Chapter 4 - Budgetary control

Chapter objectives
Structure of the chapter
Budgetary control methods
Management action and cost control
Zero base budgeting (ZBB)
Key terms

There are two types of control, namely budgetary and financial. This chapter concentrates on budgetary control only. This is because financial control was covered in detail in chapters one and two. Budgetary control is defined by the Institute of Cost and Management Accountants (CIMA) as:

"The establishment of budgets relating the responsibilities of executives to the requirements of a policy, and the continuous comparison of actual with budgeted results, either to secure by individual action the objective of that policy, or to provide a basis for its revision".

Chapter objectives

This chapter is intended to provide:

· An indication and explanation of the importance of budgetary control in marketing as a key marketing control technique

· An overview of the advantages and disadvantages of budgeting

· An introduction to the methods for preparing budgets

· An appreciation of the uses of budgets.

Structure of the chapter

Of all business activities, budgeting is one of the most important and, therefore, requires detailed attention. The chapter looks at the concept of responsibility centres, and the advantages and disadvantages of budgetary control. It then goes on to look at the detail of budget construction and the use to which budgets can be put. Like all management tools, the chapter highlights the need for detailed information, if the technique is to be used to its fullest advantage.

Budgetary control methods

a) Budget:

· A formal statement of the financial resources set aside for carrying out specific activities in a given period of time.

· It helps to co-ordinate the activities of the organisation.

An example would be an advertising budget or sales force budget.

b) Budgetary control:

· A control technique whereby actual results are compared with budgets.

· Any differences (variances) are made the responsibility of key individuals who can either exercise control action or revise the original budgets.

Budgetary control and responsibility centres;

These enable managers to monitor organisational functions.

A responsibility centre can be defined as any functional unit headed by a manager who is responsible for the activities of that unit.

There are four types of responsibility centres:

a) Revenue centres

Organisational units in which outputs are measured in monetary terms but are not directly compared to input costs.

b) Expense centres

Units where inputs are measured in monetary terms but outputs are not.

c) Profit centres

Where performance is measured by the difference between revenues (outputs) and expenditure (inputs). Inter-departmental sales are often made using "transfer prices".

d) Investment centres

Where outputs are compared with the assets employed in producing them, i.e. ROI.

Advantages of budgeting and budgetary control

There are a number of advantages to budgeting and budgetary control:

· Compels management to think about the future, which is probably the most important feature of a budgetary planning and control system. Forces management to look ahead, to set out detailed plans for achieving the targets for each department, operation and (ideally) each manager, to anticipate and give the organisation purpose and direction.

· Promotes coordination and communication.

· Clearly defines areas of responsibility. Requires managers of budget centres to be made responsible for the achievement of budget targets for the operations under their personal control.

· Provides a basis for performance appraisal (variance analysis). A budget is basically a yardstick against which actual performance is measured and assessed. Control is provided by comparisons of actual results against budget plan. Departures from budget can then be investigated and the reasons for the differences can be divided into controllable and non-controllable factors.

· Enables remedial action to be taken as variances emerge.

· Motivates employees by participating in the setting of budgets.

· Improves the allocation of scarce resources.

· Economises management time by using the management by exception principle.

Problems in budgeting

Whilst budgets may be an essential part of any marketing activity they do have a number of disadvantages, particularly in perception terms.

· Budgets can be seen as pressure devices imposed by management, thus resulting in:

a) bad labour relations
b) inaccurate record-keeping.

· Departmental conflict arises due to:

a) disputes over resource allocation
b) departments blaming each other if targets are not attained.

· It is difficult to reconcile personal/individual and corporate goals.

· Waste may arise as managers adopt the view, "we had better spend it or we will lose it". This is often coupled with "empire building" in order to enhance the prestige of a department.

Responsibility versus controlling, i.e. some costs are under the influence of more than one person, e.g. power costs.

· Managers may overestimate costs so that they will not be blamed in the future should they overspend.

Characteristics of a budget

A good budget is characterised by the following:

· Participation: involve as many people as possible in drawing up a budget.
· Comprehensiveness: embrace the whole organisation.
· Standards: base it on established standards of performance.
· Flexibility: allow for changing circumstances.
· Feedback: constantly monitor performance.
· Analysis of costs and revenues: this can be done on the basis of product lines, departments or cost centres.

Budget organisation and administration:

In organising and administering a budget system the following characteristics may apply:

a) Budget centres: Units responsible for the preparation of budgets. A budget centre may encompass several cost centres.

b) Budget committee: This may consist of senior members of the organisation, e.g. departmental heads and executives (with the managing director as chairman). Every part of the organisation should be represented on the committee, so there should be a representative from sales, production, marketing and so on. Functions of the budget committee include:

· Coordination of the preparation of budgets, including the issue of a manual
· Issuing of timetables for preparation of budgets
· Provision of information to assist budget preparations
· Comparison of actual results with budget and investigation of variances.

c) Budget Officer: Controls the budget administration The job involves:

· liaising between the budget committee and managers responsible for budget preparation
· dealing with budgetary control problems
· ensuring that deadlines are met
· educating people about budgetary control.

d) Budget manual:

This document:

· charts the organisation
· details the budget procedures
· contains account codes for items of expenditure and revenue
· timetables the process
· clearly defines the responsibility of persons involved in the budgeting system.

Budget preparation

Firstly, determine the principal budget factor. This is also known as the key budget factor or limiting budget factor and is the factor which will limit the activities of an undertaking. This limits output, e.g. sales, material or labour.

a) Sales budget: this involves a realistic sales forecast. This is prepared in units of each product and also in sales value. Methods of sales forecasting include:

· sales force opinions
· market research
· statistical methods (correlation analysis and examination of trends)
· mathematical models.

In using these techniques consider:

· company's pricing policy
· general economic and political conditions
· changes in the population
· competition
· consumers' income and tastes
· advertising and other sales promotion techniques
· after sales service
· credit terms offered.

b) Production budget: expressed in quantitative terms only and is geared to the sales budget. The production manager's duties include:

· analysis of plant utilisation
· work-in-progress budgets.

If requirements exceed capacity he may:

· subcontract
· plan for overtime
· introduce shift work
· hire or buy additional machinery
· The materials purchases budget's both quantitative and financial.

c) Raw materials and purchasing budget:

· The materials usage budget is in quantities.
· The materials purchases budget is both quantitative and financial.

Factors influencing a) and b) include:

· production requirements
· planning stock levels
· storage space
· trends of material prices.

d) Labour budget: is both quantitative and financial. This is influenced by:

· production requirements
· man-hours available
· grades of labour required
· wage rates (union agreements)
· the need for incentives.

e) Cash budget: a cash plan for a defined period of time. It summarises monthly receipts and payments. Hence, it highlights monthly surpluses and deficits of actual cash. Its main uses are:

· to maintain control over a firm's cash requirements, e.g. stock and debtors

· to enable a firm to take precautionary measures and arrange in advance for investment and loan facilities whenever cash surpluses or deficits arises

· to show the feasibility of management's plans in cash terms

· to illustrate the financial impact of changes in management policy, e.g. change of credit terms offered to customers.

Receipts of cash may come from one of the following:

· cash sales
· payments by debtors
· the sale of fixed assets
· the issue of new shares
· the receipt of interest and dividends from investments.

Payments of cash may be for one or more of the following:

· purchase of stocks
· payments of wages or other expenses
· purchase of capital items
· payment of interest, dividends or taxation.

Steps in preparing a cash budget

i) Step 1: set out a pro forma cash budget month by month. Below is a suggested layout.

		Month 1	Month 2	Month 3
		$	$	$
Cash receipts
	Receipts from debtors
	Sales of capital items
	Loans received
	Proceeds from share issues
	Any other cash receipts
Cash payments
	Payments to creditors
	Wages and salaries
	Loan repayments
	Capital expenditure
	Taxation
	Dividends
	Any other cash expenditure
Receipts less payments
Opening cash balance b/f		W	X	Y
Closing cash balance c/f		X	Y	Z

ii) Step 2: sort out cash receipts from debtors

iii) Step 3: other income

iv) Step 4: sort out cash payments to suppliers

v) Step 5: establish other cash payments in the month

Figure 4.1 shows the composition of a master budget analysis.

Figure 4.1 Composition of a master budget

OPERATING BUDGET	FINANCIAL BUDGET
consists of:-	consists of
Budget P/L acc: get:	Cash budget
Production budget	Balance sheet
Materials budget	Funds statement
Labour budget
Admin. budget
Stocks budget

f) Other budgets:

These include budgets for:

· administration
· research and development
· selling and distribution expenses
· capital expenditures
· working capital (debtors and creditors).

The master budget (figure 4.1) illustrates this. Now attempt exercise 4.1.

Exercise 4.1 Budgeting I

Draw up a cash budget for D. Sithole showing the balance at the end of each month, from the following information provided by her for the six months ended 31 December 19X2.

a) Opening Cash $ 1,200.

	19X2										19X3
Sales at $20 per unit	MAR	APR	MAY	JUN	JUL	AUG	SEP	OCT	NOV	DEC	JAN	FEB
	260	200	320	290	400	300	350	400	390	400	260	250

Cash is received for sales after 3 months following the sales.

c) Production in units: 240

270

300

320

350

370

380

340

310

260

250

d) Raw materials cost $5/unit. Of this 80% is paid in the month of production and 20% after production.

e) Direct labour costs of $8/unit are payable in the month of production.

f) Variable expenses are $2/unit. Of this 50% is paid in the same month as production and 50% in the month following production.

g) Fixed expenses are $400/month payable each month.

h) Machinery costing $2,000 to be paid for in October 19X2.

i) Will receive a legacy of $ 2,500 in December 19X2.

j) Drawings to be $300/month.

An example

A sugar cane farm in the Lowveld district may devise an operating budget as follows:

· Cultivation
· Irrigation
· Field maintenance
· Harvesting
· Transportation.

With each operation, there will be costs for labour, materials and machinery usage. Therefore, for e.g. harvesting, these may include four resources, namely:

· Labour:

-cutting
-sundry

· Tractors
· Cane trailers
· Implements and sundries.

Having identified cost centres, the next step will be to make a quantitative calculation of the resources to be used, and to further break this down to shorter periods, say, one month or three months. The length of period chosen is important in that the shorter it is, the greater the control that can be exercised by the budget but the greater the expense in preparation of the budget and reporting of any variances.

The quantitative budget for harvesting may be calculated as shown in figure 4.2.

Figure 4.2 Quantitative harvesting budget

Harvesting	1st quarter	2nd quarter	3rd quarter	4th quarter
Labour
Cutting	nil	9,000 tonnes	16,000 tonnes	10,000 tonnes
Sundry	nil	300 man days	450 man days	450 man days
Tractors	nil	630 hours	1,100 hours	700 hours
Cane trailers	nil	9,000 tonnes	16,000 tonnes	10,000 tonnes
Imp, & sundries	nil	9,000 tonnes	16,000 tonnes	10,000 tonnes

Each item is measured in different quantitative units - tonnes of cane, man days etc.-and depends on individual judgement of which is the best unit to use.

Once the budget in quantitative terms has been prepared, unit costs can then be allocated to the individual items to arrive at a budget for harvesting in financial terms as shown in table 4.2.

Charge out costs

In table 4.2 tractors have a unit cost of $7.50 per hour - machines like tractors have a whole range of costs like fuel and oil, repairs and maintenance, driver, licence, road tax and insurance and depreciation. Some of the costs are fixed, e.g. depreciation and insurance, whereas some vary directly with use of the tractor, e.g. fuel and oil. Other costs such as repairs are unpredictable and may be very high or low - an estimated figure based on past experience.

Figure 4.3 Harvesting cost budget

Item harvesting	Unit cost	1st quarter	2nd quarter	3rd quarter	4th quarter	Total
Labour
Cutting	$0.75 per tonne	-	6,750	12,000	7,500	26,250
Sundry	$2.50 per day	-	750	1,125	1,125	3,000
Tractors	$7.50 per hour	-	4,725	8,250	5,250	18,225
Cane Trailers	$0.15 per tonne	-	1,350	2,400	1,500	5,250
Imp. & sundries	$0.25 per tonne	-	2,250	4,000	2,500	8,750
		-	$15,825	$27,775	$17,875	$61,475

So, overall operating cost of the tractor for the year may be budgeted as shown in figure 4.4.

If the tractor is used for more than 1,000 hours then there will be an over-recovery on its operational costs and if used for less than 1,000 hours there will be under-recovery, i.e. in the first instance making an internal 'profit' and in the second a 'loss'.

Figure 4.4 Tractor costs

		Unit rate	Cost per annum (1,000 hours)
		($)	($)
Fixed costs	Depreciation	2,000.00	2,000.00
	Licence and insurance	200.00	200.00
	Driver	100.00 per month	1,200.00
	Repairs	600.00 per annum	600.00
Variable costs	Fuel and oil	2.00 per hour	2,000.00
	Maintenance	3.00 per 200 hours	1,500.00
			7,500.00
	No. of hours used		1,000.00
	Cost per hour		7.50

Master budget

The master budget for the sugar cane farm may be as shown in figure 4.5. The budget represents an overall objective for the farm for the whole year ahead, expressed in financial terms.

Table 4.5 Operating budget for sugar cane farm 19X4

		1st quarter	2nd quarter	3rd quarter	4th quarter	Total $
Revenue from cane			130,000	250,000	120,000	500,000
Less: Costs
	Cultivation	37,261	48,268	42,368	55,416	183,313
	Irrigation	7,278	15,297	18,473	11,329	52,377
	Field maintenance	4,826	12,923	15,991	7,262	41,002
	Harvesting	-	15,825	27,775	17,875	61,475
	Transportation	-	14,100	24,750	15,750	54,600
		49,365	106,413	129,357	107,632	392,767
Add: Opening valuation		85,800	135,165	112,240	94,260	85,800
		135,165	241,578	241,597	201,892	478,567
Less: Closing valuation		135,165	112,240	94,260	90,290	90,290
Net crop cost		-	129,338	147,337	111,602	388,277
Gross surplus		-	66,200	102,663	8,398	111,723
Less: Overheads		5,876	7,361	7,486	5,321	26,044
Net profitless)		(5,876)	(6,699)	95,177	3,077	85,679

Once the operating budget has been prepared, two further budgets can be done, namely:

i. Balance sheet at the end of the year.

ii. Cash flow budget which shows the amount of cash necessary to support the operating budget. It is of great importance that the business has sufficient funds to support the planned operational budget.

Reporting back

During the year the management accountant will prepare statements, as quickly as possible after each operating period, in our example, each quarter, setting out the actual operating costs against the budgeted costs. This statement will calculate the difference between the 'budgeted' and the 'actual' cost, which is called the 'variance'.

There are many ways in which management accounts can be prepared. To continue with our example of harvesting on the sugar cane farm, management accounts at the end of the third quarter can be presented as shown in figure 4.6.

Figure 4.6 Management accounts - actual costs against budget costs Management accounts for sugar cane farm 3rd quarter 19X4

Item Harvesting		3rd quarter			Year to date
		Actual	Budget	Variance	Actual	Budget	Variance
Labour
	- Cutting	12,200	12,000	(200)	19,060	18,750	(310)
	- Sundry	742	1,125	383	1,584	1,875	291
Tractors		9,375	8,250	(1,125)	13,500	12,975	(525)
Cane trailers		1,678	2,400	722	2,505	3,750	1,245
Imp & sundries		4,270	4,000	(270)	6,513	6,250	(263)
		28,265	27,775	(490)	43,162	43,600	438

Here, actual harvesting costs for the 3rd quarter are $28,265 against a budget of $27,775 indicating an increase of $490 whilst the cumulative figure for the year to date shows an overall saving of $438. It appears that actual costs are less than budgeted costs, so the harvesting operations are proceeding within the budget set and satisfactory. However, a further look may reveal that this may not be the case. The budget was based on a cane tonnage cut of 16,000 tonnes in the 3rd quarter and a cumulative tonnage of 25,000. If these tonnages have been achieved then the statement will be satisfactory. If the actual production was much higher than budgeted then these costs represent a very considerable saving, even though only a marginal saving is shown by the variance. Similarly, if the actual tonnage was significantly less than budgeted, then what is indicated as a marginal saving in the variance may, in fact, be a considerable overspending.

Price and quantity variances

Just to state that there is a variance on a particular item of expenditure does not really mean a lot. Most costs are composed of two elements - the quantity used and the price per unit. A variance between the actual cost of an item and its budgeted cost may be due to one or both of these factors. Apparent similarity between budgeted and actual costs may hide significant compensating variances between price and usage.

For example, say it is budgeted to take 300 man days at $3.00 per man day - giving a total budgeted cost of $900.00. The actual cost on completion was $875.00, showing a saving of $25.00. Further investigations may reveal that the job took 250 man days at a daily rate of $3.50 - a favourable usage variance but a very unfavourable price variance. Management may therefore need to investigate some significant variances revealed by further analysis, which a comparison of the total costs would not have revealed. Price and usage variances for major items of expense are discussed below.

Labour

The difference between actual labour costs and budgeted or standard labour costs is known as direct wages variance. This variance may arise due to a difference in the amount of labour used or the price per unit of labour, i.e. the wage rate. The direct wages variance can be split into:

i) Wage rate variance: the wage rate was higher or lower than budgeted, e.g. using more unskilled labour, or working overtime at a higher rate.

ii) Labour efficiency variance: arises when the actual time spent on a particular job is higher or lower than the standard labour hours specified, e.g. breakdown of a machine.

Materials

The variance for materials cost could also be split into price and usage elements:

i) Material price variance: arises when the actual unit price is greater or lower than budgeted. Could be due to inflation, discounts, alternative suppliers etc.

ii) Material quantity variance: arises when the actual amount of material used is greater or lower than the amount specified in the budget, e.g. a budgeted fertiliser at 350 kg per hectare may be increased or decreased when the actual fertiliser is applied, giving rise to a usage variance.

Overheads

Again, overhead variance can be split into:

i) Overhead volume variance: where overheads are taken into the cost centres, a production higher or lower than budgeted will cause an over-or under-absorption of overheads.

ii) Overhead expenditure variance: where the actual overhead expenditure is higher or lower than that budgeted for the level of output actually produced.

Calculation of price and usage variances

The price and usage variance are calculated as follows:

Price variance = (budgeted price - actual price) X actual quantity
Usage variance = (budgeted quantity - actual quantity) X budgeted price

Now attempt exercise 4.2.

Exercise 4.2 Computation of labour variances

It was budgeted that it would take 200 man days at $10.00 per day to complete the task costing $2,000.00 when the actual cost was $1,875.00, being 150 man days at $12.50 per day. Calculate:

i) Price variance
ii) Usage variance

Comment briefly on the results of your calculation.

Management action and cost control

Producing information in management accounting form is expensive in terms of the time and effort involved. It will be very wasteful if the information once produced is not put into effective use.

There are five parts to an effective cost control system. These are:

a) preparation of budgets

b) communicating and agreeing budgets with all concerned

c) having an accounting system that will record all actual costs

d) preparing statements that will compare actual costs with budgets, showing any variances and disclosing the reasons for them, and

e) taking any appropriate action based on the analysis of the variances in d) above.

Action(s) that can be taken when a significant variance has been revealed will depend on the nature of the variance itself. Some variances can be identified to a specific department and it is within that department's control to take corrective action. Other variances might prove to be much more difficult, and sometimes impossible, to control.

Variances revealed are historic. They show what happened last month or last quarter and no amount of analysis and discussion can alter that. However, they can be used to influence managerial action in future periods.

Zero base budgeting (ZBB)

After a budgeting system has been in operation for some time, there is a tendency for next year's budget to be justified by reference to the actual levels being achieved at present. In fact this is part of the financial analysis discussed so far, but the proper analysis process takes into account all the changes which should affect the future activities of the company. Even using such an analytical base, some businesses find that historical comparisons, and particularly the current level of constraints on resources, can inhibit really innovative changes in budgets. This can cause a severe handicap for the business because the budget should be the first year of the long range plan. Thus, if changes are not started in the budget period, it will be difficult for the business to make the progress necessary to achieve longer term objectives.

One way of breaking out of this cyclical budgeting problem is to go back to basics and develop the budget from an assumption of no existing resources (that is, a zero base). This means all resources will have to be justified and the chosen way of achieving any specified objectives will have to be compared with the alternatives. For example, in the sales area, the current existing field sales force will be ignored, and the optimum way of achieving the sales objectives in that particular market for the particular goods or services should be developed. This might not include any field sales force, or a different-sized team, and the company then has to plan how to implement this new strategy.

The obvious problem of this zero-base budgeting process is the massive amount of managerial time needed to carry out the exercise. Hence, some companies carry out the full process every five years, but in that year the business can almost grind to a halt. Thus, an alternative way is to look in depth at one area of the business each year on a rolling basis, so that each sector does a zero base budget every five years or so.

Key terms

Budgeting
Budgetary control
Budget preparation
Management action and cost control
Master budget
Price and quantity variance
Responsibility centres
Zero based budgeting