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M06_ATRI3622_06_SE_C06.QXD 204 CHAPTER 6 5/29/09 10:37 AM Page 204 BUDGETING Whether budgets seem to be effective and how they can be made more effective are crucial issues for managers. We shall examine this topic in detail in the next chapter, after we have seen how budgets can be used to help managers to exercise control. Who needs budgets? Until recently it would have been a heresy to suggest that budgeting was not of central importance to any business. The benefits of budgeting, mentioned earlier in this chapter, have been widely recognised and the vast majority of businesses prepare annual budgets. However, there is increasing concern that, in today’s highly dynamic and competitive environment, budgets may actually be harmful to the achievement of business objectives. This has led a small but growing number of businesses to abandon traditional budgets as a tool of planning and control. Various charges have been levelled against the conventional budgeting process. It is claimed that budgets l cannot deal with a fast-changing environment, and are often out of date before the start of the budget period; l focus too much management attention on the achievement of short-term financial l l l l l l targets. Instead, managers should focus on the things that create value for the business (for example, innovation, building brand loyalty, responding quickly to competitive threats, and so on); reinforce a ‘command and control’ structure that concentrates power in the hands of senior managers and prevents junior managers from exercising autonomy. This may be particularly true where a top-down approach, that allocates budgets to managers, is being used. Where managers feel constrained, attempts to retain and recruit able managers can be difficult; take up an enormous amount of management time that could be better used. In practice, budgeting can be a lengthy process that may involve much negotiation, reworking and updating, and may add little to the achievement of business objectives; are based around business functions (sales, marketing, production, and so on). However, to achieve the business’s objectives, the focus should be on business processes that cut across functional boundaries and reflect the needs of the customer; encourage incremental thinking by employing a ‘last year plus x per cent’ approach to planning. This can inhibit the development of ‘break-out’ strategies that may be necessary in a fast-changing environment; can protect costs rather than lower costs. In some cases, a fixed budget for an activity, such as research and development, is allocated to a manager. If the amount is not spent, the budget may be taken away and, in future periods, the budget for this activity may be either reduced or eliminated. Such a response to unused budget allocations can encourage managers to spend the whole of the budget, irrespective of need, in order to protect the allocations they receive; promote ‘sharp’ practice among managers. In order to meet budget targets, managers may try to negotiate lower sales targets or higher cost allocations than they feel is really necessary. This helps them to build some ‘slack’ into the budgets and so meeting the budget becomes easier (see reference 2 at the end of the chapter). Although some people believe that many of the problems identified can be solved by better budgeting systems such as activity-based budgeting and zero-base budgeting and by taking a more flexible approach, others believe that a more radical solution is required. M06_ATRI3622_06_SE_C06.QXD 5/29/09 10:37 AM Page 205 BEYOND CONVENTIONAL BUDGETING 205 Beyond conventional budgeting In recent years, a few businesses have abandoned budgeting, although they still recognise the need for forward planning. No one seriously doubts that there must be appropriate systems in place to steer a business towards its objectives. It is claimed, however, that the systems adopted should reflect a broader, more integrated approach to planning. The new systems that have been implemented are often based around a ‘leaner’ financial planning process that is more closely linked to other measurement and reward systems. Emphasis is placed on the use of rolling forecasts, key performance indicators (such as market share, customer satisfaction and innovations) and/or ‘scorecards’ (like the balanced scorecard, which we shall meet in Chapter 9) that identify both monetary and non-monetary targets to be achieved over the long term and short term. These are often very demanding (‘stretch’) targets, based on benchmarks that have been set by world-class businesses. The new ‘beyond budgeting’ model promotes a more decentralised, participative approach to managing the business. It is claimed that the traditional hierarchical management structure, where decision making is concentrated at the higher levels of the hierarchy, encourages a culture of dependency where meeting the budget targets set by senior managers is the key to managerial success. This traditional structure is replaced by a network structure where decision making is devolved to ‘front-line’ managers. In the new structure a more open, questioning attitude among employees is encouraged. There is a sharing of knowledge and best practice, and protective behaviour by managers is discouraged. In addition, rewards are linked to targets based on improvement in relative performance rather than to meeting the budget. It is claimed that this new approach allows greater adaptability to changing conditions, improves performance and increases motivation among staff. Figure 6.8 sets out the main differences between the traditional and ‘beyond budgeting’ planning models. Real World 6.8 looks at the management planning systems at Toyota, the well-known Japanese motor vehicle business, a business that does not use conventional budgets. REAL WORLD 6.8 Steering Toyota Peter Bunce is at the forefront of those who argue that budgeting systems have an adverse effect on the ability of businesses to compete effectively. The following is an outline of Toyota’s planning and control systems, written by him: Toyota is a well-known example of a sense-and-respond organisation. Instead of pushing products through rigid processes to meet sales targets, its operating systems start from the customer – it is the customer order that drives operating processes and the work that people do. The point is that in sense-and-respond companies, predetermined plans and performance contracts are an anathema and represent insurmountable barriers; which is why adaptive organisations like Toyota don’t have them. However, in industries such as manufacturing, planning has a vital role to play as they have to ensure that they will have sufficient capacity for expected levels of customer orders and they have to manage and coordinate the supply chain. Every year Toyota Motor Europe develops what it calls its Original Business Plan (OBP). The OBP is just a forecast (or financial plan) for the year and provides a baseline for understanding actuals and changes, for communicating, discussion and reaching consensus (a key element of Toyota’s way of working) and also for ‘ M06_ATRI3622_06_SE_C06.QXD 206 CHAPTER 6 5/29/09 10:37 AM Page 206 BUDGETING Real World 6.8 continued management reviews. The OBP doesn’t have any of the toxic elements of a traditional budget such as agreeing and coordinating fixed targets, rewards and resources for the year ahead, and the measuring and controlling performance against such an agreement. Nor is it a reference for bonuses as it doesn’t contain any targets or goals (aspirational goals are set separately by Toyota). Toyota Motors Europe also undertakes quarterly forecasts to update the OBP. These are much lighter than the OBP and don’t go into much detail. Source: Bunce, P., ‘Transforming financial planning’, www.bbrt.org, June 2007. Figure 6.8 Traditional versus ‘beyond budgeting’ planning model The traditional model is based on the use of fixed targets, which determine the future actions of managers. The ‘beyond budgeting’ model, on the other hand, is based on the use of stretch targets that can be adapted. The traditional hierarchical management structure is replaced by a network structure. Source: ‘Beyond budgeting’, www.beyondbudgeting.plus.com. M06_ATRI3622_06_SE_C06.QXD 5/29/09 10:37 AM Page 207 LONG LIVE BUDGETS! It is perhaps too early to predict whether or not the trickle of businesses that are now seeking an alternative to budgets will turn into a flood. However, it is clear that in today’s highly competitive environment a business must be flexible and responsive to changing conditions. Management systems that in any way hinder these attributes will not survive. Long live budgets! It is worth remembering that, despite the criticisms, budgeting remains a very widely used technique. Real World 6.3 provides evidence for this. Furthermore, a glance through the annual report of virtually any well-known business will reveal that budgeting is used and is not, therefore, regarded as an impediment to success. Real World 6.9 is an account of a round table discussion at a Better Budgeting forum held in 2004. REAL WORLD 6.9 Alive and kicking A round table discussion at a Better Budgeting Forum held in London in March 2004 was attended by representatives of 32 large organisations, including BAA (the airport operator), the BBC, Ford Motors, Sainsbury (the supermarket business) and Unilever (the household goods group). The report of the forum discussions said: If you were to believe all that has been written in recent years, you’d be forgiven for thinking that budgeting is on its way to becoming extinct. Various research reports allude to the widespread dissatisfaction with the bureaucratic exercise in cost cutting that budgeting is accused of having become. Budgets are pilloried as being out of touch with the needs of modern business and accused of taking too long, costing too much and encouraging all sorts of perverse behaviour. Yet if there was one conclusion to emerge from the day’s discussions it was that budgets are in fact alive and well. Not only did all the organisations present operate a formal budget but all bar two had no interest in getting rid of it. Quite the opposite – although aware of the problems it can cause, the participants by and large regarded the budgeting system and the accompanying processes as indispensable. and later, in what could have been a reference to the use of ‘rolling forecasts’ among businesses that claim to have abandoned budgeting, it said: It quickly became obvious that, as one participant put it, ‘one man’s budget is another man’s rolling forecast’. What people refer to when they talk about budgeting could in reality be very different things. This presumably meant that businesses that abandon ‘budgets’ reintroduce them under another name. Source: The Chartered Institute of Management Accountants and The Faculty of Finance and Management of the Institute of Chartered Accountants in England and Wales, Better Budgeting, March 2004. It could be argued that Toyota’s ‘Original Business Plan’ (see Real World 6.8) is really a budget by another name. The definition of a budget is a business plan, as we saw earlier in the chapter. Real World 6.10 provides survey evidence of senior finance staff that reveals considerable support for budgets. Nevertheless, many recognised that budgeting is not always well managed and acknowledged some of the criticisms of budgets that were mentioned earlier. 207 M06_ATRI3622_06_SE_C06.QXD 208 CHAPTER 6 5/29/09 10:37 AM Page 208 BUDGETING REAL WORLD 6.10 Problems with budgets The survey of the opinions of senior finance staff at 340 businesses of various sizes and operating in a wide range of industries in North America that was mentioned earlier showed that 86 per cent of those surveyed regarded the budget process as either ‘essential’ or ‘very important’. However, l l l l 66 per cent thought that budgeting in their business was not agile or flexible enough. 59 per cent were not very confident that budget targets would be met in 2008. 67 per cent felt that their business devoted inappropriate amounts of time to budgeting (51 per cent felt it was too much and 16 per cent too little). 76 per cent felt that their businesses used inappropriate software in the budgeting process (generally using a spreadsheet rather than custom-designed software). Source: ‘Perfect how you project’, BPM Forum, 2008. In the next chapter we shall look in some detail at how budgets can be adapted for use as devices for exercising management control. SUMMARY The main points of this chapter may be summarised as follows: A budget is a short-term business plan, mainly expressed in financial terms. l Budgets are the short-term means of working towards the business’s objectives. l They are usually prepared for a one-year period with sub-periods of a month. l There is usually a separate budget for each key area. Uses of budgets l Promote forward thinking. l Help co-ordinate the various aspects of the business. l Motivate performance. l Provide the basis of a system of control. l Provide a system of authorisation. The budget-setting process l Establish who will take responsibility. l Communicate guidelines. l Identify key factor. l Prepare budget for key factor area. l Prepare draft budgets for all other areas. l Review and co-ordinate. l Prepare master budgets (income statement and statement of financial position (balance sheet)). l Communicate the budgets to interested parties. l Monitor performance relative to budget. M06_ATRI3622_06_SE_C06.QXD 5/29/09 10:37 AM Page 209 FURTHER READING Preparing budgets l There is no standard style – practicality and usefulness are the key issues. l They are usually prepared in columnar form, with a column for each month (or other period). l Each budget must link (co-ordinate) with others. Criticisms of budgets l Cannot deal with rapid change. l Focus on short-term financial targets, rather than on value creation. l Encourage a ‘top-down’ management style. l Time-consuming. l Based around traditional business functions and do not cross boundaries. l Encourage incremental thinking (last year’s figure, plus x per cent). l Protect rather than lower costs. l Promote ‘sharp’ practice among managers. Budgeting is very widely regarded as useful and is extensively practised despite the criticisms. ‘ Key terms Budget p. 176 Control p. 177 Limiting factor p. 179 Forecast p. 179 Periodic budget p. 180 Continual budget p. 180 Rolling budget p. 180 Master budget p. 181 Management by exception p. 184 Budget committee p. 186 Budget officer p. 186 Incremental budgeting p. 192 Budget holder p. 192 Discretionary budget p. 192 Zero-base budgeting (ZBB) p. 193 Activity-based budgeting (ABB) p. 201 References 1 BPM Forum, ‘Perfect how you project’, BPM Forum, 2008. 2 ‘Beyond budgeting’, www.beyondbudgeting.plus.com. Further reading If you would like to explore the topics covered in this chapter in more depth, we recommend the following books: Atkinson, A., Banker, R., Kaplan, R. and Young, S. M., Management Accounting, 5th edn, Prentice Hall, 2007, chapter 11. Drury, C., Management and Cost Accounting, 7th edn, Cengage Learning, 2007, chapter 15. Hilton, R., Managerial Accounting, 6th edn, McGraw-Hill Irwin, 2005, chapter 9. Horngren, C., Foster, G., Datar, S., Rajan, M. and Ittner, C., Cost Accounting: A Managerial Emphasis, 13th edn, Prentice Hall International, 2008, chapter 6. 209 M06_ATRI3622_06_SE_C06.QXD 210 CHAPTER 6 5/29/09 10:37 AM Page 210 BUDGETING REVIEW QUESTIONS Answers to these questions can be found in Appendix C at the back of the book. 6.1 Define a budget. How is a budget different from a forecast? 6.2 What were the five uses of budgets that were identified in the chapter? 6.3 What do budgets have to do with control? 6.4 What is a budget committee? What purpose does it serve? EXERCISES Exercises 6.5 to 6.8 are more advanced than 6.1 to 6.4. Those with coloured numbers have answers in Appendix D at the back of the book. If you wish to try more exercises, visit the students’ side of the Companion Website at www.pearsoned.co.uk/atrillmclaney. 6.1 Daniel Chu Ltd, a new business, will start production on 1 April, but sales will not start until 1 May. Planned sales for the next nine months are as follows: Sales units May June July August September October November December January 500 600 700 800 900 900 900 800 700 The selling price of a unit will be a consistent £100 and all sales will be made on one month’s credit. It is planned that sufficient finished goods inventories for each month’s sales should be available at the end of the previous month. Raw materials purchases will be such that there will be sufficient raw materials inventories available at the end of each month precisely to meet the following month’s planned production. This planned policy will operate from the end of April. Purchases of raw materials will be on one month’s credit. The cost of raw material is £40 a unit of finished product. The direct labour cost, which is variable with the level of production, is planned to be £20 a unit of finished production. Production overheads are planned to be £20,000 each month, including £3,000 for depreciation. Non-production overheads are planned to be £11,000 a month, of which £1,000 will be depreciation. Various non-current (fixed) assets costing £250,000 will be bought and paid for during April. Except where specified, assume that all payments take place in the same month as the cost is incurred. The business will raise £300,000 in cash from a share issue in April. M06_ATRI3622_06_SE_C06.QXD 5/29/09 10:37 AM Page 211 EXERCISES Required: Draw up the following for the six months ending 30 September: (a) A finished inventories budget, showing just physical quantities. (b) A raw materials inventories budget showing both physical quantities and financial values. (c) A trade payables budget. (d) A trade receivables budget. (e) A cash budget. 6.2 You have overheard the following statements: (a) ‘A budget is a forecast of what is expected to happen in a business during the next year.’ (b) ‘Monthly budgets must be prepared with a column for each month so that you can see the whole year at a glance, month by month.’ (c) ‘Budgets are OK but they stifle all initiative. No manager worth employing would work for a business that seeks to control through budgets.’ (d) ‘Activity-based budgeting is an approach that takes account of the planned volume of activity in order to deduce the figures to go into the budget.’ (e) ‘Any sensible person would start with the sales budget and build up the other budgets from there.’ Required: Critically discuss these statements, explaining any technical terms. 6.3 A nursing home, which is linked to a large hospital, has been examining its budgetary control procedures, with particular reference to overhead costs. The level of activity in the facility is measured by the number of patients treated in the budget period. For the current year, the budget stands at 6,000 patients and this is expected to be met. For months 1 to 6 of this year (assume 12 months of equal length), 2,700 patients were treated. The actual variable overhead costs incurred during this six-month period are as follows: Expense Staffing Power Supplies Other Total £ 59,400 27,000 54,000 8,100 148,500 The hospital accountant believes that the variable overhead costs will be incurred at the same rate during months 7 to 12 of the year. Fixed overheads are budgeted for the whole year as follows: Expense Supervision Depreciation/financing Other Total £ 120,000 187,200 64,800 372,000 Required: (a) Present an overheads budget for months 7 to 12 of the year. You should show each expense, but should not separate individual months. What is the total overheads cost for each patient that would be incorporated into any statistics? (b) The home actually treated 3,800 patients during months 7 to 12, the actual variable overheads were £203,300, and the fixed overheads were £190,000. In summary form, examine how well the home exercised control over its overheads. (c) Interpret your analysis and point out any limitations or assumptions. 211 M06_ATRI3622_06_SE_C06.QXD 212 CHAPTER 6 6.4 5/29/09 10:37 AM Page 212 BUDGETING Linpet Ltd is to be incorporated on 1 June. The opening statement of financial position (balance sheet) of the business will then be as follows: Assets Cash at bank Share capital £1 ordinary shares £ 60,000 60,000 During June, the business intends to make payments of £40,000 for a leasehold property, £10,000 for equipment and £6,000 for a motor vehicle. The business will also purchase initial trading inventories costing £22,000 on credit. The business has produced the following estimates: 1 Sales revenue for June will be £8,000 and will increase at the rate of £3,000 a month until September. In October, sales revenue will rise to £22,000 and in subsequent months will be maintained at this figure. 2 The gross profit percentage on goods sold will be 25 per cent. 3 There is a risk that supplies of trading inventories will be interrupted towards the end of the accounting year. The business therefore intends to build up its initial level of inventories (£22,000) by purchasing £1,000 of inventories each month in addition to the monthly purchases necessary to satisfy monthly sales requirements. All purchases of inventories (including the initial inventories) will be on one month’s credit. 4 Sales revenue will be divided equally between cash and credit sales. Credit customers are expected to pay two months after the sale is agreed. 5 Wages and salaries will be £900 a month. Other overheads will be £500 a month for the first four months and £650 thereafter. Both types of expense will be payable when incurred. 6 80 per cent of sales revenue will be generated by salespeople who will receive 5 per cent commission on sales revenue. The commission is payable one month after the sale is agreed. 7 The business intends to purchase further equipment in November for £7,000 cash. 8 Depreciation will be provided at the rate of 5 per cent a year on property and 20 per cent a year on equipment. (Depreciation has not been included in the overheads mentioned in 5 above.) Required: (a) State why a cash budget is required for a business. (b) Prepare a cash budget for Linpet Ltd for the six-month period to 30 November. 6.5 Lewisham Ltd manufactures one product line – the Zenith. Sales of Zeniths over the next few months are planned to be as follows: 1 Demand July August September October Units 180,000 240,000 200,000 180,000 Each Zenith sells for £3. 2 Receipts from sales. Credit customers are expected to pay as follows: l 70 per cent during the month of sale l 28 per cent during the following month. The remaining trade receivables are expected to go bad (that is, to be uncollectable). Credit customers who pay in the month of sale are entitled to deduct a 2 per cent discount from the invoice price. M06_ATRI3622_06_SE_C06.QXD 5/29/09 10:37 AM Page 213 EXERCISES 3 Finished goods inventories. Inventories of finished goods are expected to be 40,000 units at 1 July. The business’s policy is that, in future, the inventories at the end of each month should equal 20 per cent of the following month’s planned sales requirements. 4 Raw materials inventories. Inventories of raw materials are expected to be 40,000 kg on 1 July. The business’s policy is that, in future, the inventories at the end of each month should equal 50 per cent of the following month’s planned production requirements. Each Zenith requires 0.5 kg of the raw material, which costs £1.50/kg. Raw materials purchases are paid in the month after purchase. 5 Labour and overheads. The direct labour cost of each Zenith is £0.50. The variable overhead element of each Zenith is £0.30. Fixed overheads, including depreciation of £25,000, total £47,000 a month. All labour and overheads are paid during the month in which they arise. 6 Cash in hand. At 1 August the business plans to have a bank balance (in funds) of £20,000. Required: Prepare the following budgets: (a) Finished inventories budget (expressed in units of Zenith) for each of the three months July, August and September. (b) Raw materials inventories budget (expressed in kilograms of the raw material) for the two months July and August. (c) Cash budget for August and September. 6.6 Newtake Records Ltd owns a chain of 14 shops selling compact discs. At the beginning of June the business had an overdraft of £35,000 and the bank had asked for this to be eliminated by the end of November. As a result, the directors have recently decided to review their plans for the next six months. The following plans were prepared for the business some months earlier: Sales revenue Purchases Administration expenses Selling expenses Taxation payment Finance payments Shop refurbishment May £000 June £000 July £000 August £000 Sept £000 Oct £000 Nov £000 180 135 52 22 230 180 55 24 320 142 56 28 140 75 48 21 120 66 46 19 110 57 45 18 5 – 5 – 5 14 250 94 53 26 22 5 18 5 6 5 – 5 – Notes: 1 The inventories level at 1 June was £112,000. The business believes it is preferable to maintain a minimum inventories level of £40,000 of goods over the period to 30 November. 2 Suppliers allow one month’s credit. The first three months’ purchases are subject to a contractual agreement, which must be honoured. 3 The gross profit margin is 40 per cent. 4 Cash from all sales is received in the month of sale. However, 50 per cent of customers pay with a credit card. The charge made by the credit card business to Newtake Records Ltd is 3 per cent of the sales revenue value. These charges are in addition to the selling expenses identified above. The credit card business pays Newtake Records Ltd in the month of sale. 5 The business has a bank loan, which it is paying off in monthly instalments of £5,000. The interest element represents 20 per cent of each instalment. 6 Administration expenses are paid when incurred. This item includes a charge of £15,000 each month in respect of depreciation. 7 Selling expenses are payable in the following month. 213