«Paul M. Collier Aston Business School, Aston University Accounting for Managers Accounting for Managers: Interpreting accounting information for ...»
References Chandler, A. D. J. (1962). Strategy and Structure: Chapters in the History of the American Industrial Enterprise. Cambridge, MA: Harvard University Press.
Child, J. (1972). Organizational structure, environment and performance: The role of strategic choice. Sociology, 6, 1–22.
Johnson, H. T. and Kaplan, R. S. (1987). Relevance Lost: The Rise and Fall of Management Accounting. Boston, MA: Harvard Business School Press.
Merchant, K. A. (1987). How and why ﬁrms disregard the controllability principle. In W. J. Bruns and R. S. Kaplan (eds), Accounting and Management: Field Study Perspectives, Boston, MA: Harvard Business School Press.
Seal, W. (1995). Economics and control. In A. J. Berry, J. Broadbent and D. Otley (eds), Management Control: Theories, Issues and Practices, London: Macmillan.
Solomons, D. (1965). Divisional Performance: Measurement and Control. Homewood, IL:
Richard D. Irwin.
Williamson, O. E. (1975). Markets and Hierarchies: Analysis and Antitrust Implications. A Study in the Economics of Internal Organization. New York, NY: Free Press.
Anthony and Govindarajan (2000) described budgets as ‘an important tool for effective short-term planning and control’ (p. 360). They saw strategic planning (see Chapter 12) as being focused on several years, contrasted to budgeting that
focuses on a single year. Strategic planning:
precedes budgeting and provides the framework within which the annual budget is developed. A budget is, in a sense, a one-year slice of the organization’s strategic plan. (p. 361) Anthony and Govindarajan also differentiated the strategic plan from the budget, on the basis that strategy is concerned with product lines while budgets are concerned with responsibility centres. This is an important distinction, as although there is no reason that proﬁt reports for products/services cannot be produced (they tend to stop at the contribution margin level, perhaps because of the overhead allocation problem described in Chapter 11), traditional management accounting reports are produced for responsibility centres and used for divisional performance evaluation, as described in Chapter 13.
What is budgeting?
A budget is a plan expressed in monetary terms covering a future time period (typically a year broken down into months). Budgets are based on a deﬁned level of activity, either expected sales revenue (if market demand is the limiting factor) or capacity (if that is the limiting factor). While budgets are typically produced annually, rolling budgets add additional months to the end of the period so that there is always a 12-month budget for the business. Alternatively, budgets may be re-forecast part way through a year, e.g. quarterly or six-monthly, to take into account changes since the last budget cycle (hence the common distinction made by organizations between budget and forecast. A forecast usually refers to a revised estimate, or a budgetary update, part-way through the budget period.)
Budgeting provides the ability to:
ž implement strategy by allocating resources in line with strategic goals;
ž co-ordinate activities and assist in communication between different parts of the organization;
ACCOUNTING FOR MANAGERSž motivate managers to achieve targets;
ž provide a means to control activities; and ž evaluate managerial performance.
In establishing the budget allocation to speciﬁc proﬁt centres, cost centres or departments, there are four main methods of budgeting: incremental, priority based, zero based and activity based.
Incremental budgets take the previous year’s budget as a base and add (or subtract) a percentage to give this year’s budget. The assumption is that the historical budget allocation reﬂected organizational priorities and was rooted in some meaningful justiﬁcation developed in the past.
Priority-based budgets allocate funds in line with strategy. If priorities change in line with the organization’s strategic focus, then budget allocations would follow those priorities, irrespective of the historical allocation. A public-sector version of the priority-based budget is the planning, programming and budgeting system (PPBS) that was developed by the US space programme. Under PPBS, budgets are allocated to projects or programmes rather than to responsibility centres. Prioritybased budgets may be responsibility centre based, but will typically be associated with particular projects or programmes. The intention of PPBS and priority-based budgeting systems is to compare costs more readily with beneﬁts by identifying the resources used to obtain desired outcomes. An amalgam of incremental and priority-based budgets is priority-based incremental budgeting. Here, the budgetholder is asked what incremental (or decremental) activities or results would follow if budgets increased (or decreased). This method has the advantage of comparing changes in resources with the resulting costs and beneﬁts.
Zero-based budgeting identiﬁes the costs that are necessary to implement agreed strategies and achieve goals, as if the budget-holder were beginning with a new organizational unit, without any prior history. This method has the advantage of regularly reviewing all the activities that are carried out to see if they are still required, but has the disadvantage of the cost and time needed for such reviews.
It is also very difﬁcult to develop a budget while ignoring current resource allocations.
Activity-based budgeting is associated with activity-based costing (ABC, see Chapter 11). ABC identiﬁes activities that consume resources and uses the concept of cost drivers (essentially the cause of costs) to allocate costs to products or services according to how much of the resources of the ﬁrm they consume. Activity-based budgeting (ABB) follows the same process to develop budgets based on the expected activities and cost drivers to meet sales (or capacity) projections.
Whichever method of budgeting is used, there are two approaches that can be applied. Budgets may be top down or bottom up. Top-down budgets begin with the sales forecast and, using the volume of sales, predict inventory levels, stafﬁng and production times within capacity limitations. These are based on bills of materials, labour routings and standard costs. For services, the top-down budget is based largely on capacity utilization and stafﬁng levels needed to meet expected demand. In both cases, senior management establishes spending limits within which departments allocate costs to speciﬁc line items (salaries, travel, ofﬁce BUDGETING 209 expenses etc.). Senior managers set the revenue targets and spending limits that they believe are necessary to achieve proﬁts that will satisfy shareholders. Bottomup budgets are developed by the managers of each department based on current spending and agreed plans, which are then aggregated to the corporate total.
Top-down budgets can ignore the problems experienced by operational managers. However, boards of directors often have a clear idea of the sales growth and proﬁt requirement that will satisfy stock market conditions. By contrast, the result of the bottom-up budget may be inadequate in terms of ‘bottom-line’ proﬁtability or unachievable as a result of either capacity limitations elsewhere in the business or market demand. Therefore, the underlying factors may need to be modiﬁed.
Consequently, most budgets are the result of a combination of top-down and bottom-up processes. By adopting both methods, budget-holders are given the opportunity to bid for resources (in competition with other budget-holders) within the constraints of the shareholder value focus of the business.
The budgeting process Budgets are based on standard costs (see Chapter 9) for a deﬁned level of sales demand or production activity. The typical budget cycle – the period each year
over which budgets are prepared – will follow the sequence:
1 Identify business objectives.
2 Forecast economic and industry conditions, including competition.
3 Develop detailed sales budgets by market sectors, geographic territories, major customers and product groups.
4 Prepare production budgets (materials, labour and overhead) by responsibility centre managers in order to produce the goods or services needed to satisfy the sales forecast and maintain agreed levels of inventory.
5 Prepare non-production budgets by cost centre.
6 Prepare capital expenditure budgets.
7 Prepare cash forecasts and identify ﬁnancing requirements.
8 Prepare master budget (proﬁt and loss, balance sheet and cash ﬂow).
9 Obtain board approval of proﬁtability and ﬁnancing targets.
Good practice in budgeting at the level of each responsibility centre involves looking at the causes of costs and the business processes in use. Bidding for funds for capital expenditure or to fund new initiatives or projects is an important part of budgeting because of the need to question past practice and continually seek improvement. The process of budgeting is largely based on making informed
ž how business-wide strategies will affect the responsibility centre;
ž the level of demand placed on the business unit and the expected level of activity to satisfy (internal or external) customers;
ž the technology and processes used in the business unit to achieve desired productivity levels, based on past experience and anticipated improvements;
ACCOUNTING FOR MANAGERSž any new initiatives or projects that are planned and require resources;
ž the headcount and historic spending by the business unit.
In preparing a budget it is important to carry out a thorough investigation of current performance, i.e. to get behind the numbers. For example, as many costs (particularly in service industries) follow headcount (as we saw in Chapter 10), it is essential that salary and related costs are accurately estimated, and the impact of recruitment, resignation and training is taken into account in cost and productivity calculations.
The complexity of the budget will depend on a number of factors, such as:
ž knowledge of past performance;
ž understanding of market trends, seasonal factors, competition etc.;
ž whether the business is a price leader or price follower (see Chapter 8);
ž understanding the drivers of business costs;
ž the control that managers are able to exercise over expenses.
How well these factors can be understood and modelled using a spreadsheet will depend on the knowledge, skills and time available to the business. Typically, budgets either at the corporate or responsibility centre level will contain a number of subjective judgements of likely future events, customer demand and a number of simplifying assumptions about product/service mix, average prices, cost inﬂation etc.
Once the budget is agreed in total, the budget needs to be allocated over each month. This is commonly based on working days or takes into account seasonal ﬂuctuations etc. This is a process of proﬁling or time-phasing the budget. Proﬁling is important because the process of budgetary control (see Chapter 15) relies on an accurate estimation of when revenue will be earned and when costs will be incurred.
Table 14.1 is a simpliﬁed example of a budget for a small hotel.
It shows some statistics that the Superior Hotel has used for its budget for next year. Both last year’s and the current year’s ﬁgures are shown. For ease of presentation, the budget year has been divided into four quarters and some simplifying assumptions have been made. The hotel capacity is limited to the number of rooms, but in common with the industry rarely achieves full occupancy, although there are substantial variations both during the week and at peak times. The main income driver is the number of rooms occupied, the price able to be charged (which can vary signiﬁcantly depending on the number of vacant rooms) and the average spend per head on dining, the bar and business services.
The statistical information, together with estimations of direct costs (food and drink) and expenses, is based on historical experience and expected cost increases.
The budget for the year for the Superior Hotel, based on these assumptions, is shown in Table 14.2.
A budget for a retailer will require an estimation, separate from the sales forecast, of the level of inventory to be held. This results in a purchasing budget. Similarly, a budget for a manufacturing business will involve developing a production budget (materials, labour and overhead) by cost centre in order to produce the Table 14.1 Service budget example: Superior Hotel – budget statistics
goods or services needed to satisfy the sales forecast and maintain agreed levels of inventory.
The ﬁrst problem to consider is stock, which is shown in the following example.
Retail budget example: Sports Stores Co-operative Ltd Sports Stores Co-operative (SSC) is a large retail store selling a range of sportswear.
Its anticipated sales levels and expenses for each of the next six months are shown in Table 14.3.
Although there are several hundred different items of stock and the product mix does ﬂuctuate due to seasonal factors, SSC is only able to budget based on an average sales mix and applies an average cost of sales of 40%.
SSC carries six weeks’ inventory, i.e. sufﬁcient stock to cover six weeks’ sales (at cost price). At the end of each month, therefore, the stock held by SSC will equal all of next month’s cost of sales, plus half of the following month’s cost of sales.
This is shown in Table 14.4.