Chapter 14 - Motivation, budgets and responsibility accounting

Question 1

How do we define budget?

Answer 1

Budget - a quantitative expression of a proposed plan of action by management for a future time period and is an aid to the coordination and implementation of the plan. It can cover both financial and non-financial aspects of these plans and acts as a blue-print for the company to follow in the forthcoming period

Budgets covering financial aspects quantify management’s expectations regarding future income, cash flows and financial position.

For example, a budgeted income statement, a budgeted cash-flow statement and a budgeted balance sheet.

Underlying these financial budgets can be non-financial budgets for, say, units manufactured, number of new products introduced to the market, or head count.

Question 2

What is a master budget?

Answer 2

Master budget - coordinates all the financial projections in the organisation’s individual budgets in a single organisation-wide set of budgets for a given time period. i.e. it summarises the financial projections of all the organisation’s budgets and plans.

It expresses management’s comprehensive operating and financial plans – the formalised outline of the organisation’s financial objectives and their means of attainment.

Usually covers 1 fiscal year

Question 3

Current thinking concerning budgetary control systems suggests two opposite views. What are the two viewpoints?

Answer 3

On the one hand, there is the view that espouses incremental improvement to budgetary processes in terms of linking such processes more closely to operational requirements and planning systems and increasing the frequency of budget revisions and the deployment of rolling budgets.

Conversely, an alternative view advocates the abandonment of budgetary control and its replacement with alternative techniques to enable firms to become more adaptive and agile.

Question 4

What are two major roles of budgets?

Answer 4

Decision management - incorporates planning and process purpose. Budgets assemble knowledge, communicate the knowledge and sets up plans for future decisions. We want to give the managers the information they need to make the best decisions possible. Use budgets to facilitate the decision making of managers

Decision control - when we assign a budget to a manager, we also assign design rights to that manager. Budgets can be used to compare actual with planned results and measure performance.

Question 5

What is the planning purpose of budgeting?

Answer 5

The planning purpose of budgeting entails decisions about the organization’s activities during the budget period - strategic planning, resource distribution and coordination

Resource distribution - estimation of resource demands of different departments/units to fulfil their plans

Coordination - balancing of all factors of production/service and all departments/business functions

Uncover bottlenecks before they occur

Goal: all parts of the organisation follow the same plan

Question 6

What is the “process” role/function of budgeting?

Answer 6

Not tied too much to the actual budget, the process of budgeting forces the company to communicate

Relates to activities performed during the preparation of budget

Reflection - budgeting forces managers to think about matters that are important in a longer-term perspective

Communication:
Getting the firm’s objectives understood and accepted by all departments and functions
Budgeting forces sharing of information across the organization
Top-down: communication of objectives and priorities
Bottom-up: communication of opportunities, resource needs, constraints, risks etc.
Lateral: communication enhances ability to work together toward common objectives
External: communication with suppliers, customers, banks etc.

Question 7

What is the accountability role of budgets?

Answer 7

Managers are made accountable for fulfilling their budget

Monitoring - Supervisors evaluate performance in accordance with the budget
Managers account for reasons of deviations

Remember the point is not to blame the manager, we want to find the reason for the deviation - we want the opportunity to learn and react (very important)!

Motivation - Achieved through setting of goals/targets
Rewards are usually tied to reaching goals

Question 8

What are the advantages of budgeted performance measures relative to measuring performance based on past performance?

Answer 8

Budgeted performance measures can overcome two key limitations of using past performance as a basis for judging actual results. One limitation is that past results incorporate past miscues and substandard performance.

A second limitation of past performance is that the future may be expected to be very different from the past

Question 9

How difficult should a performance target be?

What are the advantages of highly achievable targets?

Answer 9

Planning purpose: target should equal expected performance (best-guess)

Motivational purpose: target should include stretch

Advantages of highly achievable targets: (1) increased manager commitment, retained motivation (even if there are difficulties), (2) higher manager achievement, (3) reduced costs of interventions by higher-level managers and (4) reduced gameplaying

Question 10

What are the problems around budgeting (gaming and tactical behaviour)?

When do the problems arise?

Answer 10

Gaming and tactical behaviour - dysfunctional behaviour to achieve individual (or departmental) rather than corporate goals

Problem of gaming the system arises when budgets are used to (1) evaluate managers’ performance and (2) compensate (or promote) them based on performance relative to budget target

Gaming occurs during budget process (1) and in the actions taken in budget period (2)
(1) Negotiating easier targets and/or excessive resources (slack)
(2) Increased spending at the end of the year (if the manager has spent too little, he or she might be afraid of getting a smaller budget for the next year)
Deferring needed spending, accelerate sales near the end of the year
Taking a “big bath” when budgets cannot be achieved
(might have an incentive to spend everything this year so next year’s budget is easier to achieve)

Question 11

How can the problems around budgeting be mitigated?

Answer 11

Budgets only serve the organization’s financial planning needs

Use performance evaluations based on relative performance contracts with hindsight

Rewards are based on subjective performance evaluations with emphasis on group performance

Performance evaluation using various non-financial measures

Radical decentralization of the organization

Question 12

What timeline should the budget cover and what is a rolling budget?

Answer 12

The purpose(s) for budgeting should guide the time period chosen for the budget

Most frequently used - a year
Some businesses use rolling budgets. A rolling budget is a budget or plan that is always available for a specified future period by adding a month, quarter or year in the future as the month, quarter or year just ended is dropped.

There is always a 12-month budget in place. Rolling budgets constantly force management to think concretely about the forthcoming 12 months, regardless of the month at hand.

Question 13

2 Describe the major components of the master budget

Answer 13

Operating budget - the budgeted profit statement and its supporting budget schedules.

The supporting budget schedules cut across different categories of the value chain from R&D to customer service.

The financial budget is that part of the master budget that comprises the capital investment budget, cash budget, budgeted balance sheet, and budgeted statement of cash flows. It focuses on the impact of operations and planned capital outlays on cash.

The final master budget is often the result of several iterations. Each of its drafts involves interaction across the various business functions of the value chain.

The budgeted financial statements of many companies include the budgeted profit statement, the budgeted balance sheet, and the budgeted statement of cash flows.

Question 14

3 What are the steps to prepare the budgeted profit statement and its supporting budget schedules ?

Answer 14

Step 1: Revenue budget
Step 2: Production budget
Step 3: (a) Direct materials usage budget (remember fifo or weighted average)
(b) Direct materials purchases budget (a calculation of how much cash we need to buy the materials we are using)
Step 4: Direct manufacturing labour budget
Step 5: Manufacturing overhead budget
Step 6: (a) Unit costs of finished goods
(b) Closing stock budget
Step 7: Cost of goods sold budget (COGS = opening finished goods stock + cost of goods manufactured - closing finished goods stock)

Question 15

4 Describe the uses of computer based financial planning models

Answer 15

Mathematical representations of relationships across operating and financial activities and financial statements

The value of budgets to managers in their strategic analysis and planning is enhanced by conducting sensitivity analysis

Commercial software packages are now available for more complex tasks, such as sensitivity analysis for the financial statements found in a master budget. These packages do the calculations for financial planning models, which are mathematical representations of the relationships across operating activities, financial activities and financial statements.

Managers can use this information to plan actions that they may need to take if faced with these scenarios.

Question 16

5 Explain kaizen budgeting and its importance for cost management

Answer 16

Kaizen budgeting is a budgetary approach that explicitly incorporates continuous improvement during the budget period into the resultant budget numbers.

Kaizen budgeting captures the continuous improvement notion that is a key management concern. Costs in kaizen budgeting are based on future improvements that are yet to be implemented rather than on current practices or methods.

Important in practice as it is an easy way to try to incorporate continuous improvement.

Disadvantage - looks at continuous improvement, not incorporation of big innovations (the focus is on smaller steps, not on innovation)

Disadvantage - not always a real plan behind the number (i.e. just decrease a number by a certain percentage, not really knowing why)

Disadvantage - can create stress

Question 17

What is activity-based budgeting?

Answer 17

Focuses on budgeted cost of activities necessary to produce and sell products and services the cost of activities necessary to produce and sell products and services

It separates indirect costs into separate homogeneous activity cost pools

Management uses the cause-and-effect criterion to identify the cost drivers for each of these indirect cost pools

Question 18

6 Illustrate an activity-based budgeting approach

Answer 18

Four key steps are:
1 Determine the budgeted costs of performing each unit of activity at each activity area.

2 Determine the demand for each individual activity based on budgeted, production, new product development and so on.

3 Calculate the costs of performing each activity.

4 Describe the budget as costs of performing various activities (rather than budgeted costs of functional or conventional value-chain spending categories).

Question 19

What are the benefits of activity-based budgeting?

Answer 19

Benefits of activity based budgeting: (1) ability to set more realistic budgets, (2) better identification of resource needs, (3) linking of costs to outputs, (4) clearer linking of costs with staff responsibilities, and (5) identification of budgetary slack.

Question 20

What is responsibility accounting?

Answer 20

Responsibility accounting is a system that measures the plans (by budgets) and actions (by actual results) of each responsibility centre.

The responsibility accounting approach traces costs to either (1) the individual who has the best knowledge about why the costs arose, or (2) the activity that caused the costs.

Responsibility accounting affects behaviour

Question 21

What is a responsibility centre?

Answer 21

A responsibility centre is a part, segment or subunit of an organisation whose manager is accountable for a specified set of activities. The higher the manager’s level, the broader the responsibility centre he or she manages and, generally, the larger the number of subordinates who report to him or her.

Question 22

What is the relationship between organisational structure and responsibility?

Answer 22

Organisational structure is an arrangement of lines of responsibility within the entity.

To attain the goals described in the master budget, an organisation must coordinate the efforts of all its employees

This means assigning responsibility to managers who are accountable for their actions in planning and controlling human and physical resources.

Budgets exist not for their own sake, but to help managers achieve their own pursuits and thereby contribute to meeting those of the organisation.

Each manager, regardless of level, is in charge of a responsibility centre.

Question 23

The company sets goals for the reponsibility centre and these should be (name three requirements)?

Answer 23

The company sets goals for the responsibility centre and these should be:

specific and measurable (thereby creating focus)

in the (long-term) interest of the organization

Increase coordination between business units (responsibility centres)

Question 24

What are four major types of responsibility centre, and what do they focus on?

Answer 24

Four major types of responsibility centre are:

1 Cost centre – manager accountable for costs only. Focus heavily on productivity goals e.g. output/time unit, number of produced units/employees, number of outputs per machine hour.

2 Revenue centre – manager accountable for revenues only, focus on volume and revenue growth.

3 Profit centre – manager accountable for revenues and costs (and profits or loss). Focus on operating or contribution margin, capacity usage.

4 Investment centre – manager accountable for investments, revenues and costs (and profits or loss). Manager is also responsible for expanding and maintaining the company’s competitiveness, which gives the manager responsibility for investing. Measuring tools: ROI or residual income

Question 25

Which problems can occur within each of the responsibility centre?

Answer 25

1 Cost centre – The cost/productivity focus may conflict with other management tasks.

2 Revenue centre –Too much focus on volume and revenue growth can cause problems if associated costs and usage of resources are not taken into account.

3 Profit centre – Coordination problems may arise if products have a sales or a production interdependency (e.g., using same scarce production resources). Profit centres can try to maximize own profits without looking at the company as a whole.

4 Investment centre – Similar problems as in profit centres

Question 26

What is controllability and what is the controllability principle?

Answer 26

Controllability - the degree of influence that a specific manager has over costs, revenues or other items in question

Controllability principle:

Managers should only be held accountable for those items which are under the control of the manager and can be influenced by him or her

Question 27

What is controllable cost?

Answer 27

Controllable cost - any cost that is primarily subject to influence of a given manager of a given responsibility centre for a given time span

Question 28

8 Explain how controllability relates to responsibility accounting

Answer 28

A responsibility accounting system could either exclude all uncontrollable costs from a manager’s performance report or segregate such costs from the controllable costs.
In practice, controllability is difficult to pinpoint as (1) few costs are clearly under the sole influence of one manager and (2) with a long enough time span, all costs will come under somebody’s control.
Managers should avoid overemphasising controllability. Responsibility accounting is more far-reaching. It focuses on information and knowledge, not control.
The key question is: Who is the person who can tell us the most about the specific item in question, regardless of that person’s ability to exert personal control?

Question 29

Performance reports for responsibility centres may also include uncontrollable items because this approach could change behaviour in the directions top management desires. For example, some companies have changed the accountability of a cost centre to a profit centre. Why?

Answer 29

Because the manager will probably behave differently. A cost-centre manager may emphasise production efficiency and de-emphasise the pleas of sales personnel for faster service and rush orders. In a profit centre, the manager is responsible for both costs and revenues.

Question 30

How can feedback and variance be useful to managers (name four ways variance can be helpful)?

Answer 30

Budgets coupled with responsibility accounting provide systematic help for managers, particularly if managers interpret the feedback carefully.

Nevertheless, variances, properly used, can be helpful in four ways:
1 Early warning. Variances alert managers early to events not easily or immediately evident.
2 Performance valuation.
3 Evaluating strategy.
4 Communicating the goals of the organisation. The budget-making exercise and budgeting information are useful in conveying to managers across the organisation the goals of subunits and the wider corporate goals.

Question 31

What are two key questions managers should investigate variances to answer?

Answer 31

What caused the variance?

What should/could be done to correct the variance?

Question 32

What is a cash budget?

Answer 32

A cash budget shows the expected cash inflows and outflows of the bank account (receipts and disbursements).
Therefore, it shows in which months there will be a cash deficit and in which months there will be a cash surplus.

Question 33

What are operating and what are financing decisions?

Answer 33

Operating decisions are about the acquisition and use of scarce resources.

Financing decisions centre on how to obtain the funds to acquire resources.

Question 34

What is the relationship between budgets and strategy?

Answer 34

Budgeting is most useful when done as an integral part of an organisation’s strategic analysis.

Strategy can be viewed as describing how an organisation matches its own capabilities with the opportunities in the marketplace to accomplish its overall objectives.

Budgets provide feedback about effects of strategic plans