Accounting, Behaviour

&
Organisations

ACCT1014/2119

Topic 3
Budgeting and the Strategic Management
of Costs and Revenues
 Objectives

After completing this topic you should be able to:

• Be able to describe the strategic budgeting cycles
– Consider potential assumptions underlying profit planning
– List the 3 questions relating to business planning
– Be able to list the different costs that make up ‘operating expenses’
– Be able to list the different types of ‘assets’ that make up the ‘investment
in assets’ component of the profit wheel
• Recognise key financial measures associated with strategic
budgeting
• Discuss the importance of participatory budgeting
• Recognise the different roles of budgeting
• Apply working capital management in organisational settings

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 The budget cycle

• The series of steps to develop and use budgets

Reassess vision and
core competencies
Evaluate and reward Reconsider long
performance term strategies

Investigate Develop operating

differences between plans
actual and budget

Monitor actual results Translate strategies

compared to budget and operating plans
into master budget

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The interconnected strategic budgeting cycles

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The income cycle

• The income cycle is the first step in developing a strategic

budget

–Need to make many assumptions about?

–markets, customers, suppliers
–cause and effect relationships
–opportunities etc..

–Involves the whole organisation

–requires interaction between managers
–requires different information sources

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The income cycle steps

Step 1: Estimate the level of sales

• This is the first step because operating expenses (the
second step) are often a function of sales volume
• How do we forecast the level of sales?
–science
–judgment
• What are the information requirements?
–expected impact of external factors
–expected impact of internal decisions

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The income cycle steps
Step 2: Forecast operating expenses
• Identify the different costs and cost behaviour
–e.g. Consider an airline ….
–Fuel and flight attendants wages vary with the number
of flights
–Meals and drinks vary with numbers of passengers
–Leasing of check-in counters and salaries of airport
management vary with the number of airports used by
the airline
–Building costs, insurance and corporate headquarters
salaries do not vary with passenger, flight or airport-
related volumes.

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The income cycle steps

Step 2: Forecast operating expenses

• Note the costs that vary and those that do not?
–These are classified into: ‘variable costs’ and
‘fixed’ (or non-variable) cost categories?
• Some costs are considered ‘mixed’ in that they are
partly fixed and partly variable.
–e.g. Airline ‘advertising’ cost has a fixed component (cost
to make the advert); a variable component (a cost every
time the advert played)
• It is important to recognised the difference between
variable and fixed costs when profit planning

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The income cycle steps

• Variable Costs
– Definition ~ costs that change proportionally
with changes in activity levels
– typically estimated based on relationship with
sales or production
– cause effect relationships need to be identified
– usually input/output relationships can be
quantified (i.e. 1kg input for a unit of output)
– often standard costs can be determined
– need to identify changes in input/output
relationships between one period and the next
• e.g. Variable costs include: raw materials in a production facility;
energy costs; casual labour

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 The income cycle steps

• Fixed Costs
– Definition ~ costs that do not vary with small
changes in activity level such as production, sales
and service provided (also considered as ‘non-
variable’ costs)
– Three types of fixed (non-variable) costs
a) ‘committed’;
b) ‘discretionary’;
c) ‘activity-based indirect’

See next slide for more details …..

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The income cycle steps

Fixed (non-variable) Costs cont.

a) Committed Costs
– determined by previous management decisions
– e.g. salaries, depreciation, long-term leases
– not subject to discretion during the current planning period
b) Discretionary costs
– level of costs can be altered at will
– managers are not committed to any level of expenditure
– difficult to determine input/output relationships
– e.g. advertising expense (input) to sales volume (output)?

c) Activity-based indirect costs

– cannot be traced directly to product or service but change
with underlying support activity
– estimation process requires identification of cost drivers
– e.g. materials handling, setup costs, supervision, administration costs

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 The income cycle steps
• Step 3: Calculate expected profit
– Best estimates/forecasts of sales and associated costs will lead to more
accurate ‘profit’ determination and subsequent investment plans

• Step 4: Price the investment in new assets

– need to estimate required investment to support expected sales
– new assets and working capital (short-term assets)
– develop a capital investment plan (long-term assets)
– must reflect and support intended strategy
– choose between alternative investments

• Step 5: Complete the cycle by testing key assumptions

– sensitivity analysis to test for impact of best; worst; most likely scenario

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 The ‘Cash’ and ‘ROE’ cycles
The ‘Cash Cycle’
• Aim is to forecast whether company will have enough cash to
operate and determines whether profit plan is feasible
• Highlights the significance of resources tied up in accounts
receivable, inventory and other working capital accounts
• The operating cash flow cycle
– Inventory  sales  accounts receivable  cash
• The ‘Return on Equity (ROE) Cycle’
• Recognises that asset utilisation generates profit
• Provides a measure of profitability (return) to shareholders
– ROE = Net Income ÷ Shareholders’ Equity
– ROE is a surrogate measure for overall company financial performance

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 Return on Capital Employed
• ROE measure is used by shareholders to evaluate shareholder
profitability
• Return on capital employed (ROCE) is used within the firm to
estimate asset utilisation (and evaluate managers)

ROCE = Net income X Sales

Sales Capital Employed

• ROCE breaks down asset turnover component of ROE

– Represents asset profitability and asset turnover (see ROCE Tree)
• “Capital employed” refers to assets within managers’ direct control
• Note ROE, ROCE, ROI are all defined versions of “Returns (income)
on investment (asset) or (ROA)”

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ROCE Tree

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 ROE Calculations

Calculate overall return on equity

• ROE = Net income ÷ shareholders equity
• need to ensure all levels of an organisation work
toward maximising ROE
• decompose measure into its component parts

Net Income
ROE =
Shareholder’s Equity

Net income Sales Assets

ROE =  
Sales Assets Shareholder’sEquity
Profitability Asset Financial Leverage
Ratio Turn Ratio

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The Key Financial Measures in Strategic Budgeting
• ‘Sales’ and ‘Profit’ (or ‘Net Income’) generated from
the profit cycle are combined with measures from
the Cash and ROE cycles
• Together determine financial measures such as:
–Return on Equity (ROE)
–Working Capital (short term asset utilisation)
–Free Cash Flow (FCF)
–Return on Capital Employed (ROCE)
–Return on Investment (ROI); Return on Assets (ROA)
* Note: A general understanding of these financial measures is all that is
required for this course

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 The Budget Cycle
• The three interconnecting strategic budgeting cycles are used
to evaluate different strategies answering questions about:
–what level of profit is expected?
–is there enough cash available to support strategy?
–what return to shareholders will the strategies provide?
• Managers make trade-offs by assessing their organisational
capabilities, resources and competitive advantage
• The amount and quality of the data inputs will determine the
relative usefulness of the strategic budgeting exercise
• Participation from all levels (value-chain activities) of the
organisation is important in improving the quality of data

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The roles of budgeting in management control

Budgets are used for the following management control

purposes:
1. As a profit or operating plan
2. As a basis for resource allocation
3. As a communication and authorization tool
4. As a motivating device
5. As a guideline for operations and tool for controlling
operations
6. As a means for performance evaluation

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