Using Budgets to Achieve Organizational Objectives

Using Budgets to Achieve Organizational Objectives
Chapter 10  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Resource Flexibility In many business decisions, especially decisions affecting the short-term, the firm’s capacity-related costs are considered as given and fixed Relevant costs in the short run are flexible costs Ideally, the supply of capacity resources is based on the amount needed to produce the projected volume of product The budgeting process makes clear that some resources, once acquired, cannot be disposed of easily if demand is less than expected  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

The Budgeting Process (1 of 5)
The process that determines the planned level of most flexible costs Budgeting for capacity-related resources is discussed as a separate topic in another chapter Budgeting also includes discretionary spending such as for R&D, advertising, and employee training These do not supply the firm with capacity but they do provide support for the organization’s strategy by enhancing its performance potential Once authorized, discretionary spending budgets are committed or fixed; they do not vary with level of production or service  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Budgets serve as a control for managers within the business units of an organization Planning and control are the core of the design and operation of management accounting systems Budgets play a central role in the relationship between planning and control Budgets reflect in quantitative terms how to allocate financial resources to each part of an organization, based on the planned activities and short-run objectives of that part of the organization  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

A budget is a quantitative expression of the money inflows and outflows that reveal whether a financial plan will meet organizational objectives Budgeting is the process of preparing budgets Budgets provide a way to communicate the organization’s short-term goals to its members  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Budgeting the activities of each unit can Reflect how well unit managers understand the organization’s goals Provide an opportunity for the organization’s senior planners to correct misperceptions about the organization’s goals Budgeting also serves to coordinate the many activities of an organization In this sense, budgeting is a tool that forces coordination of the organization’s activities and helps identify coordination problems  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Budgets help to anticipate potential problems and can serve to help provide solutions Budgeting reflects the cash cycle and provides information to help the organization plan any borrowing needed to finance the inventory buildup early in the cash cycle If budget planning indicates that the organization’s sales potential exceeds its manufacturing potential, then the organization can develop a plan to put more capacity in place or to reduce planned sales Managers need to be able to anticipate problems since putting new capacity in place can take several months to several years  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Forecasting Demand for Resources (1 of 2)
Budgeting involves forecasting the demand for four types of resources over different time periods: Flexible resources that create variable costs (or flexible costs) May be acquired or disposed of in the short term Intermediate-term capacity resources that create capacity-related costs For example, forecasting the need for rental storage space that might be contracted on a quarterly, semi-annual, or annual basis  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Forecasting Demand for Resources (2 of 2)
Resources that, in the intermediate and long run enhance the potential of the organization’s strategy Discretionary expenditures, which include research and development, employee training, maintenance of capacity resources, advertising, and promotion Long-term capacity resources that create capacity-related costs For example, a new fabrication facility for a computer chip manufacturer, which might take several years to plan and build and might be used for ten years  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Master Budget Two major types of budgets comprise the master budget:
Operating budgets Summarize the level of activities such as sales, purchasing, and production Financial budgets Identify the expected financial consequences of the activities summarized in the operating budgets  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Operating Budgets (1 of 3)
The sales plan Identifies the planned level of sales for each product The capital spending plan Specifies the long-term capital investments, such as buildings and equipment, that must be paid in the current budget period to meet activity objectives The production plan Schedules all required production The materials purchasing plan Schedules all required purchasing activities  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

The labor hiring and training plan Specifies the number of people the organization must hire or release to achieve its activity objectives, as well as all hiring and training policies The administrative and discretionary spending plan Includes administration, staffing, research and development, and advertising These plans specify the expected resource requirements of selling, capital spending, manufacturing, purchasing, labor management, and administrative activities during the budget period  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Operations personnel use the plans represented in the operating budget to guide and coordinate the level of various activities during the budget period Operations personnel also record data from current operations that can be used to develop future budgets  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Financial Budgets Planners prepare the financial budgets to evaluate the financial consequences of investment, production, and sales plans Projected balance sheet Projected income statement Projected statement of cash flows Planners use the projected statement of cash flows in two ways: To plan when excess cash will be generated They can use it to make short-term investments rather than simply holding cash To plan how to meet any cash shortages  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Demand Forecast An organization’s goals provide the starting point and the framework for evaluating the budgeting process To assess the plan’s acceptability, planners compare the tentative operating plan’s projected financial results with the organization’s financial goals The budgeting process is influenced strongly by the demand forecast An estimate of sales demand at a specified selling price  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Developing the Demand Forecast
Organizations develop demand forecasts in many ways: Market surveys conducted either by outside experts or by internal sales staff Statistical models to generate demand forecasts from trends and forecasts of economic activity in the economy and the relation of past sales patterns to this economic activity Assume that demand will either grow or decline by some estimated rate over previous demand levels Regardless of the approach used, the organization must prepare a sales plan for each key line of goods and services  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Importance of Sales Plans
The sales plans provide the basis for other plans to acquire the necessary factors of production: Labor Materials Production capacity Cash Because production plans are sensitive to the sales plans, most organizations develop budgets on computers Planners can readily explore the effects of changes in the sales plans on production plans  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Level of Detail in Budget (1 of 2)
Choosing the amount of detail to present in the budget involves making trade-offs: More detail in the forecast improves the ability of the budgeting process to identify potential bottlenecks and problems by specifying the exact timing of production flows Forecasting and planning in great detail for each item can be extremely expensive and overwhelming to compute  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Level of Detail in Budget (2 of 2)
Production planners use their judgment to strike a balance between The need for detail The cost and practicality of detailed scheduling Planners do this by grouping products into pools Each product in a given pool places roughly equivalent demands on the organization’s resources Planning is simplified  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

The Production Plan Planners determine a production plan by matching the completed sales plan with the organization’s inventory policy and capacity level The plan identifies the intended production during each of the interim periods comprising the annual budget period Interim periods may be defined as days, weeks, or months Depending on how regularly the people managing the acquisition, manufacturing, selling, and distribution activities need information  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Inventory Policy (1 of 3) The inventory policy is critical and has a unique role in shaping the production plan Planners use the inventory policy and the sales plan to develop the production plan One policy is to produce goods for inventory and attempt to keep a target number of units in inventory at all times This level production strategy is characteristic of an organization with highly skilled employees or equipment dedicated to producing a single product Reflects a lack of flexibility  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Inventory Policy (2 of 3) Another inventory policy is to produce for planned sales in the next interim period within the budget period Organizations moving toward a just-in-time inventory policy produce goods to meet the next interim period’s demand as an intermediate step in moving to a full just-in-time inventory system Each interim period becomes shorter and shorter until the organization achieves just-in-time production The scheduled production is the amount required to meet the inventory target of the level of the next interim period’s planned sales  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Inventory Policy (3 of 3) Another inventory policy is a just-in-time (JIT) inventory policy In a JIT inventory strategy, demand directly drives the production plan Production in each interim period equals the next interim period’s planned sales A JIT inventory policy requires: Flexibility among employees, equipment, and suppliers A production process with little potential for failure  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Aggregate Planning Aggregate planning compares:
The production plan The amount of available productive capacity This comparison assesses the feasibility of the proposed production plan It does not develop a detailed production schedule to guide daily production in the organization It determines whether the proposed production plan can be achieved by the capacity the organization either has in place or can put in place during the budget period Planners may need to consider ways to modify existing facilities  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

The Spending Plan (1 of 4) Once planners identify a feasible production plan, they may make tentative resource commitments The purchasing group prepares a plan to acquire the required raw materials and supplies Since sales and production plans change, the organization and its suppliers must be able to adjust their plans quickly based on new information At some point the plans have to be locked in place and no additional changes made For example, commitment to a production schedule in a large automotive assembly plant occurs about eight weeks before production takes place Provides managers the time to put raw materials supply in place and schedule the production  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

The Spending Plan (2 of 4) The personnel and production groups prepare the labor hiring and training plans Works backward from the date when the personnel are needed to develop hiring and training schedules that will ensure the availability of the needed personnel When an organization is contracting, it will: Use retraining plans to redeploy employees to other parts of the organization, or Develop plans to discharge employees Because they involve moral, ethical, and legal issues and may involve high severance costs, layoffs are usually avoided unless no alternative can be found  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

The Spending Plan (3 of 4) Other decision makers in the organization prepare an administrative and discretionary spending plan Summarizes the proposed expenditures on activities such as for R&D, advertising, and training Discretionary expenditures provide the required infrastructure for the proposed production and sales plan “Discretionary” means the actual sales and production levels do not drive the amount spent The senior managers in the organization determine the amount of discretionary expenditures Once determined, the amount to be spent on discretionary activities becomes fixed for the budget period and is unaffected by product volume and mix  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

The Spending Plan (4 of 4) The appropriate authority approves the capital spending plan to acquire new productive capacity A long-term planning process rather than the one-year cycle of the operating budget drives the capital spending plan Capital spending projects usually involve time horizons longer than the period of the operating budget  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Choosing Capacity Levels (1 of 4)
Three types of resources determine capacity: Flexible resources that the organization can acquire in the short term If suppliers do not deliver the resources or deliver unacceptable products, production may be disrupted Capacity resources that the organization must acquire for the intermediate term Capacity resources that the organization must acquire for the long term The level chosen reflects the organization’s assessment of its long-term growth trend  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Organizations develop sophisticated approaches to balance the use of short, intermediate, and long-term capacity to minimize the waste of resources We may classify resource-consuming activities into three groups Activities that create the need for resources (and resource expenditures) in the short-term Activities undertaken to acquire capacity for the intermediate-term Activities undertaken to acquire capacity needed for the long-term Planners classify activities by type because they plan, budget, and control short, intermediate, and long-term expenditures differently  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Analysts evaluate short-term activities by considering efficiency and asking: Is this expenditure necessary to add to the product value perceived by customers? Can the organization improve how it does this activity? Would changing the way this activity is done provide more satisfaction to the customer? Choosing the production plan (i.e., choosing the level of the short-term activities) fixes the short-term expenditures that the master budget summarizes  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Analysts evaluate intermediate- and long-term activities by using efficiency and effectiveness considerations and asking: Are there alternative forms of capacity available that are less expensive? Is this the best approach to achieve our goals? How can we improve the capacity selection decision to make capacity less expensive or more flexible? Choosing the capacity plan (i.e., making the commitments to acquire intermediate and long-term capacity) commits the firm to its intermediate and long-term expenditures  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Handling Infeasible Production Plans
Planners use forecasted demand to plan activity levels and provide required capacity If planners find the tentative production plan infeasible, then they have to make provisions to: Acquire more capacity, or Reduce the planned level of production Occurs when projected demand exceeds available capacity  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Interpreting The Production Plan
Production is the lesser of: Total demand Production capacity Demand is the quantity customers are willing to buy at the stated price Production capacity is the minimum of: The long-term capacity The intermediate-term capacity The short-term capacity  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

The Financial Plans Once the planners have developed the production, staffing, and capacity plans, they can prepare a financial summary of the tentative operating plans The projected balance sheet serves as an overall evaluation of the net effect of operating and financing decisions during the budget period The income statement serves as an overall test of the profitability of the proposed activities A cash flow forecast helps an organization identify if and when it will require external financing  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

The Cash Flow Statement
The cash flow statement has three sections: Cash inflows from cash sales and collections of receivables Cash outflows For flexible resources that are acquired and consumed in the short term For capacity resources that are acquired and consumed in the intermediate and long term Results of financing operations  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Financing Operations Summarizes the effects on cash of transactions that are not a part of the normal operating activities Includes the effects of: Issuing or retiring stock or debt Buying or selling capital assets Short-term financing Often involves obtaining a line of credit, secured or unsecured, with a financial institution The line of credit allows a company to borrow up to a specified amount at any time  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Using The Financial Plans (1 of 2)
Organizations can raise money from outsiders by borrowing from banks, issuing debt, or selling shares of equity Based on the information provided by the cash flow forecast, organizations can plan the appropriate mix of external financing to minimize the long-run cost of capital  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Using The Financial Plans (2 of 2)
A cash flow forecast helps an organization Identify if and when it will require external financing Determine whether any projected cash shortage will be: Temporary or cyclical Can be met by a line-of-credit arrangement, or Permanent Would require a long-term loan from a bank, further investment by the current owners, or investment by new owners (or a combination)  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

What If Analysis Using a computer for the budgeting process, managers can explore the effects of alternative marketing, production, and selling strategies For example, a manager may consider raising prices, opening a retail outlet, or using different employment strategies Alternative proposals like these can be evaluated in a what-if analysis The structure and information required to prepare the master budget can be used easily to provide the basis for what-if analyses  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Sensitivity Analysis (1 of 2)
What-if analysis is only as good as the model used to represent what is being evaluated The model must be complete, it must reflect relationships accurately, and it must use accurate estimates Otherwise, it will not provide good estimates of a plan’s results Planners test planning models by varying the model estimates If small changes in an estimate used in the production plan have a dramatic effect on the plan, the model is said to be sensitive to that estimate  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Sensitivity Analysis (2 of 2)
Sensitivity analysis is the process of selectively varying a plan’s or a budget’s key estimates for the purpose of identifying over what range a decision option is preferred Sensitivity analysis enables planners to identify the estimates that are critical for the decision under consideration  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Variance Analysis (1 of 2)
To help interpret production and financial outcomes, organizations compare planned (or budgeted) results with actual results A process called variance analysis Variance analysis has many forms and can result in complex measures, but its basis is very simple: An actual cost (or revenue) amount is compared with a target cost (or revenue) amount to identify the difference  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Variance Analysis (2 of 2)
Accountants call the difference a variance A variance represents a departure from what was budgeted or planned An investigation will try to determine: What caused the variance What should be done to correct that variance  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Sources of Budgeted Costs
Budgeted or planned costs can come from three sources: Standards established by industrial engineers Such as cost of steel that should go into the door of an automobile based on the door’s specifications Previous period’s performance For example, the cost of steel per door that was made in the last budget period A benchmark, the best in class results achieved by a competitor The cost of steel per comparable door achieved by the competitor that is viewed as the most efficient  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Variances (1 of 4) The financial numbers are the product of a price and a quantity component: Budgeted amount = expected price * expected quantity Actual amount = actual price * actual quantity Variance analysis explains the difference between planned and actual costs by evaluating: Differences between planned and actual prices Differences between planned and actual quantities  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Variances (2 of 4) Accountants focus separately on prices and quantities because in most organizations: One department or division is responsible for the acquisition of a resource Determining the actual price A different department uses the resource Determining the quantity A variance is a signal that is part of a control system for monitoring results A variance provides a signal that operations did not go as planned  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Variances (3 of 4) Supervisory personnel use variances as an overall check on how well the people who are managing day-to-day operations are doing what they should be doing When compared to the performance of other organizations engaged in comparable tasks, variances show the effectiveness of the control systems that operations people are using  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Variances (4 of 4) If managers learn that specific actions they took helped lower the actual costs, then they can obtain further cost savings by repeating those actions on similar jobs in the future If they can identify the factors causing actual costs to be higher than expected, then they may be able to take the necessary actions to prevent those factors from recurring in the future If they learn that cost changes are likely to be permanent, they can update their cost information when bidding for future jobs  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

First-Level Variances
The first-level variance for a cost item is the difference between the actual costs and the master budget costs for that cost item Variances are favorable (F) if the actual costs are less than estimated master budget costs Unfavorable (U) variances arise when actual costs exceed estimated master budget costs  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Planning Variances A flexible budget adjusts the forecast in the master budget for the difference between planned volume and actual volume It reflects a cost target based on the level of volume that is actually achieved, rather than the planned volume that underlies the master budget Cost differences between the master and the flexible budget are called planning variances They reflect the difference between planned output and actual output They arise entirely because the planned volume of activity was not realized  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Flexible Budget Variances
Flexible budget variances are the differences between the flexible budget and the actual results Reflect variances from the target level of costs adjusted for the actual level of activity A manager’s focus should be on these variances to determine whether cost-cutting activities have been successful Flexible budget variances reflect: Quantity variances -- the difference between the planned and the actual use rates per unit of output Cost variances -- the difference between the planned and the actual price or cost per unit of the various cost items  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Second & Third-Level Variances
The second-level variances are the planning variance and the flexible budget variance Together they add up to the first-level variance The direct material flexible budget variances and direct labor flexible budget variances can be decomposed further into third-level variances: Efficiency variances Price variances Together they explain the flexible budget component of the second-level variance  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Direct Material Variances (1 of 2)
The material quantity variance is calculated as: Quantity variance = (AQ-SQ) x SP Where: AQ = actual quantity of materials used SQ = standard (estimated) quantity of materials required SP = standard (estimated) price of materials  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Direct Material Variances (2 of 2)
The material price variance is calculated as: Price variance = (AP-SP) x AQ Where: AP = actual price of materials SP = standard (estimated) price of materials AQ = actual quantity of materials used The sum of these two second-level variances is the total flexible budget variance for direct materials The price variance may, however, be calculated using the quantity purchased rather than the quantity used  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Direct Labor Variances
The labor cost variances are determined in a manner similar to the material quantity and price variances: Efficiency variance = (AH-SH) x SR Rate variance = (AR-SR) x AH Where: AH = actual number of direct labor hours AR = actual wage rate & SR = standard rate SH = standard (estimated) number of direct labor hours The sum of the rate variance and the efficiency variance equals the total flexible budget direct labor variance  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Support Activity Cost Variances (1 of 2)
Support costs can reflect either flexible or capacity-related costs The quantity of capacity-related costs may not change from period to period, but the spending on them may fluctuate E.g., engineers can travel, take courses, vacation, quit, and be replaced with someone else Monitoring spending variances on capacity-related resources is possible and desirable Even if one cannot monitor efficiency variances, which will show up as changes in used and unused capacity  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Support Activity Cost Variances (2 of 2)
Flexible support costs reflect behind-the-scenes operations that are proportional to the volume of activity but are not directly a part of the product or service provided to the customer For example, an indirect support cost in a factory would be the wages paid to employees who move work in process around the factory floor as the product is being made Flexible support costs consist of a quantity (or usage) component and a price component Flexible support cost variances may be analyzed in a manner similar to direct material or direct labor variances  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Budgeting In Nonmanufacturing Organizations (1 of 3)
As in manufacturing organizations, budgeting helps nonmanufacturing organizations perform their planning function by coordinating and formalizing responsibilities and relationships and communicating the expected plans Budgeting serves a slightly different but equally relevant role in natural resource companies, service organizations, not-for-profit organizations, and government agencies  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

In the natural resources sector, the focus is on balancing demand with the availability of natural resources Because the natural resource supply often constrains sales, success requires managing the resource base effectively to match supply with potential demand In the service sector, the focus is on balancing demand and the organization’s ability to provide services, which is determined by the organization’s level and mix of skills People rather than machines usually represent the capacity constraint in the service sector Planning is critical in high-skill organizations because people capacity is expensive and services cannot be inventoried when demand falls below capacity  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

In not-for-profit organizations, the focus of budgeting has been to balance revenues raised by taxes or donations with spending demands In government agencies planned cash outflows, or spending plans, are called appropriations Appropriations limit a government agency’s spending Many governments are looking for ways to eliminate unnecessary expenditures and to make necessary expenditures more efficient These agencies must establish priorities for their expenditures and improve the productivity with which they deliver services to constituents  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Periodic Budgeting The basic budgeting process described in this chapter involves many organizational design decisions, such as the length of the budget process, the basic budget spending assumptions, and the degree of top management control In a periodic budget cycle, the planners prepare budgets periodically for each planning period Periodic budgeting is typically performed once per budget period—usually once a year Planners may, however, update or revise the budgets  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Continuous Budgeting In continuous budgeting, as one budget period passes, planners drop that budget period from the master budget and add a future budget period in its place Usually a month or a quarter The length of the budget period reflects the competitive forces, skill requirements, and technology changes that the organization faces Long enough for the organization to anticipate important environmental changes and adapt to them Short enough to ensure that estimates for the end of the period will be reasonable and realistic  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Periodic v. Continuous Budgeting
Advocates of periodic budgeting argue that continuous budgeting takes too much time and effort and that periodic budgeting provides virtually the same benefits at a smaller cost Advocates of continuous budgeting argue that it keeps the organization planning, and assessing, and thinking, strategically year-round rather than just once a year at budget time  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Controlling Discretionary Expenditures
Organizations generally use one of three general approaches to budget discretionary expenditures: Incremental budgeting Zero-based budgeting Project funding Each has benefits distinct from the others  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Incremental Budgeting
Incremental budgeting bases a period’s expenditure level on the amount spent during the previous period If the total budget for discretionary items increases by 10%, then: Each discretionary item is allowed to increase 10%, or All items may experience an across-the-board increase of, for example, 5% and the remaining 5% increase may be allocated based on merit Some people have criticized incremental budgeting because it does not require justification of the organization’s goals for discretionary expenditures  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Zero-Based Budgeting (1 of 2)
Zero-based budgeting (ZBB) requires that proponents of discretionary expenditures continuously justify every expenditure Zero-based budgeting is not appropriate for budgeting that relates to engineered costs that vary in proportion to production The starting point for each line item is zero Zero-based budgeting arose, in part, to combat indiscriminate incremental budgets where projects that take on a life of their own and resist going out of existence  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Zero-Based Budgeting (2 of 2)
Under ZBB, planners allocate the organization’s resources to the spending proposals they think will best achieve the organization’s goals This approach to project budgeting has been used primarily to assess government expenditures In profit-seeking organizations, ZBB has been applied only to discretionary expenditures Even for engineered costs, ZBB could be effective when combined with the reengineering approach Critics of ZBB complain it is expensive because it requires so much employee time to prepare  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Project Funding Some critics of ZBB have proposed an intermediate solution to mitigate the disadvantages of ZBB and incremental budgeting The intermediate solution is called project funding A proposal is made for discretionary expenditures with a specific time horizon or sunset provision Projects with indefinite lives (sometimes called programs) should be continuously reviewed to ensure that they are living up to their intended purposes Requests to extend or modify the project must be approved separately  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Activity-Based Budgeting
A recent approach to budgeting is activity-based budgeting, which is based on activity-based costing Activity-based budgeting uses knowledge about the relationship between the quantity of production units and the activities required to produce those units to develop detailed estimates of activity requirements underlying the proposed production plan The two main benefits of activity-based budgeting are It identifies situations when production plans require new capacity It provides a more accurate way to project future costs  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Managing the Budgeting Process (1 of 2)
Many organizations use a budget team, headed by the organization’s budget director or the controller, to coordinate the budgeting process The budget team usually reports to a budget committee, which generally includes the chief executive officer, the chief operating officer, and the senior executive vice presidents The composition of the budget committee reflects the role of the budget as the planning document that reflects and relates to the organization’s strategy and objectives  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Managing the Budgeting Process (2 of 2)
The danger of using a budget committee is that it may signal to other employees that budgeting is something that is relevant only for senior management Senior management must take steps to ensure that the organization members affected by the budget do not perceive the budget and the budgeting process as something beyond their control or responsibility  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Behavioral Aspects of Budgeting
Because of the human factor involved in the process, budgets often do not develop smoothly Social scientists have engaged in extensive study about the human factors involved in budgeting Two related areas are of particular importance with respect to the behavioral issues they raise: Designing the budget process Influencing the budget process  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Designing the Budget (1 of 2)
How should budgets be determined and who should be involved in the budgeting process? Three common methods of setting budgets are: Authoritarian A superior simply tells subordinates what their budget will be Participation All parties agree about setting the budget targets, using a joint decision-making process Consultation Managers ask subordinates to discuss their ideas about the budget but determine the final budget alone  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Designing the Budget (2 of 2)
Research shows that the most motivating types of budgets are those that are tight With targets that are perceived as ambitious but attainable Recently, companies such as Boeing and General Electric have implemented what are known as stretch targets Stretch targets exceed previous targets by a significant amount and usually require an enormous increase in a goal over the next budgeting period The theory is that only in this manner will companies completely reevaluate the ways in which they develop and produce products and services  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Influencing The Budget Process
When incentives and compensation are tied to the budget, some managers have been known to play budgeting games in which they attempt to manipulate information and targets to achieve as high a bonus as possible (or the best evaluation) Participation provides employees the opportunity to affect their budgets in ways that may not always be in the best interests of the organization Subordinates might ask for resources above and beyond what they need to accomplish their budget objectives  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Budget Slack Budget slack is created by requiring excess resources or distorting performance information If subordinates succeed in creating budget slack, they will find it easy to meet or exceed their budgeted objectives Budgeting games can never be eliminated, although some organizations have devised methods to decrease the amount of budget slack Management can use a long, iterative process to formulate the budget to remove much slack An incentive system may provide higher levels of bonuses based on attaining higher targets  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

If you have any comments or suggestions concerning this PowerPoint presentation, please contact: Terry M. Lease Sonoma State University  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

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