BUDGETING
OVERVIEW
Objective
To describe, illustrate and comment on the planning and control uses of
budgeting.
OBJECTIVES OF
BUDGETING
STAGES IN
QUANTITATIVE
THE BUDGET STANDARDS
TECHNIQUES
PROCESS
Ideal Learning curves
Basic Linear regression
Expected Time series
Current
BUDGETARY METHODS OF BEHAVIOURAL
SYSTEMS PREPARATION ASPECTS
Fixed Incremental Target setting
Flexible ZBB Hopwood
Flexed ABB Budget politics
Periodic Budget bias
Rolling McGregor
Responsibility accounting
Management by objectives
The Examiner has identified budgeting and budgetary control as a major topic and has
specifically referred to the topics of:
techniques such as the learning curve
alternative approaches such as incremental, ZBB and ABB.
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BUDGETING
1 OBJECTIVES OF BUDGETING
1.1 Co-ordination
Of the different activities of an organisation.
Should help achieve goal congruence.
Particularly important in decentralised organisations.
1.2 Responsibility
Delegation of responsibility to managers of business units eg cost centres,
profit centres, investment centres.
Part of responsibility accounting.
1.3 Utilisation
Optimal use of scarce resources.
Part of Manufacturing Resource Planning (MRPII)
1.4 Motivation
Budgets provide targets for individuals.
Care must be taken to ensure targets are not too easy or too difficult to
achieve or demotivation could occur.
1.5 Planning and control
Budgets are short term, quantified versions of long term strategic plans.
Control achieved through variance analysis.
1.6 Evaluation
Budgets can be used as standards for performance evaluation.
However it is difficult to quantify some elements of business performance eg
customer satisfaction, employee morale, innovation.
1.7 Telling
Communication of corporate plans and objectives.
Should help goal congruence.
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BUDGETING
2 STAGES IN THE BUDGET PROCESS
Examples
Establish long term corporate • Sales volume maximisation
objectives • Sales revenue maximisation
• Profit maximisation
Long
Produce a specific (but
term
rolling) corporate plan
planning
Produce sales forecasts which would
enable plans to be achieved
Functional Financial
Redraft long term plan in the Sales Capital expenditure
form of annual budgets Production Cash
Material usage
Budget Materials purchases
officer Labour
Fixed overhead
+
Short
term Budget
planning MASTER BOARD
committee
and BUDGET APPROVAL
budgetary
control
Compare budgets with actual
performance: calculate variances
Take action on variances
− improve performance
− revise plans
3 BUDGETARY SYSTEMS
3.1 Fixed budgets
Prepared at the anticipated level of activity.
Budget will be compared with actual results with no adjustment made for any
changes in activity level.
Limited use – does not give fair performance evaluation if variable costs are
significant.
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BUDGETING
3.2 Flexible budgets
Recognise different cost behaviour patterns and so change with volume of activity.
Prepared at a number of possible activity levels.
Only useful if actual activity level matches one of the budgeted levels.
3.3 Flexed budgets
The budgeted cost (or revenue) attributed to an actual level of activity achieved.
Gives useful comparison of actual results to budget (variance analysis) provided
no stepped fixed costs
constant variable costs per unit ie no economies/diseconomies of scale.
3.4 Periodic budgets
Once each year (eg a budget produced for the next 12 months).
Suitable for stable businesses where forecasting is easy and tight control is
not necessary.
3.5 Rolling budgets
Kept continuously up to date by adding another accounting period when the
earliest has expired.
At the end of each month, add another month to the budget.
The aim is to always have a budget for the next 12 months, say.
Time consuming however.
More frequent budgeting is assuming increasing significance and has been widely
adopted in the US.
4 METHODS OF BUDGET PREPARATION
4.1 Incremental budgeting
Starts with previous period’s budget or actual results.
Add/subtract an incremental amount to cover
− any known changes to the business
− inflation.
Only the increment needs to be justified.
May be appropriate for stable business with good cost control.
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BUDGETING
4.1.1 Advantages 4.1.2 Disadvantages
Quick. Inefficiencies may be compounded eg
budget slack.
Easy.
Cost effective.
Assuming historic figures are Budget holder might spend to the limit of
acceptable, only increment need the budget just to ensure future budget not
be justified. cut – dysfunctional behaviour.
4.2 Zero based budgeting (ZBB)
4.2.1 Basic features
Managers justify all income and expenditure items for each budgeting cycle.
Starts with assumption that the budget for next period is zero.
Budget holder prepares a “decision package” for the department which
includes:
function of department
goal of department
measure of performance
level of funding required and justification
consequences to the company of the department not performing its
function.
Senior management rank decision packages.
Resources allocated to departments according to ranking.
4.2.2 Advantages 4.2.3 Disadvantages
Justification of entire budget rather Time consuming and expensive.
than just increment.
Efficient allocation of resources. Budget holders may feel threatened as
their existence is being questioned.
Identifies unnecessary expenditure.
Useful for discretionary cost centres An inefficient way to confirm that
eg research and development. resources are required on a recurring basis.
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BUDGETING
4.3 Activity based budgeting (ABB)
Follows principles of activity based costing (ABC).
Budgets are prepared for each activity within a department, rather than for the
whole department.
Cost drivers are identified for each activity.
4.3.1 Major benefits
May identify non-value added activities which can be estimated.
If incidence of cost drivers can be reduced then cost savings can be made.
5 STANDARDS
5.1 Ideal standard
Calculated assuming 100% efficiency from all factors of production eg no
losses, no idle time.
Too difficult as a target, therefore may lead to demotivation.
5.2 Basic standard
Long-run average standard.
Based on historic data ie past performance.
Out of date.
Likely to be too easy to achieve in the future.
5.3 Expected standard
Based on normal efficiency eg after normal loss, expected idle time, normal
machine down time.
May be a useful standard to use in variance analysis.
But may not be an appropriate target for motivation as can be met without
any improvement over normal efficiency.
5.4 Current standard
A standard established for use over a short period of time, reflecting current
conditions.
Obtained by adjusting the expected standard.
Use is time consuming eg new current standards must be recalculated each
month.
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BUDGETING
6 BEHAVIOURAL ASPECT OF BUDGETING
6.1 Target setting
Research has shown that
targets can be used to motivate employees
if individuals have higher levels of intended achievement, then
actual achievement rises.
But if targets are too easy to achieve eg basic standards, individuals will not
be motivated to improve performance.
On the other hand, targets that are too difficult eg ideal standards, cause
demotivation.
Research suggests that targets which are just out of reach are optimal for
motivation eg just above the current standard.
This is only a general rule, the optimal target may be different from
individual to individual.
Performance Optimal
level budget
Budget
Zero Adverse
variance variance
Actual
performance
Easy Hard
Degree of budget difficulty
Note that an adverse variance will be produced even though performance has
been maximised. Care must be taken to ensure the budget holder does not
react adversely to this.
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BUDGETING
6.2 Hopwood’s management style
Style
Budget Profit conscious Non-accounting
Features constrained
Involvement with High High Low
costs
Job-related High Medium Medium
tension
Manipulation of Extensive Little Little
data
Relationships Poor Good Good
with superiors
and colleagues
6.2.1 Budget constrained style
Managers are evaluated on ability to meet budgets in the short term.
6.2.2 Profit conscious style
Ability to increase the overall effectiveness of the area and meet long term
organisational objectives eg reduction in long run average costs.
6.2.3 Non-accounting style
Accounting data is not important for performance evaluation. Qualitative
factors are seen as more important eg customer satisfaction.
6.3 Budget politics
Budgeting is a political process. Conflicts must be expected due to the multiple
objectives of organisations and the personal objectives of individuals.
Budget holders may develop bargaining strategies
threatening to cut vital services if extra resources are not made
available eg fire services refusing to attend emergencies unless
government increases their wages
forming alliances with budget setters.
6.4 Budget bias
Building slack or padding into a budget.
Manager of profit centre might understate budgeted sales and/or overstate
budgeted expenditure.
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BUDGETING
6.4.1 Reasons
Reward systems may be linked to performance compared with budget. This
encourages the manager to build slack into the budget to maximise personal
gain.
To reduce work related stress by having easier targets.
“Gaming” – some individuals enjoy trying to beat the system.
6.5 McGregor’s theories of motivation
Douglas McGregor developed two theories of human behaviour at work.
Theory X − people dislike work
− people dislike responsibility
− they are only motivated by money
− they must be told what to do.
Theory Y − people seek responsibility
− they want to participate in decision making.
The type of employee working for an organisation therefore has implications for the
budgetary process.
Employee type X Y
Motivated by Money Many factors
Dues participation
increase motivation? No Yes
Management style Authoritarian Participative
approach approach
Budgeting style TOP DOWN BOTTOM UP
APPROACH APPROACH
Features Senior management Junior management
prepare budgets prepare budgets
Imposed on junior Senior management review
management to ensure consistent with
organisation objectives
Quicker than bottom up
approach But risk of budget
bias/slack
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BUDGETING
6.6 Responsibility accounting
A system of accounting that segregates revenues and costs into area of separate
responsibility (business units) which are then assigned to managers/budget holders.
Budget holders are then evaluated on performance compared to budget.
6.6.1 Features
Business units may be cost, revenue, profit or investment centres
System of performance evaluation must be communicated in advance to
budget holders
Budget holders should only be assessed on items within their control
Delegates operational responsibility to junior management, releasing time for
senior management strategic planning.
6.7 Management by objectives (Mbo)
A system of management incorporating clearly established objectives at every level of
the organisation.
6.7.1 Features
Subordinate writes as “management letter” setting out key objectives, how
they will be achieved and performance measurement criteria.
Discussed and agreed with superior.
Starts with top management and moves down through organisation.
Should help achieve goal congruence – personal goals consistent with
organisational goals.
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BUDGETING
Example 1 – Behavioural aspects of budgeting
Moto Ltd manufactures plastic components which are supplied to a large number of
users in the electrical products sector. The firm has a reputation for high quality
products and the business has grown significantly over the last five years. The
market is very competitive and much of the success has been due to flexibility and
to the development of an experienced cohesive management team.
Last year a new managing director was appointed. His main task was to increase
profitability over a three year period in anticipation of a public flotation. The
appointment resulted in the implementation of new management policies designed
to improve efficiency and accountability. These included the following:
(1) Responsibility accounting systems based on a matrix structure integrating
production departments and functional management.
(2) The formation of an executive budget committee to set all departmental
and manager budgets. The committee comprised functional directors, the
chief accountant and the managing director.
(3) Monthly reporting systems for all budgetees based on conventional full-
cost variance analysis and profit-based sales analysis.
(4) A bonus system for all production department supervisors and functional
managers based on achievement of monthly budgets.
Results during the first six months of the new policies did improve but more
recently performance has not been impressive and managers have begun to notice a
change in the organisational climate. The product range has been rationalised and
much of the highly skilled special work has been dropped. The stringent budget
requirements have put considerable pressure on departmental and functional heads
who now see much less of each other despite the interdependence between them.
The enthusiasm for the new management systems has now been transformed into a
fear of monthly results, fuelled by recent demotions and appointments from outside.
The following were typical of managerial reaction after the latest monthly results:
“Last month’s budgets were impossible. My department operated at its most
efficient level for months and I still didn’t make the target.”
“What I can’t understand is why the published budgets look nothing like our own
submitted estimates.”
“My results totally ignore the breakdown in my main supplying department.”
“I may have made my budget but I wouldn’t like to guarantee either the quality of
the output or the accuracy of the output figures.”
“The only response I got to last month’s performance was no bonus and a nasty
memo.”
Requirement
Critically evaluate the situation at Moto Ltd, making full use of the information
available.
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BUDGETING
7 QUANTITATIVE TECHNIQUES FOR BUDGETING
7.1 Learning curve theory
7.1.1 The learning effect
If workers specialise there is a tendency for labour hours per unit to fall as
they become more familiar with the task.
During World War II empirical evidence from aircraft production found the
rate of improvement to be so regular that it can be reduced to a formula.
The learning effect starts from the production of the first unit/batch. Each
time cumulative production then doubles, the cumulative average time per
unit falls to a fixed percentage of the previous average time.
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BUDGETING
7.1.2 Tabulation
Example 2
A product will take 100 hours for the first unit and an 80% learning curve applies.
Required:
(a) Complete the table and graph below.
Solution
Table
Units Cumulative Cumulative Incremental
average time total time total time
1 100 100 100
double
2
double
4
double
8
double
16
Graph
Cumulative
average
time
Cumulative
output
What is the cumulative average time to produce 10 units?
The table does not cover this.
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BUDGETING
7.1.3 Learning curve formula
Although the graph could be used, to provide an estimate, it is more accurate to use the
following formula:
b
y = ax
Where y = cumulative average labour hours per unit
a = number of labour hours for the first unit
x = cumulative number of units
b = the learning coefficient
log (learning curve rate as a decimal)
=
log 2
Example 2 continued
Required:
(b) Use the formula to check the cumulative average time for 8 units
Solution
b Log 0.8 − 0.0969
= =
Log 2 0.3010
Example 3
It is estimated that it will take 500 hours to produce the first unit of a new product.
Workers have a 95% learning effect.
Required:
Calculate how long it will take to produce the seventh unit.
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BUDGETING
Solution
y =
=
b
Time for seventh unit =
Average time for seven units =
Total time for seven units =
Total time for six units =
Time for seventh unit =
Example 4
McSporran Ltd is a new business. It is budgeting costs for the production of kilts.
Work studies show that the first batch will have a labour cost of £2,000 and an 85%
learning effect applies.
In period one budget production is 5 batches.
In period two budget production is 7 batches.
The wage rate per hour will be constant.
Required:
Calculate the budgeted labour cost for period two.
Solution
Note – as the wage rate is constant it is possible to use £s rather than hours in the formula.
Labour cost for period two =
b =
Total cost for 12 batches =
Total cost for 5 batches =
Labour cost for period two =
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BUDGETING
In practice (and in many questions) the learning curve effect does not continue forever.
At some point a “steady state” is reached – beyond this point hours per unit is constant.
7.1.3 Conditions for a learning curve to apply
The activity is labour intensive.
The units are identical ie a repetitive task
Low labour turnover.
No prolonged breaks in production.
7.1.4 Applications
Standard setting – the labour standard should be set/revised based upon the
expected learning effect.
Budgeting – variable costs are expected to fall with an increase in production
– particularly important to cash budgeting.
Pricing decisions – an accurate labour cost may be predicted into the future.
Work scheduling – manpower planning eg as part of MRPII.
7.2 Linear regression
A statistical technique which can be used to attempt to predict future costs
from historical data.
It produces a “line of best fit” from cost and output data.
Costs
LINE OF
x
BEST FIT
x
x
x
x x
x x
Output
The line of best fit can then be used to forecast cost for budgeted future
output levels.
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BUDGETING
7.3 Time series analysis
A time series is a set of observations taken at equal periods of time eg
quarterly sales figures.
Analysis can explain the variation in observations into four factors.
− Long term trends eg demographic change.
− Cyclical variations eg economic growth/slowdown.
− Season variations eg higher sales at Christmas.
− Residual or random factors eg strikes, fires.
Forecasts can then be made of future trends to be used in budgeting.
FOCUS
You should now be able to
discuss the design of alternative budget models including fixed, flexed, zero
based and incremental
discuss the behavioural aspects of budgetary planning and control
describe and use learning curve theory.
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BUDGETING
EXAMPLE SOLUTIONS
Solution 1
Tutorial note
Because of the importance of this topic area, this solution is written in tutorial style.
The object is to demonstrate how a pass mark could be achieved by using an approach
which could be applied to other questions.
The case study type of question is probably the most difficult and involves an initial
stage of identifying the problems.
Stage I: Summarising the problems raised in the case study
(Start perhaps by using general categories.)
For example, the problems raised fall into a number of areas.
External Not competing as efficiently
Loss of product quality
Internal Worsening results
Poor morale and motivation
(These can then be broken down to fit into some of the traditional areas of debate on
behavioural and organisational aspects of budgeting. Coverage does no need to be
comprehensive. Keep it relevant.)
(More detailed analysis – could be a list at this stage.)
1 Lack of participation in budget-setting and performance appraisal.
2 Performance measures ignoring interdependencies and uncontrollable factors.
3 Too much budgetary pressure linked to high performance targets.
All of these problems are occurring during the period of organisational change and the
current results indicate a mismanagement of the change. The organisation is now
resisting the enforced changes and this is at least partially a failure of the management
of the budgetary control system. The price is being paid for the short-run gains.
(This last paragraph is a brief attempt to put the problem into a general context.)
Stage II: Relating the issues to general theories
There are three main theories with which to contend.
(a) Scientific management
(b) Participative approach
(c) Contingency theory
(The best bet is to leave (c) for conclusions.)
(Try and relate the case study information to (a) or (b).)
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BUDGETING
Example The management system introduced in recent times has taken on several of
the characteristics of a scientific management approach. These include the
following.
(a) Top Down budgeting
(b) Linking budget performance to economic rewards
(c) Adopting a very short-run view of performance
(d) Setting budgets which are too difficult
(e) Ignoring report formats
(f) A generally authoritarian management style.
(Make full use of your knowledge of the theory but relate your analysis to the facts.)
Example. This change of management system appears not to have improved
organisational effectiveness. The reasons include the following.
(a) Disruption of traditional customer servicing and product specialisation
(b) Exclusion of non-economic rewards
(c) Disintegration of existing management groupings.
Importantly, Moto was already a successful organisation.
(You would be able to pick up some marks for commenting on an alternative approach
– the participative.)
Example. Policies might have been more successful if some aspects of the participative
model had been considered. Of particular relevance would be the following.
(a) More consultation e.g Bottom Up budgeting
(b) More supportive feedback
(c) More words and less figures in reports – to reflect the interdependencies
(d) Extending reporting horizons – one month is a very short period
(e) Generally improving communications between managerial levels
(Much of this section should be based on the memorised features of the two models.
Do not suggest that either is a universal solution.)
Stage III: Conclusions and reference to the contingency approach
(The conclusions should attempt to present a “balanced” view of the case which can be
conveniently “couched” within a contingency approach. Try to keep relating back to
the facts of the case as much as possible.)
(First, the general conclusion.)
Example. The reactions of the managers clearly indicate attitude problems which are
beginning to affect motivation and performance. These consequences seem
at least partially due to the new management system and style, incorporating
a very tight budgetary control system. There is no one optimal management
system to solve the problem, but Moto must try to achieve a better match
between its control systems and its organisational situation.
(Note. This kind of comment is useful as a lead in to the contingency approach.)
One would conclude that this match could involve introducing
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BUDGETING
(a) more participation
(b) more supportive feedback with full recognition of interdependencies
(c) removal of the bonus payment system
(d) a change of attitude at the top regarding quality and job satisfaction.
(Then, the conclusion on the appropriate method of analysis.)
Example The assessment of Moto’s position should not be made exclusively by
reference to individual management theories, such as scientific management.
The approach should be “situationally specific”. Contingency theory
describes an open-systems approach which recognises the interaction of
(a) environmental forces
(b) technology
(c) formal structures
(d) behavioural forces
(e) decision processes.
Therefore all of these factors would need to be taken into account before revisions to
the management control package should be made.
Solution 2 – Learning effect
Units Cumulative Cumulative Incremental
average time total time total time
1 100 100 100
double × 80%
2 80 160 60
double × 80%
4 64 256 96
double × 80%
8 51.2 409.6 153.6
double × 80%
16 40.96 655.36 245.76
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BUDGETING
Cumulative
average
time
100 x
80 x
64 x
51.2 x
40.96
x
Cumulative
0 output
1 2 4 8 16
(b) Using formula
b Log 0.8 − 0.0969
= = = – 0.3219
Log 2 0.3010
y = 100 × 8 –0.3219 = 100 × 0.512 = 51.2 hour
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BUDGETING
Solution 4 – Learning curve formula
y = axb
b Log 0.95 − 0.0223
= = = –0.074
Log 2 0.3010
Time for seventh unit = Time for seven units – time for six units.
Average time for seven units = 500 × 7–0.074 = 433 hours
Total time for seven units = 433 × 7 = 3,031 hours
Total time for sic units = 6 (500 × 6–0.074) = 2,627 hours
Time for seventh unit = 3,031 – 2,627 = 404 hours
Solution 3 – Labour cost
Note – as the wage rate is constant it is possible to use £s rather than hours in the formula.
Labour cost for period two = Total cost for 12 batches – total cost for 5 batches
(period one and two) (period one)
Log 0.85 − 0.0706
b = = = –0.2345
Log 2 0.3010
Total cost for 12 batches = 12 (2,000 × 12–0.2345) = £13,401
Total cost for 5 batches = 5 (2,000 × 5–0.2345) = £6,856
Labour cost for period two = 13,401 – 6,856 = £6,545
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