Qualification Paper Chapter Learning Objective Template ID Source

ACCA F5 6. Budgeting-1 CD1

Chapter Learning Objectives

Upon completion of this chapter you will be able to:

Explain why organisations use budgeting Explain how budgets can contribute to performance management Describe the factors which influence behaviour at work Discuss the issues surrounding setting the difficulty level for a budget Explain the benefits and difficulties of the participation of employees in the negotiation of targets Explain how corporate and divisional objectives may differ and can be reconciled Identify and resolve conflicting objectives, explaining the implications of the conflict and method of resolution

Budgeting

Purposes

Behavioural aspects

Performance management

Factors influencing behaviour

Behavioural implications

1 Purpose of Budgets
Qualification Paper Chapter Learning Objective Content, illustration and TYU included? Source

ACCA F5 6 Explain why organisations use budgets Yes ACCA 2.4 Study notes and study text and some original

1.1 Why do organisations use budgets ?

A budget is a quantitative plan prepared for a specific time period. It is normally expressed in financial terms and prepared for one year.

Illustration A frequently asked question in formulating the corporate plan is Where do we see ourselves in ten years time? To answer this successfully the firm must consider: what it wants to achieve (its objectives) how it intends to get there (its strategy) what resources will be required (its operating plans) how well it is doing in comparison to the plan (control). The budget is a short term operating plan, linked to the corporate plan, and will be used for detailed control.

Aims of budgeting Planning A budgeting process forces a business to look to the future. If a business does not look to the future it will fail in the short, medium or long term. It will fail because the organisation will become out of kilter with its environment. Control Actual results are compared against the budget and action is taken as appropriate. Communication The budget may form the basis of the reporting hierarchy. It is a formal communication channel that allows junior and senior mangers to converse. Co-ordination

The budget allows the business to co-ordinate all diverse actions towards a common corporate goal. Evaluation The budget may be used to evaluate the results of a part of the business such as a cost centre. It may further be used to evaluate the actions of a manager within the business. The costs and revenues appraised must be within the control that we are evaluating. Motivation The budget may be used as a target for managers to aim for. Authorisation and delegation

Test your understanding 1 Explain the difference between a budget and a forecast. Solution (to be put at end of chapter) An organisation may produce a range of forecasts under different scenarios to explore possible courses of action. The budget is the agreed plan towards which all of the organisation is working and which is used to measure actual performance.

Qualification Paper Chapter Learning Objective Content, illustration and TYU included? Source

ACCA F5 6 Explain how budgets can contribute to performance management Yes ACCA 2.4 study text and original

1.2 Budgets and performance management

Responsibility accounting divides the organisation into budget centres, each of which has a manager who is responsible for its performance. The budget is the target against which the performance of the budget centre or the manager is measured. The advantages of this approach are that There is a clear published target known throughout the organisation that is linked to the overall organisation aims (goal congruence) Managers may be involved in setting the targets which may make them more realistic Budget targets can be linked to individual rewards which may provide motivation to improve performance

The disadvantages of the approach are that

Managers may work towards specific short term budget targets to the detriment of long term organisational goals Managers may distort results to try to exceed targets and gain rewards

Management by exception is the practice of focusing on activities which require attention and ignoring those which appear to be conforming to expectations. When measuring performance it may be appropriate to concentrate on activities which are deviating from plan. Managers should use a flexed budgeting approach to adjust fixed budget targets to reflect actual volumes of output achieved. Managers should be measured against controllable costs and revenues

Illustration A simplified performance report for an operating division is shown below; 000 750 420 330 110 220 Uncontrollable fixed costs (share of general overhead) 150 Profit 70 Sales Variable costs Contribution Controllable fixed costs (or avoidable fixed costs) In this example, the key performance measure for the division is neither the contribution margin nor the net profit. It is contribution minus controllable fixed costs or profit before deducting apportioned general overheads.

Test your understanding 2 A wage award is agreed which exceeds the allowance incorporated in the budget. Discuss whether this is a controllable cost. Solution (to be put at end of chapter) For the production manager the additional cost is uncontrollable. It could be argued that the higher wage award could be controlled by the human resources function or at a senior level in the organisation.

2. Behavioural aspects of budgeting

Qualification

ACCA

Paper Chapter Learning Objective Content, illustration and TYU included? Source

F5 6 Describe the factors which influence behaviour at work. Yes CIMA P1 study text, ACCA 2.4 study notes and some original

2.1 Budgets and behaviour

Individuals react to the demands of budgeting and budgetary control in different ways and their behaviour can damage the budgeting process. Behavioural problems include dysfunctional behaviour and budget slack.

Dysfunctional behaviour is when individual managers seek to achieve their own objectives rather than the objectives of the organisation.

Budget slack (or bias) is a deliberate over-estimation of expenditure and/or under estimation of revenues in the budgeting process.

Illustration For many organisations in both the private and public sectors the annual budget is the basis of much internal management information. When preparing and using budgets, however, management and the accountant must be aware of their behavioural implications. Required: Explain the behavioural implications of budgets and the budgeting process. Solution The following are some of the relevant points: Budget difficulty- the budget should be set at the correct level to motivate employees Budgets and performance evaluation linking budgets to reward systems can lead to dysfunctional behaviour The degree of participation it is generally believed that participating in setting budgets improves motivation The management style the style of management adopted will influence behaviour

Research was carried out by Hopwood (1973) into the manufacturing division of a US steelworks, involving a sample of more than two hundred managers with cost centre responsibility. Hopwood identified three distinct styles of using budgetary information to evaluate management performance.

Budget constrained style Here, the main emphasis in performance evaluation is the managers success in meeting budget targets in the short term, with no consideration for other aspects of performance that are not targeted in the budget. A manager is criticised for poor results compared to the budget, for example if his actual spending exceeds the budget limit. Profit conscious style The performance of a manager is measured in terms of his ability to increase the overall effectiveness of his area of responsibility, in relation to meeting the longer term objectives of the organisation. At a cost centre level of responsibility, performance might be judged in terms of reducing costs over the longer term, rather than meeting short-term cost targets. Short-term budgetary information needs to be used with care and in a flexible way to achieve this purpose.

Non-accounting style With this style, performance evaluation is not based on budgetary information, and accounting information plays a relatively unimportant role. Other, non-accounting performance indicators are as important as the budget targets. Hopwoods research suggested that each style of performance evaluation had the following behavioural effects. With the budget constrained style, much attention was given to costs and there was a high degree of job-related pressure and tension. This often led to the manipulation of data in accounting reports. With the profit-conscious style, there was still a high involvement with costs but less jobrelated pressure. Consequently, there was less manipulation of accounting data. Relationships between managers and their colleagues and superiors were also better than with a budget-constrained style. With the non-accounting style, the results were very similar to the profit conscious style, except for a much lower concern with cost information. Hopwood found some evidence that better managerial performance was achieved where a profit conscious or non-accounting style was in use. Poor performance was often associated with a budget-constrained style. Subsequent studies by Otley (1978) involving profit centre managers in the UK coal mining industry contradicted Hopwood's earlier findings. One particular area of difference was that the UK study showed a closer link between the budget-constrained style and good performance. The manager evaluated on a rather tight budget-constrained basis tended to meet the budget more closely than if it was evaluated in a less rigid way.

Test your understanding 3 A manager is awarded a bonus for achieving monthly budgetary targets. State three possible behavioural implications of this policy. What should be done to try to improve the process ? Solution (to be put at end of chapter) The manager may try to delay discretionary short term expenditure, for example maintenance, at the expense of long term performance to improve results. manipulate results to make sure the relevant targets are achieved incorporate budgetary slack into the targets to make them easier to achieve

The process can be improved by measuring performance against a variety of targets, including non-financial targets, and linking performance to long term objectives.
Qualification

ACCA

Paper Chapter Learning Objective Content, illustration and TYU included? Source

F5 6 Discuss the issues surrounding setting the difficulty level of a budget yes ACCA 2.4 study notes, ACCA 2.4 study text + original

2.2 Setting the difficulty level of a budget

Targets will assist motivation and appraisal if they are at the right level. Not too difficult, as this will demotivate staff, not too easy, as managers are unlikely to strive for optimal performance.

An expectations budget is a budget set at current achievable levels. This is unlikely to motivate managers to improve but may give more accurate forecasts for resource planning. An aspirations budget is a budget set at a level which exceeds the achievable level. This will motivate managers to improve if it is seen as attainable but may always result in an adverse variance. This must be managed carefully.

Targets should be: communicated in advance dependent on factors controllable by the individual based on quantifiable factors linked to appropriate rewards and penalties chosen carefully to ensure goal congruence.

Illustration The concept of budget difficulty can be demonstrated diagrammatically as follows.

P e rfo rm a n c e M e a s u re , e .g . p ro fit Budget ta rg e t

A c tu a l p e rfo rm a n c e

E asy budget

D iffic u lt b u d g e t

Test your understanding 4 Explain whether an organisation should set an expectations budget or an aspirations budget. Solution (to be put at end of chapter) A budget has many purposes including Planning Control Performance evaluation Motivation An expectations budget is useful for planning, control and performance evaluation but is unlikely to encourage managers to improve. An aspirations budget sets targets which exceed current performance and provide a target for improvement. Managers may decide to set two budget targets to overcome this problem.
Qualification Paper Chapter Learning Objective

ACCA F5 6 Explain the benefits and difficulties of the participation of employees in the negotiation of targets No illustration too much overlap with other objectives ACCA 2.4 study notes + original

Content, illustration and TYU included? Source

2.3 Participation in setting targets

Managers may be involved in setting budget targets or these may be imposed by senior management without consultation. Advantages of participation include;

Increased motivation (ownership of target) Better understanding of an individual managers aspiration level so that the target can be set at a suitable level for an individual

Disadvantages of participation Time consuming May result in a wide range of targets which are seen as unfair Managers may understate targets to make them easier to achieve (ie incorporate budgetary slack) Negotiation may become a political process which draws attention away from running the business.

Test your understanding 5 A sales manager has achieved 550,000 of sales in the current year. Business is expected to grow by 10% and price inflation is expected to be 3%. Suggest a suitable budget target for the forthcoming year. Solution (to be put at end of chapter) Sales are expected to be 500,000 x 10% x 3% = 623,150. The manager may accept this as a fair target for performance appraisal, planning and control purposes. To encourage the manager to improve further an aspirations target incorporating a further improvement, say to 650,000, could be used and linked to the reward system.

Qualification Paper Chapter Learning Objective

ACCA F5 6 Explain how corporate and divisional objectives may differ and can be reconciled yes ACCA Paper 9 (old syllabus) + original

Content, illustration and TYU included? Source

2.4 Divisional performance evaluation

An organisation will want to measure and compare the performance of divisions and set targets for divisional managers, but this will have to be done with caution. Divisional targets should be linked to the achievement of corporate objectives and the performance evaluation system will have to be designed carefully to ensure that conflicts between corporate and divisional objectives do not arise. The most common methods of measuring divisional performance involve the use of return on investment (ROI) and/or residual income (RI).

ROI

Controllable divisional profit 100 Controllable divisional investment

RI

Controllable divisional profit

Imputed interest cost on controllable divisional investment

Illustration An organisation has a controllable profit of 50,000 and capital employed of 230,000. The cost of capital is 14%. ROI = 50,000/230,000 x 100 = 21.7% RI = 50,000 14% x 230,000 = 17,800 There are potential problems in using ROI or RI to measure performance; Targets set should take into account: - the difficulty of the economic environment in which a division is operating; - the motivational value of tough or lenient targets for the divisional manager concerned. An agreed definition of controllable profit and controllable investment should be used Targets should be linked to long term corporate objectives to avoid short term decisions being made which are detrimental to long term performance. The most common examples of these are - rejecting investments with positive NPVs because of the impact on ROI in the short term - reducing expenditure on activities such as research and development, maintenance and training - reducing costs at the expense of quality

Advantages of ROI As a relative measure it enables comparisons to be made with divisions or companies of different sizes It is used externally and is well understood by users of accounts. The primary ratio splits down into secondary ratios for more detailed analysis ROI forces managers to make good use of existing capital resources and focuses attention on them, particularly when funds for further investment are limited. The nature of the measure is such that it can clearly be improved not just by increasing profit but by reducing capital employed; it therefore encourages reduction in the level of assets such as obsolete equipment and excessive working capital.

Disadvantages of ROI Disincentive to invest - a divisional manager will not wish to make an investment which provides an adequate return as far as the overall company is concerned if it reduces the division's current ROI. Existing assets may be sold if, by doing so, ROI is improved even though those assets are generating a reasonable profit. Most conventional depreciation methods will result in ROI improving with the age of an asset. This might encourage divisions hanging on to old assets and deter them from investing in new ones. Alternatively a division may try to improve its ROI still further by leasing its assets. It is suggested that gross book value or even replacement cost should be used when evaluating performance. Also complex depreciation calculations are recommended by academics to overcome some of these difficulties. Corporate objectives of maximising total shareholders' wealth or the total profit of the company are not achieved by making decisions on the basis of ROI.

Residual income overcomes many of the disadvantages of ROI, specifically: It reduces the problem of under investing or failing to accept projects with ROI's greater than the group target but less than the division's current ROI. As a consequence it is more consistent with the objective of maximising the total profitability of the group. It is possible to use different rates of interest for different types of asset. The cost of financing a division is brought home to divisional managers.

There are certain problems common to both measures. Calculation of profit - apart from issues such as its controllability there is some scope, even within the strictures of a group accounting policy, for some variation in treatment of depreciation. Also the need to increase profit may lead to cutting down on discretionary costs such as training, advertising and maintenance which, whilst improving short-term profit figures, will jeopardise the long-term future of a business. Standards for these should be set and monitored. Asset measurement - again group policies should ensure a consistent treatment, but comparison is difficult when some divisions buy and some lease assets. Thought has to be given to the treatment of permanent bank overdrafts; are these current liabilities or a source of finance? Conflict with investment decisions - the performance of a division will be influenced by investment decisions that it makes; however those decisions should be made on the basis of NPV calculations, whereas the subsequent performance of the division is assessed by a different criterion. Clearly there is likely to be a problem when a long-term investment decision is accepted, but the short-term effect on profit is detrimental.

Illustration Division X of ABC plc, currently generating an ROI of 12%, is considering a new project. This requires an investment of 1.4 million and is expected to yield net cash inflows of 460,000 per annum for the next four years. None of the initial investment will be recoverable at the end of the project. ABC plc has a cost of capital of 8%; annual accounting profits are to be assumed to equal annual net cash inflows less depreciation, and tax is to be ignored. Solution NPV of project at 8% This can be computed using the annuity discount factor for four years at 8%: NPV = 460,000 3.312 - 1,400,000 = 123,520 The project is therefore worthwhile accepting from the companys point of view. ROI and RI using straight line depreciation Annual depreciation on a straight-line basis will be 1.4m/4 = 350,000 per annum. ROI and RI computations will be as follows:

Year 1 000 NBV at start of year Net cash inflow Depreciation Profit Interest on capital @8% RI 1,400 _____ 460 350 ___ 110 112 ___ (2) ___ 7.9%

Year 2 000 1,050 _____ 460 350 ___ 110 84 ___ 26 ___ 10.5%

Year 3 000 700 ___ 460 350 ___ 110 56 ___ 54 ___ 15.7%

Year 4 000 350 ___ 460 350 ___ 110 28 ___ 82 ___ 31.4%

ROI on NBV

If the managers performance is measured (and rewarded) on the basis of RI or ROI he is unlikely to accept the project. The first years RI is negative, and the ROI does not exceed the companys cost of capital until year 2, or that currently being earned until year 3. Divisional managers will tend to take a short-term view; more immediate returns are more certain, and by year 3 he may have moved jobs.

Test your understanding 6 Division Z has the following financial performance: Operating profit Operating assets Cost of borrowing 40,000 150,000 10%

Would the division wish to accept a new possible investment costing 10,000 which would earn profit of 2,000 pa if the evaluation was on the basis of (a) (b) ROI; Residual income?

Solution (to be put at end of chapter)

(a)

Current ROI =

40, 000 = 26.7% 150, 000

If the investment is accepted, revised ROI

42 , 000 = 26.3% 160, 000

ie, REJECT the project (b) Current RI = 40,000 (10% 150,000) = 25,000

Revised RI = 42,000 (10% 160,000) = 26,000 ie, ACCEPT the project Note here is a classic example of ROI giving the wrong conclusion in that a project that was worthwhile as far as the company was concerned is rejected since it reduces the division's current ROI.

3. Conflicting Objectives
Qualification Paper Chapter Learning Objective

ACCA F5 6 Identify and resolve conflicting objectives, explaining the implications of the conflict and method of resolution

Content, illustration and TYU included? Source

Original

Throughout this chapter there have been examples of conflicting objectives that occur in budgeting. The implications of the conflicts and the method of resolution will often be specific to the organisation and will depend on

the specific purpose for which the budget is to be used the management style and culture of the organisation the knowledge and experience of the managers preparing budgets

Illustration It is generally believed that participation in the target setting process is to be encouraged as it should lead to increased motivation, which is an important purpose of budgeting. Participation may conflict with accurate planning, however, as managers may attempt to incorporate budgetary slack into targets to make them easier to achieve. Organisations may attempt to overcome the problems created by participation in different ways; by training managers in budgeting so that they are aware of the problems caused by inaccurate budgeting by linking rewards to the achievement of overall company objectives by using a rigorous system to justify any increases in budget allowances

Test your understanding 7 Identify four other areas of budgeting which may result in conflicting objectives. Suggest implications of these conflicts and how they could be resolved. Solution (to be put at end of chapter) Four possible areas are; Target setting conflict between setting a target based on current levels of performance for planning and control and a higher level for motivation Responsibility accounting conflict between including only controllable costs for motivation purposes and all costs for control purposes Linking budget targets to a reward system this may lead to improved performance but may also result in manipulation of data and dysfunctional behaviour Divisional targets using ROI may provide a measure which can be used for comparison and may motivate the division to improve performance but may also lead to the rejection of good investments.

Chapter Summary
Qualification Paper Chapter Template ID Source

ACCA F5 6

Budgeting

Purposes Planning Control Communication Co-ordination Authorisation Motivation

Behavioural aspects

Performance management Responsibility accounting Management by exception Controllable versus uncontrollable costs

Factors influencing behaviour Target setting Participation in budget process Linking of reward systems to targets

Behavioural implications Dysfunctional behaviour Budget slack Short termism