Managing Finance and Budgets

Managing Finance and Budgets Lecture 11 Budgetary Control

Session 11 – Budgetary Control Objectives By the end of this week, you will: • Be able to discuss how a budget is constructed. • Be able to state different budgeting principles, and how these might be used in different situations. • Know how budgetary targets might be used as controls. • Be able to discuss some of the ways in which managers react to budgetary targets • Know some of the non-financial measures used in budgeting.

Menu • A : The Budget-Setting Process • B : Approaches to Budgeting • C : Monitoring & Controlling Performance • D : Behavioural Issues • E : Using Non-Financial Measures • F : Follow-up work

Section A: The Budget-Setting process

The Budgetary Context • Last week, we saw that the creation of a budget is simply one element in the Planning & Control Process. • This process sees a budget as both a planning tool and a means of control. • We looked at planning in the last presentation; in this presentation we will concentrate mainly on the control element. • Before we do this, this section will look in a bit more detail as to how precisely budgets are created.

The Planning & Control Process – a summary Mission, Aims, Objectives Market, Products, Services Sales, Costs, Profits, Returns 1. Identify key objectives Limiting factors: External & internal Environment - market size, production capability, competition 2. Identify available options 3. Evaluate and select options Markets, products, financing, physical resources, human resources 4. Prepare detailed plans or budgets Short-term plans: Sales, Cash, Stock, Labour, Production à Master budget 5.Collect information and control Identify variances and respond as appropriate

Steps in the budget setting and control process Click on each box for an explanation 2. Communicate budget guidelines to relevant managers 1. Establish responsibility for the budget-setting process 4. Prepare the budget for the area of the limiting factor 3. Identify the key or limiting factor 6. Review and co-ordinate budgets 5. Prepare draft budgets for all other areas 8. Communicate the budgets to all interested parties 7. Prepare the master budgets 9. Monitor actual performance relative to the budget 10. Act to ensure performance conforms to the budget

Step 1: Establish Responsibility • Normally, this is the work of a Budget Committee, consisting of a senior representative of each of the important areas (Sales, Production etc.) • Often a Budget Officer is appointed to carry out tasks required by the committee. • This person is often an accountant.

Step 2: Communicate Guidelines • At this stage, all previous work (e.g. strategic planning, overall business objectives for the year) are communicated to the heads of the various departments. • This will normally be an interactive process, and heads of departments will often have played an important part in drawing up the planning documents. • At this stage, it may be the case that each departmental or section head will be asked to prepare a draft budget for the following year for their area, as a ‘bid’ for funding, within the guidelines set. (This may also occur later – at step 5)

Step 3: Identify the Limiting Factor • The Key or Limiting Factor is the aspect of business that is crucial to it achieving the objectives set. • For many businesses this is sales; however in some circumstances it may be labour, or even the ability to maintain supplies of raw materials. It may even be, a cash flow issue, where an overdraft needs to be carefully managed. • Clearly this will need to be as a result of detailed analysis of the current position. • It should also be noted that the Limiting Factor may change from year to year.

Step 4: Prepare the Budget for the Limiting Factor • Often, this is simply preparing the Sales budget. If so, it would be based on market research and on evidence from sales in past years*. • If the Limiting Factor is another area, clearly, the capacity of the business to operate in that area would need very careful analysis of the available evidence to ensure that the information is as accurate as possible. • This factor will now define the overall activity level of the business for the next 12 months. *N.B. In research by Dury et. al, 1993, 85% of all businesses based such targets on opinions of sales staff. (see M & A. p 368)

Step 5: Prepare draft budgets for all areas • Once the details of the Limiting Factor Budget are known, other budgets can then be prepared. • Two methodologies can be employed: 1. A Top-Down approach: Senior management of each area originates the targets, then filters then down, requiring managers lower down to prepare budgets which conform to these targets. 2. A Bottom-Up approach: Targets are fed upwards from the lowest levels, then negotiate with the manager higher up in order to achieve a budget which conforms to the constraints set by the limiting factor. • The Bottom-Up approach clearly involves more effort, and may result in several rounds of negotiation at different levels before agreement is reached. It does however hold the promise of achieving greater consensus.

Step 6: Review & Co-ordinate • All budgets are submitted to the Budget Committee for scrutiny, to ensure that they are complementary, and dovetail together well. • Where discrepancies occur, the budget committee will exert its authority and budgets will be returned for amendment.

Step 7: Prepare Master Budgets • The Master Budgets are normally: • The budgeted Profit & Loss account • The budgeted Balance Sheet • Possibly a Budgeted Cash Flow • This work is undertaken by the budget committee.

Step 8: Communicate Budgets • The budgets agreed by the committee are now passed to individual managers. • Normally this is filtered down through senior, middle and junior management layers, to the budget holder.

Step 9: Monitor Performance • Monitoring of performance may be carried out weekly, monthly or quarterly. • Examination of actual performance against targets will be done by the budget holder – the person responsible for the budget, and the target. • Where there is significant variation from the budgeted value, managers would be expected to act.

Step 10: Ensure Performance matches the Target • This is the process of control. • There are two ways in which we may match performance with target: Modifying behaviour: it may be clear that an ‘overspend’ is occurring, or that predicted sales are not being achieved. If so, curbs to spending must be put in place, and sales campaigns re-energised. Modifying the target: it may become clear that targets were unrealistic. If so, new targets must be negotiated, and a new budget issues with amended targets. This would undoubtedly have repercussions elsewhere in the business. • The latter part of this presentation concerns itself with the details of this process.

SAQ 10.1 Why do you think the process for budget setting so complex? Why, for example could not one person (for example, the finance director) decide on the budget then just tell everyone? Solution

SAQ 10.1 There are two main reasons: • Firstly, whoever is in charge of the budget needs to have as full a picture as possible before setting it. That requires consultation and lots of discussion. • Secondly, individual budget holders have to believe in the budget, and understand their relationship with the whole. This can only be done through a process of discussion & negotiation. NB In fact, in many SMEs, ‘one person deciding on the budget and then telling everyone else’ is good description of what happens. This may not be the best way, however!

Section B: Methods of Budget-Setting

Methods of budget-setting • In the previous section, we looked at the process by which a budget comes into being. • Here we look at the different budgeting methods and principles. • These methods may be used across the whole of a company, or particular parts of it, and the methods used may vary from year to year, depending upon the circumstances.

Budgets – Time horizons Periodic budget • This is a one-off budget set for a year (e.g.) • It is normally broken down into monthly or weekly amounts Continual Budget • This will be updated continually (still for one year, but a new month will be added to replace the one which has passed.)

Methods used in budget-setting Incremental Budgeting: - same as last year with a bit added Zero Base Budgeting - budget holders required to justify why any money is needed Activity Based Budgeting - those responsible for activities which incur costs hold the budgets Standard costing - standard quantities & costs used to generate targets. Sensitivity Analysis - computer software used to answer ‘what-if’ questions.

Different Forms of Budgeting Click on each box for a fuller explanation Incremental Budgets Zero-Base Budgets Activity-Based Budgets Standard Costs SAQ 10.2 Sensitivity Analysis

Incremental Budgeting • Traditional form of budgeting, common in local & central government • Costs and allocations of monies tend to be on a ‘historical’ basis, i.e. what happened in previous years • Adjustment (increments) are made on the basis of changes (e.g. inflation, increases in productivity, workforce etc.) that happen from year to year. • Often used for ‘discretionary’ budgets (i.e. where budget holder is responsible for allocating a sum of money within a department) • No clear relationship between the input or output (e.g the raw materials required or the level of sales produced)

Zero-Base Budgeting (ZBB) • Draws on the philosophy that ALL spending needs to be justified. • All budgets are allocated a zero base, and will be increased from this only if a good case can be made out for the money • Senior management will be using the criterion of ‘value for money’ to allocate scarce resources. • ZBB encourages managers to adopt a questioning approach; this leads to more strategic thinking and allocation of resources to enable this strategy to happen • Clear links required between input/output and the resourcing

Activity-Based Budgeting (ABB) • Derives from the philosophy of Activity-Based Costing, that it is activities which drive costs. This is applied to the the Budget process. • If ‘cost-driving’ activities can be identified, then the cost of the output can be achieved more accurately) • Central feature: budget holders (those who are responsible for meeting a particular budget) have control over the events that affect performance in their area. • ABB tries to generate budgets in such a way that the manager who has control over these cost drivers is accountable for the costs. • Typical problems: increased levels of activity generated from outside the manager’s control, e.g. Manufacturing Budget thrown into disarray by a new sales contract

Standard Costing • Embodies the idea that standard quantities and costs can be planned for individual units such as sales items, labour rates, raw materials etc. • The standards are targets, and become benchmarks by which actual performance s measured. • The targets may be derived from experience, market assessments, current rates (e.g. labour, fees etc.), but should be realistic. • Variances (differences between the budgeted amounts and the actual amounts) are always based on standards.

Sensitivity Analysis This is a tool used in setting technically complex budgets: • It investigates changes to profit due to adjustments in key variables • It identifies key areas for managers to focus onfor maximum effect In order to use it, managers need to: • Identify key questions to be answered – e.g. what is the effect on profits of 10% decrease in sales? Or a 10% increase in cost of sales? • Use of spreadsheets or other types of computer software in order to create ‘what-if’ analyses, perform goal-seeking or other complex tasks.

SAQ 10.2 1. What do you think might be the advantages and disadvantages of zero-based budgeting? 2. How might any disadvantages be overcome? Solution

Advantages Little Wastage of Resources Strategic use of resources, enable plans to be fulfilled more easily Disadvantages Time Consuming Managers can often feel threatened by ZBB SAQ 10.2 Solution The disadvantages might be countered by using the approach selectively, for example only every third year, or on particular budgets which tend to require strategic input, e.g. training, advertising, research & development.

Section C: Monitoring & Controlling Performance

Budgetary Control Structures Budgets provide a useful mechanism for control. • This starts with the detailed planning within the budget, which forms the basis for exercising control • In addition we need a basis for measuring actual performance against planned performance • Finally in exercising control, we need a means of finding out where and why events deviated from the plan, and ways of rectifying these.

The budgetary control process Click on each box for a fuller explanation Prepare budgets Perform and collect information on actual performance Respond to variances between planned and actual performance and exercise control SAQ 10.3

Steps in the budget setting and control process Click on each box for an explanation 2. Communicate budget guidelines to relevant managers 1. Establish responsibility for the budget-setting process 4. Prepare the budget for the area of the limiting factor 3. Identify the key or limiting factor 6. Review and co-ordinate budgets 5. Prepare draft budgets for all other areas 8. Communicate the budgets to all interested parties 7. Prepare the master budgets 9. Monitor actual performance relative to the budget 10. Act to ensure performance conforms to the budget

Performance Monitoring Techniques The figures within a budget serve as a basis for measuring the performance of a team or department. The following interrelated techniques can be used: • Simple Performance Comparison • Flexible Budgeting • Variance Analysis

This Budget is part of the Profit and Loss budget for a manufacturing company The amounts shown represent targets to be achieved for a particular product line during the next 12 months. This allows us to compare our prediction with what actually happens. Budget Sales (Units): 1000 £ 000 Budget Value of Sales100 Direct Costs Materials 40 Labour 20 Total Direct Costs 60 Gross Profit 40 Overheads Admin Salaries 20 Travel 5 Other costs 20 Total Overheads 45 Net Profit (5) Simple Performance Comparison

Comparison of Actual Performance (1) Original Budget Actual Figures Sales 1000 Units Sales 1040 Units Original Actual £ 000 Budget Figures Value of Sales100 104 Direct Costs Materials 30 37 Labour 25 24 Total Direct Costs 55 61 Gross Profit 45 43 Overheads Admin Salaries 20 19 Travel 5 8 Other costs 17 17 Total Overheads 42 44 Net Profit 3 (1) Here we can see what has happened at the end of the period: Although we have produced and sold slightly over target, the sharp rise in the cost of materials means that we have made an overall loss.

Comparison of Actual Performance (2) Original Budget Sales (Units): 1000 Actual Sales (Units): 1500 Original Actual £ 000 Budget Figures Value of Sales100 150 Direct Costs Materials 30 47 Labour 25 25 Total Direct Costs 55 72 Gross Profit 45 78 Overheads Admin Salaries 20 27 Travel 5 10 Other costs 17 23 Total Overheads 42 60 Net Profit 3 18 Here the original sales targets have been well exceeded, and we have increased our profits considerably However all is not as well as it seems!

Flexible Budgeting • If it becomes apparent before the end of the year that there is a huge discrepancy between the actual performance and the budget, it may be necessary to revise targets. • This might happen if there are unexpected surges or slumps in demand, or the economic situation changes. • This does not mean that we dispense with the budget altogether, and write a new one. • Flexible budgeting allows selected targets to be revised. • The revised budget is said to be ‘flexed’.

Comparison with Flexed Budget Original Budget Sales (Units): 1000 Actual Sales (Units): 1500 Original Flexed Actual £ 000 Budget BudgetFigures Value of Sales100 150 150 Direct Costs Materials 30 4547 Labour 25 3025 Total Direct Costs 55 7572 Gross Profit 45 7578 Overheads Admin Salaries 20 2027 Travel 5 810 Other costs 17 1723 Total Overheads 42 4560 Net Profit 3 3018 Here we have written in new targets on the basis of the new sales figures. We can now see that despite the fact that we have increased our profits, this is well below what we should have achieved.

Variance Analysis • Used to analyse performance and promote management action • Variance - the difference between the budgeted amount and the actual amount; this can be adverse : the difference will ultimately lead to a reduction in the budgeted profit favourable: the difference will ultimately lead to an increase in the budgeted profit. • Variances might cover: Sales Volume, Pricing, Direct Materials Usage, Direct Materials Price, Direct Labour Efficiency, Direct Labour rate, Fixed Overheads

Budgeted profit plus All favourable variances minus All adverse variances equals Actual profit Relationship between the budgeted and actual profit

Sample Variance Analyses Sales Volume Variance The difference between the profit as shown in the flexed budget and the actual profit Flexed Budget: Profit : £30,000 Actual Figures Profit: £12,000 Sales Volume Variance: £18,000 Adverse

Typical Variance Analyses carried out Direct Material PRICE variance (Actual material purchased x standard price) less Actual cost of material purchased Direct Material USAGE variance (Standard quantity of material required for actual production x standard price) less (Actual material x standard price Total Direct Material variance Standard direct material cost less Actual direct material cost

Total direct materials variance Direct materials usage variance Direct materials price variance Relationship between the total, usage and price variances of direct materials

Types of Control There are essentially two types of control used in budget management: • Feedback Control: where the information from actual performance is used to cause actions to be taken to rectify an unfavourable situation. • Feedforward control: where action is taken in advance to anticipate what might occur, and therefore avoid an unfavourable outcome.

Key elements for budgetary control • Achievable yet rigorous targets • Accurate, relevant, customised and timely reporting • Short reporting periods (e.g. one month) • Clear lines of responsibility • Accountability of the budget holder • Records of action taken to control operations • Flexibility provided where appropriate • Serious attitude from higher management towards importance, relevance and accuracy of budgets

The use of Targets for Control • Targets in themselves are a useful means of control. These are devolved down to junior managers who are able to monitor & self-correct. • Regular upwards reporting of performance to targets means that problems which occur will be relatively minor and easier to deal with. • It is only when large variances occur between targets and actual performance that further investigation & intervention is required.

Investigating Variances • This can be expensive in terms of time and money. • Knowing the reason for a variance is only useful if an investigation into its cause can yield a method for rectifying it. • To decide whether this should be done, we can use the statistical notion of significance. In this case, we would regard variance to be significant if it was greater than 5%. In this case: Significant adverse variances will need to be acted upon. Significant favourable variances should be investigated. Insignificant variances should simply be kept under review. • We can only act on variances if the cause of them is known, and there are clear courses of action to be taken

Managing Finance and Budgets