1 The Budgeting Process January 16 th 2007. 2 Lecture Objectives Explain how budgeting fits into the overall framework of decision-making, planning and.

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The Budgeting Process

January 16th 2007

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Lecture Objectives

• Explain how budgeting fits into the overall framework of decision-making, planning and control

• Describe the purposes and uses of budgets in organisations

• Identify the various stages in the “traditional” budgeting process

• Describe some of the benefits of effective budgeting and assess some of the limitations of budgeting

• Construct cash budgets from relevant data

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Overview of the planning process

• Identify the objectives of the organization.• Identify potential strategies.• Evaluate alternative strategic options.• Select course of action.• Implement the long-term plan in the form

of the annual budget.• Monitor actual results.• Respond to divergencies from plan.

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Overview of the planning process

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Why do we produce budgets? • To aid the planning of actual operations:

– by forcing managers to consider how conditions might change and what steps should be taken now.

– by encouraging managers to consider problems before they arise.

• To co-ordinate the activities of the organization:– by compelling managers to examine relationships between

their own operation and those of other departments.• To communicate plans to various responsibility centre

managers:– everyone in the organization should have a clear

understanding of the part they are expected to play in achieving the annual budget.

– by ensuring appropriate individuals are made accountable for implementing the budget.

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Why do we produce budgets?

• To motivate managers to strive to achieve the budget goals:– by focusing on participation– by providing a challenge/target.

• To control activities:– by comparison of actual with budget (attention

directing/management by exception).

• To evaluate the performance of managers:– by providing a means of informing managers of how

well they are performing in meeting targets they have previously set.

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Stages in the budgeting process

• Communicate details of budget policy and guidelines to those people responsible for preparing the budget.

• Determine the factor that restricts output.• Preparation of the sales budget.• Initial preparation of budgets.• Negotiation of budgets with higher management.• Co-ordination and review of budgets.• Final acceptance of budgets.• Ongoing review of the budgets.

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Budgets moving up the organisation hierarchy

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The Integrated Process

• Primary budget drives all others

• Planned increase in sales affects

– production

– purchases

– labour

– cost of overheads

– financing/cash

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An Example - Scenario• Marsupial Ltd manufactures 2 products - the Echidna and the Platypus.

• The Echidna is manufactured in Department 1 and the Platypus in Department• The products consume 2 materials - A and B, and also direct labour

•• Details of standard costs and usage are given below:• Standard costs per unit• Material A - £5.20 per kilo• Material B - £8.80 per kilo• Direct labour - £10.00 per hour•• Overhead recovery is on the basis of direct labour hours.•• Standard usage of materials and labour per unit of product• Echidna Platypus• Material A5 kilos 8 kilos• Material B3 kilos 4 kilos• Labour 6 hours 10 hours

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An Example - Scenario• Other data:• Echidna Platypus• Forecast sales 9,000 6,000• Selling price per unit £350 £400• Budgeted closing inventory 1,500 700• Budgeted opening inventory 800 300•• Direct Materials Inventories•• Material A Material B

• Budgeted opening inventory (kgs) 700 600

• Budgeted closing inventory (kgs) 1,300 1,000

•• Budgeted Overheads• Dept 1 Dept 2• Variable (controllable) £ 3.50 2.00• Fixed (non-controllable) £ 290,000 150,000

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Required

• Draw up the following budgets…

• Sales Budget

• Production Budget

• Direct Materials Usage Budget

• Direct Materials Purchases Budget

• Direct Labour Budget

• Factory Overhead Budget

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Sales Budget

• Product Units sold Unit selling price Total Revenue (£)

• Echidna 9,000 350 3,150,000

• Platypus 6,000 400 2,400,000

• 5,550,000

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Production Budget

• Dept 1 (Echidna) Dept 2 (Platypus)

• Units to be sold 9,000 6,000

• Planned closing inv.1,500 700• Total units required 10,500 6,700• Less opening inventory 800 300

• Units to produce 9,700 6,400

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Direct Materials Usage Budget

• Dept 1 Dept 2 Totals• Units Unit Price Total Units Unit Price Total Total Units Cost

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• 48,500 £5.20 252,200 51,200 £5.20 266,240 99,700 518,440 (A)

• 29,100 £8.80 256,080 25,600 £8.80 225,280 54,700 481,360 (B)

• 508,280 491,520 999,800

• Material A is first• Material B is second

• Total Units calculated as:• Production budget X Kilos per unit = 9,700 X 5 = 48,500

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Direct Materials Purchases Budget

• Material A Material B

• Production requirement (DM usage) 99,700 54,700

• Planned closing inventory 1,300 1,000• 101,000 55,700

• Less opening inventory 700 600

• 100,300 55,100

• Planned purchase price £5.20 £8.80

•• Budgeted Purchases £521,560 £484,880

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Direct Labour Budget

• Dept 1 Dept 2

• Budgeted production (units) 9,700 6,400

• Hours per unit 6 10

• Total budgeted hours 58,200 64,000

•• Budgeted wage rate £10.00 £10.00

•• Total wages £582,000 £640,000

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Factory Overhead Budget • Anticipated activity - Department 1 = 58,200 hours• Anticipated activity - Department 2 = 64,000 hours•

• Dept 1 Dept 2

• Controllable overhead * 203,700 128,000

• Non-controllable overhead 290,000 150,000

• Total overhead 493,700 278,000

•• Budgeted departmental overhead rate ** £8.48 £4.34

•• * 58,200 X £3.50• ** 493,700/58,200

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The Cash Budget

• Will Deal with Cash Budget as separate entity

• See Drury for cash budget link to integrated example

• Illustration – Alf Smith Example

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Does Budgeting work?

• Bourne et al. (“Lore Reform” – 2002) suggest some main criticisms of planning and budgeting.

• Among these such criticisms as– major barrier to responsiveness– rarely strategically focussed– encourage “gaming”– based on unsupported assumptions– make people feel undervalued

• Point to the “theory” of the budget being lost in practice

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The impact of incremental budgeting

• Early (& simplistic) principle that says

• Budget concerned with increment in operations in coming budget period

• Therefore adjust/inflate previous budget in line with known/anticipated price rises

• But much “base-level” activity does not change

• Perpetuates past inefficiencies/errors

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Activity-based budgeting (ABB)• Conventional budgeting is inappropriate for those activities

where the consumption of resources does not vary proportionately with the volume of the final output of products or services.

• For support activities conventional incremental budgets merely serve as authorization levels for certain levels of spending.

• Incremental budgeting results in the cost of non-unit level• activities becoming fixed.• ABB aims to authorize only the supply of those resources that

are needed to perform activities required to meet budgeted production and sales volumes.

• The ABB process is the reverse of the ABC process:– Budgeted output of cost objects…– Determine the necessary activities…– Determine the resources required for the budget period

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Stages in Activity Based Budgeting

• Estimate the production and sales volume by individual products and customers

• Estimate the demand for organizational activities • Determine the resources that are required to

perform organizational activities • Estimate for each resource the quantity that

must be supplied to meet the demand • Take action to adjust the capacity of resources

to match the projected supply • Periodically actual results should be compared

with an adjusted (flexible) budget

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Zero Based Budgeting (ZBB)

• Zero Based Budgeting (ZBB) is an approach to budgeting that starts from the premise that no costs or activities should be factored into the plans for the coming budget period, just because they figured in the costs or activities for the current or previous periods.

• Rather, everything that is to be included in the budget must be considered and justified.

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Stages in ZBB

• Developing Decision Packages– The “decision package” is a term associated with

ZBB, and refers to an analysis of each discrete activity, according to cost and purpose.

– The analysis should also extend to considering the benefits of the activity, alternative courses of action, how to measure performance, and the consequences of not performing the activity.

• Rank the Decision Packages• Allocate Resources

– Rank of DPs feed into prioritisation of Resource allocation

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Pros & Cons of ZBB• Pros

– Questions accepted beliefs – Focuses on value for money – Clear links between budgets and objectives– Involves operational managers actively, and can lead to better

communication and consensus – Is an adaptive approach to changing circumstances– Can lead to better resource allocation

• Cons– Adds to the time and effort involved in budgeting– May be difficulties in identifying suitable performance measures

and decision criteria– Questioning current practice can be seen as threatening –

careful management of the “people” element is essential– May be uncertainty about costs and resources of options other

than current practice