APM ch. 5 Budgeting and control

What is performance mgmt?

Any activity designed to improve an organisation’s performance and ensure goals are being met.

Budgeting in perf management

It is an important tool for planning and control within an organisation and contributes to perf management by providing targets against which to compare actual results (thrg variance analysis) and develop corrective measures.

Method of budgeting

1. Fixed and flexible budgets

2. incremental budgets

3. zero based budgets

4. rolling budgets

5. activity based budgets

What is top-down budget

Non-participative budget is imposed on the budget holder by senior management.
budget holder does not participate in budget setting process

advantages and disadvantages of top-down

advantages:

• senior managers retain control

• budget setting process can be quicker

• avoids budgetary slack

• avoids dysfunctional behaviour (divisional manager lack strategic perspective, focus on division needs and may not be in line with corp obj.

disadvantages

• lack of acceptance from divisional managers

• takes up more time for senior mgmt

• senior managers may have lack local knowledge & not fully appreciate what is actually achievable in each division

bottom up budget

participative budget involves budget holders in the setting of budget

Adv & dis of bottom-up budget

Advantages:

• improved motivation due to sense of ownership and empowerment

• increases divisional managers’ understanding

• frees up senior mgmt resource

• improves quality of decision making since division managers r close to their product markets

Disadvantages:

• lead to budgetary slack

• lead to dysfunctional behaviour

• senior managers lose control

• budget setting more time-consuming

• lead to bad decisions from inexperienced managers

Incremental budget

starts with the previous period's budget or actual results, and adds (or subtracts) an incremental amount to cover inflation and other known changes (e.g. an extra worker or additional machine).

When is incremental budget suitable?

Stable business in which costs not expected to change significantly

should be good cost control (managers efficient in controlling costs, work hard to be efficient and to eliminate waste)
limited discretionary costs (avoidable costs such as training, r&d

non-essential nature means that inclusion in the budget should be justified rather than automatic

advantages of incremental budget

1. quickest and easiest and low cost

2. assume historic fig are acceptable only increment needs to be justified

3. avoids reinventing the wheel if env is table and therefore costs are not expected to change sig

4. works weel in an env where there is good cost control and or limited discretionary costs

disadvantages of incremental budget

1. backward looking

2. builds in previ problems, inefficiencies and wastage

3. increments does not encourage managers to be more efficient in controlling costs, reduce waste or to find new innovative ways of doing things

4. activities do not have to be justified and so uneconomic activities may be continued

5. managers may build in slack

6. managers may spend up to their budget (to ensure they get an increment from the highest possible base figure)

Zero based budgeting

a method of budgeting that requires each cost element to be specifically justified. Without approval, the budget allowance is zero.

suitability of zero based budgeting

• Fast moving (dynamic) businesses/industries.

• For allocating resources in areas of discretionary spending

• Public sector organisations such as local authorities. These organisations have strict constraints on the amount of funding they receive, and this funding should be put to the best use

process of ZBB

1 Determine the activities that are to be used as the objects of a decision package

2.Each of the individual activities is then described in a decision package (purpose of activity, cost and benefits expected from given activity). drawn up in such a way package can be evaluated and ranked against other packages

3 Each decision package is evaluated and ranked using cost/benefit analysis

4 The resources are then allocated to the various packages based on the order of priority

advan and disadvan of ZBB

adv:

• resources should be allocated efficiently and economically

• inefficient or obsolete operations will be identified and discontinued or budgetary allocation altered

• ZBB leads to increased staff involvement at all levels. should lead to better comm & motivation

• responds to changes in bus. environ. & so is more suited in fast moving org/ industries

• knowledge & understanding of cost-behavoir patters of org will be enhanced

disadv:

• time consuming and costly (profit seeking org unlikely to use) rather use in particular area

• may emphasise short term benefits to detriment of long-term benefit

• budgeting process may become too rigid, and company may not be able to react to unforeseen opp or threats

• need for mgmt skills that may not be present in org

• managers may feel demotivated due to large amount of time spent on budgeting process

• difficult to compare and rank diff types of activity

• rankings of packages may be subj. where benefits are of a qualitative nature

rolling budgets suitability

1. when Accurate forecasts cannot be made, e.g. in a dynamic business environment or in a new business.

2. For any area of business that needs tight control since the budget should be more realistic and accurate.

advantages of rolling budgets

1. planning and control based on a more accurate budget

2. much better info upon which to appraise the perf of mgmt, rolling budgets reduce the elements of uncertainity since they concentrate on the short-term

3. always a budget that extends for a fixed period into the future

4. forces mgmt to take the budgeting process more seriously. budget is reassessed and update regularly

disadvantages of rolling budget

1. more costly and time consuming

2. an increase in budgeting work may lead to less control of the actual results

3. danger that budget may become the last budget plus or minus a bit

4. may be demotivating because tartes are changed regularly and/ or employees feel they spend a large proportion of their time budgeting

advantages of ABC

1. provides a more accurate cost per unit since it recog overhead costs are not all related to prod and sales vol. leading to better pricing, decision making, perf mgmt & control

2. costs are categorised by activities and provides more relevant info to managers

3. better insight into what drives overhead costs = better cost control

4. applied to all overhead costs not just prod overhead

5. can be used just as easily in service costing as prod costing

disadvantages of ABC

1. benefits might not justify cost (initial setup cost, staff train cost, cost of potential staff resis, cost of changing system to capture info require and ongoing cost of using ABC) especially if overheads are primarily volume related or small proportion of total costs.

2. impossible to assign all overheads to specific activities

3. choice of cost drivers may in inappropriate

4. may be difficult to assign responsibility for individual cost pool

5. limited benefit if activity costs are already well-controlled and process is already efficient

6. customers may not tolerate changes made as a result of the exercise i.e. price increase

what is abc?

ABC budgeting prepares budgets using overhead costs derived from activity based costing.

What is ABM?

Activity based management is the use of ABC information for management purposes to improve operational and strategic decisions. It applies ABC principles in order to satisfy customer needs using the least amount of resources.

Operational ABM advantages

ABM can help operational managers make decision that can improve operational efficiency and hence performance:
1. It may identify and then reduce or eliminate activities that do not add value to customer and refocus on value adding activities. this cut costs without reducing product value

2. find ways to continually improve value-adding activties. abm may establish ways to produce prod more efficiently by understanding what drives cost of activities and find ways to reduce the incidence of these cost drivers without impacting quality.

3. may identify design improvement e.g change in des. to prevent quality prob and associates costs such as wastage

Risks related to use of oprtational ABM

1. Some activities will have an implicit value that is not necessarily reflect in the financial value. e.g. pleasant workplace = retain/attract talent but risk of op abm is that this abm is eliminated

Strategic ABM

1. ABC information helps managers determine which products to sell and develop and based on profitability (product profitability)

   • identify the underlying cost drivers which helps understand the resource implication of various course of actions. This prevents us from choosing unfeasible course of action and eliminate non-profit making products

   • helps re-pricing

   • helps set price of new products

2. assists in building better relationship with customers & suppliers through working closely with Customer to understand their needs & with Suppliers to improve quality cost

3. customer profitability analysis (CPA) apportioning overheads to diff types of customer. understands which customer should be focused on and where cost efficiencies can be made.

ABB?

Activity based budget uses costs determined in ABAC to prepare budgets for each activitiy.
1. cost driver for each activity is identified. A forecast is made of the no. of units of the cost driver that will occur in the budget period.

2. Given the estimate of the no. of units of cost driver, the activity cost is estimated.

advantages of ABB

1. ABB draws attention to costs of overhead activities which can be a large propor. of total operating costs

2. Recog that it is activities that drives costs. if we can control the drivers then costs would be better managed and understood

3. can be used to identify csfs, e.g. a specific activity that must be done efficiently or accurately

4. provides useful information for TQM environment by relating cost of an activity to the level of service provided. focuses on controlling costs without neg impact on quality.

disadvantages of ABB

1. time consuming and takes effort to establish an ABB system

2. staffing issues e.g. resistance to change or cost of training staff

3. cost of adapting information system so they can collect and process large amount of activity and cost driver infromaiton

4. ABB might not be appro. for org and its activtiies and cost structure

5. difficult to identify indivi respon for acitivties and hence, accoutnability for achivement of acitvity budget

6. can be argued short term many overhead costs are not controllable and do not vary directly wtih changes in volume of activity of the cost driver

Fixed budget vs flexible budget

A fixed budget is a budget prepared at a single level of activity. A flexible budget is prepared at a number of activity levels and can be 'flexed' or changed to the actual level of activity for budgetary control purposes.

planning variance

Difference between original standard and revised one. cause by inaccurate forecasts/ standards in org budget setting.

operational variance

diff between revised standard and actual performance. Due to decisions by operational managers

advantage & dis of splitting plan & op variance

Adv: Line managers can concentrate on improving op matters for which they are truly responsible and accountable.

Dis: too often all adverse var. are explained away as planning errors

if revised standard is harder to achieve than org. manager could become unmotivated by moving target

What is BB?

Beyond Budgeting is an approach to PM and control that tries to resolves weakness and limitation of traditional approaches to budgeting.

principles of BB

1. Governance and transparency

   • employees bound by clear org mission and set of values (common cause) rather than a central plan

   • governance is through shared values and sound judgement

   • information is open and transparent

2. accountable teams

   • org consists of network of AT who are empowered & trusted to regulate their perf w/ limited centralised and hierarchical control & no micro mgmt

   • team managers & employees are given high degree of freedom to make decisions tht generate value

   • teams r responsible for relationship w customers, suppliers and other stakeholders

   • budgets may be used but these will be set at local level (bottom up)

3. Goal, targets and rewards

   • managers will be given a range of challenging but controllable, goals and targets linked to shareholder value

   • targets often based on external benchmarks

   • innovation and continuous improvement is encouraged and rewarded

4. planning and control

• planning is continuous and inclusive process

• rolling budgets may be used.

• focus is not future not past events. controls r based on fast, frequent feedback and not budget variances