«Paul M. Collier Aston Business School, Aston University Accounting for Managers Accounting for Managers: Interpreting accounting information for ...»
In Table 14.4, for example, the inventory required at the end of February (£48,000) is the cost of sales for March (£34,000) plus half the cost of sales for April (£14,000). In order to budget for the inventory for May and June, SSC needs to estimate its sales for July and August. As this is the peak selling time, the sales are estimated at £90,000 and £85,000 respectively. The cost of sales (based on 40%) is therefore £36,000 for July and £34,000 for August. Using these ﬁgures, the inventory required at the end of June (£53,000) is equal to the cost of sales for July (£36,000) and half the cost of sales for August (£17,000).
SSC also needs to know its inventory on 1 January, which is £45,000. Purchases
can be calculated as:
Table 14.4 shows the calculation of total purchases.
However, it can also be shown in the Proﬁt and Loss report format introduced in previous chapters. This format is shown in Table 14.5.
The second example is the construction of the production budget for a manufacturing business.
Manufacturing budget example: Telcon Manufacturing
Telcon is a manufacturer. Its budget is shown in Table 14.6.
Telcon estimates its sales for July and August as 1,400 units per month. Its production budget is based on needing to maintain one month’s stock of ﬁnished goods, i.e. the cost of sales for the following month. Its ﬁnished goods inventory at the beginning of January is 1,000 units. Table 14.7 shows that the production required of £56,250 is greater than the cost of sales of £53,250 because of the need to produce an additional 400 units at a variable cost of £7.50, i.e. an increase in inventory of £3,000.
However, in order to produce the ﬁnished goods, Telcon must also ensure that it has purchased sufﬁcient raw materials. Once again, it wishes to have one month’s stock of raw materials (2 kg of the materials are required for each unit of Table 14.5 Sports Stores Co-operative closing stock
ﬁnished goods). There are 2,000 units of raw materials at the beginning of January.
Table 14.8 shows the materials purchases budget.
The purchases budget of £31,600 is more than the materials usage of £30,000 from the production budget because an additional 800 kg of materials is bought at £2 per kg (i.e. £1,600), due to the need to increase raw materials inventory.
Once a proﬁt budget has been constructed, it is important to understand the impact on cash ﬂow. The purpose of the cash forecast is to ensure that sufﬁcient cash is available to meet the level of activity planned by the sales and production budgets and to meet all the other cash inﬂows and outﬂows of the business.
Cash surpluses and deﬁciencies need to be identiﬁed in advance to ensure effective business ﬁnancing decisions, e.g. raising short-term ﬁnance or investing short-term surplus funds.
There is a substantial difference between proﬁts and cash forecasts (for a
detailed explanation see Chapter 6) because of:
Cash forecasting example: Retail News Group Retail News is a store selling newspapers, magazines, books, confectionery etc. Its budget for six months has been prepared and is shown in Table 14.9.
Retail News makes half of its sales in cash and half on credit to business customers, who typically pay their account in the month following sale. Credit sales in December to customers who will pay during January amount to £3,500.
Retail News’ sales receipts budget is shown in Table 14.10.
Retail New’s debtors have increased by £1,000 from £3,500 to £4,500, since 50% of the sales in June (£9,000) will not be received until July.
As in the previous examples, we also need to determine the purchases budget for Retail News, which needs stock equal to one month’s sales (at cost price) at the end of each month. The stock at the beginning of January is £4,500. The sales and cost of sales estimated for July are £12,000 and £4,800 respectively. The purchases budget is shown in Table 14.11.
Purchases are £27,900 compared with a cost of sales of £27,600, because inventory has increased by £300 (from £4,500 to £4,800). However, purchases are on credit Table 14.9 Retail News Group budget
and Retail News has arranged with its suppliers to pay on 60-day terms. Therefore, for example, purchases in January will be paid for in March. Retail News will pay for its November purchases in January (£3,800) and its December purchases in February (£3,500). The creditor payments budget is shown in Table 14.12.
Retail News creditors have increased by £1,100 from £7,300 (£3,800 for November and £3,500 for December) to £8,400 (£3,600 for May and £4,800 for June).
We can now construct the cash forecast for Retail News using the sales receipts budget and creditor payments budget. We also need to identify the timing of cash ﬂows for all expenses. In this case, we determine that salaries and wages, selling and distribution costs and rent are all paid monthly, as those expenses are incurred. Electricity and telephone are paid quarterly in arrears in March and June. The annual insurance premium of £6,000 is paid in January. As we know, depreciation is not an expense that involves a cash ﬂow.
However, the business also has a number of other cash payments that do not
affect proﬁt. These ‘below-the-line’ payments are:
ž capital expenditure of £2,500 committed in March;
ž income tax of £5,000 due in April;
ž £3,000 of dividends due to be paid in June;
ž a loan repayment of £1,000 due in February.
The opening bank balance of Retail News is £2,500. The cash forecast in Table 14.13 shows the total cash position.
In summary, the bank balance has reduced from an asset of £2,500 to a liability (bank overdraft) of £575 due to a net cash outﬂow of £3,075. The main issue here is that, in anticipation of the overdrawn position of the bank account in January, April and June, Retail News needs to make arrangements with its bankers to extend its facility.
Table 14.12 Retail News Group creditors’ payments budget
One last thing remains, which is for Retail News to reconcile the proﬁt with the cash ﬂow and the movement in working capital over the budget period. This is shown in Table 14.14.
Theoretical perspectives on budgeting Although the tools of budgeting and cash forecasting are well developed and made easier by the wide use of spreadsheet software, the difﬁculty of budgeting is in predicting the volume of sales for the business, especially the sales mix between different products or services and the timing of income and expenses.
Buckley and McKenna (1972) emphasized the importance of participation in the budget process; frequent communications and information ﬂow throughout the organization; inclusion of the budget in decisions about salary, bonuses and career promotion; and clear communication by accountants to non-accountants as elements of ‘good budgeting practice’. However, Buckley and McKenna also recognized the behavioural effects of budgeting, such as the impact of setting difﬁcult budget targets and the introduction of bias.
Lowe and Shaw (1968) carried out research into sales budgeting in a retail chain, in which annual budgeting was an ‘internal market by which resources are allocated’ (p. 304) and in which managers had to co-operate and compete. Lowe and Shaw identiﬁed three sources of forecasting error: unpredicted changes in
ACCOUNTING FOR MANAGERS
the environment; inaccurate assessment of the effects of predicted changes; and forecasting bias.
Lowe and Shaw examined the sources of bias: the reward system; the inﬂuence of recent practice and norms; and the insecurity of managers, arguing that bias may be a common phenomenon as in ‘the desire to please superiors in a competitive managerial hierarchy’ (p. 312). They also explained counterbias as ‘the attempt by other managers to eliminate that part of a forecast which stems from the personal interest of the forecaster’ (p. 312).
However, there are also problems with aggregation of divisional budgets into a corporate budget. Berry and Otley (1975) explored the estimation of budget ﬁgures made by individuals at one hierarchical level in an organization, and the coupling of these estimates to those made at a higher level to show the resulting bias in estimating that takes place. Otley and Berry (1979) argued that quite mild deviations from ‘expectation budgets’ at the unit level can produce severe distortions when budgets are aggregated to the organizational level.
An interpretive or critical perspective is appropriate for a study of budgeting, in particular because budgets are one of the main sources of power in organizations,
as a result of the inﬂuence of accountants over budgetary allocations. CzarniawskaJoerges and Jacobsson (1989) depicted budgets as:
mechanisms in budgetary processes for reducing the level and amount of conﬂict. (pp. 29–30) Covaleski and Dirsmith (1988) described the budgetary process between a state university and its state government and argued that budgeting systems help to represent vested interests in political processes and maintain existing power relationships. Other aspects of power relate to shifts in the dominant coalition within organizations. Covaleski et al. (1993) presented a case study of the introduction of diagnostic-related costing in hospitals in which case-mix accounting systems ‘appear also to determine power by redistributing that power from physician to administrator’ (p. 73).
In a UK university, Ezzamel (1994) studied the budgeting system and how it was involved in power relations at two levels. First, it provided a vehicle through which the proposed reallocation of funds was translated, communicated and given initial visibility. Second, it provided a basis for much of the discourse that took place between the various constituencies.
Preston et al. (1992) described the process of management budgeting in the UK hospital system, showing how budgeting was ‘fabricated’ – put together in a fragile manner – and, in the process of its design and implementation, new possibilities for decision-making and deﬁnitions of responsibility emerged. Preston
et al. emphasized how people:
attempt to enmesh accounting innovations within the functioning of organizations and the processes by which new patterns of language, meaning and signiﬁcance emerge through the fabrication of accounting and budgeting systems. (p. 562)
[r]esistance and scepticism occurs from the outset and is a central element in the fabrication process... resistance not only impedes and constrains the process, but also shapes it in speciﬁc ways designed to overcome the scepticism. (p. 589) A ﬁnal word in relation to budgeting concerns risk. Collier and Berry (2002) identiﬁed risk as being managed in four different domains: ﬁnancial, operational, political and personal. These were the result of the unique circumstances, history and technology in different organizations that had led to different ideas about risk. These domains of risk revealed how participants in the budgeting process inﬂuenced the content of the budget through their unique perspectives.
The research distinguished the content of budgets from the process of budgeting.
It contrasted three types of budget. In the risk-modelled process, there is an explicit use of formal probability models to assess the effect of different consequences over a range of different assumptions. In the risk-considered process, informal sensitivity (or what-if) analysis is used to produce (for example) high, medium and low consequences of different assumptions. The risk excluded budget manages risk outside the budget process, and the budget relies on a single expectation of
ACCOUNTING FOR MANAGERSperformance. Collier and Berry found that little risk modelling may be used in practice, and that the consideration of risk during the budgeting process inﬂuenced the content of budgets that were largely risk excluded.
Case study: Svenska Handelsbanken – is budgeting necessary?
Jan Wallander is an executive director of Handelsbanken. He was appointed to the role when the bank, the largest commercial bank in Sweden, faced a crisis.
Although at the time Swedish banks did not use budgets, Handelsbanken had started to install a sophisticated budgeting system.
Wallander (1999) was very critical of budgeting. For example:
You can make forecasts very complicated by putting a lot of variables into them and using sophisticated techniques for evaluating the time series you have observed and used in your work. However, if you see through all this technical paraphernalia you will ﬁnd that there are a few basic assumptions which determine the outcome of the forecast. (p. 408) The accuracy of the budget therefore depends on how accurate the assumptions
are. Wallander argued that there are two reasons to abandon budgeting:
1 If there is economic stability and the business will continue as usual, we use previous experience in order to budget. Wallander argued that we do not need an intricate budgeting system in this case, because people will continue working as they presently are. Even when conditions are not normal, the expectation is that they will return to normal.
2 If events arise that challenge economic stability then budgets will not reﬂect this, because, Wallander says, ‘we have no ability to foresee something of which we have no previous experience’ (p. 411).
He concluded that traditional budgeting is ‘an outmoded way of controlling and steering a company. It is a cumbersome way of reaching conclusions which are either commonplace or wrong’ (p. 419).