMS Difficulty in relating results to Inputs Better than Administrative centers, because often semi-tangible output can be seen e.g. patents, new products, new processes. An R&D project may be on for many years, before the company can see benefits: E.g. a new drug could take 10 years, before launch. NOW IT HAS COME DOWN (say 3-5 years). The importance of PLM solutions : It is difficult to establish the value of the
output.

Not all products succeed in the market. Issues of timing, changing tastes, LUCK MATTERS! It is difficult to even decide which area in research will even be useful LACK OF GOAL CONGRUENCE The technical perspective is to develop the best, maximum features, .THIS COSTS MONEY. But how much money to sink in , must be balanced properly The value R&D sees in its own baby, is not what customer sees! Here good selling skills can make a big difference DISCUSSION : CISCO small / incremental projects. Continue if customer confirms value. AGILE PRODUCT DEVELOPMENT METHODS- show value on day one, if possible. Co-create along with customer. The concept of alpha & beta customers
5. Budgetary Control as a Control Tool 42

The R&D continuum: Basic research, applied research, development to Product Testing. Basic research unplanned, only broad area of research is known (what we will discover is completely unknown). As we move towards Product Testing activities and outcomes become more measurable & predictable. Significant time between basic research & successful product.
XEROX started research in photo-optics. Took 24 years before the photo-copying machine was launched! > 90% research efforts fail to generate profitable outcomes.

Research & Development Centerscontd.

A possible MCS solution: 15% of an engineers time can be spent on innovation in any topic of personal interest. The need to establish an innovation culture maximum new value uncovered at minimum cost & risk . IBM, Microsoft, Apple, Google, .. Tatas are the only company in the league world class innovators R&D Program Management What should be the optimum R&D budget
% of revenue (is typically industry specific i.e. pharmaceutical 19%, computers 10%, Mfg 3-5% )

The budget is modified only annually. Many projects have to be planned over the long term. Expenses are calendarized. Performance Measurement Compare actual expenses, with budgeted The concept of earned value. To measure the effectiveness of the project
5. Budgetary Control as a Control Tool 43

Marketing Centers
Marketing involves two very different types of activities i.e. order-getting & order fulfillment. Order Getting Marketing:
Include test marketing, sales force activity, advertising & sales promotion The sales target is critical control point. Expenses are less important. Order Book is the most important number for a sales person. There is (should be) a good co-relation between expenses in sales promotion & advertising. Expense budgets tend to be short-term / flexible. Costs tend to discretionary costs

Order Fulfilling Logistics:

All activities after an order is received. Similar to an expense center like manufacturing. The expenses are proportional to sales volume / number of transactions (i.e. tend to be engineered costs)

OVERALL RESPONSIBILITY OF MARKETING : Generate Revenue

Revenue = no of units sold X price / unit >> both must be optimised. Measure of performance : Actual Revenue vs Budgeted, on an ongoing basis

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University Questions
1. Compare (any three) : a. Rolling budget and zero based budget. ch 4 pg 155-6 b. Engineered cost and budget" and "Discritionery cost and budget". Ch 4 pgs 154-157 c. ZBB vs. Traditional Budget ch 4 pg 155-6

2. What are the differences between Engineered Expense Center and Discretionary Expense Center? Give your answer with respect to following control characteristics. [18] a) Budget Preparation. b) Cost variability. c) Type of Financial Control. d) Measurement of Performance. Give examples to support your answer. {ch 4 pg 151-7}
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