Flexible Budget Management - Assignment Example

a) A budget is a financial or quantitative statement, containing the plans and policies to be pursued by an organisation during a specified accounting period usually a fiscal year. (Blocher et al, 2005: Owe and Law, 1999). It is usually prepared prior to the accounting period and it is used as a means for budgetary control. A budget is drawn up for each functional area of the company or organization. Also, a capital budget, a cash flow budget, stock budget and a master budget containing a budgeted income statement and balance sheet is prepared. (Owe and Law, 1999). Budgets are prepared in a section in the organization referred to as the budget centre, which is responsible for comparing budgets with actual performance as part of the budgetary control process. (Owe and Law, 1999). Regular financial statements are usually prepared on the basis of each budget center and as such each budget centre is aware of its budgeted and actual performance as well as any subsequent variances. (Owe and Law, 1999). Some of the different budgets prepared in the budget centres include, sales budget, production budget, direct materials usage and purchases budget, direct labour budget, factory overhead budget, cost of goods sold budget, selling and general administrative expenses budget, cash receipts budget, cash budget, budget income statement and budget balance sheet. (Blocher et al, 2005). Two types of budgets have been identified, which include a fixed budget and a flexible budget. A fixed or static budget is a budget that is prepared at the beginning of the accounting period and is based on cost and revenue estimates (Blocher et al, 2005; Owe and Law, 1999). This budget does not consider the circumstances that lead to the achievement of different levels of activity from that budgeted and as a result the budget cost allowances for each cost item are not changed for the variable items. (Owe and Law, 1999). A flexible budget on the other hand, is a budget prepared at the end of the accounting period when actual results for the period are known. It is prepared by adjusting receipts and payments to the actual level of activity attained. (Blocher et al, 2005). Deviations from budgeted production level will lead to a change in the firm’s revenues and expenses. (Blocher et al, 2005). Therefore a flexible budget takes into account the fact that changing circumstances will lead to a change in the values for income and expenditure on some items and thus provides allowances for each variable cost item to allow for the actual levels of output achieved. (Owe and Law, 1999). Budget cost allowances refer to the amount of budgeted expenditure that a cost centre or budget centre is allowed to spend according to its budget, having regard to the level of activity (or other basis or cost insurance) actually achieved during the budgeted period. The budget cost allowance is usually based on the level of activity achieved and whether the cost item is classified as a fixed or a variable cost. (Owe and Law, 1999). For the manufacturing company, it might need to prepare a flexible budget that adjusts for budgeted production units to actual production units, budgeted sales units to actual sales units, budgeted selling price to actual sales price. For a distribution company it will have to adjust for budgeted purchase price to actual purchase price per unit, budgeted sales to actual sales. Flexible budgets can assist management answer a lot of questions concerning its operation. According Blocher et al (2005), some of the pertinent questions that can be answered using a flexible budget include: 1. Why net income has gone down 2. Why the expenses have gone from 75 to 80 percent of sales. Can management do something to prevent the same thing from happening next year? 3. Why selling and general expenses have increased $10,650? 4. What are the reasons for the deterioration in operating results? Is it because of changes in a. Units sold? b. Sales price? c. Sales mix? d. Manufacturing or merchandising cost? e. Selling and general expenses? By using a flexible budget management can answer the above questions and revise its budget for subsequent periods. The most common difference between flexible and Master budgets is in the number of budgeted output units. Other factors, such as units selling prices and unit variable costs, are the same in flexible budgets as the amounts in the master budget. (Blocher et al, 2005). Total fixed costs usually remain the same. (Blocher et al, 2005). From the foregoing, if Parks Manufacturing Parks, adopts a flexible budget it will be easier for it to apply its management by results bonus scheme because targets set using flexible budgets are easier to meet than those set using fixed budgets since managers become are free to provide information they feel might have led to variances. By using flexible budgets management would be able to understand why they cannot attain certain levels of activity and by so doing targets can be revised. By adopting a flexible budget, managers will not be penalized for not achieving targets due to circumstances beyond their control since after analyzing variances it will be possible for the company to better understand whether the variance is due to circumstances within the manager’s control or not. Also managers tend to hide information when the company adheres to a strict fixed budget as a basis for measuring their performance. By so doing they do not provide information about what might have led to variances for fear that they might be sanctioned. Thus by adopting a flexible budget, parks manufacturing will better measure the performance of her managers and managers who cannot attain certain targets because of circumstances beyond their control will not be penalized for not doing so. b) Parks Manufacturing Parks Variable Overhead Budget for 2006 Direct Labour Hours 48000 54000 60000 80% Activity Level 90% Activity Level 100% Activity Level £ £ £ Indirect labour 72 000 81 000 90 000 Consumer supplies 36 000 40 500 45 000 Miscellaneous Variable Costs 25 920 29 160 32 400 Semi-variable costs 17 800 18 600 19 800 Total Variable costs (1) 151 720 169 260 187 200 Fixed Costs Depreciation 36 000 36 000 36 000 Maintenance 20 000 20 000 20 000 Insurance 8 000 8 000 8 000 Rates 30 000 30 000 30 000 Management salaries 50 000 50 000 50 000 Total Fixed Costs (2) 144 000 144 000 144 000 Total Overhead costs (1) +(2) 295 720 313 260 331 200 Notes: i. The direct labour hours is calculated by multiplying the activity level (%) by 60000 direct labour hours. ii. Indirect labour cost is calculated by multiplying the total direct labour hours by £1.5. iii. Miscellaneous variable cost is 6% of total direct labour cost plus indirect labour cost. For example, under the 80% activity level Total direct cost = 48,000 x £7.5 = £360,000 Indirect labour cost = 48,000 x £1.5 = £72,000 Total £432,000 Miscellaneous Variable cost = 0.06 x £432,000 = £25,920 The same procedure is also applied for the 90% and 100% activity levels. iv. Semi variable costs are assumed to correlate with direct labour hours in the same way as for the past five years. For example the semi-variable cost for 53,000 direct labour hours in 2004 was £18,600 thus that for 54,000 units will approximately be the same. c). A volume-based costing system is a costing system that assigns overheads to products based on the output level achieved. (Blocher et al, 2005). Overhead or indirect costs are arbitrarily assigned to products based on either labour or machine hours rather than based on the product’s demand for activities and thus resources. (Blocher et al). Activity based costing (ABC) on the other hand is a cost accounting system that recognizes the fact that costs are incurred by each activity that takes place within the organization and that products (or customers) should bear costs in proportion to their demand for activities. (Owe and Law, 1999). ABC was proposed by Professor Johnson and Kaplan in their book “Relevance Lost: The Rise and Fall of Management Accounting (1987)”. (Owe and Law, 1999). Using ABC cost drivers are identified alongside activity cost pools and these cost pools are used as the basis for allocating costs to products. (Owe and Law, 1999). Supporters of ABC assert that ABC provides accurate cause-and-effect allocations that cannot be achieved by using volume based costing systems. (Owe and Law, 1999). ABC considers the fact that products consume activities and activities consume resources, which in turn consume money. Therefore it assigns costs to products based on the products demand for activities and thus resources, which are costly to acquire. (Blocher et al, 2005; Cooper and Kaplan, 1992) A volume based costing system on the other hand allocated costs to products using arbitrary methods such as direct labour hours. These systems have proven to be appropriate when manufacturing systems used to be labour intensive, when labour used to be the principal value-adding activity in the raw material conversion process. (Cooper and Kaplan, 1992). However, with the advent of sophisticated technological developments and automation of manufacturing processes, direct is no longer directly working in the conversion of materials to products. Instead labour is simply engaged in setting up machines and supervising production activities (Kaplan and Cooper, 1992). Products that are manufactured in low quantities tend to incur more costs that those that are produced in large batches. The costs incurred per unit on these low-volume products are usually higher than that for the high-volume products. (Kaplan and Cooper, 1992). Therefore, when a volume based costing system is used to allocate overhead costs to products both low- and high-volume products are allocated equal amounts of costs. (Kaplan and Cooper, 1992). By applying ABC, low-value-added activities and high-value-added activities can be identified and thus low-value-added activities can be eliminated or phased out. High-value added activities are activities that that significantly increase the value of products or services to customers. (Blocher et al, 2005). Thus eliminating a high-value added activity reduces customer satisfaction and thus market share as well as profit and firm value. For example installing an anti-virus into a Computer to protect it from viruses increases satisfaction to customers since customers will not want to find their systems damaged by viruses or Spam. (Blocher et al, 2005) A low-value-added activity on the other hand is an activity that consumes time, resources and space, but adds little or no satisfaction to the customer. If eliminated customer satisfaction does not decrease significantly. (Blocher et al, 2005). d) Three non-financial performance measures include customer satisfaction, Internal business processes, and innovation. (Blocher et al, 2005). Customer satisfaction measures the quality, service, and low cost among others and how well the firm satisfies its customers. Critical success factors for customer satisfaction include customer returns and complaints, customer survey. The higher the number of customer returns and complaints, the lesser it will be for the company to meet its targets. Therefore by measuring the number of customer complaints and returns, the firm can better understand the needs of the customer and revise its strategy to better satisfy them and as well increase their value. Increasing customer value increases firm value as well. This leads to an increase in shareholder value, which remains one of the most important reasons for operating any business venture. (Libby et al, 2002). The number of customers retained and the number of sales referrals is critical to the success of the business as it in turn determines the market share and thus sales forecasts and future profitability. (Libby et al, 2002). Quality, performance and cost are the primary concerns of customers (Best of Harvard Business Review, 1992). Therefore providing customers with high quality, high performance and low cost products can increase customer satisfaction, which will in turn increase market share as well as sales revenue. Internal business processes measures the firms quality, productivity, flexibility and equipment readiness. (Blocher et al, 2005). Quality can be measured by the number of defects, number of returns, customer survey, amount of scrap, amount of rework, field service reports, warranty claims and vendor quality defects. (Blocher et al, 2005). For example, the lower the number of defects, warranty claims, scrap and amount of rework, the higher the quality. Productivity is measured by cycle time; which measures the time taken from raw materials to finished products, labour efficiency, amount of waste rework and scrap. Product innovation is measured by the number of design changes, number of new patents or copyrights, skills of research and development staff. (Blocher et al, 2005) The higher the number design changes made by the company, number of patents held by the company, and the more skilful the research and development staff, the more innovative the company will be and thus the more profitable. Timeliness of new products is also an essential success factor. (Blocher et al, 2005). The shorter the time the company takes to ship new launch and ship new products as compared to competitors, the more profitable the company will be as it will be possible for it to benefit from early sales before competitors start launching the same products. e) Budgeting can play a number of roles in a company’s financial planning and control activities. A company relies on the master budget as it carries out its strategic plan to meet the company’s strategic goals. (Blocher et al, 2005). The sales budget, which shows expected sales in units at their expected selling price is prepared for a period based on the forecasted sales level, production capacity for the budget period, and long-term plan and short-term goal of the firm. (Blocher et al, 2005). The sales budget remains the corner stone of the budgetary preparation process because other budgets are prepared only after the sales level has been determined. (Blocher et al, 2005). After determining the level of sales, the firm can then move ahead to prepare the production budget which is a plan for acquiring the resources needed to carry out the manufacturing operations so as to satisfy expected sales and maintain the desired ending inventory. (Blocher et al). The production budget can therefore help the firm decide on its ending inventory level. Insufficient inventory leads to lost sales and too much inventory can go obsolete. (Blocher et al, 2005). The firm can therefore address these issues during the production budgeting process. Based on the production budget, the firm can prepare the direct labour budget. This budget helps the human resource department to plan for hiring and repositioning of employees. A good direct labour budget will help the firm avoid emergency hiring and labour shortages as well as eliminate the need to lay off workers. (Blocher et al, 2005). After preparing the direct labour budget, the other budgets that follow include: factory overhead, cost of goods manufactured and sold budget, merchandise purchase budget, selling and general administrative expenses budget, cash receipts budget, cash budget, and an income statement and balance sheet budget. (Blocher et al, 2005). These budget are aggregated into a single budget know as the master budget. The master budget is a comprehensive budget consisting of all interrelated operating and financial budgets. (Blocher et al, 2005). Budgets reflect targets set by the organisation to be met within a specific time frame. Therefore budgets can help the organisation to determine why its targets are not being met and to measure the performance of managers as earlier observed under the discussion for flexible budgets. By using budgets the company can calculate and understand variances and by so doing revise the strategy of the organisation. Best of HBR. (1992). The High Performance Organisation. Harvard Business Review. Pp 172-180 Blocher E., Chen K., Cokins G., Lin T. (2005). Cost Management A strategic Emphasis. 3rd Edition McGraw Hill. Cooper R., Kaplan R. S. (1992). Activity-Based Systems: Measuring the Costs of Resource Usage. Accounting Horizons. Vol. 6(3), Pp 1-12. Libby, Theresa, Salterio, Steven E. and Webb, Alan (2002). "The Balanced Scorecard: The Effects of Assurance and Process Accountability on Managerial Judgment" Available at SSRN: http://ssrn.com/abstract=317486 or DOI: 10.2139/ssrn.317486 Owe G., Law E. J. (1999). A Dictionary of Accounting. Oxford University Press, 1999. Oxford Reference Online. Oxford University Press. http://www.oxfordreference.com/views/ENTRY.html?subview=Main&entry=t17.e1562 Read More