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Chapter 10. Budgetary Control. ‘Knowledge is control’. Budgetary planning is only one part in the overall budgetary process. Actual performance needs to be monitored and compared to the budgeted targets set to evaluate performance.
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Chapter 10 Budgetary Control
‘Knowledge is control’ • Budgetary planning is only one part in the overall budgetary process. • Actual performance needs to be monitored and compared to the budgeted targets set to evaluate performance. • Actual performance will always differ from the fixed budget as the business environment is quite dynamic as events and conditions may not turn out as anticipated in the budget. I • The budgetary control process involves the preparation of flexible budgets and the calculation of variances.
Framework for planning, decision-making and control Decision Set business objectives Identify potential strategies Long Term Planning Process Decision Evaluate and select strategies Implement strategies Compare actual results with plan Control Process Investigate variances and take corrective action
Compare actual results to plan (5) • Measure actual performance. Actual performance needs to be measured frequently to ensure any differences with budget are identified. • Compare actual results with budgeted. As actual performance is measured, it must be compared to budgeted targets with variances (differences) identified and categorised as favourable or adverse.
Investigate variances and take corrective action (6) • Investigate differences (variances). Significant variances require investigation and corrective action while insignificant variances may just require monitoring. Management must decide on the correct type of action to remedy the situation. Variances may be due to: • Unreasonable targets set in the budget. • Once-off or random events that distort actual performance. • Inefficiencies within the organisation. • Take corrective action. If any variance is due to an unreasonable target or standard, then management should review and set a more appropriate target level. If however the variances are caused by inefficiencies within the organisation, corrective action should be taken to limit the inefficiencies.
Flexible budgets • ‘Flexing variable costs from original budgeted levels to the allowances permitted for actual volume achieved while maintaining fixed costs at original level’ • Flexible budgets as defined by CIMA Official Terminology
Flexible budgets • It is far more informative for the business to compare performance under similar conditions. • The use of flexible budgets allows the fixed budget to be adjusted (flex the fixed budget) to allow for actual activity in making the comparison between actual and budgeted performance. • The flexible budget is used as a tool to improve management control information
The budgetary control process • The control process must take place at frequent intervals. • The business should be organised into various decision centres where costs and revenues can be traced to individual managers with responsibility for making the decisions and controlling the costs and revenues of these departments or cost centres. • Any investigation of variances should also be directed at the planning process and the realism of the budget target.
Flexible budgeting - steps • Step 1 – Measure actual performance. • Step 2 – Compare actual results with budgeted. • Step 3 – Calculate and investigate differences (variances). • Step 4 – Take corrective action.
Example 10.1: The budgetary control process • Step 1: Measure actual performance. (provided in question) • Step 2: Compare actual results with budgeted. • Prepare the fixed budget based on the data given. • Prepare the flexible budget. • Enter the actual results. Step 3:Calculate the variances. Level 1 analysis Level 2 analysis Step 4: Take corrective action.
Statement reconciling budgeted net profit to actual net profit
Take corrective action • Operating variances are caused by operating issues within a business and are usually controllable by management. • Planning variances are caused by targets that are either unrealistic and unachievable, resulting in high adverse variances, or, too easily achieved, resulting in high favourable variances. These variances are under the control of management. • Random variances are caused by chance and management have no means of controlling them.
Take corrective action • The sales variances are the largest and have the most significant impact on profits. Did the business reduce prices to boost sales? If they did why did it not work? Although sales volume increased, it did not increase enough to compensate for the decrease in the average spend. Should the business continue with this policy or should prices be increased slightly as profit can be more sensitive to price changes than to volume changes? This is very much a decision point and requires knowledge of the company's consumer base and existing and potential markets.
Take corrective action • The materials variance is not significant and should only be monitored. It is essential in any business to maintain procedures to ensure competitive pricing from its suppliers. Portion control, wastage and risk of theft should be monitored. • The direct labour cost variance is €3,000 favourable representing a 5 per cent (3,000 ÷ 60,000) difference between budgeted and actual. Management must investigate this variance and understand why it occurred. • The fixed labour cost increased by over 7 per cent (7,000 ÷ 98,000). Reasons for this increase should be forthcoming. Was the budgeted figure unrealistic and if so why?
Take corrective action • The fixed overhead variance is €4,000 favourable, representing a 6.5 per cent (4,000 ÷ 62,000) difference between budgeted overhead figure and actual. What caused this reduction? Is the budgeted figure unrealistic and if so why? A detailed breakdown of what constitutes fixed overhead costs should uncover reasons for this favourable variance. A favourable variance should also initiate questions such as, ‘did the company cut back on expense items such as repairs to the property to achieve short-term savings?’ This action could result in more costly repairs next year and hence is an example of poor decision-making. It is important to be aware that so called favourable cost variances could lead, in the long-term, to large adverse cost variances.
The control process • The control process just outlined is known as feedback control and its main objective is to assess whether a businesses performance is in line with budget and to get operations back on track as soon as possible, if it is not. • Feed-forward control is where, in the planning process, information may come to light regarding what is likely to go wrong in the future and hence steps can be taken now to avoid this scenario. • Essentially feedback control focuses on correcting actual problems, whereas feed-forward control focuses on predicting and eliminating possible future problems.
Sales mix • Many businesses sell a number of products or services, all at different profit margins. • A business can be in the situation where although sales increased from a volume perspective, profits fell due to the company selling less of its more profitable items. • Changes in sales mix will result in differences between budgeted net profit and actual net profit. • it is important to separately identify the sales mix variance from sales volume and sales price/cost variances.
Steps in calculating volume, mix and price or cost variances
Example 10.2: Calculation of sales mix variance • The sales volume margin variance is an adverse variance of €131,500 due to the fact that the company sold less package holidays than anticipated. This variance is simply the difference between contribution in the fixed and first flexible budget. • The sales margin mix variance is €153,000 favourable. This variance tells us that actual profit was greater than budgeted due to the fact that the company sold more of its most profitable holiday packages (luxury) and less of the least profitable packages (budget and mid-range) than anticipated in the budget. This variance is simply the difference between contribution in flexible budgets 1 and 2.
Example 10.2: Calculation of sales mix variance.Workings for sales and variable cost figures
