Study notes 39

NotesPaper P3 Performance Strategy p44

Paper F3 Financial Strategy p47

S t u d y

Over the many years I have delivered CIMA courses, I’ve noticed that few candidates seem to examine the syllabus in detail. Students might be aware of the broad headings but not of all the items under them.

Unfortunately, this will reduce their chances of success. They will tend to prepare a set of generic answers that could be roughly adapted to any question in one particular area of the syllabus. Such answers rarely gain high marks.

This article will focus on one of the main parts of the P2 syllabus – topic C, “Budgeting and management control” – and examine some of the important components relating to budgeting. I won’t cover every item in this area, nor will I discuss generating a budget or the characteristics of the various types of budgets, because the study text does that. What I will do is describe the angles from which it may be examined so that we can see what the examiner is actually testing.

Management accounting is built on the three pillars of planning, control and decision-making. It’s essential to distinguish among the three different types of planning: strategic, budgetary

Paper P2

ManagementPerformance

By Norwood Whittle, FCMA, CGMA CIMA course leader at the University of Northampton and lead marker for P2

Too many students go into the exam without a firm grasp of the syllabus and how topics will be examined. This leads them to give unfocused answers when they need to show their knowledge of specific areas

In association with

and operational. These three are related, the main difference being the length of time they cover. Strategic planning focuses on achieving the organisation’s long-term objectives; budgetary planning covers the short to medium term; and operational planning refers to short-term or day-to-day processes.

Candidates must be able to: l Describe the three types of planning. l Distinguish among them. l Explain how a budget is carried out within the framework of the strategic plan.

The two most important control tools are standard costing and variances, and budgets. This key area of the syllabus will be examined regularly and you must be able to apply your knowledge to questions about specific aspects of budgets and budgeting control, instead of writing generic answers. You must also be able to suggest the most appropriate budget technique for the scenario given, so you’ll need to be familiar with the main features of the different types of budgets.

Remember that the syllabuses under the Performance pillar are progressive, which means that aspects covered in both the P1 and C01 papers can be examined in the P2 paper.

When preparing for the P2 exam, review these two syllabuses and confirm your understanding of how to:l Form a budget committee.l Identify any principal budgeting factor. l Review and co-ordinate action of the budget.l Agree the budget period.l Prepare functional budgets.l Prepare a master budget.

Let’s consider some of the main items in this part of the syllabus.

Budget v budgetary controlCandidates need to be able to do the following:l Define a budget. l Define budgetary control and describe the steps of producing a budget. Judging from many

‘Students might be aware of the syllabus’s broad headings, but not of all the items under them’

answers in past exams, it’s clear that many candi-dates don’t appreciate that budgetary control is the process that an organisation completes in pre-paring a budget. Budgetary control is the practice of systematically comparing the results actually achieved with those budgeted for.l Understand the principles of standard costing and variance analysis, and how this technique dovetails with the preparation of a budget.l Relate the theory to any scenario.

The theory of systemsYou need to be aware of the basic control system theory and how this applies in budgetary control. Candidates need to be able to:l Describe how a system is a set of related parts co-ordinated to accomplish a set of goals.l Describe the key characteristics and components of a system – inputs, process, outputs, environment and boundary – and relate these to any scenario.

Feedback v feed-forward control systemsMost budgetary control systems work on the feedback principle. Information on actual results are compared against control data – in this case, the budget – and any variances from the control data will normally prompt immediate action (feedback) to bring future results back in line with the budget. Feedback control involves acting after the event, but in some situations it may be more appropriate to adopt a feed-forward approach. This is where there is monitoring at an early stage of a process, which may show that an adjustment should be made at a later stage before the final output. Feed-forward control loops react to forthcoming dangers.

Candidates need to be able to:l Explain the concepts of feedback and feed-forward control systems.l Compare and contrast the two systems.l Explain the difference between negative and positive feedback.l Describe how a feedback control loop might work in the context of a budgetary control system.l Describe the components of the control system (sensor, comparator and effector).

Top-down v bottom-up (participative)You need to be able to discuss the advantages and disadvantages of the top-down and bottom-up

approaches, appreciating in particular that the bottom-up approach allows less senior managers to get more involved in setting budgets. It also allows the business to take full advantage of its managers’ local knowledge and expertise. The main drawbacks of this approach are that it can be time-consuming and lead to the introduction of “slack” to allow the budget to be achieved easily.

Candidates need to be able to:l Understand the circumstances under which each technique is appropriate.l Discuss the advantages and disadvantages of each technique.l Appreciate the behavioural implications of adopting either approach.

Incremental v zero-based budgetsIt’s quite common, particularly in the public sector, to fix a budget on the basis of what happened the year before, perhaps with some adjustments for changes that are nearly certain to occur – e.g. an agreed pay rise. This is known as incremental budgeting and it’s often used for functions such as R&D, advertising and training. Budgets relating to this type of expenditure are known as dis-cretionary budgets.

In contrast, zero-based budgets (ZBBs) are based on the principle that all expenditure must be justified. Hence, it is not assumed that an activity will automatically be financed in the forthcoming year just because it was financed the year before.

Candidates need to be able to:l Describe incremental budgeting.l Understand the nature of discretionary costs and discretionary budgets.l Understand the circumstances under which an incremental budget is more appropriate and those under which a ZBB is more appropriate. l Describe the main characteristics of a ZBB – e.g. decision packages.l Discuss the pros and cons of ZBBs.

Rolling (continual) budgetsMost budgets are prepared periodically, usually for the next financial year. This is appropriate in most cases. But when it’s hard to predict events accurately for the next 12 months – owing to a high level of inflation, say – it may be more appropriate to adopt a rolling approach in which a detailed budget is produced for the first three months

Study notes 41

Performance Management

‘Zero-based budgets are based on the principle that all expenditure must be justified’

Paper P2

42

Paper P2Performance Managementand a less detailed macro budget is produced to cover the subsequent nine months.

Candidates need to be able to:l Describe the main characteristic of a rolling budget, especially any disadvantages – e.g. the fact that they are extremely time-consuming.l Understand the circumstances under which a rolling budget approach would be beneficial.l Discuss whether the traditional budget or the rolling budget is likely to be more beneficial for planning purposes.

Fixed v flexible budgetsWhen managers compare actual results against the budget, the comparison needs to be meaningful – otherwise, it won’t be valid. For many businesses, revenues and costs in a period are fairly predictable and the budget could be prepared for one level of activity. But this wouldn’t be suitable for enterprises where the level of activity could vary widely – e.g. ice cream sales in a cold, wet summer. In such circumstances a flexible budget would be more appropriate and a budget would be prepared for different levels of activity.

Candidates need to be able to:l Describe the main characteristics of fixed budgets and flexible budgets.l Understand the circumstances that would favour one approach over the other.l Generate a flexible budget having been given the necessary data – e.g. costs that are fixed and those that vary with output.l Apply the high-low technique to establish the fixed cost and variable cost per unit of output.l Present the flexible budget so that a non-financial person can understand it.

Activity-based budgeting (ABB)Candidates need to appreciate that ABB extends the principles of activity-based costing. With the ABB approach, budgets are prepared according to activity rather than function, as is normally the case with a traditional budget. ABB starts with output (the sales budget) and then works through to find the activity costs, whereas activity-based costing is the other way around. It starts by establishing activity costs and then attaches these costs to units of output. If an activity-based budget is put in place, it should give a better understanding of the effect on budget costs of changes in the

usage of the cost driver because of how cost drivers, activities and costs are explicitly related.

Candidates need to be able to:l Describe the main characteristics of activity-based budgets.l Discuss how activity-based budgets compare with traditional budgets.l Describe how control should be improved in an ABB environment.l Discuss the advantages of ABB.

Beyond budgetingIt is important for candidates to be able to question the continued use of traditional budgets. Most businesses fully accept the need for planning well ahead, but it’s often suggested that the budget systems adopted should reflect a broader, more intelligent approach. The beyond budgeting model promotes a more decentralised, participative approach to managing a business and is based on the use of “stretch targets” that can be adapted.

Candidates need to be able to:l Describe the main principles associated with beyond budgeting.l Compare beyond budgeting with the traditional approach, particularly highlighting the disad-vantages of the latter.l Explain how beyond budgeting allows greater adaptability to changing business conditions.l Explain how beyond budgeting can increase moti-vation among staff – i.e. the behavioural aspect.

Study notes

‘Preparing the budget for one level of activity wouldn’t be suitable for enterprises where the level of activity could vary widely – e.g. ice cream sales in a cold, wet summer’

Further reading CIMA Official Study Text – P2 Performance Management (2012-13 edition), CIMA Publishing, 2012.

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