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Part 3 PERFORMANCE MEASUREMENT AND CONTROL Managers need information to help them measure relative successes and failures in performance. They also need information to help control operations. Evaluation of performance and control of activity requires a forward-looking plan, followed by a system that monitors achievements against that plan. Part 3 explains how management accounting helps answer questions of the following type: l l l l l l l What is our budget for all activities for the next 12 months, analysed into components for each part of the organisation? How can we use budgets for performance measurement and control? What are the limitations of budgets as a tool of management planning and control? How should information be presented to various levels of management and to employees within the organisation, to give information on performance and feedback for improvement? How is the performance of a division within an organisation measured? How do standard costs help in setting performance targets and monitoring achievements? What special methods are required to deal with continuous processes? Chapters 13 and 14 explain the use of budgets and some of the challenges faced in budgeting. In particular, Chapter 14 explains how to compare budgets with actual outcomes by calculating variances. Chapter 15 extends the analysis of variances by describing standard costing. Chapter 16 describes methods of evaluating and reporting on performance within departments of an organisation, while Chapter 17 extends this analysis to divisional performance. LEVEL 2 LEVEL 1 Part 3 PERFORMANCE MEASUREMENT AND CONTROL Chapter 13 Preparing a budget Chapter 14 Control through budgeting Chapter 16 Performance evaluation and feedback reporting Chapter 15 Standard costs Chapter 17 Divisional performance Chapter 13 Preparing a budget Real world case 13.1 This case study shows a typical situation in which management accounting can be helpful. Read the case study now but only attempt the discussion points after you have finished studying the chapter. Transport for London produced the budget shown below for Walking, Cycling and Accessibility. The budget description follows the table: 2003/04 2004/05 2004/05 Total costs Operating budget Capital budget £m £m £m Walking Cycling Accessibility 7.1 13.6 6.1 0.9 0.6 2004/05 Total budget £m 6.7 11.6 6.9 7.6 12.2 6.9 Walking This activity consists of a programme of measures that aim to create and promote a connected, safe, convenient and attractive environment that increases the levels of walking in London in accordance with the Mayor’s Transport Strategy objectives. Proposals have been developed in partnership with TfL, the London boroughs and interest groups (London cycling campaign & Living Streets). Deliverables in 2004/05 l New and upgraded pedestrian crossings (21 crossings under development); l Removal of footbridges and closures of subways and replacement with surface level facilities (four junctions under development); l Provision of new or improved facilities at signalised junctions and footway upgrading existing strategic routes (numerous locations); l Providing new footbridges across railways and upgrading existing facilities (four sites); l Improved interchanges between bus and rail services (five sites); l Pedestrian signing, security improvements, refuges, pavement widening at crossings, removal of clutter and installation of dropped kerbs (numerous locations); l Co-ordination of the annual Car Free Day. Indicators of success 90 pedestrian schemes to be delivered by March 2005. l Source: Transport for London website www.tfl.gov.uk/tfl/. Discussion points 1 How does this budget provide useful information for managing transport activity? 2 If you were a member of the Council being asked to approve this budget, what further information would you need? Chapter 13 Preparing a budget Contents Learning outcomes 13.1 Introduction 316 13.2 Purpose and nature of a budget system 13.2.1 Long-range planning 13.2.2 Strategy 13.2.3 Budgets 13.2.4 Forecasts 316 316 316 317 319 13.3 Administration of the budgetary process 13.3.1 The budget committee 13.3.2 The accounting department 13.3.3 Sequence of the budgetary process 319 319 320 320 13.4 The benefits of budgeting 13.4.1 Planning 13.4.2 Control 13.4.3 Communication and co-ordination 13.4.4 Basis for performance evaluation 324 324 325 326 327 13.5 Practical example – development of a budget 13.5.1 Vision statement and objectives 13.5.2 Budget details for Year 5 as agreed by line managers after negotiations 13.5.3 Preparation of individual budgets 13.5.4 Master budget 13.5.5 Interpretation of the practical example 327 328 13.6 Shorter 13.6.1 13.6.2 13.6.3 budget periods Worked example: data Quarterly budgets Comment on cash budget 336 336 337 340 13.7 What the researchers have found 13.7.1 The budget process 13.7.2 Frequency of budgeting 340 340 340 13.8 Summary 341 After reading this chapter you should be able to: l Explain the purpose and nature of a budget system. l Describe the administration of the budgetary process. l Explain the benefits of budgeting. l Prepare the separate budgets that lead to a master budget. l Prepare quarterly budgets. l Describe and discuss examples of research into the budget process. 328 329 333 335 315 316 Part 3 Performance measurement and control 13.1 Introduction This chapter considers the purpose and nature of the budgetary process and explains the method of preparation of budgets, with particular emphasis on the planning process. The use of budgets for control is touched upon in this chapter but is discussed in more detail in Chapter 14. No two businesses will have an identical approach to budget preparation. Some involve all employees in the process, while others deliver the budget as handed down from senior management with little or no consultation. This chapter discusses systems where there is a relatively high degree of participation and negotiation in setting budgets. It should be recognised that in some businesses the senior managers will take decisions without such extensive consultation. A discussion of the relative merits of consultation are well beyond the scope of this book, but in learning about the budgetary process it may help the student to think about the ways in which each person having responsibility for administering a budget might also have a part to play in its construction. 13.2 Purpose and nature of a budget system The purpose of a budget system is to serve the needs of management in respect of the judgements and decisions it is required to make and to provide a basis for the management functions of planning and control, described in Chapter 1. That chapter also refers to the importance of communication and motivation as an aspect of management to which management accounting should contribute. In Figure 1.2 there is an illustration of the interrelationships of these management functions in respect of the process by which a business such as a chain of shops supplying motorcycles might go about planning to open a new shop in the suburbs of a city. Where this type of planning is taking place, management accounting assists through a budget system by providing quantification of each stage of the planning process. That example of the motorcycle shop illustrates a simple type of long-range planning but a more complex example would show the way in which the longrange planning leads on to successively more detailed developments, finishing with a collection of short-term operational budgets covering a period such as a year, six months or perhaps no more than one month ahead. 13.2.1 Long-range planning In long-range planning, the senior managers of a business will begin by specifying a vision statement which sets out in the broadest terms their vision of the future direction of the organisation. Based on this, the senior managers will then prepare a list of objectives which will specify the intended future growth and development of the business. For example, a company might state its vision and its long-range corporate objectives, for a five-year period ahead, in the terms shown in Exhibit 13.1. The corporate objectives shown in Exhibit 13.1 relate to the business as a whole. They will then be taken down to another level of detail to create objectives for each division of the business. Within divisions, they will be translated into departmental objectives. 13.2.2 Strategy Having a vision statement and corporate objectives is an essential first step, but the organisation must then decide exactly how it will achieve those objectives. The term strategy is used to describe the courses of action to be taken in achieving the objectives set. Chapter 13 Preparing a budget Exhibit 13.1 Company’s vision statement and long-range corporate objectives Vision The company intends to maintain its position as the market leader in the electrical goods repair industry, having regard to providing investors with an adequate rate of growth of their investment in the business. Corporate objectives l The company intends to increase the value of the investment by its shareholders at a minimum rate of 4 per cent per annum, in real terms. l The company intends to remain in the electrical goods repair business and to concentrate on this as the core business. l The company will provide service in the customer’s home and at its main repair centres. l The company will continue to maintain its geographical focus on the high-earning suburban areas around the three largest cities. l The company seeks to enlarge its market share in those geographical areas to 20 per cent of the total market. l The company has a profit objective of 30 per cent gross profit on turnover. Developing the strategy will involve senior management from the various functions such as marketing, customer service, production, personnel and finance. These functions are separate, but must work together in the interests of the company as a whole. Each functional manager has to understand how the plans made by that function will affect other functions and the company as a whole. This requires communication and co-ordination with the assistance of a management accountant. For the purposes of quantifying the strategy of the business, management accounting has developed specialist techniques under the global heading of budgetary planning and control. The rest of this chapter explains the processes involved. 13.2.3 Definition Budgets A budget is a detailed plan which sets out, in money terms, the plans for income and expenditure in respect of a future period of time. It is prepared in advance of that time period and is based on the agreed objectives for that period of time, together with the strategy planned to achieve those objectives. Each separate function of the organisation will have its own budget. Figure 13.1 shows a typical scheme of budget structure within an organisation. It shows how the organisation moves from setting objectives, through the strategy stage and into the preparation of budgets. The long-term objectives are set first. It is important to note at that stage any key assumptions which might have a critical effect on future implementation of those objectives. The implementation of those long-term objectives is then formed into a strategy which results in some intermediate objectives for the short term. Again, it is important to note any key assumptions which might later cause the organisation to question the objectives. In many businesses the critical factor determining all other budgets is the sales forecast. The business exists primarily to make sales and hence generate profit, so each separate function will be working towards that major target. Each function of the business then prepares its own budget as a statement of its operational plan for achieving the targets that have been set. In practice, these budgets would be prepared at the same time with a great deal of interaction among the managers of the various functions. That is difficult to show in a diagram. Figure 13.1 shows only the main budget relationships, moving from the sales 317 318 Part 3 Performance measurement and control Figure 13.1 Budget planning and relationships forecast to the production plan and the resulting working capital needs (stock, debtors and trade creditors) and capital investment in fixed assets. The various detailed budgets are brought together within a finance plan and then formed into conventional accounting statements such as budgeted profit and loss account, cash flow statement and balance sheet. This package is sometimes referred to as the master budget. The process leading to the preparation of the master budget, as outlined in Figure 13.1, will be used in the next section of this chapter as a basis for explaining the administration of the budgeting process. Chapter 13 Preparing a budget Activity 13.1 13.2.4 Imagine you are the managing director of a large company about to embark on budget preparation for the following year. How would you manage the various people you would need to meet in order to make operational the budget relationships shown in Figure 13.1? Would you meet them all together or have separate meetings? Would you take sole charge or would you establish teams? Write down your thoughts on this before you read the next section and then check it against your ideas. Forecasts Forecasts involve making predictions. The prediction could be a description such as ‘we forecast that sales prices next year will rise by more than cost inflation’. Or the prediction could be quantified, for example ‘we forecast a five per cent increase in demand for our product.’ For planning purposes, a forecast is more useful if it contains some quantification. Definition A forecast is a prediction of future events and their quantification for planning purposes. So what is the difference between a budget and a forecast? Both are looking forward and both involve quantification. However, the forecast generally comes at an early stage in the planning process when managers are looking to the future to make plans and anticipate problems. Once the plans are made, the budget is prepared as a quantification of the planning. The sequence is: 13.3 Administration of the budgetary process The budgetary process has to be administered effectively in terms of initial planning, final approval and subsequent monitoring of implementation. A budget committee is usually formed to manage each stage of the budgetary process. The accounting staff will have a close involvement. The budget preparation procedures will need to be set out in a manual which is available to all participants. A continuing cycle evolves in which initial budgets are prepared, negotiations take place with line managers, the initial budgets are revised, the final budget is accepted and, later on, there is a review of actual and budgeted performance. The cycle then starts over again. 13.3.1 The budget committee To implement the strategy decisions, a budget committee will be formed, comprising the senior managers who are responsible for designing the strategy. The budget committee receives the initial budgets from each functional manager. If the initial budget is based on unrealistic targets, then the functional manager will be asked to modify the budget within the organisation’s overall targets. There is a motivational aspect of budget preparation, so it is important that the functional manager understands the need for revising the budget within the organisation’s strategy. Budget negotiation can be quite a delicate process. Fiona McTaggart describes her experiences of the initial budget formation in a conglomerate company having a stock exchange listing: 319 320 Part 3 Performance measurement and control FIONA: There are four divisions whose activities are quite dissimilar but the linking theme is their ability to generate cash for the group which, in turn, is translated into dividends for the shareholders and capital investment for the divisions. The budget committee is formed from the board of directors of the holding company. Budget negotiations start each year when each divisional manager sets targets in six critical areas: capital expenditure, turnover, gross and net profit margins, cash flow and working capital requirements. The budget committee knows over the years that the transport division manager is always too enthusiastic for capital expenditure and has to be persuaded to be more cautious in replacing and expanding the fleet. The musical instrument division is on a steady-state pattern without much growth, but is regarded as a steady source of cash flow, so is not encouraged to be more ambitious. The knitwear division has some problems associated with fashion goods and tends to be too conservative in its planning. A measure of risk taking is encouraged and almost every year that division has to be asked to revise its initial turnover targets upwards. The fourth division is stationery supplies and their problem is profit targets in a competitive sector. Little can be done about gross profit, but there is plenty of scope for cost efficiencies to improve the contribution of net profit to cash flow. 13.3.2 The accounting department The staff of the accounting department will work with operations managers to initiate the preparation of budgets and will advise and assist in the practical aspects of budget preparation. They should have the knowledge and experience to provide advice to line managers on the preparation of budgets. The accounting department will have the computer facilities to prepare and co-ordinate the budget preparation process. The accounting staff must involve themselves with the operations team in the budget exercise and must understand the commercial issues. They may have to offer challenges to the operations managers, but such challenges will be aimed at ensuring improved budgets for the benefit of the whole organisation as well as for the operational unit. 13.3.3 Sequence of the budgetary process Figure 13.1 shows the relationships among the various budgets but does not portray the time sequence of the budgeting process. The principal stages of this sequence are: (a) communicate the details of objectives and strategy to those responsible for preparation of budgets and co-ordinate the overall linkage of objectives and strategy; (b) communicate the details of budget preparation procedures to those responsible for preparation of budgets and respond to concerns or questions; (c) determine the limiting factor which restricts overall budget flexibility and forms the focus of the budget cascade and evaluate the impact of the limiting factor; (d) prepare an initial set of budgets; (e) negotiate budgets with line managers; (f) co-ordinate and review budgets; (g) accept budgets in final form; (h) carry out ongoing review of budgets as they are implemented. Communicate objectives and strategy The long-range plan should be contained in a strategy document which is circulated within the organisation at intervals throughout the year. Regular circulation, with invitations to comment and a visible process of revision to accommodate changing circumstances, means that those responsible for the preparation of budgets have the fullest understanding of the basis for the budget process. The strategy document should contain clear narrative descriptions of the objectives of the organisation, Chapter 13 Preparing a budget supplemented by quantified illustrations of the impact on the organisation as a whole and on major divisions. The objectives may initially be expressed in non-financial terms such as production or sales targets by volume, or workforce targets by quantity and quality. Ultimately, all these non-financial targets will have a financial implication. Communicate procedures For communication of budget preparation procedures within the organisation there must be a budget manual. This will set out the timetable for budget preparation, formats to be used, circulation lists for drafts and arbitration procedures where conflicts begin to show themselves. Determine the critical factor The critical factor sets the starting point of the budgeting process. For many organisations, sales are the critical factor. There is no point in producing goods and services which do not sell. There may be occasions when the demand is not a problem but the supply of materials or labour resources is restricted. (Such restrictions on production factors should be temporary in a competitive market because materials will eventually be found at a higher price, while labour will move from one geographical area to another or will train to develop new skills within the area.) For this chapter it will be assumed that sales are the critical factor. That assumption is the basis of the chart of budget relationships shown in Figure 13.1 where the cascade flows down from the top to the foot of the page. Preparing an initial set of budgets The sales budget is a representation of the volume of sales planned for the budget period, multiplied by the expected selling price of each item. For most organisations, sales volume is the major unknown item because it depends on customers whose choices may be difficult to predict. In practice an organisation will carry out some form of market research, ranging from very sophisticated market research surveys to some simple but effective techniques such as contacting past customers and asking them about their intentions for the period ahead. Sales representatives will, as part of their work, form continuous estimates of demand in their region of responsibility. Past performance in sales may usefully be analysed to identify trends which may be an indicator of future success in sales. From the sales plan flow the operational budgets. Figure 13.1 shows the subsequent pattern of budget development once the sales budget has been determined. The production plan, setting out quantities of resource inputs required, leads into operational budgets for direct labour, direct materials and manufacturing overhead which combine resource quantities with expected price per unit. At the same time, budgets for administration and marketing are being prepared based on quantities and prices of resources needed for production and sales. That information provides the basis for a profit and loss account matching sales and expenses. A cash flow estimate is also required based upon working capital needs and fixed asset needs. Working capital depends on the mix of stock, debtors and creditors planned to support the sales and production levels expected. Fixed asset needs derive from the capital projects budgeted as a result of the objectives of the organisation. This all feeds into a finance plan from which the master budget emerges containing the budgeted profit and loss account, the budgeted cash flow statement and the budgeted balance sheet. Negotiate budgets with line managers The success of the budgetary process is widely held to depend on the extent to which all participants are involved in the budget preparation process. A bottom-up budget 321 322 Part 3 Performance measurement and control process starts by asking those who will ultimately implement the budget to make proposals, and have an involvement in, the budget process. That does not mean that they take over control of the budget but it does give them a greater sense of ownership of the resulting budget. Definition A bottom-up budget is initiated by inviting those who will implement the budget to participate in the process of setting the budget. It is also called a participative budget. A top-down budget process starts with the senior management sending down budgets and targets based on the organisational goals and strategies. The budget is imposed on those who will implement it, without inviting them to share in its preparation. Definition A top-down budget is set by management without inviting those who will implement the budget to participate in the process of setting the budget. It is also called an imposed budget. A negotiated budget combines these two approaches so that the budget allowances are set as the result of negotiation between budget holders and the management to whom they are responsible. In a negotiated process, the budgets will be initiated in each of the departments or areas responsible but each budget may have an impact on other line managers. There may be a problem of restricted resources which requires all budgets to be cut back from initial expectations. There may be a programme of expansion which has not sufficiently been taken into account by those preparing the budgets. Whatever the particular circumstances, a negotiation stage will be required which will usually involve the budget committee in discussions with various line managers. At the very least, this will be a communications exercise so that each participant understands the overall position. More often it will be an opportunity for fine-tuning the plans so that the benefit to the organisation as a whole is maximised. Although Figure 13.1 is presented as a downward-flowing cascade because of the increasing level of detail involved, it does not adequately represent the negotiation processes involved. Figure 13.2 is a different way of showing the budgetary process outlined in Figure 13.1. It emphasises people rather than the documentation resulting from the process, and also shows the combination of the ‘bottom-up’ preparation of budgets with the ‘top-down’ approval by senior management. In Figure 13.2, the mauve lines show some of the interactions which might take place in the negotiation stage, distinguishing negotiations among the line managers and negotiations between the line managers and the budget committee. Quite deliberately, the lines are shown without directional arrows because the negotiation process is two-way. Even then a two-dimensional diagram cannot do justice to the time span and the sequence of negotiations over a relatively short space of time. Co-ordinate and review budgets The mauve lines of Figure 13.2 depict one-to-one links in the negotiation process. Participants in each separate negotiation will reach a point where they are satisfied with the discussion, or else they understand where and why their opinions differ. However, the budget committee has an obligation to serve the interests of the organisation as a whole. The separate budgets resulting from the negotiation process are brought together in a meeting of the budget committee. At this meeting the separate budgets are co-ordinated. If the sales manager has budgeted for a 10 per cent