CPTG

TITRE 149 MANAGEMENT CONTROL

Lecture 2: Budgeting
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CPTG
TITRE 149 MANAGEMENT CONTROL
Quick review of last session
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 Basics of MCS

Basics of management control

Management Control Systems (MCS)

“includes everything managers do to help ensure that their
organization’s strategies and plans are carried out”*.

 Central issue: strategy implementation

 Helps to reduce information asymmetry gap
 Relies on both, financial and non-financial information

Sources: *Merchant/Van der Stede (2007), Management Control Systems, p. XIII; Sveiby (1997), The new organizational wealth, p. 8; Anthony/Giovindarajan
(1998), Management Control Systems, p. 6 and p. 8.

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 Basics of MCS

Management and its components

Objectives can be:

Objective Setting financial vs. non-financial

quantified, explicit vs. implicit
economic, social, environmental, or societal

Strategies define how organizations should

Strategy Formulation use their resources to meet their objectives

Management Control

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 Basics of MCS

Controls can focus on:

ACTION CONTROLS
The actions taken

The results produced RESULTS CONTROLS

The types of people PEOPLE(Personnel/culture)

CONTROLS
employed and their
shared values and
norms
Or any combination

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Agenda

1 Planning & Budgeting

1.1. Definition of budgeting & advantages
1.2. Behavioural issues
1.3. The master budget
1.4. Illustration of budgeting – Mega Carpets

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 From strategic planning to budgeting

Uncertainty, Potential for

Degrees of success
freedom
Strategic planning

Budgeting o wn
a k d
Bre
Precise steps for into
realization

Time horizon
Source: based on Ansoff (1965), Corporate Strategy.

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Definition of budget

 A budget is a quantitative expression of a proposed plan of action

by management for a future time period and is an aid to the
coordination and implementation of the plan. (C. T. Horngren, A. Bhimani, S. M.
Datar, G. Foster, Management and Cost Accounting, 3rd ed., Pearson Ed., 2008)

1.The act of preparing a budget is called budgeting.

2.The use of budgets to control an organization’s activities is known
as budgetary control.

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 Why do we produce budgets?

1.To aid the planning of actual operations:

• by forcing managers to consider how conditions
might change and what steps should be taken now.
• by encouraging managers to consider problems
before they arise.

2.To co-ordinate the activities of the organization:

• by compelling managers to examine relationships
between their own operations and those of other
departments.

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 Why do we produce budgets?
3.To communicate plans to various responsibility center
managers:
• everyone in the organization should have a clear
understanding of the part they are expected to
play in achieving the annual budget.
• by ensuring appropriate individuals are made
accountable for implementing the budget.

4.To motivate managers to strive to achieve the budget

goals:
• by focusing on participation
• by providing a challenge/target
• by creating a consensus.
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 Why do we produce budgets?

5.To control activities:

• by comparison of actual with budget.

6.To evaluate the performance of managers:

• by providing a means of informing managers of
how well they are performing in meeting targets
they have previously set.

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Functions of Budgeting

Planning
Facilitating
Communication and
Control Coordination

Functions

Evaluating
Performance &
Means of
Providing
allocating
Incentives
resources

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Authoritative budgets vs. Self-Imposed Budgets

 Authoritative budgeting - occurs when a superior informs subordinates what their budget will be
without requesting input.

 Stretch targets (e.g. Boeing, general Electric) - exceed previous targets by a significant
amount and usually require an enormous increase in a goal over the next budgeting period.

 A self-imposed budget or participative budget is a

budget that is prepared with the full cooperation and
participation of managers at all levels.

 Consultative budgeting occurs when managers ask

subordinates to discuss their ideas about the budget
but no joint decision making occurs.

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Advantages of Self-Imposed Budgets

 Individuals at all levels of the organization are viewed as members of the team whose judgments
are valued by top management.
 Budget estimates prepared by front-line managers are often more accurate than estimates
prepared by top managers.
 Motivation is generally higher when individuals participate in setting their own goals than when
the goals are imposed from above.
 A manager who is not able to meet a budget imposed from above can claim that it was
unrealistic. Self-imposed budgets eliminate this excuse.

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 Behavioural issues in budgeting


When incentives and compensation are tied to the budget, some managers engage in
behaviour that is dysfunctional to their organizations. => budgeting games = attempt
to manipulate information and targets to achieve as high a bonus as possible (e.g.
budgetary slack etc.)

Budgetary slack - Subordinates may want some additional cushion in
performance requirements in case there is an unforeseen change in the work
environment that detrimentally affects resources or impairs their ability to meet
the budget.

E.g. requiring excess resources and distorting performance information

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Human Factors in Budgeting

The success of a budget program depends on three important factors:

 Top management must be enthusiastic and committed to the budget process.

 Top management must not use the budget to pressure employees or blame them
when something goes wrong.
 Highly achievable budget targets are usually preferred when managers are rewarded
based on meeting budget targets.

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The Budgeting Process

- Base budget goals on past performance

- Collect data from organizational units
- Begin several months before end of current year Factors considered in Sales Forecasting:
- Develop budget within the framework of a sales
forecast
General economic conditions
 Shows potential industry sales
Industry trends
 Shows company’s expected market share
Market research studies
Anticipated advertising and promotion
Previous market share
Price changes
Technological developments

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The Master Budget

A set of interrelated budgets that constitutes a plan of action for a specified time
period.

Contains two classes of budgets:

 Operating budgets: Individual budgets that result in the preparation of the
budgeted income statement – establish goals for sales and production personnel
 Financial budgets: The capital expenditures budget, the cash budget, and the
budgeted balance sheet – focus primarily on cash needs to fund operations and
capital expenditures

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The Master Budget: An Overview

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 Stages in the budgeting process
1.Communicate details of budget policy and
guidelines to those people responsible for
preparing the budget.
2. Determine the factor that restricts output.
3. Preparation of the sales budget.
4. Initial preparation of budgets.
5. Negotiation of budgets with higher
management.
6. Co-ordination and review of budgets.
7. Final acceptance of budgets.
8. Ongoing review of the budgets.
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Operating Budgets: Revenue (Sales) Budget

First budget prepared

Derives from the sales forecast
 Management’s best estimate of sales revenue for the budget period
 Every other budget depends on the sales budget
 Prepared by multiplying:
 expected unit sales volume for each product
times
 anticipated unit selling price

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Operating Budgets: Sales Budget
Example – Mega Carpets Company
Expected sales volume: 3,000 units in the first quarter with 500-unit increments
for each following quarter
Sales price: £60 per unit

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Operating Budgets: Production Budget
 Shows the units that must be produced to meet anticipated sales
 Derived from sales budget plus the desired change in ending finished goods (ending finished
goods less the beginning finished goods units)

 Required production in units formula:

 Essential to have a realistic estimate of ending inventory

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Operating Budgets: Production Budget
Mega Carpets Company
 Mega Carpets Co. believes it can meet future sales needs with an ending inventory
of 20% of next quarter’s sales.

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Operating Budgets: Direct Materials Budget

Shows both the quantity and cost of direct materials to be purchased

Derived from the direct materials units required for production (from the production
budget) plus the desired change in ending direct materials units

Budgeted cost of direct materials to be purchased = Required direct materials units to be

purchased x budgeted cost of direct materials per unit

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Operating Budgets: Direct Materials Budget

Mega Carpets Company (continued)


Additional data

An ending inventory of 10% of next quarter’s production requirements is

sufficient

The manufacturing of each unit requires 2 kilos of raw materials at an

expected price of £4 per kilo

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Operating Budgets: Direct Materials Budget

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Operating Budgets: Direct Labor Budget

Shows both the quantity of hours and cost of direct labor necessary to meet
production requirements
Critical in maintaining a labor force that can meet expected production

Total direct labor cost formula:

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Operating Budgets: Direct Labor Budget
Mega Carpets Company
 Units to be produced from the production budget
 Two hours of direct labor required for each unit
 Anticipated hourly wage rate £10

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Operating Budgets: Manufacturing Overhead

Shows the expected manufacturing overhead costs for the budget period
Distinguishes between fixed and variable overhead costs

Example – Mega Carpets Company

Fixed cost amounts are assumed constant: (quarterly amounts) -

supervisor salaries £ 20,000; depreciation £3,800; property taxes
£9.000; maintenance £ 5,700
Expected variable costs per direct labor hour:
indirect materials: £1.00
indirect labor: £1.40
utilities: £0.40
maintenance: £0.20
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Operating Budgets: Manufacturing Overhead

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Operating Budgets: Selling and Administrative
Projection of anticipated operating expenses
Distinguishes between fixed and variable costs

Mega Carpets Company

Fixed cost amounts are assumed constant from one quarter

to another:
- Advertising £ 5,000; sales salaries £15,000; office salaries
£7,500; depreciation £1,000; property taxes £1,500
Expected variable costs per unit sold (from sales budget):
sales commissions: £3.00
freight-out: £1.00

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Operating Budgets: Selling and Administrative

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Operating Budgets: Budgeted Income Statement

Important end-product of the operating budgets

Indicates expected profitability of operations
Provides a basis for evaluating company performance
Prepared from the operating budgets
Sales Budget
Production Budget
Direct Materials Budget
Direct Labor Budget
Manufacturing Overhead Budget
Selling and Administrative Expense Budget

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Operating Budgets: Cost of goods sold budget
Mega Carpets Company
To find cost of goods sold:
1. determine the unit cost of one carpet

2. determine Cost of Goods Sold by multiplying budgeted

units sold (sales budget) times unit cost:

15,000 units X £44 = £660,000

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Operating Budgets: Budgeted Income Statement

 Additional estimated data for budgeted income statement:

Interest Expense - £100
Income Taxes - £12,000

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A sales budget is:

a. Derived from the production budget.

b. Management’s best estimate of sales revenue for the
year.
c. Not the starting point for the master budget.
d. Prepared only for credit sales.

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Basic steps in developing operational budgets in an
international context

1. Sales/Revenue budget
2. Production budget (in units)
3. Direct materials budget (usage & purchases budget)
4. Direct manufacturing labor budget
5. Manufacturing overhead budget
6. (Closing stock budget)
7. Cost of goods sold budget
8. Other (non-production) costs budget: Selling & Admin. expense (SG&A) budget
9. Budgeted operating income statement

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Financial Budgets: Cash Budget

Shows anticipated cash flows

Often considered to be the most important output in preparing financial budgets

Contains three sections:

 Cash Receipts
 Cash Disbursements
 Financing

Shows beginning and ending cash balances

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Financial Budgets: Cash Budget

 Basic Format

Cash Budget

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Review Question

 Each of the following budgets is used in preparing the budgeted income statement
except the:

a. Sales budget.
b. Selling and administrative budget.
c. Capital expenditure budget.
d. Direct labor budget.

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Budgeting: Service Companies

Critical factor in budgeting is coordinating professional staff needs with

anticipated services
Problems if overstaffed:
Disproportionately high labor costs
Lower profits due to additional salaries
Increased staff turnover due to lack of challenging work
Problems if understaffed:
Lost revenues because existing and future client needs for services cannot
be met
Loss of professional staff due to excessive work loads

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Budgeting: Not-for-Profit Companies

Just as important as for profit-oriented company

However, budget process differs significantly from that of a profit-oriented company

Budget on the basis of cash flows (expenditures and receipts), not on a revenue and
expense basis

The starting point is usually expenditures, not receipts

Management’s task is to find receipts needed to support

planned expenditures

Budget must be strictly followed, overspending being often illegal

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Usual problems with budgets

Managers not involved in the elaboration of the budget

- The budget is taken as a constraint imposed by the management and stake-holders

(cost control, financial management).
- The budget seems to be unrealistic

- It is not used to monitor activities

Managers take part in the budgeting process, but…

- Too much time is spent

- Going back and forth on many occasions, heavy negotiations,…

In any case, budgeting and planning are usually highly useful for any company
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