Managing Finance and Budgets

Managing Finance and Budgets Lecture 10 Budgetary Control

Session 10 – Budgetary Control KEY CONCEPTS • Forms of budget-setting • Financial control structures and techniques • Behavioural Issues • Non-financial measures

Section A: Forms of Budget-setting

Forms of budget-setting • Incremental budgeting • Zero base budgeting • Activity Based Budgeting • Standard costing

Incremental Budgeting • Traditional form of Budgeting, Common in local & central government • Costs and Allocations of monies tend to be on the basis of what happened in previous years • Adjustment (increments) are made on the basis of changes (e.g. inflation, increases in productivity, workforce etc.) that happen from year to year. • Often used for ‘discretionary’ budgets (i.e. where budget holder is responsible for allocating a sum of money within a department) • No clear relationship between the input or output (e.g the raw materials required or the level of sales produced)

Zero-Base Budgeting (ZBB) • Draws on the philosophy that ALL spending needs to be justified. • All budgets are allocated a zero base, and will be increased from this only if a good case can be made out for the money • Senior management will be using the criterion of ‘value for money’ to allocate scarce resources. • ZBB encourages managers to adopt a questioning approach; this leads to more strategic thinking and allocation of resources to enable this strategy to happen • Clear links required between input/output and the resourcing

Activity-Based Budgeting (ABB) • Applies the philosophy of Activity-Based Costing to the Budget process, recognising that activities ‘drive’ costs • If ‘cost-driving’ activities can be identified, then the cost of the output can be achieved more accurately) • Central feature: budget holders (those who are responsible for meeting a particular budget) have control over the events that affect performance in their area. • ABB tries to generate budgets in such a way that the manager who has control over the cost drivers is accountable for those costs. • Typical problems: increased levels of activity generated from outside the manager’s control, e.g. Manufacturing Budget thrown into disarray by a new sales contract

Standard Costing • Embodies the idea that standard quantities and costs can be planned for individual units such as sales items, labour rates, raw materials etc. • The standards are targets, and become benchmarks by which actual performance s measured. • The targets are derived from experience, market assessments, current rates (e.g. labour, fees etc.) • The targets should be realistic. • Variances (differences between the budgeted amounts and the actual amounts) are always based on standards.

Activity One What are the advantages and disadvantages of zero-based budgeting? How might any disadvantages be overcome?

Advantages Little Wastage of Resources Strategic use of resources, enable plans to be fulfilled more easily Disadvantages Time Consuming Managers can often feel threatened by ZBB Activity One- Solution The disadvantages can be countered by using the approach selectively, for example on every third year, or on particular budgets which tend to require strategic input, e.g. training, advertising, research & development.

Section B: Financial Control Techniques

Financial Control Techniques • Flexing (but not ignoring) budgets • Management by exception • Variance Analysis

Prepare budgets Perform and collect information on actual performance Respond to variances between planned and actual performance and exercise control The budgetary control process

Budgetary Control Structures Budgets provide a useful mechanism for control. • This starts with the detailed planning within the budget, which forms the basis for exercising control • In addition we need a basis for measuring actual performance against planned performance • Finally in exercising control, we need a means of finding out where and why events deviated from the plan, and ways of rectifying these.

This Budget is part of the Profit and Loss budget for a manufacturing company The amounts shown represent targets to be achieved for a particular product line during the next 12 months. This allows us to compare our prediction with what actually happens. Budget Sales (Units): 1000 £ 000 Budget Value of Sales100 Direct Costs Materials 40 Labour 20 Total Direct Costs 60 Gross Profit 40 Overheads Admin Salaries 20 Travel 5 Other costs 20 Total Overheads 45 Net Profit (5) Performance Comparison

Comparison of Actual Performance (1) Original Budget Actual Figures Sales 1000 Units Sales 1040 Units Original Actual £ 000 Budget Figures Value of Sales100 104 Direct Costs Materials 30 37 Labour 25 24 Total Direct Costs 55 61 Gross Profit 45 43 Overheads Admin Salaries 20 19 Travel 5 8 Other costs 17 17 Total Overheads 42 44 Net Profit 3 (1) Here we can see what has happened at the end of the period: Although we have produced and sold slightly over target, the sharp rise in the cost of materials means that we have made an overall loss.

Comparison of Actual Performance (2) Original Budget Sales (Units): 1000 Actual Sales (Units): 1500 Original Actual £ 000 Budget Figures Value of Sales100 150 Direct Costs Materials 30 47 Labour 25 25 Total Direct Costs 55 72 Gross Profit 45 78 Overheads Admin Salaries 20 27 Travel 5 10 Other costs 17 23 Total Overheads 42 60 Net Profit 3 18 Here the original sales targets have been well exceeded, and we have increased our profits considerably However all is not as well as it seems!

Flexible Budgets • If it becomes apparent before the end of the year that there is a huge discrepancy between the actual performance and the budget, it may be necessary to revise targets. • This might happen if there are unexpected surges or slumps in demand, or the economic situation changes. • This does not mean that we dispense with the budget altogether, and write a new one. • Flexible budgeting allows selected targets to be revised. • The revised budget is said to be ‘flexed’.

Comparison with Flexed Budget Original Budget Sales (Units): 1000 Actual Sales (Units): 1500 Original Flexed Actual £ 000 Budget BudgetFigures Value of Sales100 150 150 Direct Costs Materials 30 4547 Labour 25 3025 Total Direct Costs 55 7572 Gross Profit 45 7578 Overheads Admin Salaries 20 2027 Travel 5 810 Other costs 17 1723 Total Overheads 42 4560 Net Profit 3 3018 Here we have written in new targets on the basis of the new sales figures. We can now see that despite the fact that we have increased our profits, this is well below what we should have achieved.

Management by Exception • By using flexible budgets, decision-making and responsibility can be delegated to junior management. • Control is retained by senior management, since they can use the budgetary targets to determine which junior managers are meeting targets. • This means that energy can be concentrated on those areas which are under-performing – the exceptions. • This process is called Management by Exception.

Variance Analysis • Used to analyse performance and promote management action • Variance = difference between the Budgeted amount and the actual amount; this can be adverse or favourable. • Variances might cover: Sales Volume, Pricing, Direct Materials Usage, Direct Materials Price, Direct Labour Efficiency, Direct Labour rate, Fixed Overheads • They can be calculated using absorption costing or marginal costing • Limitations include out-of-date standards; inappropriate absorption of fixed overheads into cost units; and focus on price at expense of other more important issues (j-i-t)

Sample Variance Analyses Sales Volume Variance The difference between the profit as shown in the flexed budget and the actual profit Flexed Budget: Profit : £30,000 Actual Figures Profit: £12,000 Sales Volume Variance: £18,000 Adverse

Sample Variance Analyses Direct Material PRICE variance (Actual material purchased x standard price) less Actual cost of material purchased Direct Material USAGE variance (Standard quantity of material required for actual production x standard price) less (Actual material x standard price Total Direct Material variance Standard direct material cost less Actual direct material cost

Total direct materials variance Direct materials usage variance Direct materials price variance Relationship between the total, usage and price variances of direct materials

Budgeted profit plus All favourable variances minus All adverse variances equals Actual profit Relationship between the budgeted and actual profit

Key elements for budgetary control • Achievable yet rigorous targets • Accurate, relevant, customised and timely reporting • Short reporting periods (e.g. one month) • Clear lines of responsibility • Accountability • Action taken to control operations • Flexibility where appropriate • Serious attitude from higher management towards importance, relevance and accuracy of budgets

Section C: Behavioural Issues

Budgets – Behavioural issues Budgets are often: • Restrictive; it becomes more difficult to take advantage of opportunities since the expenditure has already been allocated. • Inflexible; money often needs to be spent within a particular time-frame. It discourages managers from thinking strategically. • Seen as a maximum instead of a target • Prone to end-of-year expenditure ‘binges’ • Catalysts for organisational conflict

Budgets - Behavioural issues • Budgets must be seen as attainable. Highest performance is achieved by setting the most difficult specific goals which are acceptable to manager • Control information must be understood • Aims of budgets must be understood • Participation in setting processes is crucial to acceptance, job satisfaction and motivation • Participation is also likely to increase accuracy • Participation should decrease distortion and manipulation... but may not as managers may deliberately introduce ‘slack’ (I.e. deliberately over-or under estimate items during the budget-setting negotiations)

Budgets for performance evaluation Where evaluation of performance is based on the ability of the manager to meet the budget a range of factors occurs: • Rigidity – the manager feels straitjacketed by the budget, and restrained from taking risks, as this might create adverse variances. • Fixation- There is a focus on budget at expense of other criteria • Manipulation: Figures are often ‘massaged’ or distorted in order to present the department in the best light. • Exaggeration: Introduction of slack during budget-setting processes

Activity Two A Sales Manager believes that she could reach her overall sales budget target by reducing prices and selling a higher volume of units. Why might it not be sensible for her to do so? What overall issues does this raise about budget monitoring and control?

Activity Two Solution 1 A Sales Manager reaches her overall sales budget target by reducing prices and selling a higher volume. This is not sensible because: • Production targets will have been set in the production budget; this will involve budgeting for raw materials and labour etc. Suddenly selling more will cause problems elsewhere; this will mean that higher stock levels will be required, and may cause problems with debtors. • Similarly, reducing prices will reduce profitability. This will have an effect on the company’s balance sheet, and may ultimately reduce dividends to shareholders.

Activity Two Solution 2 What overall issues does this raise about budget monitoring and control? • Budgets are interrelated, and targets are set to dovetail; individual managers need to know how their targets match with those of others. One way to do this is through a budgetary committee, and participation in the budgetary process. • Managers not only need targets, they need to know to what extent under ‘normal conditions’ those targets can be flexed, that is, by how much can we exceed or fall short without a new budget needing to be set?

Section D: Non-Financial Measures in Budgets

Non financial measures in budgeting • The budget itself tends to be a document which apportions money according to a strategic plan • In manufacturing, the money sets numerical targets for input, throughput and output. • However, in service industries and in other areas such as Education and the National Health Service it is difficult to measure ‘output’ using conventional financial means. • It is increasingly the case that other, non-financial measures are used as a basis for reporting. • These measures are incorporated into budgeting process

Examples of Non financial measures General Examples of these include: • Customer satisfaction • Product quality • Delivery efficiency • Supplier quality • Supplier delivery • Set-up times • Throughput times • Wastage • Employee satisfaction

Specific Non financial measures There are two specific examples : • Patient Waiting Times in the NHS • Pupil Performance Indicators for Schools In both cases: • These are Non-financial Measures which appear as targets for specific institutions. • These are treated in the same way as other budgetary measures, i.e. institutions are compared with one another (league tables) and their past performance (looking for year-on-year improvement) • These are elements of control; resources follow the successful achievement of targets.

Activity Three What particular problems might be caused in a hospital by the incorporation of non-financial targets such as “Average patient waiting time” in an A & E Department as part of their budgetary considerations?

Activity Three – Solution (1) The problems are exactly the same as those outlined for financial targets: • Rigidity – managers may feel straitjacketed by the targets and manage purely to meet rather than exceed them; this means that ‘natural grass-roots development’ tends to be stifled. (e.g. new types of procedure which might ultimately lead (in the long run) to improved patient care will not be implemented, as in the short run this might result in failure to meet targets.) • Fixation- There is a focus on the target at expense of other criteria.In the example given, it could lead to undifferentiated patient care (e.g. a patient with a cut finger becomes as important as road traffic accident victim)

Activity Three – Solution (2) • Manipulation: The department is reorganised in such a way as to present figures which meet the target, but do not necessarily result in improvements. (e.g. All patients are met at the door by a doctor, and then asked to wait – this technically reduces the waiting time to zero, but does not improve the service) • Exaggeration: Accounting procedures are put in place which locally redefine what the target means. (e.g. Average patient waiting time redefined as: the time before first treatment divided by the total number of separate visits by a doctor or nurse subsequently.)

Follow-up to Lecture Ten - Activities • KEY CONCEPTS: Forms of budget-setting Financial control structures and techniques Behavioural Issues Non-financial measures

Managing Finance and Budgets