1. ACC602 Strategic Management Accounting
TOPIC 2: Profit Planning – using the strategic planning and budgeting systems
Slides adapted from Langfield-Smith et al., McGraw-Hill
Reference Chapter 9 of the recommended textbook

2. Learning Outcome:
After the completion of this topic, you should be able to:
Interpret how the budgeting process fits into the wider strategic planning processes of an organization.
Formulate how budgets are developed and used in responsibility accounting systems.
Evaluate the different types of budgets and its relevance in decision making.
Evaluate the different components of an annual budgets and the relevance of each in management accounting information.
Prepare the operating budgets of manufacturing and services firms.
Evaluate the behavioral consequences of budgets.

3. Budget
A budget is a detailed plan that shows the financial consequences of an organisation’s operating activities for a future time period.
Acts as a financial model that summarises future operations
Viewed as a core component of an organisation’s planning and control system
Short term planning, often for a one-year period.
Involves estimating financial outcomes of planned activities in greater detail.

4. Strategic planning
Long term planning usually undertaken by senior managers
Involves making decisions about the types of businesses and markets that an organisation operates in and about how those businesses and activities will be financed.
Acquisition of certain companies, selling existing business, moving operation or restructure of operations
Can involve a horizon of three or more years
Resource requirement and financial outcomes are estimated in broad terms

5. Purpose of budget Planning Facilitating communication and coordination
Allocating resources
Controlling profits and operations
Evaluating performance and providing incentives

6. Responsibility Accounting
Budgets are usually developed along responsibility accounting lines
Responsibility accounting – describes the practice of holding managers responsible for the activities and performance of their area of business
Budgets can be used as a benchmark to measure performance of people and departments.
A responsibility accounting system is built around the framework of responsibility centres.

7. Responsibility Centre
Is a unit in an organisation (department or a division) where the manager is held accountable for the unit’s activities and performance.

8. Four common Types of responsibility centres
Cost centres
Revenue centres
Profit centres and
Investment centres

9. Cost Centers Incurs costs but does not directly generate revenues.
Managers have authority to incur costs.
Managers evaluated on ability to control costs.
Usually a production department or a service department.

10. Profit Centers Profit centers Incurs costs and generates revenues.
Managers judged on profitability of center.
Examples include individual departments of a retail store or branch bank offices.

11. Investment Centers Investment centers
Incurs costs, generates revenues, and has investment funds available for use.
Manager evaluated on profitability of the center and rate of return earned on funds.
Often a subsidiary company or a product line.
Manager able to control or significantly influence investment decisions such as plant expansion.
LO 4

12. Types of Responsibility Centers

13. Annual budget – planning tool
Master budget
Comprehensive set of budgets that covers all aspects of a firm’s activities
Consist of many separate interdependent budgets (next slide)
Budgets are developed for specific time periods
Covers a year
Can be prepared for a quarter of the year or for a month
Level of detail will vary
Large businesses – more comprehensive and formal process takes place over several months
Smaller businesses - less formal and less detailed

14. Components of annual budget
Strategic Planning
Budget Assumptions
Sales Budget
Operating Budgets
Cost Budgets
Capital expenditure Budget
Financial Budgets
Budgeted Balance sheet
Budgeted Income Statement
Cash Budget

15. Rolling (continuous) Budgets
Budgets that are continually updated by periodically adding a new time period, such as a quarter, and dropping the period just completed

16. Strategic Plans and Budget Assumptions
Managers need to understand the strategy of the organisation and to formulate the budget that supports strategic plans
Example, entering new product market or withdraw from others or to place greater emphasis on achiever higher level of customer service
Various assumptions must be made about the competitive and economic environment for the coming year
Includes things like changes in interest rates, government legislation, increases in wage rate, etc

17. Operating Budgets
Includes sales budgets (based on forecast sales for goods and services) and series of costs budgets (specify how operations will be carried out to meet the forecast sales demand)

18. Sales budget
Sales forecast is a critical step in the budgeting process
Factors (will differ depending on the industry and the nature of the firm) to consider when forecasting sales:
Internal Factors:
Past sales levels and trends for the company
New products planned by the company
The pricing policy of the company
Planned advertising and product promotion
External Factors:
General economic trends
Economic trends that directly relate to the company’s industry
Other factors expected to affect the sales (health concerns)
Political and legal events
Expected activities of competitors and customers

19. Costs Budgets
The types of budgets that are prepared will depend on the nature of the business (manufacturing, service, retail or wholesale firm)

20. Manufacturing firms Starting point sales budget
Develops a production budget (number of units of products to be manufactured)
Based on forecast sales, adjusted for planned inventory levels
Costs budgets for direct material, direct labour and overhead are developed based on production budget
Budgets are also developed for selling and administrative expenses (cost of running support departments such as accounting and human resources, cost relating to senior management, etc)

21. Operating budgets in manufacturing firms
Sales Budget
Beginning and ending work in process and finished goods inventory
Production Budget
Beginning and ending raw materials inventory
Direct materials Budget
Direct Labour Budget
Manufacturing overhead Budget

22. Retail and wholesale businesses
Starting point – Sales budget
Instead of preparing a production budget for goods, a retailer or wholesaler develops a purchases budget to determine the quantity and costs of goods that it needs to purchase for resale.
Planned levels of finished goods inventories will be taken into account in the purchase budget
Other costs budgets are similar to those of a manufacturing firm

23. Service firms
Based on the sales budget for its services, a service firm develops a set of budgets that show how the demand for those services will be met.
Example, an airline company
A budget of planned kilometers to be flown
Materials budgets for aircraft spare parts, aircraft fuel and in-flight food
Labour budgets for flight crews and maintenance personnel
An overhead budget – selling and administrative budgets

24. Financial Budgets
Once the operating budgets are complete, the financial budgets are prepared.

25. Cash budget and capital expenditure budget
Is prepared by all types of businesses
Cash budget shows detailed expected cash receipts and planned cash payments
Will reveal when firm will have cash shortages or surpluses throughout the year.
Capital expenditure budget is a plan for acquisition of long-term assets (example, building, plant, equipment, etc)
May include inflows (sales of old equipment) and outflows (purchase of new equipment for cash), therefore the effect is shown in the cash budget.

26. Budgeted income statement and Balance Sheet
Budgeted income statement shows the expected revenues and planned expenses of the firm during the budget period
Budgeted balance sheet sets out the expected position at the end of the budget period
The component budgets are broken down into shorter time periods to have more detailed and accurate planning and for ongoing costs control to take place.

27. Budgets in not-for-profit organisations
Many not-for profit organisations provide services free of charge, therefore, there is no sales budget
Budgets are prepared for the level of services to be provided and the cost budgets would be formulated to support these levels of services.
Budgets are prepared to show their anticipated funding.

28. Government budgeting
Government budgeting is the critical exercise of allocating revenues and borrowed funds to attain the economic and social goals of the country.
It also entails the management of government expenditures in such a way that will create the most economic impact from the production and delivery of goods and services while supporting a healthy fiscal position.

29. Government budgeting
Government budgeting is important because it enables the government to plan and manage its financial resources to support the implementation of various programs and projects that best promote the development of the country. (infrastructure, health, education, welfare, etc, etc,etc)
Through the budget, the government can prioritize and put into action its plans (please correct from plants to plans), programs and policies within the constraints of its financial capability as dictated by economic conditions.

30. Government budgeting
Budgeting for the national government involves four distinct processes or phases :
budget preparation,
budget authorization,
budget execution and
accountability.
While distinctly separate, these processes overlap in the implementation during a budget year. Budget preparation for the next budget year proceeds while government agencies are executing the budget for the current year and at the same time engaged in budget accountability and review of the past year's budget.

31. Budgets in government agencies
During budget preparation, trade-offs and prioritization among programs must be made to ensure that the budget fits government policies and priorities.
Next, the most cost-effective variants must be selected.
Finally, means of increasing operational efficiency in government must be sought.
The budget formulation process has four major dimensions:
Setting up the fiscal targets and the level of expenditures compatible with these targets.
This is the objective of preparing the macro-economic framework. · Formulating expenditure policies.
Allocating resources in conformity with both policies and fiscal targets. This is the main objective of the core processes of budget preparation.
Addressing operational efficiency and performance issues.

32. In a local government council, the funds would include the rates and taxes charged to residents and businesses, government funding and any special funding such as grants
Budgets are also prepared to plan and control special projects or events. Example a soccer tournament to be held

33. Budget Administration
Process will differ in small and large organisations
Larger organisations have more formal process
Senior accounting manager may be responsible for administration (devising process by which budget data will be gathered and preparing the final budget)
Budget manuals may be prepared to communicate budget procedures and deadlines to all employees
Budget committee consisting of key senior executives may be appointed to advise the accountant during the preparation of the budget

34. Behavioural consequences of budgeting
Impact of budgeting system on individuals’ behaviour in organisation
Affects everyone in the organisation:
Those who prepare the budget
Those who use the budget to facilitate decision making
Those whose performance is evaluated during budget
Human reaction can influence the organisation’s overall effectiveness. (whether the resources are utilised efficiently in order to achieve the objectives)

35. Top-down budgeting
Where senior managers impose budget targets on more junior managers with little or no consultation
Budgets may be set at corporate level
Cost effective and timely
Budget targets may be unrealistic
Lack of commitment of middle and junior managers

36. ‘This is my budget’ rather than ‘this is the budget you imposed on me’
Bottom-up budgeting
A participative process in which people at the lower managerial and operational levels play an active role in setting their own budget
After negotiation and revision the budget will be approved by senior managers
Encourage coordination and communication
Greater understanding and appreciation of the objectives and strategy of the wider organisation
More accurate budget – those people close to operations have the best knowledge (realistic budget)
‘This is my budget’ rather than ‘this is the budget you imposed on me’

37. Participative budgeting
A process where managers who are accountable for budget performance help to develop their own initial budget estimates
Leads to employee empowerment and greater motivation, therefore improved performance
Involves a lot of negotiation and revision of budget estimates
Lengthy and time-consuming process
Expensive
Disagreements may arise
Opportunities for padding the budget arise unless there are incentives to encourage people to provide accurate budget estimates

38. Budgetary slack: Padding the budget
Budgets are used as benchmarks to compare against actual results (way of evaluating performance of a manager)
Padding the budget - Practice of underestimating revenues and overestimating costs so that budget targets are easier to achieve
Budgetary slack – the difference between the revenue or cost projection that a person provides and a realistic estimate of that revenue or costs

39. Reasons for Budgetary slack
Performance will look better to their superiors
To cope with uncertainty
To compete for limited resources

40. How to solve the problem of budgetary slack
Don’t use budget as a negative evaluating tool
Managers can be given incentives not only to achieve budgetary targets but also to provide accurate budget estimates
Asking managers to justify some or all of their projections

41. Budget difficulty and goal congruence
goal congruence – when managers are committed to achieving the goals of the organisation, while still satisfying their personal goals
The situation in which the organisation’s goals coincide with an individual’s goals
Purpose of the budget is to evaluate performance and motivate employees to direct their efforts towards organisational goals
For budgets to be motivational, employees must accept the budget targets as their own targets (this is our target…if we are able to achieve it……..we will reap benefits from it)

42. Budget difficulty and goal congruence
Expectation Budget
Optimal performance budget
Performance
Budget level
Adverse budget variance
Actual Performance
Budget Difficulty
Easy
Difficult

43. Budget difficulty and goal congruence
Budget acceptance is more likely when:
Targets are developed with participation of employees
Targets are considered achievable
There is frequent feedback on performance
Employees are held responsible for activities that they believe are within their control
Achievement of targets is accompanied by rewards that are valued

44. Illustrative example
Refer to the illustrative example.

45. Self-Study Problem
Go through the self study problem and appendix (6th edition pages 435 – 442)

46. Tutorial questions
9.21
9.22
9.23
9.25

47. Reference:
Smith, L. (etal), 6th ed, “Management Accounting 6/e – Information for Managing and Creating Value. McGraw Hill. Australia.Pages