concepts and techniques of responsibility budgeting, developing responsibility budgets and budgeting...

Concepts and Techniques of Responsibility Budgeting, Developing Responsibility Budgets and Budgeting With MBO System

Team Members Roll No Nishit Shetty 279

Kamlesh Damania 212 Chetan Bhagwat 205

Melwyn Gonzalves 225 Viral Desai 215 Bhavesh Joshi 231

Amol Naik 246

Sr.no Particulars Pg# Roll No

1 Concept and Technique of Responsibility Budgeting 3-5 205

Governance arrangement, Administrative process, Contractual Relationship

2 Types of Responsibility Centres 6-7 231

Strategic management perspective on Responsibility Budgeting and accounting

3 Diagnostic versus Interactive Control 8-10 215

The other Axis of Responsibility Centre Design

4 Transfer pricing & Developing responsibility budgets 11-16 279

Advantages & disadvantages

5 Operating budget types: Sales Budget, Production budget 17-19 246

6Factory overhead budget, Alternative calculation for Budgeted factory

overhead cost, Ending inventory budget, Cost of goods sold budget,Selling & Administrative expense budget, Budgeted income statement

20-25 225

7 Financial Budget 26-32 212

Budgeting with MBO system

Concept and Technique of Responsibility Budgeting

The gist of 20th century thinking management control is expressed by the mantra: let the managers manage; make the managers manage. Responsibility budgeting is to empower managers to manage and, at the same time, motivate them to use their collective intelligence to create value through exchange in product and financial markets and by establishing and sustaining mutually beneficial relationships with customers, suppliers, and especially other members of their organizations.

In this article explain the nature of responsibility budgeting, its intellectual justification, its antecedents, and its present and future use. This is not a straightforward task. We cannot simply explain how responsibility budgeting is used and how it works. Responsibility budgeting makes sense only as a part of a framework of structural, procedural, and monitoring/reporting relationships. We must, therefore, also explain the framework that gives it utility and power. At the same time, responsibilities budgeting and accounting, or their functional equivalents, make an essential contribution to the efficacy of this broader framework of relationships. One cannot arbitrarily mix and match administrative relationships and expect that the outcome will be productive. The efficacy of administrative relationships depends upon their congruity with each other as well as with the purposes and products of the entity in question and the productive and information processing technologies available to it.

Responsibility budgeting is now the most common remote control system used by large-scale organizations in the private sector. Within the accounting literature, agency theorists (e.g., Zimmerman 1995) tend to interpret responsibility budgeting as a practice for structuring the contractual relationship between providers of economic resources (principals) and those who apply those resources in economic activity (agents). The broad outline of this relationship is one where substantial decisional authority is decentralized to agents, within the context of well-specified rules determining how agents will be rewarded for their efforts. Rewards are to be based on economic quantities of interest to principals, such as returns on capital employed. According to this perspective, the management process mainly involves acquiring and deploying assets and, to influence this process, principals must establish a consistent set of delegated decisions (grants of authority to acquire assets), performance measures (resulting from the use of assets by agents), and rewards (incentives for the agent to acquire and utilize assets in the principal's interests).

Prepared By: Chetan Bhagwath

In responsibility budget formulation, an organization's policies, the results of all past policy (capital budgeting) decisions, are converted into financial targets that correspond to the domains of administrative units and their managers. In responsibility budget execution, operating performance is monitored and subordinate managers are evaluated and rewarded. Operating performance targets must be expressed in financial terms. This makes it possible to make comparisons across unlike responsibility centers, thereby permitting the relative performance of managers to be evaluated and increasing the motivational efficacy of internal competition. In traditional responsibility budgets this also has the effect of keeping higher levels of administration ignorant of operating details, thereby discouraging them from meddling in the affairs of their responsibility center managers.

Governance Arrangements, Administrative Processes, Contractual Relationships

All governance arrangements and administrative processes are primarily mechanisms for motivating and inspiring people to serve the policies and purposes of the organizations to which they belong. This means that all governance arrangements and all administrative processes can be treated as relationships and that administrative design and implementation can be thought of as negotiating and maintaining those relationships.

One way of describing relationships uses contractual language and talks about principals and agents. This language implies a hierarchical relationship, in which a nominal subordinate (agent) serves the purposes of a superior (principal). On the presumption that behavior is largely self-interested, principal-agent relationships are problematic (give rise to agency costs) only where (a) the efforts of the agent cannot be perfectly observed; (b) the interests of agent and principal diverge; and (c) agents pursue their own interests, i.e., behave opportunistically.

One of the key goals of governance arrangements and administrative processes is the minimization of agency costs. Of course, agency costs also include all resources used to reduce divergences of interest, i.e., identifying collectively beneficial relationships, negotiating contributions, and devising procedures for monitoring performance and sanctioning defectors. Included here are a whole panoply of activities extending from the employment of security guards to the design and implementation of new or reconfigured accounting and reporting systems. Hence, minimizing agency costs means minimizing the sum of costs that result from opportunistic behavior plus the costs of avoiding or controlling that behavior. Economic theory tells us that we find this optimum where the marginal costs of controls equal their marginal benefits, as shown in Figure 1.1


Traditional or Weberian bureaucracies rely on rules to govern or prevent opportunistic behavior. In other words, principals specify in detail what agents must do (or must not do), carefully monitor their actions, and sanction all deviations accordingly. The problem with this approach is that agents often have better information about some things than do principals. Principals hire agents because of their superior expertise and to spare themselves the burden of being perfectly informed about every aspect of an organization's operations. In neither case will principals have the knowledge needed to specify in detail what the agent should do without thereby sacrificing performance. This means that rules are not always a wholly satisfactory solution to the principal-agent problem. It is this fact that makes the application of agency theory to the public sector especially important, for it is in the public sector that the opportunity costs arising from detailed rules often seem highest.


Types of Responsibility Centers

The agency theory view lends itself to a description of responsibility centers in terms of the authority of managers to acquire assets and the kinds of financial targets that would align responsibility with authority:

Discretionary expense center managers are accountable for compliance with an asset acquisition plan (expense budget). They have no independent authority to acquire assets. Their superiors must authorize each acquisition. Managerial accountants generally believe that a unit should be set up as a discretionary expense center only where there is no satisfactory way to match its expenses to final cost objects. Most governmental organizations are discretionary cost centers.

Cost center managers are responsible for producing a stated quantity and/or quality of output at the lowest feasible cost. Someone else within the organization determines the output of a cost center &emdash; usually including various quality attributes, especially delivery schedules. Cost center managers are free to acquire short-term assets (those that are wholly consumed within a performance measurement cycle), to hire temporary or contract personnel, and to manage inventories.

1. In a standard cost center, output levels are determined by requests from other responsibility centers and the manager's budget for each performance measurement cycle is determined by multiplying actual output by standard cost per unit. Performance is measured against this figure &emdash; the difference between actual costs and the standard.

2. In a quasi-profit center, performance is measured by the difference between the notational revenue earned by the center and its costs. For example, let's say an air logistics center rebuilt 500 F-16 jet engines and 200 F-15 engines for the Air Combat Command. The notational revenue earned was $2.5 million per F-16 (500) = $1.25 billion and $5 million per F-15 (200) = $1 billion, or $2.25 billion total. If the logistics center's operating costs (including non cash expenses such as depreciation of plant and equipment and imputed rents) were $1.8 billion, it would earn a quasi-profit of $425 million ($2.25 billion - $1.8 billion). These notational revenues (or transfer prices) usually reflect historical costs or market prices.

Profit center managers are responsible for both revenues and costs. Profit is the difference between revenue and cost. Thus, profit center managers are evaluated in terms of both the revenues their centers earn and the costs they incur.

In addition to the authority to acquire short term assets, to hire temporary or contract personnel, and to manage inventories, profit center managers are usually given the authority to make long term hires, set salary and promotion schedules (subject to organization wide standards), organize their units, and acquire long lived assets costing less than some

Prepared By: Bhavesh Joshi

specified amount. Note, however, real revenue can be earned only on sales outside the organization -- AFMC's sales of services to foreign governments and private firms earns revenue, for example; services performed for other elements of the Air Force would merely earn notational revenues or transfer prices.

Investment center managers are responsible for both profit and the assets used in generating profit. Thus, an investment center adds more to a manager's scope of responsibility than does a profit center, just as a profit center involves more than a cost center. Investment center managers are typically evaluated in terms of return on assets (ROA), which is the ratio of profit to assets employed, where the former is expressed as a percentage of the latter. In recent years many have turned to economic value added (EVA), net operating "profit" less an appropriate capital charge, which is a dollar amount rather than a ratio. If, for example, the logistics center described earlier had assets of $7.5 billion ($5 billion in fixed assets and $2.5 in current assets, primarily work-in-progress and parts inventories) and the federal government's cost of capital were 5 percent, its quasi-EVA would have been $50 million ($425 million - $375 million); its ROA would have been 5.7 percent.

A Strategic Management Perspective on Responsibility Budgeting and Accounting

The practice has also been described in terms of organizational design and strategic management. In these terms, responsibility budgeting and accounting takes place within an organizational configuration known as an M-form, where decisional authority over strategy formulation is reserved to top management, while decisional authority over strategy implementation is decentralized to business units headed by general managers (Mintzberg 1983).

From the management strategy perspective, a responsibility budget is merely an artifact of the management process conducted within such a structural set up. Specifically, the responsibility budget formalizes a performance target for a given business unit over a specified time scale. In the typical case, goals are expressed in terms of economic quantities that reflect the utilization of resources and the financial results obtained as well as other scorecard measures. Responsibility accounting systems are set up to produce these measures so that divisional performance can be compared with targets in a timely manner and, where necessary, adjusted. Because business strategies are usually conceived along product-market lines (single product, differentiated products, multiple products) and because the M-form structures provide a general manager for each product line (rather than for regions or functions), in the management control and strategic management literatures, responsibility budgeting and accounting is broadly endorsed as the mode of organizing and managing large, multiproduct firms whose outputs are by definition heterogeneous.

Prepared By: Bhavesh Joshi

Diagnostic versus Interactive Control

Under traditional responsibility budgeting and accounting systems, top management exercises control "by the numbers" from a small corporate headquarters, using financial targets, which it sets for the operating divisions. Robert Simons (1995: 102) refers to this kind of control as diagnostic control. Diagnostic control severely restricts the upward flow of operating information within organizations &emdash; making decentralization a necessity as well as an ideal.

This approach, however, is based on the assumption managers know how to improve performance. Hence, as Bob Behn observes," all that is required is to give them either (a) the correct incentives or (b) the necessary flexibility, and they will do it &emdash; they will just know what managerial actions will be most effective in improving performance." Unfortunately, managers don't necessarily know what to do. Consequently, he suggests that "maybe we also need a help-the-managers-manage strategy" (Behn 2003: 2).

An alternative to diagnostic control or control by the numbers is control by debate and dialogue, what Simons calls interactive control. Control by debate and dialogue is a help-the-manager-manage strategy. It is by design a learning process, proceeding from strategic vision through choices and their consequences to better understanding, clearer vision, improved choices, and higher valued consequences. Simons observes that both diagnostic control and interactive control are consistent with the practice of decentralization. However, decentralization is possible under diagnostic control only where top management attends to top management functions and refrains from meddling in the conduct of operations. This takes considerable self-restraint. Nevertheless, Simon argues that the best-managed, decentralized organizations are precisely those where less emphasis is given to meeting financial targets per se than to the effectiveness with which operating managers engage in reflective argumentative exchange and where target setting is a bottom-up process. To meet the burden of argument in this context, operating managers must persuade their superiors that they fully understand every aspect of their businesses &emdash; costs, trends, operating efficiency, marketing strategy, competitive position &emdash; and that their action plans and programs will realize the larger organizational purpose or interest.

The other Axis of Responsibility Center Design

Responsibility centers are usually classified according to a second axis or dimension:

The integration axis -- i.e., the relationship between the responsibility center's objectives and the overall purposes and policies of the organization;

Prepared By: Viral Desai

On this axis, a responsibility center can be either a mission center or a support center. The output of a mission center contributes directly to an organization's objectives or purpose. The output of a support center is an input to another responsibility center in the organization, either another support center or a mission center.

Formerly, in most large complex organizations in the private sector, individual production units were typically standard cost centers; staff units were typically discretionary expense centers. Indeed, only mission centers were allowed to be investment centers. The reasons for this are complex, but they go to difficulties associated with expensing intermediate and joint products. Mission centers in private sector organizations produce final products that are easily priced and that are expensed following generally accepted accounting practice. In contrast, support centers produce intermediate products and these were, until recently, hard to cost, let alone price, with accuracy. Attempts to do so were often either excessively arbitrary or prohibitively costly.

Nowadays, however, advances in information technology, managerial accounting, and organizational design have made it possible and, in some cases, beneficial to treat every responsibility center in an organization as an investment center.

Paradoxically, public sector organizations are a mirror image of large complex organizations in the private sector. We know now how to treat support centers in most organization as quasi-profit or even investment centers. But, because the final products of government's core mission centers are public goods that are passively enjoyed, pricing final outputs remains for the time being and for the foreseeable future either excessively arbitrary or prohibitively costly. This means, for example, that, while it might make sense to treat services with direct commercial counterparts such as military depot maintenance, spare parts management, or facilities support centers as investment centers, it will continue to be necessary to treat the armed forces' combatant commands as discretionary expense centers.


Fortunately, as far as exhaustive expenditures are concerned, about 75 percent of the activities performed by the US federal government fall into the support category and, for the most part, state and local governments are not in the business of supplying pure public goods.


Transfer Pricing

Under responsibility budgeting, support centers provide services or intermediate goods to other responsibility centers in return for a notational transfer price, organizations are structured to take advantage of specialized knowledge and local conditions, center managers make decisions and are held responsible for the overall financial performance of their centers. Sound transfer pricing is, therefore, the key to aligning the incentives of responsibility center managers with organizational interests.

Transfer pricing is also important to transparency within organizations. It helps to determine the costs of services provided by one unit to another, which is central to measuring performance relative to a financial target, and therefore plays a major role in establishing, as well as manipulating, the incentives facing responsibility center managers. Transfer pricing also reveals the internal costs of service decentralization where costs are incurred in transferring decision rights to others within an organization. When one sub-unit transfers tangible assets, knowledge, skills, etc., to another, both units calculate the cost as a means of revealing their liquid and tangible asset use internally and in external provision of service.

There are two common approaches to transfer pricing:

Laissez-faire transfer pricing: buying and selling responsibility centers are completely free to negotiate prices, to deal, or not to deal; and

Marginal or incremental cost pricing: the responsibility center selling the service is required to charge the buying responsibility center whichever is less of market or incremental cost.

(A third method is based upon fully distributed average cost of the service or product.)

However, the circumstances that justify large complex organizations -- economies of scale and scope -- render these simple transfer-pricing mechanisms problematic. Scale economies are usually the result of large, lumpy investments in specialized resources -- technological knowledge, product specific research and development, or equipment. These investments tend to give rise to bilateral monopoly, a circumstance that provides an ideal environment for opportunistic behavior on the part of suppliers and customers. For example, once an intermediate product producer has acquired a specialized asset, customers may be able to extract discounts by threatening to switch suppliers. In that case, the supplier may find it necessary to write off a large part of the specialized investment. Or, if demand for the final good increases greatly, the intermediate product supplier may be able to extort exorbitant prices from customers. Hence, where the relationship between intermediate product supplier and customer is at arm's length, opportunistic behavior may eliminate the payoff to what would otherwise be cost effective investments.

Prepared By: Nishit Shetty

For example, the Report of the Commission on Roles and Missions of the Armed Forces (Commission, 1995; see also Thompson & Jones, 1994) suggested that budget authority should flow through the combatant commands to the military departments. Were that the case, lacking a long-term credible commitment on the part of the Joint Chiefs and the combatant commanders, the navy's investment in specialized assets like aircraft carriers would permit it to be exploited in peacetime. In wartime, of course, the tables would be turned.

The new economics of organizations tells us that vertical integration occurs because it can mitigate this problem, in part through the substitution of direct supervision for remote control (see Williamson, 1985). For example, in a study of military procurement, Scott Masten (1984) demonstrated that specialized investments are critical to vertical integration. Where intermediate products were both complex and highly specialized (used only by the buyer), there was a 92 percent probability that they would be produced internally; even 31 percent of all simple, specialized components were produced internally. The probability dropped to less than 2 percent if the component was unspecialized, regardless of its complexity.

Unfortunately, the problems that arise in arm's length transactions where there are few alternative suppliers/customers also arise where one attempts to replicate free market forces within the organization, allowing buying and selling responsibility centers complete freedom to negotiate prices (laissez-faire transfer pricing). Traditionally, economists have argued that services should be transferred at marginal or incremental cost to the buying responsibility center. But this can seriously distort the evaluation of support center performance and tend to eliminate incentives to improvement.

As a result, organizations face a serious dilemma. They can maximize short run performance by using marginal cost in internal transactions, thereby seriously distorting performance measurement and incentives, which will cause shortfalls in long-run performance. Or they can sacrifice short-term performance by relying on laissez-faire transfer pricing, thereby obtaining superior measures of the support center's contributions to organizational performance, and improve the chances of maximizing performance in the long term. Organizations can, promote short-run performance by using incremental cost pricing or they can promote long-term performance by using laissez-faire pricing, but they cannot do both simultaneously using either of these simple transfer pricing mechanisms.

In theory, bilateral monopoly can be governed quite satisfactorily by unbalanced transfer prices, multi-part transfer prices, or quasi-vertical integration. Under unbalanced transfer prices, the selling responsibility center is credited with the full cost of the transacted item (often standard cost), plus an agreed upon markup, the buying center is charged its marginal cost, and the organization’s accounts are adjusted to reflect the difference between the two.


Unbalanced transfer prices are rarely used, however, where market prices are available. Under, multi-part transfer prices, the service delivered is decomposed to reflect underlying cost drivers and priced accordingly (your home phone bill is an excellent example of a multi-part tariff). Under quasi-vertical integration, the buyer invests in specialized resources and loans, leases, or rents them to their suppliers. Quasi-vertical integration is common in both the automobile and the aerospace industries, and, of course, it is standard procedure for the Department of Defense to provide and own the equipment, dies, and designs that defense firms use to supply it with weapons systems and the like (See Monteverde & Teece, 1982). Other organizations that rely on a small number of suppliers or a small number of distributors write contracts that constrain the opportunistic behavior of those with whom they deal.

In still other cases, desired outcomes can be realized through alliances based on the exchange of hostages (e.g., surety bonds, exchange of debt or equity positions) or just plain old-fashioned trust based on long-term mutual dependence. Toyota, for example, relies on a few suppliers that it nurtures and supports (Womack, Jones, Roos, 1990). They have substantial cross-holdings in each other and Toyota often acts as its suppliers' banker. Toyota maintains tight working links between its manufacturing and engineering departments and its suppliers, intimately involving them in all aspects of product design and manufacture. Indeed, it often lends them personnel to deal with production surges and its suppliers accept Toyota people into their personnel systems.

Toyota's suppliers are not completely independent companies with only a marketplace relationship to each other. In a very real sense, they all share a common purpose and destiny. Yet Toyota has not integrated its suppliers into a single, large bureaucracy. It wanted its suppliers to remain independent companies with completely separate books -- real profit/investment centers, rather than merely notational ones -- selling to others whenever possible. Toyota's solution to the bilateral monopoly problem appears to work just fine. In fact, with the exception of unbalanced transfer prices, none of the solutions to the bilateral monopoly problem noted here presumes vertical integration. All that is required is full access to cost and production information. Of course, all of these solutions to the transfer pricing/organizational design are potentially available to government organizations. Indeed, many of them were pioneered by federal acquisitions personnel or imposed by public utility commissions. They are not, however, widely understood or appreciated by public administrators and financial managers.


Developing Responsibility Budgets

Responsibility Accounting

Responsibility accounting is an underlying concept of accounting performance measurement systems. The basic idea is that large diversified organizations are difficult, if not impossible to manage as a single segment, thus they must be decentralized or separated into manageable parts. These parts, or segments are referred to as responsibility centers which include: 1) revenue centers, 2) cost centers, 3) profit centers and 4) investment centers. This functional approach allows responsibility to be assigned to the segment managers that have the greatest amount of influence over the key elements to be managed. These elements include revenue for a revenue center (a segment that mainly generates revenue with relatively little costs), costs for a cost center (a segment that generates costs, but no revenue), a measure of profitability for a profit center (a segment that generates both revenue and costs) and return on investment (ROI) for an investment center (a segment such as a division of a company where the manager controls the acquisition and utilization of assets, as well as revenue and costs).

Advantages and Disadvantages

Responsibility accounting has been an accepted part of traditional accounting control systems for many years because it provides an organization with a number of advantages. Perhaps the most compelling argument for the responsibility accounting approach is that it provides a way to manage an organization that would otherwise be unmanageable. In addition, assigning responsibility to lower level managers allows higher level managers to pursue other activities such as long term planning and policy making. It also provides a way to motivate lower level managers and workers. Managers and workers in an individualistic system tend to be motivated by measurements that emphasize their individual performances. However, this emphasis on the performance of individuals and individual segments creates what some critics refer to as the "stovepipe organization." Others have used the term "functional silos" to describe the same idea.7 Consider Exhibit 9-6. Individuals in the various segments and functional areas are separated and tend to ignore the interdependencies within the organization. Segment managers and individual workers within segments tend to compete to optimize their own performance measurements rather than working together to optimize the performance of the system.


http://maaw.info/Chapter9.htm#Footnote%207

Summary and Controversial Question

An implicit assumption of responsibility accounting is that separating a company into responsibility centers that are controlled in a top down manner is the way to optimize the system. However, this separation inevitably fails to consider many of the interdependencies within the organization. Ignoring the interdependencies prevents teamwork and creates the need for buffers such as additional inventory, workers, managers and capacity. Of course, a system that prevents teamwork and creates excess is inconsistent with the lean enterprise concepts of just-in-time and the theory of constraints. For this reason, critics of traditional accounting control systems advocate managing the system as a whole to eliminate the need for buffers and excess. They also argue that companies need to develop process oriented learning support systems, not financial results, fear oriented control systems. The information system needs to reveal the company's problems and constraints in a timely manner and at a disaggregated level so that empowered users can identify how to correct problems, remove constraints and improve the process. According to these critics, accounting control information does not qualify in any of these categories because it is not timely, disaggregated, or user friendly.


This harsh criticism of accounting control information leads us to a very important controversial question. Can a company successfully implement just-in-time and other continuous improvement concepts while retaining a traditional responsibility accounting control system? Although the jury is still out on this question, a number of field research studies indicate that accounting based controls are playing a decreasing role in companies that adopt the lean enterprise concepts. In one study involving nine companies, each company answered this controversial question in a different way by using a different mix of process oriented versus results oriented learning and control information. Since each company is different, a generalized answer to this question for all firms in all situations cannot be given in a textbook. However, a great deal more information is provided in the next chapter to help you answer this question for the companies you are likely to encounter in practice. This chapter concentrates on the planning aspects of budgeting, while the next chapter addresses the control methodology


The Operating Budget

Preparing an Operating Budget is a sequential process of developing nine sub-budgets. Except for one or two exceptions the sub-budgets must be prepared in the following order: sales, production, direct materials, direct labor, factory overhead, ending inventory, cost of goods sold, selling & administrative and income statement (see Exhibit 9-4). Each part is described below.

1. SALES BUDGET

Developing a sales budget involves the following calculations:

Budgeted Sales $ = (Budgeted Unit Sales)(Budgeted Sales Prices)

Current Period Cash Collections = Current Period Cash Sales + Current Period Credit Sales Collected in Current Period + Prior Period Credit Sales Collected in Current Period

These calculations are relatively simple, but where does the budget director obtain this information? Well, sales forecasting is a marketing function. Sales estimates are frequently generated by the company's sales representatives who discuss future needs with customers (wholesalers and retailers). Statistical forecasting techniques can also be used to make estimates of expected future sales, considering the company's previous sales performance and various assumptions about the future economic climate, and the actions of competitors and consumers. Pricing is also a marketing function, but many prices are based on costs plus a markup (the supply function) and consideration of what consumers are willing and able to pay for the product (the demand function). Thus, the budgeted sales price is usually determined after the budgeted unit cost has been calculated (see 6b. below).

The information needed to develop an equation for collections is provided by the finance department and is normally based on past experience. These calculations are somewhat more involved than they appear to be in the equation above because of the effects of cash discounts and the time lags between credit sales and collections. Cash discounts are frequently used to speed up cash inflows. This puts the funds back to work sooner and reduces the need for short term loans. However, even with a generous cash discount for prompt payment, collections for credit sales are typically spread out over several months. The examples illustrated below provide some of the possibilities.

Prepared By: Amol Naik

2. PRODUCTION BUDGET

Preparing a production budget includes consideration of the desired inventory change as follows:

Units To Be Produced = Budgeted Unit Sales (from 1) + Desired Ending Finished Goods - Beginning Finished Goods

The desired ending inventory is usually based on the next periods sales budget. Considerations involve the time required to produce the product, (i.e., cycle time or lead time) as well as setup costs and carrying costs. In a just-in-time environment the desired ending inventory is relatively small, or theoretically zero in a perfect situation. In the examples and problems in this chapter, the ending finished goods inventory is stated as a percentage of the next period's (month's) unit sales.

3. DIRECT MATERIAL BUDGET

The direct materials budget includes five separate calculations.

a. Quantity of Material Needed for Production = (Units to be Produced)(Quantity of Material Budgeted per Unit)

The quantity of material required per unit of product is determined by the industrial engineers who designed the product. Materials requirements are frequently described in an engineering document referred to asa "bill of materials".

b. Quantity of Material to be Purchased = Quantity of Material Needed for Production + Desired Ending Material - Beginning Material

This calculation is more involved than equation 3b appears to indicate because it includes information for two future periods. The desired ending materials quantity is normally based on the next period's (month's) materials needed for production and this amount depends on the third period's budgeted unit sales. Of course inventories of raw materials (just like finished goods) are kept to a minimum in a JIT environment. Factors that influence the desired inventory levels include the reliability of the company's suppliers, as well as ordering and carrying costs.

c. Budgeted Cost of Material Purchases = (Quantity of Material to be Purchased)(Budgeted Material Prices)


This amount is needed to determine cash payments. Once the quantity to be purchased has been determined, the cost of purchases is easily calculated. Budgeted material prices are provided by the purchasing department.

d. Cost of Material Used = (Quantity needed for Production)(Budgeted Material Prices)

The cost of materials used is needed in the cost of goods sold budget below.

e. Cash Payments for Direct Material Purchases = Current Period Purchases Paid in Current Period + Prior Period Purchases Paid in Current Period

The information needed to determine budgeted cash payments is provided by accounting, (accounts payable) and is usually based on past experience. Normally the budget should reflect a situation where the company pays promptly to take advantage of all cash discounts allowed, thus 3e may be equal to 3c.

4. DIRECT LABOR BUDGET

Fewer calculations are needed for direct labor than for direct materials because labor hours cannot be stored in the inventory for future use. Time can be wasted, but not postponed.

a. Direct Labor Hours Needed For Production = (Units to be Produced)(D.L. Hours Budgeted per Unit)

The amount of direct labor time needed per unit of product is determined by industrial engineers. Estimates are frequently made using a technique referred to as motion and time study. This involves measuring each movement required to perform a task and then assigning a precise amount of time allowed for these movements. The cumulative time measurements for the various tasks required to produce a product provide the estimate of a standard time per unit. There are alternative techniques that are less expensive, but motion and time study provides estimates that are very precise. Learning curves provide another quantitative technique that is helpful in establishing labor standards.

b. Budgeted Direct Labor Cost = (D.L. Hours needed for Production)(Budgeted Rates Per Hour)

The budgeted rates per hour for direct labor are provided by the human resource department. Frequently the labor (union) contract provides the source for this information. Many different types of labor may be required with different levels of expertise and experience. Thus, Equations 4a and 4b may include several calculations.


5. THE FACTORY OVERHEAD BUDGET

The factory overhead budget is based on a flexible budget calculation as described in Exhibit 9-3. More specifically, the calculation is as follows:

a. Budgeted Factory Overhead Costs = Budgeted Fixed Overhead + (Budgeted Variable Overhead Rate)(D.L. Hours needed for Production from 4a)

This is a cumulative equation that combines the equations for the company's various types of indirect resources. This same idea was illustrated in Chapter 4 when introducing predetermined overhead rates. The predetermined overhead rates developed in Chapter 4 and the budgeted overhead rates discussed in this chapter are conceptually the same.

A plant wide rate based on direct labor hours is used as the overhead allocation basis in this chapter and subsequent chapters mainly to simplify the illustrations. Keep in mind however, that although many companies are still using a single production volume based measurement for overhead allocations, most companies use departmental rates and many companies are now using activity based rates.

The calculation for cash payments reflects one of the differences between cash flows and accrual accounting. Since some costs, like depreciation, do not involve cash payments in the current period, these costs must be subtracted from the total overhead costs to determine the appropriate amount.

b. Cash Payments for Overhead = Budgeted Factory Overhead Cost - Depreciation and other costs that do not require cash payments

Alternative Calculation for Budgeted Factory Overhead Costs

Although budgeted factory overhead costs can be calculated in the manner presented above, there is an alternative approach that illustrates the difference between budgeted and standard costs. Budgeted factory overhead costs can be calculated by determining the standard factory overhead costs and then adjusting for the planned production volume variance. The planned production volume variance is similar to the capacity (or idle capacity) variance illustrated in Chapter 4. It is the difference between the denominator inputs used to calculate the overhead rates, i.e., direct labor hours in our example, and the budgeted direct labor hours needed for production, multiplied by the budgeted fixed overhead rate.

Prepared By: Melwyn Gonsalves

The alternative calculation for factory overhead costs is:

Budgeted factory overhead costs = (Total budgeted overhead rate per hour)(D.L. hours needed for production from 4a)+ Unfavorable planned production volume variance or - Favorable planned production volume variance

Multiplying the total overhead rate by the number of direct labor hours needed for production provides the standard or applied overhead costs. However, if the number of direct labor hours needed for planned production (i.e., budgeted hours) is not equal to the number of hours used to calculate the overhead rates (i.e., denominator hours), then standard fixed overhead costs will not be equal to budgeted fixed overhead costs. The difference is the planned production volume variance. This is illustrated graphically in Figure 9-1.


Since the difference is caused by the way fixed overhead costs are treated, it can be illustrated by comparing standard fixed overhead costs with budgeted fixed overhead costs. Figure 9-1 shows that if planned or budgeted hours (BH1) are less than denominator hours (DH), the planned production volume variance (PPVV) is unfavorable and represents underapplied fixed overhead. However, if planned or budgeted hours (BH2) are greater than denominator hours (DH), then the planned production volume variance (PPVV) is favorable and represents overapplied fixed overhead.

The difference between budgeted and standard total factory overhead costs can be illustrated by simply adding variable overhead costs to the graph. Since budgeted and standard variable overhead costs are always equal at any level of production, the difference between standard and budgeted total overhead costs is the same as the difference between standard and budgeted fixed overhead costs. The difference is the planned production volume variance. This is illustrated in Figure 9-2


Summary of the PPVV Concept

At any particular level of production, e.g., 1,000 hours, budgeted and standard variable overhead costs are always equal. However, budgeted and standard fixed overhead costs are only equal when the budgeted hours planned for the month are equal to the denominator hours used to calculate the overhead rates. The difference between the budgeted hours planned and the denominator hours, multiplied by the fixed overhead rate is the difference between budgeted and standard fixed overhead costs as well as the difference between budgeted and standard total overhead costs. When working with a budget this difference is referred to as the planned production volume variance.

6. ENDING INVENTORY BUDGET

The dollar amount for the ending inventory of finished goods is needed below to determine cost of goods sold. The dollar amounts for ending direct materials and finished goods are needed for the balance sheet.

a. Ending Direct Materials = (Desired Ending Materials from 3b)(Budgeted Prices)

b. Budgeted or Standard Unit Cost = (Quantity of D.M. required per Unit)(Budgeted Prices) + (D.L. Hours required per Unit)(Budgeted Rate)+ (Total Overhead Rate)(D.L. Hours required per Unit)

The budgeted or standard unit cost can be calculated at any time after the budgeted quantities per unit and input prices are obtained. The calculation is placed here because it is needed for 6c.

c. Ending Finished Goods = (Desired Ending Finished Goods from 2)(Budgeted Unit Cost)

7. COST OF GOODS SOLD BUDGET

Cost of goods sold is needed for the income statement. One method of determining budgeted COGS involves accumulating the amounts from the previous sub-budgets as follows.

a. Budgeted Total Manufacturing Cost = Cost of Direct Material Used (from 3d.) + Cost of Direct Labor Used (from 4b.)+ Total Factory Overhead Costs (from 5a.)


b. Budgeted Cost of Goods Sold = Budgeted Total Manufacturing Cost (from 7a.) + Beginning Finished Goods (from previous ending or calculate from 2 and 6b) - Ending Finished Goods (from 6c or calculate from 2 and 6b)

This is the same approach used in Chapter 2 to determine cost of goods sold, but when developing a budget we typically assume no change in Work in Process. Therefore, budgeted cost of goods manufactured is equal to budgeted cost of goods sold.

Alternative Calculation for Budgeted Cost of Goods Sold

Budgeted cost of goods sold can also be calculated by determining standard cost of goods sold, and then adjusting for the planned production volume variance. The alternative calculation for cost of goods sold is:

Budgeted Cost of Goods Sold = (Budgeted unit sales)(Budgeted unit cost)+ Unfavorable planned production volume varianceor - Favorable planned production volume variance

Although budgeted unit cost equals standard unit cost, budgeted cost of goods sold is not equal to standard cost of goods sold. Again, the difference between standard and budgeted costs is the production volume variance. There are two reasons to become familiar with this alternative. First, it helps strengthen your understanding an important concept that appears again in subsequent chapters, e.g., Chapters 10 and 12. A second reason is that the alternative approach provides a much faster way to calculate budgeted cost of goods sold. Therefore it can be used as a stand alone method, or as a way to check the accuracy of your calculations in 7a and b.

You may wonder why a company would plan a production volume variance in the budget. This occurs because the denominator activity for a particular month is normally the average monthly production based on one twelfth of the planned production for the entire year. The denominator may also be an average based on normal, practical, or theoretical maximum capacity for the year. When the planned production for a particular month is higher or lower than the monthly average, a planned production volume variance results. Actual production volume variances also occur as we shall see in the next chapter.

8. SELLING & ADMINISTRATIVE EXPENSE BUDGET

The preparation of the selling and administrative expense budgets is very similar to the approach used for factory overhead.


a. Budgeted Selling and Administrative Expenses = Budgeted Fixed Selling & Administrative Expenses + (Bud Variable Rate as a Proportion of Sales $)(Budgeted Sales $)

b. Cash Payments for Selling & Administrative Expenses = Budgeted Selling & Administrative Expenses - Depreciation and other cost which do not require cash payments

Although we will place less emphasis on this part of the master budget, (mainly to simplify the illustrations) these costs are usually significant. Also remember that many appropriation budgets (treated as fixed costs) may be included, particularly for certain administrative costs. In addition, as pointed out earlier in the text, a more precise traceable costing approach might be used for management purposes where some selling and administrative costs are allocated (i.e., traced to products) in determining a more precise product cost. Remember however, that selling and administrative costs are treated as expenses (period costs) in the conventional inventory valuation methods.

9. BUDGETED INCOME STATEMENT

Preparing the budgeted income statement involves combining the relevant amounts from the sales, cost of goods sold and selling & administrative expense budgets and then subtracting interest, bad debts and income taxes to obtain budgeted net income. These amounts are provided by the finance department. In a comprehensive practice problem, the applicable amount for interest expense may need to be calculated from information associated with the cash budget. Bad debt expense is based on the expected proportion of uncollectable stated in the information related to cash collections.

a. Budgeted Sales $ - Budgeted Cost of Goods Sold = Budgeted Gross Profit

b. Budgeted Gross Profit - Budgeted Selling & Administrative Expenses = Operating Income

c. Operating Income - Interest Expense - Bad Debts Expense = Net Income Before Taxes

d. Net Income Before Taxes - Income Taxes = Net Income After Taxes


The Financial Budget

The financial budget includes the cash budget, the capital budget and the budgeted balance sheet. The cash budget, budgeted balance sheet & Capital budget are discussed below.

CASH BUDGET:-The cash budget is prepared after the operating budgets (sales, manufacturing expenses or merchandise purchases, selling expenses, and general and administrative expenses) and the capital expenditures budget are prepared.-The cash budget starts with the beginning cash balance to which is added the cash inflows to get cash available. -Cash outflows for the period are then subtracted to calculate the cash balance before financing. If this balance is below the company's required balance, the financing section shows the borrowings needed. -The financing section also includes debt repayments, including interest payments. The cash balance before financing is adjusted by the financing activity to calculate the ending cash balance. -The ending cash balance is the cash balance in the budgeted or pro forma balance sheet.

BUDGETED BALANCE SHEET

Preparing the budgeted balance sheet involves accumulating information from the previous period’s balance sheet, the various operating sub-budgets, the cash budget and other accounting records.ASSETS

a. Current Assets:Cash (from the cash budget 10c) Accounts Receivable (from the sales budget and previous balance sheet) Direct materials (from the ending inventory budget 6a) Finished goods (from the ending inventory budget 6c)

b. Long Term Assets: Land (from previous balance sheet and budgeted activity) Buildings (from previous balance sheet and budgeted activity)

Prepared By: Kamlesh Damania

Equipment (from previous balance sheet and budgeted activity) Accumulated depreciation (from the accounting records)

LIABILITIES c. Current Liabilities: Accounts Payable (from various operating sub-budgets) Taxes Payable (from income statement) d. Long term Liabilities:Notes payableBonds payableConvertible bondCapital Lease obligation

Post retirement benefit obligationsOther accrued expenses.

SHAREHOLDERS EQUITY

e. Common Stock (from previous balance sheet and budgeted activity)

f. Retained Earnings (from previous balance sheet and income statement)

Total Shareholders’ Equity

Total Liabilities and Shareholders’ Equity.

Capital Budget: Capital budgeting is vital in marketing decisions. Decisions on investment, which take time to mature, have to be based on the returns which that investment will make. Unless the project is for social reasons only, if the investment is unprofitable in the long run, it is unwise to invest in it now.

The classification of investment projects

a) By project size

Small projects may be approved by departmental managers. More careful analysis and Board of Directors' approval is needed for large projects of, say, half a million dollars or more.


b) By type of benefit to the firm

an increase in cash flow

a decrease in risk

an indirect benefit (showers for workers, etc).

c) By degree of dependence

mutually exclusive projects (can execute project A or B, but not both)

complementary projects: taking project A increases the cash flow of project B.

substitute projects: taking project A decreases the cash flow of project B.

d) By degree of statistical dependence

Positive dependence

Negative dependence

Statistical independence.


Budgeting with MBO System

Management by objectives (MBO) is a process of defining objectives within an organization so that management and employees agree to the objectives and understand what they need to do in the organization in order to achieve them. The term "management by objectives" was first popularized by Peter Drucker in his book The Practice of Management in 1954.

The essence of MBO is participative goal setting, choosing course of actions and decision making. An important part of the MBO is the measurement and the comparison of the employee’s actual performance with the standards set. Ideally, when employees themselves have been involved with the goal setting and choosing the course of action to be followed by them, they are more likely to fulfill their responsibilities.

Management by objectives can also be described as a process whereby the superior and subordinate jointly identify its common goals, define each individual's major areas of responsibility in terms of the results expected of him, and use these measures as guides for operating the unit and assessing the contribution of each of its members.

Responsibility Center Management

Known as RCM, it is the managerial framework for our internal budgeting and financial reporting activities

There are two basic types of Centers: Revenue-generating and Non-revenue-generating.

Revenue-generating centers are expected to:

o fund the direct cost of their own operations

o cover their share of services provided by the administrative Service Centers (via Allocated Costs)

o maintain internal budget balance

Budgeting and control:

a) Budget: · A formal statement of the financial resources set aside for carrying out specific activities in a given period of time. It helps to co-ordinate the activities of the organisation. An example would be an advertising budget or sales force budget.

b) Budgetary control:

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


· Any differences (variances) are made the responsibility of key individuals who can either exercise control action or revise the original budgets. There are a number of advantages to budgeting and budgetary control:

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

· Promotes coordination and communication.

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

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

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

Advantages to budgeting and budgetary control:

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

- Promotes coordination and communication. Clearly defines areas of responsibility. Requires managers of budget centres to be made responsible for the achievement of budget targets for the operations under their personal control.

-Enables remedial action to be taken as variances emerge.

-Motivates employees by participating in the setting of budgets.

-Improves the allocation of scarce resources.

-Economizes management time by using the management by exception principle.


Characteristic of good budget:

Participation: involve as many people as possible in drawing up a budget. Comprehensiveness: embrace the whole organization. Standards: base it on established standards of performance. Flexibility: allow for changing circumstances.

· Feedback: constantly monitor performance.

· Analysis of costs and revenues: this can be done on the basis of product lines, departments or cost centers.

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

a) Budget centers: Units responsible for the preparation of budgets. A budget centre may

Encompass several cost centers.

b) Budget committee: This may consist of senior members of the organization, e.g.

Departmental heads and executives (with the managing director as chairman). Every part of the organization should be represented on the committee, so there should be a representative from sales, production, marketing and so on. Functions of the budget committee include:

· Coordination of the preparation of budgets, including the issue of a manual Issuing of timetables for preparation of budgets

· Provision of information to assist budget preparations

· Comparison of actual results with budget and investigation of variances.

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

· liaising between the budget committee and managers responsible for budget preparation · dealing with budgetary control problems.


ensuring that deadlines are met

· educating people about budgetary control.

d) Budget manual:

This document: Charts the organization, details the budget procedures contains account codes for items of expenditure and revenue timetables the process clearly defines the responsibility of persons involved in the budgeting system.

concepts and techniques of responsibility budgeting, developing responsibility budgets and budgeting...

Documents

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responsibilities budgeting

administrative expense

sales budget

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operating budget types

beneficial relationships