Budgets and Budgetary control

Budgets and Budgetary control is carried out via a MASTER BUDGET devolved to responsibility centres, allowing continuous monitoring of actual results versus budget

Budgetary Control

Budgetary control is carried out via a MASTER BUDGET devolved to responsibility centres, allowing continuous monitoring of actual results versus budget. These budget and budgetary control notes are prepared by mindmaplab team and covering budgetary control system, meaning, definition, the types of budgetary control, the methods of budget monitoring and control with examples. These cost management budgetary control notes includes budgeting and budgetary control questions and answers with pdf notes. We have also prepared the Budgetary control pdf version download.

Flexible budgets and Budgetary control

Flexible budgets

A fixed budget contains information on costs and revenues for one level of activity. Whereas, a flexible budget shows the same information, but for a number of different levels of activity. Flexible budgets are useful for both planning purposes and control purposes.

A flexible budget is a budget which, by recognising different cost behaviour patterns, is designed to change as volume of activity changes.

Flexible budgets are prepared using marginal costing and so mixed costs must be split into their fixed and variable components (possibly using the high/low method).

Flexible budgets should be used to show what cost and revenues should have been for the actual level of activity. Differences between the flexible budget figures and actual results are variances.

Flexible budgets may be prepared in order to plan for variations in the level of activity above or below the level set in the fixed budget.

The BUDGET COST ALLOWANCE/FLEXIBLE BUDGET is the budgeted cost ascribed to the level of activity achieved in a budget centre in a control period. It comprises variable costs in direct proportion to volume achieved and fixed costs as a proportion of the annual budget.

Flexible budgets are essential for control purposes. They represent the expected revenues, costs and profits for the actual units produced and sold and are then compared to actual results to determine any differences (or variances).

Care must be taken to distinguish between controllable costs and uncontrollable costs in variance reporting

Flexible budgets using ABC data

Instead of flexing budgets according to the number of units produced or sold, in an ABC environment it is possible to use more meaningful bases for flexing the budget. The budget cost allowance for each activity can be determined according to the number of cost drivers.

The link between standard costing and budget flexing

The calculation of standard cost variances and the use of a flexed budget to control costs and revenues are very similar in concept.

However, there are differences between the two techniques:

Standard costing variance analysis is more detailed e.g. the total cost variance is analysed further to determine how much of the total variance is caused by a difference in the price paid (e.g. the material price variance) and how much is caused by the usage of material being different from the standard. In flexible budget comparisons only total cost variances are derived.
For a standard costing system to operate, it is necessary to determine a standard unit cost for all items of output. All that is required to operate a flexible budgeting system is an understanding of the cost behaviour patterns and a measure of activity to use to flex the budget cost allowance for each cost element.

Budgetary control

Budgetary control is carried out via a MASTER BUDGET devolved to responsibility centres, allowing continuous monitoring of actual results versus budget, either to secure by individual action the budget objectives or to provide a basis for budget revision’.

Budgetary control is based around a system of budget centres. Each budget centre will have its own budget and a manager will be responsible for managing the budget centre and ensuring that the budget is met.

Budget Centre – A budget centre is ‘A section of an entity for which control may be exercised through budgets prepared’.

Budgetary control and budget centres are therefore part of the overall system of responsibility accounting within an organisation.

The correct approach to budgetary control is to compare actual results with a budget which has been flexed to the actual activity level achieved.

Feedback and Feed Forward controls

Feedback Control

Feedback is the comparison of actual results against expected results and if there is a significant difference, then it is investigated and if possible and desirable it is corrected. This is the most common type of control system.

Feedback control is the measurement of differences between planned outputs and actual outputs achieved, and the modification of subsequent action and/or plans to achieve future required results.

Corrective action that brings actual performance closer to the target or plan is called negative feedback. With negative feedback, the control action is intended to bring actual performance back into line with the budget. For example, if actual costs are higher than budget, control action might be taken to cut costs.

Corrective action that increases the difference between actual performance and the target or plan is called positive feedback. With positive feedback, control action would be intended to increase the differences between the budget and actual results. For example, if actual sales are higher than budget, control action might be taken to make this situation continue.

*Budgetary control systems are feedback control systems.

Feedforward Control

Feedforward is the comparison of the results that are currently expected (budgeted) in the light of the latest information and the desired results (forecast). If there is a difference, then it is investigated and corrected.

Feedback happens after the event and discovers that something has gone wrong (or right). Whereas, Feedforward is more proactive and aims to anticipate problems and prevent them from occurring.

Feedforward control a feedforward control system operates by comparing budgeted results against a forecast. Control action is triggered by differences between budgeted and forecast results.

Whereas feedback is based on a comparison of historical actual results with the budget for the period to date, feed-forward looks ahead and compares:

the target or objectives for the period, and
what actual results are now forecast.

Target costing is an example of feed-forward control.

Behavioural implications of budgeting

Although the principal purpose of a budgetary control system is to assist in planning and control, it can also have an effect on the behaviour of those directly affected by the budget.

The purpose of a budgetary control system is to assist management in planning and controlling the resources of their organisation by providing appropriate control information. The information will only be valuable, however, if it is interpreted correctly and used purposefully by managers and employees.

The correct use of control information therefore depends not only on the content of the information itself, but also on the behaviour of its recipients. A number of behavioural problems can arise:

The managers who set the budget or standards are often not the managers who are then made responsible for achieving budget targets.
The goals of the organisation as a whole, as expressed in a budget, may not coincide with the personal aspirations of individual managers.

The management accountant should therefore try to ensure that employees have positive attitudes towards setting budgets, implementing budgets (that is, putting the organisation’s plans into practice) and feedback of results (control information).

Participation in budgeting

It has been argued that participation in the budgeting process will improve motivation and so will improve the quality of budget decisions and the efforts of individuals to achieve their budget targets.

There are basically two ways in which a budget can be set:

top down (imposed budget)
bottom up (participatory budget)

Imposed style – Top down

An imposed/top-down budget is ‘A budget allowance which is set without permitting the ultimate budget holder to have the opportunity to participate in the budgeting process.

In this approach to budgeting, top management prepare a budget with little or no input from operating personnel, which is then imposed upon the employees who have to work to the budgeted figures.

The times when imposed budgets are effective:

In newly formed organisations
In very small businesses
During periods of economic hardship
When operational managers lack budgeting skills
When the organisation’s different units require precise co-ordination

Advantages of imposed style

There are a number of reasons why it might be preferable for managers not to be involved in setting their own budgets:

Involving managers in the setting of budgets is more time consuming than if senior managers simply imposed the budgets.
Managers may not have the skills or motivation to participate usefully in the budgeting process.
Managers may build budgetary slack or bias into the budget in order to make the budget easy to achieve and themselves look good.

Disadvantages of imposed style

The feeling of team spirit may disappear.
The acceptance of organisational goals and objectives could be limited.
The feeling of the budget as a punitive device could arise.
Lower-level management initiative may be stifled.

Participative Budgets – Bottom up

Participative/bottom up budgeting is ‘A budgeting system in which all budget holders are given the opportunity to participate in setting their own budgets’.

In this approach to budgeting, budgets are developed by lower-level managers who then submit the budgets to their superiors. The budgets are based on the lower-level managers’ perceptions of what is achievable and the associated necessary resources.

Advantages of participative budgets

The morale of the management is improved. Managers feel like their opinion is listened to, that their opinion is valuable.
The lower level managers will have a more detailed knowledge of their particular part of the business than senior managers and thus will be able to produce more realistic budgets.

Disadvantages of participative budgets

They consume more time.
They may cause managers to introduce budgetary slack and budget bias.
They can support ’empire building’ by subordinates.
An earlier start to the budgeting process could be required

If managers are involved in preparing a budget, poor attitudes or hostile behaviour towards the budgetary control system can begin at the planning stage:

Managers may complain that they are too busy to spend much time on budgeting.
They may build ‘slack’ into their expenditure estimates.
They may argue that formalising a budget plan on paper is too restricting and that managers should be allowed flexibility in the decisions they take.

Negotiated style of budgeting

A negotiated budget is a ‘Budget in which budget allowances are set largely on the basis of negotiations between budget holders and those to whom they report’.

At the two extremes, budgets can be dictated from above or simply emerge from below but, in practice, different levels of management often agree budgets by a process of negotiation.

Final budgets are therefore most likely to lie between what top management would really like and what junior managers believe is feasible. The budgeting process is hence a bargaining process and it is this bargaining which is of vital importance, determining whether the budget is an effective management tool or simply a clerical device.

Budget slack

Budget slack is the ‘Intentional overestimation of expenses and/or underestimation of revenues during the budget setting’.

Budget slack occurs when managers deliberately underestimate sales or overestimate costs to avoid being blamed for future poor results.

The use of budgets as targets

Once decided, budgets become targets. As targets, they can motivate managers to achieve a high level of performance:

There is likely to be a demotivating effect where an ideal standard of performance is set.
A low standard of efficiency is also demotivating,
A budgeted level of attainment could be ‘normal’: that is, the same as the level that has been achieved in the past.

Budgets which are set for motivational purposes need to be stated in terms of aspirations rather than expectations, budgets for planning and decision purposes need to be stated in terms of the best available estimate of expected actual performance. The solution might therefore be to have two budgets:

A budget for planning and decision-making based on reasonable expectations (expectations budget)
A second budget for motivational purposes, with more difficult targets of performance (that is, targets of an intermediate level of difficulty) (aspirations budget)

In certain situations, it is useful to prepare an expectations budget (for planning and decision-making purposes) and an aspirations budget (to act as a motivational tool).

Budgets and motivation

Budgets serve many purposes, but in some instances their purposes can conflict and have an effect on management behaviour. There are no ideal solutions to the conflicts caused by the operation of a budgetary control system. Management and the management accountant have to develop their own ways of dealing with them, taking into account their organisation, their business and the personalities involved.

How senior management can offer support:

Making sure that a system of responsibility accounting is adopted
Allowing managers to have a say in formulating their budgets
Offering incentives to managers who meet budget targets
Not regarding budgetary control information as a way of apportioning blame.

Budget centre managers should accept their responsibilities – In-house training courses could be held to encourage a collective, co-operative and positive attitude among managers.

Support from the management accountant

The management accountant can offer support in the following ways:

Explain the meaning of budgets and control reports.
Keep accounting jargon in these reports to a minimum.
Provide control information with a minimum of delay.
Make sure that actual costs are recorded accurately.

Beyond budgeting

The argument for abolishing budgets, referred to as ‘beyond budgeting’.

Beyond Budgeting is ‘the idea that companies need to move beyond budgeting because of the inherent flaws in budgeting especially when used to set incentive contracts. It is argued that a range of techniques, such as rolling forecasts and market-related targets, can take the place of traditional budgets.’

The two fundamental concepts of the BB approach are the use of adaptive management processes rather than fixed annual budgets and a move to a more decentralised way of managing the business with a culture of personal responsibility.

The Beyond Budgeting Round Table (BBRT), an independent research collaborative lists the following ten criticisms of budgeting:

Budgets are time-consuming and expensive.
Budgets provide poor value to users.
Budgets fail to focus on shareholder value.
Budgets are too rigid and prevent fast response.
Budgets protect rather than reduce costs.
Budgets stifle product and strategy innovation.
Budgets focus on sales targets rather than customer satisfaction.
Budgets are divorced from strategy.
Budgets reinforce a dependency culture.
Budgets lead to unethical behaviour.

Two fundamental concepts underlie the beyond budgeting (BB) approach.

Use adaptive management processes rather than the more rigid annual budget. Traditional annual plans tie managers to predetermined actions which are not responsive to current situations. Managers should instead be planning on a more adaptive, rolling basis, but with the focus on cash forecasting rather than purely on cost control. Performance is monitored against world-class benchmarks, competitors and previous periods.
Move towards devolved networks rather than centralised hierarchies. The emphasis is on encouraging a culture of personal responsibility by delegating decision making and performance accountability to line managers.

BB implementation

A BB implementation should incorporate the following six main principles:

The responsibilities of managers within an organisation should be clearly defined.
Managers should be given goals and targets which are based on key performance indicators and benchmarks. These targets should be linked to shareholder value.
Managers should be given a degree of freedom to make decisions. A BB organisation chart should be ‘flat’.
Responsibility for decisions that generate value should be placed with ‘front line teams’ in line with the concept of TQM.
Front line teams should be made responsible for relationships with customers, associate businesses and suppliers.
Information support systems should be transparent and align with the activities that managers are responsible for.

Rolling budgets

A rolling budget is a ‘budget continuously updated by adding a further accounting period (month or quarter) when the earliest accounting period has expired’. Rolling budgets are also called ‘continuous budgets. Rolling budgets are for a fixed period, but this need not be a full financial year.

Suitable if:

accurate forecasts cannot be made. For example, in a fast-moving environment, or
for any area of business that needs tight control.

A typical rolling budget might be prepared as follows:

If rolling annual budgets are prepared quarterly, four rolling budgets will be prepared each year, each for a 12-month period. A new quarter is added at the end of the new budget period, to replace the current quarter just ending:

One budget might cover the period 1 January – 31 December Year 1.
The next rolling budget will cover 1 April Year 1 to 31 March Year 2.
The next rolling budget will cover 1 July Year 1 to 30 June Year 2.
The next quarterly rolling budget will cover 1 October Year 1 to 30

The reason for preparing rolling budgets is to deal with the problem of uncertainty in the budget, when greater accuracy and reliability are required.

Advantages of rolling budgets

They reduce uncertainty in budgeting.
They can be used for cash management.
They force managers to look ahead continuously.
When conditions are subject to change, comparing actual results with a rolling budget is more realistic than comparing actual results with a fixed annual budget.

Disadvantages of rolling budgets

Preparing new budgets regularly is time-consuming.
It can be difficult to communicate frequent budget changes.

Spreadsheets and budgeting

It is also true to say that budgets are a planning device designed to assist in the achievement of an organisation’s longer-term plans.

There are likely to be a number of alterations made to the first draft of the budget to see the effects of such changes.
The alteration of one value will cause many other values to alter.

The use of a spreadsheet allows these alterations to be made accurately and very quickly by the use of formulae. This is often referred to as ‘What If’ analysis.

A spreadsheet is a computer package which stores data in a matrix format where the intersection of each row and column is referred to as a cell. They are commonly used to assist in the budgeting process.

Advantages of spreadsheets

Large enough to include a large volume of information
Formulae and look up tables can be used so that if any figure is amended, all the figures will be immediately recalculated. This is very useful for carrying out sensitivity analysis.
The results can be printed out or distributed to other users electronically quickly and easily.
Most programs can also represent the results graphically e.g. balances can be shown in a bar chart.

Disadvantages of spreadsheets

Data can be accidentally changed (or deleted) without the user being aware of this occurring.
Educating staff to use spreadsheets / models and which areas /cells to use as inputs can be time consuming.
Version control issues can arise.
Errors in design, particularly in the use of formulae, can produce invalid output.