6 Section A Planning and Budgeting Concepts Two terms that are related to the accomplishments of goals and objectives are efficiency and effectiveness. Efficiency is the attempt to fulfill the objectives of the company while using the least amount of inputs. On the other hand, effectiveness has to do with the actual accomplishment of goals. Though both of these are important, in reality it is obvious that effectiveness is of ultimate importance. If a company is efficient but does not accomplish what is needed, then the efforts and resources used were wasted. When the objectives of one level of the company dovetail (are in agreement with each other) with the objectives of the next highest level, the company has achieved a means-end relationship. This results when the achievement of the objectives of one level enables the next highest level to achieve its objectives as well. Note: No matter how important planning is to an organization or how developed its methodology, the planning process will never replace the control process. Both are necessary. Question 1: Which of the following is not a significant reason for planning in an organization? a) Promoting coordination among operating units. b) Forcing managers to consider expected future trends and conditions. c) Developing a basis for controlling operations. d) Monitoring of profitable operations. (CMA Adapted) Types of Plans and General Principles In order for plans to be as effective as possible, they must be coordinated among the different units and departments in the company so that they are in alignment with the larger goals of the company. If this is not the case, different parts of the company may be working at cross-purposes and the company will not move in a positive direction. Strategic Plans (Long-Term Plans) Planning is done initially on a long-term basis, called strategiC planning. StrategiC plans are broad, general, long-term plans (usually five years or longer) and are based on the objectives of the organization. StrategiC planning is done by the companys top management. This type of planning is neither detailed nor focused on speCific financial targets, but instead looks at the strategies, objectives and goals ofthe company by examining both the internal and external factors affecting the company. Internal factors include current facilities, current products and market share, corporate goals and objectives, long-term targets, technology investment, and anything else in the direct control of the company itself. As already mentioned, external factors also need to be taken into account in strategiC planning. Some of the external factors are the economy, labor market, domestic and international competition, environmental issues, technological developments, developing new markets, and political risk in other countries (or the home country). This process of reviewing the long-term objectives and economic environment of the firm (both internally and externally) will enable the company to identify any threats, opportunities or limitations that it faces. By identifying threats and limitations early, the company will be better prepared to prevent them from occurring or to limit their effect. By identifying opportunities early, the company is in a better position to act appropriately and capitalize on these situations. 7 Planning and Budgeting Concepts CMA Part 1 Part of this strategic plan will be a review of the capacity and the capital resources of the company. Though these two items are related, they will be looked at separately. Capacity is the ability of the company to produce its products or services. Capital resources are the companys fixed assets. Capacity may exceed capital resources if the company has arranged to use another companys resources to produce its product or is using facilities temporarily. In the long term, the company will need to make certain that its capacity will be able to meet the expected demand and also decide how to obtain this capacity. The firm may either purchase or lease the necessary fixed assets, but a plan is required to determine how the company will obtain the necessary financing for whatever option it chooses (this is the process of Capital Budgeting). By taking all of this information into account, the company is in a position to make long-term business plans. These plans may be related to dropping or adding product lines or specific products, making long-term capital investments in increasing capacity or capital resources, or decreasing these. It may also generate a plan that will lead the company into a different business model altogether (for example, a shift from production of a product to servicing and supporting the product, leaving production to another company). Note: Strategic planning is directional, rather than operational. This means the company focuses on where it wants to go instead of specifically how it will get there. Intermediate and Short-Term Plans The strategiC plan is then broken down into intermediate or tactical plans (one to five years), which are designed to implement specific parts of the strategic plan. Tactical plans are made by upper and middle managers. Short-term or operational plans (one week to one year) are developed from the tactical plans. Operational plans focus on implementing the tactical plans to achieve operational goals, and operational plans include budgeted amounts. It is operational plans that drive the day-to-day operations of the company. Operational plans are developed by middle and lower-level managers. The shorter the time frame, the lower the level of management that should make the plan. Thus, strategic plans are developed by top management, tactical plans are developed by upper and middle managers, and operational plans are developed by middle and lower-level managers. This means that the board of directors should not be involved in developing weekly work plans for an assembly line. All shorter-term plans need to work towards the strategiC plans of the company. If the tactical and operational plans are not working towards that goal, the company will not be able to meet the longer-term, strategiC goals that they have set. Short-term or operational plans are the primary basis of budgets. Operational plans refine the overall objectives from the strategiC and tactical plans in order to develop the programs, policies and performance expectations required to achieve the companys long-term strategic goals. Most budgets are developed for a period of one year or less. Thus, the budget formulates action steps from the organizations short-term objectives. The budget reflects the companys operating and financing plans for a specific period: a year or a quarter or a month. The budget contains the action plans to achieve the short term objectives. The one exception to this is the capital expenditures budget. The capital expenditures budget is generally developed for a long period of time and the relevant impact is incorporated into the operating and financial budgets each year. 8 Section A Planning and Budgeting Concepts Other Types of Plans Plans may also be single-purpose plans, which are developed for a specific item such as construction of a fixed asset, the development of a new product or the implementation of a new accounting system. These are also incorporated into the operating and financial budgets during the relevant years. Standing-purpose plans have relevance and use for many different items. Plans such as marketing and operation plans fall into this category. Contingency planning is planning that a company develops to prepare for possible future events (especially negative events). This is in a sense what if? planning. Preparing different plans for different situations is more expensive because it entails developing multiple plans. However, multiple plans for different situations enable the company to be better prepared for what may occur. Companies do this when they think that the cost of contingency planning will eventually lead to greater savings than the cost of the planning itself. Contingency plans are much more important for companies that are more likely to be significantly influenced by outside events. If there is no plan for a situation in which a negative event occurs, the damage will be much greater to the company because it will not be able to react quickly, and its immediate reaction may not be the correct one. A contingency plan enables companies to respond quickly and in the best possible manner. Note: Despite the benefits of having a formal plan, there are also some drawbacks to this process. A plan that is too formal can constrain creativity, or a strict dedication to the plan can cause the company to miss some opportunities that would be beneficial to them. Question 2: Certain phases of the planning process should be formalized for all of the following reasons except that: a) Informal plans and goals lack the necessary precision, understanding and consistency. b) Formal plans can act as a constraint on the decision-making freedom of managers and supervisors. c) Formalization requires the establishment and observance of deadlines for decision-making and planning. d) Formalization provides a logical basis for rational flexibility and planning. (CMA Adapted) Question 3: Strategy is a broad term that usually means the selection of overall objectives. Strategic analysis ordinarily excludes the: a) Trends that will affect the entitys markets. b) Target production mix and schedule to be maintained during the year. c) Forms of organization structure that would best serve the entity. d) Best ways to invest in research, design, production, distribution, marketing and administrative activities. (CMA Adapted) 9 Planning and Budgeting Concepts CMA Part 1 Question 4: Which one of the following management considerations is usually addressed first in strategic planning? a) Outsourcing. b) Overall objectives of the firm. c) Organization structure. d) Recent annual budgets. (CMA Adapted) Budgeting The Relationship Among Planning, Budgeting and Performance Evaluation Planning, budgeting and performance evaluation are interrelated and inseparable. Here is an overview of the process: 1) Management develops the plan, which consists of goals, objectives and a proposed plan of action for the future. The plan includes the companys short-term as well as long-term goals and objectives and its business opportunities and risks. For example, a plan may look at the future from the pers pective of expanding sales, increasing profit margin, or whatever the company sees as long-term goals. In the process of determining its plans and goals, management will look at external economic factors (the expected labor market, tax rates, health of the economy, etc.) as well as what they cur rently do well or need to fix. The plan is a guide showing where the company needs to be in the future. The budget should include performance of the company as a whole as well as the perfor mance of its individual departments or divisions. Managers at all levels need to reach an understanding of what is expected. 2) The plan developed by management leads to the formulation of the budget. The budget expresses managements plans for the future in quantitative terms. The budget also identifies the resources that will be required in order to fulfill managements goals and objectives and how they will be allo cated. 3) Budgets can lead to changes in plans and strategies. Budgets provide feedback to the planning process because they quantify the likely effects of plans that are under consideration. This feedback may then be used by managers to revise their plans and possibly their strategies as well, which will then cause revisions to the budget during the budgeting process. This back and forth exchange may go on for several iterations before the plans and the budget are adopted. 4) Once the plans and the budget have been coordinated and the budget adopted for the coming period, as the organization carries out its plans to achieve the goals it has set, the master budget is the document it relies upon as its operating plan. By budgeting how much money the company ex pects to make and spend, the company creates a series of ground rules for people within the organization to follow throughout the year. 5) Actual results are compared to the plan. The budget is a control tool. Controlling is defined as the process of measuring and evaluating actual performance of each organizational unit of an enterprise and taking corrective action when necessary to ensure accomplishment of the firms goals and objec tives. The budget functions as a control tool because it expresses what measures will be used to evaluate progress. A regular (monthly or quarterly) comparison of the actual results-both revenues and expenditures -with the budgeted results will give the companys manage ment information on whether the companys goals are being met. This comparison should include narrative explanations for variances, discussing the reasons for the differences, so that mid course corrections can be made if necessary. 1 0 Section A Planning and Budgeting Concepts 6) Sometimes, this control will result in the revision of prior plans and goals or in formulation of new plans, changes in operations and revisions to the budget. For example, if changes occur in the com panys external environment that cause variances in revenues and/or costs to become extreme, a new short-term plan and a revised budget covering the remainder of the year may be necessary in order to properly respond to the changes occurring. 7) Changed conditions during the year will be used in planning for the next period. For example, if sales decline, the company may plan changes in its product line for the next period in order to reverse the trend. The master budget is the culmination and the goal of the budgeting process. The master budget is a summarized set of budgeted financial statements, including budgeted balance sheet, budgeted income statement, and budgeted statement of cash flows. A projected financial statement is called a pro forma financial statement; however, the master budget is not called a pro forma financial statement. The term pro forma is used to refer to a forecasted financial statement prepared for a specific purpose, for example to do what if analysis in the process of planning. A company might prepare many different sets of pro forma financial statements for the same period in its planning process. A pro forma financial statement is not used for formal variance reporting as the master budget and the flexible budget are, although if an action that was forecasted is implemented, the company would probably want to compare the actual results with the forecasted, pro forma, ones. But pro forma financial statements are not a part of the formal budgeting process. They are used for planning and decision making purposes, and the amounts in them may be quite different from the amounts in the master budget. Planning and the use of pro forma financial statements is discussed more in the topic of Top-Level Planning and Analysis in this section. The master budget is prepared for just one activity level, and the activity level used is whatever it is projected to be before the period begins. When flexible budgeting is used, the flexible budget is also prepared for just one activity level, but that activity level is the actual activity level achieved during the period. Therefore, the flexible budget amounts cannot be finalized for a reporting period (usually a month at a time) until the period is past and the actual achieved activity level for that period is known. The master budget and the flexible budget will be discussed in detail in the section on Budget Methodologies. The master budget is created using both non-financial and financial assumptions, which come about as a result of the planning process. For instance, companies develop budgets for the number of units of each product that they expect to manufacture and sell, the number of employees they will need, and so forth. The master budget is a result of both operating and financing decisions. Operating decisions are concerned with the best use of the companys limited resources. Financing decisions are concerned with obtaining the funds to acquire the resources the company needs. A budget that is broken down according to departmental lines will provide more feedback and function as more of a control tool than one that is not departmentalized, because each department manager will be responsible for meeting his or her departments budget. Ideally, each department manager will also have been responsible for developing his or her departments budget. These underlying budgets are used in developing the master budget. The master budget is the consolidation of all the departmental budgets. It comprises operating budgets and financial budgets. Operating budgets are used to identify the resources that will be needed to carry out the planned activities during the budget period, such as sales, services, production, purchasing, marketing, and R & D. The operating budgets for individual units are compiled into the budgeted income statement. Financial budgets identify the sources and uses of funds for the budgeted operations. Financial budgets include the cash budget, budgeted statement of cash flows, budgeted balance sheet, and the capital expenditures budget. 1 1 Planning and Budgeting Concepts CMA Part 1 Advantages of Budgets When properly developed and administered, budgets • Promote coordination and communication among organization units and activities, • Provide a framework for measuring performance, • Provide motivation for managers and employees to achieve the companys plans, • Promotes the efficient allocation of organizational resources, • Provide a means for controlling operations, and • Provide a means to check on progress toward the organizations objectives. Coordination and Communication Coordination means balancing the activities of all the individual units of the company in the best way so that the company will meet its goals and the individual units of the company will meet their goals. For example, when the sales manager shares sales projections with the production manager, the production manager can plan and budget to have the needed inventory ready to sell. And the sales manager can make better forecasts of future sales by coordinating and communicating with branch managers, who may be closer to the customers and know what they want. Measuring Performance Budgets make it possible for managers to measure actual performance against planned performance. The current years budget is a better benchmark to measure current performance against than is last years results. Last years results may have been negatively impacted by poor performance and the causes have now been corrected. Using last years results would set the bar too low. Furthermore, the past is never a good predictor of the future, and the budget should reflect the conditions anticipated for the coming period, not the conditions that existed in the past period or periods. Performance should not be compared only against a budget, though, because that can result in lower level managers setting budgets that are too easy to achieve. It is also important to measure performance relative to the performance of the industry and even relative to prior years performance. Motivating Managers and Employees Challenging budgets improve employee performance, because no one wants to fail, and falling short of the budgeted numbers is perceived as failure. Goals should be demanding but achievable. If they are so high that they are impossible to achieve, however, they are de-motivating. Efficient Allocation of Organizational Resources The process of developing the operating budgets for the individual units in the organization includes identifying the resources that each unit will need to carry out the planned activities. For example, the process of developing the production budget requires projections for direct materials and direct labor that will be required to produce the planned output. The process of budgeting for administrative salaries requires forecasts of administrative employees that will be needed by each department. If funds will be available for only a certain number of administrative employees in the organization, some units projections may have to be adjusted. This leads to efficient allocation of organizational resources. 12 Section A Planning and Budgeting Concepts Characteristics of Successful Budgeting There are a number of characteristics involved in successful budgeting, and some of these we have already mentioned. 1) The budget must start with the companys short- and long-term plans. Without input from planning, the budget will usually just recreate the previous years results with minor changes, mak ing it useless as a planning tool. 2) The budget must have the support of management at all levels. The support of top management is critical to gain the support of lower-level managers, and the support of lower-level managers is critical in order to gain the support of the affected employees. 3) The people who are charged with carrying out the budget need to feel ownership of the budget. That means they need to have input into the budgets development rather than having the budget imposed upon them. 4) The budget should be a motivating device. It should help the people in the organization to work toward the organizations goals for the improvement of the company. The budget is more likely to be successful if everyone concerned, from managers to their employees, sees the budget as a tool to help them do a better job, and not as a rigid taskmaster or as a tool for top management to use to assess blame. S) The firms management should assess the future as it pertains to the firms strategic goals and use the budgeting process to minimize the adverse effects that anticipated problems may have on operations. 6) A budget should be flexible. If conditions change during the budget period, the budget should not be used as an excuse for not doing something that is strategically important to the company, such as acting on an unforeseen business opportunity that arises. Or, if an unplanned large maintenance ex pense is needed, the budget should not require a manager to postpone repairs if doing so will hurt the company in the long run. The expression, Its not in the budget should not be used. In situa tions like these, the budget should be able to be changed. 7) To be useful, the budget should be an accurate representation of what is expected to occur. A budget with inaccurate numbers will not have the confidence of the people who are affected by it and will be useless. The accuracy of the budget can be affected by the means used to reward managers. If managers are rewarded according to how far above the budget their revenues are and/or how far below the budget their expenses are, they may be motivated to build budgetary slack into their budgets (budgeting revenues low and expenses high), resulting in an inaccurate budget. It may be more beneficial to reward managers based on how accurate their forecasts have been when com pared with actual results. 8) A budget should be coordinated, and operating activities of diverse business units should be syn chronized. For example, the sales manager will want to make as many sales as possible, whereas the credit manager will want to limit bad debt write-offs. A coordinated effort to establish credit stan dards that both managers can support should be incorporated into the budgeting process. 9) Budgeting should not be rigid. If revenue decreases are anticipated for the coming year, an across the board cost reduction applied to all areas can create additional problems. 10) The time period for a budget should reflect the purpose of the budget. If a new product is under consideration and the purpose is to budget for the total profitability of the product, the capital budgeting period should include the design, manufacturing, sales and after-sales support for the ex pected life of the product. 13 Planning and Budgeting Concepts CMA Part 1 Time Frames for Budgets A budget is generally prepared for a set period of time, commonly for one year, and the annual budget is subdivided into months or possibly quarters. Usually a budget is developed for the same time period as is covered by a companys fiscal year. When the budget period is the same as the fiscal year, budget preparation is easier and comparisons between actual results and budgeted results are facilitated. (This comparison is called a variance report.) Budgets can also be prepared on a continuous basis. At all times, the budget covers a set number of months, quarters or years into the future. Each month or quarter, the month or quarter just completed is dropped and a new month or quarters budget is added on to the end of the budget. At the same time, the other periods in the budget can be revised to reflect any new information that has become available. Thus, the budget is continuously being updated and always covers the same amount of time in the future. This is called a rolling budget or a continuous budget. When continuous budgeting is used, budgeting and planning are always being done. Advantages are: • Budgets are no longer done just once a year. • A budget for the next full period (usually 12 months) is always in place. • The budget is more likely to be up-to-date, since the addition of a new quarter or month will often lead to revisions in the existing budget. • Managers are more likely to pay attention to budgeted operations for the full budget period. Firms usually have longer-term budgets, as well. Budgets for the years beyond the coming year usually contain only essential operating data, though, and do not attempt to present a full operating and financial budget. But having a long-term budget along with the coming years master budget enables management to quantify the effect of its strategic plans on future short-term operations. Who Should Participate in the Budgeting Process All levels of management need to participate in the budgeting process. Management at all levels of the company need to understand and support the budget. For this reason, budgeting needs to be both bottom up and top down. Lower-level managers need to be involved, and this is the bottom up part. • Their knowledge is more specialized and they have the hands-on experience of running the business on a day-to-day basis. • Their participation will make them more committed and more accountable for meeting the budget. Top management support is essential, and this is the top down part. • The support oftop management is needed in order to obtain successful development and administra tion of the budget • Top management support is necessary in order to gain lower-level management participation. If lower level managers feel that top management does not support the effort, they are not likely to support it either. 14 Section A Planning and Budgeting Concepts The Budget Development Process We will discuss specific budgets and their development later. However, the process for developing each budget is the same. 1) Budget guidelines are set and communicated. This may be done by a budget committee or by senior management. The initial budget guidelines govern the preparation of the budget. Information considered in the development of the budget guidelines includes the general outlook for the economy and the markets the company serves, strategic objectives and long-term plans, expected operating result for the current period (since a budget for the coming period is developed toward the end of the current period but not after the current period has been completed), specific corporate decisions for the coming period such as corporate downsizing, response to environmental requirements, and short-term objectives. 2) Initial budget proposals are prepared by responsibility centers. Each responsibility center manager prepares an initial budget proposal, using the budget guidelines as well as their own know ledge about their own area, such as introduction of new products or changes to be made in product design or manufacturing processes. 3) Negotiation, review and approval. The responsibility center managers submit their initial budget proposals to the next level up for review. The initial proposals are reviewed for their adherence to the budget guidelines and to determine whether the budget goals are reasonable and in line with the goals of the next higher unit and with those of other budget units. Any changes that are needed are negotiated between the responsibility center managers and their superiors. The budgets go through successive levels of management and at each point may be re-negotiated. These negotiations are the most important part of the budget preparation process and also the most time-consuming part. Eventually, all of the individual unit budgets are combined into a consolidated master budget (first draft). That consolidated master budget is reviewed at the topmost level to determine whether it meets the requirements without being unachievable, and negotiations begin again for revisions. Fi nally, when the consolidated master budget meets the approval of the budget committee or senior management, the CEO approves the entire budget and submits it to the board of directors for final approval. 4) Revisions. Even after the budget has finally been adopted, it should be able to be changed if the assumptions upon which it was built change significantly. New information about internal or external factors may make revision of the budget necessary. In addition, periodic review of the approved budget for possible changes or use of a continuous budget which is continually being updated might be advisable. Although updating the budget provides better operating guidelines, too-frequent and too-easy budget revisions might encourage responsibility centers to not take the budgeting process seriously enough. Therefore, the budget should be revised only when circumstances have changed significantly and the changes are beyond the control of the responsibility center manager or the or ganization. 5) Reporting on variances. A budget is meaningless unless actual results are compared to the planned results for the same period. The budget needs to be used to monitor and control operations to meet the companys strategic objectives. The comparison between actual and plan is called va riance reporting, and it should take place at every budget unit level. Responsibility center managers should report on variances within their responsibility centers at the end of each reporting period (monthly or quarterly) to their superiors, who then compile the reports they receive into a variance report that is sent to the next level up, and so on. Variance reporting should include not only the amounts of the variances but also the causes of the variances that can be identified. 6) Use of the variance reports. The variance reports should be used at every level to identify prob lem areas and to make adjustments to operations, if necessary. For example, a production variance report might reveal that direct materials usage during the past month was greater than planned for the actual output that was produced. The production manager should be the one to investigate that and determine the cause. The variance may have been caused by inferior materials that included too much defective material. If that is the case, then the purchasing manager may need to get involved in the variance reporting, since the purchasing manager is responsible for the materials purchased. If a change in supplier is needed to correct the situation, that change should be made immediately. 15 Planning and Budgeting Concepts CMA Part 1 Best Practice Guidelines for the Budget Process Best practices in budgeting include the following, most of which we have already discussed: • The development of the budget should be linked to corporate strategy. Linking them gives the managers and employees a clearer understanding of strategic goals, which leads to greater sup· port for goals, better coordination of tactics, and, ultimately, to stronger company performance. • Communication is vital. Management must communicate strategic objectives. But in order to develop those objectives, management needs information from all areas of the organization about customers, competitors, the economy, new technology, and so forth. Much of this information comes from customer contact and support units. Effective communication among all levels of the organiza tion leads to challenging but achievable budgets. • Design procedures to allocate funding resources strategically. This can be done during the review process for the individual responsibility center budgets. Managers reviewing several responsi· bility center budgets can see how changes in one budget will affect other budgets. The companys weighted average cost of capital should be a consideration in the allocation process, as well. The de· gree of risk involved in competing plans, the costs or advantages associated with deferring action, as well as factors such as expected developments in interest rates may also be used to allocate re sources. By using these types of measures to allocate funding, companies can better select plans whose benefits will produce the desired results. And by monitoring the results of their allocations, companies can refine and improve their allocation procedures. • Managers should be evaluated on performance measures other than meeting budget targets. Meeting budget targets should be secondary to other performance measurements. See the topic of Budgetary Slack immediately following this one and the section on Performance Measure ment in this textbook for further discussions of this. • Link cost management efforts to budgeting. Accurate cost information during the budgeting process is basic to budgeting. Companies that use accurate cost management techniques and pro vide managers developing their budgets with access to cost information improve both the accuracy and the speed of their budget process. • The strategic use of variance analysis. Use of variance analysis to identify weaknesses enables managers to identify areas where their organization needs to improve its performance. However, this attention should be focused on those variances that have a significant impact on profitability, so that decision making and budgeting do not get bogged down in insignificant details. • Reduce budget complexity and budget cycle time. The budget process should be streamlined as much as possible through controlling the number of budgets that are needed and by standardizing budgeting methods. Automate budgeting as much as possible through the use of information tech nology, and make sure that the budget developers know how to use new technologies. • Develop budgets that can be revised if necessary. By having a process in place to revise the budget when change is warranted, a company can respond to competitive threats or opportunities more quickly. Furthermore, when budget developers know that the budget will have some flexibility, they will feel less need to pad their budgets with budgetary slack (see below for discussion of budge tary slack), which they otherwise might do in order to cover any possible development. This leads to more realistic budgets. • Review the budget on a regular basis throughout the year. These reviews should report on changes in business conditions and alert managers that new tactics may be called for if they are to meet their targets forthe year. This goes along with revising the budget when necessary. The budg· et should not be revised to cover up for poor performance or poor planning, but best practice companies choose to revise the budget rather than stick with a budget that no longer reflects current conditions. 16 Section A Planning and Budgeting Concepts Budgetary Slack and Its Impact on Goal Congruence Goal congruence is defined as aligning the goals of two or more groups. As used in planning and budgeting, it refers to the aligning of goals of the individual managers with the goals of the organization as a whole. Sometimes, the performance of an individual managers unit will benefit from an action, but the overall performance of the company is either not impacted at all or it may actually be negatively impacted. Or, an individual division manager may reject a capital investment that would improve the companys total profits because the proposed projects return on investment would cause his own divisions return on investment to decrease. When things like these occur, it is because the goals of the individual managers are not aligned with the goals of the company. The companys strategic objectives are communicated to individual managers as part of the planning and budgeting process. However, there is a hazard in budgeting, because it may lead to behaviors on the part of managers that benefit them but are not congruent with the goals of the company. This is more likely to occur if managers performance will be evaluated according to whether they meet their budget targets. Managers who develop the budgets they are going to be accountable to meet may build budgetary slack into their budgets in order to make sure their budgets are achievable without any risk of failure. Budgetary slack is the difference between the budgeted performance and the performance that is actually expected. It is the practice of underestimating budgeted revenues and overestimating budgeted costs to make the overall budgeted profit more achievable. On the positive side, budgetary slack can provide managers with a cushion against unforeseen circumstances. This can limit managers exposure to uncertainty and thereby reduce their risk aversion. The reduced anxiety about risk may help the managers make decisions that are more closely congruent with the goals of senior management. Or, it may not. Budgetary slack creates more problems than it solves. The negative results of budgetary slack are that it misrepresents the true profit potential of the company and can lead to inefficient resource allocation and poor coordination of activities within the company. The planning inaccuracy spreads throughout the company. For instance, if sales are planned too low, production will also be planned too low, possibly leading to product shortages; the advertising program and distribution expense budgets may be planned incorrectly; the cash budget might be inaccurate; and so forth. The best way to avoid the problems of budgetary slack is to use the budget as a planning and control tool, but not for managerial performance evaluation. Or, if the company does use the budget to evaluate managers, it could reward them based on the accuracy of the forecasts they used in developing their budgets. For example, the companys senior management could say that the higher and more accurate a division managers budgeted profit forecast is, the higher will be the managers bonus. Responsibility Centers and Controllable Costs Control in an organization is exercised through responsibility centers. Therefore, as we have maintained throughout this discussion, budgeting must also be done at the responsibility center level. However, responsibility center managers should be responsible for budgeting only the costs that they can control. Some costs are controllable by a given manager and some costs are not. When referring to costs that are controllable, we are referring only to costs for which the manager has the authority to make the decisions about how the money will be spent. When we refer to non-controllable costs for a manager, we are referring to costs that are ordinarily controlled at a higher level in the organization, such as the managers salary or bonus. The managers salary or bonus is controllable, but not by the manager. However, the managers salary will usually be assigned to his or her responsibility centers budget and will appear on reports comparing actual results to the budgeted amount. The allocation of indirect costs may be another non-controllable cost, since indirect costs may be allocated on any of a number of bases, some of which may be controllable by the manager of the responsibility center and some of which may not be. 17 Planning and Budgeting Concepts CMA Part 1 Each budgeted cost assigned to a responsibility center should be identified as either controllable or non controllable by that responsibility centers management. For example, salaries in the accounting system may be segregated in two accounts: controllable salaries and non-controllable salaries. Each would then be budgeted by the person who has control over it, and that person would be responsible for explaining the variances. All costs should be included on some managers variance report and identified as the responsibility of that manager. If an expense is classified as non-controllable on a given managers budget reports, then that expense should be included as a controllable expense on the report of the higher-level manager who makes the decisions that affect that expense. It is also important to recognize that fixed costs and indirect costs are not necessarily uncontrollable, and variable costs and direct costs are not necessarily controllable. The nature of each cost will vary according to its characteristics. This distinction between controllable and non-controllable costs is especially important if a managers performance evaluation will be dependent upon meeting budgetary targets. (Although we have said this is not a good idea, it may be done in some organizations, anyway). If other performance measures are used to evaluate the manager, this distinction may be less important. However, the person who is responsible for making the decisions that affect a cost should still be the person who reports on variances between the actual and budgeted costs, because that person is responsible for budgeting the cost and for making spending decisions. That person should also be the one to make any operational adjustments that those variances may identify as needed. Cost Standards in Budgeting The term standard cost is almost a synonym for budgeted cost. We will discuss standard costing in more detail later, because a standard cost system is a common method of cost measurement for manufacturing costs. For now, a few basic concepts are important because standard costs are also budgeted costs. Standard costs are costs for direct materials, direct labor and manufacturing overhead that are predeter mined or estimated as they would apply under specified conditions. Standard costs are a fundamental element of the budgeting process. They are used to develop the budgeted costs for manufactured goods. Standard costs can be developed using various assumptions, and management needs to determine what assumptions to use in their development. Standard costs may be either: • Ideal, also called theoretical costs, attainable only under the best possible conditions; or • Currently attainable, also called practical or expected costs, challenging to attain, but attaina ble under normal conditions. Currently attainable or practical expected costs are the costs that are used in most standard costing systems and are incorporated into the flexible budget. Note: A flexible budget is a budget that is prepared using the standard costs and the actual level of sales. It is essentially what the budget would have been if the company had known the actual level of sales when it developed the budget. Flexible budgeting is covered in much more detail in the section on Budget Methodologies in this textbook. Ideal, theoretical costs are probably not attainable and so are not practical for use in standard costs, but they can be useful for some special analytical and decision-making purposes and as goals to strive for. A standard cost specification is developed for each product (in process manufacturing) or for each job (in job order manufacturing). It consists of the standard costs for material, labor, and overhead for the product or job, and it is developed by means of cost analyses and engineering studies. In developing a standard cost specification, the costs for materials, labor and overhead in each of the various responsibility centers through 1 8 Section A Planning and Budgeting Concepts which the work flows are included in the analysis. Standard cost specifications are designed in accordance with each individual situation. Flexible budgets work with standard cost systems. The standard cost system provides data for the computation of the predetermined overhead rates to use in the flexible budget and for variance analysis of overhead expense. Most companies use practical expected standard costs in their standard cost system and in their flexible budgets. If they choose not to do this, then management will have an additional variance to report: the variance between the practical expected costs and the ideal theoretical costs. Setting Standard Costs Standard costs are derived from general standards for operations. Several resources are used in determining standards for operations. These are: 0 Activity analysis, 0 Historical data, 0 Target costing, 0 Strategic decisions, and 0 Benchmarking. Activity Analysis Activity analysis is the most accurate way of determining standard costs, if it is properly executed. It involves identifying and evaluating all the input factors and activities that are required to complete a job, a project or an operation efficiently. Activity analysis is performed by people from several different areas, including product engineers, industrial engineers, management accountants and the production workers. Product engineers specify the components to be used in the manufacturing of a product. Industrial engineers analyze the procedures required to complete the manufacturing process. Management accountants work with the engineers to complete the analysis. The analysis specifies the quantity and the quality of the direct materials, the required skills and experience of the employees who will produce the product, and the equipment to be used in producing the product. The management accountants contribute the costs of the direct materials, the employees, the overhead and other items to arrive at the total standard cost. Historical Data While activity analysis is the most accurate means to determine standard costs, the cost of the activity analysis itself can be prohibitively high. If a firm cannot justify the high cost of activity analysis, it can use historical data instead. Data on costs Involved In the manufacture of a similar product In prior periods can be used to determine the standard cost of an operation, if accurate data is available. Analysis of historical data is much less expensive than activity analysis for determining standard costs. However, a standard cost based on the past may perpetuate past inefficiencies. Furthermore, a standard based on the past does not incorporate continuous improvements, which are an important standard in the competitive environment in which businesses operate today. Target Costing Target costing is used when a firm has a set selling price at which it desires to sell its product in order to be competitive. The target cost is the cost that yields the required profit margin for the product, given a set selling price. Standards are then determined so that the product can be manufactured at the target cost. 19 Planning and Budgeting Concepts CMA Part 1 Strategic Decisions Strategic decisions can also affect a products standard cost. If management has made a strategic decision to pursue kaizen, the Japanese term for continuous improvement, this will impact the standard because the standard will be set at the most challenging level at all times. Other strategic decisions that can affect a products standard cost include things like a management decision to replace an obsolete piece of equipment with a new machine will require that standards and standard costs be updated. Benchmarking Input into the standard-setting process may come from benchmarks, or industry information about current practices of other firms. These other firms need not be in the same industry or country. If they have similar operations, they can offer good guidelines even if they are from a different industry or country. Benchmarking data can also come from associations of manufacturers that collect information from their members. In benchmarking, the best performance anywhere can be chosen as the attainable standard. Using the best performing company as a standard can help a firm maintain its competitive edge. However, the benchmark must be evaluated in light of the companys own unique situation. The Standard-Setting Process The standard costs developed for use in the accounting system can, and indeed should, also be used in developing the production budget. A company can use either an authoritative or a participative procedure in setting the standard costs that will be used in the standard cost system and in the flexible budget. • When following an authoritative standard-setting process, management sets the standards and they are handed down to those charged with their execution. Advantages of an authoritative stan dard-setting process include: proper consideration of all the factors that will affect the costs; managements expectations will be reflected in the resulting standard costs; and the standard setting process can be handled more expeditiously than when more individuals are involved. The dis advantage of authoritative standard-setting is that the affected employees will not see them as their own and will be less likely to accept them, which in turn will reduce their motivation to achieve the standards. • A participative standard-setting process involves all the employees who will be affected by the standard. When employees participate in setting the standards, they are more likely to accept them and not see them as unreasonable. The disadvantage to setting standards in a participative manner is that the resulting standards may not support achievement of the firms strategic goals or operating objectives. Even when an authoritative standard-setting process is followed, production employees and supervisors must be Involved In some aspects of the process. These people are close to the production process, and their input is important if management expects to do a good job of setting the standards. The actual standard-setting is accomplished through the efforts of management, product design engineers, industrial engineers, manage ment accountants, production supervisors, purchasing, personnel, and employees affected by the standards. Establishing Direct Materials Standards Three considerations go into establishing a standard cost for direct materials: • Quality, • Quantity, and • Price. Specifying the quality is the first step, because the quality of the direct materials will affect all phases of production, such as the quantity of the materials that will be required, the time required for processing, and 20 Section A Planning and Budgeting Concepts the amount of supervision that will be needed during the production process. The marketing department, engineering department, production department and management accountants all need to be involved in making the determination of the quality in order to assess the trade-offs that will be involved as well as determine the optimum quality that will produce the lowest overall cost. After the quality has been specified, the standard for the quantity of direct materials needed to manufacture the product is set. The quantity standard is based upon the product design, the cost drivers of the manufacturing activities, the quality of the direct materials, and the condition of the plant and equipment that will be used to manufacture the product. The industrial engineering department, the production department and the management accountants work together to develop the quantity standard. The price standard is developed after the quality and quantity standards, because the quality and quantity standards are considerations in setting the price standard. Timing of the purchases is a consideration, as well. A vendors record of reliability for delivering the product on time is often more important than finding the lowest price, because the result of shopping only for price may be missed deliveries. Establishing Direct Labor Standards The standard for direct labor depends on the type of work, the nature of the manufacturing process, the type of equipment that will be used, and the required skill level of the employee. The quantity standard for direct labor is determined by the industrial engineers, the production department, the labor union, the personnel department, and the management accountants, using the factors listed above. The price standard for direct labor, or the standard wage rate, is provided by the personnel department and is a function of the competitive labor market and any labor contracts that may exist. The standard wage rate varies according to the type of employees needed and the skill level required. The cost standard for labor, whether direct or indirect, includes not only the hourly wage or salary paid, but also the employee benefits provided and the payroll taxes that must be paid. Employee benefits may include medical insurance, life insurance, pension plan contributions, and paid vacation. Payroll taxes include unemployment taxes and the employer portion of Social Security and Medicare taxes. Workers compensation insurance is a requirement, as well. Estimates of these other costs should be made and included in the direct labor standard cost. Establishing Overhead Standards Overhead standards are generally based on normal operating conditions, normal volume, and desired efficiency. The total overhead costs come from the budgeted factory overhead costs. These are divided by a predetermined level of activity to calculate a standard overhead rate. Determining the Level of Activity In relation to the allocation rate, the company must decide what activity to use for its budgeted amount of the activity level. The traditional method uses either machine hours or direct labor hours to allocate overhead. The company must decide how much output it will produce during the coming year. And, as a function of output, how many machine hours, or how many direct labor hours, it plans to use during the year. As this is one of the two figures used in the determination of the manufacturing overhead rate, it will greatly impact the allocation rate. The allocation rate is established for the full year. The budgeted overhead rate for the year multiplied by each months budgeted activity level will be used to calculate the monthly budgeted overhead (see example following this explanation). In general, a company has four choices to determine the output level. Two relate to what the plant can supply; and two relate to the demand for the plants output. These are called denominator-level capacity concepts, because they describe the denominators that can be used in the calculation of per unit overhead costs.
Posted on: Sat, 19 Oct 2013 11:09:02 +0000
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