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Find more at www.downloadslide.com PART FOUR INFORMATION FOR PLANNING, CONTROL AND PERFORMANCE MEASUREMENT Find more at www.downloadslide.com 15 The budgeting process 16 Management control systems 17 Standard costing and variance analysis 1 18 Standard costing and variance analysis 2: Further aspects 19 Divisional financial performance measures 20 Transfer pricing in divisionalized companies T he objective in this section is to consider the implementation of decisions through the planning and control process. Planning involves systematically looking at the future, so that decisions can be made today which will bring the company its desired results. Control can be defined as the process of measuring and correcting actual performance to ensure that plans for implementing the chosen course of action are carried out. Part Four contains six chapters. Chapter 15 considers the role of budgeting within the planning process and the relationship between the long-range plan and the budgeting process. The budgeting process in profit-oriented organizations is compared with that in non-profit organizations. Chapters 16 to 18 are concerned with the control process. To fully understand the role that management accounting control systems play in the control process, it is necessary to be aware of how they relate to the entire array of control mechanisms used by organizations. Chapter 16 describes the different types of controls that are used by companies. The elements of management accounting control systems are described within the context of the overall control process. Chapters 17 and 18 focus on the technical aspects of accounting control systems. They describe the major features of a standard costing system: a system that enables the differences between the planned and actual outcomes to be analyzed in detail. Chapter 17 describes the operation of a standard costing system and explains the procedure for calculating the variances. Chapter 18 examines more complex aspects relating to standard costing. Chapters 19 and 20 examine the special problems of control and measuring performance of divisions and other decentralized units within an organization. Chapter 19 considers how divisional financial performance measures might be devised which will motivate managers to pursue overall organizational goals. Chapter 20 focuses on the transfer pricing problem and examines how transfer prices can be established that will motivate managers to make optimal decisions and also ensure that the performance measures derived from using the transfer prices represent a fair reflection of managerial performance. Find more at www.downloadslide.com 15 THE BUDGETING PROCESS LEARNING OBJECTIVES • • • • • • • • • I After studying this chapter, you should be able to: explain how budgeting fits into the overall planning and control framework; identify and describe the six different purposes of budgeting; identify and describe the various stages in the budget process; prepare functional and master budgets; describe the use of computer-based financial models for budgeting; describe the limitations of incremental budgeting; describe activity-based budgeting; describe zero-based budgeting (ZBB); describe the criticisms relating to traditional budgeting. n the previous seven chapters we have considered how management accounting can assist managers in making decisions. The actions that follow managerial decisions normally involve several aspects of the business, such as the marketing, production, purchasing and finance functions, and it is important that management should coordinate these various interrelated aspects of decision-making. If they fail to do this, there is a danger that managers may each make decisions that they believe are in the best interests of the organization when, in fact, taken together they are not; for example, the marketing department may introduce a promotional campaign that is designed to increase sales demand to a level beyond that which the production department can handle. The various activities within a company should be coordinated by the preparation of plans of actions for future periods. These detailed plans are usually referred to as budgets. Our objective in this chapter is to focus on the planning process within a business organization and to consider the role of budgeting within this process. 358 Find more at www.downloadslide.com THE STRATEGIC PLANNING, BUDGETING AND CONTROL PROCESS THE STRATEGIC PLANNING, BUDGETING AND CONTROL PROCESS To help you understand the budgetary process we shall begin by looking at how it fits into an overall general framework of planning and control. The framework outlined in Figure 15.1 provides an overview of an organization’s planning and control process. The first stage involves establishing the objectives and supporting strategies of the organization within the strategic planning process. Strategic planning process Before the budgeting process begins, an organization should have prepared a long-term plan (also known as a strategic plan). Strategic planning begins with the specification of objectives towards which future operations should be directed. Johnson, Scholes and Whittington (2010) identify a hierarchy of objectives – the mission of an organization, corporate objectives and unit objectives.1 The mission of an organization (see Exhibit 15.1 for an illustration) describes in very general terms the broad purpose and reason for an organization’s existence, the nature of the business(es) it is in and the customers it seeks to serve and satisfy. It is a visionary projection of the central and over-riding concepts on which the organization is based. Corporate objectives relate to the organization as a whole. Objectives tend to be more specific, and represent desired states or results to be achieved. They are normally measurable and are expressed in financial terms such as desired profits or sales levels, return on capital employed, rates of growth or market share. Objectives must also be developed for the different parts of an organization. Unit objectives relate to the specific objectives of individual units within the organization, such as a division or one company within a holding company. Corporate objectives are normally set for the organization as a whole and are then translated into unit objectives, which become the targets for the individual units. It is important that senior managers in an organization understand clearly where their company is going, and why and how their own role contributes to the attainment of corporate objectives. The strategic planning process should also specify how the objectives of the organization will be achieved. 1. Strategic planning process (specification of objectives and strategies) 2. Creation of long-term plan to implement strategies 3. Preparation of the annual budget within the context of the long-term plan 4. Monitor actual results 5. Respond to deviations from plan FIGURE 15.1 Strategic planning, budgeting and control process 359 Find more at www.downloadslide.com 360 CHAPTER 15 THE BUDGETING PROCESS EXHIBIT 15.1 EasyJet mission statement ‘To provide our customers with safe, good value, point-to-point air services. To effect and to offer a consistent and reliable product and fares appealing to leisure and business markets on a range of European routes. To achieve this we will develop our people and establish lasting relationships with our suppliers.’ Source: Easyjet.co.uk/en/about/index.html Creation of long-term plan The term strategy is used to describe the courses of action that need to be taken to achieve the objectives set. When management has identified those strategic options that have the greatest potential for achieving the company’s objectives, long-term plans should be created to implement the strategies. A long-term plan is a statement of the preliminary targets and activities required by an organization to achieve its strategic plan, together with a broad estimate for each year of the resources required and revenues expected. Because long-term planning involves ‘looking into the future’ for several years ahead (typically at least five years) the plans tend to be uncertain, general in nature, imprecise and subject to change. Preparation of the annual budget within the context of the long-term plan Budgeting is concerned with the implementation of the long-term plan for the year ahead. Because of the shorter planning horizon, budgets are more precise and detailed. Budgets are a clear indication of what is expected to be achieved during the budget period, whereas long-term plans represent the broad directions that top management intend to follow. The budget is not something that originates ‘from nothing’ each year – it is developed within the context of ongoing business and is ruled by previous decisions that have been taken within the long-term planning process. When the activities are initially approved for inclusion in the long-term plan, they are based on uncertain estimates that are projected for several years. These proposals must be reviewed and revised in the light of more recent information. This review and revision process frequently takes place as part of the annual budgeting process, and it may result in important decisions being taken on possible activity adjustments within the current budget period. The budgeting process cannot therefore be viewed as being purely concerned with the current year – it must be considered as an integrated part of the longterm planning process. Monitor actual outcomes and respond to deviations from planned outcomes The final stages in the strategic planning, budgeting and control process outlined in Figure 15.1 are to compare the actual and the planned outcomes, and to respond to any deviations from the plan. These stages represent the control process of budgeting. Planning and control are closely linked. Planning involves looking ahead to determine the actions required to achieve the objectives of the organization. Control involves looking back to ascertain what actually happened and comparing it with the planned outcomes. Effective control requires that corrective action is taken so that actual outcomes conform to planned outcomes. Alternatively, the plans may require modification if the comparisons indicate that the plans are no longer attainable. The corrective action is indicated by the arrowed lines in Figure 15.1 linking stages 5 and 2 and 5 and 3. These arrowed lines represent feedback loops. They signify that the process is dynamic and stress the interdependencies between the various stages in the process. The feedback loops between the stages indicate that the plans should be regularly reviewed, and if they are no longer attainable then alternative courses of action must be considered for achieving the organization’s objectives. The loop between stages 5 and 3 also stresses the corrective action that may be taken so that actual outcomes conform to planned outcomes. Find more at www.downloadslide.com THE MULTIPLE FUNCTIONS OF BUDGETS A detailed discussion of the control process will be deferred until the next chapter. Let us now consider the short-term budgeting process in more detail. THE MULTIPLE FUNCTIONS OF BUDGETS Budgets serve a number of useful purposes. They include: 1 planning annual operations; 2 coordinating the activities of the various parts of the organization and ensuring that the parts are in harmony with each other; 3 communicating plans to the various responsibility centre managers; 4 motivating managers to strive to achieve the organizational goals; 5 controlling activities; 6 evaluating the performance of managers. Let us now examine each of these six factors. Planning The major planning decisions will already have been made as part of the long-term planning process. However, the annual budgeting process leads to the refinement of those plans, since managers must produce detailed plans for the implementation of the long-range plan. Without the annual budgeting process, the pressures of day-to-day operating problems may tempt managers not to plan for future operations. The budgeting process ensures that managers do plan for future operations, and that they consider how conditions in the next year might change and what steps they should take now to respond to these changed conditions. This process encourages managers to anticipate problems before they arise, and hasty decisions that are made on the spur of the moment, based on expediency rather than reasoned judgement, will be minimized. Coordination The budget serves as a vehicle through which the actions of the different parts of an organization can be brought together and reconciled into a common plan. Without any guidance, managers may each make their own decisions, believing that they are working in the best interests of the organization. For example, the purchasing manager may prefer to place large orders so as to obtain large discounts; the production manager will be concerned with avoiding high inventory levels; and the accountant will be concerned with the impact of the decision on the cash resources of the business. It is the aim of budgeting to reconcile these differences for the good of the organization as a whole, rather than for the benefit of any individual area. Budgeting therefore compels managers to examine the relationship between their own operations and those of other departments, and, in the process, to identify and resolve conflicts. Communication If an organization is to function effectively, there must be definite lines of communication so that all the parts will be kept fully informed of the plans and the policies, and constraints, to which the organization is expected to conform. Everyone in the organization should have a clear understanding of the part they are expected to play in achieving the annual budget. This process will ensure that the appropriate individuals are made accountable for implementing the budget. Through the budget, top management communicates its expectations to lower level management, so that all members of the organization may understand these expectations and can coordinate their activities to attain them. It is not just the budget itself that facilitates communication – much vital information is communicated in the actual act of preparing it. 361 Find more at www.downloadslide.com 362 CHAPTER 15 THE BUDGETING PROCESS Motivation The budget can be a useful device for influencing managerial behaviour and motivating managers to perform in line with the organizational objectives. A budget provides a standard that under certain circumstances, a manager may be motivated to strive to achieve. However, budgets can also encourage inefficiency and conflict between managers. If individuals have actively participated in preparing the budget, and it is used as a tool to assist managers in managing their departments, it can act as a strong motivational device by providing a challenge. Alternatively, if the budget is dictated from above, and imposes a threat rather than a challenge, it may be resisted and do more harm than good. We shall discuss the dysfunctional motivational consequence of budgets in Chapter 16. Control A budget assists managers in managing and controlling the activities for which they are responsible. By comparing the actual results with the budgeted amounts for different categories of expenses, managers can ascertain which costs do not conform to the original plan and thus require their attention. This process enables management to operate a system of management by exception which means that a manager’s attention and effort can be concentrated on significant deviations from the expected results. By investigating the reasons for the deviations, managers may be able to identify inefficiencies such as the purchase of inferior quality materials. When the reasons for the inefficiencies have been found, appropriate control action should be taken to remedy the situation. Performance evaluation A manager’s performance is often evaluated by measuring his or her success in meeting the budgets. In some companies bonuses are awarded on the basis of an employee’s ability to achieve the targets specified in the periodic budgets, or promotion may be partly dependent upon a manager’s budget record. In addition, the manager may wish to evaluate his or her own performance. The budget thus provides a useful means of informing managers of how well they are performing in meeting targets that they have previously helped to set. The use of budgets as a method of performance evaluation also influences human behaviour, and for this reason we shall consider the behavioural aspects of performance evaluation in Chapter 16. CONFLICTING ROLES OF BUDGETS Because a single budget system is normally used to serve several purposes there is a danger that they may conflict with each other. For instance, the planning and motivation roles may be in conflict with each other. Demanding budgets that may not be achieved may be appropriate to motivate maximum performance, but they are unsuitable for planning purposes. For these a budget should be set based on easier targets that are expected to be met. There is also a conflict between the planning and performance evaluation roles. For planning purposes budgets are set in advance of the budget period based on an anticipated set of circumstances or environment. Performance evaluation should be based on a comparison of actual performance with an adjusted budget to reflect the circumstances under which managers actually operated. In practice, many firms compare actual performance with the original budget (adjusted to the actual level of activity, i.e. a flexible budget), but if the circumstances envisaged when the original budget was set have changed then there will be a planning and evaluation conflict. THE BUDGET PERIOD The conventional approach is that once per year the manager of each budget centre prepares a detailed budget for one year. The budget is divided into either twelve monthly or thirteen four-weekly periods for control purposes. The preparation of budgets on an annual basis has been strongly criticized on the Find more at www.downloadslide.com ADMINISTRATION OF THE BUDGETING PROCESS grounds that it is too rigid and ties a company to a 12-month commitment, which can be risky because the budget is based on uncertain forecasts. An alternative approach is for the annual budget to be broken down by months for the first three months, and by quarters for the remaining nine months. The quarterly budgets are then developed on a monthly basis as the year proceeds. For example, during the first quarter, the monthly budgets for the second quarter will be prepared; and during the second quarter, the monthly budgets for the third quarter will be prepared. The quarterly budgets may also be reviewed as the year unfolds. For example, during the first quarter, the budget for the next three quarters may be changed as new information becomes available. A new budget for a fifth quarter will also be prepared. This process is known as continuous or rolling budgeting, and ensures that a 12-month budget is always available by adding a quarter in the future as the quarter just ended is dropped. Contrast this with a budget prepared once per year. As the year goes by, the period for which a budget is available will shorten until the budget for next year is prepared. Rolling budgets also ensure that planning is not something that takes place once a year when the budget is being formulated. Instead, budgeting is a continuous process, and managers are encouraged to constantly look ahead and review future plans. Furthermore, it is likely that actual performance will be compared with a more realistic target, because budgets are being constantly reviewed and updated. The main disadvantage of a rolling budget is that it can create uncertainty for managers because the budget is constantly being changed. Irrespective of whether the budget is prepared on an annual or a continuous basis, it is important that monthly or four-weekly budgets are normally used for control purposes. ADMINISTRATION OF THE BUDGETING PROCESS It is important that suitable administration procedures be introduced to ensure that the budget process works effectively. In practice, the procedures should be tailor-made to the requirements of the organization, but as a general rule a firm should ensure that procedures are established for approving the budgets and that the appropriate staff support is available for assisting managers in preparing their budgets. The budget committee The budget committee should consist of high-level executives who represent the major segments of the business. Its major task is to ensure that budgets are realistically established and that they are coordinated satisfactorily. The normal procedure is for the functional heads to present their budget to the committee for approval. If the budget does not reflect a reasonable level of performance, it will not be approved and the functional head will be required to adjust the budget and re-submit it for approval. It is important that the person whose performance is being measured should agree that the revised budget can be achieved; otherwise, if it is considered to be impossible to achieve, it will not act as a motivational device. If budget revisions are made, the budgetees should at least feel that they were given a fair hearing by the committee. We shall discuss budget negotiation in more detail later in this chapter. The budget committee should appoint a budget officer, who will normally be the accountant. The role of the budget officer is to coordinate the individual budgets into a budget for the whole organization, so that the budget committee and the budgetee can see the impact of an individual budget on the organization as a whole. Accounting staff The accounting staff will normally assist managers in the preparation of their budgets; they will, for example, circulate and advise on the instructions about budget preparation, provide past information that may be useful for preparing the present budget, and ensure that managers submit their budgets on time. The accounting staff do not determine the content of the various budgets, but they do provide a valuable advisory service for the line managers. 363 Find more at www.downloadslide.com 364 CHAPTER 15 THE BUDGETING PROCESS Budget manual A budget manual should be prepared by the accountant. It will describe the objectives and procedures involved in the budgeting process and will provide a useful reference source for managers responsible for budget preparation. In addition, the manual may include a timetable specifying the order in which the budgets should be prepared and the dates when they should be presented to the budget committee. The manual should be circulated to all individuals who are responsible for preparing budgets. STAGES IN THE BUDGETING PROCESS The important stages are as follows: 1 communicating details of budget policy and guidelines to those people responsible for the preparation of budgets; 2 determining the factor that restricts output; 3 preparation of the sales budget; 4 initial preparation of various budgets; 5 negotiation of budgets with superiors; 6 coordination and review of budgets; 7 final acceptance of budgets; 8 ongoing review of budgets. Let us now consider each of these stages in more detail. Communicating details of the budget policy Many decisions affecting the budget year will have been taken previously as part of the long-term planning process. The long-range plan is therefore the starting point for the preparation of the annual budget. Thus, top management must communicate the policy effects of the long-term plan to those responsible for preparing the current year’s budgets. Policy effects might include planned changes in sales mix, or the expansion or contraction of certain activities. In addition, other important guidelines that are to govern the preparation of the budget should be specified – for example the allowances that are to be made for price and wage increases, and the expected changes in productivity. Also, any expected changes in industry demand and output should be communicated by top management to the managers responsible for budget preparation. It is essential that all managers be made aware of the policy of top management for implementing the long-term plan in the current year’s budget so that common guidelines can be established. The process also indicates to the managers responsible for preparing the budgets how they should respond to any expected environmental changes. Determining the factor that restricts performance In every organization there is some factor that restricts performance for a given period. In the majority of organizations this factor is sales demand. However, it is possible for production capacity to restrict performance when sales demand is in excess of available capacity. Prior to the preparation of the budgets, it is necessary for top management to determine the factor that restricts performance, since this factor determines the point at which the annual budgeting process should begin. Preparation of the sales budget The volume of sales and the sales mix determine the level of a company’s operations, when sales demand is the factor that restricts output. For this reason, the sales budget is the most important plan in the annual budgeting process. This budget is also the most difficult plan to produce, because total sales Find more at www.downloadslide.com STAGES IN THE BUDGETING PROCESS revenue depends on the actions of customers. In addition, sales demand may be influenced by the state of the economy or the actions of competitors. Initial preparation of budgets The managers who are responsible for meeting the budgeted performance should prepare the budget for those areas for which they are responsible. The preparation of the budget should be a ‘bottom-up’ process. This means that the budget should originate at the lowest levels of management and be refined and coordinated at higher levels. The justification for this approach is that it enables managers to participate in the preparation of their budgets and increases the probability that they will accept the budget and strive to achieve the budget targets. There is no single way in which the appropriate quantity for a particular budget item is determined. Past data may be used as the starting point for producing the budgets, but this does not mean that budgeting is based on the assumption that what has happened in the past will occur in the future. Changes in future conditions must be taken into account, but past information may provide useful guidance for the future. In addition, managers may look to the guidelines provided by top management for determining the content of their budgets. For example, the guidelines may provide specific instructions as to the content of their budgets and the permitted changes that can be made in the prices of purchases of materials and services. For production activities standard costs (see Chapter 17) may be used as the basis for costing activity volumes which are planned in the budget. Negotiation of budgets To implement a participative approach to budgeting, the budget should be originated at the lowest level of management. The managers at this level should submit their budget to their superiors for approval. The superior should then incorporate this budget with other budgets for which he or she is responsible and then submit this budget for approval to his or her superior. The manager who is the superior then becomes the budgetee at the next higher level. The process is illustrated in Figure 15.2. Sizer (1989) describes this approach as a two-way process of a top-down statement of objectives and strategies, bottom-up budget preparation and top-down approval by senior management. The lower-level managers are represented by boxes 1–8. Managers 1 and 2 will prepare their budgets in accordance with the budget policy and the guidelines laid down by top management. The managers will submit their budget to their supervisor, who is in charge of the whole department (department A). Once these budgets have been agreed by the manager of department A, they will be combined by the departmental manager, who will then present this budget to his or her superior (manager of plant 1) for approval. The manager of plant 1 is also responsible for department B, and will combine the agreed budgets for departments A and B before presenting the combined budget to his or her supervisor (the production manager). The production manager will merge the budget for plants 1 and 2, and this final budget will represent the production budget that will be presented to the budget committee for approval. At each of these stages the budgets will be negotiated between the budgetees and their superiors, and eventually they will be agreed by both parties. Hence the figures that are included in the budget are the result of a bargaining process between a manager and his or her superior. It is important that the budgetees should participate in arriving at the final budget and that the superior does not revise the budget without giving full consideration to the subordinates’ arguments for including any of the budgeted items. Otherwise, real participation will not be taking place, and it is unlikely that the subordinate will be motivated to achieve a budget that he or she did not accept. It is also necessary to be watchful that budgetees do not deliberately attempt to obtain approval for easily attainable budgets, or attempt to deliberately understate budgets in the hope that the budget that is finally agreed will represent an easily attainable target. It is equally unsatisfactory for a superior to impose difficult targets in the hope that an authoritarian approach will produce the desired results. The desired results may be achieved in the short term, but only at the cost of a loss of morale and increased labour turnover in the future. The negotiation process is of vital importance in the budgeting process, and can determine whether the budget becomes a really effective management tool or just a routine to follow. If managers are successful 365