Management Control

COSTING SYSTEMS

Overheads

If a company manufactures a product, the cost will include the cost of the raw materials and components used in it and the cost of the labour effort required to make it.  These are direct costs.  The company would, however, incur many other costs in making the product which are not directly attributable to a single product but which are incurred generally in the process of manufacturing a large number of units.  These are indirect costs or overheads and include:

  • Factory rent and rates
  • Machine depreciation
  • Supervision costs
  • Lighting etc.

 

Absorption costing

A method of product costing which aims to include in the total cost of a product an appropriate share of an organisation‟s total overhead – generally an amount which reflects the amount of time and effort that has gone into producing the product.

Over-absorption: Overheads charged to the cost of sales are greater than the overheads actually incurred.

Under-absorption:        Insufficient overheads have been included in the cost of sales.

Marginal costing

An alternative to Absorption Costing.  Only variable costs (marginal costs) are charged as a cost of sales.  Fixed costs are treated as period costs and are charged in full against the profit of the period in which they are incurred.

Closing stocks are valued at marginal (variable) production cost, whereas in absorption costing stocks are valued at full production cost, which includes absorbed fixed production overhead.

If opening and closing stock levels differ the profit reported for the accounting period under the two methods of cost accumulation will be different.  However, in the long-run total profit will be the same, whichever method is used, because total costs will be the same by either method of accounting.  Different accounting conventions merely affect the profit of individual periods.

If stock levels increase between the beginning and end of a period, absorption costing will report the higher profit because some of the fixed production overhead incurred during the period will be carried forward in closing stock (reducing cost of sales), to be set against sales revenue in the following period instead of being written off in full against profit in the period concerned.

If stock levels decrease absorption costing will report the lower profit because in addition to the fixed overhead incurred, fixed production overhead which had been carried forward in opening stock is released and is also included in cost of sales.

Marginal Costing v Absorption Costing

With Marginal Costing contribution varies in direct proportion to the volume of units sold.  Profits will increase as sales volume rises, by the amount of extra contribution earned.  Since fixed cost expenditure does not alter, Marginal Costing gives an accurate picture of how a firm‟s cash flows and profits are affected by changes in sales volumes.

In contrast, with Absorption Costing there is no clear relationship between profit and sales volume and as sales volume rises the total profit will rise by the sum of the gross profit per unit plus the amount of overhead absorbed per unit.  Arguably, this is a confusing and unsatisfactory method of monitoring profitability.

If sales volumes are the same from period to period, marginal costing reports the same profit each period.  In contrast, with Absorption Costing profits can vary with the volume of production, even when the volume of sales is constant.  Under Absorption Costing there is therefore, the possibility of manipulating profit, simply by changing output and stock levels.

Absorption Costing – the effect of higher production volumes is to reduce unit costs (lower fixed cost per unit) and if sales prices are based on the “cost plus” method, the relevance of output capacity to cost/price/sales demand should be clear.  Marginal Costing fails to recognise the importance of working to full capacity.

Selling prices based on Marginal Costing might enable the firm to make a contribution on each unit of product it sells but the total contribution earned might be insufficient to cover all fixed costs.

In the long run, all costs are variable and inventory values based on Absorption Costing will give recognition to these long-run variable costs.

Opportunity Costing

An opportunity cost is the benefit foregone by choosing one opportunity instead of the next best alternative.

With Opportunity Costing the costs of resources consumed are valued at their opportunity cost rather than at the amount it actually costs to acquire them.  If no alternative use for a resource exists then the opportunity cost is zero.

The main argument in favour of Opportunity Costing is that management is made aware of how well it is using resources to make products and whether resources could be better used in other ways.

The main drawback is that it is not always easy to recognise alternative uses for certain resources, or to put an accurate value on opportunity cost.  It is only likely to be accurate if resources have an alternative use which can be valued at an external market price, such as factory rental, or staff time in the case of professional firms of accountants etc.

Opportunity Costing is often used to determine an absolute minimum below which the price should not be set.

Activity Based Costing (ABC)

Activity Based Costing involves the identification of the factors which cause the costs of an organisation‟s major activities.  Support overheads are charged to products on the basis of their usage of the factor causing the overheads.

 

A Cost Driver is the factor which causes the costs of an activity.  Examples are:

 

Activity                                   Cost Driver

 

Ordering                      Number of Orders

 

Production Scheduling                        Number of Production Runs

 

Despatching                Number of Despatches

 

Calculating product costs using ABC

 

Step 1

 

  Identify an organisation‟s major activities
Step 2

 

  Identify the factors which determine the size of the costs of an activity/cause the costs of an activity.  These are Cost Drivers
Step 3

 

  Collect the cost of each activity into Cost Pools
Step 4   Charge support overheads to products on the basis of their usage of the activity.

 

ABC v Absorption Costing

Allocation & Apportionment of Overheads

The re-apportionment of service department costs is avoided because ABC establishes separate cost pools for support activities, such as dispatching and the costs of these activities are assigned directly to products through cost driver rates.

Absorption of Overheads

The principal difference is the way in which overheads are absorbed into products.  Absorption Costing usually uses two absorption bases (labour hours and machine hours) to charge overheads to products.  ABC uses many cost drivers as absorption bases (number of orders, number of dispatches etc.)

Cost Drivers & Absorption Rates

The principal idea of ABC is to focus attention on what causes costs to increase – the Cost Drivers.

Advantages of ABC

  • It focuses attention on the nature of cost behaviour and attempts to provide meaningful product costs.
  • The complexity of manufacturing has increased with wider product ranges, shorter product life cycles, a greater importance being attached to quality and more complex production processes. ABC recognises this complexity with its multiple cost drivers.
  • It facilitates an understanding of what drives overhead costs.
  • ABC is concerned with all overhead costs.
  • It focuses attention on non-value added activities.

 

Standard Costing

Standard Costing is a method of cost accounting which incorporates standard values and their differences from actual values – variances

The standard cost is the expected cost of a single cost unit expressed in money values for a defined future period of time.  There are a large number of bases which may be used to set standards:

  • Basic Standard: Long-term standard which remains unchanged over the years and is used to show trends.
  • Ideal Standard: Standard which can be attained under perfect operating conditions – no wastage, no inefficiencies, no idle-time, no breakdown etc.
  • Attainable Standard: Standard which can be attained if production is carried out efficiently, machines are properly operated, materials are properly used etc.  Some allowance is made for wastage and inefficiencies.
  • Current Standard: Standard based on current working conditions (current wastage/inefficiencies).

 

Life Cycle Costing

Life Cycle Costing tracks revenues and costs for each product over the entire product life cycle.

 

            Introduction  =>  Growth  =>  Maturity  =>  Decline

 

Traditional systems accumulate revenues and costs on a periodic basis (12 months)

Target Costing

A Target Cost is set by subtracting a desired profit margin from a competitive market price.

The following steps may be taken:

  • Researching the market to determine what price customers will be willing to pay for a particular specification and what sales volumes are likely to be achieved.
  • Deducting an acceptable level of margin from the target price to result in the target cost at which the product/service must be made/delivered.
  • Meeting the target cost challenge – accountants, engineers and designers etc. set about the challenge to make/supply the product/service to the desired specification within the target cost.

 

If successful, target costing should ensure that the necessary specification can be made at a cost which will enable a price to be set which will deliver the margin and sales volume required to satisfy the financial objectives set for that particular product.

 

VARIANCES

 

Calculation of Standard Variances

Variance Analysis is the process by which the total difference between standard and actual results is analysed.  The variance may be Favourable or Adverse.  The main variances are:

Sales Variances:

 

Sales Volume Variance

Should Have Sold                                           units

Did Sell                                                           units

———

Variance                                          units x standard contribution (profit)

 

            2.  Sales Price Variance  
                        Actual Qty Sold – Should Have Sold For RWFx
                        Actual Qty Sold – Did Sell For RWFx
  —–
                        Variance RWFx
 

Materials Variances:

 

1. Material Price Variance

===
Actual Qty Used – Should Have Cost RWFx
                              Actual Qty Used – Did Cost RWFx
  —–
                              Variance RWFx
 

2. Material Usage Variance

===
                              Actual Prod. Should Have Used kgs
                              Actual Prod. Did Use kgs
  —–
                              Variance kgs  x  Standard Cost

 

Labour Variances

 Labour Rate Variance

Actual Hrs. Worked – Should Have Cost       RWFx

Actual Hrs. Worked – Did Cost   RWFx
      —–
               Variance     RWFx
 

2. Labour Efficiency Variance

    ===
Actual Prod. – Should Take     hours
Actual Prod. – Did Take     hours
      —–
               Variance   hours x Standard Rate

 

Variable Overhead Variances

 

  1. Variable Overhead Expenditure Variance

Actual Hrs. Worked – Should Have Cost       RWFx

Actual Hrs. Worked – Did Cost                      RWFx

—–

Variance                                                          RWFx

===

  1. Variable Overhead Efficiency Variance

Actual Prod. – Should Take                            hours

Actual Prod. – Did Take                                  hours

—–

Variance                                              hours  x  Standard Rate

 

Fixed Overhead Variances

 

  1. Fixed Overhead Expenditure Variance

Actual Expenditure                             RWFx

Budgeted Expenditure                        RWFx

—–

Variance                                              RWFx

===

  1. Fixed Overhead Volume Variance

Budgeted Expenditure                        RWFx

Actual Prod x Fixed Overhead Absorption

Rate (FOAR)                                      RWFx

—–

Variance                                              RWFx

===

 

Note: In a Marginal Costing system there is only one fixed overhead variance – the expenditure variance.

 

Variance Analysis

The Variances calculated can be analysed to interpret their impact on the organisation:

  • Material Price Variance – measures the effect on profit of paying a different price for materials from that expected.
  • Material Usage Variance – measures the effect on profit of using a different quantity of materials from expected for the actual production.
  • Labour Rate Variance – measures the effect on profit of the actual labour rate per hour differing from that expected.
  • Labour Efficiency Variance – measures the effect on profit of using a different number of hours from expected for the actual production.
  • Variable Overhead Expenditure Variance – measures the effect on profit of the actual hourly rate differing from that expected.
  • Variable Overhead Efficiency Variance – measures the effect on profit of the actual hours incurred of variable overhead differing from those expected for the actual production.
  • Fixed Overhead Expenditure Variance – measures the effect on profit of the actual fixed overhead cost being different from that budgeted.
  • Fixed Overhead Volume Variance – measures the effect on profit of under or over absorbing fixed overhead costs because of a difference between the actual and budgeted production volume.
  • Sales Volume Variance – measures the effect on profit of the sales volume differing from that budgeted.
  • Sales Price Variance – measures the effect on profit of the actual selling price differing from that budgeted.

 

Reasons for Variances

Variance                     Favourable                                        Adverse

Material Price           Unforeseen discount received            Price increase

Greater care in purchasing                  Careless purchasing

Change in material standard            Change in material standard

 

Material Usage          Higher quality mat. than standard      Defective material

More effective use of material            Excessive waste

Errors allocating mat. to job             Errors allocating mat. to job

Theft

 

Labour Rate              Use of workers @ lower rate              Wage rate increase

than standard

 

Labour Efficiency     Output produced quicker than            Lost time in excess of that

expected – motivation, better  allowed    quality equipment/materials

 

Idle Time (usually                                                                 Machine breakdown

Adverse)                                                                 Non-availability of materials

Illness/injury to workers

 

O/head Expenditure Savings in costs incurred                    Increase in cost of services                                   More economical use of services       Excessive use of services

Change in type of services used

 

O/head Volume         Savings in costs incurred                   Increase in cost of services

Excessive use of services         More economical use of services

 

Selling Price               Unplanned price increase                   Unplanned price reduction

 

Sales Volume             Additional demand                            Unexpected fall in demand

Production difficulties

 

Investigating Variances

When investigating reasons for variances the following should be considered:

  • Materiality – standard costs are averages and small variations will occur. Obtaining reasons for variations may be time consuming and further investigation is not worthwhile.
  • Controllability – if a general increase occurs in the price of a raw material there is nothing that can be done internally to control this. Uncontrollable variances require a change in the plan, not an investigation into the past.
  • Type of Standard Used – if an Ideal Standard is used variances will always be adverse. A similar problem arises if average price levels are used as standards.  If inflation exists, favourable price variances are likely to be reported at the beginning of the period and be offset by adverse price variances later in the period.
  • Variance Trend – although small variations in a single period are unlikely to be significant, small variations that occur consistently may need more attention.
  • Interdependence – one variance might be inter-related with another and much of the variance might have occurred only because the other variance occurred too. When two variances are interdependent one will usually be adverse and the other favourable.
  • Cost – the costs of an investigation should be weighed against the benefits of correcting the cause of the variance.

 

Inter-Related Variances

Variances                    

 

Explanation
Materials Price & Usage * If cheaper materials are purchased in order to obtain a favourable price variance, materials wastage might be higher and an adverse usage variance may occur.
  * If the cheaper materials are more difficult to handle there might be an adverse labour efficiency variance too.
 

 

* If more expensive materials are purchased the price variance will be adverse but the usage variance might be favourable if the materials are easier to use or of higher quality.
Labour Rate & Efficiency * If employees are paid higher rates for experience and skill, using a highly skilled team might lead to an adverse rate variance and a favourable efficiency variance.
 

 

* A favourable rate variance might indicate a larger than expected proportion of inexperienced workers which could result in an adverse labour efficiency variance and perhaps, poor materials handling and high rates of rejects too and hence, an adverse materials usage variance.
Sales Price & Volume * A reduction in selling price might stimulate bigger sales demand, so that an adverse sales price variance might be counterbalanced by a favourable sales volume variance.

* A price rise would give a favourable sales price variance

but possibly cause an adverse sales volume variance.

 

  PRICING

MARGIN and MARK-UP

It should be appreciated that both margin and mark up refer to the same absolute profit. It is simply the context in which the profit is expressed that differs.

BREAK-EVEN POINT

There is a certain level of sales at which there is neither a profit nor a loss – total income exactly equals total costs.  Management would be very interested in this level, when setting sales targets.

The Break-Even Point can be found by taking total fixed costs and dividing them by the contribution per unit.

MAKE v BUY

Many organisations consider which products/services to produce in-house and which to outsource.  In the short term the decision should be made using relevant cost principles.

If spare capacity exists the fixed costs of those resources should be ignored as they will be incurred whether the product is made or purchased.  Thus, purchase would be recommended if the buying price is less than the variable costs of manufacture.

If no spare capacity exists, manufacture could cause opportunity costs of lost contribution from existing products or extra costs of buying-in those products (if cheaper).

Before making a final decision management needs to consider many qualitative factors on outsourcing e.g. quality, delivery capability, price guarantees/stability, security, confidentiality, contract duration, ability to produce quantities required etc.

Notes:

  • The tool making staff are specialists employed part-time solely to produce gearboxes.
  • The engineering staff are full-time employees.
  • All materials are purchased on a Just-in-Time (JIT) basis.
  • Engineering staff are in short supply. AMT estimates that every additional engineering hour made available to the company could deliver a contribution of RWF100 per hour. This relates to contracts that will be declined if the gearbox is to be produced in-house.
  • The fixed overhead represents an allocation of AMT‟s fixed overhead. Included in the total fixed overhead is RWF20,000 for the annual lease of a gear box milling machine.  If AMT ceases to produce gearboxes this machine would be returned to the lessor at no penalty cost.

 

Based on annual production of 1,000 gearboxes the relevant costs and revenues associated with the decision are as follows:

BUDGETING

INTRODUCTION

For many organisations in both the private and public sectors the annual budget is the basis of much internal management information.  It is the plan for the forthcoming period, expressed in money terms.

The budget period is the time period to which the budget relates.  It is usually for the accounting/financial year and may be broken down into control periods e.g. months or quarters.

The budget manual is a collection of instructions governing the responsibilities of persons and procedures, forms and records relating to the preparation and use of budgetary data.

The budget committee is the co-ordinating body in the preparation and administration of budgets.  Their responsibilities may include:

  • Coordination and allocation of responsibility for the preparation of budgets.
  • Issuing the budget manual.
  • Communication of final budgets to budget holders.
  • Monitoring the budgeting process – comparing actual results with budget.

 

PURPOSES OF BUDGETING

Planning

Major short-term planning device to ensure that managers have thought in advance how they will utilise resources to achieve company policy in their area.

Authorisation

In some cases, expenditure which has passed through the budget review procedure automatically becomes approved for commitment – the identification of an expense for a particular budget centre is the formal approval that the head of the centre may go ahead and incur such an expense.

Control

Regular reporting system on the extent to which plans are/are not being met. Management by exception can be established so that deviations from plans are identified and actioned.

Co-ordination

Budgets ensure that no department is out of line with the others and they afford control of anyone who is inclined to pursue his/her own desires rather than corporate objectives.

Communication

Define/clarify the lines of horizontal/vertical communication.  Managers should have a clearer idea of their responsibilities and are likely to work better with others to achieve them.

Performance Evaluation

Useful tools for evaluating how the manager/department is performing.  If sales targets are met or satisfactory service provided within reasonable spending limits then bonus or promotion prospects are enhanced.

Motivation

If a manager has been involved in the budget, understands its implications and agrees it is fair he is more likely to be motivated to strive towards those expectations.

BEHAVIOURIAL FACTORS

If budgetary control is to be successful, attention must be paid to behavioural aspects, i.e. the effect of the system on people in the organisation and vice versa.

Budget Difficulty

If the performance standard is set too high or too low then sub-optimal performance could result.  The degree of budget difficulty is not easy to establish.  It is influenced by the nature of the task, the organisational culture and personality factors.  Some people respond positively to a difficult target others, if challenged, tend to withdraw.

Budgets and Performance Evaluation

The emphasis on achievement of budget targets can be increased, but also the potential for dysfunctional behaviour, if the budget is subsequently used to evaluate performance.  This evaluation is frequently associated with specific rewards such as remuneration increases or improved promotion prospects.  In such cases it is likely that individuals will concentrate on those items which are measured and rewarded neglecting aspects on which no measurement exists. This may result in some aspects of the job receiving inadequate attention because they are not covered by goals or targets due to the complexity of the situation or difficulty of measurement.

Managerial Style

The use of budgets in evaluation and control is also influenced by the way they are used by the superior.  Different management styles of budget use have been observed, for example:

Budget constrained – considerable emphasis on meeting budget targets

Profit conscious – a balanced view is taken between budget targets, long-term goals and general effectiveness.

Non-accounting – accounting data is seen as relatively unimportant in the evaluation of subordinates.

The style is suggested to influence, in some cases, the superior/subordinate relationship, the degree of stress and tension involved and the likelihood of budget attainment.  The style adopted and its implications are affected by the environment in which management is taking place.  For example, the degree of interdependency between areas of responsibility, the uncertainty of the environment and the extent to which individuals feel they influence results are all factors to consider in relation to the management style adopted and its outcomes.

Participation

It is often suggested that participation in the budget process and discussion over how results are to be measured has benefits in terms of budget attitude and performance. Views on this point are varied however, and the personality of the individuals participating, the nature of the task (narrowly defined or flexible) and the organisation structure influence the success of participation.  But a budget, when carefully and appropriately established, can extract a better performance from the department/manager than one in which these considerations are ignored.

Budget Bias (“Slack”)

Budget managers may be tempted to manipulate the desired performance standard in their favour by making the performance easier to achieve (e.g. understating budgeted sales revenue or overstating budgeted costs) and hence be able to satisfy personal goals rather than organisational goals.  This is referred to as incorporating „slack‟ into the budget.

Budget bias will lead to more favourable results when actual and budgeted costs are compared.  Corrective action may not be taken in cases where costs could have been reduced and thus, inefficiency will be perpetuated and overall profitability reduced.  Managers may incur unnecessary expenditure in order to protect existing budget bias with the aim of making their jobs easier in future periods.  Where budget bias exists, managers will be less motivated to look for ways of reducing costs and inefficiency in those parts of the organisation for which they bear responsibility.

Any organisational planning and control system has multiple objectives but primary amongst these is encouraging staff to take organisationally desirable actions.  It is never possible to predict with certainty the outcomes of all behavioural interactions, however it is better to be aware of the various possible implications than to be ignorant of them.

 

TIMETABLE

Step 1 Communicate budget policy and guidelines
Step 2 Determine the factor that restricts output
   

The principal budget factor (key budget factor/limiting budget factor) is the factor that limits an organisation‟s performance for a given period and is often the starting point in budget preparation.  In most organizations it is the sales demand.

Step 3 Prepare limiting budget factor – e.g. sales budget
Step 4 Initial preparation of budgets
  Finished Goods Stock Budget
  Production Budget
  Budgets of Resources for Production
  Overhead Cost Budget
  Raw Materials Stock Budget
  Raw Materials Purchase Budget
  Overhead Absorption Rate
Step 5 Negotiation of Budgets with Superiors
Step 6 Co-ordination of Budgets
Step 7 Final Acceptance of Budget
Step 8 Budget Review

 

 

PERIODIC v CONTINUOUS (ROLLING) BUDGETING

A periodic budget is one that is drawn up for a full budget period such as one year.  A new budget will not be introduced until the start of the next budget period, although the existing budget may be revised if circumstances deviate markedly from those assumed during the budget preparation period.  A continuous or rolling budget is one that is revised at regular intervals by adding a new budget period to the full budget as each budget period expires.  A budget for one year, for example, could have a new quarter added to it as each quarter expires.  In this way, the budget will continue to look one year forward.  Cash budgets are often prepared on a continuous basis.  The advantages of periodic budgeting are that it involves less time, money and effort than continuous budgeting.  For example, frequent revisions of standards could be avoided and the budget-setting process would require managerial attention only on an annual basis.

A major advantage of continuous budgeting is that the budget remains both relevant and up to date.  As it takes account of significant changes in economic activity and other key elements of the organisation‟s environment, it will be a realistic budget and hence is likely to be more motivating to responsible staff.  Another major advantage is that there will always be a budget available that shows the expected financial performance for several future budget periods.  It has been suggested that if a periodic budget is updated whenever significant change is expected, a continuous budget would not be necessary.  Continuous budgeting could be used where regular change is expected, or where forward planning and control are essential, such as in a cash budget.

FIXED v FLEXIBLE BUDGETS

A Fixed Budget is designed to remain unchanged regardless of the volume of sales actually achieved.  The budget is prepared on the basis of an estimated volume of production and sales but no plans are made for the event that actual volumes of production and sales may differ.  The main purpose of a fixed budget is at the planning stage when it seeks to define the broad objectives of the organisation.

A Flexible Budget, by recognising different cost behaviour patterns, is designed to change as volumes of output change.

One approach is where a company, for example, expects to sell 100,000 units, a master (fixed) budget would be prepared on this basis.  However, the company might prepare contingency flexible budgets at volumes of, say, 80,000 and 120,000 units sold and then assess the possible outcomes.

A second approach is where the budget is flexed retrospectively, so that at the end of each period the results that should have been achieved given the actual circumstances can be compared with the actual results.

Flexible budgeting uses the principles of marginal costing.  In estimating future costs it is often necessary to begin by looking at cost behaviour in the past.  For costs which are wholly fixed or variable no problem arises.  Costs which in the past have behaved as mixed are more difficult and a technique such as the “High-Low” method must be used for estimating their leve

ZERO-BASED BUDGETING (ZBB)

Zero based budgeting involves preparing a budget for each cost centre from a zero base. Every item of expenditure has then to be justified in its entirety in order to be included in the next year’s budget.

Traditional budgeting, sometimes called incremental budgeting, takes a current level of spending as a starting point, discussion then takes place on any extra expenditure or what of the current expenditure to cut.

In reality ZBB will start as from the same starting point as Traditional Budgeting; i.e. actual results or, sometimes, the previous, most recent budget.

Zero based budgeting (ZBB) is an approach which takes nothing for granted; it requires justification of all expenditure.  This technique would not suit expenditure planning in line departments of a manufacturing company because clear relationships of input and output will exist and be defined by standard values.

In less clearly defined areas such as service departments or non-profit oriented businesses ZBB might have some value if selectively applied.  ZBB would involve describing all of the organisation‟s activities in a series of decision packages, for example, visit frequency, level of eligibility for visit, type of support (medical care, food preparation, wash and clean, shopping needs etc.). The packages can then be evaluated and ranked, what is essential, highly desirable, desirable and so on.  The resources would be allocated according to the packages selected, discussion could also take place between other departments so that a wider allocation of funding is brought into the discussion.   Once the budget is set the packages are adopted up to the spending level indicated, this is the cut off point.  It is possible that economies and increased efficiency could result if departments were to justify all, not just incremental, expenditure.

It is argued that if expenditure were examined on a cost/benefit basis a more rational allocation of resources would take place.  Such an approach would force managers to make plans and prioritise their activities before committing themselves to the budget. It should achieve a more structured involvement of departmental management and should improve the quality of decisions and management information, enabling such questions as: should this be done? At what quality and quantity?, should it be done this way?, what should it cost?.

ZBB may not be simple or easy to install, could be expensive in time and effort to analyse all expenditure and difficult to establish priorities for the activities or decision packages.  Managers are often reluctant to commit themselves to ZBB because they believe they already do it.  Critics of ZBB have asserted that no real change in funding allocation takes place as a result of the exercise.  However, any system which encourages managers to examine, and communicate about their spending and performance levels must be useful providing it does not prevent individuals fulfilling their other duties and responsibilities

RESPONSIBILITY ACCOUNTING

Responsibility accounting is a system of reporting that compares budget performance with actual performance for responsibility centres, often departments of an organisation.  It is based on the recognition of individual areas of responsibility as specified in a firm‟s organisation structure and job descriptions.  It seeks to trace the costs, revenue and investment to responsibility centres so that deviations from budget can be attributed to the person(s) in charge.

Potential difficulties in operating a system of responsibility accounting are:

Clear and unambiguous identification of areas of responsibility:  For example where events or desired courses of action may be dictated or influenced by more than one person or department – often referred to as dual responsibility.

Identification of controllable costs and revenues from those which are uncontrollable by a particular person or department: This is influenced by the organisational level or hierarchical level of authority the manager occupies and the time span involved. A top manager can, in effect, control all costs by closing a department. Middle management can only influence some departmental costs.

Additionally, a cost which is uncontrollable over a month may be controllable over five years.  It may encourage focus on the short-term performance, that is, achievement of the current budget, which may neglect the long-term performance of the organisation as a whole.

FEEDBACK & FEED-FORWARD

Feedback is where actual results (outputs) are compared with those which were planned for the budget period.  Likewise, the actual inputs (costs) are compared with the budget, taking account of the actual level of outputs.  This comparison of actual with plan takes place after the event.  The intention is to learn for the future so that future deviations of actuals and plans are avoided or minimised. It is a reactive process.

Feed-forward is where prediction is made of what outputs and inputs are expected for some future budget period.  If these predictions are different from what was desired/planned, then control actions are taken which attempt to minimise the differences.  The aim is for control to occur before the deviation is reported, in this way it is more proactive. Budget generation is a form of feed-forward in that various outcomes are considered before one is selected.

TOP-DOWN v BOTTOM-UP APPROACH IN BUDGET SETTING

Top-Down – budgets are imposed by senior management and are more likely to support the strategic objectives of the company, and the operations of different divisions are more likely to be co-ordinated.  It may be an appropriate form of budget setting in small organisations where senior managers are likely to have a detailed knowledge of all aspects of the business or in situations where close control of planned costs is called for, such as business start up or difficult economic conditions.  It also has the advantage of decreasing the amount of time taken and the resources consumed by budget preparation.

There are number of difficulties with the top-down approach that make it likely that it will not regularly be used in isolation.  Staff may be demotivated if they have not been involved in the formulation of budgets that produce targets they are expected to achieve, especially if their rewards and incentives are linked to their performance against budget. This reduction in motivation could result in strategic objectives and organisational goals being less than fully supported at the operational level, with company performance and profitability suffering as a result.  Initiative and innovation could also be lost as staff simply „work to budget‟, rather than making creative suggestions for improving performance that they feel are unlikely to be rewarded, or form part of future plans.

Bottom-Up – functional and other junior managers participate in the preparation of budgets.  This is likely to lead to more realistic and more co-ordinated budgets than the top-down approach if these managers have a more detailed knowledge of the operations and markets of the organisation.  It is also likely to be useful in large, established companies where the complexity of the budget-setting process calls for detailed input from lower levels of the organisation.  This approach will also lead to higher levels of motivation and commitment, since managers will have contributed towards the targets against which their performance will be measured.

There are a number of difficulties with the bottom-up approach. For example, it can be more time-consuming than the top-down approach because of the larger number of participants in the budget-setting process.  Participants may become dissatisfied if their budget proposals are subsequently amended by senior managers.  Managers may introduce an element of budgetary slack into their budget estimates, giving them a „zone of comfort‟ in reaching budget targets.  The bottom-up approach also requires detailed planning and co-ordination of the budget-setting process, perhaps supported by a budget manual.

The top-down and bottom-up approaches represent two extremes of the budget-setting process. In practice, a compromise or negotiated approach is likely to be used, with senior management reviewing and amending the budget proposals of operational managers in the light of the organisation‟s strategic plan, and operational managers negotiating amendments to aspects of the budget they find unacceptable.

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