Accounting for Managerial Decision Making

Week 7
 Chapter 15: The Budgeting Process
It is important that management coordinate the various interrelated aspects of decision-making.
> Budgets: a financial plan for implementing management decisions.

15.1 The Strategic Planning, Budgeting and Control Process

Figure 15.1 Strategic planning, budgeting and control process

Long-term plan (strategic plan): a top-level plan that sets out the objectives that an organization’s
future activities will be directed towards.

Vision statement: a statement that clarifies the beliefs and governing principles of an organization,
what it wants to be in the future or how it wants the world in which it operates to be.
Mission statement: a statement that provides in very general terms what the organization does to
achieve its vision, its broad purpose and reason, its existence, the nature of the business(es) it is in
and the customers it seeks to service and satisfy.
> Both vision and mission statements are a visionary projection of the central and overriding
concepts on which the organization is based.

Corporate objectives: specific, measurable statements, often expressed in financial terms, of what
the organization as a whole wishes to achieve.
Unit objectives: specific, measurable statements, often expressed in financial terms, of what
individual units within an organization wish to achieve.
> Corporate objectives are normally set for the organization as a whole and are then translated into
unit objectives, which become the targets for the individual business units within the organization.

Strategy: the courses of action that must be taken to achieve an organization’s overall objectives.
> When the management has identified the strategic options that have the greatest potential for
achieving the company’s objectives, long-term plans should be created to implement the strategies.

Long-term plan: a statement of the preliminary targets and activities required by an organization to
achieve its strategic plan, together with a broad estimate for each yar of the resources requires and
revenues expected.
> The plan tend to be uncertain, general in nature, imprecise and subject to change.
Budgeting: the implementation of long-term plan for the year ahead through the development of
detailed financial plans.
> Budgets are a clear indication of what is expected to be achieved during the budget period,
whereas long-term plans represent the broad directions that top management intend to follow.

The budget is developed within the context of ongoing business and is ruled by previous decisions
that have been taken within the long-term planning process.
> Budgeting process must be considered as an integrated part of the long-term planning process.

Budgetary control process: the process of comparing actual and planned outcomes, and responding
to any deviation from the plan.
> Planning: involves looking ahead to determine the actions required to achieve the objectives of
the organization.
> Control: involves looking back to ascertain what actually happened and comparing it with the
planned outcomes.

Feedback loops: parts of a control system that allow for review and corrective action to ensure that
actual outcomes conform with planned outcomes.

15.2 The Multiple Functions of Budgets

Budgets serve a number of useful purposes
1 Planning annual operations
2 Coordinating the activities of the various parts of the organization and ensuring that the parts are
in harmony with each other
3 Communicating plans to the various responsibility centre managers
4 Motivating mangers to strive to achieve the organizational goals
5 Controlling activities
6 Evaluating the performance of managers

Management by exception: a system in which a manager’s attention and effort can be concentrated
on significant deviations from the expected results.

15.4 The Budget Period

Continuous (rolling) budgeting: an approach to budgeting in which the annual budget is broken
down into months for the first three months and into quarters for the rest of the year, with a new
quarter being added as each quarter ends.
> Budgeting is a continuous process, and managers are encouraged to constantly look ahead and
review future plans.

15.5 Administration of the Budgeting Process

The budget committee should consist of high-level executives who represent the major segments of
the business.
> Its major task is to ensure that budgets are realistic and that they are coordinated satisfactorily.

The accounting staff will normally circulate instructions and offer advice about budget preparation,
provide past information that may be useful for preparing the present budget and ensure that
managers submit their budgets on time.
> The accounting staff provide a valuable advisory service for the line managers.
15.6 Stages in the Budgeting Process
The stages in the budgeting process
1 Communicating details of budget policy and guidelines to those people responsible for the
preparation of budgets
2 Determining the factor that restricts output
3 Preparation of the sales budget
4 Initial preparation of various budges
5 Negotiation of budgets with superiors
6 Coordination and review of budgets
7 Final acceptance of budgets
8 Ongoing review of budgets

The long-range plan is the starting point for the preparation of the annual budget.
> Top management must communicate the policy effects of the long-term plan to those responsible
for preparing the current year’s budgets.

The preparation of the budget should be a bottom-up process.

> The budget should originate at the lowest levels of management and be refined and coordinated
at higher levels.

Figure 15.2 An illustration of budgets moving up the organization hierarchy.

During the coordination process, a budgeted profit statement, a balance sheet and a cash flow
statement should be prepared to ensure that all the parts combine to produce an acceptable whole.

Master budget: a document that brings together and summarizes all lower level budgets and which
consists of a budgeted profit and loss account, a balance sheet and cash flow statement.

15.7 A Detailed Illustration

Sales budget: shows the quantities of each product that the company plans to sell and the intended
selling price.
> It provides the predictions of total revenue from which cash receipts from customers will be
estimated and it also supplies the basic data for constructing budgets for production costs and for
selling, distribution and administrative expenses.

The sales budget is the foundation of all other budgets, since all expenditure is dependent on the
volume of sales.

The total of the overhead budget will depend on the behaviour of the costs of the individual
overhead items in relation to the anticipated level of production.
Cash budgets: a budget that aims to ensure that sufficient cash is available at all times to meet the
level of operations that are outlined in all other budgets.
> The overall aim should be to manage the cash of the firm to attain maximum cash availability and
maximum interest income on any idle funds.

15.8 Computerized Budgeting

In today’s world, the budgeting process is computerized instead of being primarily concerned with
numerical manipulations, and the accounting in staff can now become more involved in the real
planning process.
> Computer-based financial models enable management to evaluate many different options before
the budget is finally agreed.

15.9 Activity-Based Budgeting

The conventional approach to budgeting works fine for unit-level activity costs where the
consumption of resources varies proportionately with the volume of the final output of products
or services.
> Conventional budgets provide little relevant information for managing costs of support activities.

Incremental budgeting: an approach to budgeting in which existing operations and the current
budgeted allowance for existing activities are taken as the starting point for preparing the next
annual budget and are then adjusted for anticipated changes.
Activity-based budgeting: an approach to budgeting that takes cost objects as the starting point,
determines the necessary activities and then estimates the resources that are required for the
budget period.

Activity-based budgeting involves the following stages

1 Estimate the production and sales volume by individual products or customers
2 Estimate the demand for organizational activities
3 Determine the resources that are required to perform organizational activities
4 Estimate for each resource the quantity that must be supplied to meet the demand
5 Taken action to adjust the capacity of resources to match the projected supply

To implement activity-based budgeting, the activities that are necessary to produce and sell the
products and services and service customers must be identified.
> Estimates of the quantity of activity cost drivers must be derived for each activity.

if the estimated demand for a resource exceeds the current capacity, additional spending must be
authorized within the budgeting process to acquire additional resources.
> If the demand for resources is less than the projected supply, the budgeting process should result
in management taking action to either redeploy or reduce those resources that are no longer
required.

A major feature of activity-based budgeting is the enhanced visibility arising from showing the
outcomes, in terms of cost drivers, from the budgeted expenditure.

With conventional budgeting, the budgeted expenses for the forthcoming budget for support
activities are normally based on the previous year’s budget plus an adjustment for inflation.
> Support costs are considered to be fixed in relation to activity volume.
Activity-based budgeting provides a framework for understanding the amount of resources that are
required to achieve the budgeted level of activity.
> By comparing the amount of resources that are required with the amount of resources that are in
place, upwards or downwards adjustments can be made during the budget setting phase.

15.10 The Budgeting Process in Non-Profit-Making Organizations

The budgeting process in a non-profit-making organization normally adopts an incremental
budgeting approach with the managers of the various activities calculating the expected costs of
maintaining current ongoing activities and then adding to those costs any further developments of
the services that are considered desirable.

One difficulty encountered in non-profit-making organizations is that precise objectives are difficult
to define in a quantifiable way, and the actual accomplishments are even more difficult to measure.

Line item budgets: the traditional format for budgets in non-profit organizations, in which
expenditures are expressed in considerable detail, but the activities being undertaken are given little
attention.
> Line item budgeting shows the nature of the pending but not the purpose.

15.11 Zero-Based Budgeting

Zero-based budgeting (priority-based budgeting): an approach to budgeting in which projected
expenditure for existing activities starts from base zero rather than last year’s budget, forcing
managers to justify all budget expenditure.
> Incremental budgets: budgets where expenses for an item within the budget are based on the
previous budgeted allowance plus an increase to cover higher prices caused by inflation.

Discretionary costs: costs such as advertising and research where management has some discretion
as to the amount it will budget.
> There is no optimum relationship between inputs and output for these costs.

Zero-based budgeting involves three stages

1 A description of each organization activity in a decision package
2 The evaluation and ranking of decision packages in order of priority
3 Allocation of resources based on order of priority up to the spending cut-off level.

Decision packages: a decision package represents the incremental packages reflecting different
levels of effort that may be expended to undertake a specific group of activities within an
organization.
> The packages represents the minimum level of service or support consistent with incremental
packages.

The benefits of zero-based budgeting over traditional methods of budgeting

> Traditional budgeting tends to extrapolate the past by adding a percentage increase to the
current year. Zero-based budgeting avoids the deficiencies of incremental budgeting and represents
a move towards the allocation of resources by need or benefit.
> Zero-based budgeting creates a questioning attitude rather than one that assumes that current
practice represents value for money.
> Zero-based budgeting focuses attention on output in relation to value for money.
Priority-based incremental budgets: budgets in which managers specify what incremental activities
or changes would occur if their budgets were increased or decreased by a specified percentage,
leading to budget allocations being made by comparing the change in costs with the change in
benefits.
> Priority incremental budgets represent an economical compromise between zero-based
budgeting and incremental budgeting.

15.12 Criticism of Budgeting

Beyond budgeting: a term used to describe alternative approaches that can be used instead of
annual budgeting.
> Rolling forecasts are considered to provide more accurate information because they are
constantly updated by the latest estimates of economic trends, customer demand and data from the
most recent quarter.

Beyond budgeting also places greater emphasis on team-based rewards rather than individual
rewards because of the difficulty in identifying the incremental contribution of individuals and the
need to demonstrate that everyone is pulling together in the same direction, each dependent on the
other.
 Chapter 17: Standard Costing and Variance Analysis 1
The main features of standard cost centres are that output can be measured and the input required
to produce each unit of output can be specified.
> Standard costing is generally applied to manufacturing activities and non-manufacturing activities
are not incorporated within the standard costing system.

Standard costs: target costs that are predetermined and should be incurred under efficient operating
conditions.
Budgeted costs: expected costs for an entire activity or operation.
> A budget relates to an entire activity or operation, a standard presents the same information on a
per unit basis.

17.1 Operation of Standard Costing System

Standard costing is most suited to an organization whose activities consist of a series of common or
repetitive operations where the input required to produce each unit of output can be specified.
> Standard costing cannot be applied to activities of a non-repetitive nature, since there is no basis
for observing repetitive operations and consequently standard cannot be set.

Standard costs are developed for repetitive operations and product standard costs can be derived
simply by combining the standard costs from the operations which are necessary to make the
product.

Cost control requires that responsibility centres be identified with the standard cost for the
output achieved.
> Only be comparing total actual costs with total standard costs for each operation or responsibility
centre for a period can control be effectively achieved.

A comparison of standard products costs with actual costs that involves several different
responsibility centres is clearly inappropriate.

Figure 17.1 An overview of a standard costing system

The operation of a standard costing system also enables a detailed analysis of the variances
to be reported.
> Variances for each responsibility centre can be identified by each element of cost and analysed
according to the price and quantity content because different managers may be responsible for the
price and quantity elements.
Standard costs represent future target costs, so they are preferable to actual past costs for
decision-making.
> The external financial accounting regulations in most countries specify that if standard product
costs provide a reasonable approximation of actual product costs, they are acceptable for inventory
valuation calculations for external reporting.

17.2 Establishing Cost Standards

Control over costs is best effected through action at the point where the costs are incurred.
> The standards should be set for the quantities of material, labour and services to be consumed in
performing an operation, rather than the complete product cost standards.

Product cost standards: derived by listing and adding the standard costs of operations required to
produce a particular product.

Two approaches can be used to set standard costs

1 Past historical records can be used to estimate labour and material usage.
2 Standards can be set based on engineering studies.
> Engineering studies:

If historical standards are used, standards are set based on average past performance for the same
or similar operations.

The standard cost for each operation is derived from multiplying the quantity of input that should be
used per unit of output by the amount that should be paid for each unit of input.

Bill of materials: a document stating the required quantity of materials for each operation to
complete the product.
> A separate bill of materials is maintained for each product.

Standard material product cost: found by multiplying the standard quantities by the appropriate
standard prices.
> The standard material prices are based on the assumption that the purchasing department has
carried out a suitable search of alternative suppliers and has selected suppliers who can provide the
required quantity of sound quality materials at the most competitive price.

Separate rates for fixed and variable overheads are essential for planning and control.
> With traditional costing systems, the standard overhead rate will be based on a rate per direct
labour hour of machine hour of input.

It is necessary to unitize fixed overheads for inventory valuation purposes.

The main difference with the treatment of overheads under a standard costing system as opposed to
a non-standard costing system is that the product overhead cost is based on the hourly overhead
rates multiplied by the standard hours rather than the actual hours used.

Standard hours produced: a calculation of the amount of time, working under efficient conditions, it
should take to make each product.
> Standard hours: the number of hours a skilled worker should take working under efficient
conditions to complete a given job.

Standard hours produced is an output measure and flexible budget allowances should be based
on this.
17.3 Purposes of Standard Costing
The purposes of standard costing
> Providing a prediction of future costs that can be used for decision-making purposes.
> Providing a challenging target which individuals are motivated to achieve.
> Assisting in setting budgets and evaluating managerial performance.
> Acting as a control device by highlighting those activities which do not conform to plan and thus
alerting managers to those situations that may be out of control and in need of corrective action.
> Simplifying the task of tracing costs to products for profit measurement and inventory valuation
purposes.

Figure 17.2 Standard costs for inventory valuation and profit measurement

The variances from standard cost are extracted by comparing actual with standard costs at the
responsibility centre level, and not at the product level, so that actual costs are not assigned to
individual products.

17.4 A Summary of Variance Analysis for a Variable Costing System

Figure 17.3 Variance analysis for a variable costing system
17.5 Material Variances
The costs of the materials that are used in a manufactured product are determined by two
basic factors
1 The price paid for the materials used in production
2 The quantity of materials used in production

There is a possibility that the actual cost will differ from the standard cost because the actual price
paid will be different from the standard price and/or the actual quantity of materials used will be
different from the standard quantity.

Material price variance: the difference between the standard price and the actual price per unit of
materials multiplied by the quantity of materials purchased.
> An adverse price variance may reflect a failure by the purchasing department to seek the most
advantageous sources of supply. However, the price variance might be beyond the control of the
purchasing department.

The following alternatives are available for calculating the price variance
1 The price variance is calculated with quantity being defined as the actual quantity purchased.
2 The price variance is calculated with quantity being defined as the actual quantity used.

To assess the importance of the excess usage, the variance should be expressed in monetary terms.

Material usage variable: the difference between standard quantity required for actual production
and the actual quantity used multiplied by the standard material price.

The analysis of the material variance into the price and usage element is not theoretically correct,
since there may be a joint mutual price or quantity effect.

Total material variance: the difference between the standard material cost for the actual production
and the actual cost.

If the price variance is calculated on the actual quantity purchased instead of the actual quantity
used, the price variance plus the usage variance will agree with the total variance only when the
quantity purchased is equal to the quantity that is used in the particular accounting period.

17.6 Labour Variances

The cost of labour is determined by the price paid for labour and the quantity of labour used.
> Wage rate variance: the difference between the standard wage rate per hour and the actual
wage rate, multiplied by the actual number of hours worked.
> Labour efficiency variance: the difference between the standard labour hours for actual
production and the actual labour hours worked during the period multiplied by the standard wage
rate per hour.
> Total labour variance: the difference between the standard labour cost for the actual production
and the actual labour cost.

The wage rate variance is probably the one that is least subject to control by management.
> In most cases, the variances is due to wage rate standards not being kept in line with changes in
actual wage rates and for this reason it is not normally controllable by departmental managers.

Labour efficiency variance: represents the quantity variances for direct labour.
> Standard hours produced: the quantity of labour that should be used for the actual output.
17.7 Variable Overhead Variances
Total variable overhead variance: the difference between the standard variable overheads charged
to production and the actual variable overheads incurred.

Where variable overheads vary with direct labour or machine hours of input the total variable
overhead variance will be due to one or both of the following
1 A price variance arising from actual expenditure being different from budgeted expenditure.
2 A quantity variance arising from actual direct labour or machine hours of input being different
from the hours of input, which should have been used.

Variable overhead expenditure variance: the difference between the budgeted flexed variable
overheads for the actual direct labour hours of input and the actual variable overhead costs incurred.
> The budgeted flexed variable overheads has been derived from multiplying the actual quantity of
direct labour hours of input by the standard variable overhead rate.

Variable overhead: represents the aggregation of a large number of individual items.

> The variable overhead variance can arise because the prices of individual items have changed. It
can also be affected by how efficiently the individual variable overhead items are used.

Variable overhead efficiency variance: the difference between the standard hours of output and the
actual hours of input for the period multiplied by the standard variable overhead rate.
> If it is assumed that variable overheads vary with direct labour hours of input, the variance is
identical to the labour efficiency variance, apart from the fact that the standard variable overhead
rate is used instead of the wage rate.

17.9 Fixed Overhead Expenditure or Spending Variance

With a variable costing system, fixed manufacturing overheads are not unitized and allocated to
products.
> The total fixed overheads for the period are charged as an expense to the period in which they
are incurred.

Fixed overhead expenditure variance: the difference between the budgeted fixed overheads and the
actual fixed overhead spending.
> The fixed overhead expenditure variance explains the difference between budgeted fixed
overheads and the actual fixed overheads incurred.

Whenever the actual fixed overheads are less than the budgeted fixed overheads, the variance will
be favourable.

17.10 Sales Variance

Sales variances can be used to analyse the performance of the sales function or revenue centres on
broadly similar terms to those for manufacturing costs.
> The most significant feature of sales variance calculations is that they are calculated in terms of
profit or contribution margins rather than sales values.

A more meaningful performance measure will be obtained by comparing the results of the sales
function in term of profit or contribution margins rather than sales revenues.

Where a variable costing approach is adopted, the total sales margin variance seeks to identify the
influence of the sales function on the difference between budget and actual profit contribution.
Total sales margin variance: the difference between actual sales revenue less the standard variable
cost of sales and the budgeted contribution.
> Sales variances arise only because of changes in the variables controlled by the sales function.

Sales margin price variance: the difference between the actual selling price and the standard selling
price multiplied by the actual sales volume.

Sales margin volume variance: the difference between the actual sales volume and the budgeted
volume multiplied by the standard contribution margin.
> The use of the standard margin ensures that the volume variance will not be affected by any
changes in the actual selling prices.

17.11 Reconciling Budgeted Profit and Actual Profit

Top management will be interested in the reason for the actual profit being different from the
budgeted profit.
> The reconciliation statement represents a broad picture to top management that explains the
major reasons for any difference between the budgeted and actual profits.

17.12 Standard Absorption Costing

With an absorption costing system, an additional fixed overhead variance is calculated.
> Volume variance: the difference between actual production and budgeted production for a
period, multiplied by the standard fixed overhead rate.

Where the fixed overheads allocated to products exceeds the overhead incurred, there will be an
over-recovery of fixed overheads.
> The under- or over-recovery of fixed overheads represents the total fixed overhead variance for
the period.

Total fixed overhead variance: the difference between the standard fixed overhead charged to
production and the actual fixed overhead incurred.
> The standard cost of the actual production can be calculated by measuring production in standard
hours of output.

The under- or over-recovery of fixed overheads arises because the fixed overhead rate is calculated
by dividing budgeted fixed overheads by budgeted output.
> If actual output or actual fixed overhead expenditure differs from budget, an under- or over-
recovery of fixed overheads will arise.

The volume variance arises only when inventories are valued on an absorption costing basis.

The variance seeks to identify the portion of the total fixed overhead variance that is due to actual
production being different from budgeted production.

Volume variance: the difference between actual production and budgeted production for a period,
multiplied by the standard fixed overhead rate.
> The volume variance reflects the fact that fixed overheads do not fluctuate in relation to output
in the short term.

Whenever actual production is less than budgeted production, the fixed overhead charged to
production will be less than the budged cost and the volume variance will be adverse.
> Conversely, if the actual production is greater than the budgeted production, the volume variance
will be favourable.
 Volume efficiency variance: the difference between the standard hours of output and the actual
hours of input for the period, multiplied by the standard fixed overhead rate.

Whereas the volume efficiency variance indicated a failure to utilize capacity efficiently, the volume
capacity variance indicates a failure to utilize capacity at all.

Volume capacity variance: the difference between the actual hours of input and the budgeted hours
of input for the period, multiplied by the standard fixed overhead rate.

17.13 Reconciliation of Budgeted and Actual Profit for a Standard

Absorption Costing System
The reconciliation statement is identical with the variable costing reconciliation statement, apart
from the fact that the absorption costing statement includes the fixed overhead volume variance and
values the sales margin volume variance at the standard profit margin per unit instead of the
contribution per unit.
> The sales margin price variance is identical for both systems.

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