«Paul M. Collier Aston Business School, Aston University Accounting for Managers Accounting for Managers: Interpreting accounting information for ...»
However, Wallander did not reject planning outright. He argued that it is important to have an ‘economic model’ that establishes the basic relationships in the company, such as the ability to plan production. He commented, ‘This type of planning is something that is going on all the year round and has nothing to do with the annual budget’ (p. 416).
Handelsbanken has an information system that is focused on the information needed to inﬂuence actual behaviour. It incorporates both ﬁnancial and ‘Balanced Scorecard’ measures at the proﬁt centre level, and performance is benchmarked externally and internally. The bank rewards its staff through a proﬁt-sharing scheme.
Despite its abandonment of budgeting, Handelsbanken remains a very successful bank. Wallander concluded:
abandoning budgeting, which was an essential part of the changes, had no adverse effect on the performance of the bank compared to other banks, which all installed budgeting systems during the period. (p. 407) Conclusion In this chapter we have linked budgeting to the strategy process. We described various approaches to budgeting and the mechanics of the budgeting cycle. Through a series of examples we explored budgeting for a service, retail and manufacturing organization. We also introduced cash forecasting and the reconciliation between proﬁt and cash ﬂow.
The chapter concluded with a snapshot of theoretical perspectives on budgeting that contrast the rational-economic view of budgets with the subjectivity of budgets as a consequence of bias and aggregation, and the power that underlies the budgeting process. We also questioned whether risk is really reﬂected in the content of the budget document and whether budgets have any value at all.
The assumptions behind the production of budgets are important for planning purposes, but crucial when managers are held accountable for achieving budget targets. This is the process of budgetary control, which is the subject of Chapter 15.
References Anthony, R. N. and Govindarajan, V. (2000). Management Control Systems. (10th international edn). New York, NY: McGraw-Hill Irwin.
Berry, A. J. and Otley, D. T. (1975). The aggregation of estimates in hierarchical organizations. Journal of Management Studies, May, 175–93.
Buckley, A. and McKenna, E. (1972). Budgetary control and business behaviour. Accounting and Business Research, Spring, 137–50.
Collier, P. M. and Berry, A. J. (2002). Risk in the process of budgeting. Management Accounting Research, 13, 273–97.
Covaleski, M. A. and Dirsmith, M. W. (1988). The use of budgetary symbols in the political arena: an historically informed ﬁeld study. Accounting, Organizations and Society, 13(1), 1–24.
Covaleski, M. A., Dirsmith, M. W. and Michelman, J. E. (1993). An institutional theory perspective on the DRG framework, case-mix accounting systems and health-care organizations. Accounting, Organizations and Society, 18(1), 65–80.
Czarniawska-Joerges, B. and Jacobsson, B. (1989). Budget in a cold climate. Accounting, Organizations and Society, 14(1/2), 29–39.
Ezzamel, M. (1994). Organizational change and accounting: Understanding the budgeting system in its organizational context. Organization Studies, 15(2), 213–40.
Lowe, E. A. and Shaw, R. W. (1968). An analysis of managerial biasing: Evidence from a company’s budgeting process. Journal of Management Studies, October, 304–15.
Otley, D. and Berry, A. (1979). Risk distribution in the budgetary process. Accounting and Business Research, 9(36), 325–7.
ACCOUNTING FOR MANAGERSPreston, A. M., Cooper, D. J. and Coombs, R. W. (1992). Fabricating budgets: A study of the production of management budgeting in the National Health Service. Accounting, Organizations and Society, 17(6), 561–93.
Wallander, J. (1999). Budgeting – an unnecessary evil. Scandinavian Journal of Management, 15, 405–21.
For a useful critique of budgeting, see the ‘Beyond Budgeting Round Table’ website at www.beyondbudgeting.org Budgetary Control In this chapter, we describe the budgetary control that takes place in organizations through the techniques of ﬂexible budgets and variance analysis. However, we caution against variance analysis in circumstances where this could conﬂict with more broadly based improvement strategies within the business. The chapter also considers how cost control can be exercised in practice.
What is budgetary control?
Budgetary control is concerned with ensuring that actual ﬁnancial results are in line with targets. An important part of this feedback process (see Chapter 4) is investigating variations between actual results and budgeted results and taking appropriate corrective action.
Budgetary control provides a yardstick for comparison and isolates problems by focusing on variances, which provide an early warning to managers. Buckley
and McKenna (1972) argued:
The sinews of the budgeting process... are the inﬂuencing of management behaviour by setting agreed performance standards, the evaluation of results and feedback to management in anticipation of corrective action where necessary. (p. 137) Budgetary control is typically exercised at the level of each responsibility centre.
Management reports show, for each line item, the budget expenditure, usually for both the current accounting period and the year to date. The report will also show the actual income and expenditure and a variance.
A typical actual versus budget ﬁnancial report is shown in Table 15.1.
There are two types of variance:
ž A favourable variance occurs where income exceeds budget and/or expenses are lower than budget.
ž An adverse variance occurs where income is less than budget and/or expenses are greater than budget.
It is important to look both at the current period, which in the above example shows an underspend of £6,500 (budget of £80,000 less actual spending of £73,500),
ACCOUNTING FOR MANAGERSTable 15.1 Actual v. budget ﬁnancial report
and the year to date, which shows an overspend of £1,000. The weakness of traditional management reports for budgetary control is that the business may not be comparing like with like. For example, if the business volume is lower than budgeted, then it follows that any variable costs should (in total) be lower than budgeted. Conversely, if business volume is higher than budget, variable costs should (in total) be higher than budget. In many management reports, the distinction between variable and ﬁxed costs (see Chapter 8) is not made and it becomes very difﬁcult to compare costs incurred at one level of activity with budgeted costs at a different level of activity and to make judgements about managerial performance.
Flexible budgets provide a better basis for investigating variances than the original budget, because the volume of production may differ from that planned. If the actual activity level is different to that budgeted, comparing revenue and/or costs at different (actual and budget) levels of activity will produce meaningless ﬁgures.
A ﬂexible budget is a budget that is ﬂexed, that is standard costs per unit are applied to the actual level of business activity. It makes little sense to compare the budgeted costs of producing (say) 40,000 units with the costs incurred in producing 35,000 units. Variance analysis is then carried out between the ﬂexed budget costs and actual costs.
Flexible budgets take into account variations in the volume of activity. Using the above example, costs are budgeted at £2 per unit for 40,000 units but actual
costs are £2.10 for 35,000 units. A standard actual versus budget report will show:
This is a more meaningful comparison, because the manager responsible for cost control has spent more per unit and should not have this responsibility negated by the effect of a reduced volume, which may have been outside that manager’s control. Separately, the adverse effect of the volume variance – the difference between the original and ﬂexed budgets – is shown as 5,000 units @ £2 or £10,000.
This may be controllable by a different manager. As can be seen by comparing the two styles of presentation, there is still a £6,500 favourable variance, but the ﬂexed
budget identiﬁes the two separate components of this variance:
ž £10,000 favourable variance (in terms of cost) because of the reduction in volume from 40,000 to 35,000 units at £2 each. This is offset by ž £3,500 adverse variance because the 35,000 units produced each cost 10p more than the standard cost.
Variance analysis An important part of the feedback process (see Chapter 4) is variance analysis.
Variance analysis involves comparing actual performance against plan, investigating the causes of the variance and taking corrective action to ensure that targets are achieved. Variance analysis needs to be carried out for each responsibility centre, product/service and for each line item.
The steps involved in variance analysis are:
1 Ascertain the budget and phasing (see Chapter 14) for each period.
2 Report the actual spending.
3 Determine the variance between budget and actual (and determine whether it is either favourable or adverse).
4 Investigate why the variance occurred.
5 Take corrective action.
Not only adverse variances need to be investigated. Favourable variances provide a learning opportunity that can be repeated.
The questions that need to be asked as part of variance analysis are:
ž Is the variance signiﬁcant?
ž Is it early or late in the year?
ž Is it likely to be repeated?
ž Can it be explained (and understood)?
ž Is it controllable?
ACCOUNTING FOR MANAGERSOnly signiﬁcant variations need to be investigated. However, what is signiﬁcant can be interpreted differently by different people. Which is more signiﬁcant, for example, a 5% variation on £10,000 (£500) or a 25% variation on £1,000 (£250)? The signiﬁcance of the variation may be either an absolute amount or a percentage.
A variance later in the year will be more difﬁcult to correct, so variances should be detected for corrective action as soon as they occur. Similarly, a one-off variance requires a single corrective action, but a variance that will continue requires more drastic action. A variance that can be understood can be corrected, but if the causes of the variance are not understood or are outside the manager’s control, it may be difﬁcult to correct and control in the future.
Explanations need to be sought in relation to different types of variance:
ž sales variances: price and quantity of product/services sold;
ž material variances: price and quantity of materials used;
ž labour variances: wage rate and efﬁciency;
ž overhead variances: spending and efﬁciency.
The following case study provides an example of variance analysis.
Variance analysis example: Wood’s Furniture Co.
Wood’s Furniture has produced a budget versus actual report, which is shown in Table 15.2. The difference between budget and actual is an adverse variance of £15,200. However, the ﬁrm’s accountant has produced a ﬂexed budget to assist in carrying out a more meaningful variance analysis. This is shown in Table 15.3.
The ﬂexed budget shows a favourable variance of £3,300 compared to the ﬂexed budget. In order to undertake a detailed variance analysis, we need some additional information, which the accountant has produced in Table 15.4.
Sales variance The sales variance is used to evaluate the performance of the sales team. There are
two sales variances for which the sales department is responsible:
ž The sales price variance is the difference between the actual price and the standard price for the actual quantity sold.
ž The sales quantity variance is the difference between the budget and actual quantity at the standard margin (i.e. the difference between the budget price and the standard variable costs), because it would be inappropriate to hold sales managers accountable for production efﬁciencies and inefﬁciencies.
The sales price variance is the difference between the ﬂexed budget and the actual sales revenue, i.e. £45,000. This is calculated in Table 15.5. The variance is favourable because the business has sold 9,000 units at an additional £5 each.
The sales quantity variance is the difference between the original budget proﬁt of £70,000 and the ﬂexed budget proﬁt of £50,500 – an unfavourable variance of BUDGETARY CONTROL 229 Table 15.2 Budget v. actual report
£19,500. This is calculated in Table 15.6. The variance is unfavourable because 1,000 units budgeted have not been sold and the standard margin for each of those units was £19.50 (selling price of £170 less variable costs of £150.50), resulting in a lost contribution of £19,500.
It is important to note that the sales mix can affect the quantity and price variances signiﬁcantly. Therefore, a sales variance analysis should reﬂect the budget and actual sales mix.
We have now accounted for the variance between the original budget and the ﬂexed budget (i.e. due to volume of units sold) and between the revenue in the ﬂexed budget and the actual (i.e. due to the difference in selling price). We now have to look at the variances between the costs in the ﬂexed budget and the actual costs incurred.
Cost variances Each cost variance – for materials, labour and overhead – can be split into two types, a price variance and a usage variance. This is because each type of variance may be the responsibility of a different manager. Price variances occur because the cost per unit of resources is higher or lower than the standard cost. Usage variances occur because the actual quantity of labour or materials used is higher or lower than the routing or bill of materials (these concepts were covered in Chapter 9).
The relationship between price and usage variances is shown in Figure 15.1.